Morgan Stanley Highlights 'Valuation Disconnect' in IBM (IBM), Upgrades Stock to 'Buy'

(Updated - February 18, 2016 9:03 AM EST)

Morgan Stanley doesn't think IBM (NYSE: IBM) shares reflect its transformation to a more analytics- and cloud-focused business. Given this, analyst Katy L. Huberty said she likes the set-up in shares, and she upgraded the stock to 'Overweight' with a price target of $140.

Huberty explained, "IBM Strategic Imperatives - data, cloud, engagement - now make up 35% of revenue and grew 17% in 2015, or 26% at constant currency, reflecting a faster-than-expected transformation to higher growth / higher value solutions. For comparison, Microsoft Cloud (Azure + Office 365) accounted for 36% of revenue and grew 20% in 2015. Yet IBM's share price reflects a perpetual decline in residual income, and these higher growth categories are undervalued based on our sum-of-the-parts (SOTP) analysis. We expect the valuation disconnect to correct with new disclosures (expected at IBM's Feb 25th analyst day), stabilizing revenue trends this year (with acceleration in 2017+), and improving FCF (as early as 2H16)."

Huberty thinks revenue growth is bottoming and said FCF could surprise to the upside. She also noted considerable upside to SOTP valuation of $169 in a bull case.

The analyst concluded, "We believe IBM warrants a premium over other hardware companies that haven't invested heavily to transform to new computing paradigms. The re-accelerating growth and improving FCF conversion drive a shift in investor sentiment in our base case. Our estimates reflect moderating revenue declines as Strategic Imperatives approach half of revenue. While we are below consensus on revenue and EPS (2017 $77B MSe vs. $78B Street, and $14 MSe vs. $14.16 Street; 2018 $76B MSe vs. $79B Street, and $14.51 MSe vs. $15.36 Street), we believe the primary driver of the stock is the long-term FCF outlook. Consensus expects FCF declines of -5% over the next two years. We are more optimistic on IBM's transformation driving FCF improvement and model FCF growing 2% over the same period. IBM currently trades at 9x forward EPS, and we are confident that 1x multiple expansion is achievable given MSFT's multiple has improved by 2 turns since increasing visibility into its cloud business."

For an analyst ratings summary and ratings history on IBM click here. For more ratings news on IBM click here.

Shares of IBM closed at $126.10 yesterday.

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