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A focus on core leverage at IBM

| January 24, 2020

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.

While IBM continues to trade wide to its single A technology peers, bonds could begin to collapse closer to peers as 4Q results suggest the company is turning a corner with respect to revenue growth and management remains focused on debt reduction.

IBM’s (A2/A) credit curve is shown relative to Oracle Corp.’s (ORCL – A1/A+ (n)/A) (Exhibit 1). ORCL has spent the larger part of the past three years reducing its sizeable cash position to fund a hefty share buyback program, moving from a net cash position to a net debt position. Adjusted leverage, as per S&P’s calculations, is expected to climb to the 2.0x area by fiscal year-end 2020 (May 2020), up from 1.4x in the year-ago period. S&P has also noted that management’s lack of a clear financial policy underscores its current negative outlook and indicates that there is a one in three chance that they downgrade the rating over the next two years.  This is the opposite of IBM’s financial policy which has suspended its share repurchase program to accelerate debt reduction post its acquisition of Red Hat.  IBM’s focus on debt reduction and leverage seems to be better reflected in the CDS market, as IBM 5-year CDS currently trades 6 bp through ORCL 5-year CDS.  ORCL’s CDS has slowly been drifting wider since July 2019, while IBM’s CDS has reached a 52 week low (Exhibit 2).

Exhibit 1: IBM vs ORCL credit curves

Source: Bloomberg

Core leverage within rating agencies’ expectations

IBM reduced debt by $3.4 billion in 4Q, putting total debt reduction at $10 billion since the close of the Red Hat acquisition in June 2019.  Total debt at year-end 2019 stood at $63 billion, of which $38 billion is related to the core business and $25 billion is global financing debt. Total leverage currently stands at 3.6x while core leverage is over a turn lower at roughly 2.3x. While total leverage is optically high for the current ratings A2/A ratings profile, the rating agencies focus on the core leverage ratio for ratings purposes. That said, for comparison purposes investors can consider core leverage relative to peers.

Exhibit 2: IBM vs ORCL 5-year CDS (1/23/19 – 1/20/20)

Source: Bloomberg

Based on the current pace of debt reduction, management noted on its earnings call that they are on track to achieve a leverage ratio consistent with a mid-to-high single A rating in a couple of years.  Both Moody’s and S&P are targeting core leverage of 2.0x within 18-24 months from the close of Red Hat for the current ratings.  Based on current fiscal 2020 guidance of free cash flow (before dividends) of $12.5 billion, we estimate that IBM has roughly $6.7 billion that it could put towards debt reduction in 2020. This would put core leverage at 1.8x by year end 2020 (assuming no EBITDA growth).

Maturity profile supports debt reduction 

IBM’s debt maturity schedule lends to further deleveraging over the next couple of years as IBM has over $6 billion of debt maturing per year for the next three years. This alleviates the need to tender for bonds, which could prove costly and does not guarantee that investors participate. Furthermore, IBM has very little outstanding high coupon debt that it hasn’t already targeted, with the exception of the 7% 2025 bonds ($600 million outstanding). IBM is expected to issue debt selectively as free cash flow (less dividends) does not fully cover all debt maturing over the next three years ($22.6 billion).

Exhibit 3. IBM debt maturity schedule ($ in millions)

Source: Bloomberg

4Q operating highlights

IBM posted solid 4Q19 results which were underscored by positive sales growth.  Revenues for the quarter were up 3% (ex fx), marking its first quarter of positive sales growth since 2Q18. Growth was fueled by strong double digit performance at newly acquired Red Hat, which posted organic revenue growth of 24% in the quarter. This enabled the Cloud & Cognitive Services business, IBM’s second largest business unit in terms of sales, to post strong revenue growth of 9.4% (ex fx) for the quarter.   Investments in higher margin businesses helped position the company for strong gross margin performance.  Adjusted growth margin in the quarter expanded 230 bp year-over-year (to 51.8%). Higher RD&E and SG&A spending, primarily relating to its z15 mainframe launch, impacted growth on the EBITDA line. IBM’s adjusted EBITDA margin for the quarter was 28%, up 10 bp year-over-year.

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