September 30, 2016 / 8:31 PM / 10 months ago

Fitch Affirms IBM at 'A+/F1'; Outlook Revised to Negative

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(The following statement was released by the rating agency) CHICAGO, September 30 (Fitch) Fitch Ratings has affirmed the ratings for International Business Machines Corporation (IBM), including the Long- and Short-Term Issuer Default Ratings (IDR) at 'A+/F1'. Fitch has revised the Rating Outlook to Negative from Stable. Fitch's action affects approximately $55 billion of debt, including IBM's undrawn $10 billion credit facility. A full list of rating actions follows at the end of this press release. The revision of the Outlook to Negative incorporates Fitch's expectations that profit and free cash flow (FCF) margins could be below previous expectations of roughly flat in 2016 and 2017, after declining in each of the last two years. Profit margins should expand upon the resumption of organic revenue growth, although incremental acquisitions could delay improvements. Should acquisitions be debt financed, Fitch believes core leverage (total debt to operating EBITDA excluding debt and profitability related to IBM Global Financing ) could exceed Fitch's negative sensitivity of 1.25x. Fitch estimates core leverage of 1.1x for the latest 12 months (LTM) ended June 30, 2016, versus below 1x in each of the last several years. KEY RATING DRIVERS Increased Strategic Imperatives Revenue: Fitch believes IBM is on track to achieve its target $40 billion of revenue and 40% of total revenue for strategic imperatives (cloud, analytics, mobility and security) by 2018, which management set at the beginning of 2015. Revenue from strategic imperatives was $31 billion and represented 38% of trailing 12 month (TTM) overall revenue up from 35% for 2015. As a result, revenue from strategic imperatives could offset negative revenue from legacy offerings in the near term on a constant currency (CC) basis, including the company's significant acquisition spend over the past 18 months. Negative Legacy Growth: Fitch expects negative revenue growth from legacy on-premise software and services offerings will continue but moderate, driven by strong cloud adoption for new workloads. Fitch believes cloud migration is in the early innings but that customers will increasingly focus on hybrid cloud environments (optimized on-premise, public and private) to drive innovation. Headwinds in certain hardware markets, particularly storage and Unix-based servers, are exacerbating secular challenges for legacy software and services offerings. At the same time, renewal rates for maintenance and support remain steadily high, which should support recurring cash flows. Elevated Investment Intensity: Elevated investment intensity is supporting strategic imperatives growth but may continue pressuring profitability. Fitch expects annual R&D will remain near $6 billion, up from closer to $5 billion in each of the prior two years, to support cloud capabilities around cognitive, cloud and security. In addition, capital intensity should remain above 5% of revenue, supporting IBM's cloud infrastructure buildout. In conjunction from lower margins typically associated with acquisitions, Fitch expects core EBITDA margins could remain in the low 20s, down from a Fitch estimated 23.4% in 2015 and 24.3% in 2014. Substantial Acquisition Activity: Fitch expects meaningful acquisition spending will continue, including focus on building out the company's cognitive cloud capabilities. IBM has spent more than $8 billion on a series of acquisitions over the last 12 months on assets ranging from health data to internet of things (IoT) infrastructure, strengthening the basis of IBM's Watson Health and Watson IoT businesses. Fitch expects the company will focus on organically funding acquisitions but that larger or a series of smaller deals could be debt funded, potentially resulting in elevated leverage. In these cases, Fitch would expect debt reduction with FCF in the subsequent short term to return credit metrics back in-line with targets. Weaker Than Expected FCF: Fitch expects IBM's annual FCF (excluding the change in GF receivables) could weaken further in 2016 and 2017 but should remain solid for the rating at more than $5 billion, driven by the company's significant scale and installed base and recurring cash flows. IBM's FCF was $7.6 billion for the LTM ended June 30, 2016 but has declined in recent years in-step with profitability. FCF margins could decline from high single digits in recent years (potentially to mid-single digits) without the resumption of organic revenue growth and stabilizing profitability, given higher capital intensity to support strategic imperatives and continued dividend growth. Large & Diversified Installed Base: IBM remains the largest integrated IT provider with an extensive set of customer relationships and significant installed base in data centers. Fitch believes this base of business provides meaningful opportunities for the company to optimize customers' hybrid cloud environments and results in IBM being the largest provider of both cloud and cognitive solutions. Secular Pressures for Hardware: Fitch expects IBM's hardware (HW) sales will remain pressured by secular trends, including adoption of industry standard server (ISS) and software. Fitch expects slow decline in mainframe sales, within a product cyclicality context, but maintenance revenue to remain stable, given significant installed base and high switching costs. Unix-based server shipment headwinds should more than offset growth for the smaller Linux based server business with some upside for Power based servers. Shifts to software defined storage and all flash arrays from hard disk drives will result in continued negative storage revenue trends. KEY ASSUMPTIONS --Fitch expects low-single digit negative constant currency growth in 2016, driven by acquisitions and continued growth in strategic imperatives and continuation of negative revenue growth for legacy businesses, along with FX headwinds. Over the intermediate term, Fitch believes revenue should resume positive organic constant currency revenue growth in low single digits, with some volatility associated with the Systems segment, which is becoming a smaller portion of overall sales. --Fitch expects modest but continued profit margin pressures, driven by elevated investment levels, lower productivity as the company shifts away from legacy solutions and sub-optimal SI capacity. However, profit margin should expand upon resumption of positive organic revenue growth. --Fitch anticipates continued annual dividend growth and slightly elevated capital spending, potentially resulting in FCF margin remaining in mid- to high-single digits. --The company will use annual FCF for a combination of acquisitions and share repurchases and manage core debt to maintain core leverage below Fitch's negative threshold of 1.25x. RATING SENSITIVITIES The 'A+/F1' ratings could be stabilized if Fitch expects: --Positive near-term constant currency organic revenue growth, likely driven by continued momentum in strategic imperatives and moderating revenue declines in legacy software and services; and --Profit margins and annual FCF (less change in Global Financing receivables) will stabilize, validating IBM's strategic imperatives adoption and technology leadership. The ratings may be downgraded if Fitch expects: --Constant currency organic revenue growth will remain negative, driven by reduced momentum in strategic imperatives or greater than anticipated declines in legacy software and services; or --Fitch expects core leverage sustained above 1.25x from debt financed acquisitions or share repurchases or weaker than expected top line performance resulting in further profit erosion. LIQUIDITY Fitch expects IBM's liquidity will remain strong and supported by: --$10.6 billion of cash and cash equivalents, the majority of which Fitch believes is located outside the U.S.; and --$10 billion undrawn RCF that fully backstops the company's commercial paper program. More than $5 billion of annual FCF also supports IBM's liquidity. FULL LIST OF RATING ACTIONS Fitch affirms IBM's ratings as follows: --Long-Term Issuer Default Rating (IDR) at 'A+'; --Senior unsecured RCF at 'A+'; --Senior unsecured debt at 'A+'; --Short-Term IDR at 'F1'; --Commercial paper at 'F1'. The Rating Outlook is revised to Negative from Stable. Contact: Primary Analyst Jason Pompeii Senior Director +1-312-368-3210 Fitch Ratings, Inc. 70 W. Madison St. Chicago, IL 60602 Secondary Analyst David Peterson Senior Director +1-312-368-3177 Committee Chairperson Monica Bonar Senior Director +1-212-908-0579 Media Relations: Alyssa Castelli, New York, Tel: +1 (212) 908 0540, Email: alyssa.castelli@fitchratings.com. Date of Relevant Rating Committee: Sept. 29, 2016. Summary of Financial Statement Adjustments - --Fitch backs out profitability and debt(representing a 7:1 debt to equity ratio on finance assets) related to GF to calculate core EBITDA and core debt, ultimately arriving at core leverage. --Fitch also backs out changes to finance receivables from cash from operations to calculate FCF related to IBM's core operations. Additional information is available on www.fitchratings.com. 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