BESPOKE DETAILED REVIEW International Business Machines Corp. (IBM) Provided for Client REVIEW CONTENTS: ANALYSTS: Key Takeaways Summary Quality of Revenue Quality of Earnings Quality of Cash Flow Corporate Governance Enitan Adebonojo, CFA, CPA +1 646.517.2257 enitan.adebonojo@cfraresearch.com
Key Takeaway Increase in receivables driven by financing offered to customers especially those considered below investment grade suggests IBM is having a more challenging time maintaining or growing its revenue base. Weak revenue growth despite acquisitions and little to no growth in backlog or deferred revenue suggests revenue growth will remain challenging. Earnings in the last three years have benefited from declines in depreciation expense. Earnings also benefited in the December 2012 quarter from a decline in the level of total allowance for doubtful accounts relative to total gross receivables. Summary SOURCE DOCUMENTS December 2012 10-K 5-years of financial data RELATED IRAP Computers & Peripherals CFRA SCORE QUALITY OF REVENUE P.3 Level of receivables has increased in the last five quarters, mostly due to an increase in the level of financing offered to customers. In addition, the percentage of financing going to customers rated as below investment grade has been rising. As such, IBM appears to be taking on more risk to maintain or grow revenues. Revenue growth appears weak despite benefit derived from acquisitions. IBM does not disclose the impact of acquisition on revenues. Trends in backlog and deferred revenue do not point to future revenue growth acceleration. QUALITY OF EARNINGS P.7 Depreciation expense has declined in the last three years, which has benefited earnings. In some periods, declines coincided with an increase in average gross PP&E. Earnings benefited in the December 2012 quarter from decline in the level of total allowance for doubtful accounts relative to total gross receivables. If provisions are inadequate, it may lead to higher charges in the future. Inventory level declined in December following an increase in prior periods. Current level is not concerning. Trends in research, development and engineering expense, prepaid expense and other current assets and other accrued expense and liabilities do not raise concern regarding possible earnings benefit. QUALITY OF CASH FLOW/LIQUIDITY P.9 Both trailing-twelve-month (TTM) cash flow from operations (CFFO) and free cash flow (FCF) remained positive but are off from their peak. We found no evidence of cash flow boost or manipulation. There appears to be no risk of a near-term liquidity event given current cash balance, cash flow generation and available credit facility versus current debt. CORPORATE GOVERNANCE P.10 IBM reported certain related party transactions, which typically raise concern that such transactions may not have been negotiated at arm s length. There have been no changes in auditor since at least fiscal 2008. Cash Flow Score: 3 rd Decile Earnings Score: 2 nd Decile 2
Quality of Revenue RECEIVABLES INCREASED IN THE LAST FIVE QUARTERS MOSTLY DUE TO INCREASED FINANCING IBM s revenue growth may have benefited in the last four quarters from an increase in the level of accounts receivable mostly driven by higher level of financing offered by the Company. It also appears that IBM is financing more sales to customers that have below investment credit rating which increases the risk of its financing operations and could lead to greater losses in the future. As shown on Table 1a, total notes, accounts and financing receivables measured in days (DSO) are at the highest level for the December quarter in five years, mostly due to an increase in financing receivables. Specifically, total DSO amounted to 135 days as of December 2012 versus a range of 122 to 125 days in each of the prior three December periods, and versus 131 days at December 2008, the height of the financial crisis. Similarly, DSO-Total Financing Receivables rose to 96 days as of December 2012, the highest level in the last five December quarters and in the last fifteen quarters. A larger proportion of financing appears has been going to customers that are ranked as below investment grade, which suggests that IBM may be taking on more risk to grow revenues. Total leases and loans receivable due from below investment grade customers rose to the highest level in at least nine quarters 38.5% as of December 2012 from 33.6% in the prior year and 30.1% two years prior. (See Table 1b.) As the Company continues to increase this pool of financing, the collection risk may increase, but some of the risk is likely mitigated by the fact that IBM can repossess leased equipment if a customer no longer meets its obligation. CFRA notes however that some of the financing offered by IBM may be supporting service revenue, as total origination in the last four years has exceeded total revenue from sales. (See Table 1c.) If correct, then some of the collection risk cannot be mitigated by IBM s ability to repossess items sold if some of the below investment grade financing receivables are related to service revenues. We have no reason to believe that any service revenue relates to sale of products. According to the 2012 10-K filing, services primarily include: information technology (IT) datacenter and business process outsourcing, application management services, consulting and systems integration, technology infrastructure and system maintenance, Web hosting and the design and development of complex IT systems to a client s specifications (design and build). Despite the increase in sales to lower credit rated customers, IBM does not appear to have suffered significant losses from non performing loans. To the extent that only sales of products are financed for these customers, risk of loss may be mitigated by IBM s ability to repossess equipment from customers that no longer meet their obligations. However, further growth in revenues from such customers may be limited. 3
Table 1a: Accounts and Financing Receivable Increased in the Last Four Quarters Q2, Q2, $ Mils. ex DSO in days Dec-12 Sep-12 Jun-12 Mar-12 Dec-11 Sep-11 Jun-11 Sep-10 Notes & Accounts Rec. 10,667 9,772 10,172 10,012 11,179 9,719 10,539 10,148 10,834 9,717 ST Financing Rec. 18,038 14,925 14,982 15,160 16,901 14,145 14,715 14,365 16,257 13,592 Other Receivables 1,873 2,066 1,703 1,669 1,481 1,123 1,127 1,145 1,134 1,187 Total Current Rec. 30,578 26,763 26,857 26,841 29,561 24,987 26,381 25,658 28,225 24,496 LT Financing Rec. 12,812 10,791 10,795 10,549 10,776 9,830 10,422 10,254 10,548 9,448 Total Receivables 43,390 37,554 37,652 37,390 40,337 34,817 36,803 35,912 38,773 33,944 Total Financing Rec. 30,850 25,716 25,777 25,709 27,677 23,975 25,137 24,619 26,805 23,040 Total Revenues 29,304 24,747 25,783 24,673 29,486 26,157 26,666 24,607 29,018 24,271 DSO Notes & Acct. Rec. 33 36 36 37 35 34 36 38 34 37 ST Financing Rec. 56 55 53 56 52 49 50 53 51 51 Other Receivables 6 8 6 6 5 4 4 4 4 4 DSO Total Current Rec. 95 99 95 99 91 87 90 95 89 92 LT Financing Rec. 40 40 38 39 33 34 36 38 33 36 DSO Total Current & LT 135 138 133 138 125 121 126 133 122 128 DSO Total Financing Rec. 96 95 91 95 86 84 86 91 84 87 YoY Change Total Current Rec. 4 12 5 4 3 (5) (0) 1 (1) 1 YoY Change Total Rec. 10 17 7 5 3 (6) 0 1 (4) (3) YoY Change Total Financing Rec. 10 11 5 4 1 (3) (0) 1 (1) (3) Table 1b: Leases and Loans Receivable Below Grade Relative to Total Q2, $ mil, ex % Dec-12 Sep-12 Jun-12 Mar-12 Dec-11 Sep-11 Q2, Jun-11 Total Leases & Loans Rec. 22,512 19,793 25,683 19,506 20,058 18,407 19,393 19,206 19,626 Amounts below Investment Grade 1 8,657 7,415 7,173 7,015 6,748 5,961 6,134 5,920 5,907 Amounts below Investment Grade 38.5% 37.5% 36.4% 36.0% 33.6% 32.4% 31.6% 30.8% 30.1% / Total Leases & Loans Receivable 1. These receivables are due from customers that have a credit rating of Ba1 or lower, as reported by IBM in its filings. Table 1c: Leases and Loans Receivable Below Grade Relative to Total Leases & Loans Receivable FY, FY, FY, FY, $ mil, ex % Dec-12 Dec-11 Dec-09 Annual Sales 43,014 44,063 40,736 38,300 Originations 53,222 49,673 45,113 39,641 Annual Sales as % of Originations 123.7% 112.7% 110.7% 103.5% 4
REVENUE GROWTH FOR 2012 APPEARS WEAK, DESPITE LIKELY BENEFITS FROM ACQUISITIONS IBM s revenue growth excluding the impact of foreign currency has been weak in the last four quarters, despite numerous acquisitions made in the last few years. (See Table 2.) Growth in prior periods likely benefited from acquisitions, but IBM does not quantify the impact of these acquisitions on its revenues even though it includes disclosure of the impact of acquisitions on total expenses i.e. acquisitions increased total expense by 3%. Anecdotal disclosure of acquisition impact on IBM s businesses per the latest 10-K filing included the following: In addition to organic investments, acquisitions have provided additional capabilities, while leveraging the existing portfolio of offerings. The software business completed nine acquisitions in 2012, further increasing the company s capabilities in analytics, cloud and Smarter Planet. The company further strengthened its WebSphere portfolio during the year with the acquisitions of Worklight, DemandTec, Emptoris and Tealeaf. The acquisitions of Varicent and Vivisimo expanded the Business Analytics and Optimization software capabilities. Tivoli security revenue increased 8 percent (10 percent adjusted for currency), with strong contribution from Q1 Labs which provides next generation security intelligence. Lotus revenue decreased 2.1 percent as reported, but was flat year to year at constant currency in 2012. The social business offerings performed well, including contribution from the acquisition of Kenexa, a leading provider of recruiting and talent management solutions. So while IBM clearly indicates that acquisitions have a beneficial impact on revenues, it does not quantify the impact or disclose organic revenue growth. Q1 Labs was acquired during the December 2011 quarter and reportedly was the growth driver for a 16% increase in Tivoli revenues during fiscal 2012. While revenues from Q1 Labs in the December 2012 may have been organic, this acquisition has not anniversaried in the first three quarters of 2012. Revenues also benefited during the December 2012 quarter from the acquisition of Kenexa Corporation, which closed December 2, 2012. Based on prior filings of the Company and the assumption that revenue growth in the December 2012 quarter remained flat relative to the September quarter (19.9%), CFRA estimates that this acquisition contributed approximately $31.2 million to revenues in December 2012. This acquisition alone contributed 10bps to the December 2012 growth rate. Other acquisitions made by IBM during 2012 and 2011 were privately held companies, and as such we are unable to estimate the impact those had on IBM s growth rate. Table 2: Revenue Growth Appears Weak in 2012 Q2, % Dec-12 Sep-12 Jun-12 YoY Revenue Growth Mar-12 Dec-11 Sep-11 Q2, Jun-11 Sep-10 Services (2.0%) (4.4%) (2.7%) 0.8% 2.8% 7.9% 10.3% 6.5% 2.7% 2.7% Sales 1.0% (6.7%) (4.3%) (0.3%) 1.0% 8.1% 16.5% 10.3% 11.6% 3.7% Financing (2.5%) (9.1%) (0.6%) (5.2%) (12.7%) (1.7%) (4.4%) (3.9%) 1.1% (1.5%) Total YoY Revenue Growth (.6%) (5.4%) (3.3%) 0.3% 1.6% 7.8% 12.4% 7.7% 6.6% 3.0% Total Growth, Ex FX Impact 0.30% (1.8%) 0.5% 1.0% 1.4% 2.7% 5.1% 5.0% 3.3% 3.6% 5
TREND IN BACKLOG AND DEFERRED REVENUE DO NOT POINT TO FUTURE GROWTH ACCELERATION IBM s backlog declined slightly in nominal terms from the prior year level following another decline in the prior year. However, as reported by the Company excluding the impact of currency backlog grew year-over-year by 0.6% and was up sequentially by 1.9% in December 2012 quarter. In general even focusing on growth adjusted for currency as reported by IBM, CFRA notes that growth in prior December periods were higher. (See Table 3a.) Currently, full year revenues are expected to growth by 1.7% to $106.27 billion in 2013 despite the fact that approximately 70% of revenues come through backlog and there has been little to no growth in backlog. It is possible that IBM can continue acquiring other businesses in the near term to boost overall growth but it may not be sufficient. The current portion of deferred income measured in days fell slightly to 37 days from 38 days in the prior year but increase from 36 days two years ago. (See Table 3b.) Although this minimal decline may not pressure future revenue growth, deferred revenue likely will not drive future revenue growth either. Deferred income primarily consists of prepayments for service revenues ($7,281 million at December 2012) and to a limited extent payments for extended warranty contracts. There is limited disclosure regarding this account balance in IBM s filings. Table 3a: Trend in Backlog & Backlog Growth does not Point to Acceleration in Future Revenue Growth Q2, Q2, In millions, ex % Sep-12 Jun-12 Mar-12 Dec-11 Sep-11 Jun-11 Sep-10 Dec-12 Backlog 140,300 137,700 136,100 139,400 140,600 136,900 144,200 142,200 142,400 134,500 YoY Change Adj. for Currency 0.6% 1.3% 0.5% 0.7% 0.0% 2.3% 1.9% 1.5% 2.9% 0.4% Sequential Change Adj. for Currency 1.9% 1.1% (2.4%) (0.9%) 2.8% (5.1%) 0.0% 5.9% 3.9% Table 3b: Current Deferred Revenue Slightly Down in December 2012 $ Mils. ex DSDR in days Q2, Q2, Dec-12 Sep-12 Jun-12 Mar-12 Dec-11 Sep-11 Jun-11 Sep-10 Deferred Income - Current 11,952 11,230 12,311 13,269 12,197 11,252 12,660 12,820 11,580 10,499 Deferred Income - LT 4,491 4,263 3,889 3,904 3,847 3,634 3,641 3,724 3,666 3,487 Total Deferred Income 16,443 15,493 16,200 17,173 16,044 14,886 16,301 16,544 15,246 13,986 Total Revenue 29,304 24,747 25,783 24,673 29,486 26,157 26,666 24,607 29,018 24,271 DSDR Current 37 41 44 49 38 39 43 48 36 39 DSDR - LT 14 16 14 14 12 13 12 14 12 13 DSDR - Total 51 57 57 64 50 52 56 61 48 53 6
Quality of Earnings POSSIBLE EARNINGS BENEFIT FROM LOWER DEPRECIATION RATE IBM s earnings appear to have benefited in the last three years from declines in its depreciation expense and depreciation rate, which coincided in some periods with an increase in average gross property, plant and equipment (PP&E). However, we noted no changes in the Company s depreciation policy that would account for this decline. As shown on Table 4, depreciation expense fell to the lowest level in both nominal and relative terms in the December 2012 quarter - $820 million versus $888 million in the prior year. However, average gross PP&E increased to $40,608.5 million in December 2012 from $40,131.5 million in the prior year. Depreciation expense declined from the prior year level by $197 million in 2012, $68 million in 2011 and $116 million in 2010. Absent these declines annual EPS would have been $0.13 lower in fiscal 2012, $0.04 lower in 2011 and $0.07 lower in 2010. It is possible that some of this decline may be due to fully depreciated assets that have remained in operation, which could lead to higher expense in the future as these assets are replaced. Alternatively, the decline may also be due to replaced assets having longer lives (which may be within the stated policy) relative to assets that have been removed from service. Table 4: Decline in Depreciation Expense Appears Persistent In millions, ex % Q2, Q2, Dec-12 Sep-12 Jun-12 Mar-12 Dec-11 Sep-11 Jun-11 Sep-10 Depreciation Exp. 820.0 866.0 859.0 847.0 888.0 885.0 898.0 918.0 920.0 914.0 Ave. Gross PP&E 40,608.5 40,437.0 40,299.5 40,282.5 40,131.5 40,632.5 40,945.5 40,527.0 40,112.5 39,114.0 Depr. Exp. / Ave Gross PP&E 2.0% 2.1% 2.1% 2.1% 2.2% 2.2% 2.2% 2.3% 2.3% 2.3% POSSIBLE EARNINGS BENEFIT FROM LOWER ALLOWANCE FOR DOUBTFUL ACCOUNTS IBM s earnings may also have benefited in the last three years from declines in the level of total allowance for doubtful accounts (ADA) relative total gross receivables (GAR). The latest decline occurred in the December 2012 quarter as total ADA relative to total GAR fell to 1.8% from 1.9% in the prior year and 2.0% in the September 2012 quarter. Had ADA remained at the prior year level earnings would have been $0.02 lower in December 2012 quarter. Given the increase in financing receivables which accounts for the latest decline in total ADA, if current ADA level is not adequate, it may lead to higher charges in the future. Table 5: Allowance for Doubtful Accounts Declined Year-over-Year in Six Quarters Q2, Q2, % Dec-12 Sep-12 Jun-12 Mar-12 Dec-11 Sep-11 Jun-11 Sep-10 ADA / GAR Notes & Accts Rec. 2.3% 2.5% 2.5% 2.6% 2.2% 2.8% 2.8% 3.1% 2.9% 3.2% ADA / GAR ST Financing Rec. 1.6% 1.8% 1.8% 1.8% 1.8% 1.8% 1.9% 2.2% 2.1% 2.7% ADA / GAR Other Receivables 0.9% 1.0% 0.6% 0.5% 0.7% 1.0% 1.1% 1.0% 0.9% 0.8% Total ADA / Total GAR 1.8% 2.0% 2.0% 2.1% 1.9% 2.2% 2.2% 2.5% 2.3% 2.8% 7
INVENTORY NOT CONCERNING IBM s total and finished goods inventory declined slightly in the December 2012 quarter following increase in the prior four quarters and therefore does not raise concern regarding possible margin pressure that can arise from excess inventory. Specifically, total and finished goods (FG) inventory measured in days (DSI) amounted to 53 days and 11 days, respectively as of December 2012. This follows a year-over-year increases of 3 days to 10 day for total inventory and 2 to 6 days in finished goods in the prior four quarters. Given the decline we have no reason to raise concern. Table 6: Inventory Remained within Historical Range Q2, Days Dec-12 Sep-12 Jun-12 Mar-12 Dec-11 Sep-11 Q2, Jun-11 DSI Total 53 73 73 76 55 68 63 69 52 68 YoY Change (2) 5 10 7 3 (0) (8) (3) (4) 0 DSI - FG 11 18 20 19 12 16 14 15 9 13 YoY Change (1) 2 6 4 3 2 0 (1) (3) (1) Sep-10 TRENDS IN OTHER ACCOUNTS NOT CONCERNING Based on our analysis of accounts including but not limited to research, development and engineering (RD&E), prepaid expense and other current assets as well as other accrued expense and liabilities, we see no reason to raise concern regarding possible earnings boosts. (See Table 7.) RD&E expense increased slightly in the December 2012 quarter, following a decline in the prior year. However, this expense has been in a 5.3% to 6.8% range in the last fifteen quarters, so current level is closer to the lower end of the range. Significant declines in RD&E expense would raise concern regarding earnings boost or slower future revenue growth due to lack of investments. Prepaid expense & other current assets (OCA) as a percentage of revenues has been trending downward. Typically we would be concerned by increases that could suggest higher cost capitalization. Other accrued expense and liabilities as a percentage of revenues increased year-over-year in the last two quarters. Typically, we are concerned by significant declines that may suggest that expenses are not being accrued at historical levels, thereby benefiting earnings in the short-term. Table 7: Other Account Trends Q2, Q2, % Dec-12 Sep-12 Jun-12 Mar-12 Dec-11 Sep-11 Jun-11 Sep-10 RD&E / Sales & Software Rev. 5.5% 6.3% 6.3% 6.6% 5.4% 6.0% 6.0% 6.6% 5.6% 6.2% Prepaid Exp. & OCA / Revs. 13.7% 20.3% 19.8% 21.5% 17.8% 19.8% 17.5% 17.8% 14.6% 19.2% Other Accrued Exp. & Liabilities. / Revenues 16.5% 20.1% 17.8% 19.0% 15.4% 16.9% 19.3% 21.7% 17.8% 19.6% 8
Quality of Cash Flow / Liquidity TREND IN OPERATING CASH FLOW AND FREE CASH FLOW NOT CONCERNING There is no evidence of cash flow manipulation or unsustainable boosts, however, both trailing-twelve-month (TTM) cash flow from operations (CFFO) and TTM free cash flow (FCF) are off from their peak. In addition, there appears to be no risk of near term liquidity risk given cash balance of $10.4 billion adjusted TTM FCF generate of at least $9.6 billion in the last 10 quarters versus current debt of just $9.2 billion as of December 2012. IBM also has an untapped $10.0 billion credit facility. Table 8: TTM Operating Cash Flow and TTM Free Cash Flow off from Peak Levels Q2, Q2, $ millions Dec-12 Sep-12 Jun-12 Mar-12 Dec-11 Sep-11 Jun-11 Sep-10 CFFO 6,345 4,514 4,435 4,291 7,097 4,679 4,279 3,792 6,795 4,551 TTM CFFO 19,585 20,337 20,502 20,346 19,847 19,545 19,417 18,904 19,549 19,203 TTM FCF 15,278 15,954 16,173 16,343 15,788 15,441 15,296 14,766 15,565 15,172 Adjusted TTM FCF 1 11,556 12,100 12,596 13,264 13,977 12,289 10,224 9,617 9,643 11,110 Current Debt 9,181 9,334 7,669 6,293 8,463 6,071 7,858 8,508 6,778 5,556 Total Debt 33,269 33,667 32,435 32,053 31,320 30,160 29,773 30,257 28,624 27,455 1. TTM adjusted for the cash outflow related to acquisitions 9
Corporate Governance RELATED PARTY TRANSACTIONS In regards to certain transactions and relationships, IBM included the following disclosure in its latest proxy filing: In connection with Mr. Palmisano s retirement from the Company effective December 1, 2012, the Board approved certain a post-retirement consulting arrangement whereby he may be asked from time to time to provide services as an independent contractor. The fee for such services would be $20,000 per day for each day he provides four or more hours of services and $10,000 per day for each day he provides less than four hours. As of December 2012 no consulting fees have been paid to Mr. Palmisano. From time to time, the Company may have employees who are related to our executive officers or directors. As noted in the discussion above on General Information Board of Directors, Mr. Eskew s son is employed by the Company. He is an executive of the Company (not an executive officer). In addition, an adult child of Mr. M. E. Daniels (Senior Vice President and Group Executive, Services) and a sibling of Dr. J.E. Kelly III (Senior Vice President and Director, Research) are employed by the Company in non-executive positions. Further, a brother-in-law of Mr. M. Loughridge (Senior Vice President and Chief Financial Officer, Finance and Enterprise Transformation) and the spouse of Mr. T.S. Shaughnessy (Senior Vice President, GTS Services Delivery) are executives of the Company. None of the above-referenced family member employees are executive officers of IBM. Each employee mentioned above received compensation in 2012 between $120,000 and $500,000. Additionally, in 2012 the above-referenced family members of Messrs. Eskew, Daniels, Loughridge and Shaughnessy each received an equity grant. The compensation and other terms of employment of each of the family member employees noted above are determined on a basis consistent with the Company s human resources policies. CFRA is typically concerned that the terms of transactions with related persons may not have been negotiated at arm s length. 10
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