IBM Earnings: Margins Improves Even As Revenues Decline

International Business Machines (NYSE:IBM) posted its Q1 results on April 20^th. The company continued to report a marked slowdown in business due to weak client spending, anemic demand in the software sector, divestitures of sizable businesses (the x-86 server, microelectronics and customer care divisions) and currency headwinds. As a result, the company reported 12% a year-over-year decline in revenues to $19.6 billion (flat if adjusted for currency effects and the impact of the divested businesses). However, improved profitability boosted its gross profit margins from continuing operations 80 basis points to 49.3%. As a result, diluted EPS from continuing operations grew by 9% to $2.91. 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 8% year over year decrease in revenue to $5.2 billion (down 2% in constant currency), Global Technology Services (GTS) revenues declined by 11% year over year to $7.9 billion (1% decline in constant currency). Furthermore, its Global Business Services (GBS) revenues declined by 13% to $4.3 billion (4% decline in constant currency), despite growth in new business initiatives (i.e. cloud, business analytics and big data). IBM’s system and technology division reported a 23% year-over-year decline in revenues to $1.7 billion, reflecting the recent divestitures of the x86-server  and semiconductor businesses.  On an adjusted basis, however, segment revenues grew 30%, reflecting a long awaited sales of its new z-Systems mainframe offering (up 130%).

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Software Revenues Decline

The software business, which includes the branded middleware divisions and other middleware together with operating systems division, is the biggest contributor to IBM stock value and makes up nearly 62% of our estimate. During the quarter, the software segment (middleware and operating systems combined) reported 2% year-over-year decline in revenues to $5.2 billion. Its branded middleware segment, which makes up 43% of IBM’s estimated value, grew by 1% year over year driven by growth in Software-as-a-Service offerings, which were up nearly 50%. 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.

GTS Revenues Decline Even As Softlayer Witnesses Double Digit Growth

The Technology Services division (GTS) accounts for ~17% of IBM’s stock value according to our estimates. During Q1, GTS revenues declined by 11% year over year to $7.9 billion (1% decline 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 Q1. Many of the larger contracts signed last year did not contribute to revenue in the first quarter and accentuating the decline in GTS’s revenues. However, the company continues to see clients sign large infrastructure outsourcing deals with embedded cloud and mobile initiatives, creating large-scale hybrid IT environments. The company also stated that it witnessed double digit growth in its Softlayer business that encompass strategic outsourcing (9% of estimated value) and integrated technology service (3.9% of estimated value) division. In the first quarter, IBM opened cloud centers in Montreal, Sydney and Amsterdam.

New Business Initiatives Drive Growth at GBS

The Business Services division (GBS) contributes over 10.6% to IBM’s stock value according to our estimates. In line with our expectation, GBS reported a 13% year-on-year decline in revenue to $4.3 billion (down 4% in constant currency), primarily due to declines in traditional packaged application implementation, especially from the U.S. that contributes most to GBS revenues. 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 business analytics (20% growth) and cloud (75% 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 quarter, IBM reported that cloud delivered (as a service) $3.8 billion in annual run rate.

Server and Storage Division Revenues Declines Yet Again

During the quarter, revenues for server and storage division declined by 23% to $1.7 billion (up 30% in constant currency). The revenues for this division were boosted by increased MIPS (million instruction per second) for Z system and sale of Z13 system that went on sale at the end of March. As a result, Z system revenues grew by 130%. With Z13, 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. During the quarter, IBM was able to increase its share in the declining Unix server market and also expanded to Linux server market. The company is looking to regain its lost market share in midrange systems through the POWER8 systems, and expanding its customer base in the entry-level Linux systems as well as with large cloud-based players. With good adoption in z13 and Power systems, and launch of the remaining P8 based systems later this quarter, we expect IBM to post good growth in the coming quarters.

We are in the process of updating our IBM model. At present, we have a $197 Trefis price estimate for IBM, which is about 19% higher than the current market price.

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