Thursday, October 17, 2013

IBM's 3rd Quarter Report: Issues Outweigh the Financial Engineering

Reading up on IBM's recent history, I was genuinely surprised to see the lack of significant revenue growth since 2008; I know we've had a tech cycle on top of a recession,but still this is Big Blue.  This company likes financial engineering, befitting a company founded by engineers.  According to Forbes, Warren Buffett owns about 6% of IBM, comprising about 19% of the Berkshire equity portfolio.

Mr. Buffett likes company management, its levered return on equity, and the large return of cash to shareholders through buybacks and dividends. The relatively flattish share price alongside the continuing buybacks allows Berkshire to wind up owning a proportionately larger share of the company over time. In many ways, this is the dream profile for the ultimate value investor.

Going into the call, it struck me that HP, Microsoft, IBM and Cisco, despite the varied regard in which the companies and management are held by investors,  all share the same problems.  They have all built very large, profitable businesses selling hardware, associated middleware, application software, consulting and enterprise management services to large corporate customers.  Now, everyone agrees that what buyers purchase and how they pay for it, will be rapidly changing.  So, the common challenge is to turn these aircraft carriers around on the high seas.  As their legacy businesses decline, they have to manage a transition to an environment that won't require or favor aircraft carrier organizations in the future.  They're all in the same boat, which I guess I didn't realize.

The third quarter 2013 conference call was led by a very fast talking, matter-of-fact CFO who dutifully read the results, which he characterized as representing solid accomplishments.  There were some, but overall this quarterly report, taken in the context of no revenue growth from 2008-2012, should have been a major disappointment to management.  The financial engineering that permeated the GAAP results, on top of of significant non-GAAP adjustments, made for a very low "quality of earnings."

Consolidated revenues of $23.7 billion in the third quarter, declined 2 percent yr/yr on a constant currency ("c.c.") basis.  59% of revenues came from Global Technology Services ($9.5 bn) and Global Business Services ($4.6 bn).  These businesses were the bright spots in the quarter, which we'll see later.  The Systems and Technology group revenues of $3.2 bn declined 16 percent yr/yr, in c.c. More on this later too.

GAAP gross profit was $11, 380 million, but with $102 million in adjustments for acquisitions and $154 million in adjustments for pension plan investment assumptions, transition expenses, and plan terminations, non-GAAP adjusted operating gross profit was $11, 636 million, or a very healthy gross margin rate of 49.1 percent. The rate increased one hundred basis points, yr/yr, due to margin expansion in the services businesses (against easy comparisons) and to a better mix of software sales, due a 2 percent c.c. increase in software and to the double digit decline in hardware sales.

GAAP total operating expenses were $6,567 million in the quarter, but after adjusting for acquisitions and pension expenses, they were reduced to $6,352 million, on a non-GAAP basis.  GAAP pre-tax income of $4,812 million, after acquisition adjustments of $214 million and pension expense adjustments of $257 million, translated to $5,284 million of non-GAAP, pre-tax income.

The GAAP tax rate for the quarter was a financially engineered 16 percent, down 860 basis points over the prior year quarter.  Wow!

Diluted EPS for the third quarter of 2013 were $3.68, on a GAAP basis, compared to $3.33 in the prior-year quarter, on the same basis, an increase of 10.5 percent.  This was characterized as a solid performance, but it was really financial engineering.

The company's supplementary slides had a good reconciliation bridge from last year's third quarter diluted EPS to the 2013 year level: $3.33  was reduced by ($0.14) due to the lack of revenue growth, while margin expansion in the services businesses contributed $0.33 per share yr/yr.  The effect of share repurchases in the quarter added $0.16 per share on a yr/yr basis.  All this yields the current year's $3.68 per share. Note that the tax rate effect wasn't explicitly called out.

54 percent of the yr/yr improvement came from the margin expansion and 5% sales expansion in Global Business Services, while 46% of the yr/yr improvement came from the effect of share repurchases.  One could characterize this as a 'balanced scorecard' between operations and financial balance sheet management, but given the history of recent years and quarters, I don't think this is justified.

Anticipating the forthcoming questions about execution, the CFO mentioned the culture of performance and accountability in IBM; he noted that quarterly incentive payments declined by $177 million (if I heard this right) year-over-year to affirm the comment.  Of course, it's not clear what this means: quarterly bonuses or reduced sales force commissions which would automatically follow from lower sales, or both.  He didn't put the comment out clearly or with much conviction.

Regionally, sales in the Americas were $10.3 billion, flat on a c.c. yr/yr.  So, Big Blue or no, the IT spending cycle is stuck in neutral for all the players.  EMEA sales of $7.3 billion were down 2 percent in c.c.  Asia-Pacific sales of $5.5 billion declined 4 percent on a c.c. basis.  Together these regions account for 97% of consolidated revenue.  The BRICs amount for the remaining 3 percent. so for all the commercials about a globally smarter planet, virtually all of IBM's sales really occur in traditional markets, not a bad thing but different from the commercials.

The good questions from analysts centered on the same issues that we noted at the beginning of this post. If I can paraphrase Toni Sacconaghi of Sanford Bernstein, he said something like the following. " I want to step back a bit from the current quarter. IBM has reported negative revenue growth for the past six or seven quarters.  Without the tax rate benefit in the current quarter, this quarter would have been considered a 'miss.' What has changed at IBM, and should we think about IBM in a different way going forward?  Is this a company that reports no growth on the topline and reports less than double digit earnings growth on the bottom line?"  Questions from Goldman Sachs, Stiefel Nicholas, and Barclays were basically around the same point, namely "What does the company model look like in the future? "

For the much heralded "Road Map," the question was how to get from here, about $16 in EPS to $20 in two years.

The CFO's responses, sad to say, generally evaded the core question.  I think that he himself was thinking aloud through the questions, which is amazing, since they are the critical issues that he must have briefed about beforehand.

There was a reflection about IBM's China business that was said to be about 5 percent of IBM's revenue, which is a bit inconsistent with the geographic presentation of sales, but it could be rounding. Of this, forty percent was in hardware which declined precipitously due to the country's slowing of outside procurement as it develops a new five year plan, slated for completion in November 2013.  The CFO opined that once the new plan was published, business should return to normal in the first quarter of 2014.  Talk about rose colored glasses!  Chinese global enterprises like Lenovo, Huawei and others are integral parts of the economic plan since, in some cases the government itself is a large stakeholder.  Their designs, like IBM's are global, and to think that a US company will be able to continue with business as usual under a different Chinese economic worldview may be ill conceived.

An analyst noted that achieving the Road Map's $20 EPS would require 12 percent yr/yr earnings growth in 2014 and 2015.  What is required for this kind of acceleration?  The CFO said that Systems and Technology would have to stabilize its level of profitability compared to 2013.  To achieve this minimalist goal, he said, that the STG would have to successfully introduce new products that are planned for launch. Services should minimally require low single digit growth, although it wasn't clear what these businesses would look like ex-planned divestitures. The cloud businesses, just like HP, will have to grow at double digit rates, but not all of this will be incremental, but it should be more profitable. If I were building a model with what little I know, I would have to do a lot of hand waving to get my desired end product of $20 in earnings.

Somewhere in the end of the question period, the CFO's position changed and he said that the quarter had been challenging or disappointing, I don't recall his exact language.  Finally, this was an honest reaction. Judging from the stock trading down six percent right after the call, others agreed.

With a consolidated debt/capitalization of 64 percent, and a non-financial debt/capitalization of 39%, IBM has a strong balance sheet.  It did not make an egregiously bad large acquisition like HP did with Autonomy. It should be able to plug in several smaller, tuck-in acquisitions to help its cloud efforts.  The four horsemen will be trampling each other in the field to overpay for innovative, niche companies.  Given their lackluster revenue growth and their changing markets, they probably have little choice.

The question of "execution" is referred to often in HP CEO Meg Whitman's remarks.  Clearly, this has been a sore point too for IBM, but their stock of goodwill with the Street has insulated them from more strident choruses.  Their multiple, highly compensated sales forces and distribution channels probably need to be rationalized too over time.  Unfortunately for shareholder most of this will be under the covers.  If the customer is changing, and their budgets and desired ways of using technology are changing, then it follows that corporate go-to-market organizations will have to change with them.

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