Uncategorized

Debt reduction at IBM could tighten bonds

| October 18, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

IBM sales results were a disappointment, but management’s commitment to debt reduction, coupled with its affirmation of free cash flow guidance, is a positive for bondholders. Debt reduction is likely to be focused around upcoming maturities and the company’s liquidity position is very strong.  IBM front end paper could outperform and collapse closer to Oracle, which is currently increasing net leverage to fund share buybacks, leading to negative outlooks by S&P and Fitch.

Earnings recap

IBM’s 3Q19 sales results came in below street estimates causing the equity to sell off 5.52% on the day.  Sales of $18.03 billion in the quarter missed consensus of $18.22 billion, however EPS of $2.68 managed to come in a penny above street estimates, largely benefiting from a lower tax rate in the quarter. While the addition of Red Hat, which witnessed solid revenue growth of 20% (ex fx) in the quarter was a benefit, the growth was not able to offset continued declines in the company’s legacy business, global technology services (GTS).  GTS, which remains IBM’s largest business unit and accounted for nearly 37% of the company’s top line in 2018, posted a revenue decline of 4.1% (ex fx) in the quarter. The drop follows declines in 1Q19 and 2Q19 of 3.0% and 3.5%, respectively. Management noted that the decline reflected lower client business volumes in certain markets. Additionally the systems segment, a much smaller business unit for IBM, saw a 14% decline in revenues in the quarter primarily reflecting the end of a mainframe product cycle (z14).

Despite the sales shortfall, the adjusted gross margin of 47.4% for the quarter was flat from the year ago period. For the nine months ended 9/30/19, gross margin of 45.9% was up 50 bp from the year ago period. Furthermore, the adjusted EBITDA margin year to date was 23.4%, up 160 bp from the year ago period.  On a last twelve months basis, the adjusted EBITDA margin was even higher at 25.6%.

Full year guidance affirmed

IBM affirmed its full year guidance that it provided back in early August to reflect the Red Hat acquisition.  Management continues to expect GAAP EPS for the year to be at least $10.58 while non-GAAP EPS will be at least $12.80.  Free cash flow will be approximately $12 billion, with a conversion rate of over 100% of GAAP net income. Management expects 4Q revenue to improve sequentially in a range of 3.5%-3.7%. Management’s confidence in its full year guidance rests in the fact that 4Q is its seasonally largest quarter from a transaction standpoint.  Furthermore, it will be the first full quarter of availability for its z15 mainframe.  The new mainframe carries a strong value proposition for its customers and IBM has already witnessed a solid start with its launch.  Additionally, signings growth of 20% in the GTS business produced a sequential improvement in backlog and should provide for improved performance at the unit over the next two quarters.

Strong start to delevering

IBM repaid roughly $6.7 billion of debt in the quarter, utilizing its strong cash position to start the deleveraging process.  Currently, all share repurchases are suspended in an effort to help speed up debt reduction. During the quarter, IBM repaid $4.9 billion of core debt – debt that does not relate to the financing business – and $1.9 billion of financing debt.  This brought total debt down to $66 billion. IBM is expected to direct the majority of free cash flow after dividends to debt reduction. With free cash flow of roughly $12 billion guided for the full year, and $5.9 billion generated year to date, free cash flow generation for 4Q should be close to $6.1 billion.  That said, IBM should have $4.6 billion available for debt reduction, after dividends of just over $1.4 billion. IBM has approximately $1.8 billion of debt maturing in the quarter which is likely to get repaid. IBM also has over $6 billion of debt maturing in 2020 and just under $10 billion of debt maturing in 2021, providing a good opportunity to continue to delever without having to execute at tender offer.

Exhibit 1. Sequential debt update

Source: Company reports; Amherst Pierpont Securities

Commitment to Leverage Target Reiterated

While the strong debt reduction in the quarter helps to underscore management’s commitment to delevering, the company took time on the earnings call to reiterate its previously stated commitment.  Management noted that they remain focused on achieving a leverage target ratio consistent with mid-to-high single-A ratings within a couple of years.  We estimate that pro forma leverage at quarter end (excluding financing debt) was roughly 2.3x.  This is up from 1.0x at year end 2018.  Leverage could fall to the 2.0x area should IBM use all free cash flow (after dividends) generated in 4Q for debt reduction, assuming no EBITDA growth.

Relative value

While the sales results were a disappointment, management’s commitment to debt reduction, coupled with its affirmation of free cash flow guidance is a positive for bondholders. Debt reduction is likely to be focused around upcoming maturities, so there is little need for a sweeping tender, and the company has little high coupon debt outstanding that would warrant some kind of waterfall tender. IBM’s liquidity position is very strong with $11 billion of cash on hand and $15.25 billion of availability under its three revolvers. IBM front end paper that is 5-years and in could outperform and collapse closer to Oracle (ORCL – A1/A+ (n)/A (n)). ORCL is currently increasing net leverage to fund share buybacks which has led to negative outlooks by S&P and Fitch. Net leverage could creep up over 2.0x in the intermediate term as IBM reduces its leverage below 2.0x over the same time frame.  Currently IBM 3.375% 8/1/23 bonds are trading at 52 bp (g-spread) which is 12 bp behind ORCL 3.625% 7/15/23, a level that is attractive.  The relationship is reversed in 2022 paper where IBM is currently trading through ORCL by roughly 6 bp (g-spread). Furthermore, IBM and ORCL 5-year CDS trade relatively flat to each other at roughly 41 bp.

admin
jkillian@apsec.com
john.killian@santander.us 1 (646) 776-7714

This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This message, including any attachments or links contained herein, is subject to important disclaimers, conditions, and disclosures regarding Electronic Communications, which you can find at https://portfolio-strategy.apsec.com/sancap-disclaimers-and-disclosures.

Important Disclaimers

Copyright © 2025 Santander US Capital Markets LLC and its affiliates (“SCM”). All rights reserved. SCM is a member of FINRA and SIPC. This material is intended for limited distribution to institutions only and is not publicly available. Any unauthorized use or disclosure is prohibited.

In making this material available, SCM (i) is not providing any advice to the recipient, including, without limitation, any advice as to investment, legal, accounting, tax and financial matters, (ii) is not acting as an advisor or fiduciary in respect of the recipient, (iii) is not making any predictions or projections and (iv) intends that any recipient to which SCM has provided this material is an “institutional investor” (as defined under applicable law and regulation, including FINRA Rule 4512 and that this material will not be disseminated, in whole or part, to any third party by the recipient.

The author of this material is an economist, desk strategist or trader. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM or any of its affiliates may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This material (i) has been prepared for information purposes only and does not constitute a solicitation or an offer to buy or sell any securities, related investments or other financial instruments, (ii) is neither research, a “research report” as commonly understood under the securities laws and regulations promulgated thereunder nor the product of a research department, (iii) or parts thereof may have been obtained from various sources, the reliability of which has not been verified and cannot be guaranteed by SCM, (iv) should not be reproduced or disclosed to any other person, without SCM’s prior consent and (v) is not intended for distribution in any jurisdiction in which its distribution would be prohibited.

In connection with this material, SCM (i) makes no representation or warranties as to the appropriateness or reliance for use in any transaction or as to the permissibility or legality of any financial instrument in any jurisdiction, (ii) believes the information in this material to be reliable, has not independently verified such information and makes no representation, express or implied, with regard to the accuracy or completeness of such information, (iii) accepts no responsibility or liability as to any reliance placed, or investment decision made, on the basis of such information by the recipient and (iv) does not undertake, and disclaims any duty to undertake, to update or to revise the information contained in this material.

Unless otherwise stated, the views, opinions, forecasts, valuations, or estimates contained in this material are those solely of the author, as of the date of publication of this material, and are subject to change without notice. The recipient of this material should make an independent evaluation of this information and make such other investigations as the recipient considers necessary (including obtaining independent financial advice), before transacting in any financial market or instrument discussed in or related to this material.

Important disclaimers for clients in the EU and UK

This publication has been prepared by Trading Desk Strategists within the Sales and Trading functions of Santander US Capital Markets LLC (“SanCap”), the US registered broker-dealer of Santander Corporate & Investment Banking. This communication is distributed in the EEA by Banco Santander S.A., a credit institution registered in Spain and authorised and regulated by the Bank of Spain and the CNMV. Any EEA recipient of this communication that would like to affect any transaction in any security or issuer discussed herein should do so with Banco Santander S.A. or any of its affiliates (together “Santander”). This communication has been distributed in the UK by Banco Santander, S.A.’s London branch, authorised by the Bank of Spain and subject to regulatory oversight on certain matters by the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA).

The publication is intended for exclusive use for Professional Clients and Eligible Counterparties as defined by MiFID II and is not intended for use by retail customers or for any persons or entities in any jurisdictions or country where such distribution or use would be contrary to local law or regulation.

This material is not a product of Santander´s Research Team and does not constitute independent investment research. This is a marketing communication and may contain ¨investment recommendations¨ as defined by the Market Abuse Regulation 596/2014 ("MAR"). This publication has not been prepared in accordance with legal requirements designed to promote the independence of research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. The author, date and time of the production of this publication are as indicated herein.

This publication does not constitute investment advice and may not be relied upon to form an investment decision, nor should it be construed as any offer to sell or issue or invitation to purchase, acquire or subscribe for any instruments referred herein. The publication has been prepared in good faith and based on information Santander considers reliable as of the date of publication, but Santander does not guarantee or represent, express or implied, that such information is accurate or complete. All estimates, forecasts and opinions are current as at the date of this publication and are subject to change without notice. Unless otherwise indicated, Santander does not intend to update this publication. The views and commentary in this publication may not be objective or independent of the interests of the Trading and Sales functions of Santander, who may be active participants in the markets, investments or strategies referred to herein and/or may receive compensation from investment banking and non-investment banking services from entities mentioned herein. Santander may trade as principal, make a market or hold positions in instruments (or related derivatives) and/or hold financial interest in entities discussed herein. Santander may provide market commentary or trading strategies to other clients or engage in transactions which may differ from views expressed herein. Santander may have acted upon the contents of this publication prior to you having received it.

This publication is intended for the exclusive use of the recipient and must not be reproduced, redistributed or transmitted, in whole or in part, without Santander’s consent. The recipient agrees to keep confidential at all times information contained herein.

The Library

Search Articles