IBM Sits Poised at Cycle Trough; 30% Upside Targeted

Buying an industry leader trading at trough valuation due to technology transition. Upside in the stock will be driven by a re-rate of its earnings multiple to a less steep discount relative to its tech sector peers, once its core business stabilizes and its growth initiatives start to take hold.

BUSINESS PROFILE
*One of world’s largest providers of enterprise IT solutions, offering hardware (mainframes, servers and storage), software and IT services in an integrated approach.

*Software and services (largely annuity based) drive the vast majority of profits. Its major growth initiatives in Cloud, Big Data, etc are 27% of its overall revenue in 2014.

BACKGROUND
*Major secular technology shifts in the IT world, including cloud architecture, mobile Internet and big data have caused IBM’s large legacy businesses to underperform. Leading Web 2.0 companies have been driving the adoption of open source software solutions on commodity hardware, moving spending away from traditional IT players. However, IBM is not the only IT vendor that had to transition its business to adapt to this new landscape - MSFT, ORCL and CSCO are all making efforts to adapt.

*IBM’s large foreign currency exposure and a strong rally in US Dollar beginning in mid 2014 have made the revenue declines look much worse than the actual underlying trend. We are seeing improving revenue trends in the latest quarter - overall revenue was flat at constant currency, strong Hardware sales on higher System Z and Power-systems sales (+30% y/y cc), Strategic Imperatives revenue accelerated to over 30% y/y cc. Company maintained its full year EPS guidance of 15.75-16.50.

MAIN THESIS
*The threat of IT transition to the cloud is over-stated. IBM has successfully transitioned through the past many paradigm shifts in computing (from mainframe to microcomputer, to server-client, and now to cloud and mobile). IBM's value proposition in the technology world seems to transcend these architectural shifts. Its value to customers is that of a systems integrator, not a point solutions provider. It's not a hardware or software company, but primarily a systems and services company and should be valued as such. The shift to cloud has clearly hurt their revenue growth and it's hard to see them win in the public cloud arena vs vertical software vendors like CRM and infrastructure vendors like MSFT and AMZN. But hybrid cloud will also be an integral part of this new landscape and IBM has #1 position in it. IBM’s cloud business is healthy. IBM cloud-related sales on a year to date basis grew by more than 75% and SaaS sales increased nearly 40%.

*Streamlined product portfolio and focus on grow areas. Some of the revenue declines were engineered by the company. IBM has divested multiple lower-value-add businesses, including the commoditized x86 servers business and the semiconductor business. The effort to divest is helping gross margin improve and bring company back to growth. Gross margin has expanded from 46% in 2011 to the current 50%. There is also potential to divest the storage business to further streamline the portfolio.

*Potential inflection in the sales cycle. Strategic Imperatives (cloud, big data, mobile, social and security), now almost 30% of overall revenue in the latest quarter are projected to generate $40bn in sales (15% cc CAGR) by 2018. This does not assume that IBM takes market share and is not an aggressive target given overall industry growth rate. These growth areas are primarily software based which implies margin benefits over time. If current trajectory continues, revenue trend could potentially inflect in late 2015 and show low single digit growth in 2016.

*Historically low valuation and extremely negative investor sentiment are good contrarian indicators. After 3 years of underperformance relative to the S&P 500 index, IBM’s PE ratio has contracted from a 20% premium to a 45% discount vs average S&P 500 multiple. Sell-side analyst sentiment is around 20 year low (buy ratings at below 20%). The stock is one of the most underweight large cap stocks among mutual funds. Secular challenges affect other largest cap technology companies such as CSCO, HPQ, EMC and ORCL, but IBM has underperformed for 3 years and is trading at a 30% discount relative to these peer companies. We are now seeing signs that the worst may be over for IBM. A re-rate to a more normalized PE could drive the first 10-20% outperformance in the stock in the near term.

VALUATION
*Base Case ($180-190): Core services and software business stabilizes and declines at mid single digit. Overall revenue cycle bottoms in late 2015 and starts to show some growth in 2016, excl. currency effects.

*Upside Case ($220-240): Growth in Strategic Imperatives more than offset the decline in Core. It becomes unquestionable that overall growth trajectory has inflected. Gross margin continues to expand as a result of higher value revenue mix. Stock could re-rate back to 12-14x, which is still a conservative multiple relative to its peers.

*Downside Case ($150-160): Growth initiatives slow down and Core business continues high single-digit decline. It remains a legitimate concern that the majority of IBM’s business is in secular decline.

CATALYSTS
*Hardware product cycle to generate some modest near term momentum. Core portfolio is going to benefit from a mainframe refresh cycle with the recent introduction of z13 in Jan 2015. Z system grew 130% in the last quarter and the momentum could carry into the rest of 2015.

*Further portfolio divestitures (ex. the storage business). Monetization of Watson and some of IBM’s strategic partnerships may start to contribute more meaningfully to revenue growth.

RISK/CONCERNS
*Key risk is the management’s ability to execute on the turnaround plan which could take longer than expected. Accelerating decline in Core may more than offset the traction in growth initiatives.

*FCF conversion has been poor in recent quarters, due to cash tax headwind and pension contributions, and may continue to be weak in the near future. Stock is less cheap if looked at from a multiple to FCF perspective.

*Global economic growth and its impact on IT spending, competition in the enterprise markets, and strength of the USD are also key considerations.