Concerns exist, however, over funding technology acquisitions and stock repurchases with borrowed money.
With several of the largest U.S. corporations, including GM, taking a nose dive recently, it's somewhat unsettling to look at the financial health of those companies on which we depend for our livelihood. Fortunately for those of us who depend on the health and wellbeing of IBM, Big Blue is doing remarkably well in weathering the recession, according to one of the nation's leading credit-rating services.
Fitch Ratings evaluates the financial health of numerous organizations and recently came out with its evaluation of IBM. Fitch has a ladder of rankings it can assign based on information the organization provides, but the company makes no guarantee that the information is correct. IBM did quite well in the latest evaluation, garnering A+ ratings in the areas of long-term issuer default rating, senior unsecured credit facility, senior unsecured debt. Short-term issuer default and commercial paper ratings were tops with an F1 grade. The future rating outlook was "stable." While A+ is a great grade to receive in school, it actually is not the highest credit rating an organization can have--that would be AAA. The A+ rating is actually the third from the top, after AAA and AA. The little plus is a kind of token that Fitch throws in there if it likes what it sees but doesn't believe the company merits a nudge up to the next higher ranking.
The A+, which actually is an A rating with a little sugar coating, is defined by Fitch to be "expectations of low credit risk. The capacity for payment of financial commitments is considered strong. This capacity may, nevertheless, be more vulnerable to adverse business or economic conditions than is the case for higher ratings." So then one has to wonder, well, why didn't IBM earn a AAA rating?
The top rating is defined as "lowest expectation of credit risk... assigned only in cases of exceptionally strong capacity for payment of financial commitments. This capacity is highly unlikely to be adversely affected by foreseeable events." So we may conclude that IBM has a "strong" capacity for paying its financial commitments but not, in Fitch's terms, "exceptionally strong." One might conclude that anyone engaged in business of any kind would likely be vulnerable to "adverse business and economic conditions" and have a tough time earning a AAA rating. But what about the next higher rating of AA, which IBM failed to earn? Fitch defines that as "expectations of very low credit risk... very strong capacity for payment of financial commitments. This capacity is not significantly vulnerable to foreseeable events."
So what is it that is keeping IBM out of the realm of Fitch's two top categories? A couple of things. First, we should point out that Fitch was notably complimentary of IBM's overall business model, market position, and financial management. It lauded IBM for taking "solid measures" to protect its credit. IBM has a $10 billion revolving line of credit on which it can draw if needed. It also has more than $12 billion in cash and equivalents, more than $8 billion of which is apparently located in the United States. It's not clear from the report where the remaining $4 billion is or why it's deposited abroad, but having that much money at one's disposal represents "significant liquidity," according to Fitch, and is representative of a company that has a "solid cash position." If that isn't the understatement of the month, I don't know what is.
The company also has a stream of "considerable recurring revenue," Fitch says. This is income that comes in day in and day out from IT services, software, and financing. Altogether, this recurring revenue represents about half of everything IBM brings in during the year and helps offset the ups and downs in the economy and market in general. It's sort of like having a string of laundromats and rental properties in addition to your regular income that you earn from being a plumber and schlepping a few water heaters.
Also noted in Fitch's report is IBM's diverse customer base from both an industry and geographic standpoint. Business for Power Systems servers might not be so great in the U.S., but it could be booming in Asia, or while real estate software isn't selling, perhaps transportation software is.
The report also cites IBM's "breadth and quality of product and service offerings." Just the fact that IBM makes great products puts it at the top of the market when it comes to IT services, middleware, and servers and near the top in the disk-storage market.
The concerns that Fitch cited about IBM, however, relate to its increasing debt in areas unrelated to IBM Global Financing, which finances new systems for customers and assumes debt to do it. IBM has been following a policy for the past year or more of borrowing money to buy back outstanding shares, which Fitch calls "debt-financed share repurchases." The company also appears to be using borrowed money to buy other companies and establish itself in certain technology areas. At the same time, the company has a longstanding policy of paying cash dividends to stockholders, a tradition that has continued for decades. Fitch, apparently, doesn't see the logic in this practice in a down market since it says the dividends, which it speculates will be paid in increasingly large amounts over a long period, "could pressure free cash flow and financial flexibility in the absence of commensurate growth in profitability." In other words, regardless of whether IBM is having a good year or a bad year, it still believes it should pay stockholders a dividend. By paying the dividends, IBM is having to incur "further increases in core debt to fund acquisitions and/or share repurchases." Obviously, the company is bending over backward to maintain, or enhance, its stock value, regardless of whether or not it makes sense from a balance-sheet point of view. The company had about $14 billion in long-term debt as of 2007 versus about $21.1 billion of long-term debt as of this past March. Short-term debt declined, however. Whereas in 2007 it was about $20 billion, it is only $9.9 billion as of the March snapshot. Note the total debt being carried by the company is about $31 billion, or roughly three times annual earnings. Even with good rates, the interest on that must be well over $1 billion a year. But when you're making nearly $12 billion a year, what's to worry about! However, the economic downturn is likely to reduce that closer to $10 billion this next year, according to Fitch. Also, we should point out that $23.4 billion, or 75 percent, of the company's debt is attributable to IBM's Global Financing business, which contributed approximately 10 percent of IBM's pre-tax earnings in 2008.
There are other concerns that Fitch cites that pertain to IBM's pension fund obligations as well as some hefty notes coming due in the next 12 months--most during 2009--totaling some $7.4 billion. Fitch says that the company likely will refinance these in order to maintain its "targeted debt/equity" ratio. Well, I would hope they plan to refinance, but since the company actually has the cash on hand to pay back the loans, why would it want to? Use other people's money when you can, I always say.
The pension fund is a bit of a sore point with employees because newer employees, we're told, aren't receiving quite the deal that older workers were getting. If that's true (and that opinion came from someone who works with many IBM employees on a regular basis and is not reliable information that came from the company), it could relate to the fact that IBM is, in a way, saddled with high employee costs the way General Motors was, though GM probably had much higher costs. Fitch points out that IBM's defined benefit pension plan was actually "underfunded by $12.8 billion at year-end 2008." If I were an employee, I might be asking questions about that. But Fitch didn't seem particularly concerned since it noted the benefit plan was over-funded by $9 billion at year-end 2007. While that's quite a spread, Fitch says the company has plenty of liquidity to meet its legally mandated pension funding requirements through 2013, estimated to be about $5.6 billion.
It would appear, however, that IBM is putting less into its pension fund lately than it was a few years ago. According to Fitch, the company was putting in about $1.5 billion a year on average during the five-year period between 2004 and the end of 2008. Since it contributed only $503 million in 2007 and $917 million in 2008--or about $1.4 billion--it apparently put in some $5.9 billion during the three years ending in 2006--or nearly $2 billion a year. So the company must have pared back its contributions significantly starting in 2007. This may or may not reflect on company policy and may be a function of how well the stock market was doing at the time since the more a fund earns, the less a company has to contribute. Since the market started going down last year, it likely will mean that IBM will have to make up the difference between what the fund earns and what the company is legally required to contribute. In any case, it's clear that IBM hasn't been contributing as much to its employee pension fund the last couple of years as it apparently used to do. That doesn't necessarily mean, however, that the fund wasn't growing as fast lately as it had been in the past, but it might be worth looking into if you are an IBM employee.
For IBM, the whereabouts of its employees could have an impact on its pension fund contributions since many of them live in other countries. Says Fitch: "Depending on financial market conditions in 2009, the amount of legally mandated minimum contributions could increase due to more frequent re-measurement of funded status in certain non-U.S. countries." It's not exactly clear what this means, but apparently other countries stay on top of whether corporations are current with their pension fund contributions in a way that differs from the U.S.
We can't help but think back to when IBM recently blinked at purchasing Sun Microsystems only to have Oracle step in and gobble it up for $7.4 billion ($5.6 billion net of Suns's cash and debt). Could it have been that IBM's existing debt and upcoming financial obligations were key factors in its decision to pass on the Sun purchase, or were there other reasons that turned Big Blue away from the deal? At some point, everyone wants what they can't afford. And isn't ignoring the reality of reasonable financial limitations how we got in the financial mess we seem to find ourselves into today? If IBM were concerned about getting over extended by purchasing Sun, we can only admire a wisdom that acts on those conservative instincts.
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