IBM Earnings Preview: Transition To Cloud And Strategic Imperatives To Impact Revenue Growth     

by Trefis Team
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IBM (NYSE:IBM) is set to report its Q4 2016 earnings on January 19th. (See IBM Q4 2016 Earnings Announcement.) In Q3 2016, 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 3.7% from $2.96 billion in Q32015 to $2.85 billion in the third quarter of 2016. More importantly, revenue from its Strategic Imperatives grew by 15% year over year to $8 billion. Comprising 40% of the total, these imperatives include revenue generated from analytics, the cloud, mobile computing, security and social media.

Despite the growth in new strategic imperatives, its technology services & Cloud Platforms and Global Business Services (GBS) segments have reported weaker results over the past three-quarters as the transition to cloud services is impacting implementation of traditional packaged applications. Additionally, the server hardware business should be pressured as revenues fall from Z-system servers, which are in the late stage of the product cycle. In addition, the storage business will post decline due to the secular changes in the industry. We expect this trend continued through Q4 and our take on the expected results is as follows:

See our full analysis on IBM

The Cognitive Solutions Segment To Witness A Steady Growth

IBM’s Cognitive Solutions segment includes Solutions Software (roughly two-thirds of the segment 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 first nine months of the year, revenues for this division grew by 3.5% to $14.82 billion, driven by double-digit growth in strategic imperative revenues.

While the company has posted declines in transaction processing software revenues, as the transition to the Software as a Service (SaaS) model continues, 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.

The chief driver for cognitive solutions is the adoption of Watson solutions for analytics. The existing Watson solutions continue to witness robust growth even as the company expands its portfolio of services to new domains such as Internet of Things (IoT). Trefis believes that this trend continued in Q4 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 Order Book

The Technology Services division and cloud platform division maps onto Trefis’s GTS vertical and accounts for about 16.8% of IBM’s stock value, according to our estimates. This division is focusing on the hybrid cloud domain with infrastructure outsourcing revenue being the primary offering for the division. During the first nine months, continued momentum in the hybrid cloud with growth in Infrastructure Services drove negligible (i.e., 0.1%) growth in revenues to $26.0 billion.

IBM’s clients are signing large infrastructure outsourcing deals with embedded cloud and mobile initiatives, to create large-scale hybrid IT environments (Hybrid Clouds). These deals have had high contract values in the previous quarters and continue to buoy revenue growth for the company. We expect that this trend continued in Q4 and the company should thus post mild revenue growth for the quarter. 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 and FY2016.

GBS Revenues To Remain Tepid Even As Digital Front Office Initiatives Offsets Declines

The global business services (GBS) division contributes over 16.7% to IBM’s stock value according to our estimates. During the first nine months, GBS reported a 2.3% year on year decline in revenue to $12.6 billion, primarily due to decreases in traditional consulting and packaged application implementations, especially from the U.S. Additionally, the company was impacted by currency headwinds, pricing pressure, and client re-negotiations. We expect that these trends continued in Q4 as well. Thus, reported revenue is likely to be lower.

However, double-digit growth in digital front office, which includes business analytics and software-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 services. As a result, its strategic initiatives in Business Analytics and the Cloud have done well and likely offset the decline in the packaged (on-site perpetual license) implementations to some extent in Q4.

Server Revenues To Decline In Q4

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. During the first nine months, revenues for the system Division declined by 22.1% to $5.18 billion and pretax income declined by 66.2% to $354 million. The primary reason for this was the decline in shipments for the Z system servers, which are at the end of a product cycle. During the first nine months, Z system revenues declined by over 40% while Power system revenues declined by 23.5%. We expect this trend continued in Q4 and there was likely a decline in server revenues.

The Power Systems business is focused on high-end Unix and Linux computing. IBM has re-positioned 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. It is expanding its customer base in the mid-level Linux systems as well as with large cloud-based players. 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. 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.

The storage vertical within this division has not fared well, as a significant portion of the business is dependent on IBM server sales (also down sharply).  As a result, storage system sales experienced a 9.7% decline in revenues in the first three-quarters of 2106. We believe that this trend persisted in Q4 and revenues declined during the quarter.

At present, we have a $144 Trefis price estimate for IBM, which is about 15% lower than the current market price.

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