Can IBM Keep Earnings Hot?
As IBM (IBM ) Chairman Louis V. Gerstner Jr. prepares to retire at yearend, he can claim credit for one of the most dramatic corporate rescue missions in history. In 1993, the former RJR Nabisco Inc. chief parachuted into the troubled computer giant, slashed through a jungle of bureaucracy, and transformed Big Blue from an aging hardware maker into a tech-services juggernaut. The most impressive result: IBM's market capitalization increased from $30 billion in 1993 to $173 billion as its share price soared sevenfold, to $101.
Still, Gerstner can't escape nagging concerns that he managed this feat in part by bolstering earnings through creative financial steps. Critics say he has pushed and pulled a variety of levers--including gains from an overfunded pension plan, income from one-time asset sales, and $44 billion in share repurchases--to squeeze double-digit growth in earnings per share while eking out an annual average of just 5% revenue growth. "It's amazing what Gerstner has done," says analyst Robert Tracy of Apogee Research Inc. "Out of this turnip comes a gallon of blood."
Now, the levers are starting to jam. A financial analysis by BusinessWeek shows that earnings not from operations last year accounted for some $2.3 billion, or more than 20%, of IBM's $10.9 billion in pretax income. This year, IBM faces lower pension-fund returns, the potential for larger write-offs for bad debts, and fewer share buybacks. That means nonoperational financial methods are likely to contribute no more than 10%, or $1.1 billion, to an estimated $11.8 billion in pretax income.
The weakening of its earnings crutches carries enormous implications for IBM. Over the long run, reducing its reliance on such methods could boost the quality of its earnings. But in the short term, it will be harder for new Chief Executive Samuel J. Palmisano, who took over from Gerstner on Mar. 1., to meet the company's goal of low double-digit annual earnings growth, says Steve Milunovich, an analyst at Merrill Lynch & Co. And heightened awareness of IBM's accounting may put downward pressure on its stock as skittish investors question prospects for income that doesn't come from operations. On Mar. 11, Sanford C. Bernstein & Co. analyst Toni Sacconaghi downgraded IBM from "outperform" to "market perform," based on accounting concerns, weakness in its services, and a share price that is "not inexpensive relative to recent history."
That means Palmisano must rev up the IBM growth engine--sans fancy financial footwork. The whole machine needs a tune-up. Last year, IBM's revenue declined 2.9%, while net income shrank 4.6%. This year, most analysts expect a 3.2% rise in sales, to $88.6 billion, and 9.6% profit growth, to $8.4 billion. Some, however, are more cautious. On Apr. 2, Laura Conigliaro of Goldman, Sachs & Co. cut her estimate of IBM's 2002 sales by $4.8 billion, to $84.6 billion, and lowered her earnings growth forecast from 9% to 7%, based on weak tech spending. To hit its goals without financial maneuvering, IBM is depending on growth in its key software and services businesses. "If we keep taking share, when there's an uptick in spending, it's a pretty safe assumption we're going to continue to do well," Palmisano says.
It's either that or cut costs--something the company is already doing. On Jan. 8, IBM announced it would outsource manufacturing of its desktop computers to Sanmina-SCI Corp. to pare the $153 million loss suffered by its personal computer division last year. IBM could trim PC costs further by outsourcing laptop manufacturing, says Gartner Dataquest analyst Martin Reynolds. Others say Palmisano should dump IBM's hard-drive operation, a shrinking commodity business that does not fit its strategy of being a services leader. Despite frequent attempts to correct problems in the $4 billion division, last year it lost some $246 million, says analyst David Reinsel of IDC. "They can probably buy drives more cheaply out of house," he says.
Under pressure from shareholders, Big Blue is tweaking some of its financial tactics. On Mar. 11, IBM released its annual 10-K financial statement, breaking out new details. That comes in response to criticism that IBM didn't adequately disclose income from intellectual-property and asset sales. The latest controversy began in December when IBM didn't reveal a $290 million gain from the sale of its optical-transceiver business to JDS Uniphase Corp., which helped the company meet its 2001 profit targets. Controversy flared again on Mar. 28 when The Wall Street Journal obtained documents showing that the Securities & Exchange Commission asked IBM to amend its financial statements in 1999 and 2000. The issue: concerns about inadequate financial disclosure on IBM's tax rate, pension fund, and other items.
Back then, IBM refused to make the changes. After the debacle at Enron Corp., though, it cried uncle: Big Blue has agreed to show intellectual property sales on a separate line in its income statements. Although IBM's disclosure practices weren't illegal, and the SEC didn't bring charges, the company reworked its financial statements for the past three years to reflect the changes. "Disclosing more will help investors understand the strength of our company better," says IBM's Chief Financial Officer John R. Joyce.
That still doesn't earn IBM a clean bill of financial health. Analysts and accounting experts want IBM to disclose more data about intellectual-property sales. IBM maintains that gains from the sale of such property should be treated as a part of operations. But critics say many of those gains are nonrecurring. This year, Bernstein estimates that one-time sales of intellectual property will be $500 million, or 4.2% of IBM's pretax income, down from 8.3% last year. Despite the criticism, Joyce defends IBM's accounting and disclosure as "among the best in this or any other industry."
The most powerful tool in IBM's financial kit--its pension plan--is starting to rust. If a company's pension-fund assets are estimated to be earning more than its expenses, accounting rules require that it add the difference to income. Problem is, IBM has assumed an aggressive 10% annual rate of return for its pension plan, which contributed $904 million, or 8.3%, to 2001 pretax income. In fact, the value of IBM's pension assets fell nearly 6% last year. In 2002, IBM cut the expected rate of return to 9.5%, which IBM estimates will reduce pension income by $350 million. But that may still be too high: Rivals Compaq Computer Corp. (CPQ ) and Hewlett-Packard Co. (HWP ) use a 9% rate, according to Banc of America Securities.
Next on the list of worries is IBM's accounting for bad debt. IBM's financing unit generates 4% of the company's revenues and 10% of its profits. Some accounting experts say IBM boosts its earnings with rosy assumptions for its $37 billion credit portfolio. What rankles financial sleuths is IBM's "allowance for doubtful debt accounts," or the amount it expects to get stiffed by customers. As the economy soured last year, IBM boosted its reserves to 2.75% of loans and unpaid bills, up from 2.15% in 2000. Some analysts fret that reserves may still be too low. In 2001, HP increased its equivalent ratio from 2.12% to 6.56% as more loans went bad, says analyst Jeff Middleswart of Behind the Numbers, a financial research service. A more realistic ratio for IBM, Middleswart says, would be 4%--which would have trimmed Big Blue's pretax income by $490 million, or 4.1%, last year. CFO Joyce says the company has adequate reserves. "We remain comfortable with our allowance," Joyce says.
At least one financial tool--cutting tax bills--has been played out. When Gerstner took over in 1993, IBM paid 42.4% of its income in taxes. By moving manufacturing to locations with lower tax rates, IBM trimmed its rate to 29.5% last year. Joyce says the rate may creep up to 30% next year, slashing about $50 million, or nearly 1%, off IBM's projected net income.
Share repurchases will continue to help earnings, but less than in years past. IBM has bought 864 million of its own shares since 1995, but repurchases are slowing. Last year, IBM bought $5.3 billion in shares. This year, it plans to spend just $4.6 billion on stock buybacks--which would cut the impact of the program to 7 cents per share from 9 cents last year, according to Banc of America Securities.
Taken alone, these practices might not raise eyebrows. But some critics think that when investors add them up, they could equal trouble for Big Blue's stock price. This year, accounting jitters already have helped drive down IBM shares 16.5%, compared with no change for the Standard & Poor's 500-stock index. Some analysts say IBM's stock could fall further on concerns over whether the company can sustain its earnings without as much help from its financial tool kit. Typically, investors calculate the value of a company by using the price-earnings ratio. At IBM's Apr. 2 price of $101, its p-e ratio for 2002 income is 21.2. Take out estimated nonoperational gains, and the p-e jumps to 23.9--well above its historic level in the mid-teens.
Now, investors need to make the call. IBM's increased disclosure is a good first step. But with continued scrutiny of the bottom line and the declining oomph of IBM's financial levers, Palmisano's challenge is clear: Persuade Wall Street that its other strengths justify a historically high valuation, or generate growth through improvements in operations--not clever accounting moves.
|Corrections and Clarifications An illustration credit was missing from ``Can IBM keep earnings hot?'' (Information Technology, Apr. 15). Glynis Sweeny is the illustrator.|
By Spencer E. Ante, with David Henry, in New York