IBM Downgraded To Neutral From Outperform

We downgrade International Business Machines (IBM) to Neutral from Outperform to reflect near-term risks to the company’s top-line growth and valuation.

We believe that IBM’s long-term revenue growth potential is limited and remain cautious on currency fluctuation, which is taking a toll on sales and may be critical to earnings expansion over the next two years. While we do believe that cost-cutting initiatives and share repurchases will substantially increase earnings, we do not see the company catching up on its top-line growth.

We expect revenue to decline by 7.8% in the current year, primarily due to low growth in some segments, continued decline in hardware and rising pressures on the services business.

In the most recent quarter, IBM’s sales were down across the board and total revenue declined 13.3% (down 7% when adjusted for currency) year over year, impacted by a strong US dollar as well as the global recession.

While we are impressed by the company’s strong liquidity position, operational efficiency and improving profitability (IBM raised its 2009 EPS outlook from $9.20 to $9.70), near-term visibility remains low given the lack of long-term customer signing growth.

Moreover, pricing pressure from rivals like Hewlett-Packard (HPQ), Dell Inc. (DELL), Microsoft (MSFT), Cisco (CSCO) and Oracle (ORCL) have hurt IBM’s business. Higher profit on lower revenue indicates that the quality of IBM’s products may deteriorate and damage its brand in the long term.

Currently, IBM trades at 12.4X its 2009 earnings, a discount to the peer group average. The company’s PEG ratio of 1.34 indicates slow growth. Over the last five years, IBM shares have traded in a range of 9.4X to 19.6X the trailing 12-month earnings. Thus, it is trading at the low-end of the range at present.

We do believe that IBM is fundamentally a sound company and has a strong market position but are wary of near-term bumps. We anticipate that the overall demand environment would limit the stock’s relative appreciation in the future.

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