In the last quarter report, IBM announced revenues for $23.7bn (consensus $24.75bn) EPS at $3.99 (consensus $3.96), a light and shade result that followed a similar quarter (Q2), with a beat on earnings per share ($3,91) and a miss on revenues ($24,9bn) and the weakest quarter of the last years (Q1).

The stock in the last months has been showing a slow but constant downturn, probably tempered by the strong shares’ buyback and the Buffett’s appraisals. In our analysis, the stock seems still to show margin for a worse negative trend, mainly due to the flatness of revenues and the current sources of profit.

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One of our most important point is that even the well (or at least ‘better’) performing business units within IBM are suffering the rise of competitors and seem to have a declining outlook in the future. According to the Q3 2013 reports, the cash cows for the company are: Outsourcing services, Middleware and servers.

1)      Outsourcing services means mostly cloud computing: far from being first mover, IBM is currently trailing Amazon Web Services and fighting the hard competition of Google and Microsoft. Revenues growth is down 3% and, despite the marketing claims, IBM is far from the being the first:

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2)      The business of servers is facing a serious turnaround: competitors (Cisco, HP, Dell) are performing well while IBM claims a double-digit downturn in revenues and a 3,7% decrease in margins. Servers are now the only hardware product made by IBM and show a dangerous slowing in revenues in growing markets (IBM doesn’t even reports data for ‘stagnant’ markets).

3)      In the Middleware market IBM is the first with a nearly 30% market share, the business unit seems to perform better than the others despite a flat outlook (nearly 1% growth).

What is interesting is that, despite flat revenues and really no fast-growing markets and products, IBM is following straight the “Roadmap 2015”, which states that IBM will make $20 per share in 2015:

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Actually, in the last 6 years sales have grown 2.5%, while earnings per share have more than doubled:

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How? The driving factor seems to be the buyback plan, currently $20.6bn authorized and an expected additional share repurchase authorization at the October 2014 board meeting; then cutting workforce has been a constant move (8000 announced in this quarter), with $1 billion for restructuring  in this year, up from $803 million last year and $440 million the year before. Moreover, IBM is trying to sell its server business to Lenovo and sold a $1.3 billion customer assistance business to Synnex for $505 millions.

IBM’s board is trying everything to reach the roadmap goal, but it is losing the ground in almost all the business in which is currently a relatively relevant player. In our view, IBM cannot avoid the downturn simply using financial engineering and, even if the roadmap goal will be accomplished, the stock will face a decrease within the next year.

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To confirm our assumptions, we implemented a fundamental analysis on IBM. Our Discounted Cash Flow model is very simple and is based on the hypothesis that in the long-run IBM should have margins in line with the average ones in the sector. We predicted the Income Statement for the fiscal year ending December 31st using trailing figures obtained by the quarterly report issued on October 16th. After that, we had every relevant item of the pro-forma Income Statement converge to the average of the sector.

Revenues in the IT services sector grow by 6.33% on a yearly basis and the average EBIT margin is 11.19%. In 2013, the projected revenues growth and EBIT margin for IBM are respectively -1.39% and 26.17%. Assuming a linear convergence to the long-run average values for the IT services sector, we have that revenues growth grows by 0.86% every year of our provision, while EBIT margin for IBM decreases by 1.66% every year. We used the 24.6% marginal tax rate found in the IBM 3Q13 press release to compute provision for taxes. After having capitalized research and development expenses and operating leases, we modeled depreciation and amortization, which we added to EBIAT. In addition to that, we observed that IBM’s working capital is too low in comparison to the average of the sector. Hence, we assumed a linear increase in the amount of working capital. We also modeled dividends and capex to obtain Free Cash Flow to the Firm for the ten years of our provision. Capex keep into account the fact that IBM aims at keeping its buyback plan at high levels, which will negatively affect the Free Cash Flow to the Firm.

When it came to discount the FCFFs, our computation on the cost of capital yields a WACC of 9.87%. IBM has a levered beta of 1.25 and a cost of equity of 10.87%. The company’s good rating (AA-) allows IBM to have a low after-tax cost of debt, which lowers the WACC.

At the moment of the valuation IBM was trading at $178.97, but the intrinsic price of IBM, if such a thing exists, should be less than its current price, according to our analysis. Hence, we strongly believe the market is currently overpricing IBM.

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