IBM Corporation To Spin-Off Managed Infrastructure Services Unit By End Of 2021

Deal Overview

On October 8, 2020, IBM IBM (NYSE: IBM, $117.37, Market Capitalization: $104.5 billion) announced its plan to spin-off its Managed Infrastructure Services (MIS) business which is part of Global Technology Services (GTS) division into a new publicly traded company (“NewCo”). Post spin-off, IBM will focus on its open hybrid cloud platform and Artificial Intelligence (AI) capabilities and accelerate clients’ digital transformation journey. The stub unit will comprise of Cloud and Cognitive Software, Global Business Services, Systems and Global Financing segments. On the other hand, the spun-off unit will focus on managing and modernizing client owned infrastructures and will comprise of Managed Infrastructure Services business of Global Technology Services segment.

The transaction is subject to customary closing conditions, including Form 10 registration with the U.S. SEC, receipt of a tax opinion from counsel, and final approval by IBM’s Board of Directors. The separation will come into effect through a pro-rata spin-off to IBM shareholders. The transaction is expected to be tax-free for the company and its shareholders and is estimated to complete by the end of 2021. However, there are no further details including name of NewCo, timing of public filing of Form 10, spin-off ratio and other transaction related consideration is available as of now.

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Post separation, expected quarterly dividend paid by both the entities combined will not be lower than IBM’s pre-spin dividend per share. Later, when separation is completed, respective Board of Directors will determine the dividend policy for each company. The expected one-time transaction charges (cash charges of ~$1.5 billion and non-cash charges of ~$1 billion) will include tax charges, operational separation activities and other customary items.

J.P. Morgan Securities LLC and Lazard will serve as financial advisors for the transaction. Paul, Weiss, Rifkind, Wharton & Garrison LLP will be the legal advisor for the transaction.

The NewCo is expected to be a leading MIS provider (equipped with end-to- end capabilities) with more than 4,600 technology intensive, highly regulated clients in ~115 countries. As of June 30, 2020, the NewCo had services backlog of ~$60 billion and more than double the scale of its closest peer. The spin entity will focus on designing, operating, maintaining and modernizing client-owned infrastructures, a $500 billion market opportunity. The company will offer its expertise in hosting and network services, services management, infrastructure modernization, and migrating and managing multi-cloud environments (TTM Jun 2020 revenue: $19.0 billion).

The stub unit will focus on $1.0 trillion market opportunity including Cloud Transformational Services ($300 billion), Cloud Services and Platforms ($450 billion) and Cloud Infrastructure ($230 billion). Management plans to increase investments in hybrid cloud and AI while deleveraging and maintaining ‘single A’ credit rating for IBM. For ‘NewCo’ it will aim for an investment-grade rating.

Acquisition of Red Hat RHT

In July 2019, IBM completed acquisition of Red Hat, a leading provider of enterprise open source software solutions. The acquisition positioned IBM as the leading hybrid cloud provider and helped in accelerating its high value business model.

Deal Rationale

IBM has some legacy businesses, which are shrinking and low-margin in nature; however, the company’s strategy under new CEO Arvind Krishna with respect to these units has been changing. In April 2020, Mr. Krishna stated his intention to restructure IBM’s portfolio around two focus growth areas of hybrid cloud and AI. He hoped to generate value for shareholders by continuing to divest software and services businesses not aligned with the focus areas. We view the spin-off of the Managed Infrastructure Services unit as a concrete step in that direction.

Post spin-off completion, management expects to create two independent market leading companies with individual strategies, focused on their respective operating and financial goals. IBM will be the leading hybrid cloud and AI company, while NewCo is expected to be the world’s leading MIS provider after the deal conclusion. Management expects both the companies to deliver improved growth, possess financial flexibility, engage in partnerships or investments and capture new opportunities.

We believe that both the units represent a diverse growth and margin profile, which is one of the primary reasons for the separation decision. In FY2019, YoY revenue growth and gross margin for Cloud and Cognitive software segment was 4.5% and 76.7%, respectively. In contrast, FY19 top-line declined by 6.8% and gross margin was 34.8% for the GTS segment (the MIS unit to be spun-off is part of this segment). The separation, which seems to be the logical next step to us in IBM’s multi-year transformation strategy, can help uncover underlying growth from the previously acquired software company, Red Hat. The more compact integration of hybrid cloud and AI solutions should lead to high-value cloud and software comprising a majority of the solutions mix, driving higher margins. Post separation, IBM expects to generate sustainable mid-single digit revenue growth over the medium-term. In contrast, the infrastructure services unit has been struggling as clients have been shutting their corporate data centers in favor of co-location facilities or cloud platforms. The planned separation could help NewCo partner with a larger base of cloud vendors and expand revenue base.

Despite being in business for much longer than major cloud peers (Amazon AMZN , Microsof MSFT t and Alphabet), IBM has lagged in terms of financial and stock performance over the years. IBM’s valuation gap with these peers can probably be traced to its persistently low/negative growth and weaker margins, underpinned by its underperforming units. While the rivals focused on the booming cloud market, IBM tried to hold on to its lead in mainframe computing and IT services markets, leading to lackluster growth. Given these factors and IBM management’s focus on creating value under the new management, we believe the spin-off of underperforming units is a step in the right direction and positions the company well for a re-rating going forward.

IBM is involved in providing technological software and services to its clients located across the globe. Through its technological innovation, integrated solutions and platforms, it provides services, software, financing and fundamental research to its clients. Changing industry and economic environment has compelled IBM to operate in a dynamic business model and adapting to the client’s needs. Owing to the everchanging environment the company operates through five business segments namely Cloud & Cognitive Software, Global Business Services (GBS), Global Technological Services (GTS), Systems and Global Financing and others.

Cloud & Cognitive Software

It brings together IBM’s software platforms and solutions, that helps deliver integrated and secure cloud, data and Artificial Intelligence (AI) solutions to its clients. It further comprises of three business areas – (1) Cognitive Applications: It offers applications in areas such as Internet of Things (IoT) solutions, weather, and security software (2) Cloud & Data Platforms: It includes data platforms software like Red Hat with hybrid multi-cloud environment, Cloud Parks, analytics platform software (3) Transaction Processing Platforms: This is involved in mission critical workloads in Industries such as banking, airline and retail.

Global Business Services (GBS)

It assists client with consulting, business process and application management services. GBS serves as a digital reinvention partner for IBM clients, thus combining industry knowledge, expertise, and applications along with power of business design and cognitive and cloud technologies. It is capable of consulting, Application management and Global Process Services.

Global Technological Services (GTS)

It provides IT infrastructure and platform services to clients through which they gain access to leading-edge, high-quality services, that help them realize greater flexibility and economic value. It operates through (1) Infrastructure & Cloud Services that provides client with a portfolio of project, managed, outsourcing and cloud-delivered services that are focused with client’s IT infrastructure. (2) Technology Support Services integrate IBM Cloud, cognitive computing and multi-cloud management to deliver high performance and innovation for client.

Systems

Systems provides innovative infrastructure platforms to help clients meet their new requirements such as hybrid multi-cloud and enterprise AI workloads. It is also engaged in designing advanced semiconductor and systems technology in collaboration with IBM Research, primarily for use in our systems. It has capabilities of providing Systems Hardware, Servers, Storage Systems and Operating Systems Software.

Global Financing and others

It operates through IBM Credit LLC that accesses the capital markets directly and through its financing solutions, facilitates IBM clients’ acquisition of IT systems software and services. It also conducts client’s credit evaluation of prior to extending financing. It operates through Client Financing, Commercial Financing and Remanufacturing and Remarketing.

FY19 results

For FY19, total Revenue decreased 3.1% YOY (-1.0% in constant currency (cc)) to $77.1 billion (+0.1% vs. consensus), primarily driven by decline in Global Technology Services (-6.1%) (cc: -3.7%), Systems (-5.3%) (cc: -4.1%), Global Financing (-11.9%) (cc: -10.0%) and Other (-53.0%) (cc: -51.7%). The fall in revenue was partially offset by increase in Cloud & Cognitive Software (+4.5%) (cc: +6.2%) and Global Business Services (+0.2%) (cc: +2.4%). Non-GAAP Gross Profit fell marginally by 0.7% to $37.0 billion, while corresponding margin expanded ~113 bps to 48.0%. Non-GAAP total expenses and other income rose by 4.1% to $24.5 billion. Non-GAAP Pre-tax income from continuing operations declined by 9% to $12.5 billion (-0.4% vs. consensus) and corresponding margin contracted ~106 bps to 16.2%. Non-GAAP Net Income declined 9.6% to $11.4 billion (+0.1% vs. consensus) and corresponding margin contracted ~108 bps to 14.8%. Non-GAAP Diluted EPS came at $12.81 (FY18: $13.81).

9M20 results

For 9M20, total Revenue declined 3.8% YOY to $53.3 billion, primarily driven by fall in Global Business Services (-4.2%), Global Technology Services (-5.7%), Systems (-1.9%), Global Financing (-23.9%) and Other (-84.5%). The fall in revenue was partially offset by increase in Cloud & Cognitive Software (+5.1%). Non-GAAP Gross Profit decreased marginally by 0.5% to $25.6 billion, while corresponding margin expanded ~159 bps to 48.1%. Non-GAAP total expenses and other income increased by 11.6% to $20.0 billion.

Non-GAAP Pre-tax income from continuing operations fell by 28.5% to $5.6 billion and corresponding margin contracted ~361 bps to 10.5%. Non GAAP Net Income was down 18.2% to $5.9 billion and corresponding margin contracted ~195 bps to 11.1%. Non-GAAP Diluted EPS came at $6.60 (9M19: $8.10).

Outlook

IBM has not provided outlook on company’s financials due to uncertainty related to COVID-19.

Company Description

IBM Corporation (Parent)

Incorporated in New York in 1911, International Business Machine (IBM) Corporation is a technological giant involved in providing software solutions and technological solutions to its customers. The company offers an industry-leading portfolio of consulting in IT services, cloud, digital and cognitive offerings to customers across the globe. IBM offers its services through its five segments namely Cloud & Cognitive Software (~30% of 2019 revenue), Global Business Services (GBS) (~22%), Global Technological Services (GTS) (~35%), Systems (~10%) and Global Financing and others (~3%).

Managed Infrastructure Services – Global Technology Services (Spin-Off Entity)

The spin-off entity Managed Infrastructure Services is part of Global Technology Services (GTS), currently referred to as NewCo. The NewCo provides infrastructure and platform for IT related services to clients resulting in giving its client leading-edge and thus realize enhanced flexibility and economic value. The company provides client with a portfolio of project, managed, outsourcing and cloud-delivered services that are focused with client’s IT infrastructure. The Technology services integrate IBM Cloud, cognitive computing and multi-cloud management to deliver high performance and innovation for client. NewCo caters to more than 4,600 clients (75% of Fortune 100 companies) in 115 countries and has a backlog of ~$60 billion.

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