Why Credit Suisse Is Warning Against the Massive IBM Rally

Another issue is that the Japan tax benefit puts guidance in question. On this front, Garcha warned:

IBM disclosed the Japanese Supreme Court ruled in favour of the company that made available a tax benefit of $997 million. Now it is unclear how much of this was anticipated in the earnings per share guidance of “at least $13.50.” If the tax benefit was entirely baked in, FY16/FY17 operating EPS could be $12.44/$13.06. A second scenario is that the company reinvests the benefit to restructuring for cost reduction in the following years. However, we believe retention is unlikely as the company’s restructuring proves increasingly ineffective. The third scenario is that the benefit is not baked in. Regardless, we note that “operating EPS” stays the same at the best. We see downside in all 3 scenarios. Additionally, we see a challenging ramp ahead in FY16, given current guidance implies PTI to grow 120% from the first quarter to the fourth quarter Q4 versus a historical average of 90%.

Other key warnings from Garcha were listed as follows:

  • Internal turmoil is becoming more clear — Given the competition for technology talent, we do believe such statistics provide an overhang for the fundamental outlook for IBM.
  • Even excluding currency impact, we believe IBM is in decline and sees revenues shrinking at CAGR of 4% in the long term.
  • Services multiple pressures build — Up until now our concerns had been focused on the hardware and software segments. We now shift focus to Services. We believe PTI here could shrink by ~$0.6 billion between 2015 and 2017.
  • Cloud could be a secular problem, and margin dilutive long term — IBM is not new to this business and has its own cloud offering in the form of SoftLayer and Bluemix, but the important aspect to highlight is that IBM is not necessarily the incumbent it has been historically.
  • Restructuring proving less effective — The bottom line here is that such restructuring is proving to be increasingly ineffective in further rationalizing IBM’s cost base.
  • High levels of mainframe exposure and declining organically — Fundamentally, we demonstrate that from cycle to cycle this segment is shrinking given x86 performance improvements and saturation of the market.

One last issue on Watson was shown in the Credit Suisse report:

We note that IBM has been trying to prop up its strategic initiatives, notably Watson. Here the company’s M&A has focused on the healthcare business. The company believes that a healthcare disruption is underway. The company estimates that five leading chronic diseases pose a $47 trillion economic impact, and in the future more than 75% patients are expected to use digital health services. Out of $8 trillion spending on global healthcare, $2 trillion is wasted. The company believes these opportunities give the company a $200 billion addressable market for Watson Health.

Some investors might worry that the most negative analyst staying extremely negative would hurt the stock. So far, that has not been the case as IBM’s stock price was last seen up 0.8% at $150.80 on Wednesday morning. Its consensus analyst price target is $136.32, and the 52-week trading range is $116.90 to $176.30.

If the near 10% gain from the end of 2015 ($136.23 on a dividend-adjusted basis) in IBM shares sounds impressive, think about it against the 52-week low. That low of $116.90 was hit on February 11, 2016, when the broad stock market was in free fall, and IBM shares were last seen up a whopping 29% from that date.

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