The $340 Million Question IBM Needs to Answer On Its Q4 Earnings Call

In previous columns, I’ve stated repeatedly that I believe there are serious accounting red flags at IBM.

To catch you up briefly, I’ve detailed how, in my view, IBM has overspent on acquisitions, repeatedly found itself entangled in bribery and accounting scandals both domestically and overseas, and rewarded its executives for subpar performance. (Executives who, I believe, are also overstating the prowess of their cloud business.)

Now, before I became an investor and the founder of Worm Capital, I was — and still am — a forensic accountant. And if I were auditing IBM’s books today, it’s my belief that there’s something very fishy going on. Specifically, it has to do with a claim in IBM’s Q3 2016 financials that the company suddenly struck a deal to bring in $340 million — quarterly — by licensing their software IP to three unnamed entities.

That’s a $1.4 billion annual run-rate.

Now, if I told you someone bought a house for $100,000, that wouldn’t be too surprising, right?

But if I told you someone was going to rent a house for $100,000 for 90 days — that would raise some eyebrows. You’d probably be curious about who could afford such rent, and what kind of house would be worth renting (not owning!) for $100,000 per quarter.

And yet, none of that has happened with this absolutely massive deal at IBM. The company has not named the three entities that are supposedly renting their software for this enormous sum, nor have they disclosed the actual technology being licensed. This is a big deal, and it raises a number of very specific (and potentially uncomfortable) accounting questions for an auditor, which I will outline below.

But first, let’s back up for just a minute to understand why it’s so important to scrutinize these claims.

For the last five years, IBM has seen consecutive declines in both gross profit and revenue, key indicators of a struggling business. As I’ve written previously, they were late to the cloud business, overspent on SoftLayer, and struggling to keep up to Amazon’s ever-growing AWS platform. They are, in my view, desperate to prove to shareholders and investors that they’re hitting targets each quarter.

So on the Q3 2016 earnings call, it was surprising to hear IBM’s CFO Martin Shroeter give such a cheery explanation about the $340 million quarterly deal, but no real nuts and bolts information.

Instead, he resorted to simply boasting about the size of the deal.

Here’s what he said in October 2016:

I don’t think that we have enough to set a new annual record when we look back at the $1.7 billion that we printed 15 years ago or so, but it is certainly a focus, and keep in mind I think that these are relationships, they are long term relationships, right. So, they are not all public as some of our partners don’t want to talk about what they are doing…

We again, we license it to them, we don’t sell it to them, so we have an interest going forward as well and can get some of the upside here. So this is a really — it’s a terrific model, it’s got a lot of legs. We see an opportunity for this over the next few years to continue doing this.

Ok, here’s the problem with that statement.

1. Which businesses could possibly be paying this amount for a software license? A CFO can’t shrug off that question by saying these partners “are not all public.” There are only a few businesses in the world that could possibly afford to rent software for this enormous sum — Google, Amazon, Microsoft, etc — but these businesses have no interest in IBM’s technology. Either way, there should be an effect on the buyer’s P&L. We looked at financials of companies who might have paid IBM. But there’s no evidence in Q3 reports that anyone paid such a large fee. IBM said it was divided among three companies, but that averages out to over $100 million in rent per quarter. At CSC or HPE, for example, even a $50 million payment for software IP would’ve been noticeable.
2. Where is the offset within IBM’s financials? This is a bit more technical, but from an accounting perspective, if you’re going to license software to earn what is essentially a rental income, there needs to be an offset within IBM’s accounting — and there needs to be an effect on IBM software revenue. Put it this way: If Company X rents your software and sells that software to Company Y, you are giving up that revenue that you could have sold directly to Company Y. So what did IBM give up, exactly? I don’t think anyone is going to pay IBM $340 million in quarterly rent (again, a $1.4 billion annual run-rate) for its software without IBM giving up something exceptional — and it should been evidenced by a hit to software revenue of 15% or more. (There was no effect).
3. Lastly, the timing of the deal needs to be explained. The $340 million in quarterly rental income comes out of nowhere. Where’s the gradual build-up that is the norm for this sort of income? Given the heightened risk that paying rent involves (you’re not the owner, you lose all rights at the end of the rental period, etc.), typically you see measured stair-step increases. But not here. In my experience, licensing revenue at this size and scale doesn’t happen overnight. You see it building. Only a “sale” happens overnight like this, not a true rent situation.

So, this is the $340 million question at IBM.

One other thing. Back on the Q3 2016 earnings calls, Martin Schroeter said this:

“IP income is just one way that we monetize our technology, sometimes selling our intellectual property, other times licensing IP.”

A CFO can’t just “toggle” from selling to licensing, like selling $340 million or licensing $340 million are the same thing.

They are not the same thing, and from an accounting perspective, it’s an enormous difference. Why? Well the implied value of Software IP rented out for $340 million on a quarterly basis is $8–10 billion, using a 30x multiple. C’mon. The difference between a sale and rent is enormous.

I encourage any analysts or investigative reporters to start asking around. And if this is questioned on the January Q4 earnings call, I’m sure we’ll all be in for some interesting responses if IBM’s Martin Schroeter board is pressed to answer.

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Arne Alsin and Worm Capital clients are currently long Amazon and also own options positions in IBM and stand to benefit if the trading price of Amazon increases and/or the trading price of IBM decreases.

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