Red Flags For IBM

| About: International Business (IBM)

Summary

IBM business has deteriorated rapidly over the last five years.

The revenue declined, free cash flow declined, dividend payment increased, monetization of acquisitions has been poor, and the balance sheet is more levered.

Combination of all those raises red flags that should be considered before taking a long entry.

Shares of IBM (NYSE:IBM) may sound like a good value play. The company has a long track record of annual dividend increases. The dividend yield is high, the price to earnings is low, and the free cash flow per share is high. It may sound like it fits perfectly to the value investment strategy. No wonder Warren Buffett took a big bet on IBM in 2011. It was the perfect case according to his value investment style. However, the business has deteriorated sharply since his investment decision. There are many red flags that stand out. Particularly, my concerns point to following issues:

  • Decline in revenue over multiple quarters
  • Revenue growth driven by acquisitions
  • Decline in the sustainable cash flow
  • Tax management to manage the bottom line
  • Decrease in dividend payment ability
  • Levered balance sheet

Perhaps that was the reason why Warren Buffett reduced his stake and why Moody's downgraded the stock by one notch. All of these make the long investment argument for IBM much weaker than it was in 2011. Let me please back-up the red flags with supporting evidence.

Revenue Decline

IBM's revenue has been declining for the 20th consecutive quarter in a row. Moreover, the company recorded revenue of $91bn in the year 2006, and 10 years later, the revenue is $79.9bn. This is a decline of $11bn. Perhaps that was deliberate. The company announced a shift in the strategy towards higher-value segment years ago. And while it is short of $11bn, the profitability is only $1bn lower as measured by EBIT. One billion may look not that dramatic as a standalone number, but it will make more sense when I touch the ability to pay dividends later.

Source: IBM's 10-Ks

And it is still a decline over the full business cycle. Revenue is lower by $27bn since 2011. And sales are expected to decline further in 2017 and 2018 according to analysts' estimates.

Source: Finance.yahoo.com

Declining revenue over 20 consecutive quarters is a red flag on its own. But what raises my concern is the money IBM needed to spend on acquisitions to generate the revenue growth in strategic imperatives.

Acquisitions

IBM proudly announced in its 2011 annual report that it bought 170 companies and spent $30bn on acquisitions since 2000.

Source: IBM Annual Report 2011

Additionally, it spent a further $16.5bn on acquisitions since 2012. This is a total of $46.5bn over the 16 years of history. And the result is $79.9bn revenue in the year 2016 compared to $88.4bn in the year 2000. Perhaps the acquisition made sense and will be a great success story in the future, but 17 years of track record would suggest otherwise. Whether it will make sense in the future, we will see, but I would suggest the software bought in 2000 may be obsolete now and the current industry is more advanced already. What raises my concern is that the company needed to spend approximately $3bn annually to sustain the revenue growth in strategic imperatives.

Source: IBM's 10-Ks

Therefore, this should be treated as regular capital expenditures. Had there been no acquisitions, the revenue growth would have shrunken even more. And this is another red flag that I am presenting. The inability to monetize the acquisitions or the need to drive revenue growth by acquisitions rather than through its own innovations. IBM actually claims to be the biggest innovator during the last 24 years.

Source: Ibm.com

List of the companies awarded the most patents in 2015

Source: Fortune.com

Perhaps the company is yet to unlock the value from this intellectual property. But the track record of monetizing that is very poor. Treating acquisition spending as regular capital expenditures significantly reduces free cash flow. Therefore, this is a red flag. I will present free cash flow considering the need to sustain acquisition spending, but before that, I would like to touch on the reduced tax base in the recent years.

Tax Management

When I looked back at IBM's history, I found out that it has been paying more than 20% in taxes every year till 2013. It is perhaps a coincidence that the tax base started declining at the time when the revenue declined. But it looks strange and resembles the need to manage the bottom line through lower tax base and mitigate the weakness in the profitability.

Source: IBM's 10-Ks

My assumption is that the sustainable tax rate is at least 20% as would history suggest. Also, the benefit recognized in the past years is not likely to replicate. Therefore, I will show a restated cash flow as if IBM did not have the tax benefit which may be the case in the future.

Deteriorating Sustainable Cash Flow

I would like to present three scenarios. One with all the tax benefit and excluding the need to sustain the revenue by acquisitions. Second scenario will be when I will restate the cash flow as if the company will not have the tax benefit. And in the third scenario, I will include acquisitions as regular capital expenditures.

Scenario 1 - Free Cash Flow As Reported

Source: IBM's 10-Ks; author's calculation

In the first scenario, we can spot that free cash flow has decreased, dividend payment has increased and so the free cash to cover the dividend payments decreased from the 5.4 multiple to the latest 2.4 multiple. This is less than half what it was in 2008.

Scenario 2 - Free Cash Flow Excluding Tax Benefit

If I restate the operating cash flow and exclude the benefit from lower tax base, then the ability will decrease further.

Source: IBM's 10-Ks; author's calculation

We can see that the ability to cover the dividend payments is much weaker if at least 20% tax base is considered, which is more sustainable. The 20% tax base would result in additional $2bn tax payment in 2016 and $0.6bn in 2015. On top of that, the company spent on average at least $3bn on acquisitions to reverse the revenue decline. If I consider this as part of the regular capital expenditures, then the ability is even weaker.

Scenario 3 - Free Cash Flow Excluding Tax Benefit and Treating Acquisitions as Regular Capital Expenditures

Source: IBM's 10-Ks; author's calculation

If the company had not generated the acquisitions, then the revenue will be even lower. Therefore IBM needs to buy companies to stay in touch with new trends. By doing so, the ability to increase the dividend payment annually weakens. It will cover its payments just 1.5 times and so virtually all free cash will soon go for dividend payments. That is not sustainable. Yet, the company was still able to generate the return for shareholders or mitigate the downward trend through share purchases. This was done either through excess cash or higher leverage. And that is my next red flag.

Balance Sheet Deterioration

IBM had $10.6bn in cash and equivalents on the books in 2006. In addition, it had debt in the amount of $22.7bn. Therefore, the net debt was $12bn in 2006. This was the time when the company generated higher revenue and higher profit. Last quarter, the company recorded $10.6bn in cash and $42.8bn in debt. This is the net debt of $32.1bn. It is almost a threefold increase, and currently, the company generates lower operating cash flow and needs to pay higher dividends. And so the increased leverage and decreased free cash flow are other red flags for the company.

Source: IBM's 10-Ks; author's calculation

Takeaway

Taking everything into consideration, IBM's business has deteriorated rapidly over the last five years. Despite spending billions on acquisitions, the revenue declined. In fact, sales were lower last year than 16 years ago. The combination of lower free cash flow, higher dividend payment and levered balance sheet raises red flags for the company that deprive me from taking a long entry.

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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