Why IBM has generated higher earnings despite falling revenues

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IBM generated higher earnings despite falling revenues

IBM Corp. (IBM) management stated in the “2015 Roadmap” that it intends to achieve $20 earnings per share (or EPS) by 2015. This is evident by the high dividends and share buybacks IBM has engaged in to increase its EPS and consequently appease its investors. The funds—which should have been invested in research and development, leading to EPS growth and ultimately higher returns in the long term—are simply being returned to shareholders in the form of dividends and buybacks.

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The previous chart shows year-over-year (or YoY) growth in total debt and free cash flow. It’s evident that although EPS is increasing, its growth is falling. Debt is mounting. In contrast, free cash flow (or FCF) is declining with each passing year. 1Q14 FCF stood at $2.35 billion, compared to $13.35 billion in 2013, showing a decline of 82%. 1Q14 EPS is trailing 12 months (or TTM) EPS.

Debt and free cash flow to fund dividends and share buybacks

IBM has managed to increase its EPS with no or flat revenues in the last few years. The increase in EPS isn’t driven by operational growth, but by buying back shares.

As of March 31, 2014, IBM had $9.7 billion in cash, equivalents, and marketable securities and a total debt of $44 billion. This results in a net debt position of almost $34.1 billion. Free cash flow is also declining with each passing year, most of which is being used to pay dividends and share repurchases. Research and development investments are also declining which doesn’t bode well for long-term growth of a technology company. Among its peers, IBM’s research and development, as a percent of revenue, is lowest.

Share buybacks to boost EPS

IBM isn’t the only company that has resorted to dividends and share buybacks to push its stock prices. Like IBM, Microsoft (MSFT) and Apple Inc. (AAPL) are in similar situations regarding cash flow generation. Share buyback isn’t an uncommon practice to boost earnings and share prices. Oracle (ORCL) and Cisco (CSCO) have also adopted this route. However, their debt levels aren’t as high. As of March 31, 2014, Oracle had $22.67 billion of long-term debt while Cisco’s stood at $20.89 billion—way less than IBM’s $34.1 billion of net debt.

IBM’s strategy is to increase its EPS  by returning cash to its shareholders in the form of dividends and share buybacks at the cost research and development. The increasing debt with all the free cash flow going towards dividends and share repurchases does indicates its “low quality of earnings.”

 

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