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As Warren Buffett Throws in the Towel, What's Next for IBM?

Jamal Carnette, CFA, The Motley Fool

In a rare misfire for the Oracle of Omaha, Warren Buffett continues to admit defeat by unloading shares of International Business Machines (NYSE: IBM). Buffett's Berkshire Hathaway sold off approximately 33% of its holdings in the technology company during the quarter ended Sept. 30.

This isn't the first time Buffett has trimmed his IBM position. Earlier this year, the company sold off 33% of its stake after admitting his initial thesis was too optimistic due to "big, strong competitors." After owning more than 81 million shares as of year-end 2016, Berkshire Hathaway now reports a stake of 37 million shares as of its last holdings filing.

In the short term, this is another black eye for a company that continues to struggle. In the past five years, shares of IBM are down approximately 20% while the greater S&P 500 is up 90%. Still, with a forward price-to-earnings multiple of only 10.5 times and a yield near 4%, should you bet against Buffett and on this turnaround company?

Businessman holding a tablet projecting a falling graph.

Image source: Getty Images.

IBM had a (relatively) decent quarter

Buffett's decision to unload more shares was interesting considering IBM had a rare decent quarter. The company continues to report a shrinking top line, with the third quarter representing the 22nd consecutive of declining revenue. However, shares advanced due to better-than-expected results.

Analysts estimated IBM would report $18.6 billion in revenue and $3.28 EPS (excluding certain items). IBM beat on both by reporting $19.15 billion and $3.30, respectively. IBM also upwardly revised full-year EPS guidance by a nickel to $13.80.

IBM's ruinous Roadmap 2015

It's important to note the $13.80 in EPS guidance to understand Buffett's frustration. In 2011, then-CEO Sam Palmisano announced Roadmap 2015, in which the company promised to hit $20 EPS by that year. In 2014, current CEO Ginni Rometty backed away from that audacious goal.

To support the EPS estimate, IBM engaged in an aggressive, debt-fueled share buyback scheme, spending nearly $70 billion from fiscal years 2010 to 2014. As a comparison, IBM is currently a $135 billion company. Meanwhile, the company failed to quickly adjust to a large change in consumer behavior as many businesses shifted to off-site cloud storage instead of traditional mainframe hardware and supporting services.

Rometty has shifted the focus away from EPS estimates to "strategic imperatives," which includes next-gen technologies like artificial intelligence, cloud computing, and mobile technologies. Last quarter these initiatives represented 46% of total revenue and grew 11% on a year-over-year basis.

Are you going to bet against Buffett?

Getting in IBM while Buffett is unloading his position is essentially betting against the Oracle of Omaha. While IBM had a better quarter, including increasing its cloud-based revenue by 20%, IBM still must compete with big competitors like Amazon.com, Microsoft, and Alphabet.

With IBM, you should ask: Is the company now a value play or a value trap? While the company appears cheap on relative valuations, sluggish top and bottom line growth supports Buffett's decision to sell the company. However, if you're a value-oriented, income-focused investor looking for a turnaround story, keep IBM on your watchlist and follow the company's strategic imperatives very closely for further signs of strength.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool’s board of directors. LinkedIn is owned by Microsoft. Jamal Carnette, CFA owns shares of Alphabet (C shares). The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon, and Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.