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November 13, 1998
For our American clients and readers who may not be familiar with VNU, maybe we should point out that VNU Business Publications is one of the largest business-to-business publishing companies in the UK, with a diverse portfolio of consumer and professional information titles that reaches more than one million professionals in IT, business and finance.
You can also view this article at the VNU Web site (www.vnunet.com); just click on Newswires, then Analysis, after you get to their home page.
One factual correction is in order, though. I do not write a column for the Washington Post, as the VNU story says, but for the Washington Post's Integration Management magazine. And my Chronicles magazine columns are mostly on global economic issues, not IT. As are my regular contributions to the Washington Times on geopolitical issues (Truth in Media).
While we are at such clarifications, I have had also a regular column in the FORBES magazine's on-line edition. Until I started writing about stock buybacks in mid-1997, and other issues ticklish to Wall Street. Then, the FORBES budget for columnists suddenly dried up. :-)
Also published in and the Dominion (New Zealand)
Who Wins in IBM Stock Buyback?
By John Geralds in Silicon Valley
SAN JOSE, Nov. 13, 1998 - Yesterday, IBM's stock price closed at an all-time high of $159.43. The price has been moving up steadily since it hit its low for the last 12 months of $95.25, early this year.
One would think that such investor confidence rewarded IBM for a sterling performance in its markets, with turnover and profits roaring along on a par with the stock price.
One would be wrong. IBM's stock price continues to defy gravity despite the fact that, during Lou Gerstner's five-year term as chief executive, sales and profits have annually averaged single percentage point rises.
Why does the success of the stock bear little resemblance to the financial performance of the company?
One vocal critic of Gerstner and a long time IBM watcher, Bob Djurdjevic, believes the rise in the price has nothing to do with the company's performance but is the result of an "unspoken" deal between the company chairman and Wall Street that earns both sides pots of money.
Djurdjevic is not a person to be taken lightly. He has been tracking, analysing and consulting in this industry longer than most analysts have been in the business, some 28 years. He runs Phoenix based consultancy Annex Research, founded in 1978, and writes an IT column for the 'Washington Post' and 'The Chronicles Magazine'.
According to Djurdjevic, the tool that Gerstner is using to keep Wall Street in his lap is stock buyback - a stock boosting strategy that has become commonplace in recent years.
When a company buys its own stock on the open market, it helps to boost corporate earnings by one measure - earnings per share - a key gauge when analysing a company's performance.
During Gerstner's reign, IBM's board has approved stock buybacks to the value of $27.5 billion. "It's a waste of capital - it doesn't create a single product or a single job," said Djurdjevic, who has been a long time critic of buyback programmes at IBM and other companies.
"They're saying they can't think of a better way to invest in the technology industry. Instead they are paying off Wall Street in exchange for good opinions of IBM stock."
Djurdjevic called the repurchase a "Wall Street perversion that benefits selling institutions, to society's detriment, and artificially inflates current earnings and growth".
So while the company's sales and profits have been at best slow, IBM's earnings per share have rocketed, creating what Djurdjevic calls "an illusion of prosperity by boosting the financial results without adding a cent to the bottom line".
As an example, let's examine the latest quarterly results from IBM. The first sentence of the company's press release touted that the earnings per share went from $1.35 in the previous year to $1.56 this quarter.
Only in subsequent sentences did IBM point out that profits rose a paltry $100 million from $1.4 billion to $1.5 billion year over year. Revenues were up only eight per cent.
In the same release, IBM revealed profits for the nine months ended 30 September 1998 were $4 billion, exactly the same as a year earlier. Sales for the nine months were $56.5 billion, an increase of three per cent compared with $54.8 billion.
Hardly the financial statistics to send Wall Street's major institutional investors rushing out to buy IBM shares.
But with a major stock buyback scheme, they can hardly lose on the investment. Wall Street knows that IBM is willing to spend billions to buy the shares so it can pump up the price.
IBM is committed to spending the money as it needs to keep its earnings per share figure growing. Institutions put large blocks of shares on the market and IBM picks them up no matter what the price, causing millions of dollars to flow into the coffers of Wall Street's elite.
Who else makes money from the deal? Obviously IBM's employees, particularly its executives, who have the biggest stock options.
Gerstner has always had a huge stock option element in his compensation package. It was increased last year when he agreed to stay on for at least four and a half more years. In his latest contract, Gerstner will receive options for two million more shares. The stock options awarded Gerstner nearly equalled the 2.4 million he has received since joining IBM in 1993.
IBM's CEO recently sold 142,000 shares for a gain of about $16.6 million. Five months ago, Gertsner sold another 138,000 shares for a $14 million gain.
In total Gerstner is worth about $95 million today.
Djurdjevic said Gerstner's stock options package seemed out of proportion to the company's revenues. "Gerstner's compensation has always been running ahead of IBM's performance," he said.
The big question is what should IBM be doing with its billions if not buying back its shares.
Until IBM turned the stock buyback into a controversial weapon, technology companies and others in so-called growth sectors were expected to create new products and services that should generate earnings growth.
When asked why IBM is spending money on stock buybacks, a company spokesperson, John Bukovinsky, said: "IBM buys back shares in part because it generates so much cash from operations and has little need to build new plants. Most of our sales growth now comes from computer services, and that takes less investment than building the machines themselves."
Bukovinsky pointed out IBM believed it was a good investment of its own funds. Share buybacks were an important part of the use of cash and an important part of the company's financial model. "It's also part of a plan we laid out for Wall Street several years ago. The financial analysts recognise it and understand it. It's one element of our long term business model," he said.
He continued: "We assume a gross profit decline of about one per cent a year, primarily as a result of the changing mix in the products and services we sell. As services become the greater portion of the business, we believe the gross profit decline will be offset by improvements in the tax rate and the tax structure. As a result we will be able to maintain a net profit of about seven per cent," he explained.
"The final element of the plan is a continuing stock repurchase programme, because we believe IBM stock is a prudent and attractive investment and excellent use of our cash," Bukovinsky went on. "This programme began as part of our fundamental strategy in 1995. We have met or exceeded our model and Wall Street has recognised that. And this year we continue to be on target."
Other analysts are not as offended as Djurdjevic is by the buybacks.
"IBM generates a substantial amount of cash flow, and earning interest on the cash just isn't a good solution," said Gruntal & Company analyst David Takata. "Buying back stock is just one weapon they use to enhance shareholder value."
He also pointed out that IBM is actively acquiring smaller software and services companies. Indeed, IBM has bought some 45 companies in the past few years, most of them small.
"Some pieces of the business are doing fabulously well," said John Jones, a financial analyst with Salomon Brothers in San Francisco. "But the reality is [Gerstner's] job isn't done."
Steven Milunovich, an analyst with Merrill Lynch, said: "I think it's a reasonable use of cash. How many investment opportunities do they have that can return cost of capital? They should be investing up to that point and beyond that they should return cash to the shareholders."
IBM is not returning substantial cash to its shareholders in the traditional form of dividends. Its quarterly dividend was as much as $1.21 a share in 1992, before the stock was split, and has been as low as 12.5 cents in 1993 when Big Blue was in deep financial trouble.It has just been raised to 22 cents a share.
In the IT industry, stock buybacks are still not that prevalent. Companies such as EDS, Compaq and Unisys spent no money on stock buybacks or the amounts were low; Hewlett Packard and Sun Microsystems did repurchase some of their shares. But Dell is another company that has been a big buyer of its own stock and its share price too has rocketed.
Djurdjevic has been criticising the stock buyback schemes for years but only now, with IBM spending billions after billions, is his campaign getting noticed.
"Perhaps this is now the beginning of the end. Lately there has been a lot of publicity, maybe it is beginning to penetrate," he said.