IBM Q1 Earnings in Line, Revs Lag Again

International Business Machines Corp. (IBM) reported disappointing revenues in the first quarter of 2014, which missed the Zacks Consensus Estimate for the fifth straight quarter. However, earnings of $2.54 per share were in line with the Zacks Consensus Estimate.

Earnings per share declined 15.3% from the year-ago quarter and a massive 58.6% from the previous quarter due to lower revenue base and steep increase in total operating expenses.

The weaker-than-expected first-quarter results are expected to hurt IBM’s ability to achieve fiscal 2014 earnings target of $18.00 per share. Shares declined 4.2% ($8.20) in after-hours trading.

Revenues

IBM’s first-quarter revenues of $22.48 billion declined 3.9% from the year-ago quarter and 18.8% on a sequential basis. On a constant currency (cc) basis, excluding the divested customer care business, revenues declined 1.0% from the year-ago quarter. In Sep 2013, IBM sold off its customer care business to Synnex Corp. (SNX) for $505.0 million.

Unfavorable foreign currency movement, particularly in yen, and devaluation of Venezuelan currency, had a negative impact on revenues.

Segment Revenue Details

Growth in revenues was primarily affected by lackluster performance from the hardware segment. Hardware revenues plunged 23.0% year over year and 43.9% quarter over quarter as IBM continued to face fundamental challenges related to Power Systems, storage and System X in the quarter.

Power Systems, System Z, System X and storage revenues plunged 22.0%, 40.0%, 18.0% and 23.0%, respectively. During the quarter, IBM agreed to sell its low-end server business to China-based Lenovo Group.

IBM’s new initiatives that include the expansion of OpenPOWER ecosystem and Linux capabilities through the launch of POWER8 processor are expected to drive growth in 2014.

Global services revenues declined 2.0% year over year and 5.8% sequentially. This was primarily due to sluggish revenue growth across both Global Technology Services and Global Business Services segments.
Global Technology Services revenues, excluding the customer care business, declined 2.9% (down 1.0% on cc) year over year and 5.9% quarter over quarter. On a year-over-year basis, GTS outsourcing revenues decreased 5.0% (down 3.0% on cc); partially offset by 2.0% (up 5.0% at cc) year-over-year growth in Integrated Technology services. Maintenance revenues declined 2.0% (flat at cc) from the year-ago quarter.

SoftLayer Technologies (acquired in 2013) contributed a point to GTS revenue growth in the reported quarter. In January this year, IBM announced a $1.2 billion investment aimed at building 15 data centers worldwide in addition to its already existing 25 data centers (including 13 SoftLayer data centers).

IBM will invest $1.0 billion in Watson group, which will focus on developing cloud delivered big-data services to the market. IBM also launched BlueMix, a platform-as-a service (PaaS), based on its open architecture. BlueMix runs on SoftLayer’s global cloud platform. The PaaS allows software developers to build and manage applications that cater to different verticals such as healthcare, retail and travel, in which IBM has low presence.

After integrating Power Systems into SoftLayer’s cloud to run Watson big data services, IBM is also making middleware offerings, such as WebSphere, available to SoftLayer. This move will enable software developers to build hybrid cloud apps.

GBS outsourcing revenues fell 10.0% (down 8.0% on cc) from the year-ago quarter. Consulting & Systems Integration revenues increased 3.0% (up 5.0% at cc) on a year-over-year basis. IBM will invest $100.0 million aimed at expanding its consulting services capability with 10 new IBM Interactive Labs.

Services backlog at the end of the first quarter was flat on a year-over-year basis (up 1.0% on cc) to $138.0 billion (excluding $3.8 billion for customer care divestiture). Outsourcing backlog decreased 5.0% year over year to $86.0 billion.

Total signings amounted to $11.2 billion during the quarter, down 34.0% on a year-over-year basis (down 33.0% on cc). Outsourcing signings plunged 49.0% year over year to $5.5 billion, while transactional decreased 9.0% from the year-ago quarter to $5.7 billion.

Software revenues increased 1.6% (up 2.0% on cc) year over year but plunged 30.5% from the previous quarter. The segment benefited from growth in key branded middleware (up 5.0% at cc) that comprises of WebSphere (up 12.0% at cc), Information Management (up 2.0% at cc), Tivoli (up 7.0% at cc) and Rational (up 2.0% at cc) partially offset by Workforce solutions (down 4.0% at cc).

IBM’s cloud revenues jumped 50.0% from the year-ago quarter. Software delivered as service (SaaS) revenues increased 25.0% year over year in the first quarter. Security offerings grew more than 20% year over year during the quarter. The company expects to spend $1.0 billion on cloud-based software development through 2015.

During the quarter, IBM also acquired database-as-a-service (DBaaS) provider Cloudant, which will run on SoftLayer platform. The acquisition expands IBM’s Big Data, Analytics and Cloud computing portfolio as its data management technology will help clients to quickly build, test, deploy and scale mobile, web as well as cloud apps..

IBM’s mobile business almost doubled on a year-over-year basis driven by strong portfolio of mobile software and services. The addition of Cloudant further expands IBM’s mobile portfolio. Cloudant enables Worklight developers quickly create flexible, reliable and scalable mobile apps that include a variety of structured and unstructured data.

Global Financing revenues were almost flat on a year-over-year basis but jumped 6.4% sequentially to $534.0 million in the reported quarter.

Geographic Revenue Details

Region-wise, revenues declined 4.0% year over year (down 2.0% at cc) in the Americas, due to weak growth in hardware in the United States. Revenues from Europe/Middle East/Africa increased 4.0% (up 1.0% at cc) from the year-ago quarter, driven by growth in Germany and Italy.

Revenues from Asia-Pacific declined 12.0% year over year (down 6.0% at cc). Revenues in China declined 20.0% in the reported quarter.

Revenues from IBM’s BRIC (Brazil, Russia, India & China) markets declined 11.0% (down 6.0% at cc). Revenues from growth markets decreased 11.0% (down 5.0% at cc) year over year in the reported quarter. Latin America reported high single-digit revenue growth, driven by strong performance in Brazil.

Revenues from major markets declined 2.0% from the year-ago quarter.

Margins

Gross margin (including adjustments related to acquisition and retirement) expanded 90 basis points (bps) from the year-ago quarter. The improvement in gross margin was primarily driven by favorable revenue mix and productivity improvements. On a sequential basis, gross margin expanded 500 bps due to lower revenue base.

Total operating expense & other income as percentage of revenues increased 360 bps from the year-ago quarter to 32.9%. The sharp rise was primarily due to higher selling, general & administrative expense (up 410 bps).

Sequentially, total operating expense & other income as percentage of revenues surged 710 bps primarily due to lower selling, general & administrative expense (down 620 bps).

Higher operating expense base negatively impacted segmental pre-tax income, which declined 17.4% from the year-ago quarter and 57.2% from the previous quarter to $3.30 billion.

Net income (including workforce rebalancing charge of $870.0 million and gain of $100.0 million) declined 21.7% from the year-ago quarter and 60.1% from the previous quarter to $2.64 billion.

Balance Sheet & Cash Flow Details

IBM ended the quarter with $9.70 billion in total cash and marketable securities, compared with $11.07 billion in the previous quarter. At the end of the first quarter, total debt was $43.98 billion compared with $37.49 billion in the prior quarter.

IBM reported cash flow from operations (excluding Global Financing receivables) of $1.52 billion versus $2.43 billion in the year-ago quarter. In the reported quarter, IBM generated free cash flow of $0.6 billion, significantly down from $1.70 billion in the year-ago quarter.

IBM paid dividends worth $1.00 billion and bought back shares worth $8.2 billion in the first quarter.

Outlook

IBM forecasts fiscal 2014 operating earnings of at least $18.00 per share, an estimated 6.0% increase from $16.99 reported in 2013. Currently, the Zacks Consensus Estimate is pegged at $17.97 for 2014.

Our Take

Despite consecutive revenue misses, IBM reiterated its 2014 earnings target of $18.00, which will be difficult to achieve unless there is a substantial improvement in revenue growth over the next three quarters.

IBM also reiterated its 2015 roadmap earnings target of $20.00, which reflects approximately 11.0% year-over-year growth over estimated earnings of $18.00 for 2014. We believe IBM needs to improve its revenue growth, particularly from growth markets, to achieve this target.

We continue to believe IBM’s strong backlog and the divestiture of low-margin customer care and server business unit will boost top line and profitability in 2014. Moreover, continuing investments in cloud computing, smarter planet initiative and analytics division will boost software and services revenues, going forward.

IBM’s acquisition of Cloudant and Aspera will improve its position in the cloud computing and Big Data market in 2014. However, fundamental challenges in the hardware segment will continue to hurt sales. Moreover, intensifying competition from the likes of Oracle (ORCL) and Hewlett-Packard (HPQ) remains the primary headwind.

Currently, IBM has a Zacks Rank #3 (Hold).

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