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A recent article on Seeking Alpha basically said that IBM (NYSE:IBM) was a sale because cash flows were declining and the free cash flow yield was too small to justify the current stock price.

In this short article I want to analyze IBM's cash flow statement correctly. I will do this not in an automated or semi-automated way like recently done on this site, but going through the cash flow statement line by line, checking all the notes and comments, and evaluating which parts of the statement should be taken into account for calculating real "Owner Earnings".

In his 1986 Letter to Berkshire Shareholders Buffett explains that Owner Earnings represent:

Reported earnings plus depreciation, depletion, amortization, and certain other non-cash charges

LESS

the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume.

Note that only maintenance, but no growth investments are deducted.

IBM's 2012 cash flow statement looks like this:

(click to enlarge)

According to Mr. Buffett's definition, we should take net income (first line: $16,604) and add depreciation and amortization (line 2 and 3: $3,392 + $1,284). What shall we do with stock based compensation? The corresponding note explains that:

Stock-based compensation represents the cost related to stock based awards granted to employees. The company measures stock-based compensation cost at the grant date, based on the estimated fair value of the award and recognizes the cost on a straight-line basis (net of estimated forfeitures) over the employee requisite service period. The company estimates the fair value of stock options using a Black-Scholes valuation model.

So this is no cash that exits the door, this is a virtual cost for options awarded to employees, calculated according to a valuation model. We will factor in stock dilution when it comes to calculate Owner Earnings per share anyway, so for now we can add back this figure ($688), too.

Deferred taxes and Net (GAIN)/loss on asset sales and other should be self-explaining: the former being taxes which have not been paid (yet) with real cash, the latter being in this case real losses on assets that had been on the books at higher values than those realized at the time of the sale. So we can just take the figures as they are on the statement: +$797 - $729.

All in all, until this point we just kept the cash flow statement as it has been provided to us by IBM.

But now comes the difficult part. According to Warren Buffett's instructions, we should now add back "certain other non-cash charges". This is not very clear, so let's see:

(click to enlarge)

While all other lines are quite easy to understand, the receivables line is not clear at all, as IBM has a huge financing business. Should we really deduct the whole increase of receivables? In other Owner Earnings calculations we should, in the case of IBM however we'd better consider the corresponding notes:

As discussed on page 24, a key objective of the Global Financing business is to generate strong returns on equity. Increasing receivables is the basis for growth in a financing business. Accordingly, management considers Global Financing receivables as a profit-generating investment, not as working capital that should be minimized for efficiency. After considering Global Financing receivables as an investment, the remaining net operational cash flow less net capital expenditures is viewed by the company as free cash flow. (IBM 2012 Annual Report, page 56)

This is really interesting. When you find automated free cash flow calculations on financial websites, they probably won't consider this fact.

Sifting through the notes we will have the pleasant surprise to find the following table:

(click to enlarge)

The table not only provides us with the free cash flow calculation we were attempting to do on our own, but also shows how the management did actually use the cash that was available.

Just to be sure, let's double-check the capital expenditures line. IBM has $4.3 billion net expenditures for 2012. This corresponds (for all three years included in the table below) to the following lines in the 2012 cash flow statement:

(click to enlarge)

Note that investments in software are 100% deducted, which I consider being quite conservative, as one could also argue that at least partially new software could also be used for growth initiatives:

The company defines free cash flow as net cash from operating activities less the change in Global Financing receivables and net capital expenditures, including the investment in software. (IBM 2012 Annual Report, page 56)

The remaining lines of Cash flows from investing activities do not represent "capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume", hence we may ignore them in our Owner Earnings calculation (like IBM does, too).

Now let's check whether IBM "has a cash flow problem":

 

2012

2011

2010

2009

2008

CAGR

FCF ($ billions)

18.2

16.6

16.3

15.1

14.3

6.20%

Shares outst. (millions)

1,155

1,214

1,287

1,341

1,382

-4.40%

FCF/share ($)

15.76

13.67

12.67

11.26

10.35

11.10%

Total FCF increased at a CAGR of 6.2% and FCF/share increased at a CAGR of 11.1%.

Does IBM really have a cash flow problem?

Source: IBM Has No Cash Flow Problem At All