IBM Earnings: Shift To Cloud Impacts Revenue Growth Even As Strategic Imperatives Witness Strong Growth

International Business Machines (NYSE:IBM) posted its Q4 results after market close on January 19th. 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 (on an adjusted basis) a 1.3% year-over-year decline in revenues to $21.77 billion. For the year, the company reported that its revenues declined by 2.2% to $79.92 billion. Furthermore, the consolidated gross margin declined by 171 basis points to 50.0% for Q4 and 186 basis points to 47.92% for the full year. Net income from continuing operations grew by 90 basis points to $4.50 billion in Q4 2015, while it declined by 11.1% to $11.88 billion for FY2016 as cloud deployment took center stage.

During the quarter, IBM’s Cognitive Solutions and Technology Services and Cloud segments, buoyed by strategic imperatives, continued to report growth, while its other segments (Global Business Services and Systems) reported declining revenue. The Systems segment revenue reported the greatest decline (12.5%) primarily due to transitions in its POWER and storage systems business. ^[1] Below are the key takeaways from the earnings announcement.

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Guidance For 2017

The company expects operating (non-GAAP) diluted earnings per share of at least $13.80 and GAAP diluted earnings per share of at least $11.95. Operating (non-GAAP) diluted earnings per share exclude $1.85 per share of charges for amortization of purchased intangible assets, other acquisition-related charges and retirement-related charges. IBM expects a free cash flow realization rate in excess of 90% of GAAP net income for 2017.

Strategic Imperatives And Cloud Services Boosts Revenues

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 Q4, IBM reported that revenue from its Strategic Imperatives was $10 billion. For the year, Strategic Imperatives revenues grew by 14% year over year to $32.8 billion and make up 41% of its total revenues. Within the Strategic Imperatives, Analytics grew by 9% to $19.5 billion, Cloud revenue grew by 35% to $13.7 billion, mobile revenue grew by 35% to $4.1 billion and security revenue grew by 14% to $2.0 billion. Notably, on an annualized basis, Cloud revenue grew to $13.7 billion, up 35%, whereas total as-a-Service revenues (reported in multiple segments) grew 86% to $8.6 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, Watson Financial Services and Watson IoT. Additionally, expanded partnerships to accelerate adoption of enterprise hybrid clouds played a vital role in the 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 2% to $5.2 billion, driven by 7% 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. Cloud revenue for Cognitive Solutions division grew by 53% to $600 million. However, the company posted a decline in Transaction Processing Software revenue as the transition to the Software as a Service (SaaS) model 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 16.8% of IBM’s stock value, according to our estimates. During the quarter, continued momentum in the hybrid cloud with growth in Infrastructure Services drove 2% growth in revenues to $9.3 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. During the quarter, IBM signed 16 deals greater than $100 million. As a result of these signings, infrastructure outsourcing revenue grew by 3% during the quarter.

Revenue At GBS Declines Amidst Shift To Cloud

The Global Business Services division (GBS) contributes over 16.7% to IBM’s stock value according to our estimates. In line with our expectation, GBS reported a 4% year-on-year decline in revenue to $4.1 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 a 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 ($900 million revenue with 77% growth), offset the decline in packaged (on-site perpetual license) implementations to some extent. For the quarter, IBM reported that cloud-as-a-service revenues achieved a $1.1 billion in annual run rate, while Strategic Imperative revenues in the segment grew by 19% to $2.4 billion.

Revenues And Profitability Across Server and Storage Division Decline

During the quarter, revenues for server and storage division declined by 12% to $2.5 billion and pretax income declined by 14% to $579 million. The primary reason for this was the decline in shipments for POWER system, which is suffering due to the ongoing shift to a growing Linux market. Despite Z-system being at the end of their product cycle, it reported 4% growth in revenues as it added 8 new clients (29 for the year) for the product.

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. 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.

During Q4, Storage hardware declined by 10% reflecting the shift in value towards software-defined environments. The company continued to see double-digit revenue growth in Software-Defined Storage. Storage revenue declines were mainly driven by midrange and high-end disk.

We are in the process of updating our IBM model. At present, we have a $144 Trefis price estimate for IBM, which is about 14% lower than the current market price.

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