Analyst's Notes. Argus Recommendations

Transcription

1 Report created Aug 26, 2015 Page 1 OF 6 IBM is a leading U.S.-based provider of enterprise IT hardware, software and services. IBM's main business units are Global Technology Services (39% of 2013 revenue); Global Business Services (18% of revenue); Systems & Technology Group (17% of revenue); and Software; (24% of 2013 revenue, but 42% of pretax income). In 2013, IBM generated $99.8 billion in revenue, with revenue distribution of 43% from the Americas, 30% from EMEA, and 27% from Asia-Pacific and Other. Analyst's Notes Analysis by Jim Kelleher, CFA, August 25, 2015 ARGUS RATING: BUY Upgrading to BUY with target of $175 Our upgrade is based primarily on valuation. IBM trades at 9.2-times our 2015 EPS forecast and at 8.8-times our 2016 forecast, compared to a five-year ( ) average P/E of The shares, which have traded at 82% of the market multiple, on average, over the past five years, now trade at 61% of the market multiple on projected 2015 and 2016 EPS. Our upgrade also reflects prospects for easier comparisons and better operating performance in coming quarters. We expect earnings quality to improve as IBM benefits from the disposition of commodity-like assets and the development of next-generation strategic imperatives in the areas of cloud, big data, SaaS, enterprise mobility, and security. INVESTMENT THESIS We are raising our near-term rating on International Business Machines Corp. (NYSE: IBM) to BUY from HOLD, based on valuation and prospects for easier comparisons and better operating performance in the coming quarters. IBM's earnings will decline in 2015, in our estimation, and revenue will continue to decline this year and into IBM's earnings quality should steadily improve, however, as the company benefits from the disposition of commodity-like assets and the development of next-generation strategic imperatives in the areas of cloud, big data, SaaS, enterprise mobility, and security. IBM has prioritized the development of these strategic businesses, which maintained their solid double-digit growth in 2Q15. The company is increasingly partnering to accelerate development in areas where it is underrepresented, such as enterprise mobility, or where it needs to build complementary offerings, such as in the cloud. In addition, IBM continues to provide 'essential' high-value enterprise IT, including products from its Systems Hardware Group. While the strategic imperatives strategy is sound, at this stage IBM is still rolling off significant low-margin and slow-growth business. This transition will be a negative for Data Pricing reflects previous trading week's closing price. 200-Day Moving Average Price ($) 225 Rating EPS ($) Target Price: $ Week High: $ Week Low: $ Closed at $ on 8/21 Quarterly Annual ( Estimate) ( Estimate) Revenue ($ in Bil.) Quarterly Annual ( Estimate) 86.6 ( Estimate) FY ends Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Dec BUY HOLD SELL Argus Recommendations Twelve Month Rating SELL HOLD BUY Five Year Rating SELL HOLD BUY Rating Weight Under Over Weight Weight Argus assigns a 12-month BUY, HOLD, or SELL rating to each stock under coverage. BUY-rated stocks are expected to outperform the market (the benchmark S&P 500 Index) on a risk-adjusted basis over the next year. HOLD-rated stocks are expected to perform in line with the market. SELL-rated stocks are expected to underperform the market on a risk-adjusted basis. The distribution of ratings across Argus' entire company universe is: 48% Buy, 46% Hold, 6% Sell. Key Statistics Key Statistics pricing data reflects previous trading day's closing price. Other applicable data are trailing 12-months unless otherwise specified Overview Price $ Target Price $ Week Price Range $ to $ Shares Outstanding Million Dividend $5.20 Overview Technology Rating OVER WEIGHT Total % of S&P 500 Cap % Financial Strength Financial Strength Rating MEDIUM-HIGH Debt/Capital Ratio 77.3% Return on Equity 113.0% Net Margin 13.0% Payout Ratio 0.32 Current Ratio 1.25 Revenue $86.91 Billion After-Tax Income $11.28 Billion Valuation Current FY P/E 8.53 Prior FY P/E 8.93 Price/Sales 1.60 Price/Book Book Value/Share $13.97 Capitalization $ Billion Forecasted Growth 1 Year EPS Growth Forecast -4.54% 5 Year EPS Growth Forecast 10.00% 1 Year Dividend Growth Forecast 21.95% Risk Beta 0.79 Institutional Ownership 58.73%

2 Report created Aug 26, 2015 Page 2 OF 6 Analyst's Notes...Continued revenue in the near term and an upturn is still some time away. However, EPS comparisons could turn positive by the end of this year or early next year, depending on end-market conditions. On two-year forward forecast EPS, IBM shares trade at discounts to their five-year historical multiples and also at steep discounts to their historical relative multiples. We believe that this multiyear relative underperformance of the stock, capped by nonfundamental weakness during the late-august market meltdown, has resulted in an attractive valuation. Our new 12-month target price is $175. Our long-term rating remains BUY. RECENT DEVELOPMENTS IBM shares are down 10% year-to-date, compared to a 13% decline for the peer group and a 6% decline for the S&P 500. In 2014, IBM declined 15%, while the peer group of eight Argus-covered information processing companies rose 16%. IBM shares declined 2% in 2013, while the peer group rocketed ahead by 53%. IBM shares rose 4.3% in 2012, compared to an average 12% decline for the peer group; rose 25.3% in 2011, compared to an average 9% decline for the peer group; rose 12% in 2010, beating the average 8% advance for the peer group; and jumped 57% in 2009, while lagging the peer group. Our near-term upgrade to BUY is based primarily on valuation. IBM trades at 9.2-times our 2015 EPS forecast and at 8.8-times our 2016 forecast, compared to a five-year ( ) average P/E of The shares, which have traded at 82% of the market multiple, on average, over the past five years, now trade at 61% of the market multiple on projected 2015 and 2016 EPS. At current prices near $145, the shares are trading near the bottom of their 52-week range of $143-$199 and are down from peak prices near $215 in mid IBM stock has had a long hard fall that has resulted in part from unprecedented shifts in IT end markets and in part from the company's own obstinacy in responding to these shifts. For too long, while investors were calling on IBM to make transformative deals and jettison legacy assets, management remained focused on its 'EPS growth at any cost' strategy. Not only was this buyback-driven strategy out of sync with investors, it also cost the company precious time in realigning priorities to better match its transitioning end markets. We believe that IBM shares will be better positioned for relative outperformance in the coming months and quarters based on the company's prospects for easier comparisons, a better product mix, and stronger operating fundamentals. Late in 2014, IBM abandoned its 2015 EPS target of $20. Earlier, the company strengthened its cloud strategy with the acquisition of SoftLayer, which positioned it in both cloud enablement and cloud hosting. IBM has since turned its focus to several strategic imperatives, while simultaneously supporting 'essential' high-value enterprise IT offerings. The 2Q15 results provided evidence of early successes in IBM's transformation, while simultaneously underscoring the challenges ahead. Although revenue declined 15% on a GAAP basis in 2Q15, Growth & Valuation Analysis GROWTH ANALYSIS ($ in Millions, except per share data) Revenue 99, , ,507 98,367 92,793 COGS 53,857 56,778 54,209 49,683 46,386 Gross Profit 46,013 50,138 50,298 48,684 46,407 SG&A 21,545 23,217 23,174 22,925 22,472 R&D 6,026 6,258 6,302 5,743 5,437 Operating Income 18,149 20,286 20,443 19,490 17,790 Interest Expense Pretax Income 19,723 21,003 21,902 20,244 19,986 Income Taxes 4,890 5,148 5,298 3,363 4,235 Tax Rate (%) Net Income 14,833 15,855 16,604 16,483 12,022 Diluted Shares Outstanding 1,287 1,214 1,155 1,103 1,010 EPS Dividend GROWTH RATES (%) Revenue Operating Income Net Income EPS Dividend Sustainable Growth Rate VALUATION ANALYSIS Price: High $ $ $ $ $ Price: Low $ $ $ $ $ Price/Sales: High-Low P/E: High-Low Price/Cash Flow: High-Low Financial & Risk Analysis FINANCIAL STRENGTH Cash ($ in Millions) 10,412 10,716 8,476 Working Capital ($ in Millions) 5,808 11,196 9,822 Current Ratio LT Debt/Equity Ratio (%) Total Debt/Equity Ratio (%) RATIOS (%) Gross Profit Margin Operating Margin Net Margin Return On Assets Return On Equity RISK ANALYSIS Cash Cycle (days) Cash Flow/Cap Ex Oper. Income/Int. Exp. (ratio) Payout Ratio 6.6 The data contained on this page of this report has been provided by Morningstar, Inc. ( 2015 Morningstar, Inc. All Rights Reserved). This data (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results. This data is set forth herein for historical reference only and is not necessarily used in Argus analysis of the stock set forth on this page of this report or any other stock or other security. All earnings figures are in GAAP.

3 Report created Aug 26, 2015 Page 3 OF 6 Analyst's Notes...Continued the decline was just 1% after adjusting for currency and asset dispositions. During 2Q15, strategic imperatives - including cloud computing, data analytics, software as a service, enterprise mobility, and related businesses - accounted for more than 30% of adjusted revenue. Strategic imperatives revenue grew more than 30% annually on a currency-adjusted basis in 2Q15. Within these businesses, total cloud revenue was up 50% on a GAAP basis and 70% non-gaap. Cloud delivered as a service achieved a $4.5 billion annualized revenue run rate, compared to a $2.8 billion run rate a year earlier. Business analytics revenue grew more than 20% on a currency-adjusted basis in 2Q15 and more than 10% on a GAAP basis. Of all the transformative areas, IBM has long been strongest in analytics. This business accounted for $17 billion in 2014 revenue and remains on a strong growth curve despite the large base. IBM has sought to fill holes in its portfolios through asset acquisitions and partnerships. In June, IBM and Box Inc. announced a global partnership bringing together Box's cloud content collaboration platform with IBM's analytics and social media solutions, IBM security, and IBM cloud. The more important partnership has been with Apple. First announced in July 2014, this collaboration is designed to bring the power of IBM analytics and big data to Apple's iphone and ipad apps. The IBM-Apple partnership issued its first group of 10 vertical-specific mobile apps in December The partnership intends to bring as many as 100 vertical-specific apps to market by the end of an ambitious goal given that just 22 apps were deployed as of midyear. The learning curve is accelerating, however. Additionally, IBM continues to provide 'essential' high-value enterprise IT, including its remaining server assets (Power, system z) in the Systems Hardware Group (SHG). Second-quarter growth in SHG was driven by mainframe, which had a significant refresh beginning in 1Q15. The Power Server business, home to Watson, is being linked with data analytics to create a powerful tool for native language data dissemination, providing new opportunities in such areas as mobile medicine and advanced call center communications. While IBM's strategic imperatives are promising and essential IT is a bedrock, the company still derives most of its revenue from legacy technology businesses. The latter are being helped by the company's exit from lower-margin and commodity-like businesses, such as Customer Care BPO in Services and industry standard servers in the Systems Technology Group. We note, for example, that 2Q Services contract signings of $11.6 billion rose 17% year-over-year on an adjusted basis. The adjusted contract backlog of $122 billion also swung to positive (up 1%) in 2Q15. In July, IBM reaffirmed its 2015 adjusted EPS guidance of $15.50-$16.25, while hinting that the low end of the range was more likely. IBM is no longer chasing EPS growth for its own sake, as demonstrated by its capital allocation in 2Q15. During the Peer & Industry Analysis The graphics in this section are designed to allow investors to compare IBM versus its industry peers, the broader sector, and the market as a whole, as defined by the Argus Universe of Coverage. The scatterplot shows how IBM stacks up versus its peers on two key characteristics: long-term growth and value. In general, companies in the lower left-hand corner are more value-oriented, while those in the upper right-hand corner are more growth-oriented. The table builds on the scatterplot by displaying more financial information. The bar charts on the right take the analysis two steps further, by broadening the comparison groups into the sector level and the market as a whole. This tool is designed to help investors understand how IBM might fit into or modify a diversified portfolio. P/E Value HPQ 5-yr Growth Rate(%) IBM SNDK AAPL Growth 5-yr Net 1-yr EPS Cap Growth Current Margin Growth Argus Ticker Company ($ in Millions) Rate (%) FY P/E (%) (%) Rating AAPL Apple Inc 591, BUY IBM International Business Machine 138, BUY HPQ Hewlett-Packard Co 46, BUY SNDK SanDisk Corp 9, BUY Peer Average 196, P/E Price/Sales Price/Book PEG 5 Year Growth Debt/Capital

4 Report created Aug 26, 2015 Page 4 OF 6 Analyst's Notes...Continued quarter, it spent $1.1 billion to repurchase shares - less than the $1.3 billion it paid in dividends. IBM's earnings will decline in 2015, in our estimation, and revenue will continue to decline this year and into However, earnings quality should steadily improve as the company benefits from the disposition of commodity-like assets and the development of next-generation business focusing on cloud, big data, enterprise mobility, and security. EPS comparisons could turn positive by the end of this year or early next year, depending on end-market conditions. EARNINGS & GROWTH ANALYSIS For 2Q15, revenue of $20.8 billion fell 15% year-over-year on a GAAP basis; sales were down 1% annually after adjusting for currency and the divested system x business. Revenue slightly missed the conservative $20.9 billion consensus forecast. On sequentially higher revenue, the GAAP gross margin expanded to 49.9% in 2Q15 from 48.2% in 1Q15 and from 49.2% in 2Q14. On a GAAP basis, IBM earned $3.50 per diluted share in 2Q15, compared to $2.35 in 1Q15 and $3.92 in 2Q14. On an adjusted basis, which excludes acquisition-related and nonoperating post-retirement adjustments as well as nonoperating charges, IBM earned $3.84 per diluted share, compared to $2.91 per diluted share in 1Q15 and $4.24 in 2Q14. Adjusted 2Q15 EPS declined 9% year-over-year but topped the consensus call by $0.06. For all of 2014, IBM posted revenue of $93.4 billion, down from $99.7 billion in 2013 and $104.5 billion in IBM posted 2014 non-gaap earnings of $16.53 per diluted share, down 1% from $16.64 per share (restated) in IBM maintained its guidance for non-gaap 2015 earnings of $15.75-$16.50 per diluted share. The company does not offer revenue guidance. Given the extensive restructuring underway at IBM, the Street is modeling and valuing IBM on a non-gaap basis for Our 2015 non-gaap earnings projection is $15.78 per diluted share and our 2016 forecast is $16.53 per diluted share, which is slightly ahead of consensus. We project a high single-digit revenue decline in 2015, followed by flat revenue to a very modest top-line gain in Our long-term annualized EPS growth rate forecast for IBM is 10%. FINANCIAL STRENGTH & DIVIDEND Our financial strength rating for IBM is Medium-High. Cash was $8.75 billion at the end of 2Q15. Cash was $8.48 billion at year-end 2014, $11.1 billion at the end of 2013, $11.9 billion at the end of 2012, $11.9 billion at the end of 2011, $11.6 billion at the end of 2010, $14.0 billion at the end of 2009 and $12.9 billion at the end of Cash tallies are generally reduced by dividends and share buybacks. Cash flow from operations was $16.9 billion in 2014 and $17.5 billion in 2013 ($18.8 billion less global financing receivables). Cash flow from operations was $19.6 billion in 2012 ($22.5 billion less global financing receivables), compared to $19.8 billion ($20.7 billion less global financing receivables) in Cash flow from operations was $19.5 billion ($20.3 billion less global financing receivables) in 2010, $18.8 billion in 2009 ($20.7 billion less GF receivables), and $18.8 billion in Total debt was $38.9 billion at the end of 2Q15, including nonglobal financing debt of $12.6 billion. Total debt was $40.8 billion at the end of Debt less global financing was $16.9 billion at year-end Debt was $39.7 billion at year-end 2013, with nonglobal financing debt of $12.2 billion. Debt was $33.3 billion at year-end 2012, $31.3 billion at year-end 2011, $28.6 billion at the end of 2010, $26.1 billion at year-end 2009, and $33.9 billion at year-end Because of losses flowing through from the Globalfoundries transaction as well as repurchases and other events, stockholder's equity was reduced to $11.9 billion at the end of 2014 from $22.8 billion at the end of This caused a spike in the debt/cap ratio for non-gf debt. Excluding debt from the global financing operation, the debt/cap ratio for non-gf debt jumped to 59% at the end of 2014 from 56% at 2Q14, and from 39% at the end of That compares with 36% at the end of 2012 and 32% at the end of Debt/cap for non-gf debt was up from 23% at the end of 2010 and 16% at the end of Rising debt/cap principally reflects lower stockholders' equity, based on IBM's aggressive share repurchase program. IBM's Treasury accounts in stockholders' equity exceeded $129 billion at the end of 1H13, while retained earnings totaled $122 billion. In April 2015, IBM raised its quarterly dividend to $1.30 per share. That follows dividend hikes of 16% in April 2014, to $1.10 per diluted share; in April 2013, to $0.95, and in April 2012, to $0.85. Our annual dividend estimates are $5.00 for 2015 and $5.20 for MANAGEMENT & RISKS Virginia 'Ginni' Rometty has been CEO since 2012, succeeding Samuel J. Palmisano; Ms. Rometty has also become the company's chairman. Mark Loughridge, who served as CFO from 2004, retired at the end of 2013 and was replaced by Martin Schroeter. Steve Mills, the head of software, oversees Systems & Technology; Rod Atkins, head of S&T, reports to Mr. Mills. The services businesses are combined under IT Services head Mike Daniels; Bridgette Van Kraligen has reportedly replaced the retiring Frank Kern as head of Global Business Services. We think the reputation of IBM helps to attract highly qualified individuals, assuring a deep and talented management pool at every level of the business. The newest risk for IBM is that the slowing in demand visible in 2014 intensifies in In our view, IBM has a competitive advantage as businesses and government agencies seek to solve complex problems that extend well beyond box-based hardware or software solutions. IBM has also shown an ability to align costs in periods of challenging revenue growth. The company is moving quickly to divest low-return assets and invest in its strategic imperatives, including cloud, analytics, and engagement. More broadly, IBM's risks include competition in its hardware, software and services businesses, as well as legal issues and the possibility of further declines in IT spending. These risks are mitigated by the company's unimpeachable reputation and financial strength, which position it for net market share gains coming out of difficult economic periods. COMPANY DESCRIPTION IBM is a leading U.S.-based provider of enterprise IT hardware, software and services. IBM's main business units are Global Technology Services (39% of 2013 revenue); Global Business Services (18% of revenue); Systems & Technology Group (17% of revenue); and Software; (24% of 2013 revenue, but 42% of pretax income). In 2013, IBM generated $99.8 billion in revenue, with

5 Analyst's Notes...Continued NYSE: IBM revenue distribution of 43% from the Americas, 30% from EMEA, and 27% from Asia-Pacific and Other. INDUSTRY Our rating on the Technology sector is Over-Weight. We believe CIOs and IT managers are becoming more accustomed to transformative technology, including virtualization & cloud, big data, analytics, software-defined networking, and everything-as-a-service. The sorting-out period, in which companies adapted to increased software content and reduced hardware intensity, is now being followed by increased investment in these areas. valuations remain attractive, while growth prospects remain highly positive. For the long term, we expect the sector to increase its weighting within the S&P 500 from the current 19%-20% level to 22%-23%, based on positive company and sector fundamentals. For individual companies, these include high cash levels, low debt, and broad international business exposure. We expect the entire sector to benefit from the transformative effects generated by new developments in technology. Positives in the picture for information processing & computing companies include a second-stage PC and enterprise IT 'refresh' cycle that is being driven by the Microsoft Windows 8 launch and Intel's 'Haswell' family of PC (third-generation Core i) and server processors. Server and Storage providers stand to benefit from the battle among computing and communications companies for dominance in the enterprise data center, where virtualization and cloud enablement are prompting market-share disruption. Communications infrastructure players stand to gain from the explosion in network traffic related to the rise of social networking sites, high-bandwidth video on the network, and mobile data. In the technology sector overall, key transformative trends include acceleration in mobile broadband, driven by tablets and smartphones; social networking and the resultant explosion in bi-directional data traffic; Analytics, including Big Data and business intelligence; and Cloud, including multiple variants (public, private, and hybrid) and enabling technologies such as Virtualization, Software-Defined (SD) Networking and Data Center, and Software/Platform/Infrastructure-as-a-service. VALUATION IBM trades at 9.2-times our 2015 EPS estimate and at 8.8-times our 2016 estimate, compared to a five-year ( ) average of The shares, which have traded at 82% of the market multiple, on average, for the past five years, now trade at 61% of the market multiple on projected 2015 and 2016 EPS. Calculated comparable historical valuation in the mid-$160s has reversed a multiyear declining trend and is now above current stock prices. Our discounted free cash flow model renders a fair value in the $200s. DFCF valuation is now also in a rising trend. We believe that the multiyear relative underperformance in IBM, capped by nonfundamental weakness during the late-august market meltdown, has provided a favorable entry point. Our 12-month target price is $175. On August 25, BUY-rated IBM closed at $140.96, down $2.51. Report created Aug 26, 2015 Page 5 OF 6

6 METHODOLOGY & DISCLAIMERS Report created Aug 26, 2015 Page 6 OF 6 About Argus Argus Research, founded by Economist Harold Dorsey in 1934, has built a top-down, fundamental system that is used by Argus analysts. This six-point system includes Industry Analysis, Growth Analysis, Financial Strength Analysis, Management Assessment, Risk Analysis and Valuation Analysis. Utilizing forecasts from Argus Economist, the Industry Analysis identifies industries expected to perform well over the next one-to-two years. The Growth Analysis generates proprietary estimates for companies under coverage. In the Financial Strength Analysis, analysts study ratios to understand profitability, liquidity and capital structure. During the Management Assessment, analysts meet with and familiarize themselves with the processes of corporate management teams. Quantitative trends and qualitative threats are assessed under the Risk Analysis. And finally, Argus Valuation Analysis model integrates a historical ratio matrix, discounted cash flow modeling, and peer comparison. THE ARGUS RESEARCH RATING SYSTEM Argus uses three ratings for stocks: BUY, HOLD, and SELL. Stocks are rated relative to a benchmark, the S&P 500. A BUY-rated stock is expected to outperform the S&P 500 on a risk-adjusted basis over a 12-month period. To make this determination, Argus Analysts set target prices, use beta as the measure of risk, and compare expected risk-adjusted stock returns to the S&P 500 forecasts set by the Argus Strategist. A HOLD-rated stock is expected to perform in line with the S&P 500. A SELL-rated stock is expected to underperform the S&P 500. Argus Research Disclaimer Argus Research is an independent investment research provider and is not a member of the FINRA or the SIPC. Argus Research is not a registered broker dealer and does not have investment banking operations. The Argus trademark, service mark and logo are the intellectual property of Argus Group Inc. The information contained in this research report is produced and copyrighted by Argus, and any unauthorized use, duplication, redistribution or disclosure is prohibited by law and can result in prosecution. The content of this report may be derived from Argus research reports, notes, or analyses. The opinions and information contained herein have been obtained or derived from sources believed to be reliable, but Argus makes no representation as to their timeliness, accuracy or completeness or for their fitness for any particular purpose. This report is not an offer to sell or a solicitation of an offer to buy any security. The information and material presented in this report are for general information only and do not specifically address individual investment objectives, financial situations or the particular needs of any specific person who may receive this report. Investing in any security or investment strategies discussed may not be suitable for you and it is recommended that you consult an independent investment advisor. Nothing in this report constitutes individual investment, legal or tax advice. Argus may issue or may have issued other reports that are inconsistent with or may reach different conclusions than those represented in this report, and all opinions are reflective of judgments made on the original date of publication. Argus is under no obligation to ensure that other reports are brought to the attention of any recipient of this report. Argus shall accept no liability for any loss arising from the use of this report, nor shall Argus treat all recipients of this report as customers simply by virtue of their receipt of this material. Investments involve risk and an investor may incur either profits or losses. Past performance should not be taken as an indication or guarantee of future performance. Argus has provided independent research since Argus officers, employees, agents and/or affiliates may have positions in stocks discussed in this report. No Argus officers, employees, agents and/or affiliates may serve as officers or directors of covered companies, or may own more than one percent of a covered company s stock. Morningstar Disclaimer 2015 Morningstar, Inc. All Rights Reserved. Certain financial information included in this report: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.