IBM Earnings: Revenue Decline Continues Even As Shift To Cloud And Strategic Imperatives Gains Momentum

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IBM: International Business Machines logo
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International Business Machines

International Business Machines (NYSE:IBM) posted its Q3 results after market close on October 17th. In line with our expectation, the company reported a marginal slowdown in business as the  shift to cloud computing and  currency headwinds continued to plague the company. During the quarter, the company reported a 1% (on an adjusted basis) year-over-year decline in revenues to $19.22 billion. Furthermore, the consolidated gross margin declined by 200 basis points to 46.9% and net income from continuing operations declined by 3.65% from $2.96 billion in Q32015 to $2.85 billion in the third quarter of 2016.

During the quarter, IBM’s Cognitive Solutions and Technology Services and Cloud segments, buoyed by strategic imperative, continued to report growth, while its other segments (Global Business Services and Systems) reported declining revenue. The Systems segment revenue reported the most decline (21%) primarily as its main products, Z-System and POWER system platforms are in late the stages of the product cycle. [1] Below are the key takeaways from the earnings announcement.
See our full analysis on IBM

Strategic Imperatives And Cloud Services Boosts Revenues

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Over the past few year, IBM has been building its portfolio of services around strategic imperatives, which include analytics, cloud and mobile computing, security and social media. These services are spread across IBM’s verticals and have been the primary driver for revenue growth across divisions.

During Q3, IBM reported that its trailing twelve months revenue from its Strategic Imperatives was $32 billion, representing 40% of IBM’s revenues. For the quarter, Strategic Imperatives revenues grew by 15% year over year to $8 billion. Within the Strategic Imperatives, Analytics grew by 14% to $4.8 billion, Cloud revenue grew by 42% to $3.4 billion, mobile revenue grew by 19% to $1.2 billion and security revenue grew by 11% to $0.5 billion.  Notably, on an annualized basis, X-as-a-Service revenue grew 65% to $7.5 billion.

The growth in Strategic Imperatives revenue was driven by adoption by IBM’s customers of new Cognitive Solutions offerings and capabilities related to the Watson platform, in particular Watson Health and Watson IoT. Additionally, expanded partnerships to accelerate adoption of enterprise hybrid clouds played a vital role in growth of these services as well.

Cognitive Solutions Segment Revenues Grows

IBM’s Cognitive Solutions segment includes Solutions Software (roughly two-thirds of the business) and Transaction Processing Software (the remaining third). The segment includes many of the company’s strategic areas, including analytics, commerce and security, as well as several of the new initiatives around Watson, Watson Health, and Watson Internet of Things.

During the quarter, revenues for this division grew by 5% to $4.2 billion, driven by 11% growth in strategic imperative revenues. Furthermore, adoption of Watson solutions for analytics and expansion of Watson capabilities to various industries contributed to the growth in revenues.  Additionally, cloud revenue for cognitive solutions division grew by 75% to $0.60 billion. However, the company posted a decline in Transaction Processing Software revenue as the transition to the Software as a Service (SaaS) model continues. While Transaction Processing Software declined by 2%, Solutions Software improved by 8% as adoption through cloud continues.  In the future , we expect that the company will continue to post robust revenue growth through the adoption Strategic Imperatives solutions and cloud computing.

The Technology Services And Cloud Platforms Revenues

The Technology Services and Cloud Platform Segment maps onto Trefis’s GTS vertical and accounts for about 16% of IBM’s stock value, according to our estimates. During the quarter, continued momentum in hybrid cloud with growth in Infrastructure Services drove 1% growth in revenues to $8.74 billion. Furthermore, integrated technology services also reported growth this quarter, with improved performance in cloud, security and business resiliency services. The company continues to see clients sign large infrastructure outsourcing deals with embedded cloud and mobile initiatives, creating large-scale hybrid IT environments. As a result of these signings, infrastructure outsourcing revenue grew by 2% during the quarter.

Digital Practice Drive Growth at GBS

The Global Business Services division (GBS) contributes over 13.6% to IBM’s stock value according to our estimates. In line with our expectation, GBS reported a 2% year-on-year decline in revenue to $4.19 billion, primarily due to declines in traditional consulting and 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 reduction in elective projects as IBM’s clients continue to move away from on-premise enterprise application work to new business models focused on the cloud.

However, double-digit growth in digital front office, which includes business analytics and cloud-as-a-service (70% growth), offset the decline in packaged (on-site perpetual license) implementations to some extent. In fact digital practices now make up more than half of GBS revenues and were up double digits with strong growth in cloud analytics and mobile. 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 $0.8 billion in annual run rate (69% year over year growth in revenues to $0.8 billion), while Strategic Imperative revenues in the segment grew by 12% to $2.3 billion.

Revenues And Profitability Across Server and Storage Division Decline

During the quarter, revenues for server and storage division declined by 21% to $1.56 billion and pretax income declined by 45% to $136 million. The primary reason for this was the decline in shipments for the Z system servers, which are at the end of their product cycle, and 9% decline in storage hardware due to the ongoing shift in value towards software. Additionally, shipments and revenues for IBM’s power system was negatively impacted as transition from Unix based systems to Linux based system continues.

However, IBM has been shifting its POWER system platform to address Linux. As a result, despite the decline in overall POWER system revenues, Linux based POWER system revenue grew at a double digit rate and faster than the market. It now comprises over 15% of IBM’s POWER revenue. Additionally, IBM has re-positioned it as a systems business with the Open Power Consortium. This has led to adoption of Power system for implementation across hyperscale data centers. With the new launch of POWER midrange in high end systems for hybrid cloud computing, we expect that revenue for POWER systems will improve in the coming quarters.

We are in the process of updating our IBM model. At present, we have a $139 Trefis price estimate for IBM, which is about 19% higher than the current market price.

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Notes:
  1. IBM Third Quarter 2016 Results, www.ibm.com, 20th October 2016 []