IBM’s Revenues Decline Marginally Amidst Shift To Cloud

International Business Machines (NYSE:IBM) posted its Q3 results on October 19^th.  During the quarter, the company, on an adjusted basis, reported revenues were down a hefty 14% year over year as reported to $19.3 billion, though adjusting for currency effects and the sale of the x86 server business, the decrease was a  mere 1%.   Net income from continuing operations declined by 14% to $3 billion in the third quarter of 2015. However, the gross margin improved by 80 basis points to 50%. 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 now expects operating EPS to be in $14.75 – $15.75 range in 2015 and guided no increase in free cash flow. ^[1]

Based on the new guidance and reported segment results, we have revised our price estimate to $154, which is 5% above the current market price. In this note, we review IBM’s result.

See our full analysis on IBM

Segment Revenue Overview

Software Revenues Decline

The software business, which includes the branded middleware divisions and other middleware together with the operating systems division, is the biggest contributor to IBM stock value and makes up nearly 58% of our estimate. During the quarter and on a constant currency basis, the software segment (middleware and operating systems combined) reported a 3%  year-over-year decline in revenues to $5.13 billion. ^[1] Its key branded middleware segment, which makes up 40.2% of IBM’s estimated value, reported 1% decline in revenues. The primary reason for decline was shift to IBM’s Software-as-a-Service offerings. However growth in 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 segment reported a decline of over 7% as headwinds from divested x-86 business continued to impact revenue. Based on this result (and H12015 revenue numbers), and company’s guidance, we now estimate that perpetual license renewal rate for branded middleware software and other middleware will decline as clients opt for cloud services. We estimate renewal rate to decline to 86% for both branded and other middleware software. This impacted stock price estimate by less than 5%. Furthermore, headwinds from divested x86 vertical is impacting Operating system revenue, which is reflected in lower renewal rate and maintenance revenues. This has impacted the stock price estimate by a negligible $1.50.

 GTS Revenues Improve Marginally Due To Softlayer And New Initiatives

The Technology Services division (GTS) accounts for ~15.9% of IBM’s stock value according to our estimates. During Q3, GTS revenues grew by 1% year over year to $7.9 billion. ^[1] During the quarter, GTS integrated technology services reported growth, improving 400 basis points year over year due to several large deals signed over the past six months. Furthermore, Integrated technology services also returned to growth this quarter, with improved performance in cloud, security and business resiliency services. IBM also reported traction for its traditional IT outsourcing that integrates mobility, hybrid cloud and analytics workloads. It also stated that it witnessed double digit growth in its Softlayer business that encompasses 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. The order backlog stands close to $122 billion. ^[2]

New Business Initiatives Drive Growth at GBS Amidst Declining Revenue

The Business Services division (GBS) contributes over 11.5% to IBM’s stock value, according to our estimates. In line with our expectation, GBS reported a 5% year-on-year decline in revenue to $4.2 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. Consulting and system integration business has suffered the most. However, double-digit growth in digital front office, which includes business analytics (19% growth) and cloud-as-a-service (65% 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 $3.1 billion in Q3 2015. Based on the earnings announcement, we have reduced the revenue generated from consulting and system integration, and GBS outsourcing  this year. This lowered our price estimate by a negligible $2.50.

Server and Storage Division Revenues And Profitability Improve

Server and storage division, due to lower profitability, makes up 2.2% of our estimated stock price. During the quarter, revenues for server and storage division declined by 2% to $1.5 billion. While 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, storage revenues declined by over 14%. Z system revenues grew by 20% (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 2%. IBM has repositioned it as a systems business with an open Power consortium. IBM was able to increase its share in the entry level and high-end 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. 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. This result confirms the progress IBM has made in the first three quarters and its profit is up $600 million compared to the first three quarters of last year.

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2. Earnings transcript, www.seekingalpha.com [↩]