International Business Machines Corp. (IBM) Faces China Headwinds

International Business Machines Corp. (IBM) Faces China Headwinds

In light of the ‘controversy’ about IBM its interesting to see the latest from a recent tech conference. UBS Global Research analysts Steven Milunovich and John Roy maintain Neutral rating on International Business Machines Corp. (NYSE:IBM).

IBM’s hardware head addresses issues

Tom Rosamilia, SVP of Systems & Technology Group and Integrated Supply Chain, spoke at our tech conference. We continue to see near-term weakness for International Business Machines Corp. (NYSE:IBM) as it will take time to stabilize the hardware business, which he intends to do in 2014 through Pure Systems success, improved storage results, and an emphasis on Linux on Power.

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China on pause due to economic reforms

Investors have been interested in China weakness given Cisco Systems, Inc. (NASDAQ:CSCO)’s comments about reduced spending due to security concerns. Mr. Rosamilia was in China last week. He concludes that International Business Machines Corp. (NYSE:IBM)’s demand drop was due to accounts waiting for government priorities coming out of the third plenary session rather than a retaliation against American vendors. Still, the pause will likely take a couple more quarters to reverse.

Reviewing the hardware portfolio

He is fairly pleased with the recent mainframe cycle and believes International Business Machines Corp. (NYSE:IBM) can regain storage share with its investment in flash. We think turning Power Systems will be tough. Mr. Rosamilia reinvigorated the mainframe by putting Linux on it and is using the same playbook to emphasize Linux on Power. IBM believes it is well positioned for cloud, which it expects to result in a net revenue gain of $3bn in its 2015 roadmap. SoftLayer brings cloud disciplines that IBM did not have.

Valuation: Stock should take time to heal

The poor near-term results and questions raised about farther out earnings power can’t be ignored, in our view. Our price target of $186 is based on 10.2x our 2014 EPS estimate. The stock has sold in a multiple range of 10-16x the past five years. We think the low end of that range is appropriate given increased uncertainty. International Business Machines Corp. (NYSE:IBM) looks more expensive on EV/FCF at 13x at our price target of $186 compared with many of our names in the 7-9x range.

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