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Worth magazine Jul-Aug, 1998 issue:

MONEY WELL SPENT?

By John Fried

NEW YORK - By themselves, the numbers are impressive. In late April, International Business Machines (NYSE:IBM: recent price, $121.94) announced that it planned to buy $3.5 billion of its own stock on the open market, adding to the $19.5 billion in stock it had purchased from 1995 through 1997. That's just over 200 million shares, or about 21 percent of the company's current shares outstanding.

But look at IBM's share re-purchase outlays in conjunction with another set of numbers, and the effect is less impressive than disturbing: As the table "Big Blue's Buyback Bill" describes in detail, the amount IBM spent on buybacks from 1995 through 1997 exceeded the $15.7 billion the company earned over the same span.

Is buying back and retiring its own stock really the best way for IBM to use its shareholders" money? Shouldn't CEO Lou Gerstner put those billions to work developing smarter, faster computers or building a new plant or acquiring a company with a promising new technology? Any one of those investments could potentially produce a long-term stream of returns.

By contrast, buybacks produce no lasting value, critics say. "How many new products or jobs has IBM created as a result of the stock buybacks?" asks Bob Djurdjevic, president of Annex Research, an information-technology consulting firm in Phoenix. "The answer, of course, is zero." In Djurdjevic's view, the buybacks represent not a strategy but management's abdication of its strategic function. "There is no long-term goal," he says, "if all you are doing is distributing cash that you have earned from existing operations without creating new businesses."

IBM, of course, sees things differently. "Share buybacks are an important part of our use of cash and an important part of our financial model," says company spokesman Rob Wilson. But that only raises the question of why stock buybacks are so important. The quick answer is that, thanks to buybacks, each IBM share claims a bigger slice of profits even if the pie itself doesn't grow any bigger. In IBM's case, per-share profits have grown faster than the pie itself. In 1997, the company's earnings per share grew roughly 21 percent to $6.18, from $5.12 in 1996. Take out the amount attributable to share buybacks, and profits per share grew only about 12 percent, or 62 cents per share.

That might be more worrisome to shareholders if IBM's stock price were stagnant as well. But IBM stock is flying. Since early 1995, when the huge buybacks started, the price of IBM shares has risen 242 percent. That's no mere coincidence. Many investors see buybacks as an expression of a company's confidence in its future. And when the company is as big as IBM, that confidence can pervade the entire market. When the Dow Jones Industrial Average fell 554 points on October 27, 1997, IBM stock dropped from $98 to $90, losing 8 percent of its value. The next day, the company began aggressively buying its own stock. "When investors were very skittish about what was happening," says Dwight Blazin, technology analyst for the David Funds in New York, "the buyback added some adrenaline to the market." By the end of the day, IBM had recouped all of its losses, closing at $99.38, and the Dow had climbed 337 points.

IBM's defenders also argue that share buybacks are the most efficient means of distributing cash to shareholders. If the company paid out the funds in the form of dividends, the money would be taxed twice-once as corporate income and again as income to shareholders. By contrast, the money IBM spends on buybacks reduces the amount of taxable income it reports. And for their part, shareholders who sell stock back to IBM see their profit taxed at the capital-gains rate, which is always lower than their tax rate for ordinary income.

Shareholders at many other companies don't get the chance to sell their shares back. Since 1990, three of every four announced corporate buybacks have never been completed. Those that are completed sometimes do no more than soak up the shares issued when employees exercise stock options received as part of their compensation. Intel bought back 43 million shares in 1997, but the number of its total shares outstanding at the end of the year was almost identical to its share count at the beginning of the year. IBM's share count, by contrast, has declined by 18 percent since 1995.

So far, there's no sign that buybacks have forced IBM to stint in other areas. Research-and -development expenses have held steady at 5 to 6 percent of revenue over the past few years, while the R&D effort itself has become more efficient. For example, under the old IBM regime, two separate teams worked on fine-tuning microprocessors for the company's mid-range AS/400 computer and its high-end RS/6000 workstation. But Gerstner realized that the two units were essentially performing the same task. So now one team designs microprocessors for both machines.

Eventually, buybacks start to look less shrewd financial engineering than a failure of imagination. "Among technology stocks, share repurchases are generally perceived as a sign of weakness," says Dwight Blazin. "Your business is drying up; there are no opportunities to deploy your cash and get above-market returns. So you sink it back into your own stock." None of that potential weakness is yet apparent in IBM's surging stock price, but shareholders won't wait forever for the company's operations to deliver a greater share of profit growth. "The company has to make share buybacks the icing on the cake," says Blazin. "It can't be the growth in total."

      

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