IBM and the financial engineering economy: James Saft

October 21, 2014

Oct 21 (Reuters) – IBM’s woes are interesting not simply
because they tell us about the economy, but because they reveal
broader truths about how, and for whom, companies are run.

IBM kicked its 2015 operating earnings goal off the
back of the truck on Monday, blaming an outright fall in
third-quarter revenues on a sudden downturn in client spending.

“We saw a marked slowdown in September in client buying
behavior, and our results also point to the unprecedented pace
of change in our industry, ” said Ginni Rometty, IBM chairman,
president and chief executive officer.

IBM shares fell more than 7 percent in reaction, giving up
more than three years of gains.

In all likelihood, IBM isn’t just a company which ran into
an inflection point in the broader economy, nor is it simply an
unlucky victim of the step change in the pace of technological
innovation.

It is a company which did this after five to 10 years of
following one of the most popular corporate strategies out
there: prioritizing financial engineering over investment, and
giving primacy to living quarter by quarter rather than for the
longer term.

The result, and IBM is far from being alone here, is a
company left with a hollowed-out core franchise which has been
deprived of investment, combined with higher debt loads.

From 2000 to 2013, IBM pursued an epic campaign of buying
back shares, flattering earnings but perhaps at the expense of
investment in the future, something which, as a technology
company, is promised to no one. During that period IBM spent
more than $108 billion on share buybacks and an additional $30
billion on dividends. That compares to just $59 billion on
capital expenditure. That produced a doubling of pre-tax margin
during the period, but arguably at a cost to the value of the
core franchise, which looks less and less defensible.

Indeed, in the last six years, the company’s debt load has
about tripled but sales are essentially flat.

In July, hedge fund manager Stanley Druckenmiller drew a
line between that strategy and Federal Reserve policy, which he
said encourages companies to stint on productivity improvement
and investment in the real economy and instead use cheap money
to borrow and buy back shares.

Buying back shares improves profitability per share, a
strategy which tends to work so long as investors believe it is
not done at the expense of the company’s ability to remain
competitive.

CAN’T STEP IN SAME RIVER TWICE

IBM may simply be the unlucky victim of market forces as
technology evolves, but it is hard to look around the U.S.
economy, which has had a combination of very high profit margins
and very low capital investment, and wonder if many publicly
traded companies are in similarly vulnerable positions.

“In our view, IBM is not different from companies like
Cisco, Microsoft, Oracle and Intel,” Geneva-based Lombard Odier
fund manager Eurof Uppington said via email.

“They all face the same sort of pressures from new trends
like cloud, mobility and superscale Internet and are all
reacting in the same way using financial engineering. IBM is
probably just early.”

Lombard Odier has been critical of what it calls the GOSOBB
strategy, as in Giving Out Stock Options and Buying them Back.
While, under accounting rules, this flatters operating earnings,
it masks how much money is actually going home in employees’
pockets as compared to if share options were cash payments.

Had IBM wanted to offset the dilution caused by employee
share options in the five years to mid-year, it would have
needed almost $18 billion in share buybacks, or about a third of
all buybacks made during the period. IBM are far from unique,
much less unusual, in the scope of those figures.

The broader unanswered question here is how best to manage a
technology company, or indeed an economy, during a period of
very rapid technological change. The market tends to assume that
company revenues are far stickier, far more permanent than they
actually are. That assumption grew out of 100 or more years of
analyzing and investing in industrial companies which, while
buffeted by war, globalization and technological change, had the
luxury of operating in a more slowly changing world.

That assumption, that tendency of financial markets to focus
on the per-share earnings figure without giving due care to all
of the many forces which make those revenues possible, may leave
investors today very vulnerable.

A decade of share buybacks and underinvestment is starting
to look like it may have been a mistake.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be
an owner indirectly as an investor in a fund. You can email him
at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

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