Wednesday, February 05, 2014

IBM 39, Emerson Electric 2

Quick!  What’s wrong with this paragraph?
 Good day, ladies and gentlemen. Thank you for standing by. Welcome to Emerson's investor conference call…. This conference is being recorded today, February 4, 2014. Emerson's commentary and responses to your questions may contain forward-looking statements including the Company's outlook for the remainder of the year. Information on factors that could cause actual results to vary materially from those discussed today is available at Emerson's most recent annual report on Form 10-K as filed with the SEC. I would now like to turn the conference over to our host, Patrick Fitzgerald, Director of Investor Relations at Emerson. Go ahead. 
 If you said, “Golly, it doesn’t include the usual warnings about how the call ‘contains non-GAAP financial measures’,” then you win.
 Emerson, you see, doesn’t lead with non-GAAP financials the way some companies do—and by “some companies” we’re thinking especially about IBM, which uses non-GAAP financials the way a magician uses his sleeves.
 “We present GAAP numbers,” says Emerson’s famously frank CEO, David Farr.  “Which means we include all pension costs, all intangible amortization, and our performance share stock programs in the consolidated numbers.   We present GAAP numbers.”
 And Farr is true to his word: All the numbers Emerson’s team discusses on its calls are strictly GAAP—that is, they conform to generally accepted accounting principles. 
 In fact, in Emerson’s press release yesterday, the term “non-GAAP” appeared just twice, at the very end of the release with a table detailing a modest GAAP to non-GAAP reconciliation that would have boosted year over year earnings growth from 5% to 8% had the company chosen to use it.
 Emerson did not, however, choose to use it.
 IBM, on the other hand, has no such qualms.  
 The term “non-GAAP” appeared 39 times in IBM’s most recent quarterly earnings release, starting in the very first sentence.
 Such is IBM’s prowess at presenting the most favorable numbers possible that, as we have seen in our previous look at the number-massaging machine known as Big Blue, an 11% pre-tax income drop in the fourth quarter turned into an 11% after-tax gain, thanks to the magic of a near-non-existent 11.2% tax rate in this year’s quarter.
 Now, you may wonder how Warren Buffett, who routinely complains about the big-shots in America who pay a lower tax rate than his secretary, feels about that.
 We don’t.  After all, Buffett also complains about the big-shots who don’t pay big inheritance taxes on their wealth, yet Buffett will avoid the biggest inheritance tax bill in American history by giving away his shares in Berkshire Hathaway ahead of time, and rationalizes it thusly: he’s just following the rules.
 Surely IBM is just following the rules.
 But what rules, exactly, is IBM following?
 Fortunately, Bloomberg has the answer, here, in a story that broke yesterday around the time Emerson’s clean, all-GAAP earnings were hitting the tape.  
 Seems IBM routes “almost all sales in Europe, the Middle East, Africa, Asia and some of the Americas” through a Netherlands subsidiary, IBM International Group BV, which counted 205,000 employees at the end of 2012, “only 2% of whom actually work in the Netherlands.”
 The Dutch Connection, according to Bloomberg, helped IBM shave $1.8 billion of its expected tax provision in 2013—adding more than 10% to the $16.5 billion in net income IBM reported.
 And that, it appears, is how what might have been a 10% decline in net income for the full year became a modest, easily massaged 1% drop.
 Which is why, as we’ve seen, unlike Emerson Electric—which plays it straight down the middle—IBM prefers to focus Wall Street on its non-GAAP, AGWICTMTQGP (“Anything-Goes-When-It-Comes-To-Making-The-Quarter-Accounting-Principles”) number, where the weeds are deeper and the ball can be moved around without too many people noticing.
 The problem with non-GAAP, AGWICTMTQGP-based earnings reports, as we pointed out many times when Hewlett-Packard was popular with the beat-the-quarter crowd, is that it allows companies to include the good stuff from, say, acquisitions (revenues and gross profits) while excluding the bad stuff (intangibles and employee severance costs).
 And as HP found out this week when it years-too-late revised Autonomy’s 2010 revenues down by precisely 54%, the good stuff isn’t necessarily as good as it appears to be at the time.
 As for how all this bears on IBM’s set-in-stone $20 EPS “Roadmap” for 2015, we have no opinion except that IBM will make it.
 There may be 39 uses of the phrase “non-GAAP” in the press release announcing that $20 number, but they’ll make it.
 How can we be so confident?   Well, the recently-announced sale of the IBM server business to Lenovo for starters. 
 Lenovo is paying IBM a couple billion for a business that has a negative book value.   So IBM will have, we are told by Wall Street’s Finest, a gain of $1 billion for the non-GAAP, AGWICTMTQGP cookie jar.
 Even with the SEC investigating how IBM reports its “cloud” revenue (disclosed last year)—IBM juices up its “cloud” revenue by including hardware and IT services in the number—we would bet they make it.
 In fact, we put the odds at, oh, 39 to 2.

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

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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.


C. Fischer said...

"he is avoiding the biggest inheritance tax bill in American history by giving away his shares in Berkshire Hathaway"

He's giving them away to charity, he's not passing his wealth to his children like Sam Walton or maintaining an entire tax-dodging division like GE and (presumably) IBM do.

Anonymous said...

Invert, always invert. Isn't that what Munger talks about as an important lens through which to view problems?

Buffett lists IBM among his "Big 4" investments. Why? Because he buys all the non-GAAP earnings language from the company? I doubt it.

Since when do value investors spend time on GAAP earnings in doing their analysis? I thought the intelligent hedge fund guys used cash flow.

I don't know much about IBM but pulling up their free cash flow numbers tells me that it has ranged from $15-$18B in each of the past three years.

During those three years, they spent $40B on buying their own shares... for cash presumably. They paid $11.3B in dividends... in cash I would bet. Debt is up $5.6B, so it appears that they've generated a lot of cash and are using it in an interesting way.

There may be plenty of reasons to pass on IBM as an investment... but I suspect Buffett gets the giggles reading your reasons.

Jeff Matthews said...

C. Fischer is correct. Still, while Buffett's motive may be more pure, the end result is no taxes paid, which is something that sticks in his craw when it's the other guy avoiding the taxes. And p.s. the Walton heirs have done great things with their money for inner-city school education. Sam did good.

Anonymous, on the other hand, adds nothing to the discussion. He or she is focused on IBM as an investment, which neither of the IBM columns ever mentioned. We focused purely on the quality of earnings and the susceptibility of Wall Street analysts to manipulation by non-GAAP reporters, the biggest of which happens to be IBM, which happens to be one of Berkshire's biggest positions. We published this one to show what not to do if you want to engage in a dialogue here.


bjdubbs said...

Who's being fooled here? WS analysts? Unlikely. Here is what Herb Greenberg said about the latest call:

"On Tuesday's earnings call, after the seventh-straight quarter of negative earnings growth, analysts sounded as though they had had enough. They hammered the company on the quality of earnings -- including a tax rate that was less than half the company's normal tax rate. The tone, in general, was dubious on how IBM could hit the $20 target through real growth. It was a terrible call."

So nobody's being fooled, unless IBM management is fooling themselves, in which case they get what they deserve.

Unknown said...

Anon - and how fast is cash flow declining? Pretty fast!

Jeff Matthews said...

Thanks, sounds good, send me an email at and I'll send you details.

Anonymous said...


are you aware segments of this article have been copied in a valuewalk article and attributed to Whitney Tilson?
Check here:

Brazen plagiarism.