IBM Earnings Preview: Revenue To Decline As Shift To Cloud Services Continues

IBM (NYSE:IBM) is set to report its Q1 2017 earnings on April 18th. In Q4 2016, the company saw a marginal slowdown in revenues as the shift to cloud computing and currency headwinds continued to plague the company. IBM reported (on an adjusted basis) a 1.3% year-over-year decline in revenues to $21.77 billion. Furthermore, the consolidated gross margin declined by 171 basis points to 50%. More importantly, revenue from its Strategic Imperatives grew to $10 billion in the quarter. For the year, Strategic Imperatives revenues grew by 14% year over year to $32.8 billion. Comprising 40% of the total, these imperatives include revenue generated from analytics, the cloud, mobile computing, security and social media. We believe that this trend continued in Q1, and cognitive software solutions will report growth yet again.

Despite the growth in Strategic Imperatives, IBM’s Technology Services & Cloud and Global Business Services (GBS) segments have reported weaker results over the past year as the transition to cloud services is impacting the implementation of traditional packaged applications. Additionally, the server hardware business should continue to report a decline in revenues as both its server lines are in a later stage of the product life. In addition, the storage business will likely post a decline due to the secular changes in the industry, though the company acquired Nimble Storage for $1.09 billion in March, which should help going forward. As a result of the aforementioned factors, we expect the company’s revenues for Q1 will decline. Our take on the expected results is below.

See our full analysis for IBM

Cognitive Solutions Segment To Witness 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 Cognitive Solutions software makes up nearly 42% of IBM’s value, per our estimates. 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. This division has fared well driven by double-digit growth in strategic imperative revenues. Furthermore, Watson solutions for analytics, one of the chief drivers for Cognitive Solutions, is witnessing robust growth even as the company expands its portfolio of services to new domains such as Internet of Things (IoT). We expect these trends to drive revenue growth in Q1.

However, the company has posted declines in transaction processing software revenues as the transition to the Software as a Service (SaaS) model continues. This transition to cloud will continue to impact revenue growth in Q1. Additionally, robust revenue growth through the adoption of SaaS in the quarter should help the company post growth in the number of subscriptions licenses sold, which should offset the decline in perpetual licenses sold in the short term.

Technology And Cloud Services Revenues To Improve

The Technology and Cloud Services business accounts for about 22% of IBM’s value, according to our estimates. This division is focusing on the hybrid cloud domain, with Infrastructure Cloud Services revenue being the primary offering for the division. In the past year, continued momentum in the hybrid cloud with growth in Infrastructure Cloud Services drove growth in revenues.

IBM’s clients are signing large Infrastructure Cloud Service deals with embedded cloud and mobile initiatives, to create large-scale hybrid IT environments (Hybrid Clouds). These deals have had high contract values in recent quarters and continue to buoy revenue growth for the company. We expect that this trend continued in Q1, and the company should 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.

GBS Revenues To Remain Tepid

The global business services (GBS) division contributes nearly 7.5% of IBM’s value according to our estimates. The revenue for this division has been declining, primarily due to decreases in traditional consulting and packaged application implementations, especially from the U.S. Additionally, currency headwinds, pricing pressure, and client re-negotiations have negatively impacted revenue growth. 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. We expect that these trends continued in Q1 as well. However, the overall decline in consulting and perpetual licensing will likely result in a decline in the reported revenue.

Server & Storage Revenues To Decline In Q1

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 storage vertical within this division has not fared well, as a significant portion of the business is dependent on IBM server sales. Furthermore, the shift in value towards software-defined environments is negatively impacting traditional storage revenues. As a result, storage system sales experienced a 10% decline in revenues in 2016. We believe that this trend persisted in Q1 and revenues declined during the quarter.

At present, we have a $179 price estimate for IBM, which is slightly higher than the current market price.

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