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Another Perspective


Of Possible Interest

Jacob ben Wolf Kranz was, in the second half of the 18th century, the Preacher of Dubno or, in Yiddish, the Dubner Magid.  Dubno is a small city in the Ukraine.  Two and a half centuries later, Virginia Rometty, the Big Cheese of Big Blue, appears to have heard at least one of the Magid's tales.  Assisted by the Magid's sagacity, Rometty has soothed the savages of the sell side, beguiled the barbarians of the buy side and inveigled that illustrious investor on the outside, the Oracle of Omaha, Warren Buffet.

Yelen
Janet Yellen
The head of the Federal Reserve Bank is expected to increase interest rates;
the effect will ripple through the U.S. and eventually all the world's economies

While taking a walk in the woods one day, the Dubner Magid noticed several trees that had targets painted on them.  Smack in the center of each target was an arrow.  Before long the Maggid spotted a fellow carrying a bow and arrows.  The Maggid asked the archer if the bulls-eyes along the path were his.  The archer replied in the affirmative.

"How," the Magid asked the archer, "do you manage to aim so well?"

"It's not that difficult," replied the archer.  "First I shoot the arrow.  Then I paint the target."

Beginning in the first quarter of this year, IBM rejiggered its financial presentations.  Investors who wanted to understand the working of the company could no longer examine a breakdown of IBM's efforts that matched the descriptions provided in prior years.  Software, for example, depending on the products concerned, no longer all fell into a single reporting segment.  Instead, some software products are now part of a classification called Cognitive Solutions.  Other software offerings are now part of Technology Services And Cloud Platforms.  Operating systems are now part of the Systems segment.  This isn't entirely new.  In the past, a portion of operating systems revenue was reported with Systems, the rest with Software.

In the long run, IBM's new description of its activities may make the company easier for outsiders, particularly investors, to understand.  But for now, IBM's revised self-portrait and the limited history of the new scheme makes the company's likely future harder to forecast.  Financial analysts have become more reliant than ever on the promises and hints offered by IBM's top brass.

Debt
IBM's Debt
IBM can shoulder massive debt, particularly when the carrying costs are low

One result of this change in reporting has been an increased focus on grand totals, numbers that characterize the position of IBM as a whole.  While investment analysts have always kept an eye on IBM's corporate revenue, profit, tax rate, expenses and the like, until this year the Wall Street crowd spent considerable time examining each of Big Blue's business segments.  These days, however, it seems that the analysts who delve into details are writing about two IBMs, the Good IBM, what management calls the company's "strategic imperatives," which are growing at a 15 to 20 percent rate, and the Bad IBM, the legacy activities that are shrinking away.  Strategic imperatives means a laundry list that includes cloud computing, Watson AI and related analytic efforts, security services, social media and various mobile device goods and services.  The legacy activities at IBM include the computer systems business plus operating systems; storage devices and related software; most old-line services, particularly efforts that include work with customers' onsite systems and remote dedicated hardware; hardware maintenance and related support; and the sale of venerable software products like CICS and DB2.

Customers whose dealings with IBM are wholly or mainly tied to IBM's legacy offerings of goods and services are understandably nervous.  They depend on IBM to provide continuity.  When the company tells its shareholders that strategic imperatives rather than legacy offerings are the future of IBM, they understandably worry.  Customers who had in the past turned to IBM not only for proprietary products, for mainframes and Power-based machines, but also for X86 servers can no longer enjoy one-stop shopping; they are likely to be particularly unsure about what lies in store.

Dividends
IBM's Dividend
IBM shares pay a hefty dividend, but if other securities offer better yields,
Big Blue will be obliged to boost its payout

Adding injury to insult, when end users are visited by IBMers they now have to contend with visitors from a culture that has grown distant from that of the typical mainframe, IBM i, or AIX shop.  The end users are overwhelmingly likely to see their systems though Windows PCs.  IBMers are leaving the PC culture in droves and moving to the Macintosh and iPad world.  The reason, IBM says, is that the Apple equipment provides much better value for money than Wintel gadgets.  Notably, Big Blue has declared, Apple client devices have support costs that are stunningly lower than help and maintenance expenses for the PCs they replaced.  IBM has further emphasized its love for all things Apple by developing vertical market apps for iOS and OS X to the exclusion of apps for Windows, Android or Android's underrated second cousin, Amazon Fire.

While IBM is undoubtedly correct when it finds that Apple's products are top notch, it is nevertheless puzzling why Big Blue would show disdain for the customers' corporate culture, which it fostered for decades and in some ways perhaps for a century.  IBM seems to be insensitive to the effect on customer relations if it is seen to reject the practices of the IBM shops that use client devices descended from the very PC that IBM invented back in 1981.

It isn't like IBM to seem so distracted.  But that is what it looks like to an outside observer attempting to puzzle out just why Big Blue hasn't a clue.  Maybe there is something else tugging at the attention of IBM's top executives.  That something else might have to do with money troubles or the fear that money troubles are on the horizon.  And, sure enough, there is something troubling on the minds of many business leaders, particularly the ones in mature to say nothing of decrepit fields of endeavor.  That something is the prospect of an increase in the interest rates set by the Federal Reserve Bank.

Escher
An Escher Stairscase
This excerpt from one of the Dutch artist's illustrations
is a fascinating example of the illusion known as Penrose stairs

There is a pretty good chance that the Fed will lift its interest rates a bit, perhaps 20 or 25 basis points (a basis point is a hundredth of a percent) just to signal it expects a dismal decade may soon be over.  IBM, more than many other companies, will be affected by even a small increase in the Fed rate.  There are two obvious ways the Fed rates can affect IBM.  First, IBM spends a lot of time working the debt markets as it rolls over (and sometimes increases) around $40 billion in borrowings.  Like other borrowers, IBM has gotten away with murder by virtue of the general low-interest climate along with its outstanding creditworthiness.  If the interest rate tide comes in, however, IBM's interest costs will rise as will the borrowing costs of so many others.

In addition, IBM happens to be one of the greatest dividend stocks in the world.  Its payout is currently above 3.5 percent, based on recent share prices and the company's promise to give shareholders $1.30 per share each quarter and the expectation that the dividend will rise again next spring, as it has every year for more than 20 years.  Even if IBM shares don't gain in value, the dividend makes them an attractive investment.  But if interest rates in general go up, more attractive alternatives may attract the attention of conservative, dividend-seeking investors.  In a climate of higher yields, IBM would have to up its dividend to maintain the allure of its shares.

In other words, when the Fed cranks up interest rates, even if it moves very slowly, IBM will get hit with a double whammy.  Its borrowing costs and dividend outlays will grow in tandem.  And, chances are, the cost increase will occur before IBM's new strategy yields enough additional intake and profit to enable Big Blue to easily shoulder the increased expenses.

The inevitability of this change stems from the economic and political philosophies of the world's most powerful central banks: The Federal Reserve Bank, the European Central Bank, the Bank of England, the Bank of Japan and others.  These institutions believe that political and economic stability will arise when there is modest, managed inflation.  The rate of inflation often bandied about is 2 or 3 percent.  With modest but steady inflation, the banks seem to think, investors will be adequately rewarded.  Homeowners will enjoy steady appreciation of their property's value.  Borrowers financing cars and buildings and capital equipment and university educations will be in a tolerably well balanced relationship with lenders and with their likely future ability to repay debts.

Very little attention is given to those who are thrown under the bus of managed civilization by the endless staircase of inflation.  The poor, the disabled, retirees on a pension (particularly if the pension is basically inadequate), immigrants yet to get a grip and people with costly chronic illness won't make out too well, but, hey, they aren't pitching in very much, are they? If the world is a Penrose staircase, the kind most beautifully illustrated by M.  C.  Escher, most people won't notice and if they do they won't mind.  And if folks become disillusioned after forty or fifty productive years during which things seemed to work out, well, they will just have to resign themselves to the eventuality of a lifestyle of the old and grumpy.

It is hard for a kibitzer to believe an economic Penrose stairs can last forever, but hope springs eternalAnd Ginni Rometty, bless her Escher soul, only has to get through some of 2017 and into retirement.  Then it will be her heir's today and her gone tomorrow.

— Hesh Wiener November 2016


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