Tuesday, January 21, 2014

IBM: "I’ve Been Manipulated"?


 IBM, to IBMers, always stood for “I’ve Been Moved,” a reference to the way Big Blue moved employees around the country and around the globe to get experience as they worked their way up the ranks.
 To Wall Street, however, IBM could stand for “I’ve Been Manipulated,” because no public company we can think of does a better job of schmoozing Wall Street’s Finest and convincing them that there’s a there there, when in fact the there is not quite as there as it might seem.
 The quarterly earnings calls are curiously synthetic, almost antiseptic affairs, run by the CFO and focused strictly on the numbers: on the revenue number, on the cash flow number, on the share buyback number, and on the earnings number.  
 In particular, the per share earnings number.
 The CEO never graces the call, and no actual business operators discuss their business.  No success stories are told, no customers highlighted.  It is all about margins and currencies and so-called one-time charges and so-called one-time gains, and tax rates, and how all those things added up to the earnings per share that quarter.
 And, most especially, what that earnings per share means for The EPS Roadmap.
 But let’s back up a bit…
 In May 2007 IBM held an analyst meeting to introduce a “2010 Earnings Per Share Roadmap,” to “give our shareholders a clear understanding of the key factors driving IBM’s long-term financial objectives.”
 Those objectives were EPS growth of 14-16% and EPS of $10-$11 by 2010.
 To get there the company spelled out five “Key Drivers” of the Roadmap: revenue growth, margin expansion, share repurchases, acquisitions and retirement-related savings.
 And certainly IBM got there: in the 2010 annual report, IBM could proudly state that EPS had come in at $11.52—above the high end of the “Roadmap” range.
 And Wall Street loves companies that beat the high end of anything.
 Now, it is true that the “revenue growth” piece of the Roadmap didn’t play out as perhaps many had expected: 2010 revenues were only 1% above 2007, the year the Roadmap was laid out. 
 But the margin expansion and cost savings played out in spades: from that $1 billion in extra annual revenue sprang added gross profits, added operating profits, and added net income of $ 4 billion each, give or take (mostly give).  
 Meanwhile, ample share repurchases acted like gasoline on the fire, juicing EPS almost 60% on that tiny 1% revenue gain.
 So well did the 2010 “Roadmap” go over with shareholders and Wall Street alike, that IBM rolled out another: the 2015 Roadmap, comprising, in this order, “$8 billion of productivity improvement” (e.g. layoffs and reorgs); $50 billion in share repurchases and $20 billion in dividends; and “four growth priorities” that included emerging markets hitting 30% of revenue in 2015, business analytics (e.g. Watson, the Jeopardy champ) hitting $16 billion of revenue in 2015, cloud computing hitting $7 billion of revenue in 2015, and what IBM calls “building a smarter planet”—what everyone else calls “the internet of everything”—hitting $10 billion of revenue in 2015.
 The bottom line of all this?  $20 in earnings per share by 2015.
 But that target came with an asterisk, literally:
 The asterisk mentioned that the $20 target was a so-called “non-GAAP” EPS target, which “excludes acquisition-related and non-operating retirement-related charges.” 
 As we pointed out many times in these virtual pages during the many occasions we poked fun at Hewlett-Packard before that company, as a friend likes to say, hit the trees with no flaps down, “non-GAAP” means earnings not prepared in accordance with generally accepted accounting principles.  
 IBM’s 2010 “Roadmap” had come with no such asterisk.
 Nevertheless, IBM’s recently retired CFO, a key driver behind both “Roadmaps,” always said the $20 EPS target was “all-in,” i.e. while it included gains on sales of things, it also included losses on charges of things.
 Fortunately—and quite remarkably, the casual observer might think—those gains and charges on things at times almost exactly offset each other.
 In the first quarter of 2009, the company had a $265 million “workforce rebalancing charge” offset by a $298 million gain on an asset sale.
 And in the first quarter of 2010, another “workforce rebalancing charge”—this time $560 million—was paired with another one-time gain of $591 million.
 Neat, right?
 So adept has IBM been at matching the cost of downsizing its operations with gains on sales of bits of those operations that it was apparently hoping to generate a big enough gain from the sale of its server business to offset the $1 billion “workforce rebalancing charge” it took in 2013 (these charges are one of the bigger growth items in IBM’s P&L)—but Lenovo appeared to play hardball and the sale didn’t happen in 2013.  Meanwhile, a different, smaller sale (at a reported measly 5-times EBITA), of a service business to Synnex, didn’t close in time to help the 2013 EPS.
 Nevertheless, IBM today proudly announced that it had “delivered” fourth quarter EPS of $6.13 a share, “up 14% year-to-year” to bring the full 2013 EPS to $16.28, magically in line with Wall Street’s Finest, and right down the middle of the all-important Roadmap.
 How it got there, though, was way more complicated.
 After all, revenue dropped 5% (down 3% adjusted for currency).  Asia-Pacific revenue was down 6%.  China revenue was down 23%.  Pretax income dropped 8%.  Pretax margins were likewise down.  Free cash flow was down 13% in the quarter and 21% for the year.
 Yes, you read that correctly: free cash flow was down 21% for the year.
 Oh, and the company guided first quarter 2014 EPS to something around $2.50 a share versus Wall Street expectations of $3.27 a share—a 24% miss.
 How, then, did IBM show “up 14% year-to-year” profits in Q4 2013?  
 And how did the new IBM CFO manage to re-affirm the all-important, almighty $20 EPS Roadmap?
 Well, with a mere 11.2% tax rate, all targets are possible, profitability-wise. 
 “But wait a minute, the reasonably informed observer might ask. “What is really going on here?   Economies are recovering around the world.   Europe had a near-death experience two years ago and is healing.  China is growing nearly 8%, not shrinking 23%.  American industry is recovering broadly.  Our banks are healthier than they have been in a decade.  State budgets have revived and governments are spending again. 
 “So why the punk revenues at one of the largest, most important purveyors of IT equipment, software and services in that very same world? 
 “And why are 'workforce rebalancing charges' growing from $440 million in 2011 to $803 million in 2012 to $1 billion in 2013, even as US unemployment drops and companies from Google to Amazon to eBay to Apple to Facebook to Salesforce can’t hire engineers fast enough?
 Well, IBM blames hardware, but IBM’s software revenues were only up “3% to 4%,” and that includes acquisitions: the “all-in” approach taken by the CFO means that, unlike most companies playing the non-GAAP game, IBM does not provide organic, non-acquisition-inflated revenues.  That is 3-4% growth, inflated by acquisitions, in a world where Salesforce.com is growing 35% a year organically, and Amazon Web Services is growing…don’t ask.   
 Meanwhile, the rest of IBM’s business, a mix of consulting and outsourcing, has been fair-to-middling-to-poor.
 The reality, we think—never stated on an IBM call, because the discussion never veers from the numbers, but fairly obvious all the same it would seem—is that much of IBM’s business is tied to the “higher value, more profitable technologies,” touted in the IBM annual report as the areas towards which the company has been shifting its business mix over the years (think: helping a company install expensive SAP software on big-iron IBM hardware with white-shoe IBM consultants running the show, all financed by IBM) while shedding the stuff Wall Street did not care for (even its baby, the disk drive business, which IBM invented).
 And that kind of high cost IT infrastructure business is yesterday’s glory.  (Just ask Avon Products, which we will get to in a bit.)
 Of course, if you are an IBM shareholder, it has been a great ride.   After all, pretty much everything the company has been doing, like the song says, it has been doing for you.
 Here, for example, is how last year’s letter to IBM shareholders began:
  Notice there is not one mention—not one—of the company’s customers in that first paragraph.
 You think those customers don’t notice? 
 After reading year after year about how many billions of dollars of IBM stock were purchased by IBM using the hard-earned dollars of those customers ($14 billion in 2013, and $140 billion since 2000), you think that those customers, who weren’t thanked by IBM in that letter or on its earnings calls, don’t wonder how Amazon—purveyor of the very kind of cloud offering that is allowing companies young and old to get online without all that expensive, high margin stuff IBM pushes—speaks to its shareholders?
 Well here’s how Amazon speaks to its shareholders:
 By our count, Amazon uses the term “customer” twice in the first paragraph and six times in the first two paragraphs.  
 And instead of talking about raising gross margins, operating margins and net income margins, as IBM does in its annual report, Amazon talks about lowering prices to those customers.
 No wonder just last month Avon Products jettisoned a $100 million-plus ERP implementation that “did not show a clear return on investment.”  For the record, SAP was the ERP system, with IBM WebSphere being used to build the “user interface,” such as it was.
 And that’s exactly the kind of big budget project IBM’s wheelhouse has been crafted for. 
 And those are exactly the kind of projects that are giving way to the brave new world of Web 2.0.
 Perhaps that’s also the reason why every quarter in the last couple years IBM’s revenues seem to be down, or shy of forecasts, or both; and why every quarter last year IBM’s free cash flow was down year-over-year; and why last October the company revised its cumulative “Roadmap” cash flow downward from $100 billion to $85 billion; and why the company seems to be trying to jettison any kind of non-sexy business that makes something that plugs into a wall.
 Of course, just as there are dangers in analysts leaning too much on management for direction, there are dangers in managements leaning too much on analysts for direction—like when IBM listened to everyone telling them to get rid of that dopey old disk drive business.
 After all, that dopey old disk drive business is now a hot, hot, hot “cloud” business...the very kind of business IBM wants to brag about on its earnings call.
 But not to worry, the $20 EPS Roadmap still stands...with an asterisk, of course. 
 Makes you wonder who’s being manipulated here.


Jeff Matthews
Author “Secrets in Plain Sight: Business and Investing Secrets of Warren Buffett”
(eBooks on Investing, 2013)    $4.99 Kindle Version at Amazon.com

© 2014 NotMakingThisUp, LLC              
The content contained in this blog represents only the opinions of Mr. Matthews.   Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations.  This commentary in no way constitutes investment advice, and should never be relied on in making an investment decision, ever.  Also, this blog is not a solicitation of business by Mr. Matthews: all inquiries will be ignored.  And if you think Mr. Matthews is kidding about that, he is not.  The content herein is intended solely for the entertainment of the reader, and the author.

18 comments:

Ben said...

Good post. I've talked to technology distributors and customers who talk about various IBM acquired software businesses that "disappear" after IBM has acquired them. So would be curious what you think of Berkshire's purchase of IBM given your view on IBM and knowledge of Buffett. Why would he choose IBM when he admits to not knowing tech - I've read he thinks it is "sticky" but not sure if he really knows what he owns. Seems to go against everything he has said about technology businesses throughout the years.

scm0330 said...

Outstanding! Wish you'd post more often!

Tony said...

"in a world where Salesforce.com is growing 35% a year organically"

By organically do you mean "after spending over $2 billion in cash and issuing tens of millions of shares to acquire a litany of companies over the last three years"?

Anonymous said...

Last time I checked Return on Capital has been increasing at IBM. The company is brilliant at capital allocation. But if you prefer amazing revenue growth and cash flow from operations floated by stock options then yeah Sales Force is a great company in that regards.

Jeff Matthews said...

All reasonably successful leveraged buyouts have great returns on capital. And sure, adjust Salesforce's sales growth and IBM's sales growth for acquisitions and see who's taking share from whom...



Anonymous said...

Never came across your blog until this IBM article. You are the P.G. Wodehouse of business writing (BTW, I can't think of a higher compliment).

Curiously enough, your description of IBM made me think of Mitt Romney. Nice guy, well-meaning (well, up to a point), very successful, Blue chip, as it were..

But also: smug,condescending, full of himself, deceptive and out of touch with the world around him.

XOXO

Anonymous said...

Buffett´s rationale for IBM is that it´s a statistically cheap stock that has been able to grow over a large number of years. He doesnt understand IBM´s business as he clearly showed when he answered a question about it during last year´s BRK shareholders meeting.

Buffett is not the old nice fellow who just likes to buy beautiful business run by capable people. He likes that but he doesnt mind making money in other ways.

Jeff Matthews said...

In fact Buffett bought IBM after 50 years of reading its 10K and 10Qs plus bonding with Bill Gates over it in their first meeting--Buffett knew the financials and Gates knew the business issues--not merely "because it was statistically cheap" (it wasn't, really), but because: a) it generated a lot of cash, year after year, and b) when he discussed the company with his own CEOs they told him 'once you have IBM in your operations you can't get rid of it' (which is the same reason he bought AMEX, twice).

Nevertheless, 'Anonymous' is correct, Buffett really muffed the IBM question--he was asked what their moat was, and he didn't have a real answer. Buffett also told the story of how an ad friend told him they couldn't do without AMEX, prompting him to buy it back after selling it after making a killing during the 'salad oil scandal'--but Buffett did not tell the AMEX story to explain buying IBM, he just used it as an example of how he researches his investments.)

Unfortunately, Buffett bought IBM just as the world was figuring out how to get rid of IBM, causing those nice cash flows to start to shrink.

JM

Anonymous said...

What was the disk drive business to which you referred? Where or what is it now? Hitachi?

Anonymous said...

Jeff ,good article,

I was under the impression Buffett actually interviewed his CIO's about IBM's moat or stickiness and their answers were critical to his investment thesis. Unfortunately the BRK businesses are not particularly progressive users of technology giving WEB a slightly tilted view of the quality of the investment.

A few more notes:

1. IMHO IBM's growth initiatives are thin. I would not bet on Watson even with the massive spending.

2. Its actually possible IBM's spending on R&D and acquisitions is not enough to remain competitive.

3. Key elements of IBM's solution portfolio are becoming commoditized quicker than IBM can adjust.

4. The dollar strengthening is problematic.

5. Senior management not as dynamic as past leaders.

6. Brilliant financial architect --- retired early ...

Jeff Matthews said...

IBM sold the disk drive business to Hitachi years ago. And yes, Buffett did talk to his CEOs about IBM, as I related in response to another comment. Good point about the CFO retiring: his timing was superb!

JM

Anonymous said...

Jeff,

Did you at all consider that IBM might mention its shareholders in a letter addressed to the shareholders? Did you also consider that Amazon is addressing its customers because it can't really talk about profits and since it has no profits it can't talk about buybacks?

Jeff Matthews said...

It's not that IBM "mentions its shareholders" in its shareholder letter...it's that it doesn't mention its customers up front--that's not the culture.

But your point is amusing

JM

skip said...

I think you have picked up on something very essential about IBM and it's culture. I worked in IT for 30 years and dealt with them amongst others. Briefly, they have no joy or passion about what they do. It's numbers and a dull kind of professionalism. They won't make it.

John said...

Great post.

I find it hard to believe Buffett made such a mistake. Even he didn't understand the business and had the wrong assessment of the management, one thing he shouldn't have missed is financial engineering.

Jeff, what do you think?

Anonymous said...

Jeff warren buffett always believes in Long term holding. According to the facts which you stated, it seems IBM is not a good stock to buy for long term holding. So any idea why buffett invested in IBM?

Jeff Matthews said...

See my comment from 1/23. He knew the financials cold (had been reading them for 50 years); he was impressed with the cash flow, the capital allocation and the steady management focus; and CEOs of his own companies told him you couldn't get rid of IBM...all of which he loves in a business. However, things change.
JM

Anonymous said...

Hello Jeff, How did you relate the driver business with cloud computing. Are you saying that by selling the drive business, Hitachi has now IP related to cloud. Or are you saying that disk business is related to storage and so is cloud?

Only question in an very well analyzed write-up.