Why IBM’s Cash Flows and Earnings Are Concerning Investors
IBM Continues Acquisitions and Cloud Strategy Without Much Success (Part 11 of 14)
IBM managed decent cash flows despite no revenue growth
In spite of no revenue growth, IBM (IBM) generated decent free cash flows (or FCF) of $6.6 billion in 4Q14. The ability to consistently generate cash flows is one of the strong points of IBM, which in addition to dividends and share buybacks has lured investors to this stock.
Apart from IBM, some of its technology peers like Microsoft (MSFT), Apple (AAPL), and Cisco (CSCO) also generate a good amount of cash flows. However, owing to huge share buybacks, both Microsoft and IBM’s cash balances are depleting and debts are mounting.
To gain diversified exposure to IBM, you can invest in the Technology SPDR ETF (XLK). XLK invests 3.51% of its holdings in IBM.
Concerns over the quality of cash flows
As has been discussed in the earlier part of the series, IBM has been able to generate decent cash flows. On the face of it, this looks like a very positive sign in favor of the company. However, if we dig deeper and look at IBM’s free cash flow to net income (or NI) ratio, it gives a better insight into the quality of the company’s earnings. Free cash flows are arrived at after deduction of capital expenditure from operating cash flows.
The FCF-to-NI ratio indicates the earnings quality of companies. Ratios above one indicate higher earnings quality, because free cash flows form a majority of net income. Usually in the case of sound earnings quality, both FCF and NI are in sync. As the above presentation shows, since 2009, IBM has seen a steady deterioration in its FCF-to-NI ratio. In 2014, net income from continuing operations has been taken into consideration.
As a rule, if the FCF-to-NI ratio is around 120%, it indicates that the company has good earnings quality while companies with a ratio of ~100% can be considered as average. If the ratio is around 80% or lower, it raises concerns about the earnings quality of the company. If the ratio is below 100%, then it indicates that a deeper analysis is necessary.
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