Why IBM Took a Key Credit Rating Downgrade From Moody’s

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International Business Machines Corp.’s (NYSE: IBM) recovery has been a hard one to love. Its shares were doing great ahead of earnings, but the harsh reality is that IBM’s core IT-services business stagnation and erosion is just not yet being adequately offset by growth initiatives in machine learning, the cloud and other areas.

After multiple analysts chimed in after earnings, now IBM is even taking a credit rating downgrade. Moody’s Investors Service has downgraded the senior unsecured rating of IBM to A1 from Aa3. Its rating outlook has now been changed to stable after having been negative.

Moody’s noted that IBM has progressed in transitioning its broad portfolio toward becoming a provider of enterprise class, cloud services and solutions. The fear is that IBM’s revenue has been flat or negative for the past 19 quarters, after a multiyear industry shift of IT demand to cloud-based offerings. While a stable rating sounds good on the surface, Moody’s warned that IBM’s challenges are likely to remain longer than expected.

Moody’s identified several key points about IBM, seen as follows:

  • IBM’s strategic initiatives businesses will continue to grow at a double digit percentage level over the next few years — expanding by $4 billion or more annually off of the $34 billion revenue base as of the twelve months ended March 2017.
  • SI revenue represents 43% of total IBM revenue, ahead of the company’s target of SI comprising over 40% of revenue by 2018.
  • Continued high single-digit to low double-digit declines in its portfolio of legacy businesses will more than offset the strategic initiatives revenue growth resulting in lower profitability and cash flow over at least the next year.
  • Moody’s expects profitability and cash flow will be weaker than previously anticipated and projects profitability and cash flow will be flat to slightly lower this year and then slightly up in 2018.
  • IBM will continue to be acquisitive, but Moody’s does not anticipate large transactions that can be distracting and difficult to integrate.
    It sees IBM acquiring mainly data rich software and service oriented companies to support the growth of its cognitive solutions business to pursue growth.
  • Moody’s expects EBITDA of about $17.5 billion, and cash from operations less capital expenditures of $10 billion over the next year with dividends of about $5.5 billion it projects IBM will generate free cash flow of about $4.5 billion in 2017, down from $5.1 billion and $6.8 billion in 2016 and 2015, respectively.

Richard Lane, Moody’s senior vice president, said in the report:

Despite still solid debt protection measures and progress in transitioning its business towards becoming a provider of enterprise class, data analytics and cloud-based offerings, the downgrade reflects the transformation and high level of investments which have negatively impacted IBM’s profitability and cash flow, as well as concerns that IBM will remain challenged for a longer than previously anticipated time to grow total revenue and return to the margin profile achieved prior to 2016.

Credit rating changes can make the cost of borrowing higher for companies, even for large blue-chip Dow Jones Industrial Average components like IBM. That being said, this has had just a marginal impact on IBM’s stock.

IBM shares were last seen trading down 15 cents at $158.95. IBM’s 52-week trading range is $142.50 to $182.79, and the consensus sell-side analyst price target from Thomson Reuters is $166.70.