IBM Earnings Preview: Revenues To Decline As Shift To Cloud Continues

International Business Machines (NYSE:IBM) is set to announce its Q4 earnings on Tuesday, Janaury 19th. ^[1] For Q3, the company reported a marginal decline in revenues after adjusting for currency effects and the sale of the x86 server business. We expect that the company will continue to post marginal declines in its topline as the shift to cloud services persists and business conditions remain tepid. However, this shift to the cloud will help the company to post an company-wide improvement in margins.

Current trends indicate that its software division is transitioning to cloud services and GBS demand remains weak due to declines in traditional packaged application implementations. This should temper the overall topline growth for these businesses. However, we expect the  server division to report growth as demand for enterprise servers has improved, as its Power and Z systems product lines continue to benefit from recent major system upgrades. Furthermore, GTS revenues will improve on the back of new signings for Softlayer and outsourcing services including implementation of IaaS.

See our full analysis on IBM

Shift To SaaS Model To Impact Software Division Revenues

The software division is the biggest contributors to IBM’s stock value. Comprising branded middleware, other middleware and OS software, these divisions together make up nearly 58% of our estimated valuation. Over the past few quarters, the company has posted declines in branded middleware revenues as the transition to Software as a Service (SaaS) model continues.  This spreads subscription fees over the period of usage, versus the traditional license model. It also reflects business model changes, which impacted transaction revenue growth as its customers continue to deploy software through enterprise licensing agreements. However, since many of its software solutions such as WebSphere, Rational, 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, as more users subscribe to IBM’s middleware SaaS services, we expect that the number of subscriptions sold to increase, which should impact revenue growth in the short-term.

Both the other divisions (unbranded middleware and Operating Sysytems) also failed to report growth revenues 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 should help the company to offset the decline in revenues for the OS division.

GTS Revenues To Improve on The Back Of Outstanding Orderbook. Softlayer Integration And Demand For IaaS

The Technology Services division (GTS) accounts for ~16% of IBM’s stock value according to our estimates. Large deal signings continue to buoy revenue growth for the company.  IBM’s clients are signings large infrastructure outsourcing deals with embedded cloud and mobile initiatives, to create large-scale hybrid IT environments. We expect that GTS revenues will continue to report growth in Q4. 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. Furthermore, since cloud based subscription model for IaaS has higher profit margins, we expect the company to post marked improvement in profitability in Q4.

GBS Revenues To Remain Tepid

The global business services (GBS) division contributes over 11.5% to IBM’s stock value according to our estimates. In Q3 2015, GBS reported a 5% year-over-year decline in revenue to $4.2 billion. ^[2] 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 Q4 as well and reported revenue is likely to be lower. However, its strategic initiatives in Business Analytics (16% growth) and Cloud (>65% growth) have done well and offset the decline in packaged (on-site perpetual license) implementations to some extent. We expect this trend powered GBS revenues in Q4.

Server Revenues To Improve

The server and storage division was once the cash cow of the company.  However, it experienced a decline in revenues as white box (unbranded) servers cannibalized sales and profitability in the lower tier (x86) of the market. In response, IBM has systematically divested its weaker businesses (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 server computing market that can run over 100,000 millions of instructions per second (MIPS). It launched its mainframe offering (the  Z13) at the end of January 2015.  ((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. Furthermore, IBM is embracing open source licensing to sell more of its servers. It launched Linux 1 family of products which embraces open source based technologies that are the industry’s most powerful and secure enterprise servers designed for the Hybrid Cloud environment.  We believe that these launches have helped the company to boost the shipment and revenues from its Z system line of servers in Q4.

The Power Systems business is focused on high-end Unix and Linux computing. IBM has repositioned it as a systems business with the 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 systems to ascertain whether it has gained traction  with IBM enterprise clients.

At present, we have a $154 Trefis price estimate for IBM, which is about 18% higher than the current market price.

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1. Q4 Earnings Release Announcement, www.ibm.com [↩]
2. 10-Q [↩]