IBM's Balance Sheet And Strategy Are Colliding

Summary

• IBM has issued a moderate amount of new debt in the past few years.
• But waning operating profits and higher financing costs mean that IBM is spending much more of its operating income on debt.
• This could be a problem going forward for a couple of reasons.

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IBM’s (NYSE:IBM) cash generation has always been outstanding. In fact, despite what has become years of struggles to get back on track, one thing that has remained terrific is its ability to generate very high FCF margins. But it also likes to do acquisitions, pay a high dividend and especially, buy back stock. These things all take cash and that means that sometimes, IBM has to supplement what it produces with debt. Debt can be a good thing when used properly but it can also destroy a company’s ability to grow earnings if misused. In this article, we’ll take a look at IBM and see which category it falls into.

I’ll be using data from Seeking Alpha for this exercise.

Let’s begin by having a look at IBM’s short term and long term debt as well as the interest expense associated with it.

IBM’s debt hasn’t moved around all that much in the past few years but it is undoubtedly higher than it was in 2012. Total debt was about $33B in that year and now, it is about $43B. That’s certainly a lot of money but as I said, IBM has maintained some level of profitability and FCF generation despite some tough years so financing costs should have remained fairly low in a relative sense; more on that in a bit.

Apart from the total rising, IBM has also come to rely upon long term debt more so than the short term variety. It still has several billion dollars of ST debt so it certainly hasn’t stopped using that, but LT debt is where all the growth in the total came from. Given the rock bottom interest rates we’ve seen for the past several years, IBM is certainly not alone in striking while the iron is hot and issuing LT debt at cheap rates.

The line for interest expense is where we’ll focus now as that number has moved up quite a bit more quickly than the debt total on which it is based. Total debt has risen by roughly 30% during this time frame but interest expense is up about two-thirds, owed to IBM’s heavier reliance upon LT debt, which generally carries with it higher financing rates. But again, the idea is that debt can be a good thing so long as the company’s income statement can handle the financing costs.

To that end, here’s a look at IBM’s interest expense against its operating income for the same time frame as above. This gives us a look into just how much of IBM’s operating profits are consumed by financing costs and thus, we can get an idea of how much debt it can handle.

This chart looks menacing but if you size it up against the scale, you’ll quickly realize it isn’t. Yes, interest expense as a percentage of operating income has risen sharply in the past few years but even so, 2016 saw it at only 7%. That is off of a very low base of less than three percent in 2012 and while the increase isn’t desirable, it is quite manageable. The boost, unfortunately, is owed to fairly rapidly declining operating income against rising interest expense, a double-whammy impact that has this metric up by almost 200% over our five-year time frame. That’s not great but again, the end result is okay as it sits, providing IBM can stop the bleeding.

We’re all well aware of IBM’s struggles with its legacy business and that has prohibited operating income growth for years now. And with it taking on more debt, its interest expense is moving in the wrong direction as well. Normally when I see a company that is only spending 7% of its operating income on debt, I’d look for a creative way to boost shareholder value. That could come from a buyback or an acquisition but for IBM, I’m more concerned about what this is going to look like a year or two from now. Operating income seems to be stabilizing at least somewhat but IBM is certainly not out of the woods yet. That means that any additional financing costs it takes on are likely to negatively impact its interest expense as a percentage of operating income, and that’s something IBM doesn’t need right now.

IBM hasn’t been unreasonable or reckless with its debt issuances; quite the opposite, actually. What it has done though is see its operating income decline precipitously and that has exacerbated its higher financing costs. Seven percent of operating income isn’t bad but what will it look like in 2018 and beyond if IBM cannot right the ship? Anyone that has read my work knows I have very little faith in IBM’s management team to do anything other than sit around and hope that its strategic initiatives will produce growth at some point and that means its debt is likely to become more of a burden before it gets better. And at a time when earnings growth is difficult to come by, the last thing IBM needs is higher financing costs making it even more difficult. The downside is that its current situation will preclude things like the 2014 edition of the buyback that well exceeded its ability to finance it with FCF and that, being a central part of IBM’s strategy, is a problem. If you’re long, you’d do well to keep an eye on how much debt IBM issues because if its operating income doesn’t grow, this thing could get out of hand.

Analyst’s 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.