SEC homing in on IBM's cloudy financials

Den Howlett Profile picture for user gonzodaddy August 1, 2013
What's going on with IBM's cloud revenues? That's a question the SEC has raised. Although details are sketchy, there are good reasons to believe that the SEC wants IBM to 'fess up about the strength of that line item. We endeavor to examine why.

IBM analyst presso
Chris Kanaracus takes a single line out of IBM's latest 10-Q filing to rustle up a story about how the SEC is investigating the company's accounts. Here is the point in question on page 39 of the filing under the general heading of 'contingencies':

In May 2013, IBM learned that the SEC is conducting an investigation into how IBM reports cloud revenue.  IBM is cooperating with the SEC in this matter.

At one level, it's a bit of an oddity but digging deeper, I can see why the SEC have called them up. As Kanaracus points out, IBM does not report cloud revenue as a separate line item. Even if it did then the number is not expected to reach $7 billion until 2015. Based upon recent presentations, IBM seems to be claiming cloud revs in the $4 billion range.

Here's my best guess about what's going on.

Right now, cloud revenues are so inconsequential as it relates to IBMs total business that the company does not feel the necessity to report separately. There's no general rule that requires them to do so. The graphic above suggests that of the $7 billion it expects to see in sales from this line item, only $3 billion is incremental.

In common with many other companies, IBM shows GAAP numbers - as it must - and then entices the market to believe in other figures, some of which are impossible to substantiate or contextualize because they cannot be separately identified against any disclosed facts. In IBM's case, there are 16 references to 'cloud' in the filing, much of which centers around its acquisition of SoftLayer Technologies. But that acquisition was not announced until after the SEC started its review. What it does say though is the following:

Across the company’s segments, Smarter Planet was up over 25 percent and cloud increased over 70 percent in the first six months of 2013 versus the prior year. Business analytics revenue increased 11 percent in the second quarter with good performance across Global Business Services and Software. These initiatives address key market trends including mobile, social and big data.

[My emphasis added.]

The wording is careful but contains enough buzzword bingo statements to keep the investor community's ears well and truly pricked up.

What other pointers might there be? Larry Dignan at ZDNet shows a graphic from an IBM presentation given in February that talks explicitly to IBM's future revenue drivers. (image at top of post.) My guess is that the SEC is viewing the future revenue projection as sufficiently large that it wants to force IBM out into the open and describe what those revenues look like.

If true then I am surprised the SEC is not taking the same tack on Smart Planet - another projected $7 billion revenue item. But then when you look more closely at the graphic, you can see that IBM overlaps its solutions in four segments: Cloud, Smart Planet, Business Intelligence and Growth Markets. When viewed in that light it is easy to understand why an SEC reviewer might be puzzled since IBM is clearly conflating different kinds of measure.

Why should you care?

IBM's various cloud claims sound impressive but don't make a whole lot of sense.

IBM is making a lot of noise around cloud. It has a separate RSS feed devoted to the topic. It has signalled loud and clear that it wants investors to think of itself as an emerging cloud player. The SoftLayer acquisition - at a whopping $2 billion - was accompanied by a reiteration of IBM's forecast of $7 billion in cloud revenues by 2015 plus some more detail about cloud revenue growth:

Already one of the world’s leading cloud providers, IBM expects to reach $7 billion annually in cloud revenue by the end of 2015. IBM offers more than 100 SaaS solutions to help marketing, procurement, ecommerce, customer service, human resources, city management, and other professionals make better decisions and better serve their customers. IBM also offers Watson solutions such as Client Engagement Advisor in the cloud, superior solutions such as IBM PureSystems and SmartCloud Enterprise+, as well as mission critical cloud services for SAP.

Why didn't it up the forecast? Caution?

Yet when I look at the balance sheet and despite what is said about growth, I can find no obvious evidence of cloud business growth. Now - given the plethora of other numbers that talked about declines, it could well be the deferred income for the cloud business is indeed up. It would have to be for IBM to make the claims it does.

But then I am left wondering what SoftLayer adds to the equation given that the price paid seems incredibly rich even if we are generous enough to assume that the whole of the incremental revenue through 2015 is attributable to that acquisition. And I don't think you can.

According to Dignan:

Analysts say that the SEC probe isn't likely to amount to much. Topeka Capital Markets analyst Brian J. White said in a research note:

There are many different drivers of cloud revenue and thus the revenue recognition can be "cloudy" at times; however, we do not expect this to be a material issue for IBM.

Larry D should have learned by now - most financial analysts are well short of the mark in understanding accounts and underestimate the SEC's ability to discover problems.  Jibes aside, my bet is the SEC is seeing a mismatch between claims, PR and reported numbers and wants investors to have access to the real data so they can make up their own minds as to IBM's strength in this market. Forcing more disclosure from IBM is one way to achieve that purpose. From the buyer's perspective, the exercise will be useful.

IBM likes to play the Big Dog card and uses its long service pedigree to sell services and solutions. Nothing wrong there. But if it is overhyping its position in the market then that's another matter when it is betting a significant chunk of change on this line item.

Much of what I am saying is necessarily conjecture since details are thin on the ground so if you don't accept my version of things then thats just fine. Even so and despite the routine nature of these types of SEC inquiry, they are not undertaken lightly.

As always - we will watch for developments.

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