|By Business Wire||
|June 23, 2014 03:40 PM EDT||
Fitch Ratings has affirmed the ratings of International Business Machines Corporation (IBM) as follows:
--Long-term Issuer Default Rating (IDR) at 'A+';
--Senior unsecured revolving credit facility (RCF) at 'A+';
--Senior unsecured debt at 'A+';
--Short-term IDR at 'F1';
--Commercial paper (CP) rating at 'F1'.
The Rating Outlook is Stable. Fitch's action affects approximately $54 billion of debt, including IBM's undrawn $10 billion credit facility.
KEY RATING DRIVERS
The ratings and Outlook reflect IBM's:
--Strong company profile primarily supported by i) significant revenue market share in information technology (IT) services (No.1), servers (No.3), enterprise software (No.1) and external storage (tied for No.3); ii) solid recurring revenue (49%) from IT services, software and financing that mitigates revenue and profit volatility; and iii) highly diversified revenue base by offering, customer, industry and geography (65%+ revenue outside U.S.).
--Strong financial flexibility due to i) robust internal liquidity with a significant cash position ($9.7 billion) and $8.4 billion of post dividend free cash flow (FCF) in the latest 12 months (LTM) ended March 31, 2014; ii) solid external liquidity with an undrawn $10 billion revolving credit facility (RCF) due 2018 and ready access to capital markets; iii) strong credit protection metrics despite the recent increase in core debt; and iv) roughly $30 billion of finance receivables (58% short-term and 58% considered investment grade).
--Well-executed management strategy, including i) ability to identify early trends that present significant higher margin, long-term growth opportunities and reposition investment priorities, both organic and inorganic, to capitalize on these opportunities (i.e. analytics); ii) consistent and sizable investments in R&D (6% of revenue) to develop innovative differentiated solutions that leverage IBM's entire portfolio of offerings and command higher profit margins; iii) core competency in identifying and integrating strategic acquisitions; iv) track record of strengthening strategic focus and profitability by divesting low margin businesses.
Rating concerns center on:
--Risk of core debt (non-financing) increases to achieve financial and/or business objectives (i.e. IBM's 2015 EPS target of at least $20), such as sizable debt-financed share repurchases and/or acquisitions, resulting in a material reduction of credit protection measures.
Fitch notes IBM maintains significant incremental debt capacity at the current credit ratings. Core leverage was 0.6x at March 31, 2014 despite a material increase in core debt in the first quarter to front load share repurchases in 2014. Fitch expects the pace of share repurchases will significantly moderate through 2014, resulting in gross share repurchases below the nearly $14 billion spent in 2013.
--Increasing pace of cloud adoption will likely pressure the growth rates for certain of IBM's traditional businesses, particularly traditional software and infrastructure outsourcing business. IBM's ability to capture emerging opportunities across cloud, analytics, mobile and social, particularly solutions with higher customer value, is critical to achieving revenue growth and at least maintaining profitability. Fitch believes slower industry growth for traditional IT products and services could lead to more aggressive pricing in the absence of long-term industry consolidation.
--Consistent, material increases in cash dividends long-term, which could pressure FCF and financial flexibility in the absence of commensurate growth in profitability. This could necessitate further increases in core debt to fund acquisitions and/or share repurchases.
--IBM's dependence on mainframe (System Z) refresh cycles to maintain profitability in the Systems and Technology Group (STG) due to IBM's underperforming storage business excluding solid state arrays, weak industry demand for UNIX-based Power servers as more and increasingly diverse workloads are performed on low-cost x86 industry standard servers (ISS).
Declining demand for UNIX-based Power systems also adversely affects the profitability of STG's microelectronics business, which designs and manufactures the Power microprocessors used in Power servers. The decline in UNIX server demand also carries negative longer-term revenue and margin ramifications for IBM's support services and financing businesses relating to Power servers.
STG profitability will benefit from the successful sale of IBM's x86 business to Lenovo, which is expected to close in the second half of 2014, assuming regulatory approval. IBM's x86 business generated $4.6 billion of revenue and was essentially breakeven on a pre-tax income basis in 2013. Fitch projects STG gross margin will expand to the mid-40% range in 2015 compared with 34.2% in 2013, benefitting from the x86 divestiture and likely new mainframe cycle.
--The long-term threat to highly profitable mainframe demand and associated operating system software (zOS) from converged ISS solutions. IBM's gross profit dollars from mainframes were flat on a compound annual growth rate (CAGR) basis in the past 10 years, exemplifying the resiliency and evolution of the platform.
Fitch believes the company's lack of a strategic rationale to maintain a higher rating at the expense of financial flexibility required for acquisitions or shareholder-friendly activities limits further positive rating actions.
The ratings may be downgraded in the event of:
--A shift to more aggressive financial policies. Sustained core leverage in excess of 1.25x may result in negative rating actions.
--Greater than anticipated revenue erosion and/or profitability pressures within IBM's traditional recurring core franchises that are not offset by growth in strategic imperatives, resulting in a material, sustained deterioration in credit protection metrics.
IBM has strong financial flexibility and liquidity supported by approximately $9.7 billion of cash and equivalents as of March 31, 2014 and an undrawn $10 billion RCF expiring on Nov. 10, 2018. Liquidity is further supported by strong and consistent annual FCF, which was approximately $8.4 billion in the LTM ending March 31, 2014. Fitch expects IBM's FCF will exceed $10 billion in 2014.
Fitch expects IBM to continue to use FCF for acquisitions, particularly in the software and services industries, share repurchases, albeit at a decreased rate in the second half of 2014, and dividend payments to shareholders.
The underfunded status of IBM's worldwide defined benefit (DB) pension plans was negative $6.2 billion (94% funded) at year-end 2013, significantly improved from negative $14.4 billion (86% funded) in 2012.
Excluding unfunded nonqualified DB pension plans, the funded status of IBM's U.S. and worldwide plans at year-end 2013 was 109% and 102%, respectively. In 2014, IBM is required to make legally mandated contributions of $600 million to its international DB plans. This compares with approximately $500 million actually contributed in 2013. The amount of the 2014 pension contribution is very manageable given the amount and consistency of IBM's cash flow.
Fitch believes IBM has more than ample liquidity to satisfy its longer-term legally mandated pension funding requirements (estimated at approximately $3.3 billion through 2018). This estimate could increase due to more frequent re-measurement of funded status in certain non-U.S. countries and the performance of financial markets.
Total debt was $43.9 billion as of March 31, 2014 consisting of $9.3 billion of short-term debt and $34.7 billion of long-term debt. Fitch estimates $28.3 billion (65%) of total debt is attributable to IBM's global financing business with the remaining debt attributable to core (non-financing) operations. IBM has long-term debt maturities of approximately $2.4 billion in the remainder of 2014 and $4.1 billion in 2015.
For the purpose of financial evaluation, Fitch analyzes IBM's core business and financing activities separately, since they are capitalized differently and have dissimilar cash flow characteristics. IBM Global Finance (IGF) accounted for nearly 11% of IBM's pre-tax earnings in 2013. This, however, represents the largest component of IBM's balance sheet, constituting approximately 24% of total assets and 27% of total liabilities as of March 31, 2013.
Total leverage as of March 31, 2014 increased to approximately 1.7x from 1.3x at March 31, 2013, and interest coverage decreased to 24.4x from 26.5x in the prior 12-month period. Core leverage increased to 0.6x from 0.3x and interest coverage increased to 61.8x from 58x, respectively. Fitch expects total leverage to decrease to 1.5x by the end of 2014, nearly flat compared with year end 2013.
The main purpose of IGF is to facilitate clients' acquisition of IBM systems, software and services by providing financial and capital management solutions. IGF has a solid long-term operating record, provides strategic advantages to IBM in terms of attracting and retaining customers by delivering total solutions. IBM also generates an annuity-like revenue stream associated with multi-year leases.
IGF's primary focus on IBM's products and clients mitigates some risks associated with financing via a deep knowledge of its client base and clear insight into the solutions being financed. Asset quality metrics have remained relatively solid as a result of the relatively conservative underwriting culture and strong risk management capabilities. IGF's capitalization remains solid for the rating category and leverage levels continue to hover near management's target of 7x.
Additional information is available at 'www.fitchratings.com'.
Applicable Criteria and Related Research:
--'Corporate Rating Methodology' (May 28, 2014).
Applicable Criteria and Related Research:
Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage
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