Background: I used to be a math nerd. I still recall the excitement a smarter, nerdier math nerd in my junior high school class expressed when he and I visited one of our math teachers in his office after school and discussed International Business Machines Corporation's (NYSE:IBM) new 360 mainframe computer. It was a wow, as was everything about IBM in those days. It led the universe in patents issued. It was the glamour stock of a glamour period for growth stocks. It was famously conservative in its spending and delivered unparalleled customer service. Its stock traded in triple digits. There was no end to its growth. It had no debt and had no need to pay investors a dividend, as all its earnings were retained to go back to winning the future for technology, which everyone knew it would lead.
IBM was so famous that of course it was the inspiration for the name of the computer star of the movie "2001." That evil computer was named "HAL" because HAL is IBM transposed to the letter preceding it in the alphabet.
IBM is now a different beast from that which it once was. Its sales have been anemic for some time. Yet it is so committed to earnings "growth" that it overtly asks us to ignore basic arithmetic and basic accounting principles, in order to create a false picture of its operations, as I will attempt to show below based on Wednesday afternoon's earnings release.
This behavior is opposite to its prior image and antithetical to its obligations to investors. Worse, because no analyst has missed the reality of a downturn in IBM's businesses, the only people fooled by clever press releases and fawning media attention will be casual retail investors who believe the headlines that IBM had a good quarter and is truly doing better than the smart money had expected.
In fact, IBM has had a poor quarter and a poor first half, but just does not want to admit it.
Here's the hype: Bloomberg.com ("BBG") headlines it this way:
IBM Raises Annual Forecast After Earnings Top Analyst Estimates
And follows with this:
International Business Machines Corp. (IBM), the largest computer-services company, topped estimates with its second-quarter earnings and raised its forecast for the year after cutting costs and buying back shares.
Excluding a $1 billion restructuring expense, earnings were $3.91 a share, the Armonk, New York-based company said today in a statement. That beat the $3.78 that analysts projected on average, according to data compiled by Bloomberg. The company now expects to earn at least $16.90 a share this year, up from the $16.70 it forecast earlier this year.
IBM has managed to increase profit by shifting away from low-margin businesses, cutting jobs and repurchasing stock -- even as revenue slows.
Sounds pretty good, or at least OK. After all, IBM "topped estimates" (whatever that really means). In a declarative sentence that excludes any mention of omitted "restructuring costs," BBG states that IBM expects higher earnings for 2013 than it previously forecast. Also, IBM has "managed to increase profit."
Here's the ugly reality: This is taken from IBM's own earnings report on its website. First, the headline, then the key numbers:
IBM REPORTS 2013 SECOND-QUARTER RESULTS
RAISES 2013 OPERATING EPS EXPECTATION BY $0.20 TO $16.90,
EXCLUDING $1 BILLION SECOND-QUARTER WORKFORCE REBALANCING CHARGE
- GAAP results
- Diluted EPS: $2.91, down 13%
-Net income: $3.2 billion, down 17%
Not pretty. After reviewing a lot of non-GAAP results (meaning that these are almost irrelevant data points, GIGO if you will), finally the press release gets around to informing us of the basic, key metric: sales. Sales, it turns out, were $24.9 B, down 3%.
Adding to the ugliness, IBM guided lower for H2, saying:
The company said that a substantial second-half gain that it was expecting in its prior view of earnings per share will not likely be achieved (by) the end of 2013.
For good measure, there was an almost Orwellian touch to this release:
Revenues from the company's growth markets were flat...
That's what I call growth markets! (They did not grow in Q1, either.)
It gets even uglier farther down the press release:
Pre-tax income decreased 20% to $4.1 billion and pre-tax margin of 16.6% was down 3.4 points compared with the prior-year period.
Later on, the company discloses that free cash flow was $2.7 B, down about $1.0 B from the prior year excluding Global Financing receivables.
The reported tax rate dropped year on year, assisting EPS-- but the company would never, ever call the increased earnings resulting from that a "one-time" gain that should be excluded from earnings. But to be consistent, it should do exactly that.
Lest you think I'm being overly harsh regarding the workforce charge and the tax situation, the conference call reveals the following, per Seeking Alpha:
Toni Sacconaghi - Sanford Bernstein
Historically, you have provided EPS guidance, including all rebalancing charges and any one-time gains whether it'd be from IP or from dispositions. I am hoping you can clarify, because it's a little nebulous about whether you are changing your guidance definition of operating earnings or not.
So, the traditional metric of operating earnings would include the rebalancing charge in there and then guidance would be $16.25 at least for the year...
Regarding cash flow and taxes, IBM may be coming close to squaring the circle. Also from the Seeking Alpha transcript:
Bill Shope - Goldman Sachs
Thanks. I hate to ask the tax rate question, but I really want to try and understand the guidance best I can. Mark, you had mentioned that you had a tax benefit as well coming in the second half is that additional to the tax benefit you had this quarter? I believe your guidance before was a pointing towards roughly at 25% rate and that's within most models, so how do we think about the tax rate in the second half relative to that and how that drives the earnings guidance for full-year?
Mark Loughridge - Senior Vice President, Chief Financial Officer
Okay. So, I would you look at our book's tax rate in 2013 to be in the range of 25%, excluding into discrete tax benefit charges. Now, we did get a tax benefit in the second quarter that we recognize which relatively improved that rate.
So IBM had a tax benefit this quarter, but it will not call it a one-time gain. The tax situation is truly confusing, because the company also had this to say in response to a different question:
Mark Loughridge - Senior Vice President, Chief Financial Officer
Okay, when you look at the first half of 2013, our cash flow was down $1.1 billion. Now within that decline we did a substantial increase in our cash tax payments of $700 million.
I hope you are clear on this, because it's clear as mud to me and to an accountant I checked with. As reported, earnings in Q2 benefited from a tax benefit, but actual taxes paid increased $700 million. Got it?
Does IBM really need to put us through this? Isn't it above these games? If not, shouldn't it be?
Let's apply Occam's razor, cutting to the chase:
Basically, IBM is struggling in a tough global economic environment. There is no shame in that. It should follow Apple Inc.'s lead (NASDAQ:AAPL) and simply report and emphasize GAAP earnings, and let the chips fall where they may. Great companies exist in the real world, which has its ups and downs, and so it goes.
The first half of this year has simply been a bad show for IBM, but not a disastrous one:
The April 4, 2013 Value Line review of IBM came out before Q1 earnings, so it presents a mainstream view of the company's sales and expectations at that time. Going into Q1 earnings season, Value Line (aka the Street) anticipated $25.9 B in sales for Q2, not the $24.9 B that was actually realized. It expected $3.65 per share in earnings, not $2.91.
Value Line also reveals that IBM's sales were $26.7 B in Q2 2011. Sales were $25.8 B in Q2 last year. The downtrend continued this year. IBM is now a cyclical company.
Similarly, going back to Q1 2013, before those results were released, sales were expected to check in at $24.7 B. Actual revenue for Q1 2013: $23.4 B.
IBM has been going backward. It's moving backward faster than one might think, given that in these difficult times, R&D spending has been cut.
Business is so tough that its hardware division (Systems and Technology) recorded a pitiful operating margin of only 5.3%. Sic transit gloria.
By the way, getting the lowdown via the web on exactly what this famous workforce rebalancing (itself an Orwellian-sounding term) actually consists of is like pulling teeth. IBM's 8-K does disclose that on April 18, 2013 (the date of its Q1 earnings release), it stated that as opposed to 2012, when it took its workforce rebalancing charges spread out across all four quarters, it was going to take these charges this year primarily in Q2. So I went back to IBM's Q1 earnings press release and found almost nothing related to that topic. Then I gave up. Presumably "workforce rebalancing" is little other than Newspeak for layoffs.
IBM stock, unsurprisingly for the times we are in, traded up $5 after hours. It now trades for more than two times sales per share. Shareholder equity of $17.8 B is dwarfed by intangibles plus goodwill assets of $32.3 B. Thus IBM has a negative $14.5 B tangible net worth. While this metric of course reflects the accounting treatment for its immense dollar volume of share buybacks, and thus overstates the situation, the fact is that a corporation does not get to use cash twice. IBM has used that cash to reward selling shareholders for selling their shares to the company, as well as paying modest dividends.
What have patient shareholders actually received for their patience? (Of course, these patient shares hardly include many insider shares, as insiders have evidenced, year after year, a distinct lack of enthusiasm for actually purchasing IBM stock other to than to exercise options and then sell them.)
To address the total return question, I have arbitrarily gone back as far as Value Line goes with its data, which is 1997. From 1997 until today, IBM has paid an average dividend of about 1% of the then-share price. The stock has appreciated from a midyear 1997 price of $45.91 to today's $200 or so (using the after-hours price), or 9.63% per year.
So let's say that the total return has perhaps been 10.63% per year.
How has my favorite alternative risk-free benchmark, the most hated mainstream investment I know of, fared? That would be the 30-year zero coupon Treasury bond, of course, a decent pure interest rate proxy.
The average yield at midyear 1997 on this instrument, trading as a par bond, was 6.8%, meaning that a zero coupon bond would have traded at a minimum at 7.0%. That corresponds to a 1997 bond price of $13.14, to mature at $100 in 30 years and returning 7% compounded annually. Where would that bond be trading today?
Sixteen years later, in 2013, it would now be a 14-year bond. With the 10-year par Treasury trading at 2.49% today, I'm guessing that a 14-year zero would be around 3.0%. That equates to a price of $66.11. The compound annual appreciation from $13.14 to $66.11 is 10.63% per year for 16 years.
Strange but true, and I didn't try multiple dates to get to this equality. It just happened. Using real world numbers derived from Yahoo! Finance and an online calculator, it would appear that there has been no important difference between the total return to investors from IBM and a zero-coupon 30-year Treasury bond since 1997.
Conclusion: As have so many other stocks, IBM for the past 16 years has ended up just being a proxy for the secular decline in interest rates. It now is a troubled company that feels forced to resort to obfuscating its results rather than presenting them clearly.
It is unclear that with these difficulties, IBM will do any better for investors than a Treasury security. It would appear that better and less-complicated risk-reward opportunities can be found elsewhere in the investment universe.