IBM Earnings: Revenues And 2015 Guidance Disappoints As Restructuring Continues

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IBM: International Business Machines logo
IBM
International Business Machines

International Business Machines (NYSE:IBM) posted its Q4 results on January 20th. The company continued to report a marked slowdown in business due to weak client spending, anemic demand in the software sector and divestitures of sizable businesses (the x-86 server, microelectronics and customer care divisions). As a result, the company reported 12% a year-over-year decline in revenues to $24.1 billion (down 2 percent, adjusting for currency effects and the impact of the divested businesses), and 13% decline in non-GAAP net income to $5.8 billion. Furthermore, the guidance given by the company for FY2015 indicates that revenues will continue to be under pressure, albeit with higher profitability in the absence of divested businesses. IBM expects Operating EPS to be in $15.75 – $16.50 range in 2015.

While its core software business posted 7% year over year decrease in revenue  to $7.6 billion (down 3%  in constant currency), Global Technology Services (GTS) revenues declined by 8% year over year to $9.2 billion (2% growth in constant currency). Furthermore, its Global Business Services (GBS) revenues declined by 8% to $4.3 billion (3% decline in constant currency), 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 39% year-over-year decline in revenues to $2.4 billion (down 12% in constant currency), primarily due to product transitions and market disruptions.

See our full analysis on IBM

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Business Restructuring Affects 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. 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. The company also announced that it was transferring its semiconductor manufacturing operations to Globalfoundries, an alliance partner, an alliance partner that will henceforth act as a foundry.  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 related patents as well. It has also established a 10-year supply agreement for Power and other devices with the foundry. As a result of all three divestitures, IBM’s revenues were negatively impacted by $7 billion for FY14, however, its margin profile improved since these businesses posted pretax losses of about $500 million. The company reported that its GAAP operating margins improved by 1% to 53% in Q4 due to this restructuring.

Software Revenues Decline

The software business, which includes the middleware divisions together with operating systems division, is the biggest contributor to IBM stock value and makes up nearly 63% of our estimate. During the quarter, the software segment (middleware and operating systems combined) reported 7% year-over-year decline in revenues to $7.6 billion (down 3% in constant currency).

Its branded middleware segment, which makes up 43% of IBM’s estimated value, declined by 6% year over year (3% in constant currency) as its flagship software offerings (i.e., WebSphere, Information Management and Workforce solutions) witnessed declines. This decrease indicates that the company is focused on Software as a Service (SaaS) model, which spreads subscription fees over the period of usage, for its middleware software division. It also reflects business model changes, which impacted transaction revenue growth as its customers continue to deploy software through enterprise licensing agreements. The Operating System also failed to report growth as the product cycles of the associated hardware platforms (Power and Z systems) have yet to gain momentum.  We expect the demand for its Power and Z systems will grow as both are on the cusp of major product upgrades picks up that (we suspect) are eagerly awaited. Thus,  we expect revenues for operating system division will grow.

Cloud Data Rollout to Positively Impact GTS Revenues in Future

The Technology Services division (GTS) accounts for 15.6% of IBM’s stock value according to our estimates. During Q4, GTS revenues declined by 8% year over year to $9.2 billion (actually up 2% in constant currency). As part of a long-term strategy, IBM sold its customer care business process outsourcing (BPO) services business in Q4 2013 to focus on higher margin verticals. [1] The divestiture of this business was completed in Q1 FY14 and continued to negatively impact GTS revenues in Q4. 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 (9% of estimated value) and integrated technology service (3.9% of estimated value) division. In the fourth quarter, IBM opened cloud centers in Melbourne, Paris, Mexico City, Tokyo, and Frankfurt.

New Business Initiatives Drive Growth at GBS

The Business Services division (GBS) contributes over 7.6% to IBM’s stock value according to our estimates. In line with our expectation, GBS reported a 8% year-on-year decline in revenue to $4.3 billion (down 3% in constant currency), 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 (on site perpetual licenses) implementations to some extent. As new verticals become a larger part of GBS, they’ll contribute more to the top line performance going forward. For the fiscal year 2014, IBM reported that cloud delivered (as a service) $3 billion in revenues, up approximately 75%. Year-end, the annual run rate of cloud services now exceeds $3.5 billion.

Server and Storage Division Revenues Declines Yet Again

Server and storage division is witnessing a continuing decline in revenues. During the quarter, revenues for this division declined by 39% to $2.4 billion (down 12% in constant currency). While revenues from System-Z and Power Systems declined by 26% (23% in constant currency) and 13% (11% in constant currency), respectively, revenues from storage declined by 8%(5% in constant currency).

The hardware business has been under pressure for a number of quarters. The System-Z mainframe business was in the last quarters of a product cycle; as a result, sales of system Z have suffered as customers wait out the new release. However, last week the company has launched Z13 system with an investment outlay of over a billion dollars. With this generation of mainframe, the company has dramatically enhanced the capabilities around analytics, mobile, security and cloud to address the needs its clients.  Therefore, we expect that the shipment and revenues from Z system will improve in the future and boost overall revenues for server divisions.

Power Systems business is focused on high-end Unix and Linux computing. IBM has repositioned it as a systems business with an open Power consortium. The company is looking to regain its lost market share in midrange systems through the POWER8 systems, its latest launch. Early adopters thus far are positive on the emerging platform, but the business may well have changed in fundamental ways.

We are in the process of updating our IBM model. At present, we have a $204 Trefis price estimate for IBM, which is about 30% higher than the current market price.

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