As IBM Faces Falling Revenue, Red Hat Deal May Change Narrative

(Bloomberg) -- International Business Machines Corp. is scheduled to report its first-quarter results after the market closes on Tuesday, but when it does, IBM will not be the company that analysts are most interested in.

The company in October announced that it would acquire Red Hat, and while the deal isn’t expected to close until the second half of the year, analysts are looking ahead to the prospects of the combined company, and whether Red Hat’s position in the fast-growing cloud-computing market will be enough to turn sentiment on IBM, which has lagged the overall technology sector for years.

Shares fell 0.4 percent on Tuesday, but have risen about 34 percent from a nine-year low hit in December.

Credit Suisse cheered the Red Hat deal in a note published last week, starting coverage on IBM with an outperform rating and Street-high price target of $173. “IBM and Red Hat together form a powerful competitor to guide customers” into a “hybrid-first” world, analyst Matt Cabral wrote to clients.

The bullishness of this view was something of an anomaly, however. Just six firms have a buy rating on IBM shares, compared with the 15 that recommend holding it. And while the company’s adjusted earnings haven’t missed expectations since the third quarter of 2014, according to Bloomberg data, it also hasn’t done much to inspire much enthusiasm. Both first-quarter earnings and revenue are expected to decline from the year-ago period.

“IBM remains a ’show me’ story until revenue performance starts to improve,” wrote Goldman Sachs in a note previewing the upcoming results. Analyst James Schneider affirmed his neutral rating and $140 price target, writing that IBM “needs to show a material improvement in terms of its revenue and margin trajectory for the stock to move higher from current levels.”

This view was echoed by Cleveland Research, which has a neutral rating on the company, which it called a “mixed story.”

“The company continues to face structural risk from its installed base of clients migrating towards cloud and open source competitors in the long-term due to IBM’s underinvestment in cloud and relatively closed strategy,” analyst Ari Terjanian wrote. While the Red Hat deal is a step to address this issue, “it remains too early to judge whether these efforts will be successful.”

ANALYST COMMENTARY

• Bloomberg Intelligence
  • “Corporate adoption of cloud, digital and other emerging technologies should fuel healthy growth in IBM’s Global Business Services,” analyst Anurag Rana wrote
  • “Interest in IBM’s infrastructure services will also drive improving growth in its Global Technology segment, with the utilization of hybrid-cloud environments”
• Stifel (buy, PT $145)
  • At the stock’s current valuation, “further multiple expansion is possible with continued improvement in the core and/or more positive sentiment surrounding the RHT acquisition”
• Wedbush (neutral, PT $165)
  • “Management is clearly making an aggressive effort to accelerate the shift in IBM’s revenue base into high-growth, digital software/services” with the Red Hat deal, but “in order for us to become more constructive on the name, we need to see indications that results at stand-alone IBM has stabilized”
  • “A combination of depressed P/E multiples, relatively low expectations and negative sentiment could trigger a stock rally post-any potential improvements in revenue growth, margins, and FCFs metrics”

ESTIMATES & FORECASTS

• 1Q adj. EPS est. $2.22 (range $2.15 to $2.28)
• 1Q revenue est. $18.44 billion (range $17.94 billion to $18.62 billion)
• 1Q gross margin est. 44.94%
• 2Q adj. EPS est. $3.26
• 2Q revenue est. $19.36 billion

DATA

• 6 buys, 15 holds, 2 sells; avg PT $146
• Implied 1-day share move after earnings: 4.8%
• Shares rose after 4 of the past 12 earnings announcements
• Adj. EPS beat ests. in 12 of the past 12

TIMING

• Earnings expected April 16 after the market closes
• Call 5 p.m. ET

To contact the reporter on this story: Ryan Vlastelica in New York at rvlastelica1@bloomberg.net

To contact the editors responsible for this story: Catherine Larkin at clarkin4@bloomberg.net, Steven Fromm

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