IBM has been looking like a hero. The granddaddy of technology companies, once dismissed as too senile to "get" the Net, has survived to fight another day, reporting gains in its earnings that Net companies see only in their dreams. But on closer examination, some investors wonder if IBM is doing the dreaming.
Last week, the company announced $21.6 billion in second-quarter revenues and $2 billion in earnings. Incredibly, those earnings were 8.5 percent better than last year's second quarter, though revenues were actually down. At first blush, outgoing CEO Lou Gerstner's cocky attitude toward younger tech companies would seem justified. (He has called Net companies "dot toast.") And with numbers like last week's, he might swagger into retirement next year when his contract expires March 1.
But it's not Gerstner's retirement that's worrying some on Wall Street - it's IBM's use of proceeds from the retirement program for its thousands of current and former employees. Critics say IBM is using pension funds to artificially prop up earnings.
To understand this complaint, you need to understand a little pension arcana. There are two types of pension plans: defined contribution and defined benefit. The accounting for the former is simple. A company just shows the expense of its contributions to the plan. By contrast, the accounting for a defined benefit plan - the type employed by IBM and many old industrial companies - is complicated. Such plans require companies to make assumptions about how many employees will ultimately qualify for benefits, how long they will live and, most important, the expected rate of return on pension investments.
That rate of return provides the wiggle room that IBM has used to inflate recent earnings, critics charge. Bill Fleckenstein, portfolio manager of Fleckenstein Capital Management, says it's conservative to assume a 7 percent to 8 percent return on money set aside for pensions. IBM assumed a 9.5 percent rate of return on pension investments before 2000. Since then it raised the rate to 10 percent, declaring its plan "overfunded." With that one change, millions flowed into the IBM balance sheet, lowering costs and increasing earnings.
According to a report by Credit Suisse First Boston accounting analyst Jane Adams, IBM reported annual revenue growth of 7.2 percent in 1999 and 1 percent in 2000. Adams notes, however, that the use of pension income boosted IBM's revenues by 6.8 percent in 1999 and by 10.15 percent in 2000. In other words, much of IBM's revenue growth in those years came from pension receipts, not from the sale of goods and services.
Fleckenstein is shorting IBM stock, in part because of concerns about its treatment of the pension fund. "This is just pure garbage," he says. "The balance sheet is funky." He isn't alone: Short interest in IBM (a measure of investors betting on a fall in IBM's share price) grew by 69.9 percent in June.
IBM did not return a call seeking comment, but it has denied adjusting the return rates to inflate earnings. Indeed, it's all perfectly legal. When companies decide that their pension plans are overfunded, they're entitled to raise the return rates. As long as IBM's pension investments grow as projected, there's no problem. The concern on Wall Street is that IBM's pension estimates have obscured the results of a struggling company.
IBM is unusual among tech companies in doing such accounting, as most others are too young to have richly funded pension plans. For the moment, it's a competitive advantage that could let Gerstner ride happily into the sunset. But if questions continue about the returns, it could turn into an ugly farewell.
