IBM Earnings: Margins Improve Despite Fall In Revenues

International Business Machines (NYSE:IBM) posted its Q3 results on October 16^th. The company reported decline in revenues due to cross currency headwinds and decline in revenues from growth markets. While the revenues declined by 4% year-on-year to $23.7 billion, the company reported 6% growth in net income to $4 billion. Diluted GAAP EPS also rose by 11% to $3.68 during the quarter. Additionally, IBM reported better margins for its core business divisions as restructuring efforts started paying off.

Its core software business posted mid-single digit gains, primarily due to 4% y-o-y growth in branded middleware revenues. Furthermore, Global Business Services (GBS) revenues grew by 5% y-o-y in constant currency to $4.6 billion, buoyed by growth in its cloud computing and analytics initiatives. However, its Global Technology Services (GTS) revenues declined by 1% to $9.5 billion. Additionally, the server and storage division continued to disappoint and reported 16% y-o-y decline in revenues to $3.2 billion.

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Growth Economies Disappoint

While revenues from the Americas’ were flat at $10.3 billion, the EMEA region (Europe/Middle East/Africa) reported a moderate decline of 2% in revenues to $7.3 billion. However, the decline in total revenues was accentuated by the decline in revenues from growth markets, which declined by 5%. This decline was driven by a 12% decline in revenues from BRIC countries — Brazil, Russia, India and China. Additionally, IBM reported 22% decline in revenues from China, which accounts for a major chunk of revenues from BRIC nations. In its earnings announcement, the company stated that it has taken corrective steps to get the growth from emerging economies back on track. It expects revenues from growth economies to rise in 2014. ^[1]

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 55% of our estimate. During the quarter, the Software division (Middleware and Operating Systems combined) reported 2% y-o-y growth in revenues to $5.8 billion. This growth was below company’s expectation as cross currency headwinds and cyclicity of software business negatively impacted the division during the quarter.

However, key branded middleware reported good growth once again as revenues from this grew by 4%. IBM’s Rational Suite of software and Social Workforce solutions reported double digit growth at 14% and 15% respectively. Additionally, its flagship WebSphere software reported a modest 1% growth in revenues. Since these solutions cater to the growing markets that include mobile, social and security tools, we expect software division to post robust growth in the near future.

Low Margin Contract Restructuring Weighs On GTS

The Technology Services division (GTS) accounts for 23% of IBM’s stock value according to our estimates. As part of a long-term strategy, IBM sold its customer care business process outsourcing (BPO) services business to focus on high margin verticals. ^[2]

During Q3, GTS revenues declined by 1% y-o-y to $9.5 billion. In the past few quarter, IBM has been restructuring GTS’s low margin contracts to boost profitability. This strategy yielded results as its gross profit margins improved by 170 basis points to 39% during the quarter. However, restructuring outsourcing contracts negatively impacted GTS revenues as IBM chose not to sign low margin contracts.

New Business Initiatives Drive Growth At GBS

The Business Services division (GBS) contributes over 11% to IBM’s stock value according to our estimates. GBS reported a 5% y-o-y growth in revenue to $4.6 billion, buoyed by growth in Business Analytics (8% growth), Smarter Planet (20% growth) and Cloud (70% growth). Additionally, the company delivered over a $1 billion in cloud revenue during the quarter. As new verticals become a larger part of GBS, they’ll contribute more to the top line performance going ahead.

Outsourcing Backlog Suffers

While IBM continued to report a solid 2% growth in backlog to $141 billion, the new signings for the company declined by 4%. The primary reason for the decline in signings was soft demand for outsourcing, which witnessed 14% decline in new contracts. Additionally, backlog was also negatively impacted due to restructuring of low margin contracts.

Going ahead, we expect the backlog to improve due to rise in the number of long term high margin contracts. Additionally, we expect that long term contracts will add more stability to IBM’s 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.

Server & Storage Revenues Decline

During the quarter, server and storage division revenues declined by 16% to $3.2 billion. While its System-Z reported 7% growth in revenues, Power Systems and System-X revenues continued to decline by 37% and 16% respectively. The decline in these servers was in line with the decline in global server shipments. ^[3]

However, the demand for System-Z is on the rise as IBM’s clients continue to demand mainframes with high processing power and big data analytics capability. System-Z is an important driver for our revenue forecast of server division. We expect System-Z shipments to rise in the near future. 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 25% higher than the current market price.

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1. Earnings Transcript, October 16 2013, www.seekingalpha.com [↩]
2. See IBM’s BPO Business Sale Can Lift Profit Margins [↩]
3. Worldwide Server Market Revenues Decline -6.2% in Second Quarter as Market Demand Remains Weak, August 27 2013, www.idc.com [↩]