The Big Blue Canary in Armonk
The IBM unbeat goes on. Its sales plunged again for the 14th straight quarter while its net income was down by 14% from last year. Even management’s dodgy ex-items earnings guidance for 2015 was lowered by 6% with only one quarter to go.
Nor is this a passing swoon. IBM’s Q3 revenues were actually back to 2002levels. As the Zero Hedge chart demonstrates, it is hard to find a worse trend in revenue since Bethlehem Steel disappeared a few decades ago:
But the ugly sales charts above aren’t the half of it. The real story is that IBM’s relentless decline is proof positive that financial engineering is a destructive toxin that is leeching the lifeblood of the nation’s business enterprises.
Indeed, IBM is a Big Blue Canary. The abysmal facts of its self-destruction over the last decades should be a wake-up call to the bubble-blind Keynesians who run the Fed.
But these academic theoreticians and power-obsessed apparatchiks haven’t noticed—–even as they continue to jabber about the sheer noise emitted by the BLS. When it comes to what is actually important—–like the health and stability of the financial system——they have no clue about the manner in which their so-called “extraordinary” policies of ZIRP and QE have actually booby-trapped the financial system with explosive time-bombs.
Thus, IBM’s share price plunge of 35% since its peak valuation of $215 two years ago is a hint of things to come—-a warning that even the casino gamblers will dump and run when the destructive and unsustainable effects of financial engineering become sufficiently evident.
Stated differently, IBM has lost $100 billion of market cap since its 2013 peak. But that wasn’t due to a fundamental deterioration in its business model or a quantum change in the competitive environment in which it operates.
Instead, even the fast money gamblers in the hedge fund sector finally caught up with the long term damage to its earnings potential and competitive viability that resulted from its massive, sustained foray into gross financial engineering.
So doing they have provided a powerful demonstration that today’s towering stock market valuations did not arise out of a return to prosperity on main street. Instead, like in the case of IBM’s share price doubling between 2011 and 2013, they have been vastly inflated by central bank and tax policy induced diversion of massive amounts of corporate cash to the stock market in order to goose share prices and the value of executive stock options.
Needless to say, IBM’s C-suite was no outlier. Its repudiation as dramatized in the chart below lies in the future for most of corporate America.
It cannot be gainsaid that financial engineering has left great enterprises like IBM and Hewlett-Packard financially crippled and lacking the resources to effectively compete, innovate and grow. Despite a steady stream of bolt-on acquisitions, for example, IBM’s revenues have dropped by 22% from a peak of $107 billion in 2011 to $83 billion during the LTM period just reported.
At the same time, the $5 trillion of corporate cash which was flushed into stock buybacks, M&A deals and LBO’s since the 2008 crisis has left the stock market stranded high and dry and vulnerable to a thundering collapse.
That’s because this massive flow of financial engineering dollars functioned as a big fat bid for company shares that did not reflect real demand from investors and savers. The sell-side shills keep insisting that its all about their forward earnings hockey sticks, but that just plain malarkey. You can’t hide a $5 trillion elephant in the room.
Indeed, the 24/7 financial engineering practiced by the C-suite in corporate America essentially amounts to self-dealing by public companies and the Wall Street fast money which drafts on their maneuvers and announcements. This insidious process temporarily inflates share prices but ultimately leaves them vulnerable to collapse when the self-dealing and front-running stops.
In fact, after an extended period of time, the worst of both worlds materializes. Companies become so financially weakened that they are forced to curtail the flow of cash into the stock market, causing their artificially elevated share prices to deflate. At the same time, their quarterly performance begins to deteriorate and disappoint due to accumulated balance sheet leverage and prolonged underinvestment in capital assets, R&D and operational improvements, thereby inducing even further stock price declines.
As is evident in the chart above, IBM is now the poster boy. During the last decade its C-suite conducted a non-stop exercise in massive financial engineering.
It deployed every trick in the book including massive stock buybacks, generous dividends, chronic M&A deals, siphoning cash from its depreciation and amortization accounts, starving R&D, fiddling its tax rate lower and taking on a huge increase in its balance sheet leverage. And that is to say nothing of the temporary earnings inflation that resulted from the Fed’s campaign to squash the dollar after the Lehman crisis.
It goes without saying that all of this was conducted on a grand scale due to IBM’s massive size and global presence. To wit, during the nearly 11 years since 2005 (43 quarters through September 2015 YTD), its cumulative sales topped $1 trillion and its net income amounted to $140 billion.
But the latter is also where the trouble starts. During the same period IBM repurchased 40% of its stock on a net basis and upwards of 50% on a gross basis—–that is, before given effect to the continuous cornucopia of new stock options its board showered on management. It also paid a rich and rising dividend during the last 43 quarters. In all, cumulative buybacks total $133 billion and dividends another $42 billion.
In short, IBM distributed $175 billion or 125% of its cumulative net income to shareholders.That’s obviously a recipe for eventual corporate liquidation and extinction, and one that might have been appropriate to an Eastman Kodak tethered to a specific, narrow film technology the was made obsolete by the digital age. But IBM claims to be a leader of that very digital technology revolution and conducts a massive software and consulting business based in the latest technology developments.
Stated differently, the motivation at Armonk for flushing $175 billion it didn’t have into the stock market was not financial euthanasia; it was not to help IBM, as it were, go quietly in the night; it was not an assisted corporate suicide.
It was done pure and simple to goose IBMs short-term stock price and fatten executive option winnings.
And this destructive policy was happily adopted by its executives and board because the Fed had made debt dirt cheap; and because years of massive financial repression, Wall Street coddling and the Greenspan/Bernanke/Yellen Put had created a class of hedge fund speculators who draft on corporate financial engineering; and finally because the sharp bias of the IRS code in favor of tax-deductible debt and lightly taxed capital gains had provided a massive subsidy to debt-financed stock buybacks and executive stock options.
In other words, the Fed and the IRS have teamed up to put the main street economy at risk, even as their policies shower management, boards, insiders and the Wall Street casino with massive unearned windfall gains. Self-evidently, Sam Palmisano, who was CEO from 2002-2012 was the original architect of IBM’s financial engineering policy and is thereby among those fully accountable for its ruination. But like so many other CEOs in the era of Bubble Finance, he walked off with $100 million for his efforts.
Needless to say, Armonk’s strip-mining policy appeared to work for a while. Its share price rose from $60 at the 2002 bottom to a peak of $215 in March 2013. Including IBM’s generous 3% dividend, total returns to shareholders averaged 16% per year over the period.
And the sell-side pitchmen of Wall Street said it was all warranted. After all, IBMs earnings rose from $5 to $16 per share over the decade or at a 12% annual rate. IBM was proclaimed a global growth machine that would never stop rising and a one-decision stock that would keep on giving.
Except none of that was true. What happened was that IBM lawyers and accountants managed to shuffle its tax domicile sufficiently to lower its tax rate from 34.6% in 2005 to 19.6% in its most recent LTM period. Likewise, its share count dropped from 1.6 billion to 970 million during the period owing to its massive buyback program.
Moreover, IBM also drastically reduced its R&D spending during the period, thereby further inflating reported EPS. In fact, in inflation adjusted dollars R&D spending dropped by 27% from $7 billion to $5 billion per year.
That surely is a case of killing the golden goose—given the fact that IBM functions in a fiercely competitive global high tech industry populated by state-supported national champions who are more often interested in expansion than profits.
In any event, had IBM’s tax rate, share count and R&D spending remain constant, it’s LTM profits would have been $7.00 per share, not $14.65. Compared to earnings of $5.00 share in 2005 that amounts to a meager 3.5% growth rate
And there is more. During this same 43 quarter period, IBM recorded $52.5 billion of depreciation and amortization charges on its capital stock. But in order to fund its giant financial engineering program, it pilfered billions from these accounts, plowing just $48 billion back into CapEx. Yet in the high tech industry, companies ordinarily spend far more than their deprecation to stay competitive and accommodate growth of output.
Actually, IBM’s C-suite had a another route to growth, and its involved a trick. Over the past decade it has been a non-stop deal machine, announcing dozens of small and medium sized acquisitions every year. They totaled more than $24 billion on a cumulative basis.
But like the man said, there was something deeply wrong with that picture. IBM’s R&D spend at 5% of sales could have easily been boosted to 7-10% like most of its large international competitors. Given its vast corporate research facilities and institutional knowledge base, there is virtually nothing that it could not have developed in house with another $5 billion per year of R&D spend that it ended up acquiring through chronic M&A maneuvers,
But here’s the thing. R&D hits earnings today, while M&A offers the C-suite a double goody. Namely, IBM funded its deals with 100% debt at an after-tax cost of less than 1.75%, and set up vast cookie jars full of purchase accounting reserves at the time of each deal.
No wonder every acquisition was held to be instantly “accretive” by the sell-side analysts! The Fed handed over subsidized finance and the corporate accountants stumped-up rising amounts of phantom income from the cookie jars in Armonk. And if deals failed, they were deleted from earnings as “non-recurring” expense.
Eventually free lunches and financial engineering scams reach an unsustainable peak, and that is where IBM is today. It was once synonymous with the idea of a Blue Chip credit. When I joined Salomon Brothers in 1987, in fact, its capital markets desk was adept at arbitraging the thin line of daylight between the US Treasury and IBM’s AAA yield.
No more. IBM’s net debt was just $9 billion in 2005. Now it is $30 billion and rising.
So mind the Blue Canary in Armonk. While the intellectual mountebanks at the Fed, especially Vice-Chairman Fischer, puzzle about the stubborn decline in US productivity and “potential” growth, the truth lies in plain sight.
Big Blue and much of corporate America is being destroyed by massive financial engineering, while insiders and speculators harvest obscene windfall gains from this fraudulent diversion of corporate cash.
Needless to say, these self-destructive policies would never happen on the free market in a neutral tax regime. Real entrepreneurs and businessmen do not commit economic suicide.
The truth is, the current so-called secular stagnation of the US economy is being manufactured in Washington. When the rest of corporate America succumbs to the resulting IBM swoon, perhaps the American people will finally pick-up their pitchforks and torches.
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