The Credit Suisse report further notes that IBM is facing fundamental headwinds in both its Software and Services businesses, with a global decline in total contract value and increasing competition hurting its key business segments. The 2% or so currency headwinds likely will build into 2015, according to the research report, and when taken together with declining share buybacks suggest that Wall Street’s estimates are materially too optimistic.
Even with a forthcoming mainframe cycle, Garcha remains concerned that the fundamental headwinds facing IBM are challenging. Four additional concerns remain:
1) post a new deep dive on Services we see a weak order book and shrinking industry-wide deal sizes causing revenue headwinds and margin pressures;
2) following a thorough analysis of their cloud, it may ultimately be margin dilutive for IBM even if the company drives revenue;
3) restructuring becoming less effective;
and 4) prior concerns over the significant rate of organic decline remain, despite a mainframe cycle, and even this could be optimistic.
Garcha’s view on IBM’s mainframe business is that the new systems can process 2.5 billion transactions per day. This matters because this figure is equal to that of 100 Cyber Mondays. It can encrypt volume mobile transactions and provide real-time analytics 17 times faster than competitive systems at a greater value. The report said:
Combined with IBM’s MobileFirst solutions, enterprises can deliver better performing and secure mobile apps with end-to-end infrastructure management. Along with SPSS analytics, the new mainframe will support Hadoop and integrate with hybrid cloud, with the ability to run up to 8,000 virtual servers and deliver low TCO. IBM Global Financing will support the launch with payment deferrals. While the release will provide a cyclical respite, the market will continue to contract and this is factored in our numbers.
On that forward price-to-earnings (P/E) ratio looking so cheap, Garcha believes that IBM is not cheap on a free cash flow basis. This is also how Garcha evaluates all IT hardware stocks. His expectation is that IBM’s enterprise value should be valued at 10 times free cash flow rather than 13 times.
IBM shares were not radically moving on the fresh research report. After 90 minutes of trading on Thursday, IBM shares were up four cents at $155.84, against a 52-week trading range of $150.50 to $199.21. The Thomson Reuters consensus price target of $166.10 is over $41 higher than Garcha’s $125 target for Credit Suisse, but the highest analyst price target is still all the way up at $198.