The Mystery Behind the Huge IBM Upgrade at Merrill Lynch

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If there has been on Dow Jones Industrial Average stock that has managed to disappoint in recent years, International Business Machines Corp. (NYSE: IBM) probably first comes to mind. According to Merrill Lynch, that negativity may be about to end. What is interesting was that IBM shares were actually down marginally on Wednesday despite that post-election surprise rally.

IBM was raised to Buy from Neutral on Thursday by Merrill Lynch, and Big Blue’s price target was raised to $185 from $170. Is it possible that the post-election trend might end up working for IBM too? Before thinking IBM is a new regime winner, the words “Trump” and “Republican” were not mentioned a single time in the entire report.

According to Merrill Lynch’s Wamsi Mohan, IBM could have several drivers of earnings growth in 2017. Mohan sees earnings growth to resume in 2017 after moderating mergers and acquisitions, and from the mainframe cycle in 2017, and Mohan even sees organic growth in 2018. There is also optionality from artificial intelligence and flat free cash flow.

There are other issues to consider as well. One is IBM’s 3.6% dividend yield. A surprise note is that IBM now remains grossly under-owned by major investors (even if it is a key Berkshire Hathaway stock). As far as how under-owned Big Blue is, Merrill Lynch believes that IBM now has only a 0.30 relative weighting in the S&P 500.

More reasons to expect good news from IBM were seen as follows:

  • Savings from restructuring efforts and lower restructuring charges will create tailwinds to 2017.
  • The pace of investments is likely to not increase, driving benefits from increased utilization.
  • SaaS revenues will start to drive a higher percentage of growth.
  • The constant currency organic growth is expected to decline at a slower pace and can potentially cross over to positive in 2018.
  • The mainframe cycle in 2017 can drive a recovery in transactional revenues.
  • A recent CIO survey suggests that IBM is gaining mindshare in business intelligence, analytics and Watson.
  • IBM shares trade at discounted valuations on earnings versus peers.

There are at least some concerns noted that could derail the IBM story. Mohan sees downside risks to the firm’s price objective that could come from the following potentialities:

  • A weaker IT spending environment
  • Increased FX (currency) headwinds
  • Risk with transformation to more strategic initiatives
  • An increased pace of deterioration in the core business

Merrill Lynch’s investment rationale points out even more of the bias behind the call:

We view IBM as a defensive investment given its high exposure to recurring sales, cost cutting levers, solid balance sheet, potential share gains, and relatively stable margins. We believe IBM will embark on further cost cutting, and enhance its services and software offerings through acquisitions. Longer term, we expect IBM to take share in IT spending with its Cloud and AI initiatives. We believe 2016 should be a bottom for earnings and FCF, and positively view its improving fundamentals.

IBM closed down 0.23% at $154.81 on Wednesday but shares were up 2.3% at $158.40 shortly after the opening bell. IBM had a consensus analyst target price of $156.38 prior to the call, as well as a 52-week trading range of $116.90 to $165.00.

Thomson Reuters now shows that IBM’s post-call consensus analyst price target is $157.10, but the median price target there is $160.00. The consensus price target was $156.48 a month ago, $154.98 just two months ago and $153.90 about three months ago. Over the course of that same time, the median price has remained $160.00.