Summary

Certain critics have asserted that IBM’s R&D spending is inadequate, due to wasting money on excessive buybacks.

International Business Machines Corp. (NYSE:IBM) has historically spent 6% of revenue on R&D, and continues to do so.

Critics have misinterpreted R&D expense by failing to mention the accounting treatment of IP (Intellectual Property) income, which is booked as a reduction of expenses.

Here’s what got me going. It’s taken from an article originating on InvestorPlace and published by Kiplinger.

As Credit Suisse analyst Kulbinder Garcha explained in a recent research report, International Business Machines has spent a sizable fortune on buybacks of IBM stock in recent years, but that has led to led to “an underinvestment in R&D.”

For perspective, the number of shares outstanding has fallen from 1.115 billion in 2012 to 957 million as of the most recently reported quarter. At the same time, the company’s research and development expense was $4.4 billion for the past four quarters, versus a total R&D expenditure of $6.3 billion in 2012.

This certainly reads like a damning indictment of IBM’s management. However, an examination of the facts demonstrates that the criticism is invalid.

Taking a Closer Look

IBM has a set policy of spending 6% of revenue on R&D. From the most recent 10-K:

IBM annually invests approximately 6 percent of total revenue for R&D, focusing on high-growth, high-value opportunities.

What the critics elect to ignore is that R&D has remained consistent at approximately 6% of revenue. IBM divested its Microelectronics (Chip) business since it lacked appropriate scale to compete with the likes of Intel (NASDAQ:INTC) and TSMC (NYSE:TSM). Here is R&D as a percentage of revenue, taken from Morningstar:

TTM R&D expense is currently at 5.46%, relatively close to the 6% goal as stated by management. But the above is a condensed version of the financials, and doesn’t show IP income, which is booked as a reduction of expenses. Instead, the statement reduces R&D expense by the amount of IP income.

Accounting for IP Income

Here is how the accounting works, from the most recent 10-K:

Doing the math for 2015, $5,247 less $682 (from the 10-K) equals $4,565 (5.6% of revenue, which was $81,741). However, $5,287 (the actual expense number) is 6.5% of revenue. The point is, revenue is not an expense, regardless of where it is booked on the income statement.

Here are the financials from Morningstar, expressed in dollars rather than percent. The numbers match the 10-K when R&D expense is reduced by IP income.

The quote from Kiplinger mentions $4.4 billion TTM expense for R&D. That matches the $4,379 million condensed figure Morningstar provides when the view is changed from percentage to dollars.

IP income for nine months of 2016 was $1,110 million. Simply adjusting the TTM figures by adding back nine months of IP income, R&D expense is 6.8% of revenue. I rest my case.

Accounting Complexity for Investors

A majority of investors, at least retail investors, don’t have an in-depth knowledge of accounting. Some of them attempt to overcome this disadvantage by taking a skeptical view of financial information as presented by management.

In my experience, misinterpretations of financial information are not uncommon among those who desire to make a bear case against specific companies. The average sell-side analyst or professional stock writer should be well-informed on contra items and could easily make the adjustments detailed above. Failure to do so, in my opinion, is a disservice to readers and investors.

As a matter for thought and discussion, critics note IBM’s failure to grow revenue. When IP income is booked as a reduction to expense, it doesn’t show up on the top line.

Getting Back to Buybacks

Some time ago, I wrote an article covering buybacks in considerable detail in an effort to be helpful to retail investors who need to develop an opinion on the issue as it affects companies in which they have an interest. I won’t repeat the essay here. However, I will make one salient point about IBM’s buybacks.

As of 9/30/2016, IBM had repurchased 1,273 million shares at a cost of $158,170 million. That works out to $124.25 per share, with shares currently trading in the $167 area. IBM did not overpay for shares it bought back.

Remember the dollar reduction in R&D was caused by the divestiture of the chip business. Intel spends 21.7% of revenue on R&D to the tune of $12 billion per year. IBM didn’t have the scale to compete on an equal footing and it was far more prudent to return funds to shareholders than it would have been to try to match Intel’s R&D spending in order to compete.