IBM Will Meet Or Beat On Q3; Bernstein Concerned With Q4, FY17

Bernstein analysts expect International Business Machines Corp. (NYSE: IBM) to beat or meet consensus view when the company reports its third-quarter results on October 17. The report is also expected to reaffirm its FY16 EPS and free cash flow (FCF) guidance. But, the brokerage is concerned with the fourth-quarter and FY 17 EPS performance.

Lead analyst A.M. (Toni) Sacconaghi expects third-quarter EPS of EPS of $3.22, versus consensus of $3.24 and IBM's implied guidance of $3.11 - $3.24 (midpoint $3.17). The analyst projects revenue of $19.2 billion versus consensus of $19.0 billion.

"We expect IBM to reaffirm full year EPS guidance of 'at least $13.50' on the Q3 earnings call, along with its cash flow guidance of "at the high end of $11–$12 billion,"" Sacconaghi wrote in a note.

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The analyst urged investors to focus on the following four key metrics in the third quarter results:

1. "Overall and SW revenue growth on an organic and constant currency basis (we forecast -3 percent and -3 percent to -4 percent, resp.)."
2. "Growth of strategic imperatives (we forecast 10–12 percent)."
3. "GBS margins (-250 bps YoY) and services signings ($11.6 billion)."
4. "The pace and magnitude of restructuring actions."

Are Expectations Too High?

However, the analyst is concerned that expectations for fourth quarter EPS, FY 17 EPS and FCF may be too high.

"We note that Q4 will likely be one of the most back-end loaded quarters in history, and for FY 17, consensus is expecting margins to improve by > 200 bps, which may be optimistic," Sacconaghi highlighted.

The analyst said operating margins could be 100 bps lower than consensus — "at consensus revenue levels, the lower margin level would point to $13.31 in EPS, versus current consensus of $14.11."

Analyst Take

As such, Sacconaghi cut FY 17 EPS forecast to $13.65 from $13.83 (and consensus of $14.11) and sees implied fourth quarter EPS guidance of $5.02.

Further, the analyst sees a number of forces affecting IBM's operating margins in FY17 on a year-over-year basis, including savings from IBM's first quarter 2016 restructuring plan.

In addition, Sacconaghi's preliminary estimate of IBM's FCF for FY17 is between $10 billion and $11 billion, below FY 16's expected level of close to $12 billion. IBM has said FY16 FCF will be "at the high end" of its $11 billion–$12 billion range.

Further Justification

Meanwhile, the analyst remains surprised at IBM's strong stock performance YTD given its poor fundamental results in the first half. The trends show that the stock tends to be flat or outperform in the period between December 1 and April 15, but then has underperformed meaningfully between April 16 and November 30.

Although the stock has indeed underperformed by 20 bps since mid-April this year, the weakness has been far less pronounced than in prior years.

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"Given that we believe Q4 estimates and FY 17 guidance could be at risk, we believe that January results are more likely to be a negative catalyst for the stock than anything before year end, and caution that the market's strong appetite for yield could provide support for the stock, in spite of any disappointments," Sacconaghi noted.

As such, Sacconaghi rates the stock Market-Perform with a price target of $140 as he struggles to see upside in the name, given full valuation and there is little evidence that the company's growth rate is positively inflecting.

Shares of IBM closed Thursday's trading at $156.88.

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