IBM (IBM) investors are finding a lot of reasons to sell IBM stock right now, after the company reported less-than-stellar earnings.
However, there was nothing about the company’s operating performance that I considered unexpected, but rather continued action regarding the company’s corporate strategy that I find bothersome.
It’s this action that could ultimately threaten IBM’s longevity and keep IBM stock underperforming long term.
Three Problems for IBM Stock
The biggest problem for IBM stock and the company’s future is that management continues to emphasize stock buybacks, and heavy spending on buybacks are putting the company at serious long-term risk.
During this last quarter IBM spent $1.5 billion on buybacks and nearly $1.3 billion on dividends. Combined, that’s $2.8 billion that IBM returned to shareholders, $200 million more than the $2.6 billion in free cash flow.
There’s three problems with how IBM is returning capital to shareholders.
First, IBM is still making acquisitions in the cloud. Therefore, since IBM is operating at a free cash flow loss after returning capital, it is forced to use debt … and IBM has $39.7 billion in debt right now!
Second, IBM’s buybacks are not working. IBM stock declined 13.5% during the last three months. Thus, $1.5 billion in buybacks did not do much for the stock.
Third, this has been an ongoing problem. IBM consistently spends far more on dividends and buybacks than it creates in free cash flow. While it boosts earnings per share, it also leads to higher debt, which thereby puts IBM’s credit at risk and limits what the company can spend on investments to better the business.
Specifically, IBM really hit rock bottom on spending back in the third quarter of last year.
At the end of Q3 in 2014, IBM’s free cash flow had declined 21% to $13 billion. Meanwhile, it had spent $4 billion on dividends and a ridiculous $18.5 billion on stock buybacks during the same period. That put IBM at a net FCF loss of $9.5 billion in the 12-months ended Q3 2014.
With that said, IBM had been showing improvements in recent quarters on what it spent on buybacks. During the fourth quarter of last year it spent just $132 million and only $1.2 billion in the first quarter of this year. Combined, IBM was spending far less than its free cash flow in those respective quarters.
However, the second and third quarters have taken IBM back, reverting to old spending habits that will ultimately weigh on IBM stock.
When excluding financing receivables of $1.1 billion in the second quarter, IBM has created almost $6 billion in free cash flow through three quarters. Meanwhile, it has spent a whopping $7.5 billion on dividends and buybacks during the same span.
Bottom Line on IBM Stock
All things considered, the continued spending on dividends and buybacks that exceed free cash flow is not good for the long-term direction of IBM stock. It takes from other areas where IBM could invest in its business to find growth long-term.
That said, there’s a reason that IBM stock fell 5% after reporting earnings. IBM should be reinvesting its free cash flow into that business, not adding debt to do so; and management should not be so worried about the stock to try and create buying pressure with stock buybacks.
Fact is, if IBM takes care of the business, then IBM stock will follow. Given the lavish spending on buybacks and dividends that we’re seeing, there are some serious spending habbits that must change before IBM stock will return to old form.
As of this writing, Brian Nichols did not hold a position in any of the aforementioned securities.
