IBM: Is The Current Roadmap The Right One?

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Bernstein Research analysts A.M. (Toni) Sacconaghi Jr., Eric C. Garfunkel and Jonathan Cofsky rate International Business Machines Corp. (NYSE:IBM) as Market-Perform as the company has had an excellent track record delivering on its roadmap EPS targets.

IBM’s EPS targets

Since 2006, International Business Machines Corp. (NYSE:IBM)’s financial guidance to the Street has been expressed as a multi-year EPS target and accompanying “roadmap”, which is currently set for “at least $20/share” in FY 2015. The company has had an excellent track record delivering on its roadmap EPS targets, and until about 1 year ago, its stock has benefitted richly. IBM first introduced its 2006-10 roadmap in 2007, calling for EPS to increase from $6.06 in FY06 to $10 in FY10 (and $11 factoring in expected pension savings at the time). IBM actually reached its $10 target in FY09, and eventually delivered $11.52 in GAAP EPS in FY10. While IBM’s revenue growth lagged its original target (2.2%/year vs. a target of 7-8% including growth initiatives and acquisitions), the company more than made up for the shortfall through margin expansion/cost reductions and share repurchases.

Moreover, International Business Machines Corp. (NYSE:IBM) announced a new roadmap in 2010 that called for EPS to increase to $20 by FY15 (~12% EPS CAGR), which the company comfortably delivered on 2011 and 2012. IBM’s ability to meet and eclipse its targets was well rewarded by the market, as the stock outperformed by 88% from the date when IBM introduced its first roadmap (May 17, 2007) through the end of 2012.

IBM underperformed in 2013

However, 2013 was a watershed year. While International Business Machines Corp. (NYSE:IBM) meaningfully eclipsed its original FY 13 EPS guidance of $16.70 (it delivered $16.97) and upheld its 2015 bogey, the stock underperformed by more than 30% – in part because its EPS was viewed to be very poor quality. Exhibit 1 provides an EPS waterfall for both FY13 and FY14E EPS. Even though IBM delivered 11% EPS growth in FY13, revenues declined, and the company saw a sharp decline in hardware profitability, which fell by $1.7B YoY (~$1.20 in EPS). While IBM was able to offset much of the decline through cost savings and margin expansion in software and services, IBM also excluded a $1B restructuring charge from non-GAAP EPS, a stark change from previous years when restructuring expenses (and any gains that offset charges) were included in the P&L. Moreover, a lower tax rate (which declined from 24.0% to 16.3%, due to various one-time items) generated over 85% of the company’s EPS growth ($1.48 out of $1.72). Additionally FCF was $15.0B, dramatically below net income of $18.7B.

Consensus estimates for 2014 reaffirmed

Similarly, when International Business Machines Corp. (NYSE:IBM) recently reaffirmed consensus estimates for 2014 and its target for 2015, investors appeared skeptical – in part because of the expected quality of its earnings. IBM’s announced sale of its server business to Lenovo Group Limited (ADR) (OTCMKTS:LNVGY) (HKG:0992) (resulting in an expected $0.75 gain this year) less than 48 hours after earnings was a stark reminder to investors that IBM has so much financial flexibility to hit its EPS targets, that the metric is no longer relevant. IBM’s EPS target of “at least $18.00” represents 6.1% EPS growth, but is actually more like 15%, given that as IBM will face the a big headwind from its unsustainably low 2013 tax rate. With revenues expected to decline this year, 2014 EPS growth is expected to come from cost savings from another ~$1B restructuring, as well as reduced share count from very significant share repurchases.

Additionally, International Business Machines Corp. (NYSE:IBM) announced the sale of its x86 server business to Lenovo Group Limited (ADR) (OTCMKTS:LNVGY) (HKG:0992) only 2 days after earnings, which is expected to result in a $1B ($0.75) gain – we believe that while IBM hopes to hit $18 without the $1B gain, the gain appears to be insurance and will be included if IBM is otherwise unable to achieve it.

Share buybacks and cost cutting

The upshot is that International Business Machines Corp. (NYSE:IBM)’s EPS bogey now appears viewed as an interesting place holder and increasingly decoupled from the fundamentals of its business. Rather, investors are moving their focus to revenue growth and free cash flow, which are deemed to be less fungible metrics. The concern for the stock is that both are likely to remain challenged over the foreseeable future. With strong cost cutting and significant share buybacks (we expect the company to spend $15B on repurchases in FY14, and to front-load them), many investors expect IBM to hit its $20 EPS target, but remain concerned about the long-term health of the business. Revenue growth is likely to remain weak through FY14 (at constant currency, we forecast YoY growth of -0.9% in Q1; -3.2% in Q2; -0.2% in Q3 and +1.0% in Q4) and IBM’s guidance suggests that FCF will remain materially below non-GAAP net income (~$16B vs. net income of $18.4B) for the second consecutive year. We believe that IBM’s stock is unlikely to re-rate until the company can deliver improved revenue growth and is able to generate FCF that is relatively in line with non-GAAP net income.

If the $20 EPS bogey is no longer relevant, why did CEO Ginni Rometty and new CFO Martin Schroeter recently choose to uphold it? Many investors believe that unleashing the shackles of the 2015 EPS target might enable International Business Machines Corp. (NYSE:IBM) to invest more and make selective high value acquisitions, rather than look to cost cut and repurchase shares. We expect IBM to repurchase $15B or more of its shares this year, and rebalance its workforce by at least 13,000 heads. Many investors believe IBM should be investing in its future by buying new technologies and investing in building capability, rather than rightsizing the organization. So why is IBM steadfastly driving to its roadmap? It is hard to say.

Perhaps International Business Machines Corp. (NYSE:IBM) genuinely believes it can invest and do what’s right for the business while simultaneously achieving its roadmap. Perhaps it is worried about disappointing Wall Street (though some believe the stock might go up if IBM reduced or eliminated its 2015 target in a constructive manner). Another possible explanation is that the roadmap/prevailing financial model is the way executives have always run the company, and changing it is uncomfortable and/or requires a different skill set and risk appetite.

A final theory is that International Business Machines Corp. (NYSE:IBM)’s financial incentives (senior executives’ incentive programs are based 60% on operating net income near-term and 80% of operating EPS long term) make the choice simple.

Investment conclusion

International Business Machines Corp. (NYSE:IBM) is rated market-perform with a price target of $180.

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