Courtesy of Doug Short.
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There are a lot variables regarding IBM’s debt issuance, maturation, servicing, and rollover that I simply do not have time to fact check. The reason for the IBM case study is not to be wholly accurate, but to place IBM’s current stock buyback and debt issuance programs in context with abnormally low Fed fund rates today juxtaposed against a backdrop of higher future interest rates in 2017-2019 and the recent back up in Treasury yields at the short end of the yield curve as the Fed telegraphs a higher Fed funds rate sometime in 2015.
Why do this? Because we want to overlay IBM’s stock buyback and Debt Issuance with the NY Fed models assuming “excess high returns” for the US stock market through 2018 and the GMO (Grantham, Mayo, & Otterloo) 7 year expectancy models at 2013 year end assuming negative US equity returns through 2020 year end. I am going to postulate in what follows that both models can be right, and further that much of the “excess high returns” forecast by the NY Fed are already behind us. It is important to note that the NY Fed models were written in early 2013 before the US stock market rallied an additional +20%. The GMO 7-year expectancy models was generated after that 20%+ US stock market rally in 2013.
IBMs stock buyback program began well before Q1 2012, so the information conveyed by ZH below is incomplete (For instance, IBM’s Cash Flow statement shows 12.6b stock buybacks in 2011 vs 12.8b stock buybacks in 2013) . Nor do we know much about its debt issuance program before Q1 2012. In particular, we don’t know when this new debt issuance will need to be rolled over. But, we do see a lot of 5 year corporate debt issuance. Assuming a 5 yr rollover, beginning in 2017 and extending through 2019, IBM will need to rollover about 31b in debt just from the 2012-2013 time series. The bulk of that new debt will likely need to be rolled over at end of 2018-2019. This will be rolled over at higher rates, as the FOMC believes the path trajectory for the Fed funds rate will climb to 150bps by end of 2016. Beginning in 2017, then, and accelerating in 2019, IBM may have a new drag on its net income. Namely, higher debt service. Unless IBM can pay down its debt through increased revenues, IBM debt service is likely to accelerate in 2018 assuming a 5 yr debt rollover schedule (shown below).
The reason this is material for long term investors is that the NY Fed has determined that US equities should enjoy “excess high returns” through 2018. (But the NY Fed study was done when the SP500 was trading around 1525, and the SP500 has already increased 25% to 1892 in Q2 2014 a year later. Since “Siegel’s Constant” assumes +6.5% annualized returns for US equities over a long term time series, much of those excess high returns for US equities may have been front-end loaded in 2013 just prior to the back up in yields at the short end of the US Treasury curve. It may or may not be coincidence that IBMs debt issuance accelerated in Q4 2013 & Q1 2014 as interest rates at the short end of the yield curve shot higher.
At the end of 2013, GMO published its 7 year forecasting model through 2020. Their models indicate negative real returns for US large cap and US small cap. It is possible that both the NY Fed models through 2018 and the GMO models through 2020 are right. So, investors would do well to remember the SP500 2013 yr high at 1846 that GMO is using as a “high watermark” in its 7 yr model. While higher highs than 1846 can be seen between 2014-2018, consistent with the NY Fed models, it is also entirely possible that as the SP5000 large cap companies such as IBM rollover their debt at higher rates in 2017-2019, that the SP500 also mean reverts by end of 2020 such that the SP500 2013 high at 1846 is higher than the SP500 price at the end of 2020.
Zerohedge noted that beginning in 2012, “IBM generated enough cash to where the incremental debt-funded buybacks did not result in a major change in the company’s net leverage, [but beginning in Q2 2013] organic cash flow declined so much that IBM had no choice but to see its net debt surge” 75% from $20 billion in Q1 2012 to nearly $35 billion in Q1 2014.
IBM’s current market cap is 197b. Its current debt to equity ratio is an obscene 262%. ZeroHedge notes this 262% debt to equity ratio is a record for IBM. From 1987 though 2007, its debt to equity ratio peaked around 160%. During the Lehman crisis in September 2008, its debt to equity ratio spiked to 250%. Remember, the stock market was crashing in September 2008, so debt to equity ratios of most US companies were spiking. This time around, the US stock market is at record highs. That’s a huge qualitative difference between 2014 and 2008-2009. This, notes ZH “leaves Big Blue in a very unpleasant situation: should it continue buying back stock at record levels, all funded through new debt issuance, preserving for one more quarter the illusion that EPS is stable [and] growing… while revenues keep declining [and] in the process risk its pristine credit rating, or should IBM finally throw in the towel, and instead preserve its balance sheet while allowing EPS to finally track revenue growth. Or lack thereof.”
“Considering that for IBM its balance sheet is far more precious than its income statement and what its stock does over the near-term especially since its price per share is just shy of all-time highs, we can only assume that IBM will promptly slow down if not end outright, its stock buyback gimmick routine. First IBM, and then every other investment grade company that like Big Blue has postponed the day of income statement reckoning by unleashing record amounts of debt on what was once upon a time a pristine balance sheet.”
IBM’s 2013 Interest Expense was 402m. Net Income was 16.5b. If short term rates rise 150bps by 2017, the risk is that IBMs interest expense on $34b will increase roughly 500m in the next 3-5 yrs.
IBM earned $16.28 in 2013 and 2.54 in Q1 2014. Revenues are expected to fall -2.3% in 2014. Yet, they must earn 13.74 over the next three quarters to earn just what they did in 2013. Despite the $8b stock buybacks in Q1 2014 and $6b stock buybacks in Q3 13, the Q1 2014 eps of 2.54 was still 21% below what IBM earned in Q2 2013 and 36% below what IBM earned in Q3 2013.
FY 2013 is setting up to be a year of peak earnings for IBM, despite the exponential rate of increase in its stock buyback program over the last two quarters. It is interesting to note IBMs exponential increase in its debt issuance in Q4 13 and Q1 2014 dovetails nicely with the removal of asset purchases QE by the Fed. The removal of asset purchases, coupled with the Fed indicating they will begin to raise the Fed funds rate in 2015 has resulted in higher short term rates across the short end of the yield curve.
When we consider IBMs stock price, we see that it set an intermediate term high in March 2013 at 216. It may well turn out to be a primary cycle high similar to the high it set in July 1999 at 139. Notably, peaks and troughs in IBM have been harmonizing near multiples of 70-72 since 1999. A return move to 140-144 should surprise no one. And if IBM’s earnings fall 20% to around $13.00 from its $16.28 peak earnings in FY 2013, @ 140, it would potentially be repriced at 11x current ttm earnings (extrapolating a potential earnings contraction of 20% into 2015). The August 2011 yr low (a year of a powerful 12.5 billion buyback program) at 157 is a good place to set a price alert. Trend support from 1993-2008 is sloping into 150 and the average price since 1999 and 2002 is sloping into 125. Old highs near 130-140 also speak to long-term support for IBM.
Please contact John at jb2@structurallogic2.com if you would like to subscribe to Structural Logic Research.
John Bougearel is a Chartered Market Technician CMT and founder of Structural Logic Inc., a registered Commodity Trading Advisor offering managed accounts for clients. Structural Logic Research publishes a daily financial newsletter for institutional and retail clients. John is a featured financial market educator for the ICE Exchange, Market Technicians Association, and various FCMs and IBs. John has authored two books, The Changing Role of Gold and Riding the Storm Out: What Do Investors Do Now. John is also a featured financial analyst on Bloomberg’s roundtable, Fox News, and other financial news networks. John received his B.A. from St. Olaf College in 1985.
(c) John Bougearel
