Why IBM Continues To Lose Its Luster

Apr.24.14 | About: International Business (IBM)

Summary

IBM may be in a lot of trouble.

IBM’s management is doing more to destroy shareholder capital than it is doing to generate economic value at this juncture.

We don’t think Warren Buffett will tolerate such activity at the helm for much longer.

Share buybacks are not always a good thing. We typically like a firm's buyback program if it is executed at a level below that of the company's cash-flow-derived intrinsic value estimate. The buyback activity at these levels creates value in the sense that the cash reduced on the balance sheet (as a result of the repurchases) is less than the positive impact of a lower share count (equity value is divided by shares outstanding to arrive at intrinsic value per share). Under a scenario where a company buys back stock above its intrinsic value estimate, management is effectively destroying shareholder capital - the cash reduced on the balance sheet (as a result of the repurchases) is more than the positive impact arising from a lower share count. Our fair value estimates are published in each company's 16-page report, which can be found as 'pdf' downloads on their respective landing pages, for example.

Rule of Thumb: If share buybacks are completed at a price level that is under a firm's fair value estimate, the activity is value-creating. If share buybacks are completed at a price level that is above a firm's fair value estimate, they are value-destroying.

We estimate IBM's (NYSE:IBM) shares are worth $180 each at the time of this writing. When the company announced that it had bought back a staggering $8.2 billion worth of shares during the first quarter in its quarterly report, we were shocked. IBM's management is doing more to destroy shareholder capital than it is doing to generate economic value at this juncture. We don't think Warren Buffett (BRK.A, BRK.B) will stick around much longer with his 6% stake if fundamental operations continue to deteriorate and especially if management continues to pursue value-destroying activities in order to achieve self-enforced, near-term earnings-per-share goals. Warren Buffett likes economic moats, but he also focuses very much on incremental returns on capital and the uses of a firm's excess cash. IBM is failing miserably in the latter two considerations.

Big Blue's first-quarter results revealed a 1% adjusted decline in revenue, and a whopping 22% decline in operating (non-GAAP) income. The buybacks slowed the decline to 15% on a diluted earnings per share basis, but clearly the results weren't up to expectations. Perhaps the only bright spot in the quarter was that services backlog of $138 billion advanced modestly, but only after adjusting for currency and excluding its divested customer care outsourcing business. More startling was that revenues from the company's growth markets decreased 11% (down 5%, adjusting for currency), with aggregate declines in Brazil, Russia, India, and China falling at a similar pace.

Looking forward, IBM continues to expect full-year non-GAAP diluted earnings per share of at least $18 in 2014, but this target is losing its luster as share buybacks mount at value-destructive prices and the company benefits from favorable and unexpectedly-low tax rates. We would like management to reconsider its earnings-per-share focus, and instead apply its faculties to distancing incremental return on invested capital to levels far above the company's cost of capital, thereby generating economic value for shareholders. At this juncture, IBM's performance continues to be of low quality.

Valuentum's Take

IBM certainly retains its bellwether status, and the company's annual dividend yield of 1.9% isn't terrible, but we think there are much better companies out there. Not only do we expect more downside in IBM's share price, but we don't think Warren Buffett will tolerate such activity at the helm for much longer. Our best ideas continue to reside in the Best Ideas portfolio.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.