The Canary In Big Blue's Mainframe: Why IBM's Q3 Bust Marks A Turning Point

IBM has long been a poster boy for the untoward effects of central bank financial repression. For most of this century the once and faded king of tech has been in a modality of slow liquidation, leveraging up its balance sheet with cheap debt to fund stock buybacks, dividends and accounting-driven two-bit M&A deals. This morning that destructive strategy-----pursued by two incompetent CEOs in a row-----came to a thundering crash.  IBM is now down by 7% and deserves to go far lower.

Perhaps even the robo-traders have had enough-----given that IBM reported its 10th straight quarter of negative revenue growth, a $4.7 billion write-down of its chips business and a huge 12% miss on even the street's phony "ex-items" earnings number. But the canary in Big Blue's mainframe was undoubtedly one simple thing, as Zero Hedge cogently noted:

".....the buyback "strategy" finally hit a brick wall."

After repurchasing an average of $6 billion shares during each of the past three quarters, buybacks dropped to only $1.7 billion in Q3. And the latter marked the lowest anualized repurchase rate since 2009. Likewise, for the first time in 10 quarters IBM's net debt also stopped growing.

But the dismal charts above are only the most recent manifestation of IBM's self-liquidation. During the 31 quarters since the end of 2006, IBM has spent $111 billion on share buybacks and another $23 billion on dividends. And it goes without saying that this staggering total of $134 billion, which was pumped into the coffers of the fast money traders who rent Big Blues shares and the mutual fund and institutional investors who index them, did accomplish wonders for its stock price. The latter vaulted in nearly a perfect chart climb from $100 to $200 per share before it recent slide.

Here's the fly in the ointment, however. During this same nearly eight year period, IBM reported net income of only $107 billion. So its paid out 125% of its earnings to shareholders----and not just for a brief interval when it was deciding on a new business model after its historic hardware business went flat.

In fact, it's new business model amounted to eating its tail. During the period when it was spending $134 billion on buybacks and dividends it invested just $33 billion in CapEx compared to about $40 billion in DD&A.  In other words, to fund its shareholder distributions and petty M&A deals it was stealing from its depreciation accounts, as well.

And that's not all of it. IBM is now in the intangible business of software and services----so what really counts, purportedly, is spending on R&D. Well, on that score it spent about $6.2 billion generating new products, processes and intellectual capital during 2007. By contrast, during the year ending in Q3 (LTM), it spent just  $5.0 billion in inflation-adjusted dollars or nearly 20% less.

So IBM's board and C-suite have eschewed the demanding work of technological innovation, business risk-taking and capital investment in the future, and, instead, have turned the world's leading technology company into a stock buyback machine on steroids. Accordingly, at the end of 2006 it had nearly 1.5 billion shares outstanding----a figure that has dropped by 33% to less than 1.0 billion during the quarter just reported.

So it is worth filtering the drastic share shrink out of the numbers. Back in 2006 IBM earned $9.5 billion or $6.06 per share on its 1.5 billion shares outstanding. After the massive loss in Q3, its LTM consolidated net income amounted to $12.7 billion. And while that computes out to about $12.35 per share on today's shrunken count, IBM's real earnings have by no means doubled.

In fact, after giving credit to the after-tax earnings impact of the $111 billion IBM has spent on stock buybacks, its LTM earnings would only amount to $9.35 per share on the 2006 share count basis. Stated differently, fully half of the per share earnings gain since 2006 touted by the sell-side analysts is due to the illusion of share repurchases.

Moreover, coughing up rivers of cash for shareholders was only one arrow in the quiver of IBM's new business model. Its lawyers and  accountants weighed in smartly, too. During fiscal 2007 Big Blue's tax rate was already low at 28%, but by dint of the best tax maneuvers money can buy, IBM's tax provision dropped to about 17% on a LTM basis. So if you hold constant IBM's tax rate-----since it cannot mine profits out of the IRS code forever---it would knock another $1.50 per share off from reported earnings.

Yet even that modest resulting growth rate of about 4% per annum since 2006 isn't all that. IBM also spent nearly $25 billion on "acquisitions" during the period---financing these deals with the kind of ultra-cheap blue chip corporate debt issues that has been on fire sale since the Fed lowered the boom on the treasury benchmark rate under QE. Consequently, IBM's acquisitions are inherently and prodigiously "accretive" to per share earnings not because they make any economic sense, but because its after-tax cost of debt capital is nearly zero.

It might wondered, however, why a globe spanning company with $100 billion in revenues, top-drawer facilities, limitless professional talent and a huge legacy of intellectual capital needs to shuffle around Wall Street making two-bit M&A deals on a continuous basis---that is, why it doesn't "build" rather than "buy".

But then just check out the "cookie jar" of accounting reserves it establishes on each deal completion along with its near zero-cost of debt capital. It becomes quickly evident that EPS "accretion" on an accounting basis may have virtually no relationship whatsoever to genuine corporate value creation--the ostensible point of the mindless M&As that preoccupy the C-suites of corporate America.

All of this is bad enough, but what lies beneath the accounting shenanigans detailed above is far worse. These debt-enabled buybacks are so cheap on an after-tax basis that the company can actually issue generous amounts of new shares in the form of stock options, and still shrink the share count. In fact, IBM's gross share repurchases amount to more than 40% of the outstandings since 2006---leaving plenty of head-room for new executive stock awards.

So even as its executives have gorged on stock option winnings from the buyback-based pumping of its reported EPS, its net share count has been cut by one-third. Not surprisingly, former CEO Sam Palmisano, for example, cashed out $110 million worth of stock options a few weeks after his retirement party. And also, not surprisingly, his successor management team has continued to bang the buyback lever----even as IBM's servile board continues to reward management for liquidating the company.

That is the real corruption resulting from financial repression. Corporate boards and executives are lining their pockets with stock option realizations which are taxed once over lightly as capital gains while costing the shareholders comparatively little. Even the traditional shareholder opposition to dilutive issuance of executive stock options has been defanged by the Fed's feckless money printing.

In short, financial repression is turning big companies like IBM into no-growth financial engineering machines that destroy price discovery and honest capital markets. In the process, these deformations turn financial markets into casinos and corporate executives into prevaricating gamblers. To be specific, most CEOs of the Fortune 500 are no longer running commercial businesses; they are in the stock-rigging game, harvesting a mother lode of stock option winnings as the go along.

Those munificently rising stock prices and options cash-outs owe much to the Fed's campaign to suppress interest rates and fuel stock market based "wealth effects". Yet as the case of IBM so vividly demonstrates, the CEOs are doing their part, too. They have become full-time financial engineers who use the Fed's flood of liquidity, cheap debt and soaring stock prices to perform a giant strip-mining operation on their own companies.  That is, through endless stock buybacks and M&A maneuvers they create the appearance of "growth" while actually liquidating the balance sheet equity and future asset base on which legitimate earnings growth depends.

At the end of the day, IBM has been a buy back machine that became a huge stock market winner by virtue of massaging, medicating and manipulating its EPS. But eliminate the accounting razzmatazz, M&A tricks and under-investment--- and IBM's true earnings might be fairly estimated at $8/adjusted share.

That means that even after today's hit, Big Blue is valued at nearly 21X. And that's for a company that has not grown in 8 years; which has had a weak-dollar tailwind inflating its earnings; and has now become personae non-grata in much of the BRIC world due to its service to the Spy State in Washington.

Still, IBM's whole financial engineering gig finally got monkey-hammered by reality. Its management is now confessing that its vaunted $20 per share 2015 target was not only an accounting illusion, but also a pipe dream in the real world of intense competition, flattening global markets, struggling sales and actual non-borrowed cash flow.

So now the era of real price discovery may begin as the prospect of eventual normalization of interest rates and Fed withdrawal from the Wall Street juicing game impends. Among much else, this prospective change in the monetary regime will mean a sharp curtailment of the stock buyback scam. IBM's Q3 earnings bust is surely an inflection point.


Below is an excerpt from "The Great Deformation: The Corruption Of Capitalism In America" where this baleful tale of corporate self-liquidation was first exposed (pp 563-565):


IBM’s huge share buyback program, by contrast, shows that financial engi- neering does not always produce such immediate untoward results. Yet it is nonetheless a dramatic illustration of how the Fed’s bubble finance régime enables companies to literally “buy” themselves a higher stock price, at least temporarily, by plowing massive amounts of cash into share repurchases, thereby creating the false impression of robust earnings growth.

Big Blue’s reported earnings thus surged 16 percent annually from $7 per share in 2007 to $13 in 2011, but those results were not apples to apples by any stretch of the imagination. The company’s stock buyback program re- duced its net share count by 22 percent, and profits on its massive overseas operations had been artificially boosted by a double-digit decline in the dollar. IBM’s reported results also reflected a 12 percent reduction in its tax rate and $16 billion of acquisitions, all highly accretive mainly because they were financed with ultra-cheap long-term debt.

In the absence of these one-timers and financial engineering maneu- vers, however, the picture was not so buoyant. Based on organic revenues, constant exchange rates, and no reduction in tax rates and share counts, earnings per share grew by about 5 percent annually, not 16 percent, over the past five years. It is far from evident, therefore, that IBM’s true mid- single-digit growth rate justified the doubling of its share price during the period.

Upon closer examination, in fact, IBM was not the born-again growth machine trumpeted by the mob of Wall Street momo traders. It was actu- ally a stock buyback contraption on steroids. During the five years ending in fiscal 2011, the company spent a staggering $67 billion repurchasing its own shares, a figure that was equal to 100 percent of its net income.

This massive and continuous stock-buying program brought approxi- mately 550 million, or 36 percent, of the company’s 1.5 billion of outstand- ing shares into its treasury, but needless to say, they did not all stay there. Nearly two-fifths of these shares reentered the float, mainly to refresh the management stock option kitty.

It goes without saying that in this instance the interests of stock traders and top management were aligned—perversely. The steady, deep shrink- age of the IBM float kept a bid under the stock and thereby delivered a “perfect” price chart, rising almost continuously from $100 to $200 per share over the past five years. It was a carry trader’s dream.

Likewise, top executives got big-time pay packages they may or may not have deserved, but in any event they were dispensed in envelopes marked “tax once over lightly.” Former CEO Sam Palmisano, for example, cashed out $110 million worth of stock options a few weeks after his retirement party.

This rinse-and-repeat shuffle of stock buybacks and options grants is undoubtedly a significant source of left-wing jeremiads about executive pay having gone to three hundred times the average worker’s compensa- tion when, once upon a time, allegedly, the ratio was more like 30 to 1. But the issue is not simply whether this kind of financial engineering has con- tributed to the sharp tilt of income flows to the top 1 percent in recent years. There can be little doubt, on the math alone, that it has.

The more crucial question, in this instance, is whether the massive CEW evident in IBM’s numbers is setting up another of the great iconic American companies for a fall sometime down the road, similar to Hewlett-Packard. The data on this score are not encouraging. Total shareholder distributions, including dividends, amounted to $82 billion, or 122 percent, of net income over this five-year period. Likewise, during the last five years IBM spent less on capital investment than its depreciation and amortization charges, and also shrank its constant dollar spending for research and development by nearly 2 percent annually. Neither of these trends is compatible with stay- ing on top in the fiercely competitive global technology industry.

Most especially, however, IBM’s earnings—like nearly all the big cap global companies—could not be flattered permanently by the Fed’s bubble finance. Already, the plunge of the euro has taken a toll on the company’s reported results, causing the artificial translation gains it booked on its huge European businesses during the weak dollar cycle through 2011 to now unwind. Indeed, with nearly two-thirds of its sales outside the United States, the company’s sales are now actually falling in dollar terms, and will likely continue to do so for the indefinite future.

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