International Business Machines (NYSE:IBM) posted its Q2 results on July 18th. Revenues declined by 3% y-o-y to $24.9 billion. The company reported GAAP EPS of $2.91 for Q2FY13, which was 13% down mainly due to $1 billion workforce rebalancing charges. Revenues from cloud computing and analytics initiative continued to see growth in Q2. Additionally, its core software business resumed growth in Q2 and posted mid-single digit gains, primarily due to 9% y-o-y growth in middleware revenues. However, its Global Technology Services (GTS) revenues declined by 5% y-o-y to $9.5 billion and Global Business Services (GBS) revenues declined by 1% y-o-y to $4.6 billion. Additionally, the Server and Storage division continued to disappoint and reported 12% y-o-y decline in revenues to $3.8 billion. However, IBM saw better margins for its core business divisions and raised its operating (non-GAAP) EPS guidance for FY13 by 20 cents to $16.90.
Work rebalancing Impacts Net Income
IBM embarked on a “workforce rebalancing” or job cuts during Q2. Most of the job cuts were in the ailing System and Technology group.  These rebalancing efforts will cost IBM $1 billion in severance and other charges this year. As a result, IBM reported a 12% y-o-y decline in net income to $3.6 billion. However, we expect that cost saving benefits from these restructuring efforts will materialize in the coming quarters.
Middleware Lifts Software Division Revenues
The Middleware division together with Operating Systems division is the biggest contributors to IBM stock value and makes up nearly 45% of our estimate. During the quarter, the Software division (Middleware and Operating Systems combined) reported 4% y-o-y growth in revenues to $6.4 billion. The primary reason for growth in the Software division was the 9% y-o-y growth in revenues from key branded Middleware division. IBM’s flagship WebSphere software reported 9% revenue growth and its Tivoli suite grew 13%. Additionally, IBM’s Rational Suite of software and Social Workforce solutions reported double digit growth at 12% and 22% respectively. These solutions cater to the growing markets that includes mobile, social and security.
The Middleware and Operating System divisions are the most important for our valuation, and these have the highest EBITDA margins at 47%. We expect IBM will continue to report revenue growth for this division as demand for software development and collaboration tools that cater to mobile and security domain remain high.
Restructuring Contract Boost Margins At GTS
The Technology Services division (GTS) near 25% to IBM’s stock value according to our estimates. In the past few quarter, IBM has been restructuring GTS’s low margin contracts to boost profitability. As a result, its gross profit margins improved by 150 basis points to 37.8%. However, restructuring outsourcing contracts negatively impacted GTS revenues as IBM chose not to sign low margin contracts in the past quarters. As a result GTS revenues declined by 5% y-o-y to $9.5 billion.
New Business Initiatives Stabilize GBS Revenue
The Business Services division (GBS) contributes over 11% to IBM’s stock value according to our estimates. GBS revenues stabilized in the quarter as its new initiatives in Business Analytics (11% growth), Smarter Planet (25% growth) and Cloud (70% growth) reported good growth. GBS reported a moderate 1% y-o-y decline in revenue to $4.6 billion. As new verticals become a larger part of GBS, they’ll contribute more to the top line performance going ahead.
Backlog To Bolster Services Revenues In Coming Quarters
IBM reported backlog growth for both its transactional and outsourcing businesses. Total backlog grew by 3% to $141 billion, up 7% in constant currency. The growth in its backlog indicates that IBM’s clients have signed new contracts or renewed old contracts with the company.
We expect the backlog to continue to improve that will add more stability and growth to its services revenues in the coming quarters. While we expect revenue from backlog to increase from $8.5 billion to $12.5 billion for GBS division, different verticals of GTS will also report growth in revenues from backlog.
System-Z Bolsters Ailing Server Division
While its System-Z reported 10% growth in revenues, Power Systems and System-x revenues continued to decline by 25% and 11% respectively. Last week, IBM announced an agreement to acquire CSL International, which expands System Z’s cloud capabilities. System-Z is an important driver for our revenue forecast of server division. We expect that adoption of System-Z will continue globally. Currently we project System-Z units shipped grow from around 22,000 in 2012 to 37,000 by the end of our forecast period.
We currently have a $234 Trefis price estimate for IBM which is about 20% higher than the current market price.Notes: