IBM Earnings: Revenues Decline, Albeit at a Slower Pace

International Business Machines (NYSE:IBM) posted its Q2 results on July 17. The company reported a marginal decline in revenues due to cross currency headwinds and disinvestment of the  customer care outsourcing business. While the revenues declined by 2% year-on-year to $24.4 billion, net income rose by 28% to $4.1 billion. Diluted GAAP EPS also grew by 42% to $4.12 during the quarter, primarily due to no impact from workforce rebalancing that existed in the previous quarters.

Its core software business posted low-single-digit gains, primarily due to 3% year-on-year growth in middleware revenues. However, Global Business Services (GBS) revenues declined by 2% year over year in constant currency to $4.5 billion and Global Technology Services (GTS) revenues declined by 1% to $9.4 billion. IBM’s system and technology division continued to disappoint and reported 11% year-over-year decline in revenues to $3.3 billion, due to product transitions and market disruptions.

See our full analysis on IBM

Branded Middleware Boosts Middleware Revenues

The software business, which includes the middleware division together with operating systems division, is the biggest contributor to IBM stock value and makes up nearly 56% of our estimate. During the quarter, the software segment (middleware and operating systems combined) reported 1% year-over-year growth in revenues to $6.5 billion. The total middleware reported good growth once again, as revenues from this grew by 3%. IBM’s flagship WebSphere software reported single-digit growth at 5%. Furthermore, its Tivoli Suite of software reported modest growth at 3%. However, workforce solutions and Rational suite of software reported steep decline in revenues at 8% and 10% respectively. Nevertheless, 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.

Cloud Data Rollout to Positively Impact GTS Revenues in Future

The Technology Services division (GTS) accounts for 21% of IBM’s stock value according to our estimates. During Q2, GTS revenues declined by 1% year over year to $9.4 billion. As part of a long-term strategy, IBM sold its customer care business process outsourcing (BPO) services business in Q4 to focus on high margin verticals. ^[1] The divestiture of this business was completed in Q1 FY14 and negatively impact GTS revenues marginally. However, since the company has been restructuring the low margin contracts, its gross profit margins improved by 60 basis points to 38.4% in Q2 2014. Furthermore, the company stated that it will rollout more cloud data center in the coming quarter to expand its footprint of services, which should augur well for its Softlayer business that encompass strategic outsourcing (10% of estimated value) and integrated technology service (5% of estimated value) division.

New Business Initiatives Drive Growth at GBS

The Business Services division (GBS) contributes over 11% to IBM’s stock value according to our estimates. In line with our expectation, GBS reported a 2% year-on-year decline in revenue to $4.5 billion, primarily due to declines in traditional packaged application implementation. However, double-digit growth in digital front office, which includes mobile (100% growth), business analytics (7% growth) and cloud (50% growth), offset the decline in packaged implementation to some extent. As new verticals become a larger part of GBS, they’ll contribute more to the top line performance going ahead.

Server and Storage Division Revenues Declines, Albeit at a Slower Pace

Server and storage division, which was once the mainstay of the company, is witnessing a continuing decline in revenues. During the quarter, revenues for this division declined by 12% to $3.3 billion. While revenues from System-Z, Power Systems and System-X declined by 1%, 29% and 3% respectively, revenues from storage declined by 13%. The hardware business has been under pressure for a number of quarters. The System-Z mainframe business is in the latter quarters of a product cycle, though its market position remains strong. As a result, sales of system Z suffered mildly by 1%. However, the Power Systems business is focused on high-end Unix and Linux computing. The company is looking to regain its lost market share in Power system, and launched entry-level or scale-out POWER8 in June, which had a good start compared to the previous cycles. Finally, with the sale of the x 86 businesses to Lenovo pending, the performance of the Systems-X business has faltered. And with the sales of servers down so sharply, the storage business is under pressure as well. Management is right-sizing the remaining businesses and aligning its offering to customers demand profile. Once this restructuring is completed, the server and storage business will be smaller and more profitable.

We are in the process of updating our IBM model. At present, we have a $227 Trefis price estimate for IBM, which is about 18% higher than the current market price.

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1. See IBM’s BPO Business Sale Can Lift Profit Margins [↩]