IBM Misses on Q3 Earnings, Revs; FY14 View Cautious

International Business Machines Corp. (IBM) reported dismal results in the third quarter of 2014. Non-GAAP earnings (including acquisition and retirement related adjustments) of $3.68 per share missed the Zacks Consensus Estimate by 62 cents. Revenues of $22.4 billion also missed the the Zacks Consensus Estimate of $23.5 billion.

However, most importantly, IBM abandoned its 2015 roadmap earnings target of $20.00 per share. Share price declined 7.11% ($12.95) to $169.10 following the disappointing result and revised outlook.

Revenues

Revenues declined 4% (down 2% at cc) year over year, due to weaker-than expected software revenues in the quarter.

Segment Revenue Details

Global services revenues declined 2.7% year over year to $13.7 billion. This was primarily due to sluggish revenue growth across both Global Technology Services and Global Business Services segments.

Global Technology Services (GTS) revenues declined 3% (down 2% at cc) year over year to $9.22 billion. On a year-over-year basis, GTS outsourcing revenues (including divested customer care business) declined 4% at cc., partially offset by 1% year-over-year growth in Integrated Technology services. Maintenance revenues declined 1% (down 1% at cc) from the year-ago quarter.

Global Business Services revenues declined 2.2% to $4.46 billion (down 1% in cc) in the quarter. Consulting & Systems Integration declined 1% on a year-over-year basis and remained flat in constant currency. GBS outsourcing revenues fell 7% (down 6% at cc) from the year-ago quarter.

Services backlog at the end of the third quarter declined 7% year over year (down 2% in cc) to $128 billion.

Revenues from the Software segment were $5.7 billion, down 2% compared with the year-ago quarter. Software-as-a-Service offerings were up nearly 50%. Revenues from IBM’s key middleware products, which include WebSphere, Information Management, Tivoli, Workforce Solutions and Rational, were down 1% from the year-ago quarter. IBM’s mobile revenues more than doubled on a year-over-year basis.

Systems and Technology revenues were down 15% on a year-over-year basis to $2.4 billion in the reported quarter. IBM continued to face fundamental challenges related to Power Systems, storage and System x in the quarter. System x revenues were down 10% in the quarter while Storage hardware revenues were down 6%. Revenues from System z mainframe server products decreased 35% compared with the year-ago quarter.

IBM’s cloud revenues jumped 50% from the year-ago quarter. Cloud delivered as a service revenues increased 80% year over year in the third quarter. Business Analytics revenues increased 8% year over year, while 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.

IBM’s new initiatives that include the expansion of OpenPOWER ecosystem added a number of new members bringing the total to 60 at the end of the reported quarter. The company recently announced that it will invest $3 billion over the next five years on research and development of next generation chip technologies.

Global Financing revenues declined 3% on a year-over-year basis to $487 million in the reported quarter.

Geographic Revenue Details

Region-wise, revenues declined 2% year over year (down 1% in cc) to $10.1 billion in the Americas. Revenues from Europe/Middle East/Africa decreased 2% (down 3% in cc) from the year-ago quarter to $7.2 billion. Revenues from Asia-Pacific declined 9% year over year (down 8% in cc) to $5 billion.

Revenues from IBM’s BRIC (Brazil, Russia, India & China) markets declined 7%. India declined during the quarter. China continued to decline as well. However, Brazil performed well during the quarter.

Revenues from growth markets decreased 6% (down 5% in cc) year over year in the reported quarter. Revenues from major markets decreased 3% (down 3% in cc) year over year in the quarter.

Margins

Gross margin (including adjustments related to acquisition and retirement) declined 90 basis points (bps) from the year-ago quarter. The decline in gross margin was primarily due to sluggish revenue growth displayed by all segments, particularly hardware and insufficient productivity and services.

Total operating expense & other income as a percentage of revenues increased 170 bps from the year-ago quarter to 28.5%. The sharp increase was primarily due to higher selling, general & administrative expense as a percentage of revenues (up 120 bps) and research & development expense (up 30 bps).

A higher operating expense base negatively impacted segmental pre-tax income margin, which contracted 180 bps from the year-ago quarter to 19.5%.

Systems & Technology reported a pre-tax loss of $99 million compared with a loss of $8 million in the year-ago quarter. GTS pretax profit declined 11.3% from the year-ago quarter to $1.68 billion. Global financing pre-tax income decreased 4% year over year to $475 million.

Net income (including acquisition and retirement related adjustments) was $3.67 billion or $3.68 per share compared with $4.14 billion or $3.77 per share in the year-ago quarter.

International Business Machines Corporation - Earnings Surprise | FindTheBest

Acquisitions & Divestitures

During the third quarter, IBM closed the x86 divestiture deal with Lenovo.

Most recently, IBM entered into a joint venture deal with GlobalFoundries to sell off its loss making chip manufacturing units at FishKill and Vermont. Per the deal, GlobalFoundries will manufacture chips for IBM for the next 10 years. IBM will pay $1.5 billion to GlobalFoundries over the next three years for the same.

Balance Sheet & Cash Flow Details

IBM ended the quarter with $9.6 billion in total cash and marketable securities, compared with $9.72 billion in the previous quarter. At the end of the third quarter, total debt was $45.7 billion compared with $46.5 billion in the prior quarter.

IBM reported cash flow from operations (excluding Global Financing receivables) of $3.2 billion versus $3.28 billion in the year-ago quarter. In the reported quarter, IBM generated free cash flow of $2.2 billion, down $0.1 billion from the year-ago quarter.

In the reported quarter, IBM returned $2.8 billion to shareholders through $1.1 billion in dividends and $1.7 billion of gross share repurchases.

At the end of the third quarter, IBM had approximately $1.4 billion remaining from the current share repurchase authorization. The company is likely to request an additional share repurchase authorization at the Oct 2014 board meeting.

Guidance

IBM forecasts fiscal 2014 operating earnings per share to be down 2% to 4% from $16.64 reported last year. Currently, the Zacks Consensus Estimate is pegged at $17.91 per share. Free cash flow is expected in between $12 to $13 billion for the full year.

IBM expects to use cash of $500 million in the fourth quarter and another $500 million in 2015 due to the Lenovo deal.

In the fourth quarter, IBM expects to take a rebalancing charge of $600 million.

Our Take

IBM reported dismal third quarter results. Hardware continues to remain a concern while modest software growth will be discomforting for investors in the near term. Sluggish revenues from the growth markets will continue to impact overall hardware revenues.

Intensifying competition from the likes of Oracle (ORCL), Hewlett-Packard (HPQ), SAP (SAP) and Microsoft (MSFT) remain a major headwind. Further, sluggish IT spending particularly for on-premise and data center hardware will continue to hurt IBM in the near term.

Nonetheless, we believe that IBM’s investments in cloud computing, Big Data, mobile and security will boost software and services revenues in the long run. The company is known for its research capabilities and the recent investments in chip development are positive for the company over the long term.

Moreover, the divestitures of loss making units ensure that these will no longer continue to be a drag on the company’s profit. We believe that though the loss of revenues due to these divestitures will initially hurt top-line in the near term, they will eventually improve IBM’s margin position in the long run.

IBM’s revenue growth will continue to benefit from its strong backlog. The partnership with Apple (AAPL) will also help it to further expand its software, services and consulting business in the enterprise market, going forward, especially with the launch of the new iPads.

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

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