IBM’s dismal result last night reminded me of some comments I heard from Jim Chanos last month about value stocks in the tech space, in this Bloomberg interview:
As opposed to, some of these companies, who basically…acquire a lot of companies, they are capitalizing their R&D…
(Cory Johnson – if they’re doing a lot of their own R&D, it’s hurting their operating margins…the accounting rules give them the benefit…and the knuckleheads, who don’t consider acquisitions as part of free cash flow, think the free cash flow still looks good)
Chanos again – Exactly, and thus, Dell, or Hewlett-Packard, or IBM, as you mentioned, if you look at acquisitions as capitalized R&D, suddenly a lot of these companies look a lot more expensive than they do on the surface.
A simple illustration of the problems at IBM is as follows:
| Sales ($BLN) | EPS | |
| 2007 | 98.8 | 7.14 |
| 2008 | 103.6 | 8.93 |
| 2009 | 95.8 | 10.01 |
| 2010 | 99.9 | 11.52 |
| 2011 | 106.9 | 13.44 |
| 2012 | 104.5 | 15.25 |
| 2013 | 101.3 | 16.77 |
Sales have grown 2.5% from 2007 to 2013, while adjusted EPS has more than doubled! Chanos’ point is that the EPS is distorted with many accounting gimmicks, numerous acquisitions being one of them. A significantly lower tax rate (16% in Q3 2013, vs. 24.6% in Q3 2012) and continued stock buybacks are two other levers that have featured prominently to boost earnings per share at Big Blue.
Looking at this quarter, revenues missed estimates about 4%, while EPS beat again. It’s much harder for management to massage revenues than earnings, so management pulls the necessary levers to meet or beat that EPS estimate. But the stock’s reaction this quarter shows an investor community that has run out of patience.
IBM experienced particular difficulties in the BRIC countries, where revenues were down 15%, 12% adjusting for currency, led by China down more than 20%. What I found notable on the conference call was that IBM management tried to strike an optimistic tone by highlighting its EPS and free cash flow targets – precisely the metrics that are easier to influence than revenues. In short, I expect many more acquisitions in the next year from IBM, as it furiously tries to meet subjective accounting targets, even as its overall business shrinks.