IBM Q2 Earnings Preview: What We Are Watching?

International Business Machines (NYSE:IBM) is set to announce its Q2 earnings on Monday, July 20^th. In the first quarter of 2015, 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 a 12% year-over-year decline in revenues to $19.6 billion (flat if adjusted for currency effects and the impact of the divested businesses). Considering, the challenging business environment, we expect that revenues across different divisions continued to decline in Q2. We continue to closely monitor 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 server offerings (Power and mainframe systems) have undergone a refresh in 2015.

See our full analysis on IBM

Software Division

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. 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. Many of its solutions such as WebSphere, Rational Suite, and 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 Q2 as well as in the near future. However, as the Linux continues to be favored over IBM’s AIX for midrange and high-end implementations, the operating system division will continue to suffer. That said, with recent refreshes both the Power line and the mainframe line (Z systems) as well, we expect revenues to stabilize, which should help the company to shore up growth. 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 15% 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 (8.5% of estimated value) and integrated technology service (4.3% 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. 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 perceived decline in revenues over the past few quarters. We expect this trend to have continued in the second quarter, and the company is likely to post another quarter of tepid revenues. However, contract restructuring will help the division to post higher profit margins.

GBS Revenues To Post Another Quarter Of Decline

The global business services (GBS) division contributes over 10.3% to IBM’s stock value according to our estimates. In Q1 2015, GBS reported a 13% 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 declines in traditional packaged application implementation. We expect that this continued in Q2 as well and reported revenue is likely to be lower. However, its strategic initiatives in Business Analytics (20% growth) and Cloud (>75% growth) have done well and we expect this trend to power GBS revenues in Q2.

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 launched a major product refresh of its mainframe offering (the  Z13)at the end of March. As a result, Z system revenues grew by 130% in Q1 and total hardware revenues were up 30%. 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 improved in Q2 as well to boost overall revenues for server division. The 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, and expanding its customer base in the mid-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 report good growth in Q2.

We currently have a $199 Trefis price estimate for IBM which is about 18% higher than the current market price.

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