IBM and Buybacks

Awhile ago, I mentioned IBM as a company that has done well for its investors, even though it has pursued a very active stock buyback program. I'd like to take a second look at this poster boy for the strategy.

An item in a recent Barron's magazine points out that IBM's earnings per share have risen sharply since 2007, but largely due to its very aggressive program of stock buybacks.   Outstanding shares have been reduced by 25% in this period, meaning that its earnings are spread over fewer shares, thus raising earnings per share. This is the flavor of the month in the world of stocks.

The company recently announced ANOTHER stock buyback, this time $15 billion, bringing the total since 2007 to $75 billion.  That's a huge figure.  People talk all the time about Apple's cash hoard, but IBM has offloaded over half as much of Apple's total hoard in the last six years!

On the face of it, IBM's ten year story is compelling.  In 2003, the stock was roughly $91 per share, in 2007 $105, and now $176, a rise of nearly 100%.  The stock has outperformed the S&P 500 index by about 50%.  Much of the outperformance coincides with the huge stock buybacks initiated in 2007.  Interestingly, though, gravity seems to be kicking in.  A fast rise following the latest buyback announcement has fizzled, and the S&P gap is shrinking rapidly.  By the way, if you look back over longer periods (25 years or more), IBM looks anemic, underperforming the S&P 500 vastly since 1988. Does that matter?  Well, if you're over fifty and have owned IBM for awhile, it probably does.

In 2006, the company earned $9.7 billion, which rose to $16.6 billion in 2012, a rise of 70%.  (For a ten-year comparison, the company earned $7.58 billion in 2003, with a rise in earnings of more than 100%).  That's impressive, especially since sales have risen far less rapidly (from $91 to $104.5 billion since 2006.  These guys know how to make money, and they've been able to increase net earnings sharply even as revenue growth has slowed greatly.  Still, that slow growth is sobering.  Can the upcoming decade offer a similar bottom line of high profit on meager sales?  Color me skeptical. 

Let's do two run-throughs.  First, let's assume an investor who has sold shares to take advantage of the buybacks.  Assuming an initial position of $105,000 in 1997 (1000 shares at $105 per share), this individual would have sold off 250 shares (25% of the entire position) at an average price of $140, netting $35,000.  The remaing 750 shares would be worth $132,000, or a total of $167,000.  This would be a 59% gain over seven years, with taxes due on the shares sold.

The buy and hold investor would still own 1000 shares, presently worth $176,000, a bit better than the seller, even before taxes! That's interesting, isn't it, Carl Icahn fans?  Grabbing the cash isn't necessarily the better option, at least short term.  Long term, well, we'll see.

Now, has this wash of cash into buybacks really been shareholder friendly?  Let's imagine a scenario where IBM had not bought back shares.  There would still be 1.5 billion shares outstanding.  The PE ratio would now be 10.9  instead of 15.  Unless you believe getting rid of cash actually improves a company's ability to earn money, you would assume earnings would, at the very least, have held steady.  Therefore, I would expect the market to value these earnings at the same 10.9 PE as now.

But, IBM would still have the $60 billion in hand, at a minimum, to add to its present $12 billion!  That constitutes nearly 1/3 of its present market capitalization of $197 billion. The additional $60 billion would amount to an additional $40 per share. At a minimum, therefore,  I calculate that the stock price would be $229 a share, or 30% higher than it is now.  

And as to net income, would it really still be flat?  Could IBM have done nothing with that extra $60 billion, other than toss it overboard like chum?  Surely they could have used it to earn a modest amount more, perhaps 10% over these last six years?  After all, I've already agreed that these guys know how to make money.  The extra $1.6 billion in earnings would (at a P/E ratio of 10.9) add another $11.6  to the stock price, so $237.6.  So I think it's entirely reasonable to assume that IBM, as a company, would now be worth nearly 35% more if it had eschewed the buybacks. 

Now we get to the crux of the issue.  Earnings that would "normally" generate a PE of 10.9 are sitting out there today with a PE of 16.  Since today's IBM is clearly weaker financially (by over $60 billion) than the hypothetical one, why would this be?  Obviously shareholders are expecting future buybacks, as IBM has obediently just promised.  What would happen if the company reneged on the promise, or simply failed to repeat a future renewal?  Bad things!  Buybacks inject steroids into stock prices; withdrawal symptoms would (will) be severe.

Now is this potential stumble any different than that following the suspension or reduction of a regular dividend? Stock prices plummet in both cases.  So what's the difference?  Well, look where the money goes. Dividends go to all shareholders.  If they are regular and predictable and rising, shareholders benefit greatly.  They build retirement portfolios on these "safe" earnings.  Buyback money goes to the sellers of stock, who must generally pay taxes on the gains.  Non-sellers might see a temporary rise in stock prices, but are vulnerable to the end game.  Substantial buybacks (like IBM's) clearly weaken a company, often just prior to market turbulence and a frantic need for cash.  And by the way, the most publicly acknowledged flaw of stock buybacks is terrible timing.  CEOs initiate them when they have money in hand, which usually coincides with high stock prices, and terminate them in downturns, when their stock is actually cheap.  This is classic buy-high/sell-low behavior. 

But, you say, IBM's game has been going on for seven years, with nice results.  Even Warren Buffett jumped in in 2011.  Why worry?  Well, what should be worrisome for IBM shareholders is that recent flattening of income.  The growth rate of earnings has been declining for five years, even as earnings per share have jumped.  Retiring shares has masked this troubling trend.  Hmm, could that actually be the point of the exercise?  Specifically, think about who gains by manipulating the stock price.  Who gets immediate rewards in stock options exercised as soon as humanly possible, and floats serenely into the sunset on golden parachutes when the storm ultimately strikes?

Update: Nearly a year later.  The same trends I discussed above continue.  IBM's revenue for 2013 declined 4.55% to $99.75 billion from 2012.  This year, the earnings drop continues, at a 4% pace.  In the first two quarters of 2014, the company bought back nearly $12 billion worth of shares.  The stock price?  Absolutely flat, year to date!  While the market is reaching all-time highs, IBM is limping along below levels reached in 2011.  All that money poured into buybacks, and the stock has gone nowhere!  Since the company's plan is to "only" buy back another $3 billion this year, what is likely to happen when the binge stops?  Of course, these wizards could simply declare another giant buyback program (how about $20 billion this time?).  The point is: no amount of trickery can evade the inevitable reckoning.  IBM is shrinking, and eventually the market will punish it for the lack of real growth.  Throwing away its lifeblood (cash) will only make the painful adjustment to reality worse.  Folks, if a company has nothing better to do with its precious cash than stock buybacks, you should RUN away!  Where?  Well, that's a difficult question, but I'll try to explore some ideas in my next post.

Update (October 21, 2014):  A couple of weeks hence, and 2014 third quarter results are in.  It's not pretty.  Operating earnings for the quarter fell 10%, resulting in a nasty drop in the stock price to $169.  So, in a year when the stock market rose steadily, IBM has dropped seven points, despite pouring $15 billion into buybacks!  The New York Times has an article that is music to my ears: The Truth Hidden by IBM's Stock Buybacks.   It points out that the company's revenue has been flat for TEN years, it has spent $108 BILLION on buybacks, $30 billion on dividends, $59 billion on capital expenditures and $32 billion on acquisitions. That $1.50 out the door for every $1 invested in the business. The article suggests that IBM has "been spending its money on the wrong things; shareholders, rather than building its own business".  I would correct that a bit: ex-shareholders have been the real winners.  The only sure way to take advantage of a buyback is to sell, after all.  The article also mentions a "dirty secret": buybacks "can have an impact on executive compensation by goosing certain metrics that boards use to measure a company's performance."  Good for the executives, bad for the shareholders, bad for the company.  The bottom line here is that the value of an investment is ultimately determined by the company's earnings stream.  No amount of financial voodoo will change that fact.  IBM's extravagant cash spew has clearly weakened the company's ability to grow earnings (through investment and acquisitions), and there will probably be hell to pay.  Warren, you might end up owning a larger share of the company due to buybacks (his rationale for climbing on board, while blithely rooting for a long-term flat stock price!), but it's a far weaker company.  Do you seriously think IBM would have NO use for that wasted $108 billion in today's dog-eat-dog world?

Update: February 1, 2015.  The saga continues.  IBM is now down to $152, a point last seen in early 2011.  This is because the company's revenue is below what it was in 2004!  Guess what, they STILL intend to buy back $6 billion of stock right away, with more to come in April.  The company has, however, abandoned its earnings goal of $20/share. Even with gigantic repurchases (lowering the number of shares participating in the earnings figure), the core business is so weak that the fantasy figure looks out of reach.  Don't worry though, Ginni Rommetty just got a $3.6 million bonus, with more to come if she meets the company's next set of goals.  So, she'll throw $6 to $15 billion more at the stock, to make sure she nabs that bonus.  It's good for her, at least, especially once she gathers in her golden parachute when the natives finally come howling for her scalp. I'm not alone in my dyspepsia, the company is now the fourth most-shorted issue in the NYSE. 

Update: October 23, 2015.  Two years after I said it, here's a paragraph from a scathing SeekingAlpha article entitled "Too Many Stock Buybacks have Hurt IBM":

"IBM has been generating huge amounts of cash over the past ten years, ranging from $8 to $16 billion, and all that cash is almost nowhere to be found. Where is all that cash? Most of it has been given to those who have sold their shares to the company. Practically, the company, as things stand right now, has been rewarding the sellers of the shares at the expense of loyal shareholders who have been holding their ownership stakes. Of course, people do not usually see it like this, but when the stock price goes down, things turn out this way. When the share price goes up, it turns out better for loyal shareholders."

I couldn't have put it better myself ... WAIT, I did, back in November of 2012:  "

"So why does Carl (Icahn) want the company (a theoretical company in this example)  to initiate a buyback?  Simply put, it's a great way to make a fast buck.  Announcing the buyback, and then initiating it, puts upward pressure on the stock.  Suddenly, extra cash is chasing the shares available for sale.  Demand outruns supply (temporarily), and the price jumps.  So, Carl sells into a rising market, pockets the quick gain, and departs.  He could care less about "stockholder value!"  He's a scorpion, stinging companies is what he does.  Lesson for non-scorpions?  Stock buybacks only benefit the folks who sell!  Those who stay are left with a company whose cash has been frittered away to others.  I think it's a form of financial rape."

Yeah, a bit overwrought (buybacks COULD make sense if the stock is frantically cheap), but anyone listening in 2012 might have taken a pass on IBM with its high of $210 and low of $193 in 2012.  A good choice, as the company has just announced further miserable results, with the stock now having fainted to $141.  Sadly, though, no one is listening ... yet.

Update January 29, 2016.  After YET another bum quarter, IBM's stock price is down to $124.  People are finally listening (not to me, of course, but to the Johnnie-come-latelies who have finally recognized that something is not right in Rometty-land.  This time they're blaming currency conversion ailments.  Otherwise, earnings would have declined by only 2%.  Yeah, it's always sumpin' with Ginni.  By the way, they just gave her a special EXTRA bonus of $5 million (for a job well done?).

The argument for IBM (articulated fatuously by Warren Buffett himself) is that the stock price doesn't matter.  He even rejoices (he says) when the stock price drops.  He, and others, say they're in the game for the dividends.  On the face of it, the argument is compelling.  IBM's dividend has risen from $.18 quarterly in 2004 to $1.30 today, a compounded growth rate of nearly 20% over eleven years.  Why that's Buffett-worthy.  No wonder Warren jumped on board.  He's found a magic formula for getting even richer, right?  Well ... let's go to the blackboard.

Say you had bought 1000 shares of IBM at the 2004 year-end price of $94. Over eleven years, you would have received $34.70 per share in steadily rising dividends.  Add that to today's share price of $124 and you would have netted $64,700 on an investment of $94,000, which happens to be 4.8% compounded, with taxes due on dividends along the way.  WAIT, WAIT!  What happened to that lovely 20% yearly growth rate?  Shouldn't you now have $698,000?  Isn't that what the dividend growth rate promises?  

Buddy, you've been jobbed.  IBM's relentless stock buy-backs have dropped the share count from 1.6 billion to just under 1 billion over this span.  The company's revenue is being spread out over fewer shares.  And something alarming has happened along the way.  The amount IBM steers to dividends has risen precipitously (making for those delicious yields), but dividends represent an ever-larger percentage of company earnings.  In 2004, dividends were just under 16% of company net income.  Now, it's 38%.  


The scenario above assumes you'd bought at at the beginning of the shell game.  What if you'd bought mid-way, when the stock was over $200 a share?  Would you still be rooting for a decline, Buffett-style?

Ginni (and her former boss) have been robbing Peter to pay Paul.  The proof of the pie is in shareholder equity.  That, folks, is what the owners of the company actually own, total assets minus total liabilities, or approximate breakup value, if you like.  At the end of 2004, the figure was $31.69 billion (already down from a peak of $43 billion in 1990).  Shareholder equity has deflated with a loud hiss ever since, to a nadir of $11.87 billion in 2014, and a still feeble $14.26 billion at the end of 2015.  That's a fat 55% loss of value, far exceeding the 38% decrease in shares outstanding over these eleven years! What happened to that equity?  Look no further than stock buy-backs (over $100 BILLION - money handed over to the stock's sellers) and lavish dividend increases.   It's a miracle this whale still floats!

Still, shareholders have in fact received steadily rising dividends.  So, why should these widows and orphans worry?  Even the near-sighted should be able to spot what's wrong with Rometty's reverse ponzi scheme.  It's unsustainable. Raising dividends by 425% over eleven years, while net income wobbles downward is no way to run a railroad.  What do you think will happen to the stock once the buybacks end or, horror of horrors, the company actually is forced to cut the dividend?  Hint: gravity!  

Of course, Rometty's  promising gigantic new revenue streams ... eventually.  "Forget the disastrous decay in the core business; the cloud will launch IBM to the stars!  And by the way, would you like to buy a nice bridge to Brooklyn?"  


March 2017.  After a huge run-up in the stock market following Donald Trump's electoral victory, IBM appears to be sitting pretty.  The price is $173.  Compared to the dismal $120 seen last year, that's a good run.  But ... $173 is actually just about where IBM was FIVE years ago!  It topped $200 several times since then, and has fallen back from those peaks.  

Now I'd call a flat five years no victory at all.  But there's still a drum-beat of positive hype regarding the company's aggressive buybacks.  A recent SeekingAlpha column just ran through the Buffett line: that flat or dropping stock prices along with steady stock buybacks are just great for the long-term dividend investor.  He points out that Buffett now owns 6.8% of the company, as opposed to 5.5% when this particular period began.  This is due to the drop in shares outstanding.  So, that's a 23% increase in Berkshire's share of IBM's equity.  That equity is actuall2016y down a bit over the same span ($18.98 billion then, $18.4 billion now), resulting in a compounded rate of return just under 5%.  Even adding dividends received into the calculation does little to improve this very modest result.  This is the best the Sage of Omaha can do?    

Furthermore,  this point in time looks particularly favorable to Warren.  It skips past that ugly year-ago low, and presumes a fairly low starting point (2012). Pick a few other starting points, and the picture dims fast. The article mentions that net buybacks over the years have been over $100 billion (perhaps somewhat less once adjusted for sneaky new issuances).  That's over FIVE TIMES the company's net present worth! Please, do you seriously think IBM is worth more now that it would have been if it had simply kept the money?  If so, Warren would own 5.5% of a company worth far more than today's shrunken total.    

You want to know the strongest argument against IBM's stock buyback program?  The company itself!  Between 2010 and 2014, it poured $70 billion into buybacks!.  In 2015 that fell to $4.7 billion.  The latest figure? $3 billion.  So, if buybacks are so magical, then why stop them?  Why throw tons of money at the market when the stock is hovering at or over $200 / share, and then nearly stop once it has plummeted?  Ginni can slather on all the lipstick she wants; the object of beautification is still a pig (to be precise: I mean the company, not Ginni).  She has a proven track record of buying high; is she her successor about to sell low?

July 2017.  Stock has swooned again, down to 145, a price last seen in 2015 and again in 2009.  So ... depending on entry point, a flat 8 years!  And Warren has finally pulled the plug.  Why didn't he listen to me sooner?  And still the company buys back shares.  

December 2018.  Another year past, and the stock is now down to $115.  Admittedly, it's been a brutal couple of months, with a full year's upside wiped out, and more.  Still, IBM stand out as a truly punk investment.  It's still getting touted as a magnificent dividend play, but really?