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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.

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