A Story of Decline and Recovery for This Wide-Moat Tech Trailblazer

The persistent underperformance of

We believe IBM is in the early stages of a transition period that will last for a few more years. In our view, the ongoing secular shift to cloud-based environments has a very long tail, and this gives IBM some time to adapt and simplify its strategy in this market--a silver lining of sorts. However, alongside the anticipated medium-term profit growth that we expect to materialize from management's initiatives, we project elevated risk levels, more uncertainty, and added volatility in the meantime.

With shares sitting roughly 17% below our $196 fair value estimate, we view IBM as fundamentally undervalued and worthy of a close look from patient investors. We believe that as its headwinds normalize over the next few years, the company can deliver steady earnings growth, while offering total-return-focused investors a healthy (and growing) income stream from dividends.

A Meaningful Step in What Is Likely to Be a Multiyear Transition When IBM reported weak third-quarter results in mid-October, much of the criticism was pointed toward the firm's two Services businesses, which underperformed internal expectations and posted a meaningful drop in backlog and signings. Although the three-year record for this segment showed some signs of deterioration (ceding $5 billion in revenue, or down 8% in total since 2011), the other two segments had generally picked up the slack, and with profitability and ROICs steadily improving over these years, probably placating some cash-flow-oriented investors.

We regard IBM as a high-quality tech enterprise with several valuable properties and services, and its shares currently trade at a discount to our discounted-cash-flow-based fair value estimate, but we don't believe the firm is currently reaching its full potential. Divesting noncore businesses and backing away from prior earnings goals are the right moves, but CEO Ginni Rometty faces a difficult turnaround task, particularly amid a shift to cloud, which threatens to disrupt portions of IBM's operating model.

IT Services Down but Not Out: Management Reaching a Pain Point We have long viewed IBM's Global Services segment, which includes Global Technology Services (GTS) and Global Business Services (GBS), as critical to the success of the IBM operating machine. In short, a consulting engagement or outsourcing project or contract often represents the customer's first impression of, and ongoing touch point to, the IBM brand. Success at this stage often drives sticky add-on hardware and software sales. All else equal, we believe that an extension of such client relationships can give IBM an advantage in terms of business insight and trends and potential wallet-share gains, which can translate into a growing backlog and, ultimately, increased revenue visibility for the firm.

Looking back over the past 18 years, it's not a bad picture. IBM's Services business has grown at roughly a 6% pace, slightly ahead of global GDP and essentially in line with the broader IT services industry (5%). However, we have become concerned by recent trends. Since the Great Recession of 2009, IBM's reported services revenue has lagged not only global GDP (by 380 basis points) but also the global IT services industry (by 330 basis points)--and its closest consulting/outsourcing peer, Accenture, which has seen its revenue rise at a 7% clip. We don't think it's management's mandate to grow its services revenue at the rate of any of these perceived benchmarks, but this does draw us to the firm's healthy (if uninspiring) multibillion-dollar backlog, which effectively hasn't outpaced GDP in any one quarter since the first half of 2011.

The pace of IBM's services recovery--or lack of top-line growth--coming out of the economic downturn has been a concern. With roughly 60% of its services revenue considered "annuity-based" and an annual backlog that has been above $100 billion for each of the past 14 years, IBM should have a relatively easy path to building its services top line. IBM is pretty well entrenched with its customers. Combine this with the firm's extensive product portfolio suite and global delivery platform, which generally scores very well with customers and third-party research providers alike, and the recent revenue and backlog shortfalls come across as even more worrisome.

We think there are at least three underlying factors that are the likely contributors to the services' relative underperformance: customer profile and contract pickiness, business size, and operating model.

Customer Profile and Contract Pickiness First, IBM has historically had the luxury of effectively picking many of its business engagements, and management periodically reiterates that it will not chase low-margin or non-value-added contracts. With the backdrop of IBM's large installed hardware base and significant annuitylike revenue, plus a stellar reputation in the marketplace, we agree that the firm was in an enviable position. Even though revenue hasn't changed all that much, over the past six-year period, IBM's global services pretax margin has averaged 16.1% and has steadily risen. This isn't a new phenomenon, either; over the past 19 years the segment pretax margin averaged 12.7% and dipped below 9.0% only once (to 7.0%, in 2005).

We acknowledge that IT budgets and large contracts float from quarter to quarter and that there will be periods of out- and underperformance, but the 10-year picture tells a different story. We believe management has approached a pain point, either due to the lack of recent core consulting wins, its mature installed hardware base, or both, which is prompting the firm to retool its service offerings in an attempt to profitably drive organic growth.

By choosing to focus on potential contracts that it deems to be higher-value or more strategic in nature, or placing less emphasis on existing annuitylike outsourcing clients, IBM may be intentionally sacrificing gross dollar growth for improving profit levels. This could leave the firm exposed to some degree over the long run, poised to defend a smaller but more profitable slice of the services.

Business Size Second, IBM has been an industry leader in the services space for nearly 20 years, with performance bolstered by the first global outsourcing wave in the mid-1990s, Y2K, and the acquisition of PwCC's business consulting division in the fourth quarter of 2002. Despite its growth headwinds, with an estimated $55.4 billion in services revenue projected this year, adjusted for the firm's recent sale of its BPO customer care business, IBM is still the runaway leader in the sector and 70% larger than its nearest competitor.

IBM consistently scores very well with its customers and third-party researchers alike across a wide range of strategic business areas, such as workplace management systems, data center outsourcing, application security testing, managed mobility suites, and integrated software quality suites. In a technology era that has rapidly moved toward themes like mobile, cloud, and analytics in recent years, IBM's size may actually be a hindrance. With expertise in deploying third-party solutions, but still somewhat tied to proprietary offerings, IBM's services division is at an interesting crossroads as business environments become even complex. IBM's breadth is still considered an asset and it can open doors, but we also get the sense that companies are constantly looking for best-of-breed solutions, and there are plenty of niches in fast-growing areas where IBM's portfolio and internal process flow may not be optimized to move at the speed of business.

Operating Model Third, IBM's global service business could be at a structural disadvantage today, owing to a predominantly IP-based delivery model. While this statement applies more to its GBS business (32% of segment revenue), rather than to GTS (at just over two thirds), we think it's an important consideration when looking at the current state of IBM's services business and where it may be headed. IBM utilizes the people-centric model that leverages the company's consulting heritage--there's a reliance on highly skilled, highly experienced people.

Taking a step back, we don't view the business as permanently impaired; IBM scores at the top of our proprietary IT Services framework. Given the changing dynamics of the IT services industry, earlier this year we introduced our proprietary vendor positioning framework, which assesses each vendor based on the following criteria: client relationships/brand, industry expertise, global delivery, intellectual property, and financial strength. One aspect in itself does not protect a company from competitive displacement, though, and we believe a well-rounded business is necessary in order to remain a market leader. That said, we believe IBM's wide economic moat and strong capital position should buy it at least some time to make appropriate fixes.

Middleware: Complexity Is Ultimately a Good Thing for IBM Middleware is a software layer that connects applications to other applications, public web services, databases, computing devices, and people. The computing shift from the client/server model to a device/cloud model is causing enterprises to rethink the way they purchase and consume software applications and computing resources. All three tiers (applications, middleware, and hardware) will increasingly be consumed as cloud services. As a result, we've seen newer application software vendors such as Salesforce.com and cloud computing providers such as Amazon quickly grow mind share and revenue over the past few years. At the other end of the spectrum, many "old guard" enterprise IT vendors, like IBM, were caught flat-footed and experienced a slowdown.

For IBM, which commands one of the industry's largest consulting wings and a sizable middleware portfolio, the company's recent underperformance in IT services comes across as even more perplexing, since its consultants should be sitting at the center of a client or prospect's cloud conversations. We think there's some merit to the view that the cloud shift will take longer to realize than bulls anticipate, which affords firms like IBM some time to recalibrate. At the same time, despite IBM's recent services segment stumbles, this (interestingly) doesn't appear to have debilitated the firm's key branded middleware franchise, which has grown at a mid-single-digit rate for the past three years. If nothing else, it may further reinforce our view of steep switching costs embedded within this legacy business.

Despite fears that the shift to PaaS is yet another structural headwind for IBM, we view the glass as half full going forward, because of three factors: (1) Technical considerations will drive a slower PaaS adoption; (2) IBM is well-entrenched in the middleware market and poised to gain via WebSphere; and (3) IBM's services experience and breadth (proprietary or not), will keep the firm among the top tier in bidding for consulting engagements.

First, the shift to the cloud has materially attracted spending in the hardware (IaaS) and applications (SaaS) markets, but the middleware (PaaS) market has not been affected in the same way. Middleware has largely been a laggard in moving to the cloud owing to, in our view, steep technical complexities which significantly reduce incentive for companies to "rip and replace." Second, IBM is the current leader within the middleware industry, and Gartner estimates that the firm captured 30% of overall market revenue in 2013, or $6.4 billion and larger than the next six players combined. IBM's middleware revenue is spread across platform, integration, and BPMS; while the firm's relative market position is greatest in platforms. Third, IBM's strength in core middleware should open up adjacent revenue opportunities through its IT services line. Specifically, because much of the SaaS adoption to date has pushed ownership of the applications out to the lines of business, we believe many companies have not taken the holistic approach of providing a homogenous integration and application platform within the enterprise. This represents a huge opportunity for IBM in not only transaction-oriented revenue, but follow-on as-a-service contracts as well, especially as it relates to the complexities of the middleware execution and cloud adoption.

Big Data/Analytics Opportunity In its first-half 2014 Market Insights report, IBM estimated that the Big Data & Analytics market opportunity will grow at a 6% GACR and reach $266 billion by 2017. We see a unique opportunity for IBM in this market given its existing analytics business and its commitment to investing for growth. IBM is a legacy vendor in the database industry and for several decades has played an important role in improving analytical work by effectively taking operational data and loading it into a format that could provide an enterprise customer with reporting and insights. However, the quantity of data has exploded as a result of new sources such as machine data, quantifiable sensors, web logs, and web applications; and new software technologies, cheaper memory, and cheaper processing allow for broader application of statistical models to drive decision-making.

The "commercialization" of Watson won't move the needle for IBM over the next several years, however, partnerships with companies such as Apple and Twitter, both announced earlier this year, will allow IBM is branch out and make a case for user adoption and the differentiation of its platform. This is a unique platform that has multiple potential uses, ranging from health care and genomic medicine to cybersecurity. (We'll leave out the culinary exploits of Watson, for now.) In short, with this extension to drive cognitive computing and embrace forward-looking analytics, while playing to its prior strength in columnar analytics, IBM's consultants have more arrows in the quiver and should be able to land incremental follow-on sales in a rapidly growing area of the tech space.

Security Security breaches are becoming commonplace, and in a report published earlier this year, the Center for Strategic and International Studies estimated that the annual cost to the global economy from cybercrime is more than $400 billion. What's interesting to us is that security products' market opportunity is projected to grow at a 7% CAGR to $43 billion by 2017 and, despite budget size today, security represents less than 4% of the total IT spend, according to the Ponemon Institute. So, to summarize, the annual economic cost of cybercrime is more than 10 times the current level of security spending today.

IBM is estimated to be the number-two or number-three player in this fragmented, multibillion-dollar market, with more than $1 billion annual revenue, and IBM's business has been growing at a solid double-digit rate for seven consecutive quarters. Its QRadar SIEM technology provides log management, event management, reporting, and behavioral analysis for networks and applications and scores very well among customers and Gartner. While the emphasis is still on fortifying the data center, we see IBM as well-positioned with its highly rated product as the industry shifts toward a more comprehensive and analytics-based approach. Through organic growth and selected acquisitions over the past few years, IBM built an integrated security portfolio designed to offer strategy, risk, and compliance protection, both on-premises and across cloud and mobile computing.

IBM Must Evolve and Support a New Cloud/Device Architecture Over the past 60 years, we believe there have been three generally accepted computing eras that resulted from advances in technology and evolution of business models. In the mainframe era, which dominated during the 1960s and 1970s, the mainframe housed a rudimentary operating system, customized applications, and all of the computing power. In the late 1970s and early 1980s, the mainframe era made the transition to the client/server era, when the technology innovation and spending shifted computing power to the PC, providing for rich hardware and software ecosystems at both the server and client (PC) levels. As networking costs have continued to decline and Internet access has become ubiquitous, the device/cloud era is fast upon us. In this era, the bulk of computer processing is centralized in the cloud supporting shared hardware and software platforms. Applications and services are accessed via a smartphone or tablet, which also carries lightweight computing capabilities.

Taking a step back, we are constantly concerned about the pace of technological change, as it has potential implications when we think about IBM and its wide economic moat. At the core of our moat stance for IBM is that it has large and well-established hardware, software, and services businesses, each of which has high switching costs and recurring revenue streams. Looking back at the firm's 100- plus year history, it hasn't been a smooth ride at all points (early 1990s come to mind), but the drive to innovate and adapt has always been present. Today, as the world moves to the era of device/web computing, IBM is making strategic bets on overarching themes of social, mobile, analytics and cloud, or SMAC.

The convergence of these four technology trends and the complexity of implementation and oversight within enterprises and governments, is leading clients to seek out IT service vendors with the most suitable solutions to help with the transition to this new SMAC era. We think these technology shifts will drive healthy demand for those vendors with the right SMAC-related service portfolios.

Solid execution on a cloud strategy will benefit IBM's services and software businesses alike. Given its historical ties to the mainframe era of computing and emerging and ongoing shifts within the technology sector, we believe that IBM will need to execute on its internal cloud strategy, in particular, in order to reinvigorate its services business and ultimately maintain its wide moat rating.

The Cloud Opportunity Is Enormous, but It's Not a Winner-Take-All Game IBM estimates that cloud market spend alone will grow at a 25% CAGR and reach $390 billion by 2017, up from approximately $160 billion last year, with healthy growth expected from all facets of cloud. This projected growth trajectory represents an enormous opportunity and risk for IBM across each of its three major business segments.

Fundamentally, our internal position is that the long-term state of cloud will gravitate toward a hybrid-based model. This approach should allow businesses to take advantage of scalability and cost-effectiveness that a public cloud computing environment offers, without exposing mission-critical applications and data to third-party vulnerabilities. However, these aren't simple implementations, and doing the right work up front can eliminate (or at least) reduce some headaches and roadblocks down the road. Ultimately, we think that a key goal of any cloud deployment should be to minimize change and disruption, which is another reason why we expect long-term adoption of hybrid-based solutions. No matter how similarly a public and private cloud are matched, design differences will inevitably exist. The greater the differences between the cloud environments, the more difficult it will be to manage multiple clouds as a single entity.

IBM's Response to the Shifting IT Services Market For IBM's part, management has made an aggressive push to transform the way that IT and business processes are delivered. On the cloud front alone, the company has invested $7 billion and completed 15 acquisitions, staffed up with over 40,000 cloud experts (10% of its global workforce and larger than most consulting firms), and launched more than 100 SaaS offerings, such as Watson Analytics, API management, and Silverpop. The company has been quick to point out selected acquisitions, such as SoftLayer (completed in the middle of 2013 for approximately $2 billion) and Cloudant (Database-as-a-Service).

With $1 billion dedicated to its PaaS offering (BlueMix) and another $1.2 billion to add another 15 cloud data centers this year (bringing the total to 40), not to mention the integration of POWER into its offerings, IBM is looking to send a clear and deliberate message that its organic research and development is cloud first, mobile first in nature. This relatively new and holistic approach is designed to establish a large ecosystem, through which IBM hopes its customers and prospects will see both the firm's willingness and ability to evolve and meet the demands of the changing (cloud-based) marketplace.

Results to Date Appear Good, but the Devil Is in the Details On the positive side, IBM stated that its cloud business achieved $4.4 billion in revenue during 2013, up 69%, and is on pace to be a $7 billion IBM business in 2015. However, there's a portion ($2.3 billion run-rate) delivered as a service, because of the private cloud, and we don't have a breakout of how the revenue bleeds between the services, software, and hardware segments (not to mention what the cannibalization rate looks like). If IBM is unable to link its cloud-based software revenue back to its Services division at some point, we believe that the inherent switching costs will be lower than they are in today's on-premises and mainframe-based operating environment. For example, if the bulk of IBM's future software sales don't include some sort of relationship component, through which customers receive consistent feedback from the IBM consultants, architectures may not be customized or optimized appropriately. Hence, inability to execute on this step--linking cloud software and services--dilutes IBM's value-add to clients while weakening the symbiotic link among its three core segments, potentially limiting the firm's service revenue and margin potential over the long run.

Management appears to understand the gravity of its current situation and long-term implications of today's secular shifts (along with the importance of course correction). On the firm's Oct. 20 earnings call, Rometty bluntly stated, "Obviously, we were disappointed in this quarter." When this blanket statement was placed in context with the rest of the call, it came across as a "mea culpa" and, we think, a broader public statement that more internal change is needed. The lackluster results undoubtedly prompted the firm's fourth-quarter charge (up to $600 million) and the removal of Erich Clemanti as the head of IBM's GTS unit.

Through its latest "reinvention," IBM is hoping to improve on three key attributes that should make it even more competitive in the marketplace: speed, engagement, and simplification. Granted, with over 400,000 employees and a 100-year-plus history, changing a culture is a tall order, but with a $1.6 billion price tag expected this year, we think management is serious about improvement. Our take: This is a major challenge that will take some time to implement, and investors shouldn't expect to see any substantial signs of success for at least a year.

The company is implementing a new vertically integrated structure (similar to that of its Watson division), for faster-growing areas like cloud and security. In basic terms, IBM has too many layers and getting an investment or product decision approved takes too long. This approach is designed to accelerate speed-to-market for its solutions while spurring more focused investments.

New investments that make IBM's software more directly consumable through digital channels are expected to extend the firm's reach. This step complements the notion of promoting engagement via social and mobile platforms to drive business communications (internal and external).

Automation has been an IT services buzzword for some time now, but IBM feels as though it has a long way to go in accelerating the use of automation in its data centers. Separately, for as large and successful (and storied) IBM is, we were somewhat surprised that the company believes it needs to more aggressively share intellectual property across its service lines (via internal automation platforms).

Shares Appear Fundamentally Undervalued, but There Are Several Moving Parts Our $196 fair value estimate implies an adjusted fiscal 2015 P/E of just over 11 times, 8% normalized free cash flow yield, and a dividend yield of 2.2%. Although the stock is trading in 4-star territory and an 18% discount to our DCF-based fair value estimate, we are taking a long-term approach to the name and don't expect a sharp rally in the shares anytime soon. The headwinds are clear; however when we take a step back and consider the firm's ongoing investments and strategic changes that management is embarking on today, plus its broad suite of products services and global delivery platform, we see a favorable risk/reward for long-term investors.

We expect IBM to look materially different in five years relative to early 2012 when Rometty took over as CEO, but with so much going on within the firm, it will take time for investors to get comfortable with both the underlying growth rates and profitability. Here are our assumptions, by segment:

Services: Modest success in the organizational restructuring, but weighed down by its size and strategy to play at the upper end of the IT services market.

Software: Growth in the mid-single-digit range reflects a commitment to core software franchises as well as strategic initiatives in data, cloud, and social/mobile.

Hardware: Cyclical and structural headwinds abound, but not going away completely.

IBM's Cash-Flow Quandary In our view, IBM has an established business that generates solid cash flow and an ingrained culture of prudent cash use. Over the past decade, IBM has cumulatively generated nearly $180 billion in cash from operations, of which $45 billion was earmarked for capital expenditures while $25 billion and $85 billion were routed to dividends and net share repurchases, respectively. This historical performance stemmed from a combination of the firm's business model, mix shift, and productivity benefits, which paints an intriguing picture. Despite delivering only nominal top-line growth since 2003, IBM has been able to more than double its EBIT margin, while ROICs have also been on a steady upward trend over the same time frame (further support of our view that management is not destroying value).

Many investors and analysts (ourselves included) have been quick to scrutinize what normalized levels of profitability and, ultimately, cash flow going will look like once the company closes on its two 2014 divestitures and moves through its current transition phase. This uncertainty clearly adds an incremental layer of risk to what has historically been perceived as a relative safe haven in the volatile technology sector. We're cognizant of risks surrounding commoditization, pressure from the cloud, and underperformance in services, each of which may translate into slower (or negative) free cash flow growth, but our long-term thesis is intact. In our financial model, we forecast that IBM can generate annual free cash flow (cash from operations less capital expenditures) of approximately $17 billion in a normalized environment. If the firm can deliver on our underlying operating assumptions, this would leave ample cash for internal investment (capital expenditures), dividends (remaining at a 30% payout ratio), share buybacks, and selected tuck-in acquisitions.

Cash-Flow Growth Will Be Slow, but We Don't Think a Breakup Creates Much Value Although IBM has established a multidecade-long record of growth and execution, some investors and pundits have followed the recent trend (see HP and EMC, for example) and started to question whether IBM would be better off as three (or two) distinct operating businesses. Today, the M&A market still appears to be quite active, and with IBM shares essentially flat over the past three years (underperforming the S&P 500 by roughly 80%), and down 13% in just the past two months, we understand investor frustration.

Our view has always been that an IBM that collectively participates in all three business lines as it does today benefits from intertwined symbiotic relationships, and this structure translates into a broader economic moat as a result. Much of the current criticism appears to be pointed at IBM's hardware business. However, we think this exact statement could be one key reason IBM is unwilling (or unable) to split. We think that, for as much as its hardware business is tied (either directly or indirectly) to software and services, and vice versa, this fact could make it nearly impossible for these segments to make a clean break from one another and begin life independently.

We believe IBM's strategy team is constantly in the news flow, and the group more likely than not screens for and sees the majority of companies that may be on the selling block, particularly in key growth areas such as analytics, cloud, mobile, and security. However, with valuations still at or near peaks, and IBM with its own internal hurdles (ranging from compatibility, culture, and speed to deployment), we expect the firm to take a more focused approach geared toward smaller tuck-ins, rather than seeking to locate a significant game-changing acquisition.