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IBM Slumps on Credit Suisse Downgrade (Update 1)

Updated from 9:30 a.m. EDT to provide more analysis in the ninth paragraph.

NEW YORK (TheStreet) -- IBM (IBM) shares fell 1.28%‎ to $193 following a downgrade from Credit Suisse, which cited concerns about the company's future organic growth, free cash flow and software revenue.

Analyst Kulbinder Garcha downgraded shares to "underperform" with a $175 price target, implying 10% downside as he believes the company is "effectively in decline." Garcha noted concerns that 34% of the company's gross profit dollars come from Mainframe and UNIX hardware and software, which are believed to be under pressure. The continued shift to the cloud hurts IBM's positioning, despite the tech giant's continued push to move into cloud software and services.

Long-term revenue growth is close to flat, with Garcha assuming a 1.4% growth rate in annual organic revenue. Much of the company's sales growth comes from outside acquisitions, and organic revenue growth is next to nothing. For 2013, Credit Suisse estimates overall organic revenues will decline 1.8%, but software will rise a paltry 1.9%. "There has been a gradual erosion in IBM's ability to grow, driven partially by pressured IT budgets and the global economic environment, but more importantly, due to the gradual decline in the company's competitive position across its industries."

There's also concern that as the company manages its portfolio of hardware, software and services, divesting unwanted products isn't going to help as much as it once did, given IBM has fewer and smaller divestitures it can potentially make. That includes selling off its -x86 server business and its Microelectronics division.

Many of the company's divestitures in recent years have been fueled by a desire to buy back shares and move into higher growth areas. Some 80% of IBM's 34 acquisitions done since 2010 have been geared towards software.

IBM's bread and butter has been its software and services business, as the company has repeatedly said it will achieve $20 per share in earnings by 2015. Credit Suisse believes it can hit the $20 per share mark, but it may not have an easy time getting there.

If it doesn't, its software business may be to blame, if software continues to lose share with "limited organic growth." With a pre-tax income margin of 40%, IBM's software business has accounted for a third of its earnings growth over the past six years, and Garcha believes that level is unsustainable. "The same level of expansion from software would imply this segment becomes the world's most profitable software business, unlikely given a more fragmented nature and a less competitive position," Garcha wrote. "For IBM, the top 3 categories make up only 50% of software revenues, far less than competitors."

Though the company trades at 10 times 2015 earnings potential, IBM's free cash flow, an important metric for earnings retention, has been declining every year since 2009, with a conversion rate of just 59%. "This conversion rate is not only the lowest of any large cap tech stock, ex-Intel, but has also deteriorated for the four straight years," Garcha penned, in the note.

The company had been continuously focusing on its $20 per share target for 2015, allowing IBM's shares to trade at a premium. This may change, Garcha noted, as the earnings presentation gets more complex and the company's guidance was recently changed. The company's "unique business model should equally not be dismissed out of hand," Garcha said.

--Written by Chris Ciaccia in New York

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