Too Many Share Buybacks Have Hurt IBM

| About: International Business (IBM)


Aggressive share buybacks have been a disaster for IBM.

The company has very thin equity and net debt of about $30 billion, making it a rather risky bet.

Any further deterioration in earnings will affect the stock badly.

Those who have held shares of IBM Corp. (NYSE:IBM) for the last five years must be quite angry at the stock, maybe at themselves, but perhaps even at Warren Buffett. Although anger doesn't fix anything, the fact that the overall stock market (let's say the S&P 500) has risen by almost 70% does not help the psyche at all. IBM, by contrast, has just languished. Mr. Buffett, regrettably for him, started buying the stock early in 2011, and has been consistently doing so since, as far as I know. I couldn't find (Warren Buffett's) Berkshire Hathaway's (BRK.A, BRK.B) average price for IBM shares, but it is definitely much higher than the current share price of less than $141 (as of Tuesday's close). Is the current situation exactly what Mr. Buffett expected, or even wished for? Of course not. Although I bet he (as any major investor in any company would never acknowledge) regrets his investment, there is one thing he has definitely been wrong about - and that is the aggressive promotion of IBM's stock buybacks. Mr. Buffett is not responsible for the company's aggressive stock buybacks - IBM's management is. But such aggressive buybacks are not good for any company's financial future, and what IBM has done - embraced and applauded by its largest shareholder, Berkshire Hathaway - has been the worst thing for the company, endangering its future strength.

Let's compare two rather similar companies, IBM and Oracle (NYSE:ORCL), though they are run in quite different ways. Up until last year, IBM had a much larger market capitalization than Oracle. However, things have turned the other way around now. Oracle has a current market cap of about $157 billion, while IBM's market cap is $137 billion. That is embarrassing for IBM, of course!

Obviously, Oracle has had much stronger earnings growth for the past ten years, tripling its net income to almost $10 billion, while IBM has come from around $8 billion to $12 billion for last year, though we must acknowledge that excluding "extraordinary" charges, net income for IBM would have been $15.7 billion. And it is also important to acknowledge the fact that IBM, being such a huge company, had a tougher time in a challenging business environment. Companies with smaller, hence more flexible, sales volumes can adapt more easily to changing market conditions. But still, it is obvious that Oracle has had a better management, and has simply done a much better job in growing sales and profits.

But what I want to pay more attention to is the FUNDAMENTAL (not related necessarily to stock fluctuations) reason why IBM is currently cheaper than Oracle, though it is still making more money. A company's valuation is not just about its current earnings, but also about its prospects and about the company's balance sheet. This is where IBM looks pretty bad, while Oracle looks, well, almost fabulous in comparison. Looking at their respective balance sheets, I would say that IBM does not look cheap at all compared to Oracle. It is not exactly cheap in regard to its forward P/E either. IBM's current P/E is close to 10 (according to management guidance), which is not exactly a bargain for a large tech company (nowadays - though it would have been considered extremely cheap in the year 2000). However, when one looks at IBM's very thin equity, that's where things look shaky, and that's actually where the current P/E comes from, which looks relatively attractive if you don't look at the balance sheet.

IBM has been generating huge amounts of cash over the past ten years, ranging from $8 to $16 billion, and all that cash is almost nowhere to be found. Where is all that cash? Most of it has been given to those who have sold their shares to the company. Practically, the company, as things stand right now, has been rewarding the sellers of the shares at the expense of loyal shareholders who have been holding their ownership stakes. Of course, people do not usually see it like this, but when the stock price goes down, things turn out this way. When the share price goes up, it turns out better for loyal shareholders.

Share buybacks are nothing bad. They are absolutely normal when a company does not find any better investment to make other than buying back its own shares, because it considers its own shares to be undervalued enough to be worth paying hard cash for them. Of course, many companies, often pressed by their assertive shareholders, buy back shares not necessarily because they see value in the shares, but because the management just wants to make those shareholders happy by influencing the share price momentarily to the upside (buying them in the open market). This aggressive approach toward share buybacks is also very often (including in IBM's case) encouraged by internal policies rewarding management for what they achieve as earnings per share (EPS), without taking into account the overall financial or strategic situation of the company, which may have taken a hit as a result of chasing EPS. And IBM is a real case for such a situation.

Over the past ten years, the company's share count has fallen from 1.63 billion in 2005 to below 0.98 billion. That is a dramatic reduction - 40% of the share count. Oracle has had a more moderate approach, reducing its share count from 5.3 billion in 2005 to 4.5 billion now. What has happened in IBM's case is that the company has generated about $150 billion in net cash since 2005, yet its current market capitalization is less than that. The most important reason behind this apparent anomaly is that IBM's current shareholder equity is a rather pathetic sum of $13.6 billion. By contrast, Oracle has a shareholder equity of about $47 billion, and no net debt. IBM also has some additional rather unsettling numbers in its balance sheet. The company's current (after Q3 results) "cash and marketable securities" stand at $9.6 billion, while its total debt is at $39.7 billion. Of course, some of the $150 billion that has been generated has gone out to all shareholders as dividends, which hasn't been unreasonably high (it is 3.4% now). However, the amount of cash which has disappeared (from shareholders to sellers) in the form of buybacks, while creating a rather significant amount of debt, sounds mind-boggling.

As I mentioned earlier, there is nothing wrong with buying back shares when you consider them bargain. But buying back your shares at the expense of endangering the future of the company, and hence the wealth of the remaining shareholders, is simply irresponsible. Can anybody in the world know for certain that any particular company will do very well in the coming 2-3 years? Can anybody know for sure no recession will come next year, or the following year? Nobody knows these things for sure. This is why prudent management is needed to safeguard a company against possible risks. How can you safeguard your company for possible mishaps? At least by NOT accumulating a lot of debt compared to your equity and your worst-case earnings potential. This is why I believe throwing away all your money (that's what IBM has done), and also taking on more than two years' worth of earnings (which seems to be going down for now) in debt is nothing short of crazy!

Imagine that, for some reasons (unexpected, benign, or catastrophic, depending on who does the interpretation), IBM ends up making no more than $10-11 billion in 2016 and 2017. With a net debt pile of around $30 billion, the share price will plummet. In case there is a recession and IBM's earnings nosedive, it won't just be the share price which will suffer (theoretically temporary), but the company will face serious existential threats because of its debt, which will no longer be as manageable as it seems today. It's just a pity that such a great company takes on such unnecessary risks. If IBM had a $30-40 billion net cash cushion, I am sure the share price would have looked much better, and a much more moderate share buyback would not have been such a risky waste as it is now. And it's not that IBM isn't a good company. I don't blame its management for anything else. Nonetheless, I would not touch IBM shares at current prices, simply because of the management's rather irresponsible approach toward share buybacks, and hence, their lack of long-term vision.

Disclosure: I/we 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.

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