IBM Set For Growth In 2017; Morgan Stanley Trims Target To $179

Katy Huberty of Morgan Stanley maintains her Overweight rating on International Business Machines Corp. IBM shares, as she believes that the company is set for growth next year, driven by Strategic Imperatives, coupled with free cash flow ahead of earnings and PTI margin pressures receding.

The analyst also pointed out that the CFO commentary on 2017 indicates earnings growth despite continued investments.

IBM’s revenue beat expectations for the third quarter in a row with organic revenue decline improving from the second quarter. PTI margin decline also improved (-1.6 point year-over-year versus a -5 point average prior three quarters) as restructuring savings begin to flow through.

On the flip side, though PTI margin trends improved, gross margin dropped 205bps year-over-year, slightly worse than the prior three quarters.

Related Link: An Attractive Contrarian Story: IBM's Q3 Delivers More Signs Transition Is Moving Forward

“We attribute the gross margin decline to 1) shifting some software revenues to IP Income as IBM increasingly licenses technology in non-Strategic businesses, and 2) continued pressure in Cognitive Computing margins as the company invests for future growth,” Huberty wrote in a note.

“Both trends are likely to continue but mix shift toward higher margin Software and Strategic Imperatives revenue combined with improving GBS and cloud margins allows for modest gross margin expansion next year, in our view,” Huberty continued.

Further Analysis

In addition, the analyst believes IBM is on track for 2017 growth, with currency impact neutralizing and momentum driven by 42 percent estimated revenue contribution from Strategic Imperatives and Global Technology Services (GTS).

Furthermore, margins are expected to improve in several areas of services and cloud, while further restructuring savings could be reinvested in growth areas.

‘We continue to see modest EPS growth in CY17 as mix shift to software and restructuring savings offset aggressive investments in growth areas like Cognitive and Cloud. Our CY17 EPS of $14 is unchanged,” Huberty noted.

However, the analyst modestly cut the price target to $179 from $182. The new target continues to assume 12.5x P/FCF on CY17 FCF, which the analyst lowered slightly to $14.33 from $14.57.

“This is in-line with the low-end of software and services peers (Oracle Corporation ORCL), however, as Watson contribution increases we see the potential IBM achieves a multiple closer to Microsoft Corporation MSFT, or 15.5x bull case FCF of $14.75,” Huberty added.

Shares of IBM closed Monday’s trading at $154.77. In the pre-market hours, the stock fell 2.57 percent to $150.80.

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