Are IBM's Earnings Really Low Quality?

Aug.11.14 | About: International Business (IBM)


IBM has been accused of having low-quality earnings.

One reason for calling the earnings “low quality” is the share buyback program increasing EPS.

I will break down the share repurchases, the cost of capital, and the impacts on earnings.

There has been a ferocious debate about the quality of IBM's (NYSE:IBM) earnings. I love debates. I decided to do a little investigating into the charges of low-quality earnings. For investors who are unfamiliar with the term, low-quality earnings represent "income" being reported from creatively engineering the financial statements to make the company appear more profitable and sustainable than it really is. Everyone should be free to their own opinion - the wealth of opinions is a huge advantage to crowd sourced content. There are a couple issues at stake, because not all analysts will agree on every detail about how to define low quality earnings. When the rules are not clearly explained, it easy to feel the other side is "cheating." By earnings, some analysts may be talking about EPS (earnings per share) while others are talking about Net Income or Income from Continuing Operations. Unfortunately, there are more than three options.

To me, one of the most interesting charges refers to management's stock buyback boosting EPS. For the highly experienced investor, this section may seem a bit obvious, but I'm writing to investors who don't have an MBA and haven't taken the tests offered by CFAI. When a company buys back stock, the earnings become more concentrated. However, if the company had to take on new debt to buy the stock, the Net Income will be decreased because of the interest expense. Earnings per share could go up or down in this scenario. The increased concentration boosts earnings per share while the decrease in net income lowers them.

Table 1 shows a simple hypothetical company:

Table 1

Hypothetical company

Share price


Shares outstanding


Net Income


Earnings Per Share


Click to enlarge

In this example there is one dollar of EPS and the share price is ten dollars. If the company buys back stock in this scenario, will it increase EPS? The answer depends on the interest rate the company has to pay. If the interest rate is less than 10%, taking out debt and repurchasing shares will increase EPS. Note that I did NOT say it was a good or bad idea for management to take out the debt. That is a different topic. Let's look at what happens in Table 2 if the hypothetical company repurchases ten shares at the current price while paying 5% interest (after adjusting for taxes):

Table 2

Hypothetical company

Share Price


Shares outstanding


Money spent on repurchases


Interest cost after taxes


Net Income


Earnings per share


Click to enlarge

In that scenario, the $100 borrowed from the bank to repurchase shares has reduced net income by five percent but reduced the shares outstanding by 10%. In the real world, it becomes more complicated because the company purchasing shares may drive up the share price. With that primer done, let's have a look at IBM in Table 3:

The table above helps us gather several bits of information that we'll be using to analyze the impact of the repurchased shares. Net Income was pulled directly from the financial statements. The harder piece to analyze for IBM is the interest cost. The way IBM structures its transactions the "interest cost" reported in the income statement does not reflect its entire interest expense. For that, you would need to go to "Note J. Borrowings." I can't link directly to it, so you'll want to click "notes to financial statements" and then "borrowing." Part of the company's interest cost is classified under "Financing" on the income statement. However, not all of the "Financing" is interest expense, so you'll only be able to get this information using the notes to the financial statements.

What is this part about "all debt" vs. "long term debt?" The company uses both short- and long-term debt. It could be assumed that it will repurchase stock using the same mix of debt they had before, or it could be done with only long term debt. There are other options, but for simplicity sake, I won't get into them. In Table 4 and Table 5 I show the calculations I used to figure out the effective rates IBM is paying. Table 4 will treat the interest as if it comes from all debt - Table 5 will treat the interest as if it only comes from long-term debt. The truth is that long-term debt has to pay a higher interest rate, so the correct answer is somewhere between these two.

Now that we have a feel for the interest rate, we need to figure out the price of the stock. Again, for simplicity sake, I'm going to pull the number of Yahoo Finance. At the time I'm writing this, the stock sells for $186.63. The stock hasn't been particularly volatile, so I'm happy just using that number. Here's the price history over the last year courtesy of Yahoo. Note that volatility appears massively overstated as the graph effectively runs from about $200 to $170 rather than from $200 to $0.

Click to enlarge

Knowing the price, the interest rate, and how much shares outstanding were reduced, we can calculate the effect that share repurchases had on the company. For simplicity sake, I'm assigning a 35% tax bracket to the debt. The average rate will be lower than that, but we want the marginal rate. In Table 6 you'll see the calculations to reach EPS if the share repurchases hadn't happened.

So in short, earnings per share for quarter 2 are boosted by around 1.25% from the reduction in shares outstanding, if we use the ending value of shares. Because EPS is calculated with weighted average shares outstanding, the boost to EPS will be lower in the present quarter.

Does this deserve to be considered low-quality earnings?

I don't see this as a big problem. The boost to EPS from this, even over the course of a year, does not bother me. Based on the rates IBM is paying, I believe the company is being financially prudent to use more debt in its capital structure. Of course, there are limits to how much debt any company should use. Using the market value of equity, I calculated the capital structure for IBM in Table 7:

You may notice that I have used the book value of debt. That's a common practice for analysts. It isn't feasible to completely revalue the company's debt unless there is a huge incentive to be precise and you expect that the values have deviated dramatically from the book values. I checked the notes for indication on the fair market value of the debt and their gains and losses largely offset. As a result, I don't feel the market value of debt is materially different from the book value of debt for the purposes of calculating the capital structure. Investors who provide capital for debt have a repayment schedule they can count on. They generally accept a lower rate of return because they can be more certain of acquiring that return. You won't find a shareholder of IBM that will say they would be happy with a total return of 3.12% per year. After using the tax shield from interest the cost drops down to a little over 2% per year.


IBM is repurchasing shares, but I don't see it as a problem. The company is getting very attractive rates on the debt it is using to repurchase the shares. Based on those attractive rates, I believe the company is successfully lowering the weighted average cost of capital. If there are casual investors who are unfamiliar with that concept, I'll consider doing an article analyzing the changing capital structure of the company.

If IBM is going to be accused of low-quality earnings, the share repurchase program should not be cited as proof. This is not proof of low-quality earnings. This is proof of management properly assessing its capital structure and choosing to incorporate more debt. IBM has done other things that may be indicative of lower quality earnings, but anyone complaining about the share buyback as proof of low quality earnings is damaging their own credibility.

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.

Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from either Yahoo Finance or the SEC database. If either of these sources contained faulty information, it could be incorporated in our analysis. The analyst holds a diversified portfolio including mutual funds or index funds which may include a small long exposure to the stock.