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Do you hear that?

20 August 2013 By Robert Cyran

IBM’s earnings engine is making sputtering sounds. The tech giant missed projections for the first time in years last quarter. Big Blue characterizes these as mere speed bumps. And Chief Executive Ginni Rometty appears hell-bent on making $20 per share in 2015, by the company’s measure of earnings. That’s almost a third more than it earned last year. Pressing on the accelerator of job cuts, software acquisitions and select disposals has worked well so far. But some of the smartest money on Wall Street is betting the company has a bigger problem, with falling sales pointing to a hole in the gas tank.

Earnings per share have increased far faster than revenue at IBM, doubling in five years against top-line growth of just 6 percent in total. This reflects increased efficiency at the group’s big consulting arm. Low-margin hardware businesses have been sold or managed for cash. The proceeds have been used to buy back stock, pay dividends, and acquire more profitable software companies. Investors have seen a 20-fold return over two decades, leaving the company valued at more than $200 billion today.

It’s a smart way to keep the bottom line increasing, but the company may have squeezed as much as it can from this stone. Gross margins have increased 6 percentage points over the past five years. And software already accounts for 45 percent of IBM’s profit, so additional acquisitions and disposals should have an increasingly less positive impact. Efficiency drives also show diminishing returns – eliminating trash cans and mandatory furloughs for employees in its hardware division are one-time fixes. Firing U.S.-based consultants and sending work overseas offers more durable cost cuts, but it can only go so far before quality and reputation suffer, and foreign costs correspondingly rise.

Keeping profit on an upward trajectory is a struggle when revenue shrinks. Sales fell 3 percent in the last quarter compared to a year ago, with services and hardware bearing the brunt. That’s the fifth quarter in a row revealing a yearly decline. IBM blamed a poor economy. But there are hints that increased use of on-demand software may be taking a bite. And if revenue is down because costs have been cut to the bone, or research and development underfunded, attempting further savings could be long-term counterproductive.

IBM’s method of measuring success also raises questions. Officially reported earnings per share fell 13 percent in the most recent quarter from a year earlier. IBM’s definition of income showed the figure rising 8 percent because of the way it accounts for pensions, acquisitions and layoff costs. IBM claims this is a better measure of the company’s underlying performance because performance of its huge pension fund fluctuates with the market, and the company is aggressively slashing costs. That means it has to spend money today on things like severance, with higher margins resulting in the future. IBM thinks the underlying business, however, is becoming more profitable.

Adding confusion to the mix is an investigation by the Securities and Exchange Commission into how the company books revenue for its cloud-based businesses. Both IBM and the watchdog remain tight-lipped on the matter and the fast-growing business is prone to accounting disputes, so there’s no way for an outside observer to say whether there’s a problem.

That’s why it’s important for investors to look at free cash flow – the most concrete measure of how most companies are performing. It’s falling at IBM: in the first half of the year, free cash flow has shrunk about 20 percent, or more than $1 billion. The company already spends most of its cash flow on buybacks, dividends, purchases of software companies and investments in its business. There’s no danger of immediate cuts – the sale of its underperforming server business, for example, could generate $5 billion of cash, according to analysts. But if cash flow continues to fall, it could mean a problem for the company further down the road.

IBM’s reputation has always been conservative and corporate. But it has been many years since the company faced such a variety of perplexing questions and concerns about its accounts and the sustainability of its profit machine. At the very least, returning to a focus on earnings using the generally accepted accounting principles method would reassure investors of the group’s blue-chip bona fides.


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