What's really ailing Big Blue shares? Hint: IBM is part bank

Concerns about IBM's third quarter are popping up almost daily. The standard set of concerns revolves around technology spending and the willingness to pay IBM's army of consultants fees for big bang projects as well as a stronger dollar. But underneath the surface there's a bigger worry that isn't being talked about too much: IBM is part bank.

It's relatively common knowledge that IBM has a big finance unit that helps fund external projects from its clients. It's a swell business that has the second best gross margins at IBM. For instance, IBM's global financing unit had gross margins of 46.7 percent in 2007, second only to the software unit's 85.2 percent. The finance unit's margins were down from the 50 percent clip posted in 2006, but it's nothing to sneeze at for sure.

The lesson here: When the credit market freezes it impacts everyone and possibly some of your friendly neighborhood technology vendors (Dell, Oracle and many others offer financing). Big Blue's financing unit, which leases hardware and finances projects, is big enough that the Securities and Exchange Commission put IBM on the "do not short" list. This list is designed to get shorts--folks that bet against stocks--off the backs of financial services companies long enough to raise capital or at least survive.

Also see: How is the credit crunch impacting your economy?

Todd Harrison at Minyanville, a financial site, dubs IBM--and General Electric and other companies with financial operations--as "financials in drag." I wish I coined that phrase, but Harrison nailed it.

Those financial worries have hit IBM's stock. Here's a look at Big Blue shares over since the company's earnings report in July.

IBM details its financial services operations in detail in its annual report and latest quarterly filing with the Securities and Exchange Commission. While all the accounting mumbo jumbo may be a bit mundane it's worth a look for customers, shareholders and anyone else in the Big Blue ecosystem. At the very least, arming yourself with a little knowledge can deflect FUD (fear uncertainty and doubt) in a highly volatile environment.

In terms of revenue the global financing unit is no big deal relative to Big Blue's overall sales. In 2007, IBM's financing unit had revenue of $2.5 billion (for external clients) out of the total $98.8 billion sales pie. To put that in context, IBM's financing unit had revenue that topped the company's business transformation outsourcing business. More context: IBM's total company debt in 2007 was $35.3 billion and global finance accounted for $24.5 billion of that chunk. IBM's financing business also funds internal clients such as its services unit's contracts. Overall the financing business rocks: Who can argue with pre-tax income of $1.38 billion on total revenue of $3.98 billion?

Here's a look at the business for 2007:

And the results for IBM's financing unit, which is reported as if it were an independent entity, for the first half of 2008:

As you can see the first half margins for IBM's financing unit are up from a year ago. In fact, as recently as July 29--IBM's last quarterly filing--the company was upbeat about its financing prospects. Here's what IBM said about the second half of 2008 in its SEC filing:

The Global Financing business continues to be well positioned to grow in the current environment. The company’s financial position provides substantial flexibility and funding capacity. Global Financing’s assets and new financing volumes are primarily IBM products and services financed to the company’s clients and business partners and substantially all financing assets are IT related assets which provide a stable base of business for future growth. The company’s recently announced System z and high-end converged System p servers are a significant financing opportunity. Global Financing’s offerings are competitive and available to clients as a result of the company’s borrowing cost and access to the capital markets.

The problem: A lot has changed since IBM's last earnings report. Perhaps IBM skated through the credit crunch without any problems, but some investors are clearly skittish.

Also see: IBM’s one-day tumble: Tough quarter or fluctuating dollar?

Tech giants may face dollar daze

Leverage, credit are bad words these days

Given IBM's track record is there really anything to be worried about? That's the $149 billion (IBM's market cap) question.

IBM details the financing business in its annual report:

The Global Financing business provides funding predominantly for the company’s external client assets as well as for assets under contract by other IBM units. These assets, primarily for Global Services, generate long-term, stable revenue streams similar to the Global Financing asset portfolio. Based on their nature, these Global Services assets are leveraged with the balance of the Global Financing asset base.

It continues:

Global Financing invests in financing assets, manages the associated risks, and leverages with debt, all with the objective of generating consistently strong returns on equity. The primary focus on IBM products and IBM clients mitigates the risks normally associated with a financing company. Global Financing has the benefit of both a deep knowledge of its client base and a clear insight into the products that are being leased. This combination allows Global Financing to effectively manage two of the major risks (credit and residual value) that are normally associated with financing.

I'm no accountant, but all folks need to hear are words like "leverage" and "credit" and you can understand the worries. Here's the line of thought: If General Electric has to cut a sweetheart deal with Warren Buffett and cut estimates because of "unprecedented weakness and volatility in the financial services markets" what exactly does that mean for IBM? The two aren't comparable (GE is a massive financial services operation), but people won't make that distinction. In this environment anything financial is toxic.

The big question: What can go wrong? Rest assured that IBM is likely to spend a little time on its third quarter conference call talking about financing and risk factors such as interest rate fluctuations and risk management (all the things banks have been botching).

Assessing the parts

IBM's financing unit has three parts:

• Client financing, which loans money to end users and internal units for terms ranging from two to seven years.
• Commercial financing provides inventory and accounts receivable financing to deals and "remarketers" of IT infrastructure.
• Used equipment sales and leasing--basically gear that comes off lease.

Obviously if IBM's clients are hurting these businesses can become an albatross. IBM has been through downturns before, but this credit crunch is more like a tsunami.

IBM writes:

In addition to the strength of the economy and its impact on corporate IT budgets, key drivers of Global Financing’s results are interest rates and originations. Interest rates directly impact Global Financing’s business by increasing or decreasing both financing revenue and the associated borrowing costs. Originations, which determine the asset base of Global Financing’s annuity-like business, are impacted by IBM’s non-Global Financing sales volumes and Global Financing’s participation rates. Participation rates are the propensity of IBM’s clients to finance their purchases through Global Financing in lieu of paying IBM up-front cash or financing through a third party.

Let's add that up: The economy is weak, interest rates are soaring and clients--especially the financial services types--are going extinct. The worries about IBM's financing unit are warranted. But these concerns could also be overblown. The problem is that we just don't know how it'll all turn out.