Mad Dog 21/21: The Case of the Vanishing Equity

Published: March 16, 2009

by Hesh Wiener

These are hard times. Blue chip companies are reducing their profit forecasts, slashing dividends, and laying off armies of employees. IBM remains an exception. It is sticking to its earnings forecast of $9.20 per share or higher for 2009, up from $8.93 in 2008. It is not cutting its dividend. And while it has had layoffs, it is also hiring in Asia. But there is still one sign that IBM lives in the same harsh world the rest of us do: The company's net worth, also called shareholders' equity, is less than half of what it was a year ago.

A company's net worth is what common sense would suggest: The difference between its assets and its liabilities. This is the actual value of IBM's shares, the amount shareholders would get if you could stop the clock, collect all that's owed to IBM, and pay all that it owes to others.

At the end of 2008, this came to $13.5 billion, or about ten bucks a share. The market price of an IBM share was about $90 at the time. By contrast, IBM's net worth at the end of 2007 was $28.5 billion, more than twice as much. At the end of 2006, IBM's net worth was maybe a few hundred million dollars more.

IBM says that its falling net worth is due to FAS 158, the accounting standards rule that forces the company to bring into its balance sheet the impact of increases and decreases in funds it has sequestered to pay for its pension liabilities. Companies can avoid this by farming out their pension management, but then they don't get to have the extra capital on their balance sheets. Except in terrible times, IBM's practices work out very well for Big Blue and the many other corporations who similarly manage the funds to support their employees' pensions.

Now it turns out that IBM can easily increase its net worth by holding the huge amount of cash it churns up, large amounts of which IBM uses to buy back its own shares. But if IBM stops buying back its shares it might not get quite the same boost in earnings per share it gets by simultaneously making more money and getting shares off the open market. Even if IBM has a rotten year and doesn't generate enough profit to hit that $9.20 minimum target it has talked about, it could still show an upturn in earnings per share if it can sop up enough shares. That means that even though IBM could in theory reduce its rate of share buybacks, it might not want to do this unless it has a rock solid way of goosing net profits.

With so much of a challenging year ahead of it, IBM might not in fact have the freedom to do as it might wish. Above all else, IBM wants to been seen as dependable by the investment community. That means it probably cannot do anything sudden about its share buybacks, its use of cash, or its major expenses, such as payroll.

The company is already doing most of the things it can, although it remains to been seen if it gets the great results it hopes for. A prominent example is the way IBM has consolidated its server technology and reduced the number of product lines that require distinct manufacturing activities. This has been very thoroughly explored in this newsletter many times in the past. In 2008, IBM's pretax profit from the accounting segment it calls Systems and Technology, which includes servers and storage, fell 28 percent from that of the prior year. But the software IBM sells generated 17 percent more income than it did the prior year.

It may be that a lot of the software revenue comes from IBM's mainframe base, but the i OS lineup, even if it is running on a consolidated Power Systems server, is a somewhat distinct server family. IBM has as much market power in its proprietary midrange market as it does at the high end, even though the barriers to migration off an i are not as daunting as those preserving legacy applications on a z box. IBM faces much more direct and indirect competition in the Unix, Linux, and Windows bases, and that competition inevitably leads to reduced profit margins. IBM has a big advantage selling DB2 in its proprietary world of i and z (even though there are alternative high-end database products for IBM mainframes); it has to work harder to sell DB2 elsewhere.

The key thing about software is that the cost of providing an incremental copy is essentially zilch for the code plus whatever the bundled support costs not covered by support fees might run, and that number is often zero, too. For IBM, it means that in a pinch it might be able to come out ahead even if it loses money on some servers as long as the deal includes software (even at a discount) and software support. The picture is even brighter when it comes to services. By controlling hardware and software technology, and by exercising pricing power to whatever extent it can, IBM's integration boosts its opportunities in services, including financing as well as business and application re-engineering. Hewlett-Packard is the only other company in the world with such a rich mix of offerings, and HP does not have the same strength in proprietary large systems that IBM does.

So, while IBM might end up reporting another lousy year when it comes to hardware profits, if it can hold onto its sales volume when the rest of the industry is slipping badly, it will gain market strength in 2009. Even if the economy is in turmoil, there are not a lot of reasons for anyone to make funeral arrangements for Big Blue. The auto industry it is not.

Still, IBM has a very big problem, the problem it has in common with every other company keeping books American style that also has a lot of money tied up in pensions. Share prices so far this year are down quite a bit and they might not bounce back before the end of the year. Investors playing the bond market, and we have to figure IBM is there, too, on behalf of its employee pension funds, are also taking a haircut. And, as is the case with shares, bonds might not weather the year with the kinds of gains it would take to give IBM a big increase in its net worth.

Come to think of it, there's hardly any kind of investment that looks good right now, and this will translate into plenty of ugly numbers on plenty of financial reports.

So far, Wall Street has chosen to ignore the declining net worth of IBM and many other companies. But just as some analysts have jumped on General Electric, pushing down the market value of its shares and making its management quite unhappy, a world in which bears become wolves is one that could turn on IBM, too. If IBM takes enough of a beating from pensions, it could find itself unable to carry out the financial strategies it usually executes without a flaw.

Sure, IBM is not directly affected by the fickle and essentially profitless PC market. It is not dependent on commodity X64 type servers for its success. (IBM's X64 business cratered in the fourth quarter, and the company profited just fine.) And its strength in the Unix universe is at the high end, where only a few vendors have servers that can shoulder the big workloads IBM's AIX boxes can carry. IBM, then, has both proprietary and Unix systems that are very muscular, the kinds of servers that help IBM sell big ticket deals that include software and services.

IBM's management believes the company will be able to ride out the storm and perhaps even expand into some of the new markets that are expected to emerge as the U.S. government deploys stimulus funds for projects that involve information technology. One area where IBM seems to believe it can succeed is medical records. Another is so-called smart infrastructure. But it remains to be seen just how IBM will actually do in these and other new endeavors. While few would doubt IBM's ability to bring great ideas and excellent technology to bear on these challenges, the U.S. government might want its strategic technology initiatives to be supported by open hardware and software. That would help bring the academic world into the mix and possibly serve another goal espoused by the U.S. government, that of improving the quality and quantity of public education.

If IBM finds itself particularly hungry for profits, it just might have to keep its business focused on the strategies that have worked so well for it during the past few years, strategies that have for the most part involved hardware, software, and services for mainstream information processing jobs. IBM is very good at this sort of thing, good enough to compensate for the damage its investments on behalf of pensioners have suffered. IBM might be just as good at new ventures, but it didn't seem to have the right gifts for the dot-com boom (and subsequent bust), it is not a force in the creation of new Internet based enterprises, and notwithstanding its vast technological resources, it might not emerge as leader in USA 2.0, either.

If it can just keep the stock analysts from spending too much time fretting over its balance sheet, IBM can remain at the top of the information technology world, even if its net worth suffers an unpleasant setback.

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