What went wrong with GE and IBM?
There is no shortage of opinions on what went wrong with former blue chip companies GE and IBM. This week GE broke below $10 and slashed its dividend to one cent. Over 2 year’s GE’s stock is down -70%. IBM has fallen, but not as much. It’s only down -29% over the same period. On Monday, IBM acquired Red Hat in a deal that is valued at $34 billion. This hail mary deal equals the purchase price of almost 40% of IBM’s market cap.
My answer to the demise of these two companies can be found by studying their cash flow statements. Over the last 10 years, both companies gave all of their profits away and didn’t properly reinvestment back into their businesses. In the last 6 years, IBM has paid $30B in dividends and bought back around $43B in stock. The market cap of IBM is now only $105B. I bet they wished that they had that $75B in cash back on the balance sheet. GE in the last 6 years paid $48B in dividends and bought back around $35B. The market cap of $80B is now less than the amount of money that they returned to shareholders in the last 6 years!!! They could have taken themselves private.
The management of these companies did what was in the best interest of short-term shareholders and not for the survival of the company. At the other end of the spectrum is Berkshire Hathaway. They have never paid a dividend, and up to this point, never bought back much stock. Buffett has used the profits of Berkshire to buy other companies that can pay him dividends. For those of you that have read the book Rich Dad Poor Dad, know that the differences between his real father (poor dad) and the father of his best friend (rich dad) is that the rich dad created enough passive income so that people were paying him dividends. In my example, IBM and GE are the poor dads and Berkshire is the rich dad.
A strong case could be made that buybacks have been the main driver of the equity rally this cycle. Goldman Sachs wrote that companies are set to buy back $1 Trillion worth of shares this year. Much of these buybacks are being fueled with all the extra profits from the lower corporate tax rate of 22% from 35%. Google searches of “buyback blackout” hit an all time high on Monday. For those of you not familiar with blackout periods, it’s when a company can’t buyback their stock because they are within a window of releasing earnings. As companies reported 3rd quarter earnings, they were unable to buyback stock as markets fell. Investors were hoping that stocks would rally as this blackout period ended. Maybe it’s a coincidence that stocks bounced this week, but the number of Google searches for “buyback blackout” is no coincidence The Wall Street Journal reported, net buybacks in the month totaled just $12 billion by Oct. 19, but jumped to $39 billion by Oct. 29, according to estimates from JPMorgan Chase & Co. That is more than the $30 billion recorded in September and just under the $48 billion recorded in August. Some analysts hope a resurgence in buybacks could help support share prices during a period of geopolitical and economic uncertainty. Others are skeptical that companies can continue purchasing their own shares at the current pace, particularly as the stream of repatriated cash that helped drive the year’s buybacks slows down. Critics say they are motivated by executives’ desire to boost the value of the stock options and allocations in their remuneration packages. Buybacks also channel profits away from the research and capital expenditure that could improve productivity in the longer term.
Steve Jobs was a critic of share buybacks. He preferred to keep all the cash on the balance sheet. He learned his lesson when Apple almost went bankrupt and he lost his job. Steve needed to go to Microsoft for a $400 million loan to survive. After this hard lesson, Steve’s strategy was to hoard cash for a rainy day. Apple’s new management has went in the opposite direction. They once had over $250b in cash and they are now down to $130B net cash. They are going spend another $100B and take cash to zero. I wonder if they haven’t been paying any attention to what happened to IBM and GE?
I believe the key to any successful buyback or dividend is that it is not done with issuing debt. It’s no different than a consumer spending on a credit card. At some point, the bill will be due and to make matters worse, interest rates will likely be higher. GE and IBM would have been much stronger companies today if they had channeled their profits back into the business. I’m very confident that in the next few years we will be reading about other companies that fell overboard buying back too much stock at over inflated values. I’ll continue to monitor buybacks closely as I expect markets to remain volatile with extreme moves in both directions.
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