In late October, I warned investors to avoid International Business Machines Corp. (NYSE: IBM) stock.
At that time, IBM stock was trading around $162 per share. Today it is trading at a shade under $158 per share, and could be heading much lower.
"Big Blue's" transition, or perhaps we can call it "turnaround," is at best stalling, and at worst, setting investors up for more disappointment as evidenced by its fourth-quarter (2014) earnings report.
In fact, let's cut to the chase right away: IBM's just reported fourth-quarter earnings laid another egg.
It's simply not going well for IBM, and here is how we need to play IBM stock today…
IBM's Financial Engineering Masks This Real Problem
This is a sick stock. And it is sick for a reason.
IBM's fourth quarter results on January 20 showed revenues were $24.11 billion compared to Wall Street consensus estimates of $24.86 billion, and 12% lower than a year ago. In fact, it was the worst quarterly drop in revenue since the financial crisis.
During the fourth quarter (2014), all of IBM's businesses encountered year-over-year declines, an increasingly familiar pattern.
Systems and Technology was down 12% (normalized for divestitures and currency), Global Services was down 8% (flat when adjusted for divestitures and currency), and Software was down 7%. There was a spot of good news with Service bookings up 21%, however all geographic markets were down by varying, but significant, amounts.
Net income was down 11.3% from a year earlier to $5.5 billion. Free cash flow was $6.6 billion, $1.8 billion lower than a year earlier. For the year, free cash flow – the most important measure of how a company is performing – came in at $12.4 billion after management originally projected it to be $16 billion at the beginning of the year.
Earnings per share for the year came in at $16.54. Based on its closing price of $152.09 per share on January 22 and assuming it makes $16.00 per share in 2015 (an optimistic assumption), the company is trading at a mere 9.5x earnings.
As usual, the company was able to cover up the deterioration in its results in the fourth quarter with the lingering effects of its massive debt buyback program, which finally slowed in the fourth quarter of last year to only $132 million.
Its shrinking share count allowed it to show only a 4% year-over-year decline in earnings per share despite the much larger 11% decline in net income measured in dollars. Since 2012, IBM has borrowed an astounding $33.6 billion and used most of that money to repurchase $33.7 billion of stock at prices significantly higher than today's stock price. In 2014 alone IBM bought back $13.7 billion of stock, which consumed almost 100% of the $12.4 billion of cash flow that the company generated during the year.
The net effect of these actions has left the company with $41 billion of total debt compared to only $12.0 billion of shareholders' equity, and a debt-to-equity ratio of 340%, which is almost unthinkable for this iconic, bellwether American company.
Indeed, the deterioration in IBM's balance sheet has been startling. Shareholders' equity has declined by over $10 billion and more than 50% in just one year from $22.9 billion in December 2013 to $12.0 billion at the end of last year.
As incredible as this might sound, sooner or later its own actions could call into question the company's investment-grade credit rating, a once unthinkable scenario.
Rather than buying back stock to pacify the greed of Wall Street, perhaps the company should have thought outside the box and invested in some businesses that could help ease its transition to a new software-based IT ecology. You can buy a lot with $33.6 billion – you can even buy a lot of things that generate positive cash flow rather than force you to borrow money that you have to pay interest on and ultimately pay back.
Instead, IBM has staked its financial future on massive stock repurchases at the top of the market, something it is likely to regret in the years ahead.
About the Author
Prominent money manager. Has built top-ranked credit and hedge funds, managed billions for institutional and high-net-worth clients. 29-year career.