Recently, Framework partner, Sheila Chesney, sent along several reports from the venerable Wall Street investing newsletter, Grant’s Interest Rate Observer, about IBM. Since Grant’s is known as the publication read by smart money types, I wanted to take the time to analyze the comments carefully.

Grant’s is bearish the firm and, since it is relatively more focused on fixed income investments, its criticisms of the firm relate to its indebtedness and to the credit quality of its clients.

I have been reading through IBM Credit, LLC’s financial statements (IBM spun off most of its global financing business into a wholly-owned subsidiary in 2017), and while I am still not finished with my analysis, have taken a close look at the credit quality of its customers.

IBM loans money to customers to purchase systems and software. It also funds working capital loans to distributors and resellers. These loans spur IBM’s sales in the same way that department store credit cards help consumers spend more at the mall. Clearly, though, if a client maxes out his or her card, then goes bankrupt, the company offering the credit is worse off. Grant’s is clearly worried that IBM is offering clients and partners credit at too easy terms and that credit quality is falling. Here’s a quote from a Grant’s article in June.

At the end of 2009, the then-$25 billion financing portfolio was 59% exposed to investment-grade names. At year-end 2017, the now-$30.7 billion portfolio was 53% exposed to investment-grade.

Grant’s also points out that many of the partners to which IBM is granting credit have deadbeat-level credit ratings (e.g.,¬†Arrow Electronics, Inc.: Bbb-; Avnet, Inc.: Bbb- with a negative outlook).

The fact that Grants does not mention is that IBM effectively buys put options on these loans — removing downside exposure to its counterparties’ credit status. Here is the relevant quote from the 2017 IBM Credit, LLC 10-K:

At December 31, 2017, substantially all Client Financing and Commercial Financing assets were IT related assets, and approximately 54 percent of the total portfolio, excluding financing receivables from IBM and receivables purchased from IBM, was with investment grade clients with no direct exposure to consumers. This investment grade percentage is based on the credit ratings of the companies in the portfolio. Additionally, the company takes actions to transfer exposure to third parties. On that basis, the investment grade content would increase by 17 points to 71 percent.

The other point to note is that Grant’s chooses to start its analysis in 2009. For those of you who need a reminder, 2009 was still pretty dicey after the Great Mortgage Kerfuffle, and my guess is that the portfolio size and composition in 2009 reflects IBM’s decision not to advance credit to clients (who probably weren’t buying anyway at that time).

Between what is likely an artifact of the choice of a starting point and ignoring the credit risk mitigation measures taken, in my view, Grant’s overstates the bearish credit case against the company. I still have more research to do, but this is my first impression.

The newsletter then switches purely to the topic of loans and leases to clients — excluding working capital loans to distributors, in other words — and provides these comments:

The [client] data showed marked long-term deterioration in credit quality. Thus, at the end of 2010, that management-curated portfolio was 70% exposed to investment-grade counterparties. By March 31 of this year, its investment-grade exposure had dropped to 57%.

Again, this sounds dire, but it seems worthwhile to take a look at a time series rather than just picking two points. I graphed out the proportion of IBM’s investment grade loans versus its non-investment grade ones for annual data starting in 2010 (the first year these data were reported). Here is that graph:

Figure 1. Source: Company Statements, Framework Investing Analysis

Indeed, we see a gradual rise in the proportion of the non-investment grade loans over this eight-year period. That said, again thinking of the timing of the early years vis-à-vis the credit crunch of the Great Recession, from this graph, I would not be surprised if the company is targeting a level of somewhere around 60% of its portfolio exposed to investment grade credits.

Also note that, since its spin-off from IBM, IBM Credit seems to be tightening lending standards some, with exposure to investment grade clients increasing from the mid-50% range to nearly 60%.

Digging down a bit further, it seems that most of the increase to non-investment grade clients occurred in the highest non-investment grade.

Figure 2. Source: Company Statements, Framework Investing Analysis

Note the shrinking of the dark green band (representing loans to the lowest investment grade clients) and proportional expansion of the light blue band (representing loans to the highest non-investment grade clients) starting in 2015. This change seems to be driving the perceived difference in credit quality, but we have no idea — other than the credit quality of the borrowers — of the terms of the underlying loans. For instance, perhaps IBM has been able to shorten loan maturities while maintaining a relatively high yield by serving more non-investment grade clients.

Keep in mind too that these values are the raw client credit scores, unadjusted for credit risk mitigation strategies. I will ask management about this, but wouldn’t be surprised if IBM’s effective exposure to non-investment grade credit on the loan or lease level is on the order of 20% – 30%.

While I still need to work through some of the other contentions regarding the strength or weakness of IBM’s balance sheet, in my opinion, these points about credit quality are overblown.