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International Business Machines Corp. (IBM - Analyst Report) reported mixed second quarter 2013 results. While earnings per share of $3.91 comfortably surpassed the Zacks Consensus Estimate by 13 cents (3.4%), revenues missed the consensus mark in the reported quarter.

Despite the revenue miss, IBM raised its full year earnings guidance by 20 cents. The company expects a strong second half based on improving software pipeline, solid backlog growth, better performance from global technology and business services, benefits from workforce rebalancing, stringent cost control and robust growth potential from its cloud, business analytics and smarter planet initiatives.

Revenues

IBM’s second quarter revenues of $24.93 billion missed the Zacks Consensus Estimate of $25.27 billion. Revenues declined 3.3% from the year-ago quarter but increased 6.5% on a sequential basis. On a constant currency (cc) basis, revenues declined 1.0% from the year-ago quarter. Unfavorable foreign currency movement, particularly in yen, had a negative impact of 2.0% on revenues.

Except software all other segment revenues declined on a year-over-year basis.  Software increased 4.1% (up 5.0% on cc) year over year and a significant 15.3% quarter over quarter to $6.42 billion.

The better-than-expected result (highest year-over-year growth on a cc basis since first quarter of 2012) was driven by 10% growth on a cc basis (up 9.0% year-over-year on reported basis) in key branded middleware WebSphere, Information Management, Tivoli, social workforce solutions (prior Lotus) and Rational products and market share gains.

Services revenues decreased 3.5% year over year but improved slightly from the previous quarter to $14.08 billion. Global technology services revenues fell 4.6% (down 2.0% on cc) from the year-ago quarter and 0.7% sequentially to $9.54 billion. Global business services revenues were $4.61 billion, down 1.3% (up 2.0% on cc) from the year-ago quarter but up 2.7% on a sequential basis.

Services backlog at the end of the second quarter increased 3.0% year over year (7.0% on cc) to $141.0 billion. IBM won 15 service agreements worth more than $100.0 million in the reported quarter. Outsourcing backlog improved at the same year-over-year rate to $90.0 billion.

On a year-over-year basis, total outsourcing revenues decreased 5.0% (2.0% on cc), while transactional revenues declined 1.0% (up 1.0% on cc) in the quarter. Maintenance revenues declined 4.0% (down 2.0% on cc) from the year-ago quarter.

Total signings amounted to $16.4 billion during the quarter, up 20.0% on a year-over-year basis (up 22.0% on cc). Outsourcing signings surged 31.0% year over year to $8.9 billion, while transactional increased 9.0% from the year-ago quarter to $7.5 billion.

Hardware/System & Technology revenues (including retail store solutions) decreased 11.8% (11.0% on cc) year over year but surged 21.0% quarter over quarter to $3.76 billion.

Systems revenues decreased 10.0% (9.0% on cc) from the year-ago quarter. Although System z revenues increased 10.0% year over year, the growth was fully offset by weak performances from Power Systems, System X and Storage, which decreased 25.0%, 11.0% and 7.0%, respectively. Revenues from Microelectronics OEM increased 6.0% (6.0% on cc) year over year in the reported quarter.

Global Financing revenues decreased 5.8% year over year and 2.4% sequentially to $487.0 million in the reported quarter.

Region wise, revenues declined 8.0% year over year (flat on cc) to $5.8 billion in Asia-Pacific. Revenues from Americas declined 3.0% year over year (3.0% on cc) to $10.7 billion. Revenues from Europe/Middle East/Africa remained flat (down 1.0% on cc) year over year at $7.8 billion.

Revenues from both IBM’s BRIC (Brazil, Russia, India & China) and growth markets remained flat (up 1.0% on cc) year over year in the reported quarter. Revenues from major markets declined 5.0% year over year (2.0% on cc) in the reported quarter.

Margins

Gross margin expanded 150 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 300 bps due to higher revenue base.

Total operating expense & other income as percentage of revenues jumped 410 bps from the year-ago quarter to 31.3%. The sharp rise was primarily due to higher selling, general & administrative expense (up 390 bps).

Sequentially, total operating expense & other income as percentage of revenues surged 200 bps from the year-ago quarter to 26.1%. The sharp rise was primarily due to higher selling, general & administrative expense (up 310 bps).

Higher gross margin base drove segmental pre-tax income (excluding workforce rebalancing charge) as a percentage of sales, which jumped 70 bps on a year-over- year and 530 bps on a sequential basis in the quarter.

Excluding acquisition and retirement related charges, consolidated pre-tax income as a percentage of revenues contracted 270 bps from the year-ago quarter but improved 100 bps from the previous quarter.

In the reported quarter, net income (including workforce rebalancing charge) as a percentage of revenues declined 140 bps from the year-ago quarter but remained flat on a sequential basis.

Earnings Per Share Details

Earnings excluding workforce rebalancing charge of $1.0 billion were $3.91 per share, which jumped 8.0% from the year-ago quarter. However, including workforce rebalancing charge, earnings were $3.22 per share that declined 8.0% year over year but increased 7.3% from the previous quarter.

The year-over-year decline in earnings was primarily attributed to weak revenue growth (negative impact of 12 cents) and workforce rebalancing charges (negative impact of 59 cents), which fully offset margin expansion (24 cents) and aggressive share repurchase (18 cents).

Balance Sheet & Cash Flow Details

IBM ended the quarter with $10.36 billion in total cash and marketable securities, compared with $11.99 billion in the previous quarter. At the end of the second quarter, total debt was $34.10 billion compared with $33.40 billion in the prior quarter.

IBM reported cash flow from operations (excluding Global Financing receivables) of $3.6 billion versus $2.4 billion in the previous quarter. In the reported quarter, IBM generated free cash flow of $2.7 billion, significantly up from $1.7 billion in the previous quarter.

IBM paid dividends worth $1.05 billion and bought back shares worth $3.6 billion in the quarter. As of Jun 30, 2013, IBM had $7.7 billion remaining under its share buyback program.

Positive Outlook

IBM forecasts fiscal 2013 operating earnings (excluding workforce rebalancing charges) of at least $16.90 per share (up from $16.70), an estimated 10.8% increase from $15.25 reported in 2012. Including workforce related charges and excluding gains from divestiture, operating earnings are expected to be at least $16.25 per share.

Our Take

IBM’s positive outlook will help it to win back investor confidence going forward. We believe that IBM’s strong backlog, improving outsourcing signings and new contract wins will boost the top line going forward.

However, slowing top-line growth in BRIC and growth markets is a headwind in our view. Additionally, sluggish IT spending and strong competition from the likes of Oracle (ORCL - Analyst Report), Hewlett-Packard (HPQ - Analyst Report) and EMC Corp. (EMC - Analyst Report) are the major concerns going forward.

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

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