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After Forking Out $110 Billion on Stock Buybacks, IBM Shifts Its Spending Focus

By Jamal Carnette, CFA – Apr 25, 2016 at 9:40AM

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Think the government is wasteful? Meet Big Blue.

Source: IBM

If there's a poster child for a myopic share repurchase plan, it has to be International Business Machines (IBM -2.08%). The company has spent roughly $110 billion since 2000 on share buybacks, or nearly 80% of its current market capitalization. Investors haven't benefited from this aggressive buyback policy. Shares are only up about 30% over the past 16 years, trailing the greater S&P 500 and Dow Jones Industrial average by healthy margins during this period.

While it's true IBM's spent approximately $90 billion on research and development during that period, the company's research and development expense as a percentage of revenue figure of approximately 6% is lower than North American Internet and Software companies figure of 12%-14%. Instead, IBM chose to spend the vast majority of its free cash flow (and borrowed funds) buying its shares in an attempt to prop up its earnings-per-share metric, which is the technology equivalent to eating your seed corn

In the beginning, CEO Ginni Rometty tried to fulfill predecessor Sam Palmisano's goal of $20 earnings per share by 2015. In 2014, after nearly three years of failure and debt-fueled stock buybacks, Rometty called off the $20-per-share target.

There's nothing wrong with ambitious EPS figures, but IBM went about it the wrong way. As a result, the company was more concerned with divesting units and lowering per-share counts than growing its top line and the health in the business. As a result, IBM was caught flat-footed when companies shifted to cloud-based computing at the expense of on-site servers. Looking at IBM's first-quarter earnings report, it appears the company is rethinking its strategy.

Increases in research and development decreases in share buybacks
In IBM's recent first-quarter report, the company repurchased $939 million in share repurchases. While that may seem like a large amount, it's actually a decrease of 19% from last year's corresponding quarter. However, this is a clear continuation from fiscal year 2015 – IBM repurchased $4.6 billion of its shares that year, which was down significantly from the $13.7 billion and $13.9 billion the company repurchased in 2014 and 2013, respectively.

It appears the company has been allocating more money to research and development. In the first quarter, IBM spent $1.46 billion in R&D expenses, an increase of 12.3% over last year's corresponding quarter. Additionally, IBM's R&D as a percentage of revenue increased to 7.8% in the quarter. In both 2013 and 2014, IBM's R&D as a percentage of revenue was 5.8%. IBM's historically never spent a large part of its revenue on R&D, and that's a potential reason the company was unable to create new revenue to replace declining hardware sales.

If you can't beat 'em, buy 'em
There's more than one way for IBM to bring new technologies to consumers. Many technology firms simply acquire high-interest technologies instead of spending the money on research and development. And IBM has been on a buying spree when it relates to cloud and big data services. After paying $2 billion for cloud-computing firm SoftLayer, IBM continued its cloud binge by buying Cloudant, Cleversafe, and Gravitant. Since 2013, the company has spent nearly $10 billion in acquisitions, most in next-gen technologies.

IBM is in the midst of a business transition, and it's possible the company's new focus of buying cloud businesses and increasing research and development in big data analytics may be unsuccessful. However, this plan is better than the company's former prescripts of spending money to buy back shares in an attempt to prop up its share price in the hope investors ignore weakness in the company's business operations.

 

Jamal Carnette has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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