IBM Earnings Preview: Will Revenues Improve?

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IBM: International Business Machines logo
IBM
International Business Machines

International Business Machines (NYSE:IBM) is set to announce its Q3 earnings on Monday, October 19th. [1] In Q2, 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. We expect that the company will continue to post marginal decline in its topline as business conditions remain tepid. While its software division is transitioning to cloud services, GBS demand remains tepid due to declines in traditional packaged application implementation. This should temper the overall topline growth for this business. However, we expect its server division to report growth as demand for enterprise server improved, as its Power system and Z systems continue to benefit from recent major system upgrades. [2] Furthermore, GTS revenues will improve on the back of new signings for Softlayer and outsourcing services.

See our full analysis on IBM

Software Division Revenues To Decline As Shift To Cloud Continues

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The software division is the biggest contributors to IBM’s stock value. Comprising branded middleware, other middleware and OS divisions together make up nearly 58% of our estimated valuation. Over the past few quarters, the company has posted decline in branded middleware revenues as the transition to Software as a Service (SaaS) model continued that 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. We expect this trend to continue in Q3 and revenues to decline. However, as more users subscribe to IBM’s middleware SaaS services, we expect that the number of subscriptions sold to increase. Furthermore, since 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.

Both the other divisions (unbranded middleware and OS) also failed to report growth in H1 as transitioning to the associated hardware platforms (Power and Z systems) that support open source software tempered revenues. That said, the recent refreshes for both the Power line and the mainframe line (Z systems) have been well received in the industry and this would help the company to shore up growth for the OS division.

GTS Revenues To Improve on The Back Of Outstanding Orderbook And Softlayer Integration

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 as outsourcing reported growth due to several large deals signed last year. [3]  As the company continues to see clients sign large infrastructure outsourcing deals with embedded cloud and mobile initiatives, creating large-scale hybrid IT environments, we expect that GTS revenues will continue to report growth in Q3. Furthermore, Softlayer business, which encompasses outsourcing and the integrated technology service division, will continue to report double digit growth on the back of its strong product portfolio for outsourcing in the cloud domain. Since cloud revenues are from subscription services, this shift will impact topline growth in the shorter with significant upside in the coming years. However, since cloud based subscription model  has higher profit margins, we expect the company to post marked improvement in profitability in Q3.

GBS Revenues To Remain Tepid

The global business services (GBS) division contributes over 12.3% to IBM’s stock value according to our estimates. In Q2 2015, GBS reported a 3% year-over-year decline in revenue to $5.8 billion. [3] 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 Q3 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 Q3.

Server Revenues To Improve

The server and storage division, which was once the cash cow of the company, but witnessed decline in revenues as white box (unbranded server) cannibalized sales and profitability in the lower tier (X86) of the market. However, IBM has systematically divested its non-profitable units (x86 and Microelectronics Fabrication units) within the hardware vertical over the past few years, and realigned its workforce to reduce costs.

The company continues to focus on the high end of the computing market. It launched its mainframe offering (the  Z13) at the end of January.  ((IBM Launches z13 Mainframe — Most Powerful and Secure System Ever Built)) With Z13, the company has dramatically enhanced the capabilities around analytics, mobile, security and cloud to address the needs its clients.  This launch has done well and Z13 has been credited with most of the growth in non-x86 server vertical. [4]  We believe that this trend continued in Q3 and expect that the shipment and revenues from Z system improved.

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. OpenPower is widely recognized as a credible substitute to x86 architecture for hyperscale and cloud settings. 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. In this earnings announcement, we continue to monitor the shipment number and revenues for Power system to ascertain whether it has gained credence with IBM enterprise clients.

At present, we have a $168 Trefis price estimate for IBM, which is about 10% higher than the current market price.

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Notes:
  1. Q3 Earnings Release Announcement, www.ibm.com []
  2. Earnings Transcript Q2, www.seekingalpha.com []
  3. 10-Q [] []
  4. Worldwide Server Market Revenues Grow 6.1% in the Second Quarter Bolstered by Strong Demand in the US and Asia/Pacific, According to IDC, August 25 2015 []