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Fleck Rap



Note: Professor Fleckenstein provides his commentary every Wednesday evening for educational purposes - his insights are not intended as investment advice. You can find his daily comments at

More Fun With Numbers

Buckle up, folks, as I have some ranting to do. Overnight markets were rather quiet. Preopening, we found out that the CPI was up 0.3% last month, according to the government. There's no point in discussing this, other than to say that I don't know why people fixate on the PPI and CPI. You do not need the government to tell you what the rate of inflation is. Open your eyes, look at your bills, and you decide.

We opened about 0.5% plus or minus to the upside, depending on the index. Shortly after the open, the Michigan confidence index was released at 96, vs. 95.6 last time and expectations of 97. In other words, results were right where they were supposed to be, and that was ignored.

Big Blue and Green All Over, Ditto Dell

The net-net of the early going saw tech under pressure, led by the Sox, which was down about 1%. IBM (IBM:NYSE) and Dell (DELL:NASD)(more about them below) were bucking the trend, both nicely green. Housing stocks were trying to bounce, and retailers were on the red side.

After the early morning selloff, the market turned quiet, and flopped and chopped until just after midday New York time. Then the sellers showed up and we basically slid all afternoon, ending on the day's lows. A check of the box scores shows that the Dow and S&P were the strongest and the Nasdaq was the weakest, down about 1.5%, led by the Sox, which was down 2%. Internet stocks got roughed up a bit, and as I mentioned before, retailers were heavy. Many speculative cats and dogs that trade for hat sizes were under pressure as well. All in all, it was just another distribution day on Wall Street.

For those keeping score at home, the S&P went out just below the mighty, mighty 200-day moving average -- the last line of defense that bulls have been clinging to. I might note that the Nasdaq, Nasdaq 100, and the Dow are all below the 200-day moving average, with the two Nasdaq indices having been under for some time. So to trying to pin your hopes on the fact that the S&P 500 hasn't taken it out is a little like spitting into the wind. I expect that when it finally gives way for real, since so many people have been clinging to it as a lifeline that it will be a pretty significant break. It continues to feel to me like the market is on borrowed time.

Sphinx-Like Fixed Income

Away from stocks, the dollar had a pretty nasty break, with the dollar index down 1% and with the euro appearing to be breaking out again after its recent consolidation. The dollar weakness helped the metals, as gold was up 0.75% and silver was up 1%. In the oddity department, crude was up 1% and change, even as the 10-year was up about 1%. I can't pretend to know what drives the fixed-income market anymore, so I won't bother trying to say why it did what it did.

The Little Financial Engineering That Could

Turning to the corporate news that matters (at least to me), let's begin with IBM. First of all, I know that everyone thinks IBM is in the computer business. Nominally, they are. But I believe their real business is financial engineering to try to keep the stock up. For those who weren't paying attention, in the tech boom/mania they experienced almost no revenue growth, i.e., mid-single digits, but through a variety of mechanisms still managed to come up with mid to high teens in the earnings-growth department.

Last night they reported earnings-per-share of $1.16, and supposedly above expectations. However, as you will soon see, about 10 cents of that gain came from the increase in the intellectual property and custom development line item, which caused their intellectual property gains to be about a couple hundred million higher than most people had apparently anticipated, and also higher than they project to see going forward (based on its answer to the last question on the conference call).

Q&A Goes Low-Carb

Before proceeding any further, I want to note that some of the math you're going to see was unearthed by my friend Fred Hickey, as he and I went through the numbers together last night. Ditto, the tax-rate comments about Dell come from Fred's sleuthing. By the way, before the call started, we were joking about what we thought would be the over/under number for questions. I set the "line" at eight, but said I'd rather take the under. Fred said he thought they'd allow six questions.

Well, they allowed seven -- after they droned on for 45 minutes. I know that's a bit of minutiae, but given that IBM is a rather large company, to allow so few questions after they spewed for so long just shows you that they don't want to have any tough questions asked. Fifteen minutes of Q&A after 45 minutes of windage for a company this size can barely be considered a conference call.

Anyway, with that long preamble aside, here's what is interesting, regarding that intellectual property sale. When you look at the press release, they go through their expenses item by item. For instance, they say SG&A increased 4% to $4.6 billion, and R&D increased 16% to $1.4 billion, etc., etc. Then, when they come to the intellectual property, they note that it "increased significantly, reflecting an IP transaction with Applied Micro Circuits (AMCC:NASD) for $208 million." That was it. They gave no details on the subject.

Intellectual Property Plumps Up a Number

(For those who don't know, they treat the sale of these "intellectual property" assets as recurring items. And oh, by the way, I might point out that they are forced to break them out now because of the hue and cry created when The New York Times tripped them up on this a couple years ago. So now we get some details, whereas they used to just bury intellectual property sales as a reduction in SG&A, and you didn't know they were doing it.)

But back to the story, intellectual property and custom development weighed in this quarter at $432 million, i.e., 18 cents a share after-tax, which amounts to 16% of IBM's per-share earnings. This compares to $199 million a year ago and $180 million last quarter, an increase of 117% year-over-year and 140% sequentially. These are meaningful changes and a significant portion of per-share earnings that they essentially try to sneak past people with little disclosure.

Obfuscation Out of Armonk

I think it's pretty obvious that when they report this line item as they do, while disclosing the other details quite clearly, that their goal is obfuscation, to try to make you think that they are doing better than they are. Coming up with these numbers takes a bit of digging, and it's not readily obvious. The bottom line: These are big numbers and big rates of change, with little explanation or disclosure. Without these IP gains, earnings would have been 10 cents less than they reported them.

I want to say one thing again about the game of making the number/missing the number. This is an exercise in silliness. Beat by a penny, miss by a penny, that whole charade is stupid, so I don't care whether they beat by a penny or miss by 5 cents. What I want to know is how the business is doing.
Tepid Revenue? Who Knew?

Turning to the anemic revenue growth, in America it grew by about 2%, in Europe it grew by 2% in constant-currency terms, and in Asia it grew by about 6% in constant-currency terms. So, no great shakes on the revenue front. But yet, they want you to believe they delivered a 16% earnings gain.

Their vaunted services bookings came in at around $10 billion, like last quarter, which was on the disappointing end of expectations, as that $10 billion last quarter was down year-over-year. Likewise, they experienced problems in software, as other companies did. Software this quarter was flat and down 4% in constant currency, vs. up 11%, and up 3% in constant currency last quarter.

I focus on this because, to repeat, for the longest time I have believed there's been lots of financial engineering of the numbers at IBM when there's been very little revenue growth. They have a very large services business, in which there are assumptions made about what rate at which expenses are accrued against the revenues they receive. Electronic Data Systems (EDS:NYSE), a major competitor, did not do so well in that area and blew up a couple years ago. Before blowing up, they stated that they were not pursuing certain business because one of their competitors was so aggressive. It doesn't take a genius to see that they were talking about IBM.

Paying Up for Abracadabra

I believe that IBM is a ticking time bomb. They continue to "make the numbers" by various means, but I see no real growth there, and I suspect that their accounting for the services revenue has been aggressive. How can it not be, given all the other aggressive stuff they do? Why this company with no growth and this potential amount of problems deserves to sell at 18 times supposed earnings is beyond me.

Nevertheless, I don't really go into this so much to make the case for why I am short the stock. I am short a list of stocks. What I want to emphasize is that here is a very large, well-followed company, and I don't see many people focusing on the details.

Dell's Turbo-Charged Tax-Rate Change

Likewise, the same is true of Dell. This morning, as they headed into their shareholders' meeting, Dell got on the tape and crowed about the fact that their earnings estimates were going to be 2 cents higher, i.e., 31 cents vs. 29 cents. (They didn't guide revenues higher, just earnings estimates.) They claimed that one cent was a tax-rate change and the other penny was for higher operating profitability. To quote the company's press release today: "Higher operating profitability is expected to produce EPS of 30 cents; the balance of the guidance increase is attributable to a further decline in the company's global tax rate."

When I saw that, I thought, I wouldn't be a bit surprised to find out that the tax-rate change was 1.6 cents, which of course would be rounded to 2 cents. (I've seen them use rounding to their advantage in the past.) Sure enough, before I had a chance to check it out, Fred called me and said, guess how much the tax-rate change boosted the earnings per share by this quarter? The answer was 1.6 cents. Ergo, the 2 cents-higher guidance was predominantly a function of the tax-rate change.

The Expedience of Rounding Errors

Why make a big deal about that? Because tax-rate changes don't happen in the middle of the night before a shareholder meeting. Dell had to have known for quite some time that they were going to be able to take their tax rate down. This was a well-timed piece of news, for which I assume they had some agenda.

Think back to last quarter. Dell preannounced midway through that they were going to make an extra $100 million, which was less than 3% revenues. It was a rounding error and not worth mentioning. Today, they made a big splash about raising their earnings-per-share estimates due to a tax-rate change that, again, they must have known about for a very long time.

Why are they doing this? Maybe to take the focus away from the fact that the IDC data released last night showed the PC business growing more slowly than expected, i.e., -4.4% sequentially, vs. -2.3% sequentially. Recall that over the last two quarters, the balance sheet showed inventory bulging, receivables soaring, and other assets (customer financing) exploding. In fact, I've been commenting for some time that Dell's balance sheet is beginning to look more like it belongs to a finance company than a PC company. They don't give any details on what have become huge line items, and it's quite similar to what happened to Gateway before they unraveled.

Inspiron & Co. Can't Inspire Confidence

As I have said before, I don't expect Dell to do a Gateway, but something is rotten in the state of Round Rock. Their balance sheet looks nothing like it should for a company in their business, and now they're making hype-filled comments. But once again, the dead fish community appeared to take them at their word, as I saw no one commenting that this was mostly a tax-rate change -- and not only a nonevent but rather fishy.

So, there is the under-surface peek at a couple of headlines from last night. This goes on repeatedly in technology. IBM and Dell are the freshest examples, but I could give others. Earlier in the week, I noted my belief that Intel (INTC:NASD) raised their guidance because they had to, having built all this inventory. I think they've been less than forthright with folks.

Here are arguably the leaders of the tech industry doing this kind of stuff, and when things really turn rotten, these companies (and many others) will have no credibility. P/Es in this arena will go to some unbelievably low level, because no one will feel like they can trust management, and they'll finally realize how bad these businesses actually are.

Maximizing the Share Price, vs. the Business

The bottom line: Too many companies have been run to maximize the share price, as opposed to maximizing the business. Companies long ago, at least in technology, took their eye off the ball in an attempt to make the stock go up, no matter what the cost. If you even have any doubt about that, just look at the hysteria over options. The whole of corporate America is acting like it's their God-given right to get rich, no matter who gets hurt in the process. I would expect that there will be a tremendous backlash when the bear market gets rolling again.

I am sick and tired of this. It's gone on far too long. Has it hurt me? No. I've been able to profit from it because I am a professional investor and reasonably proficient at debunking these myths and, more importantly, dancing around my positions. But lots of people at home have been and will be sucked in and hurt by corporate self-promotion. It's about time that stopped.

position in dell, ibm, intc

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