Fitch Rates IBM's Sr. Unsecured Notes Offering 'A '
KEY RATING DRIVERS
The ratings and Outlook reflect Fitch's expectations for relatively stable operating performance, despite the continuation of a challenging operating and competitive environment. On a constant currency and organic basis, Fitch expects revenues will decline by the low single digits in the near term, driven by the ongoing shift to cloud-based, from legacy, information technology (IT). Near-term currency headwinds should remain significant, exacerbating top-line pressures.
The ratings and Outlook incorporate Fitch's expectation that IBM's investments in strategic imperatives (data, cloud and engagement) and achievement of cloud-based efficiencies will result in double-digit growth and achieve sufficient scale in these markets to offset long-term secular decline in legacy IT demand in the medium term. Fitch also expects cash flows will remain consistent and financial policies conservative through the intermediate term.
Fitch expects IBM will sustain higher profit margins following the divestitures of the less profitable semiconductor foundry and industry standard server (ISS) businesses in 2014. Fitch estimates operating core operating EBITDA margin (excludes operating EBITDA related to the financing business) was in the high 20% for 2015, versus a Fitch estimated low- to mid-20% historically.
Fitch expects strong annual free cash flow (FCF) of more than \\$7.5 billion through the intermediate term, driven by lower capital spending following the divestiture of the more capital-intensive foundry business. Fitch expects the company will use 75%-85% of annual pre-dividend FCF for shareholder returns, which the agency believes could result in incremental debt, given our estimate that more than half of pre-dividend FCF is generated outside the U.S.
Nonetheless, Fitch expects credit protection measures will remain solid for the rating. Pro forma for the senior notes issuance, total leverage (total debt-to-operating EBITDA) exiting 2015 was higher year-over-year at 1.9x, versus 1.8x for 2014. Core leverage (which excludes debt related to the financing business) increased to 0.8x for 2015, pro forma for the senior notes issuance, versus 0.6x 2014.
The ratings and Outlook reflect IBM's:
--Highly diversified customer base from both an industry and geographic perspective.
--Considerable recurring revenue model from IBM's IT services, software and financing, which in aggregate account for approximately half of total revenue and reduce revenue and profit volatility.
--Strong Market Position: Breadth and quality of product and service offerings, resulting in leading revenue market share in IT services, middleware software, servers and number three share of the total disk storage market.
--Significant liquidity, supported by a solid cash position, committed credit facilities and strong FCF.
Fitch's concerns include:
--Consistent, material increases in cash dividends long-term, which, in the absence of commensurate growth in profitability, could pressure FCF and financial flexibility, necessitating further increases in core debt to fund acquisitions or share repurchases.
--Significant and consistent research and development (R&D) investments required to keep pace with innovation, which constrain meaningful profit margin expansion but also supports barriers to entry in certain markets.
--Expectations for debt-financed acquisitions in new IT to accelerate transformation.
--Long-term threat to highly profitable mainframe demand and associated operating system software (z/OS) from increasing penetration of industry standard servers (ISS).
--Negative low-single-digit organic revenue growth on a constant currency basis for 2016 but the resumption of positive organic growth over the medium term, driven by growth in strategic imperatives businesses.
--Profit margins will remain stable due to divestitures of less profitable businesses. Fitch anticipates core operating EBITDA margins in the high 20% range through the forecast period.
--R&D and capital spending levels remain consistent through the forecast period, pro forma for the divestiture of the highly capital-intensive foundry business.
--Annual cash pension contributions will remain in the \\$500 million to \\$600 million range.
--75%-85% of pre-dividend FCF for shareholder returns, including 10% annual dividend growth.
The ratings could be downgraded if Fitch expects:
--A shift to more aggressive financial policies, including expectations core leverage will be sustained in excess of 1.25x;
--Continued mid-single-digit organic negative revenue growth (constant currency basis) or profitability pressures within IBM's traditional recurring core franchises, signalling a weakening operating profile despite the company's strategic imperatives growth focus.
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.
Fitch believes IBM's liquidity was strong at Dec. 31, 2015 and supported by:
--\\$9.1 billion of cash and equivalents; and
--An undrawn \\$10 billion RCF expiring on Nov. 10, 2019, which fully supports IBM's commercial paper programs.
Fitch's expectation for more than \\$7.5 billion of annual FCF also supports liquidity.
Pro forma for the senior notes issuance, total debt was \\$44.9 billion as of Dec. 31, 2015, which includes \\$6.5 billion of short-term debt. Fitch estimates \\$27.2 billion (61%) of total debt is attributable to IBM's Global Financing (IGF) business with the remaining debt attributable to core (non-financing) operations.
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, and 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.
FULL LIST OF RATING ACTIONS
Fitch rates IBM's senior notes issuance as follows:
--\\$900 million of floating rate notes (FRN) due Aug. 18, 2017;
--\\$1.2 billion of 1.8% senior notes due May 17, 2019;
--\\$900 million of 2.25% senior notes due Feb. 19, 2021;
--\\$1.35 billion of 3.45% senior notes due Feb. 19, 2026;
--\\$650 million of 4.7% senior notes due Feb. 19, 2046.
Fitch currently rates IBM as follows:
--Long-Term Issuer Default Rating (IDR) 'A+';
--Senior unsecured RCF 'A+';
--Senior unsecured debt 'A+';
--Short-term IDR 'F1';
--Commercial paper 'F1'.