Can it still clean up nice?

Needed: Another IBM Re-Invention

Katie Benner is a Bloomberg View columnist who writes about technology, innovation, and the cult and culture of Silicon Valley. She lives in San Francisco.
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Most everyone hopes that Ginni Rometty, International Business Machines Corp.'s chief executive officer, can make Big Blue grow again. It's a legendary company, a blue-chip stock and a huge employer (431,212 people at last count). And it's one of the few tech companies that has survived multiple rounds of wrenching technological change and thrived.

But the road might start getting rocky for IBM, not just because cloud computing is supplanting its business. The company is also reassessing a longtime focus on earnings-per-share growth, having ditched its 2010 goal of doubling per-share earnings to $20 by 2015. The stock tanked when the company abandoned the target and is down 12 percent on the year. That EPS goal boosted the stock price for many quarters and won IBM fans like Warren Buffett; but it also played a role in making IBM one of big tech's more highly leveraged companies. If it significantly scales back its buybacks, expect a lot of volatility as the company works on a turnaround; if it continues to take on debt to repurchase stock, that could constrain the company's ability to expand into new businesses.

QuickTake IBM’s Big Blues

Ever since IBM set its EPS target, it kept investing to make the business grow. Company spokesman Ian Colley points out that IBM has spent $23 billion on acquisitions, $29 billion on capital expenditures and $42 billion on research since the beginning of 2008, and that debt funded these expenditures. Investors were supportive because investment in the business helped boost net income from $7.7 billion in 2001 to $15.6 billion a decade later.

But the tech world has changed a lot and recent investments haven't yet done as much to aid earnings. Revenue has fallen since 2011 and net income growth has slowed. (Both numbers are forecast to fall this year.) Martha Toll-Reed, senior director of corporate ratings at Standard & Poor's Ratings Services, notes that yields on IBM's debt are slightly higher than other AA-rated companies, in part because of its financial performance.

"Hardware revenue was particularly hard hit and part of the concern is that -- although software and services combined are bigger than hardware in terms of revenues -- a lot of IBM's software and services sales are still generated by sales of hardware," Toll-Reed says. Even as the company de-emphasizes hardware and plays up investments in software and services, some investors still see hardware as integral to the company's bottom line.

Thanks mainly to share buybacks, EPS growth surpassed net income gains. Dividends were increased as well. The company has spent $88 billion on stock buybacks and $24 billion on dividends since the beginning of 2008, paid for out of free cash flow and from debt sales.

The New York Times called this strategy financial engineering, the implication being that this was somehow deceptive. Reasonable people can disagree with this characterization, given that debt, after all, has never been cheaper. Tech companies such as Microsoft, Hewlett-Packard, Oracle and even Apple have all borrowed money and used leverage to boost returns. IBM's Colley says his company is no different, and I'm inclined to give him the benefit of the doubt.

But the scale of IBM's buyback strategy becomes evident when you look at retained earnings, meaning the earnings that the company keeps to reinvest in the business or pay down debt, and treasury stock, typically the stock that a company buys back from shareholders. IBM has $133.4 billion in retained earnings but $150 billion in treasury stock. To put it simply, the company has spent more on share buybacks than it's retained in earnings in its entire existence.

Here's another way to look at the situation. In 2007, 2008, 2010, 2011 and 2013 the company spent more on buybacks and dividends than it generated in net income. In most of those years, buybacks and dividends also exceeded free cash flow.

IBM says that it's very comfortable with its financial position, but years of borrowing and buybacks certainly make its balance sheet an outlier. It's got the highest debt-to-EBITDA ratio of peers like Cisco, Hewlett-Packard and Oracle; and that ratio, at 1.96, is far higher than other AA-rated companies such as Apple (0.58) and Microsoft (0.68). Its debt-to-equity ratio stands at 174 percent, versus 25 percent for Microsoft and 33 percent for Apple.

It looks like IBM is poised to take on even more debt to help grow its way out of the doldrums. Some investors and analysts have batted around the idea that IBM needs a big transformative, acquisition. (I'm pretty suspicious of transformative M&A, but that's a column for another day.) And even without a big deal it will surely have to buy to gain talent and innovation. With IBM stock under pressure its value as currency for a deal is diminished, making debt more of a necessity. It's also hard to imagine that IBM will go cold turkey on using debt to prop up EPS numbers, even without the $20 EPS target. Cloud data-base players, storage companies and others are rolling out ever cheaper products with ever-slimmer margins; investors are relatively unforgiving of companies that need a lot of time to change.

Even though shareholders are unhappy with IBM, bond investors have paid little heed to IBM's debt levels. The company is, after all, a AA-rated credit and interest rates look like they'll stay low for a while. But that could change if the markets decide that the borrowed money and the strategy aren't resulting in positive change. It won't kill IBM, but it could make life much more expensive.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the editor on this story:
James Greiff at jgreiff@bloomberg.net