Moody's Lowers IBM's (IBM) Unsecured Rating Outlook to Negative; Sees Profitability Challenges in Portfolio Transition

Moody's Investors Service ("Moody's") affirmed the senior unsecured rating of International Business Machines Corporation (NYSE: IBM) at Aa3, and concurrently changed the rating outlook to negative from stable. Despite still solid debt protection measures "the outlook change reflects concerns that IBM will remain challenged to grow revenue and profitability as it continues to transition its portfolio toward what it expects will be higher value added offerings, as embodied by the company's portfolio of data analytics and cloud-based offerings", said Moody's Senior Vice President, Richard Lane.

RATINGS RATIONALE

IBM's Aa3 senior unsecured long-term and Prime-1 short-term ratings reflect IBM's revenue, customer, and geographic diversity as well as its strong liquidity and solid debt protection metrics. The ratings also reflect the company's demonstrated progress it has made in transitioning its business to a higher value added software and services company. Over the last five years, IBM has steadily grown its "strategic imperatives" (SI) businesses (data analytics, social, mobile, security, and engagement), which represents $29 billion, or approximately 35% of IBM's total reported revenue for the fiscal year ended 2015. More than offsetting our expectations of continued growth in SI revenue, however, will be a continued high single-digit to low double-digit decline in some of its portfolio of legacy businesses. Moody's believes this will lead to another year of lower revenue in 2016, on both a nominal and constant currency basis. And while still strong, profitability and cash flow will be flat to lower in 2016.

For years, IBM has continuously remixed its business portfolio to focus on providing higher value solutions and thus higher profit margins. The sale of its industry standard servers and semiconductor manufacturing business are the most recent examples, which we view positively. Because of this strategy, IBM's gross margin has risen 350 basis points since 2010 to 49.9% from 46.4% on a Moody's adjusted basis. As the strategic imperatives continue to grow, we expect gross margins to expand, reaching the low 50% level over the next year or two while EBITDA margins approximate 27%. Despite the expectation of higher margins and the growth of its portfolio of strategic imperative offerings, we expect IBM's overall revenue and profitability will remain under pressure, driven by a decline in its legacy revenue base.

IBM's total revenue (on a constant currency basis and adjusted for divestitures) has been flat or negative for the last fourteen quarters, reflecting, in part, the ongoing, multi-year industry shift of IT demand to cloud based offerings from traditional, on-premises hardware and software solutions. Despite progress in the company's transformation, Moody's believes there will remain an extended execution risk and that revenue could continue to decline through 2017.

Moody's expects that IBM will continue to invest in strategic acquisitions, acquiring mainly data rich software and service oriented companies to support the growth of its cognitive solutions business (represented by its various "Watson" offerings) as the company continues to reach into new end-markets, such as health care, to pursue growth.

Moody's expects that IBM will generate EBITDA of about $21 billion, and cash from operations less capital expenditures of $11 billion over the next year, all adjusted using Moody's standard adjustments. With dividends of about $5 billion, we project IBM will generate free cash flow of about $6.5 billion in 2016. Based on transactions announced, Moody's expect IBM will spend approximately $6 billion in acquisitions in 2016, the highest level in several years. We expect IBM will continue to be acquisitive, as it builds out its cognitive solutions platform, however, consistent with its practices, we do not anticipate large transactions that can be distracting and difficult to integrate.

During the portfolio transformation efforts, Moody's expects IBM will continue to demonstrate conservative financial policies, maintaining shareholder returns well within the confines of free cash flow. While Moody's expects IBM will fund acquisitions with a modest amount of incremental debt in 2016, we anticipate the company will operate at an adjusted debt/EBITDA ratio of approximately 1.5x (currently 1.4x). IBM has historically maintained a liquid balance sheet, with cash over $8 billion and a $10 billion commercial paper program, fully backstopped by a five year committed revolving credit facility of equal size. This strong liquidity provides operational and financial flexibility and adds incremental support to the rating.

The negative outlook reflects concerns over IBM's ability to begin to grow revenue and profitability as it progresses with its broad portfolio transition.

An upgrade is unlikely given the negative outlook. Longer term, the ratings could be upgraded if IBM demonstrates revenue growth in the low-to-mid single-digits and reduced competitive pressures throughout its broad operations. Additionally, EBITDA margins sustained above 30% coupled with continued financial conservatism, including adjusted debt to EBITDA sustained at less than 1.0 times, and the maintenance of a strong balance sheet and alternate liquidity could also contribute to upwards rating pressure.

Downward ratings pressure could emerge if IBM is not able to establish a foundation for revenue growth in 2017 or if profitability or cash flow deteriorate. Furthermore, if management becomes more aggressive in the use of debt to fund acquisitions or shareholder friendly activities such that adjusted debt/EBITDA is sustained above 1.6 times or if its strong liquidity profile weakens, the ratings could be pressured.

Outlook Actions:

..Issuer: International Business Machines Corporation

....Outlook, Changed To Negative From Stable

Affirmations:

..Issuer: IBM International Group Capital LLC

....Senior Unsecured Commercial Paper, Affirmed P-1

..Issuer: IBM International Treasury Services Company

....Senior Unsecured Commercial Paper, Affirmed P-1

..Issuer: International Business Machines Corporation

.... Issuer Rating, Affirmed Aa3

....Subordinated Shelf, Affirmed (P)A1

....Preferred Stock Shelf, Affirmed (P)A2

....Senior Unsecured Shelf, Affirmed (P)Aa3

....Senior Unsecured Commercial Paper, Affirmed P-1

....Senior Unsecured Medium-Term Note Program, Affirmed (P)Aa3

....Senior Unsecured Regular Bond/Debentures, Affirmed Aa3

The principal methodology used in these ratings was Diversified Technology Rating Methodology published in December 2015. Please see the Ratings Methodologies page on www.moodys.com for a copy of this methodology.

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