All over the Internet we can find automated or semi-automated free cash flow (or Owner Earnings) calculations for IBM which most of the time provide only the information that the author did not read IBM's financial statements or even that accounting is not his forte. So let's try to get this straight immediately after the Q4 earnings statement.
Why do I focus on free cash flow instead of net income? First of all, the cash flow statement is not so easy to manipulate under GAAP than the income statement. Probably you have already read this somewhere else. But how would this work?
The cash flow statement provides details on a company's cash cycle, i.e. the process that converts sales into cash: E.g. cash is used to build inventory, or inventory is sold and converted into accounts receivables (because customers usually don't pay immediately); when cash is received as customer payments, receivables are reduced.
For example, a company may legitimately record a $1 million sale but, because that sale allowed the customer to pay within 30 days, the $1 million in sales does not mean the company made $1 million cash. If the payment date occurs after the close of the end of the quarter, accrued earnings will be greater than operating cash flow because the $1 million is still in accounts receivable. … An example of income manipulation is called "stuffing the channel". To increase sales, a company can provide retailers with incentives such as extended terms or a promise to take back the inventory if it is not sold. Inventories will then move into the distribution channel and sales will be booked. Accrued earnings will increase, but cash may actually never be received, because the inventory may be returned by the customer. While this may increase sales in one quarter, it is a short-term exaggeration and ultimately "steals" sales from the following periods (as inventories are sent back). … The operating cash flow statement will catch these gimmicks. When operating cash flow is less than net income, there is something wrong with the cash cycle. In extreme cases, a company could have consecutive quarters of negative operating cash flow and, in accordance with GAAP, legitimately report positive EPS. In this situation, investors should determine the source of the cash hemorrhage (inventories, receivables, etc.) and whether this situation is a short-term issue or long-term problem. (Investopedia)
In this article I will go 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
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. There are many investors that do not really understand this point. So let's consider the following example: You own an apartment house with 100 rented apartments and cash in each year (net, after expenses for maintenance and taxes) the equivalent of the value of 5 apartments. This cash represents your owner earnings. If you take it and buy another 5 apartments, it's a growth investment, as it will increase your earnings next year. It is no money you have given away, because you have simply transformed it into a different kind of cash generating asset.
IBM's 2013 cash flow statement analysis
According to Mr. Buffett's definition, we should take net income (first line: $16,5) and add depreciation and amortization (line 2: $4.7).
What shall we do with stock based compensation? The corresponding note in the last annual report 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 ($0.6 billion), too.
As we have seen in my 2012 cash flow analysis, we can take IBM's calculation of changes in working capital as it is: This means a deduction of $3 billion in this year.
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:
Should we really deduct the whole increase of Global Financing receivables? In other Owner Earnings calculations we should, in the case of IBM however we'd better consider the corresponding notes:
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. Remember our apartment house example? When IBM provides financing to its clients, receivables from Global Financing increase, yet this is not the same as the "stuffing the channel" example provided above. In fact, when a company "stuffs the channel", it delivers goods without cashing in money - it just records sales (and increasing receivables). IBM's case is different, as IBM lends its own money to its customers. So this is cash IBM already owns that is lent in order to make a profit from interest payments. It's an investment just like our hypothetical apartment owner buying another 5 apartments with his profits.
So we have to add back to operating cash flow the $1.3 billion charge for the increase of Global Financing receivables.
Sifting through the notes of the Q4/2013 charts we have the pleasant surprise to find the following table:
This table not only provides us the free cash flow calculation we were attempting to do on our own, but also shows how management did actually use the cash that was available.
The remaining lines of Cash flows from investing activities do not represent "capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume", hence we may ignore them in our Owner Earnings calculation (like IBM does, too).
Now let's see how 2013 compares to the past five years:
FCF ($ billions)
Shares outst. (millions)
Total FCF increased at a CAGR of 1% and, thanks to buybacks, FCF/share increased at a CAGR of 5.7% over the past 6 years.
Probably further adjustments to this FCF calculation could be necessary to correctly calculate Owner Earnings, as we simply have deducted all capital expenditures. We have to recognize that FCF has increased at a CAGR of 1% over the past six years and thus some of these past capital expenditures were surely growth related. But we don't know what the future will bring. To be conservative, we simply consider that all capital expenditures were maintenance related and consider the calculated FCF figure as a conservative estimate of Owner Earnings.
What about the future?
As some of you might be worried by the free cash flow / owner earnings decline in 2013, please consider that exceptionally high "workforce balancing" related payments at the beginning of the year decreased FCF/share by $0.71 and have created the conditions for stronger FCF increases in the years to come. Furthermore, the strong US dollar/yen exchange rate in 2013 was a huge headwind for IBM. In the Q3 conference call Mark Loughridge talked about a $0.5 billion currency impact YoY: that's almost half a dollar per share. On the other hand, IBM benefited from a lower tax rate in 2013, which could largely offset the exceptional workforce balancing costs at least in the income statement. As far as the cash flow statement is concerned, on IBM's Q4 conference call Martin Schroeter mentioned higher cash taxes compared to 2012. All in all, in spite of the headwinds, total FCF should have been still higher than the reported $15 billion. But then there was the impact of China's delayed economic reform plans, the end of a system z investment cycle and execution problems in the hardware business which probably caused most of the remaining decline of about $1.7 billion or about $1.55/share.
So what about the future? In the Q3 conference call, IBM stated:
So in 2014, based on that same kind of structured model that I described to you, we would see our free cash flow accepting the impact of cash taxes, growing at a rate of about 15% to 20%. Now cash taxes, we believe now in 2014 will be a headwind of about $2 billion, but even including cash taxes, we would see our free cash flow growing by a little over $1 billion. So the operational profile within that in that 15% to 20% range and on that basis, free cash flow growing faster than net income.
Going to 2015, we would see that free cash flow - the inclusion of cash taxes, growing at about 15% to 20%, again free cash flow growing more rapidly than net income, and in 2015 that cash taxes should be a tailwind as opposed to the headwind that we have been referring within 2014 and 2015.
This means that (according to IBM's Q3 projections, confirmed for 2014 during the Q4 conference call) we should expect total FCF to grow by a little over $1 billion in 2014 and another 15 to 20% in 2015. Assuming buybacks at a constant rate of 4.5% of shares outstanding per year, this leads to a projected FCF/share of $18.7 in 2015. This is not far from the Roadmap objective of $20 of non-Gaap EPS, which I would conservatively estimate to be reached in 2016 at the latest.
In the next days I will also provide a segmented revenue and income analysis as a follow-up on my 2012 revenue analysis.