IBM Earnings Preview: Marginal Decline In Revenues As Shift To Cloud Services Gains Traction

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International Business Machines

IBM (NYSE:IBM) is set to report its Q3 2016 earnings on October 17th. (See IBM 3Q 2016 Earnings Announcement.) In Q2 2016, its revenues grew by 3% in constant currency or, as reported, by 2% to $20.20 billion.  More importantly, revenue from its Strategic Imperatives grew 12% growth to total $31 billion on a trailing-twelve-months basis.  Comprising 38% of the total, these imperatives include revenue generated from Analytics, the Cloud, Mobile Computing, Security and Social Media. However, its technology services & Cloud Platforms and Global Business Services (GBS) have reported weaker results over the past two quarters as the transition to cloud services is impacting implementation of traditional packaged applications. We expect this trend continued through Q3, even as the strategic initiatives continue to post growth. Additionally, for Q3 2016, we expect that the shift to cloud computing boosted its infrastructure services revenues. However, the server hardware business is expected to suffer as Z-system servers are in late stage of the product cycle, and the storage business will post decline due to the secular decline in the industry. Our take on the expected results is as follows:

See our full analysis on IBM

The Cognitive Solutions Segment To Witness A Decline As Shift To SaaS Gains Traction

The Cognitive Solutions segment maps onto the software division and is the biggest contributors to IBM’s stock value. The segment comprises branded middleware (Transaction Processing Software) and 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. Over the past few quarters, the company has posted declines in transaction processing software revenues, as the transition to the 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 negatively impacted transaction revenue growth as its customers continue to deploy software through enterprise licensing agreements. However, many of its software solutions such as WebSphere, Rational, and Tivoli cater to the growing markets that include mobile computing, social media, cloud storage and security tools.  Accordingly, we expect that the company will continue to post robust revenue growth through the adoption of SaaS 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 negatively perpetual license revenue growth in the short-term. However, as the transition to the subscription services gains traction, revenues should improve as the transition progresses.

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The company continues to witness robust growth for its Watson Solutions among its clients as big data analytics is fast gaining traction in various industries. We believe that this trend continued in Q3 and expect the company to report double-digit growth for its strategic imperatives for the quarter.

The Technology Services And Cloud Platforms Revenues To Improve on The Back Of Outstanding Orderbook

The Technology Services division  and cloud platform division maps onto Trefis’s GTS vertical and accounts for about 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 signing large infrastructure outsourcing deals with embedded cloud and mobile initiatives, to create large-scale hybrid IT environments (Hybrid Clouds). We expect that this division will continue to report growth in revenues for Q3. Furthermore, since the cloud-based subscription model for Infrastructure as a Service has higher profit margins, we expect the company to post a marked improvement in profitability for the quarter.

GBS Revenues To Remain Tepid

The global business services (GBS) division contributes over 13.6% to IBM’s stock value according to our estimates. In Q2 2016, GBS reported a 3% year-over-year decline in revenue to $4.2 billion.  The company was impacted by currency headwinds, pricing pressure and client renegotiations, as well as declines in traditional packaged application implementation. We expect that these trends continued in Q3 as well.  Thus, reported revenue is likely to be lower. However, its strategic initiatives in Business Analytics and the Cloud have done well and likely offset the decline in packaged (on-site perpetual license) implementations to some extent. We expect this trend will offset the decline in revenues in Q3 to some extent.

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 million instructions per second (MIPS). It launched its latest mainframe offering (the  Z13) at the end of January 2015.  ((IBM Launches z13 Mainframe — Most Powerful and Secure System Ever Built)) As a result, the Z system servers are at the end of their product cycle and this has impacted IBM’s server shipments and revenues in the last two-quarters. We expect this trend continued in Q3, such that there was likely a decline in server revenues.

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. It is expanding its customer base in the mid-level Linux systems as well as with large cloud-based players. However, the past results indicate that the Power systems have not fared well. 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 $139 Trefis price estimate for IBM, which is about 10% lower than the current market price.

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