Did IBM Stock Really Deserve This Drastic Drop?

Although we don't believe in timing the market or panicking over daily movements, we do like to keep an eye on market changes -- just in case they're material to our investing thesis.

Shares of blue-chip tech company IBM (NYSE: IBM  ) are plunging today, having dipped as much as 2.6% overnight. Given Big Blue's commanding presence in the Dow Jones' (DJINDICES: ^DJI  ) price-weighted system, that's enough to shave 40 points off the Dow's total value.

It didn't take much of a push to make IBM topple this time -- just one analyst downgrade. Should one opinion (among 23 firms tracking IBM) really make this big of a difference?

Maybe so, for a couple of reasons. For one, we're talking about well-respected analyst firm Credit Suisse. For another, this downgrade from "neutral" to "underperform" sets Credit Suisse apart from the pack: It's the only published equivalent to a "sell" rating on IBM at this time. Third, analyst Kulbinder Garcha set a $175 one-year price target on the stock. That's 10.5% below last night's closing price, 10% below the next-lowest analyst target, and a huge 20.7% below the Street average.

This analyst is blazing a new trail that strays far from the consensus. He'll be a hero if he's right and a pariah if he's wrong.

So it's an audaciously big move by a highly respectable firm. The stakes are high. Actions like these make investors sit up and take notice. But numbers never tell the whole story. Does the logic behind Garcha's controversial pick make sense?

The analyst's chief argument is that IBM is converting less of its net income into free cash flows than it used to -- and less efficiently than other large-cap tech firms. He points to a free-cash-flow conversion rate of just 59% in the most recent quarter. You get to that number by dividing IBM's adjusted free cash flow of roughly $2.30 per share by $3.91 in non-GAAP earnings per share.

I would note that the recently reported second quarter saw the biggest gap between cash flows and earnings in recent memory. Management explained it with rising cash-tax payments and lower accounts-receivable collections.

IBM EPS Diluted Quarterly Chart

IBM EPS Diluted Quarterly data by YCharts.

Zooming out to a trailing-12-month view, you'll see that IBM's cash conversion really has been slipping in a historical perspective:

IBM Free Cash Flow TTM Chart

IBM Free Cash Flow TTM data by YCharts.

Crunching this data and management's comments, IBM does seem to have hit a snag in its business execution lately. It's true that uncollected accounts receivable should come back as cash at some point when the bill collectors stop coming back empty-handed. But it's up to IBM to make that happen.

Big Blue's stock has largely traded sideways over the last year, missing out on the Dow's 18% climb. Kulbinder Garcha's cash-flow analysis is on target: Unless IBM finds a way to turn the beat around, the stock is likely to suffer another year of disappointing returns.

The $175 target might be a little low, but it's up to IBM to prove this analyst wrong. I still believe in IBM as a long-term investment, but the tech giant is looking at a bumpy road ahead.

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  • Report this Comment On August 06, 2013, at 2:54 PM, ScottAtlanta wrote:

    Thanks for the overview, insights, and graphs...

    I am thinking also, about growth and how that factors in here....Some co.s are known for radical shifts or taking risks to spur growth...that can 'turn the beat around" pretty quickly. But this does not describe IBM...who's more like the spinster librarian than the teenage kids sent in to do book reports and make her life miserable. But times are so radically different...she's alone in the library....the kids do their reports elsewhere.

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