Analysts at Credit Suisse Equity Research downgraded their rating for  shares of International Business Machines Corp. (NYSE:IBM) to Underperform with a $175 price target, down by 10%. They indicated that the company’s organic growth will face challenges, its free cash flow (FCF) is declining, and its software revenue mix is becoming less effective.

IBM

Credit Suisse analysts Vlad Rom, Talal Khan, Mathew Cabral, together with Ray Bao and Andrew Ruben, noted that International Business Machines Corp. (NYSE:IBM) was considered as one of the few safe havens in the technology industry over the past few years. According to them, the company was among those that first disposed its commoditized business such as PCs and reinvested in R&D and M&A in software and services, which created higher margin annuity streams.

The analysts also emphasized that International Business Machines Corp. (NYSE:IBM) was a pioneer in taking on leverage and returned $111.3 billion in shares buyback and dividend payout from 2005 to 2012.  Furthermore, they noted that the company outperformed its $10 to $11 EPS roadmap in 2010, and demonstrated progress in its roadmap to at least $20 non-GAAP operating EPS by 2015. According to them, the goal is widely seen with credibility, and IBM deserves recognition for its previous achievements.

However, Rom and Khan together with their fellow analysts observed that IBM’s recent combination of declining EPS momentum and the change in the basis of its guidance serve as a warning to investors. They believed that the company’s optimization is ending, and its organic revenue growth will face fundamental challenges due to weakening organic revenue base and its M&A strategy is becoming weaker.

IBM showing deteriorating markers for earnings

The analysts clarified that International Business Machines Corp. (NYSE:IBM) will still be able to deliver its $20 EPS roadmap.

Some of the reasons provided by the analysts in downgrading their rating for the shares of International Business Machines Corp. (NYSE:IBM) include its current exclusive focus EPS based valuation, which they perceive as distorting; its mainframe and UNIX will begin to drag the company, and the exposure is higher than anticipated. They also said that its organic revenue growth is declining, software is losing share in key segments, and the PTI expansion is becoming more difficult.

According to the analysts, International Business Machines Corp. (NYSE:IBM) should focus on its FCF because the conversion seemed declining. They projected that the company’s FCF will be around $10 billion with 59% conversion this year, the lowest in any large cap tech stock. The analysts pointed out the FCF deterioration is a “worrying sign” for earnings direction in the future.

IBM projected to lose software sales to Oracle

The analysts wrote, “We highlight that while IBM trades at a 1yr/2yr P/E of 11.5x/10.6x, which is 20-25% lower than the S&P P/E, the company actually trades on 21.5x/15.9x FCF, or a 59%/35% premium to large cap tech. In addition, since the weak free cash flow is driven by net working capital consumption and cash impacts of restructuring, there will be less flexibility in the future for accelerated buybacks, which on average have accounted for 40% of EPS growth long term.”

The analysts also projected that the organic growth of International Business Machines Corp. (NYSE:IBM) will decline by -1.8%, but software will grow by 1.9% this year. According to them, IBM’s fragmented base of sales in software causes the company to lose shares to Oracle Corporation (NYSE:ORCL) and Microsoft Corporation (NASDAQ:MSFT). They believe that the company’s software business will experience limited growth.