IBM Earnings: Sales Slump Yet Again As Shift To Cloud Continues

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IBM: International Business Machines logo
IBM
International Business Machines

International Business Machines (NYSE:IBM) posted its Q2 results on July 21st. The company reported a marginal 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. During the quarter, the company, on an adjusted basis, reported 1% a year-over-year decline in revenues to $20.8 billion, though reported revenues were down a hefty 13.5%. Furthermore, the gross margin declined by 20 basis points to 49.9% and net income from continuing operations declined by 17% from $4.3 billion to $3.5 billion in the second quarter of 2015. 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 and guided to a moderate increase in free cash flow. [1]

Due to its divestment efforts in hardware division and the launch of new Z systems, posted 5% year-over-year growth in systems hardware revenue to $2.1 billion. (All growth rates are  on a constant currency basis.)  Additionally, Global Technology Services (GTS) revenues grew by 1% year over year to $8.1 billion, due to improvement in outsourcing signings and new signings for integrated technology services in cloud, security and business resiliency services. However, its core software business posted 3% year over year decline in revenue to $5.8 billion, and Global Business Services (GBS) revenues declined by 3% to $4.3 billion. The company reported that its cloud business average revenue run rate grew to $8.7 billion in Q2 indicating that it continues to move towards this business through its strategic initiatives. [2]

See our full analysis on IBM

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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 3% year-over-year decline in revenues to $5.8 billion. Its key branded middleware segment, which makes up 42.4% of IBM’s estimated value, reported no growth in revenues. However, IBM’s Software-as-a-Service offerings, security solutions, commerce solutions and Watson software gained traction during the quarter, which helped in offsetting the decline in key branded middleware. The Operating System failed to report growth as the headwinds from divested x-86 business continued to impact revenue growth.

GTS Revenues Improve Marginally Due To Soft layer And New Initiatives

The Technology Services division (GTS) accounts for ~15% of IBM’s stock value according to our estimates. During Q2, GTS revenues grew by 1% year over year to $8.1 billion. During the quarter, GTS outsourcing reported growth, improving three points sequentially due to several large deals signed last year that are now completing transition. Furthermore, IBM reported traction for its traditional IT outsourcing that integrates mobility, hybrid cloud and analytics workloads. Integrated technology services also returned to growth this quarter, with improved performance in cloud, security and business resiliency services. The company also stated that it witnessed double digit growth in its Softlayer business that encompass outsourcing and the integrated technology service division. The company continues to see clients sign large infrastructure outsourcing deals with embedded cloud and mobile initiatives, creating large-scale hybrid IT environments. During the quarter, it signed 22 contract for its services division at $100 million and above and the order backlog stands close to $122 billion. [3]

New Business Initiatives Drive Growth at GBS

The Business Services division (GBS) contributes over 10.3% to IBM’s stock value, according to our estimates. In line with our expectation, GBS reported a 3% year-on-year decline in revenue to $4.3 billion, 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. The company stated that its customers are migrating away from large on-premise ERP projects toward smaller initiatives with cloud, mobility and analytics as main focus, which are contracted in within an X- as-a-service model. However, double-digit growth in digital front office, which includes business analytics (20% growth) and cloud-as-a-service (70% growth), offset the decline in packaged (on-site perpetual license) 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-as-a-service revenues achieved a $4.5 billion in annual run rate compared to $2.8 billion in Q2 2014.

Server and Storage Division Revenues And Profitability Improve

During the quarter, revenues for server and storage division grew by 5% to $2.1 billion and pretax income improved by 26% (adjusted for divestiture of the x86 business). The revenues for this division were boosted by increased MIPS (million instructions per second) for Z systems and sales of the new Z13 system that went on sale at the end of March. Z system revenues grew by 15% (in constant currency). 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.

Additionally, IBM’s power system, which is focused on high-end Unix and Linux computing, gained traction with clients and revenues improved by 5%. IBM has repositioned it as a systems business with an open Power consortium. IBM was able to increase its share in the declining mid-range server market. The company is looking to regain its lost market share in midrange systems through the POWER8 system, and expanding its customer base in the entry-level Linux systems as well as with large cloud-based players. POWER8 also fills the void left from X86 business as the Power platform provides both higher capacity and better performance than the x86. 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 $199 Trefis price estimate for IBM, which is about 19% higher than the current market price.

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Notes:
  1. 8-K []
  2. IBM Second Quarter 2015 Results, www.ibm.com, 20th July 2015 []
  3. Earnings transcript, www.seekingalpha.com []