The Heat Rises Under IBM

The SEC has escalated an inquiry into first-quarter 2005 earnings announcements. Did Big Blue try to mislead Wall Street?

The first quarter of 2005 keeps coming back to haunt IBM (IBM). Not only did it miss analysts' earnings estimates, which sent its stock and credibility plunging -- but the way it communicated with Wall Street in the weeks following the quarter's close has now resulted in a formal investigation by the Securities & Exchange Commission. IBM issued a press release on Jan. 12 saying the SEC has notified it that an informal inquiry launched last summer has been escalated into a formal investigation.

IBM had little to say about the probe. "We have been cooperating fully with the SEC," says spokeman Edward Barbini. Asked what the notification from the government signals about the matter, he says: "Ask the SEC. It's their investigation." The SEC doesn't comment on such investigations.


  Corporate-governance experts say investors should take the matter very seriously. The switch to a formal investigation "signals that they have gone from asking general questions to asking more specific questions. It's not a fishing expedition," says Nell Minow, executive director of corporate-governance advisory firm The Corporate Library. Typically, when an SEC investigation becomes formal, it means the agency has the power to use subpoenas to seek documents and other information.

Minow believes that in situations like this, boards of directors should convene a special committee of independent directors to do their own internal investigation. "I want to see evidence that the board is paying extremely careful attention," she says. IBM's Barbini declined to comment.

The saga began last Apr. 5, when IBM issued a press release and conducted a conference call with analysts to announce its new policy on employee stock options. Big Blue said in response to March guidance from the SEC on share-based compensation, it would begin to expense stock options and other equity compensation beginning in the first quarter of 2005, which had just concluded.

A slide in Chief Financial Officer Mark Loughridge's s presentation headed "Financial Implications" said the effect of equity-compensation expensing on first-quarter earnings would be 14 cents per share. Analysts reduced their earnings estimate for the quarter from $1.04 to 90 cents.


  The hammer came down nine days later. IBM's earnings came in at 84 cents per share, 6 cents below estimates and way below the original estimates. At the same time, IBM said the impact of its stock expensing was 10 cents per share rather than 14 cents. Analysts, stung by the miss, raised the concern that IBM may have used the stock-expensing announcement in an attempt to soften the blow of its earnings miss.

Minow says that would be an outrage. "You're supposed to tell the truth and be open and transparent and candid about your prospects -- not obfuscate," she says.

On May 5 IBM announced a restructuring plan that ultimately resulted in a $1.7 billion charge against earnings in the second quarter. Earnings met expectations in the second and third quarters. However, several analysts are predicting that IBM's services bookings will come up short in the fourth quarter when it announces earnings on Jan. 17.

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