The Great Stock Buyback Craze Is Finally Ending
As we reported last night, whether as a result of Snowden revelations and NSA blowback by BRIC nations, or simply because the global economy is contracting far faster than rigged and manipulated markets worldwide will admit, IBM's Q1 revenues not only missed consensus earnings, but dropped to their lowest level since 2009. And yet, IBM stock is just shy off its all time highs and earnings per share have been flat if not rising during this period, leading even such acclaimed investors who never invest in tech companies as Warren Buffett to give IBM the seal of approval. How is that possible?
Simple: as we forecast first in 2012, all that investment grade companies like IBM have done in the New Normal in order to preserve the illusion of growth, is to use cash from operations, or incremental zero-cost leverage, to fund stock buybacks with the express goal of reducing the number of shares, and hence dilution, in the EPS calculation. In essence a balance sheet for income statement tradeoff. Earlier today, David Stockman touched just on this issue.
However, that "great stock buyback craze" as we call it, is finally coming to an end.
Before we explain, in order for readers to get a sense of the true perspective of how massive IBM's stock buybacks have been over the past two years, here is a chart showing the quarterly amount of net debt issued by Big Blue as well as the total notional in stock buybacks.
And yes, in the just completed quarter, IBM bought back a record $8+ billion of its own stock.
Before we proceed, for those wondering if IBM is allocating more cash to buybacks or capex, here is a quick and simple explanation.
As the chart above shows, since 2012, IBM has used roughly four times as much cash to spend on stock buybacks, as it has on capital expenditures. And not only IBM: this relationship is largely true of most investment grade companies. Incidentally, for anyone curious why there is no revenue growth, show them this chart. As long as corporate management teams seek to appease hedge fund raiders and activist shareholders who merely intend to use a company as a leveragable piggy bank vessel for a brief period of time, and buybacks explode at the expense of true investment in the future by way of capex, there simply can not be true organic growth. Period.
Now going back to the original topic, here is the first chart above presented in the form of a snapshot in time, showing that since the start of 2012 nearly identical amounts have been spent to fund stock buybacks as has been raised through net debt issuance: some whopping $34 billion of buybacks to be precise.
Summarizing the chart above: in the past 2+ years, virtually every dollar in debt IBM has issued has gone for shareholder friendly actions (this chart does not include some $8.8 billion in dividends over the same time period).
Which brings us to the topic at hand. While for a over a year, starting 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, starting about a year ago, organic cash flow declined so much that IBM had no choice but to see its net debt surge, and in fact since Q1 2012 has risen from $20 billion to nearly $35 billion, a 75% increase in just about two years!
But while net debt soaring is an unpleasant, if perfectly expected consequence of trying to mask income statement weakness with ever more debt, the piece de resistance is a chart showing IBM's Debt to Equity ratio. Because while a company can grow its debt indefinitely for a long time, unless it is also generating retained earnings, the party is ending. And as of this quarter, IBM's debt to equity ratio has risen to the highest on record, surpassing even the highs hit during the Lehman crisis!
One can be certain that the rating agencies are certainly taking a long hard look at this massive jump and are currently wonder if and to what degree they should cut IBM's credit rating.
Which, in turn, leaves Big Blue in a very unpleasant situation: should it continue buying back stock at record levels, all funded through new debt issuance, but at least preserving for one more quarter the illusion that EPS is stable and maybe even growing while revenues keep declining in the process risking the very basis of what allowed the company to kick the can for so long, 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 (all the more so since unlike many other companies it is not being accosted by random pesky hedge fund activists) 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.
Which is naturally great news for those who are sick and tired of every form of manipulation and rigging big and small that has been plaguing the market ever since Bernanke made capital markets a policy vehicle for the Fed's central-planning mandate. Because once the buyback fraud is gone, and the crackdown on HFTs' market rigging and order frontrunning practices is complete, the only entity responsible for a criminally manipulated market will be none other than the Federal Reserve. Luckily, with Yellen in charge, it is only a matter of time before that final support of this epically-rigged travesty formerly known as the market, gives way and ushers in the grand reset so critical for restoring investor faith in what was once a real and fair marketplace.
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