stock buybacks: the curious case of IBM

Regular readers will know that I’m not a fan of stock buybacks by companies.  I believe that even though buybacks are advertised as returning cash to shareholders in a tax-efficient way, their main effect–even if not their purpose–is to keep the dilutive effects of management stock options away from the attention of ordinary shareholders.  Admittedly, I haven’t done a study of all firms that buy back stock, but in the cases I have looked at the shares retired this way somehow end up offsetting new shares issued to management.  As a result, you and I never see the slow but steady shift in ownership away from us and toward employees.

In recent years, activist investors have made increasing stock buybacks a staple of their toolkit for “helping” stick-in-the-mud companies improve their returns.  Certainly, accelerating buybacks can give a stock an immediate price boost.  But since I don’t believe that the usual activist suspects have your or my long-term welfare as shareholders at heart, I’ve had an eye out for cases where extensive buybacks have ceased to work their magic.

I found IBM.

Actually I should put the same ” ” around found that I put around helping two paragraphs above.  I stumbled across an article late last year in, I think, the Financial Times that asserted all IBM’s earnings per share growth over the past five years came–not from operations–but from share buybacks.  A case of what Japan in the roaring 1980s called zaitech.  Hard to believe.

I’ve finally gotten around to looking.  I searched in vain for the article.  I found a relatively weak offering from the New York Times Dealbook, whose main source appears, somewhat embarrassingly for the authors, to have been IBM market-speak in its annual report.  I did find an excellent two-part series in the FT that I’d somehow missed but which appeared earlier this month.  It’s useful not only conceptually but also for IBM history.

IBM

The FT outlines the essence of the IBM plan to grow eps from $11.52  in 2010 to $20 by this year–a target abandoned last October by the new CEO..  Of the $8.50 per share advance, $3.50 was to come from revenue growth, both organic and from acquisitions; $2.50 each were to come from operating leverage–which I take to be the effect of keeping SG&A flat while revenues expanded–and share buybacks.

What actually happened from 2010 through 2014 is far different:

–IBM’s revenues, even factoring in acquisitions, fell by 7% over the five years

–2014’s operating profit was 5% higher than 2010’s

–net profit grew by 7.0%, aided by a lower tax rate,

–nevertheless, earnings per share grew by 35%!

How did this happen?

Over the five years, until share buybacks came to a screeching halt in 4Q14, IBM spent just about $70 billion on the open market on its own stock.  That’s over 3x the company’s capital expenditures over the same period.  It’s also about 3x R&D expenditure, which is probably a better indicator for a software firm.  And it’s over 3x dividend payments.

The buying reduced the share count by 315 million to 995 million shares.  The actual number of shares bought, figuring a $175 average price, would have been about 400 million.  I presume the remainder are to offset shares issued to employees exercising stock options (although there may be some acquisition stock in there–no easy way to find that out).

results?

What I find most interesting is that, other than a flurry in the first half of 2011, the huge expenditure did no good.  IBM shares have underperformed pretty consistently, despite the massive support given by the company.  And IBM has $13 billion more in debt that it had before the heavy buybacks began.

Where is the company now?

I don’t know it well enough to say for sure, but it appears to me that it has taken recent earnings disappointments to jolt IBM into the realization that the 2010 master plan hasn’t worked.  A half-decade of the corporate equivalent of liposuction and heavy makeup has not returned the firm to health.  Instead, IBM has burned up a lot of time   …and a mountain of cash.

I think it’s also reasonable to ask how ordinary IBM shareholders have benefitted from the $60+ per share “returned” to them through buybacks.  I don’t see many plusses.  The stock dropped by about $20 last October, when IBM officially gave up the 2010 plan, so some investors were fooled by the company’s zaitech.  But spending $60+ to postpone a $20 loss that happened anyway doesn’t seem like much of a deal.

Only the board of directors knows why almost five years elapsed before anyone noticed the plan had long since gone off the rails.

which is the better question: where is the oil price floor or where is the ceiling?

I read sports for a radio station for the blind each Thursday.  I was listening, as usual, to Bloomberg radio in my car while on the way.  I caught the tail end of a conversation in which a guest was apparently trying to explain the difference between a copper mine (a multi-billion dollar, multi-year project) and a shale oil well ( up and drilling for cheap in a month or two).  This came as a revelation to the show’s hosts.  Part was probably showmanship, but it also underlined to me how little knowledge about mining and basic materials industries survives on Wall Street.

A basic rule of any commodities business (regular readers will know I spent six years as an oil and mining analyst and another couple managing money in stock markets with large commodity exposure) is that in times of oversupply the price only stabilizes when it falls (and remains) below the out-of-pocket costs of the most expensive producers.  The bottoming process may take a surprisingly long time.  That’s because producers may choose to operate at a loss for a while, if the costs of starting up again are high (think:  blast furnace steel) and the oversupply is perceived to be temporary.

–In the case of oil, Saudi Arabia is doing all it can to convince the world that the oversupply is not temporary.  That’s one worry out of the way.

–The consensus belief is that the floor is around $40.

Presumably this information is being factored into today’s stock prices.  Therefore, it isn’t so interesting.

the ceiling

The better question, I think, is how high the oil price might go once high-cost supply has left the market.

base metals

For a base metals mining project, reassembling a crew + machinery to restart a shuttered mine is expensive and may take half a year.  And certainly no one is going to begin to develop a new mine until price visibility is very high.

shale oil

For shale oil, on the other hand, startup might only require a handful of people and maybe a month.  In addition, if I thought I could get, say, $70 a barrel for my oil a year or two down the road instead of $45 today, I’d deliberately pull at least some of my wells out of production and wait–assuming I had my debt repayments under control.  For that portion of my output, I’d be ready to turn the spigot instantly.

I don’t know exactly what price level triggers a return of shale oil to the market, creating potential oversupply again.  But production will return very quickly.

The trigger is clearly not as high as $100.  If I were analyzing oil companies for their rebound potential, I’d hope for $70 but base my figures on $60.  The analysis itself would tell me whether $60 is high enough.

My general conclusion, though, is that oil isn’t going back to the levels of a year ago for a long time.

an aside

The best petroleum economists in the world are in OPEC.  It’s impossible that Saudi Arabia doesn’t know with much greater precision what I’ve been writing about.  Why should it be talking of oil at $100 or $200 in the near future?

Maybe for public consumption at home.  A more devious mind would suggest it’s to persuade lawmakers in the US, the most profligate user of oil, not to take the sensible course of raising gasoline taxes and thereby tempering future demand increases.  The country’s lobbyists are doubtless hard at work in Washington, as well.

Warren Buffett’s latest portfolio moves: the 4Q14 13-f

Investment managers subject to SEC regulation (meaning basically everyone other than hedge funds) must file a quarterly report with the agency detailing significant changes in their portfolios.  It’s called a 13-f.  Today Berkshire Hathaway filed its 13-f for 4Q14.  I can’t find it yet on the Edgar website, but there has been plenty of media coverage.

Mr. Buffett has built up his media and industrial holdings, as well as adding to his IBM.  The more interesting aspect of the report is that it shows him selling off major energy holdings–ExxonMobil, which he had acquired about two years ago, and ConocoPhillips, which he had been selling for some time.  Neither has worked out well.

There’s also a smaller sale of shares in oilfield services firm National Oilwell Varco and a buy of tar sands miner Suncor–both presumably moves made by one of the two prospective heirs working as portfolio managers at the firm (whose portfolios are much smaller than Buffett’s.  Buffett has told investors to figure smaller buys and sells are theirs.)

Three observations:

–the Buffett moves would have been exciting–maybe even daring–in 1980.  Today, they seem more like changing exhibits in a museum.

–if I were interested in Energy and thought it more likely that oil prices would rise than fall, I’d be selling XOM, too.  After all, it’s one of the lowest beta (that is, least sensitive to oil price changes) members of the sector.

But I’d be buying shale oil and tar sands companies that have solid operations and that have been trampled on Wall Street in the rush to the door of the past half-year or so.  That doesn’t appear to be Mr. Buffett’s strategy, however.  His idea seems to be to cut his losses and shift to areas like Consumer discretionary. (A more aggressive stance would be to increase energy holdings by buying the high beta stocks now, with the intention of paring back later by selling things like XOM as prices begin to rise.)  NOTE:  I’m not recommending that anyone actually do this stuff.  I’m just commenting on what the holdings changes imply about what Mr. Buffett’s strategy must be.

–early in my career, I interviewed for a job (which I didn’t get) with a CIO who was building a research department for a new venture.  I was a candidate because I was, at the time, an expert on natural resources.   The CIO said the thought there were three key positions any research department must fill:  technology, finance and natural resources.  All require specialized knowledge.    I’d toss healthcare into the ring, as well.  I’d also observe that stock performance in these more technical areas is influenced much less by the companies’ financial statements than is the case with standard industrial or consumer names.

Mr. Buffett is an expert on financials–he runs a gigantic insurance company, after all.  On tech and resources, not so much, in my opinion.  Financials are the second-largest sector in the S&P 500, making up 16% of the total.  Tech makes up 19.5%; Energy is 8.3%; Healthcare 14.9%.  The latter three total 42.7% of the index.  As a portfolio manager, it’s hard enough to beat the index in the first place.  Being weak in two-fifths of it makes the task even harder.

investment wildcard: Grexit

My first employer on Wall Street had an unusually aggressive negotiating style.  At one time, a big brokerage firm wanted to buy the company he founded.  They agreed on a price after lengthy negotiations.  Two weeks later, my boss reopened the negotiations and successfully raised the bid.  Then he did it again.

On the day the contracts were going to be signed, he asked for another 5%, figuring, I think, that the buyer would have no choice but to acquiesce rather than see all the time and effort it had put into the deal go up in smoke.

The buyer walked out the door instead.

According to the Japanese companies I’ve talked to over the years, Chinese government officials use the same psychological ploy–agree, let the other side relax and celebrate  …and then ask for more.  The one difference with China is that twenty years ago manufacturing there gave you both a labor cost and a capital cost advantage over making things elsewhere (the only instance of this I’ve seen in thirty years as an analyst).  So there was no question of going elsewhere.

From my casual observation, Greece has been using this same negotiating style with the rest of the EU over the past few years.  I suspect, however, that Greece’s position is closer to that of my old employer rather than China’s.

How so?

–Greece is small, representing only about 3% of the EU’s GDP.  Arguably, the most important thing it brings to the union is the cachet of once having been the cradle of democracy.

–EU financial institutions are much better able to withstand the shock of a Greek exit from the union than they were in the depths of the financial crisis.

–Greece has complied with virtually none of the dozen-plus structural reform mandates required by the current bailout, which expires at the end of this month.  This gives the EU no reason to believe that Greece will follow through on any terms it agrees to now

–allowing an unrepentant Greece to remain in the EU under far more relaxed standards than afforded to, say, Spain, could easily prove more destabilizing to the EU than cutting ties

–the negative economic consequences for Greece of Grexit could be enormous–enough to provide a cautionary example for other states, or regions within states to reconsider separatist movements.

my take

I think Greece is holding a much weaker hand than is commonly perceived.  I think that the chances Greek government negotiators will take the one step too far that will cause the other side to leave the room are significant–although I have no idea how to quantify that.  Finally, I think any negative reaction to an actual Grexit, ex Greek stocks, which I imagine would do very poorly, would be shorter and milder than the consensus thinks.