Financial Engineering Is Not A Bad Thing - As Long As You Are Aware Of It

| About: International Business (IBM)
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While Apple and IBM have both borrowed money to repurchase shares, their share prices have moved in different directions.

While Apple's sales continue to expand, IBM's revenue has declined consistently going back several quarters.

Financial engineering is a beneficial practice for companies that can obtain inexpensive debt financing and return the proceeds to shareholders.

However, financial engineering is unsustainable over the long term and will become especially problematic when the U.S. Federal Reserve starts to raise interest rates.

Individual investors should investigate companies carefully to ensure they can recognize when this type of financial engineering is present and make investment decisions accordingly.

There are dozens of valuation methods you can use to evaluate a business, but the simple price to earnings ratio remains the most popular. However, while examining P/E ratios can be a useful endeavor, investors need to be diligent that other metrics are also analyzed. Otherwise, it is easy to overlook the type of financial engineering that IBM (NYSE:IBM) has engaged in recently.

There are a pair of important points to outline here.

First, let me state that this article will contain plenty of charts. They say a picture is worth a thousand words, which would make this article a novel of sorts. However, these simple charts tell this story better than mere words can.

Second, I do not have any inherent objection to financial engineering. In fact, if inexpensive financing is available to a company, which can then utilize the proceeds to repurchase shares, management should certainly explore this possibility. In the majority of cases, I contend this process creates value for shareholders. The problem is that investors sometimes do not conduct a proper amount of due diligence and end up buying shares of a company experiencing problems with the underlying business operations somewhat hidden thanks to the effects of financial engineering.

Apple (NASDAQ:AAPL) recently issued $3.5 billion in euro-denominated debt. The interest rates were shockingly low: just 1.08% on 8-year bonds and 1.67% on 12-year bonds. However, even its more "expensive" $5.5 billion in USD debt issued last year had an interest rate of only 2.4%. When you consider that Apple does not pay taxes on interest payments, the effective cost of this debt ranges from approximately 0.7% to 1.8%. Meanwhile, the stock's current dividend yield is 1.7% (paid with after tax profits). In Apple's case, given its significant cash holdings and the potential tax consequences of repatriating these funds, this financial engineering is hugely beneficial to its shareholders. One important point to remember here is that Apple's sales are still growing at an impressive rate:

The firm's operations are strong and this financial engineering has allowed the company to buy back more than $44 billion worth of shares in its recently completed fiscal 2014. These two factors (plus an interesting slate of upcoming products) have aided AAPL's gain of approximately 40% over the last 52 weeks:

But this article is not intended to focus solely on Apple; rather the above paragraphs merely contrast one successful version of financial engineering with what has occurred at IBM recently. IBM's three-year stock chart is ugly, especially when you consider how strongly the broader market has performed during this period:

However, over the last three years, the company's earnings per share have grown at a modest, yet consistent pace.

Investors who focused solely on IBM's EPS and compared it to the firm's share price would likely have been tricked into assuming that the company's valuation was compelling. Conversely, a simple chart showing IBM's revenue during this time frame paints a starkly different view:

But perhaps IBM was doing a fantastic job cutting costs, improving its level of efficiency and widening its margins during this period?

Not so much. IBM's earnings per share growth was not caused by increasing sales or improving margins, but instead by financial engineering. The company's total net income during this three-year period stayed roughly flat:

In 2013 alone, the company borrowed nearly $7 billion and spent $12.8 billion buying back its shares. The number of IBM shares outstanding since December of 2011 is as follows:

While the firm's debt to equity ratio during this time has increased significantly:

There are two major issues with this type of financial engineering.

First, until organic growth returns (if it ever does), more debt must be utilized to maintain earnings growth. And as the amount of leverage on a firm's balance sheet increases, the cost of this debt (the interest rate) rises and management's flexibility becomes limited.

Second, the U.S. Federal Reserve will increase interest rates at some point in the future. When this occurs, the math behind this procedure begins to break down rapidly and eventually the outstanding debt needs to be repaid.

Now, these two problems are not impossible to overcome. In Apple's case, the company was able to obtain particularly inexpensive debt financing because of its notable cash balance. In addition, the company generated approximately $50 billion in free cash flow during the last 12 months, which it could use to promptly repay the debt if necessary.

Meanwhile, IBM has generated $13 billion in free cash flow over the last four quarters, which is impressive, but well short of the firm's $45+ billion in total debt outstanding. Of course, IBM is run by intelligent men and women well versed in financial theory and they surely recognize both of these points. However, my concern is that many individuals looked solely at IBM's earnings per share growth, assumed the company's operations were firing on all cylinders, bought shares as a result of its seemingly attractive P/E ratio and got burned.

Keep in mind that back in 2012, IBM was selling 10-year debt for less than 2% and, even earlier this year, was able to obtain an interest rate of less than 4% to issue long-term debt. Financial engineering is not IBM's biggest problem; quite simply, the company's underlying business is not performing well. While some investors might argue that management is using financial engineering as a tool to help cover up flaws in the business, I suggest that instead this process has actually helped the company's stock price perform better than it would have otherwise.

In any event, individual investors should be able to easily determine when financial engineering is occurring. There is no excuse for failing to notice it and then blaming a company's management. Of course, if an over-leveraged balance sheet leads to the financial instability of a firm, management should be held accountable, but at this point IBM is still far away from reaching that stage.

In general, I favor management teams that return cash to shareholders via dividends or buybacks (or a combination of both methods). In a number of specific cases (such as Apple), borrowing funds to repurchase shares creates immense value for shareholders. However, other times, a company struggling to generate any organic growth utilizes financial engineering to make itself appear more attractive than its fundamentals indicate. Given the presence of record low interest rates, this process has never been easier than it is today.

Fortunately, individual investors can protect themselves from unknowingly adding a company to their portfolio that is borrowing vast amounts of money to repurchase its own shares. Certainly, examining a firm's P/E ratio and EPS growth history and outlook is a prudent first step when investing in any company. But don't stop your analysis there - look at revenue growth, investigate the company's most recent annual cash flow statements and glance at its overall net income to ensure you do not get unwittingly caught up in the financial engineering game.

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.