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IBM has the Big Blues
News of an SEC investigation is not good, especially since the stock was pricey to begin with.
June 3, 2003: 1:18 PM EDT
By Paul R. La Monica, CNN/Money Senior Writer

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NEW YORK (CNN/Money) - One of the more amusing IBM commercials on TV depicts a bunch of frazzled managers talking about using a time machine to go back and correct past mistakes.

Of course, there is no such thing as a time machine. But IBM executives might want to start boning up on their HG Wells -- it could come in handy now that the Securities and Exchange Commission is looking for Big Blue accounting skeletons.

IBM's stock tumbled nearly 4 percent on Tuesday following the company's announcement late Monday that the SEC was investigating revenue recognition practices in its Retail Store Solutions division from 2000 and 2001.

IBM said that the probe appeared to be the outgrowth of an SEC investigation of one of its customers (which it would not name). The Retail Store Solutions unit sells point-of-sale computer systems and kiosks to major retailers. The SEC would not comment about the probe. (For more about the investigation, click here.)

Reason to worry?

Is the sell-off an over-reaction? The company does not break out sales for the retail division but Richard Williams, strategist with independent research firm Summit Analytic Partners, estimates that it accounts for less than 1 percent of IBM's total revenues. IBM (IBM: Research, Estimates) reported revenue of $85.1 billion in 2000 and $83.1 billion in 2001.

So that amounts to about $1.6 billion in sales that are possibly being looked at -- not a gigantic amount for a company the size of IBM, but not insignificant either. Still, Williams said the dollar amount is not the point.

"The biggest risk for IBM is not the restatement of revenues and growth, it's more the potential for a crisis of confidence," said Williams, who has a small short position in the stock, which means he is betting that it will go down.

IBM's accounting has been a frequent target of criticism during the past few years and this investigation could reopen some ugly wounds.

In 2000, the SEC asked IBM to amend its 1999 annual report due to concerns about how IBM was accounting for gains from its pension fund and asset sales. The matter was resolved without IBM restating numbers.

Last year, following criticism of how IBM disclosed an asset sale to JDS Uniphase, the SEC launched a preliminary investigation of IBM's accounting but took no action.

And skeptics have long maintained that IBM's aggressive use of share buybacks and other accounting maneuvers, albeit legal, have helped the company hit earnings targets during tough times.

"IBM was one of many companies that were good at managing expectations in a period where investors were conditioned to expect earnings surprises," said Arnie Berman, technology strategist for Soundview Technology Group.

Uncertainty and valuation are causes for concern

The mere whiff of accounting concerns was enough for one analyst to downgrade the stock on Tuesday. "I don't know if investors have the stomach for this, the uncertainty of it all," said the analyst, Kimberly Caughey of Parker/Hunter, a Pittsburgh-based retail brokerage.

She added that even though the SEC is only looking at one division, there is no guarantee that the investigation won't expand, especially since the SEC has taken a tougher public stance under new chairman William Donaldson. Caughey doesn't own IBM and her firm has no investment banking relationship with it.

But John Rutledge, manager of the Evergreen Technology fund, thinks that IBM will be vindicated without a lengthy review.

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"When all is said and done, IBM will come out pretty darn clean," said Rutledge. "There are always going to be issues popping up with a company of this size but I don't think this marks a new era of worry." IBM makes up about 2.3 percent of his fund's assets.

Nonetheless, the IBM news serves as a good time to re-examine the stock's valuation. Regardless of what the SEC finds, shares appear ripe for a pullback.

IBM, like most tech stocks, has been hotter than a jalapeno during the past few months. Before Tuesday's drop, shares of Big Blue were up 16 percent since the current tech rally began on March 11 and 60 percent since the market's October 9 nadir.

As such, IBM was trading at 20 times 2003 earnings. That might be a bit rich for a company that is expected to post earnings growth of less than 10 percent this year and 13 percent next year.

It's even richer now that the SEC is looking at it.


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Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer.

Morningstar: © 2014 Morningstar, Inc. All Rights Reserved.

Factset: FactSet Research Systems Inc. 2014. All rights reserved.

Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved.

Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor’s Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2014 and/or its affiliates.