IBM Earnings: Revenues Miss Expectations Amidst Corporate Restructuring

International Business Machines (NYSE:IBM) posted its Q3 results on October 20. The company reported a marked slowdown in business due to weak client spending and an anemic demand in software sector. As a result, the company reported 4% year-over-year decline in revenues to $22.39 billion (excluding revenues from discontinued operations that include the x86 server business and Microelectronics), and 17% decline in net income to $3.5 billion. The market reacted negatively to the results and the stock price declined by 7% during the trading session on Monday. Even before the results were announced, sentiment surrounding the stock was negative after IBM said that it had at last achieved an agreement to transfer its loss-making semiconductor unit to Globalfoundries Inc.

For the quarter, the company witnessed wide decline in sales across its businesses.  While its core software business posted 1.6% decline in revenues to $5.70 billion, Global Technology Services (GTS) revenues declined by 2.9% year over year in constant currency to $9.21 billion. Furthermore, its Global Business Services (GBS) revenues declined by 2.2% to $4.49 billion, despite growth in new business initiatives (i.e.,  cloud, business analytics and big data). IBM’s system and technology division continued to disappoint and reported 15% year-over-year decline in revenues to $2.43 billion, due to product transitions and market disruptions.

See our full analysis on IBM

Business Restructuring To Affect Topline And Profitability

IBM’s system and technology division, which was once a strong cash generator for the company, has witnessed a steady decline that the company has been unable to properly confront. While this division contributed 25% to IBM’s total revenues in 2006, its contribution fell to just 14% in 2013. The company has also systematically divested its non-profitable units within the hardware business over the past few years, and realigned its workforce to reduce costs. Recently, the company closed the deal sell its x-86 server division as well to Lenovo for $2.1 billion. On Monday, the company announced that it was transferring its semiconductor unit to Globalfoundries, an alliance partner and the former chip manufacturing operations of AMD. Though framed as a sale, IBM is contributing a significant amount to the deal.  It is paying Globalfoundries $1.5 billion to take the unit over and transferring its large patent portfolio as well.  It has also established a 10-year supply agreement for Power and other devices with the foundry.  As a result of these divestitures, IBM’s revenues will  be lower by $7 billion, however, its margin profile will improve since these businesses posted pretax losses of about $500 million. The company is also recording a $4.7 billion charge on the deal.  Note that IBM’s Semiconductor business is a strategic asset for both the company and the US government.  IBM is a technology leader, supplies critical ASICs to government agency systems, and is engaged as the leading partner in state and other research consortia. The level of regulatory review will be very high and there could be opposition.

Growth Economies Disappoint

While revenues from the Americas’ were flat at $10.1 billion, the EMEA region (Europe/Middle East/Africa) reported a decline of 8% in revenues to $5 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 7% decline in revenues from BRIC countries — Brazil, Russia, India and China.

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 47% of our estimate. During the quarter, the software segment (middleware and operating systems combined) reported 2% year-over-year decline in revenues to $5.7 billion. While IBM’s flagship WebSphere software reported single-digit growth at 7%, Rational suite of software reported steep decline in revenues at 12%. 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 Q3, GTS revenues declined by 2% year over year to $9.2 billion. As part of a long-term strategy, IBM sold its customer care business process outsourcing (BPO) services business in Q4 2013 to focus on high margin verticals. ^[1] The divestiture of this business was completed in Q1 FY14 and continued to negatively impact GTS revenues in Q3. Furthermore, the company stated that it will roll out more cloud data center infrastructure  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 1% year-on-year decline in revenue to $4.5 billion, primarily due to declines in traditional packaged application implementation. Moreover, the company continues to be impacted by pricing pressure and client renegotiations, as well as a reduction in elective projects. However, double-digit growth in digital front office, which includes mobile (>100% growth), business analytics (8% growth) and cloud (80% 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 15% to $2.43 billion. While revenues from System-Z, Power Systems and System-X declined by 35%, 12% and 9% respectively, revenues from storage declined by 6%. 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; as a result, sales of system Z suffered by 35%. 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 midrange systems, and launched entry-level or scale-out POWER8 systems in June, which had a good start compared to the previous cycles. Finally, with the sale of the x86 businesses to Lenovo approved, IBM can move towards reorganizing this troubled business.  It remains a strategic, if very depleted, business to IBM’s integrated technology model and it is now even more dependent on outside parties for critical, even proprietary offerings.

We are in the process of updating our IBM model. At present, we have a $227 Trefis price estimate for IBM, which is about 35% higher than the current market price.

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