IBM's Q1 Feeds The Bear Case, But Catalysts Remain Intact

Reviewing International Business Machines Corp.'s IBM first quarter results, Morgan Stanley said the results feed the bear case, although believing that catalysts for inflection in the second half of 2017 remain intact.

Analyst Katy Huberty feels the continuous deterioration in gross margins at a rate faster than in the second half of 2016 is most concerning. The analyst pointed to management's message that 2017 is the year when investments would deliver returns, helped by increased focus on gross margins, although it didn't give any clear timing.

The analyst feels first half revenue and profits in GTS will be pressured by the combination of two customers in sourcing projects and two unexpected delayed outsourcing deals.

"As a result, our 2Q estimates move lower requiring better than normal earnings seasonality in the second half of this year," the analyst said.

Catalysts Intact

Morgan Stanley, however, opined that catalysts for inflection in the second half is intact. The firm noted that strategic imperatives grew 13 percent at constant currency, with the rate faster than in the fourth quarter of 2016 and the run rate required to achieve revenue stability in 2018.

Mainframe, which added 1 point to revenue growth and $400 million to pre-tax income during the first two quarters of past product cycles, could provide a near-term boost to growth and profits, given its impending launch later this year, the firm said.

Morgan Stanley expects total company PTI, adjusted for lower workforce rebalancing, to be flat to down slightly year-over-year in 2017 compared to a 16 percent drop last year.

Focus on Gross Margins

The firm views gross margins as the cleanest read on the company delivering on the back of heavy investments during 2015-16.

"If we don't see meaningful strides toward Y/Y gross margin stability across most segments later this year, we see the risk that IBM returns to low-end of software peer multiples, represented by our $142 bear case," the firm said.

Cloud Could Lift Valuation

Morgan Stanley thinks IBM's $3 billion Public Cloud business will grow in line with the market at a 33 percent 2016-20 CAGR, with gross and operating margins expanding toward industry peers by 2020.

"However, pricing and/or demand pressures in the rest of the business could mask any cloud margin improvement putting pressure on the multiple investors are willing to pay for the non-cloud business," the firm concluded.

Morgan Stanley has an Overweight rating and $212 price target for shares of IBM.

At the time of writing, IBM shares were down 5.62 percent at $160.50.

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