Bloomberg News

IBM Pays More to Borrow in Bond Market as Sales Decline

February 10, 2014

IBM's SoftLayer Technologies Data Center

IBM is increasing its bet on the cloud with a plan to invest $1.2 billion in its SoftLayer Technologies Inc. network-infrastructure business. Photographer: Ben Torres/Bloomberg

International Business Machines Corp. (IBM:US)’s borrowing costs are rising even as those of its peers fall, underscoring concerns that the world’s largest seller of computer services is struggling (IBM:US) to find its place in the cloud.

IBM sold 10-year bonds last week with a 3.625 percent coupon, exceeding the cost of similar-maturity 3.375 percent notes issued in July even as average yields for debt in the company’s AA rating tier contracted. Quarterly revenue dropped 5.5 percent in the last three months of 2013 to $27.7 billion, the biggest decline since the U.S. economy exited its last recession, as an industrywide shift to offsite data storage erodes demand for IBM’s hardware (IBM:US).

Big Blue Tries to Adapt. Again.

“It’s an early signal that bondholders want a slightly larger premium to hold IBM because of the disappointing results, the challenges it’s facing in the hardware business and favoring shareholder returns over improving balance-sheet fundamentals,” said Nikhill Patel, an analyst at San Antonio-based Frost Investment Advisors LLC, which oversees about $10 billion and doesn’t own IBM bonds.

Druckenmiller Short

Debt investors are demanding higher interest rates about two months after money manager Stan Druckenmiller said he’s betting against the stock of IBM, the only company in the Dow Jones Industrial Average (INDU) to deliver a loss to shareholders last year. The century-old Armonk, New York-based business has attempted to support its equity by selling assets, using tax havens and repurchasing shares, which has coincided with an increase (IBM:US) in its ratio of debt to cash flow.

James Sciales, a spokesman for IBM, didn’t respond to a request for comment on its finances.

The company, with $39.7 billion of total debt (IBM:US) at year-end that leads global technology peers, raised an additional $4.5 billion with its four-part offering on Feb. 6, according to data compiled by Bloomberg. The transaction included $2 billion of the 10-year securities, $1.5 billion in five-year debt split equally between floating-rate notes and 1.95 percent debentures, and $1 billion of two-year floaters.

The 3.625 percent bonds paid 95 basis points more than similar-maturity Treasuries, a wider spread than the extra 83 basis points of yield IBM garnered six months ago. That signals its perceived creditworthiness (IBM:US) has deteriorated, though the new spread contracted from an initial estimate of 105. Average spreads for AA rated corporate debt and for bonds of investment-grade technology companies narrowed during the same period. A basis point is 0.01 percentage point.

The transaction was also IBM’s largest dollar-denominated bond sale on record, Bloomberg data show.

The new IBM notes traded at 100.23 cents on the dollar at 3:25 p.m. in New York to yield 3.6 percent, or 92 basis points more than benchmarks, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

2013 Decline

IBM bonds lost almost 2 percent last year, a deeper decline than the average 1.3 percent drop for an index tracking the industry’s debt, Bloomberg data show.

Equity owners (IBM:US) such as Warren Buffett’s Berkshire Hathaway Inc. also lagged behind (IBM:US) benchmarks. IBM stock fell 0.2 percent on a total-return basis in 2013 as the Standard & Poor’s 500 index rallied 32 percent and technology shares gained 28 percent.

“The market’s certainly been disappointed with IBM’s performance over the past several quarters,” Michael Hodel, an analyst at Morningstar Inc. in Chicago, said in a telephone interview.

The share performance has supported Druckenmiller’s Nov. 22 claim that IBM is “one of the more higher-probability shorts I have seen in years.” From 1986 through 2010, the former chief strategist for billionaire George Soros produced average annual returns of 30 percent at his hedge fund Duquesne Capital Management LLC.

Cloud Computing

Shawn Pattison, a spokesman for Druckenmiller at Abernathy MacGregor Group, declined to comment on the investor’s outlook.

The technology giant has stumbled in an industrywide shift into the cloud era, where information is kept online instead of onsite. That’s eroded demand (IBM:US) for IBM’s hardware, helping drag down revenue. The company is aiming for $20 a share in adjusted earnings by 2015, up from $11.67 in 2010 and $16.28 last year.

IBM seeks out high-margin areas of the information technology industry where there is room for growth, Steve Mills, senior vice president of software and systems, said in an interview last month. Since 2005, the company has divested hardware businesses with products that have become ubiquitous, including its PC division, printers unit and low-end server segment.

“Value is something that we are very good at selling,” Mills said. “Volume is a challenge.”

AA Tier

Bond investors demanding a greater premium based on the company’s recent struggles and shareholder-return policy is “warranted,” though over the long term IBM should keep its rating (IBM:US) in the AA tier and succeed with its strategy, according to Morningstar’s Hodel. IBM is ranked Aa3 by Moody’s Investors Service and an equivalent AA- at S&P.

Chief Executive OfficerGinni Rometty is focusing more on software and services in a bid to reignite sales. IBM is increasing its bet on the cloud with a plan to invest $1.2 billion in its SoftLayer Technologies Inc. network-infrastructure business. The company is also spending $1 billion to build a new division around its Watson supercomputer, which can analyze large volumes of data and answer questions.

While cloud revenue is increasing, the transition has brought a new crop of competitors (IBM:US) and lessened hardware demand, Krista Macomber, an analyst at Technology Business Research Inc., wrote in a Jan. 21 report.

‘Long-Term Health’

To boost profits, the company has sold lower-margin businesses, getting $505 million for a customer-service unit last month and agreeing to let Lenovo Group Ltd. buy its low-end server business this year for $2.3 billion.

“Many investors expect IBM to hit its $20 EPS target, but remain concerned about the long-term health of the business,” Toni Sacconaghi, an equity analyst at Sanford C. Bernstein & Co., said in a Feb. 3 report.

IBM’s earnings have benefited from a tax strategy that sends profits through a Dutch subsidiary, leading to its lowest tax rate in two decades, and Sacconaghi said he expects the company to boost per-share earnings this year by laying off 13,000 or more workers and spending at least $15 billion to repurchase stock.

The company has bought (IBM:US) back about $65 billion of its shares since 2010. By reducing the amount of stock in circulation by about 17 percent in the last four years, the buybacks have helped increase earnings (IBM:US) per share even as revenue drops.

‘Undoubtedly Mixed’

IBM’s most recent results “were undoubtedly mixed with more negatives than positives,” Ping Zhao, an analyst at CreditSights Inc. in New York, wrote in a Jan. 21 report. Given IBM’s weak stock price and desire to meet its earnings-per-share target next year, it will probably “continue to aggressively repurchase its shares -- possibly funded by more debt,” wrote Zhao, who said she prefers bonds of Oracle Corp. (ORCL:US) to those of IBM.

IBM began its existence as Computing-Tabulating-Recording Co. in 1911. Three years later, Thomas Watson left his sales job at National Cash Register Co. to help bolster C-T-R, supplying tabulators to the U.S. government during World War I and more than doubling the company’s revenue in his first four years.

The company adopted its current name in 1924 and dominated the world market for tabulators, time clocks and electric typewriters. It began making computers in the 1950s and had an almost-80 percent share of that market in the 1960s and 1970s.

Leverage Increases

IBM has been rewarding shareholders with dividend (IBM:US) increases and share buybacks, raising its quarterly payout to 95 cents from 65 cents in 2011, Bloomberg data show. Bloomberg Dividend Forecasts show the company will boost it to $1.10 in an April 22 declaration. Dividend payments amounted to $4.1 billion in 2013, the data (IBM:US) show.

The company’s debt has increased to 1.6 times its adjusted earnings before interest, taxes, depreciation and amortization, from 1.2 times in 2012, Zhao said in the report.

Though IBM’s overall creditworthiness is intact, “the main issue is a general concern of increased leverage to reward shareholders,” said Alan Shepard, an analyst and money manager at Madison Investment Advisors, whose firm oversees about $16 billion in Madison, Wisconsin.

To contact the reporters on this story: Charles Mead in New York at cmead11@bloomberg.net; Alex Barinka in New York at abarinka2@bloomberg.net

To contact the editors responsible for this story: Shannon D. Harrington at sharrington6@bloomberg.net; Nick Turner at nturner7@bloomberg.net


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