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International Business Machines Corp. (IBM - Analyst Report) reported disappointing revenues in the fourth quarter of 2013, which missed the Zacks Consensus Estimate for the fourth straight quarter.

Despite a decline in revenues, stringent cost cutting and aggressive share buyback helped IBM report strong bottom-line growth in the quarter. Earnings of $6.13 per share comfortably surpassed the Zacks Consensus Estimate by 12 cents (2.0%)    

In addition to the mixed results, IBM’s fiscal 2014 earnings guidance was unsatisfactory. Shares declined 2.6% ($4.88) in after-hours trading.

Revenues

IBM’s fourth-quarter revenues of $27.70 billion missed the Zacks Consensus Estimate of $28.35 billion. Revenues declined 5.5% from the year-ago quarter but increased 16.8% on a sequential basis.

On a constant currency (cc) basis, revenues declined 3.0% from the year-ago quarter. Unfavorable foreign currency movement, particularly in yen, had a negative impact of approximately 2.0% on revenues.

The year-over-year decline in revenues was primarily due to 26.1% plunge in hardware revenues and a 2.3% decline in global services revenues (up 1.0% on cc). Software increased a modest 2.8% year over year (up 4.0% at cc) in the reported quarter.

Sequentially, hardware revenues surged 31.2%, while software soared 40.4%. Global services revenues increased a modest 4.4% on a quarter-over-quarter basis.

Management noted that the company is facing headwinds related to Power, storage and X86 server unit in the hardware segment, which negatively impacted results. IBM is looking to divest the low-end X86 server business and has restarted discussions with China’s Lenovo Group.

In the quarter, System z revenues fell 37.0% year over year, Power Systems declined 31.0%, System X plunged 15.0% and storage revenues decreased 12.0% at cc. MIPS declined 26.0% in the fourth quarter.

Among IBM’s service business, global business service segment reported modest growth (0.6% up year over year) that partially offset a lackluster performance from global technology services (down 3.6% from the year-ago quarter).

IBM’s service business reported revenue growth from the major markets after first half of 2012, which is positive. However, decline in growth market revenues is a major concern, going forward.  

Management also noted that revenues from existing service customers declined in the quarter, due to sluggish macroeconomic conditions. SoftLayer contributed 1.0% to cloud revenue growth in the last quarter. IBM noted that growth from emerging fields of analytics, cloud computing and security is encouraging.

Services backlog at the end of the fourth quarter increased 2.0% year over year (5.0% on cc) to $143.0 billion. Outsourcing backlog improved 1.0% year over year to $91.0 billion.

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

Total signings amounted to $17.5 billion during the quarter, down 2.0% on a year-over-year basis (up 1.0% on cc). Outsourcing signings surged 11.0% year over year to $9.3 billion, while transactional decreased 14.0% from the year-ago quarter to $8.2 billion.

Software benefited from growth in key branded middleware (up 6.0% at cc) WebSphere (15.0% at cc), Information Management (5.0% at cc), Tivoli (double-digit growth) and market share gains.

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.

Region-wise, revenues declined 3.0% year over year (down 2.0% at cc) to $12.2 billion in the Americas. Revenues from Europe/Middle East/Africa increased 1.0% (down 2.0% at cc) year over year at $9.2 billion. Revenues from Asia-Pacific declined 16.0% year over year (down 6.0% at cc) to $5.9 billion.

Revenues from IBM’s BRIC (Brazil, Russia, India & China) markets declined 14.0% (down 11.0% at cc).  Revenues from growth markets decreased 9.0% (down 6.0% at cc) year over year in the reported quarter. Revenues from major markets declined 2.0% from the year-ago quarter.

Margins

Gross margin expanded 30 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 350 bps due to higher revenue base.

Total operating expense & other income as percentage of revenues increased 120 bps from the year-ago quarter to 25.8%. The sharp rise was primarily due to higher selling, general & administrative expense (up 110 bps).

Sequentially, total operating expense & other income as percentage of revenues declined 100 bps from the year-ago quarter to 25.8%. The decline was primarily due to lower selling, general & administrative expense (down 40 bps).

Higher operating expense base negatively impacted segmental pre-tax income as a percentage of revenues, which declined 80 bps on a year-over-year basis. Pre-tax income as a percentage of revenues surged 450 bps on a sequential basis in the quarter.

In the reported quarter, net income (including workforce rebalancing charge) as a percentage of revenues increased 300 bps from the year-ago quarter and 540 bps on a sequential basis.

Earnings per Share Details

Earnings jumped 13.7% from the year-ago quarter and 53.6% sequentially to $6.13 per share. The year-over-year increase in earnings was primarily due to margin expansion (73 cents) and aggressive share repurchase (30 cents).
 
Balance Sheet & Cash Flow Details

IBM ended the quarter with $11.07 billion in total cash and marketable securities, compared with $10.23 billion in the previous quarter. At the end of the fourth quarter, total debt was $37.49 billion compared with $36.18 billion in the prior quarter.

IBM reported cash flow from operations (excluding Global Financing receivables) of $9.46 billion versus $3.28 billion in the previous quarter. In the reported quarter, IBM generated free cash flow of $8.4 billion, significantly up from $2.24 billion in the previous quarter.

IBM paid dividends worth $13.09 billion and bought back shares worth $17.9 billion in 2013.

Outlook

IBM forecasts fiscal 2014 operating earnings of at least $18.00 per share (up from $16.70), 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 missing revenues, IBM 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 that IBM’s strong backlog, improving outsourcing signings and new contract wins will boost the top line, going forward. However, declining sales in the hardware segment remains a major concern.

The divestiture of low margin X86 business unit will boost IBM’s profitability in 2014. Moreover, continuing investments in cloud computing, smarter planet initiative and analytics division will boost software and services revenues, going forward.

However, sluggish IT spending and intensifying competition from the likes of Oracle (ORCL - Analyst Report), Hewlett-Packard (HPQ - Analyst Report) and SAP AG (SAP - Analyst Report) in the software, services and server market are the primary headwinds.

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

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