Here’s How IBM Is Hurting the Dow Today

A tough assessment for the future of International Business Machines (NYSE:IBM) by Credit Suisse analyst Kulbinder Garcha sent shares of the technology company plummeting on Tuesday, and that tumble dragged down the Dow Jones Industrial Average as well.

The problem IBM faces is weak demand for mainframes — thanks to the technological shift to cloud computing — and fierce competition in software, two trends that will leave the company’s existing businesses “effectively in decline,” Garcha wrote in a note to clients, acquired by The Wall Street Journal. “While we commend IBM’s operating performance in recent years, future organic growth will be challenging,” he wrote. “We are also concerned by deteriorating fiscal cash flow and a less effective mix up to software revenue.” A further problem isolated by the the Credit Suisse analyst is that some valuation metrics also suggest the company trades at a large premium to its peers.

Garcha downgraded his rating on IBM rating from neutral to underperform, and cut the price target to $175 from $200. The average rating target held by analysts is $220 per share. As a result, shares fell as much as 2.20 percent, or $4.31 to $191.21, in midday trading on Tuesday. And, because IBM is a component of the Dow Jones Industrial Average, the company’s tumble sent shock waves throughout the broader market.

IBM’s stock accounted for approximately 33 points — or about one third — of the 105-point decline the Dow had etched out by midday Tuesday. The sizable drop is closely related to the nature of the index; the Dow is a price-weighted index, meaning that the greater the price of a particular stock, the greater the effect that component can have on the index. In comparison, the S&P 500 is weighted by its components’ market capitalizations. Right now, IBM is the most expensive stock included in the index and so it holds the biggest weighting. In fact, it accounts for more than 10 percent of the index, according S&P Dow Jones Indices.

In general, Wall Street is not overly confident about IBM’s short-term prospects. According to Yahoo! Finance, about 14 of the 25 analysts that cover the company have hold ratings on the stock, which is a relatively high proportion. The number of strong buy recommendations have fallen in the past several months as well. If Garcha’s assessment is an accurate forecast, IBM will have to weather a few storms, meaning the high proportion of hold ratings may be justified.

The company’s last quarterly earnings report gave a similar warning. In mid-July, the company posted its fifth-straight quarterly drop in revenue, a result that highlighted the need for Chief Executive Virginia Rometty to find a new engine to jumpstart the technology company’s sales. It is still a main provider of computer hardware, software, and services to large multinational corporations and governments around the world, but the company is facing challenges from rivals that rent computing power and software over the Internet.

According Garcha, 34 percent of IBM’s gross profits are generated by its hardware and software products tied to older mainframe and Unix architectures.

For now, IBM trades at a premium to many of its peers. Garcha wrote in the client note that the company trades at 21.5 times 2013 free cash flow and 15.9 times expected 2014 free cash flow — levels that represent 59 percent and 35 percent premiums, respectively, to large-cap tech stocks like Hewlett-Packard (NYSE:HPQ) and Microsoft (NASDAQ:MSFT).

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