Don't Be Fooled: IBM Still Reporting Low-Quality Earnings

Aug. 5.14 | About: International Business (IBM)


IBM has become the poster child for poor earnings quality.

A focus on accounting EPS can punish return on invested capital (as money is plowed back into overpriced stock to boost EPS). This is what management is doing.

It's hard to accept that IBM is no longer the IBM it once was - it is playing EPS games and pulling the wool over investors' eyes.

The agreement with Apple is a sign that IBM has conceded defeat - and would rather work with Apple than suffer at the hands of the revolutionary iPhone maker.

There are a plethora of other tech names that we prefer in either the Best Ideas portfolio or Dividend Growth portfolio.

Warren Buffett doesn't seem to care, as he owns 6% of the firm. But we think it's worth pointing out that IBM's (NYSE:IBM) second quarter results, released July 17, continue to fit the theme of low-quality earnings that we brought to light after its fourth quarter 2013 performance. Please don't misunderstand - IBM is a fantastic company with significant competitive advantages. But that doesn't make it immune to independent, objective financial analysis. Let's have a look at the quarterly results.

For earnings growth to be sustainable, the top line must be expanding, as cost cuts, by definition, are finite. In IBM's second quarter report, revenue dropped 2%, while its services backlog - a key indicator of future revenue performance - dropped 1%, after adjusting for its divested customer care outsourcing business. These clearly are meager declines - and the firm is seeing nice growth in mobile and cloud revenue (up 100% and 50% year-to-date, respectively) - but when it comes to evaluating bottom-line performance, we'd prefer to see revenue expand. Revenue performance in the firm's growth markets, which fell 7% in the period, is most concerning. Sales in BRIC countries - Brazil, Russia, India and China - dropped 2%.

IBM's quarterly operating results were muddied by a $1 billion charge in the prior-year period related to workforce rebalancing. Adjusting for that charge, operating (non-GAAP) net income would have fallen roughly $300 million from the prior-year adjusted number, to $4.3 billion. This is much different than the headline increase of 21% that was relayed in the press release. In the second quarter, IBM's tax rate came in at 20%, down 2.1 percentage points on a year-over-year basis. Operating (non-GAAP) net income for the six months ended June 30, 2014, was $7 billion, flat year to year. This comparison is unadjusted for the $1 billion charge in the prior-year period, meaning core operating profit remains under pressure.

All-in, year-to-date, operating (non-GAAP) diluted earnings per share were $6.82 compared with $6.23 per diluted share for the 2013 period, an increase of 9.5%. But with revenue declining and core profits under pressure, the year-over-year increase continues to be bolstered by a lower tax rate and massive share buybacks (1) - two sources of low-quality earnings. For us to turn positive on the trajectory of IBM's financial profile, we'd need to see the firm's revenue turn the corner, especially as it relates to its growth markets. We're hoping that the recent agreement with Apple (NASDAQ:AAPL) will help the firm right the ship, but we're not holding our breath. We believe Apple holds most of the bargaining power in the relationship.

Valuentum's Take

Equity financial analysis should be objective, and we think investors benefit from having an unbiased view that is grounded in numbers. It's easy to get excited about owning Big Blue, especially with Warren Buffett in one's corner, but it's equally, if not more, important to understand some of the concerns related to IBM. We have little doubt that the firm won't hit its $20 per share operating earnings-per-share target for 2015, but the firm is doing so in a low-quality way.

Unlike other tech giants such as Apple and Google (NASDAQ:GOOG) that are driving top-line expansion, IBM continues to suffer from revenue declines and a management strategy too focused on accounting EPS instead of return on invested capital - the most important metric for shareholders.

(1) The weighted-average number of diluted common shares outstanding in the second quarter 2014 was 1.01 billion compared with 1.11 billion shares in the same period of 2013. As of June 30, 2014, there were 998 million basic common shares outstanding.

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

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