How to Boost EPS 101

By Charles Cody - July 2, 2012 | Tickers: KO, COKE, IBM | 0 Comments

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Ever wonder how companies like Coca-Cola (NYSE: KO) and IBM (NYSE: IBM) seemingly make or beat their earnings numbers quarter after quarter? One trick that executive managers use to artificially boost earnings per share (EPS) is to reduce the float. This means that the company buys back shares outstanding (i.e., the float), so that reported net income is divided by fewer shares. Morally, this isn't a bad thing especially if you already own the stock because Wall Street uses quarterly EPS, revenue, and future guidance as its basis for buy, sell, or hold recommendations to their clients. These recommendations can generate a lot of activity for a specific stock, and so it makes sense that better revenue and EPS numbers will help create buying activity -- all good for the company, its shareholders, and of course the executive management team.

For example, KO's EPS reported last quarter were $0.89 versus $0.82 a year ago, or an increase of $8.54%. Note that the EPS percentage increase is higher than its net income increase. Net income a year ago was $1.903 billion versus $2.054 billion this quarter, a 7.54% increase. A year ago, there were 2.292 billion shares outstanding and last quarter there were only 2.263 billion shares outstanding, a decrease of 29 million shares representing 1.92% float reduction. Revenue advanced year over year only 5.90%, from $10.5 billion to $11.1 billion. The float reduction represents about a $.02 per share EPS difference.

KO has tremendous cash flow and you may ask why this presents a moral dilemma? In my opinion, the $7.4 billion dollars spent to buy back shares could have been better used. KO's balance sheets show the company ADDED an additional $6.813 billion in long term debt over the last year, and spent $4.239 billion to reduce shares. The addition of debt reduces cash flow and the dividend was increased from $0.47 to $0.51 a share during the period, an 8.51% increase. The $2.04 annual dividend represents a 2.70% yield. My point is, it could be higher and that shareholders would receive a greater benefit from larger dividend yields. (Class 201 could be analyzing the benefits of dividend yields at a 15% tax rate versus short term capital gains at the ordinary income tax rate.)

IBM reported $2.61 in earnings (diluted) last quarter versus $2.31 a year ago, a 13% increase.  IBM's net income equaled $3.066 billion last quarter, but $2.863 billion a year ago -- a smaller 7.09% rise. Note that the net income percent increase is smaller than EPS. Like Coca Cola, for the quarter ending Mar. 31 IBM increased its long term debt year over year by $4.011 billion dollars to $25.76 billion while decreasing its shares outstanding by 67.8 million shares. Net income for the last 12 months ending Mar 31, 2011 was $15.095 billion; it was $16.058 billion for the last 12 months 2012.  Undiluted EPS during the periods were $12.09 and $13.59 respectively.  The earnings boost brought about by float reduction equals $0.73, and about $11.46 in stock price based on a PE on March 31 of 15.62.  Again, the $4 billion spent with debt to reduce the float could have benefited shareholders with a higher dividend yield.  By the way, IBM shows a 19% operating cash flow margin, and free cash flow of $3.447 billion for the latest quarter, so it's not as if the company is cash strapped.

The real issue is that manipulating EPS benefits senior management more than shareholders because pay packages are normally tied to stock price appreciation, and we know the way to get the stock price to rise when a company is a slow growth behemoth is to artificially boost EPS.  A corollary issue is that leveraging the balance sheet, even with the cheapest money available in our lifetimes, is not a good thing because, eventually, the debt must be paid back.

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