Summary
- Taking
a closer look at IBM debt.
- The
hidden debt represented by pension liabilities.
- The
enormity of pension liabilities at IBM.
A popular part of the narrative surrounding IBM (NYSE:) on Seeking Alpha
(and elsewhere) is IBM's high headline debt number (about $39 billion according
to the ). This is often combined with a statement along
the lines of: IBM has taken on enormous debt to fund its financial engineering
shenanigans, aka share repurchases.
It has been pointed out (mainly in commentary on Seeking Alpha) that most of
IBM's debt is in its Global Financing (GF) segment (roughly $26 billion).
Financing (i.e., a bank like entity) utilizes debt like a mammal utilizes
oxygen. Roughly, the point is that GF utilizes IBM's stellar debt rating to
borrow in capital markets at low rates and then turns around and lends at
higher rates to customers, making a profit off the spread (this is only a
rough, but essentially right, approximation to GF operations). The risk in such
an activity primarily stems from the degree of leverage, duration mismatch (the
classic problem of borrowing short term to lend long term) and credit risk
(will the borrowers repay). In IBM's case there's also residual value risk associated
to equipment leases (think of the risk to a dealer in leasing a car), but we
don't need to get into the nitty gritty here.
The purpose of this article is not to assess the risk in Global Financing
(for the moment, suffice it to say that I think that it is minimal). Instead, I
wish to address a follow-up argument that is often made along the lines of
"in the end all debt is debt, whether is financing or core or
whatever."
I'm going to do this in a
twisted way by pointing out that IBM detractors
who worry about the $39 billion debt number should be focusing on a much
more
dangerous liability which sports a much higher headline number. Namely,
IBM's total pension benefit obligation at year end 2014 exceeded $100
billion (see the ).
Let me be clear, I am NOT saying that IBM is in a GM style
sinkhole. IBM's pension liabilities seem to be quite conservatively funded.
My intention is to simply point out that anyone worrying about IBM's debt
load endangering the financial future of the company and ignoring the fact that
GF debt is offset by receivables (i.e., the loans due from borrowers) should
instead be focusing on the much bigger elephant of pension liabilities.
After all, if one is going to ignore offsetting assets in GF, then the same
should be done for pensions (yes, I do think this is asinine, but this is the
logical end of the argument made by debt detractors).
In fact, as I will explain in a moment, a dollar of pension liabilities can
be much more problematic than a dollar of good old fashioned debt. Let me also
make the following (deliberately provocative and sarcastic) statement: any
ex-IBMer concerned by his/her beloved company's debt load and who bleeds true
blue and wishes to help the company in these difficult times in any possible
way should consider forfeiting his/her company pension as this is the biggest
and most dangerous financial liability facing the company in the future.
The financial tape worm represented by pension obligations
Good old fashioned debt (like loans, bonds issued, etc.) is relatively
simple to understand - the company borrows X dollars, pays an R% interest rate
on them for Y years and then pays back X dollars at the end of the Y years. I'm
ignoring fancier versions of this involving callability covenants, collateral,
etc., since in a nutshell the above is what standard debt looks like.
My point is that in this sort of debt the financial obligations of the
company and the schedule along which they must be met are quite precise.
However, we should remember that debt is really just another word for future
financial obligation or a promise to make a cash payout in the future.
This is exactly what defined pension benefits are. Let me illustrate by
simply quoting the master of explaining these things in a simple fashion ():
Assume that you, personally, make irrevocable promises to pay pensions of
$300 per month for life after they reach 65 to, say, four household employees.
To make it easy, let's say that they each are 55 years of age at present. If
you make that promise today, you have reduced your net worth today
by about $70,000...
Why are you immediately $70,000 poorer? Well, if you set aside a $70,000
fund not and invest it at 7% interest - and let all such interest remain in the
fund to be compounded - the principal value of the fund will grow to about
$140, 000 in ten years when your employees reach 65. And to buy them a lifetime
annuity of $3,600 per year will then cost about $35,000 each, utilizing the
entire accumulated capital of the fund. So if you make the promise and it is
binding - legally or morally - figure you have spent today $70,000, even though
you don't have to pay out a dime of cash for 10 years.
The point is that defined benefit pensions are for all practical purposes
exactly like debt (a future financial obligation). However, unlike old
fashioned debt, the amount of the obligation is not very precise. To explain,
let me continue quoting Buffett:
Now take it one step further and assume that your employees are earning $600
per month but, instead of promising them $300 per month upon retirement, you
promise them 50% of their salary at the time they retire. If their increases
run 7.2% per year - and they probably will in the world I foresee - they will
be earning $1,200 per month by the time they reach 65. And it will now cost you
$70,000 each to purchase annuities for them to fulfill your promise...
In a corporation the bill will have to be paid out of current and future
revenues - with interest - and frequently with what is, in effect, a
cost-of-living escalator.
The point is that defined pension benefits often have a number of
adjustments and estimates built into them. Moreover, when one tries to put a
present value to this pension debt, one in effect has to make a number of
estimates (discount rate, return on capital put aside in a pension fund, life
expectancy, health cost trends, cost of living adjustment).
That is, in effect, pension liabilities behave like long-term debt with
final payment and interest rates subject to change.
In other words, one should be a lot more wary of future liabilities
represented by pensions than the comparatively precise nature of old fashioned
debt.
The enormity of IBM's
pension liabilities
Now of course this is a well recognized problem, and corporations have to
regularly make sure that their pension plans are adequately funded with capital
invested to meet these future obligations. So is the case with IBM.
However, remember that the debt that IBM uses in Global Financing is also
offset by financing receivables, and debt detractors choose to ignore this,
arguing that "debt is debt." Hence, using this line of argument, we
should ignore IBM's pension assets, and simply look at the headline pension
liability number which is in excess of $100 billion.
I mean this is $100 billion in debt (and let's call it that because that is
what it essentially is) which even though is a legacy debt (defined benefit
pension plans at IBM, and most other public corporations, have been wisely
discontinued) can balloon in the future and has a coupon in flux!
To put it in a snarky way, this is a gift for IBM bears: if you are an IBM
bear using the company's debt as part of your argument, please do your homework
and use the big pension number as opposed to the comparatively much smaller
usual debt number.
Added later: Looking at the comments section, it would
appear that several readers either seem to have missed the point, had a knee
jerk reaction to the title (in other words didn't even bother to read the
article), or I failed to make my sarcasm/snark completely clear.
To avoid any further misinterpretation, let me make this crystal clear: the
point that I am making is that complaining about GF debt without accounting for
the fact that it is offset by receivables/loans is as ridiculous as looking at
pension liabilities in isolation without considering the funded status of the
plan.
A secondary purpose of the article is to point out the ticking time bomb
that pension liabilities can represent (even if a plan has been closed to new
participants, is at first glance well funded, discount rates, expected returns,
inflation adjustments, life expectancy, etc. are in constant flux, and the
present value of pension obligations can change drastically).
It is NOT being claimed that IBM's funding of its pension
plan is anything but rock solid. However, it is being pointed out that the
numbers are quite large.
The overall point is that in the case of IBM, the bears who cite the
company's debt have simply not done their homework (if they had, then the
pension liabilities would be the more significant item to pick up on, than the
relatively paltry amount of debt). Of course, this would require said bears to
actually crack open a 10-K (and think) as opposed to regurgitating numbers from
some third hand source like Yahoo Finance or Morningstar.
