Wide-Moat IBM Aims for New Growth Target

On Feb. 26, IBM held its investor briefing at its Watson business unit headquarters in "Silicon Alley" in New York. We hoped that five key topics (cognitive computing, cloud, services, partnerships, and core businesses) would be addressed, and management did touch on each in some detail. The key new growth target that management offered was the goal of achieving $40 billion in revenue from the firm's strategic initiatives--analytics, cloud, and engagement--by 2018, which equates to a four-year CAGR of 12% for this basket of businesses.

We were encouraged by Watson's early traction, but we still view this initiative as a work in progress. The partnership with Workday announced during the session was a positive surprise and yet another example of IBM's willingness to pair up strategically with outside parties, which we see as an important step to realizing $40 billion in just a few years. On the other hand, investors are still struggling to assess IBM's highly profitable but mature core businesses, which accounted for 73% of 2014 revenue. The pace of any expected revenue decline over the medium term is debatable, but it is an important issue given that management expects much of its strategic growth to come at the enterprise level and often from existing customers. We had assumed a low-single-digit fade in our base case, but given the perspective offered at the investor briefing, we have trimmed our financial model further. Some of this will be offset, as we'll give the company credit for gains across its strategic initiatives, but the bottom line is that we think organic revenue growth is still a few years off for IBM. Stiffer foreign-exchange headwinds are now expected to drag down revenue by 7% in the first quarter and 6% for the full year 2015, though IBM's EPS and cash-flow targets for the year are unchanged. As a result of these factors, we lowered our fair value estimate to $178 per share from $196 and increased our uncertainty rating to high.

The Legacy of an Iconic Turnaround IBM's iconic turnaround from the early 1990s, driven primarily by cost reductions and a shift toward software and higher-value services, provided a good start for the firm's ongoing transition. Although high-end mainframes remain an important source of IBM's competitive advantage and profits, its fortunes no longer rest exclusively on the long-term success of these proprietary platforms. IBM is navigating the secular trend toward distributed, open-standards computing by diversifying its hardware platforms, broadening its software portfolio, and building a formidable services organization. The result has been solid long-term financial performance. Since 2004, IBM's organic revenue, gross profit, and operating profit have compounded at annual rates of 3%, 6%, and 12%, respectively, while returns on invested capital have remained well above the firm's cost of capital (in the 50% range). Other tech giants have grown faster over the past decade, but few technology companies can point to a track record of cash flow that is as consistent as IBM's.

Still, IBM is not impervious to emerging long-term threats. Cloud computing is shifting the enterprise IT landscape and creating new challenges for incumbent vendors. As computer resources are increasingly delivered by cloud providers rather than traditional enterprise IT departments, demand for IBM's high-end servers and related software could dampen. Additionally, the middleware and systems management markets will undergo significant change as software-as-a-service gains wider adoption. Finally, large vendors continue to push into each others' territories as they look to deliver a larger portion of the IT stack. Despite these emerging threats, we believe IBM's product development and entrenched customer relationships will ensure that the firm maintains its competitive advantage.

Our Fair Value Estimate Is $178 per Share Our fair value estimate of $178 accounts for declines in IBM's core business and foreign-exchange headwinds. Our fair value estimate implies forward price/adjusted earnings of approximately 12 times, EV/EBITDA of 9.2 times, and free cash flow yield of approximately 7%. We forecast flat annualized revenue growth and 3.6% annualized operating profit growth through 2019. Management continues to allocate significant resources toward expanding its software portfolio, and we expect this segment to grow at roughly 4.5% per year through 2019, with relatively stable gross margin. Certain segments of IBM's software portfolio are fairly mature, including database and portions of its middleware and systems management portfolio. Other areas, such as business intelligence, are poised for above-average growth over the next several years as companies apply new analytic tools to massive, growing volumes of unstructured data.

We forecast flat revenue for IBM's services business, which is partially due to the already massive size of this business and partially due to management's discipline in pruning low-margin contracts from its portfolio. Although competitive pressures are mounting in lower-end outsourcing portions of the services market, we think IBM's technical and business expertise and growing software portfolio will allow the firm to maintain blended gross margins of roughly 34% as it focuses on more complex projects and generates more recurring maintenance revenue.

Cloud computing and increasing competitive pressures from

We forecast IBM's operating expenses to grow slightly slower than revenue over the next five years, based on our expectation that management will maintain firm control over IBM's business and financial model while executing on its efficiency initiatives.

Economies of Scale Reinforce Wide Moat We assign IBM a wide economic moat rating. IBM has large and well-established hardware, software, and services businesses, each of which has high switching costs and recurring revenue streams. IBM's server hardware business is focused at the high end of the server market, and the firm has recently stepped back from playing in the commodified space. We do not expect the mainframe market to grow, but it's important to consider that migrating mainframe-based applications to alternative architectures can be expensive and risky. As a result, we believe that IBM's mainframe business will remain fairly steady and profitable. IBM's infrastructure-management software also tends to be very sticky, as IT personnel rely on it to operate their data centers and are reluctant to switch to new, less familiar systems. Software maintenance contracts provide profitable recurring revenue, and unlike the proprietary server business, the firm's software business continues to grow. Finally, about half of IBM's services business is composed of long-term outsourcing contracts ($128 billion backlog) that are sticky and provide recurring annual revenue.

While we think each business holds its own competitive advantages, it is the combination of these businesses which provides IBM with economies of scale in product development and distribution, and an edge in acquiring new customers that further reinforces the wide moat around the company. Additionally, though we generally don't attach much value to brands in the enterprise technology sector, IBM's established brand image as a trusted leader in computing provides the firm with a significant competitive advantage in acquiring new services business.

Management Continues Exemplary Stewardship We view IBM's stewardship of shareholder capital as Exemplary. IBM's management team has capably navigated the secular trend toward distributed, open standards computing by diversifying its hardware platforms, broadening its software portfolio, and building a formidable services organization. The result has been solid long-term financial performance. Since 2004, IBM's organic revenue, gross profit, and operating profit have compounded at annual rates of 2.2%, 6%, and 12%, respectively, while returns on invested capital have remained firmly above the firm's cost of capital. Other technology firms have grown faster over the past decade, but few technology companies can point to a track record that is as consistent or shareholder-friendly as IBM's.

Virginia M. Rometty took over as CEO of IBM in January 2012 and was added as chairwoman of the board in late 2012. Rometty was formerly senior vice president and group executive for sales, marketing, and strategy and has been with the company since 1981. Rometty stated early in her tenure as CEO her intention to continue to execute to IBM's long-run operating strategy of shifting its portfolio to higher-value software and services. So far she has not been shy about selling off noncore or commodity portions of the IBM portfolio, while bolting on acquisitions which fill gaps in the software or enterprise offering. The company has taken a realistic approach to its market opportunities, and is actively managing its investments in strategic areas and balancing its incredibly important core customers, which is a difficult task. We are encouraged by management's track record of achieving its stated long-run targets and the board's transparency relating to IBM's future strategic and financial road maps.