IBM Earnings Preview: Revenues To Decline As Business Environment Remains Challenging

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IBM: International Business Machines logo
IBM
International Business Machines

International Business Machines (NYSE:IBM) is set to announce its Q1 earnings on Monday, April 20th. In the fourth quarter of 2014, the company reported 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% year-over-year decline in revenues to $24.1 billion and 13% non-GAAP net income to $5.8 billion. Considering the challenging business environment, we expect that revenues across different divisions will continue to decline in Q1.  However, we are closely monitoring the new signings in the services business as this will help us ascertain the order backlog outstanding for 2015. We expect its server and storage division to report another quarter of disappointing results, as the company works to fix this struggling business. Both of its key offerings (Power and mainframe systems) are on the cusp of major product transitions. Customers have deferred purchases in anticipation and we and other analysts are eager to see to what degree they upgrade and turn this business around.

See our full analysis on IBM

Software Division

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The software division is the biggest contributors to IBM’s stock value. Branded middleware, other middleware and OS divisions together make up nearly 62% of our estimated valuation. Branded middleware reported decline on the back of  transition to 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. Both the other divisions (unbranded middleware and OS) also failed to report growth as the product cycles of the associated hardware platforms (Power and Z systems) have yet to gain momentum with new upgrades.

However, demand for enterprise software is on a rebound, which should boost demand for branded middleware software. According to Gartner, IBM is a leader in application infrastructure and middleware software with 30% market share, nearly double that of its closest competitor, Oracle. [1]   Gartner also notes that IBM leads in eight out of the 11 application infrastructure and middleware markets, and this makes it the undisputed leader for middleware software. [2] Many of its solutions such as WebSphere, Rational Suite, Tivoli cater to the growing markets that include mobile, social, cloud storage and security tools. We expect that the company will continue to post robust revenue growth in the future as its clients continue to favor IBM solutions for their middleware and application development needs. Therefore, we expect the branded middleware division to post growth in Q1 as well as in the near future. In operating system domain, however, duress likely continued through the first quarter, due to the fact that Linux continues to be favored over IBM’s AIX for midrange and high-end implementations.  That said, with recent  refreshes both the Power line and the mainframe line as well, we expect revenues to stabilize, which should help the company to shore up growth. (See be,ow.)  Therefore, we are closely monitoring the growth in new licenses for operating system as it will help us to ascertain the demand for its servers in today’s market in greater detail.

Revenues From GTS To Remain Tepid

According to our estimates, the global technology service division makes up 17% of IBM’s stock value. Revenues from this division have declined over the past few quarter as a result of contract restructuring and a decline in outsourcing backlog. Furthermore, discretionary IT spending from clients remains weak, which is negatively impacting outsourcing revenues. The decline was further accentuated by the sale of the customer care business in 2013, which had a significant contribution to backlog and revenues.  However, IBM is focusing on rolling 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 GTS outsourcing (9% of estimated value) and integrated technology service (4.8% of estimated value) division. In the past few quarters, IBM’s cloud initiative reported growth of over 70% and is the primary reason for IBM’s revenues stabilizing in its technology and global business services division. IBM projects that cloud services will generate $7 billion in revenue this year, but we estimate that the top line will be meaningfully higher due to the acquisitions and initiatives that IBM has undertaken in the past few years. We expect that most of the gains in GTS will come from growing cloud services. Since cloud revenues are from subscription services, this shift has led to decline in revenues over the past few quarters. We expect this trend to have continued in the first quarter, and the company to post another quarter of declining revenues. However, contract restructuring will help the division to post higher profit margins in Q1.

GBS Revenues To Post Another Quarter Of Decline

The global business services (GBS) division contributes over 10.6% to IBM’s stock value according to our estimates. In Q4 2014, GBS reported a 8% year-over-year decline in revenue to $4.3 billion. The company was impacted by currency headwinds, pricing pressure and client renegotiations, as well as a reduction in elective projects. We expect this to continue in Q1 and revenue to be lower. However, its strategic initiatives in Business Analytics (8% growth) and Cloud (>100% growth) have done well and we expect this trend to power GBS revenues in Q1.

Server Revenues Under The Scanner

The server and storage division, which was once the cash cow of the company, is witnessing a continuing decline in revenues. The company has systematically divested its non-profitable units within the hardware vertical over the past few years, and realigned its workforce to reduce costs. The company closed the sale of its x86 server business to Lenovo in Q4 2013. The x86 division caters to the blade and rack server market, which is facing intense competition from the white box (i.e., unbranded) and better-positioned server manufacturers. In 2014, IBM agreed to pay Globalfoundries $1.5 billion to take over the chip-manufacturing division. We believe that this should help the company to report bottom-line growth. Furthermore, the company has embarked upon a “workforce rebalancing” or job cuts to improve its profitability. Most of the company’s cost cutting measures are centered on the ailing system and technology business. We believe that IBM can stem further declines in this under-performing division, and margins for the company can improve significantly in Q1.

The remaining server businesses—including z-Systems mainframes, the Power systems, and its range of high-performance computing platforms—each face specific issues. During the quarter, mainframes were at the trailing end of the product cycle, and the company announced the launch of the new Z system server in January. 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 are confronting severe disruptions in the Unix server market. However, the company is looking to regain its lost market share in midrange systems through the POWER8 systems, its latest launch.  We believe that POWER8 should gain traction in coming quarters. In short, this challenged division is experiencing a range of issues, though the trends may well be on the cusp of more meaningful improvement in Q1 and beyond.

We currently have a $197 Trefis price estimate for IBM which is about 20% higher than the current market price.

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Notes:
  1. See Gartner’s Worldwide Application and Infrastructure market analysis here. []
  2. Report: IBM Named Market Share Leader in Application Infrastructure and Middleware Software for 13 Consecutive Years, April 1 2014, www.ibm.com []