Wednesday, April 16, 2008

every silver lining ...

every silver lining has a touch of grey.

since I am feeling so very negative, I might as well play the bear for now.

first of all, on some recent earnings: IBM just beat its numbers and raised guidance. here's what they said:

revenue rose 11%
net income rose 26%

IBM definitely grew more profitable over the last 12 months... but how did they do it?

the gross profit margin rose, and they got a bigger boost from a falling income tax rate.
they also bought back stock, cutting their share count by 8%.

as a result:

earnings per share rose 36%

this number, plus the raised guidance, got all the jubilation. it should push IBM shares out of an eight-month consolidation pattern. it's one of the better-looking members of the DJIA right now.
perhaps the most import number in the IBM report:

excluding the benefit of the falling dollar, revenue rose just 4%. that's right-- more than half the growth rate was currency-related.

sam palmisano has done a good job of turning this company into an a vehicle for investors seeking to offset the ailing greenback. IBM is essentially serving the same purpose as oil or gold at this point. only 31% of their employees are in the USA. but I would assume the USA still accounts for more than half the cost structure. (people in the USA probably earn much more on average than overseas employees. I don't like to assume, but it seems pretty safe since their headquarters and senior executives are here. besides, they don't disclose their labor costs by region.) as the dollar falls, their costs shrink relative to revenue. this explains the margin expansion.

so, overall it was a good quarter for IBM and I think the stock could end the year above $150. but, one should ask how long they can milk the falling dollar for profits?

here's another touch of gray:

interest expense rose 144%

and, more curiously:

total debt fell 0.3%

IBM is paying way more to carry the same amount of debt. what happened? were they hiding a subprime mortgage that suddenly reset?

IBM's effective annual interest rate more than doubled from about 8% to 20%. (interest expense represented 5% of total debt in Q1.. that is about 20% on a full-year basis.)


short-term obligations rose to 43% of their total debt from 35%.

again, that's a strange combination... short-term financing is supposed to be cheaper than long-term financing. this should be especially true when you consider the fed slashed the overnight rate 3 percentage points since the last time IBM reported Q1 earnings. they blamed their share buyback program ... I don't like seeing interest costs more than double when the debt load actually fell.

they're spending money to buy back shares, and paying for it with relatively expensive short-term debt. this has worked pretty well so far. but people should recognize it for what it is: financial engineering.

palmisano is doing more than selling IT hardware and services. he's turned big blue into a vehicle for investors to play the weak dollar, borrowing in the US to buy back stock. if the dollar keeps falling, that debt will shrink relative to its increasing foreign earnings. the real value of that debt magically declines. shareholders literally profit from a weakening dollar.

still, any interest-rate spike like that we saw in Q1 is potentially troubling. IBM must ride the roller coaster of refinancing debt from one month to the next in a difficult credit environment, or bite the bullet and term it out. this strategy exposes them to more risks.

another other potentially troubling feature on IBM's balance sheet was:

cash reserves declined 25.5%.

as a result, balancing out debts and assets, book value (shareholder equity) only rose 0.9%.

there's no doubt they're in a weaker financial condition than a year ago. it's not as bullish as it looks. finally:

accounts recievables fell 1.7% and they didn't seem to provide any kind of strongly bullish news on their backlog.

I am not suggeting IBM will have any sort of credit or financial problems. I don't think anything of the kind. they are a very strong and respected credit. my points are simply that IBM is in a weaker financial position than a year ago, and earnings are at a greater risk of credit-market disruptions.

people shouldn't take too much heart in this supposedly great quarter. it's more of a well-constructed EPS story than any true greatness.

it doesn't tell a bullish tale of the US economy in any way. still, the chart is quite bullish and the shares should outperform.


another reason why I called this post "every silver lining ... " was infosys's bullish forecast.

the company speaks of robust growth -- despite all the pain at US financials. maybe it is actually because of the pain at US financials. one fund manager recently told me banks will rely more, not less, on outsourcing as a way to cut costs after the credit crunch.

this thesis still needs to be tested more, but the proximity of the two events -- the investor's comments and the INFY forecast -- is important. it means our own mortgage-market profligacy could force banks to kick americans out of their jobs. it would be a sick irony of the credit crunch -- especially since the people getting laid off would most likely be at lower levels, rather than the people who made all the bad decisions in the first place.

for the US, it is one more touch of gray in a silver-plated earnings forecast.

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