Big Blue's Stock May Be Affected by IBM's 'Bank'

Concerns about IBM’s (IBM) third quarter are popping up almost daily. The standard set of concerns revolves around technology spending and the willingness to pay IBM’s army of consultants fees for big bang projects as well as a stronger dollar. But underneath the surface there’s a bigger worry that isn’t being talked about too much: IBM is part bank.

It’s relatively common knowledge that IBM has a big finance unit that helps fund external projects from its clients. It’s a swell business that has the second best gross margins at IBM. For instance, IBM’s global financing unit had gross margins of 46.7 percent in 2007, second only to the software unit’s 85.2 percent. The finance unit’s margins were down from the 50 percent clip posted in 2006, but it’s nothing to sneeze at for sure.

The lesson here: When the credit market freezes it impacts everyone and possibly some of your friendly neighborhood technology vendors (Dell (DELL), Oracle (ORCL) and many others offer financing). Big Blue’s financing unit, which leases hardware and finances projects, is big enough that the Securities and Exchange Commission put IBM on the “do not short” list. This list is designed to get shorts–folks that bet against stocks–off the backs of financial services companies long enough to raise capital or at least survive.

Todd Harrison at Minyanville, a financial site, dubs IBM–and General Electric (GE) and other companies with financial operations–as “financials in drag.” I wish I coined that phrase, but Harrison nailed it.

Those financial worries have hit IBM’s stock. Here’s a look at Big Blue shares over since the company’s earnings report in July.

IBM details its financial services operations in detail in its annual report and latest quarterly filing with the Securities and Exchange Commission. While all the accounting mumbo jumbo may be a bit mundane it’s worth a look for customers, shareholders and anyone else in the Big Blue ecosystem. At the very least, arming yourself with a little knowledge can deflect FUD (fear uncertainty and doubt) in a highly volatile environment.

In terms of revenue the global financing unit is no big deal relative to Big Blue’s overall sales. In 2007, IBM’s financing unit had revenue of $2.5 billion (for external clients) out of the total $98.8 billion sales pie. To put that in context, IBM’s financing unit had revenue that topped the company’s business transformation outsourcing business. More context: IBM’s total company debt in 2007 was $35.3 billion and global finance accounted for $24.5 billion of that chunk. IBM’s financing business also funds internal clients such as its services unit’s contracts. Overall the financing business rocks: Who can argue with pre-tax income of $1.38 billion on total revenue of $3.98 billion?

Here’s a look at the business for 2007:

And the results for IBM’s financing unit, which is reported as if it were an independent entity, for the first half of 2008:

As you can see the first half margins for IBM’s financing unit are up from a year ago. In fact, as recently as July 29–IBM’s last quarterly filing–the company was upbeat about its financing prospects. Here’s what IBM said about the second half of 2008 in its SEC filing:

The Global Financing business continues to be well positioned to grow in the current environment. The company’s financial position provides substantial flexibility and funding capacity. Global Financing’s assets and new financing volumes are primarily IBM products and services financed to the company’s clients and business partners and substantially all financing assets are IT related assets which provide a stable base of business for future growth. The company’s recently announced System z and high-end converged System p servers are a significant financing opportunity. Global Financing’s offerings are competitive and available to clients as a result of the company’s borrowing cost and access to the capital markets.

The problem: A lot has changed since IBM’s last earnings report. Perhaps IBM skated through the credit crunch without any problems, but some investors are clearly skittish.

Comments

[CM in MA:]

Good article. As an IBM long, I appreciate your legwork to put the numbers in context.

2008 Oct 02 10:48 AM

[IsThisRight:]

The 'financial engeneers (FEs)' talk about financial revenues as if all businesses operate on the same basis ( i.e you borrow money or get deposit, and then lend it out). Then they compare one company to the other. These FEs, without trying to understand any deeper how 'business' is done, do their utmost to be visible in the press by making predictions based on their own observations of past events.

In the case of 'IBM Banks', let's ask a few questions.
- Do they take get their high margins by borrowing and lend it out at a interest rates? From this they get 46% on the money? In my world, this is a corner loan - called loan shark! Since the company has best high-grade customers, I doubt that these customers are dummies. So my deduction is that this not how 'IBM Bank' earns this High money.

- What else does the 'IBM Bank' do as a business that could account for the high margin? OH, they lend money to customers doing mission-critical services... And that part of the business is growing ( like relieving traffic jam, or placing 100's of operating banks in China...). So by financing the customer's expense for these services, the bank earns more.
Yeah, this is good but still does not account for 46% margin.

-What else do they do to be so good? Ah, the 'IBM Banks' are "USED CAR SALESMEN" ( oops used computer salesmen) around the world.
Imagine being IBM Banks as owner of oops 3-4-5 year big and mid-size computers, kept in a pristine corporate computer centers. Due to efficiency or growth, the first user of these computers want to upgrade. Then the 'owner' of the computer has to take back the 'used computer' still in great operating conditions. By reselling the same computer to someone else who is in dire need for that size computer and making a profit. It is like leasing the best Benz, take it back and resell it at high-value! Ah, that part of the used car ( oops used computer) can have a high margin since the profit on the sale when added to the fact that two sales are made (1 sale to the 1st customer for a newer model and a sale to a 2nd buyer).

Ok, now we can understand that a bank is a bank and a 'used car' sales operation( oops IBM Bank is a bank and 'used computer' sales operation). As a seperate financial unit, due to accounting law, these used-computer sales are not reported in brand sales, but are reported as income in the finance unit. Oops, the cost of the used-computer is the trade-in cost which was established 3-4 years ago! In a conservative bank, Interest money was earned on the original equipment and part of that earning in the past 3-4 years was set aside as a risk mitigation ( in case the trade-in value is less than the resell price). But if the used-equipment sales keep rolling forward, the abl keeps making profits.

Now does the fear about the sub-prime sludge the same as the IBM Bank prospects? You tell me. Oh by the way, in an economic slowdown but a lot more companies might consider used equipments rather than buying new, the margins on the used computers go higher!
The trick is to slow down the expenses on new mnfg to match demand... not to slow the bank who has equipment with higher margin for sale!

This is why a high-level GRADE is assigned to the IBM Bank bonds.

2008 Oct 02 11:28 AM

[SeeTheLight:]

@ Is this right:

I think you might be a little confused. The 46% margin means simply that for each dollar earned in interest it only costs 56 cents to earn it. This doesn't imply that IBM is charging loans at Loan shark rates.

For example. Let's say some one buys (not leases) a mainframe for $100,000. Then they finance it at 8% per annum. IBM's server group records the $100K revenue and the financing group earns 8K revenue in the first year. Then of that 8K revenue, it costs the finance group around 4.5K to earn it (paying salaries, borrowing costs, etc.). Obviously this example is a little simplified but it should illustrate it.

Pretty sure there are no loan sharking practices here, simply making it easier to buy the mainframe. If someone wants to lease a computer and re-sell it back later... why not? And It's not like IBM is forcing them to use their financing arm, they can go to bank if they want.

Hope that helps.

2008 Oct 03 02:32 PM

[SeeTheLight:]

@ Is this right:

I think you might be a little confused. The 46% margin means simply that for each dollar earned in interest it only costs 56 cents to earn it. This doesn't imply that IBM is charging loans at Loan shark rates.

For example. Let's say some one buys (not leases) a mainframe for $100,000. Then they finance it at 8% per annum. IBM's server group records the $100K revenue and the financing group earns 8K revenue in the first year. Then of that 8K revenue, it costs the finance group around 4.5K to earn it (paying salaries, borrowing costs, etc.). Obviously this example is a little simplified but it should illustrate it.

Pretty sure there are no loan sharking practices here, simply making it easier to buy the mainframe. If someone wants to lease a computer and re-sell it back later... why not? And It's not like IBM is forcing them to use their financing arm, they can go to bank if they want.

Hope that helps.

2008 Oct 03 02:33 PM