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International Business Machines Corp. (IBM - Analyst Report) reported non-GAAP earnings of $4.32 per share in the second quarter of 2014. Earnings per share (EPS) including acquisition and retirement related adjustments jumped 34.2% from the year-ago quarter and beat the Zacks Consensus Estimate by a penny.

The year-over-year growth in EPS was primarily driven by better-than-expected revenue results, margin expansion due to stringent cost cutting and aggressive share buyback. Management also provided positive outlook for the second half of 2014.

However, share price declined 2.03% ($3.90) in after-hours trading due to modest growth in the software segment.

Revenues

IBM’s second-quarter revenues declined 2.3% year over year to $24.36 billion, which beat the Zacks Consensus Estimate. 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 divested its customer care business to Synnex Corp. (SNX - Snapshot Report) for $505.0 million.

Segment Revenue Details

Global services revenues declined 1.4% year over year (up 1.0% at cc) to $13.95 billion. This was primarily due to sluggish revenue growth across both Global Technology Services and Global Business Services segments.  

Global Technology Services revenues declined 1.3% (down 1.0% at cc) year over year to $9.41 billion. On a year-over-year basis, GTS outsourcing revenues decreased 4.0% (down 4.0% on cc); partially offset by 5.0% (up 5.0% at cc) year-over-year growth in Integrated Technology services. Maintenance revenues declined 1.0% (down 1.0% at cc) from the year-ago quarter.

SoftLayer Technologies (acquired in 2013) contributed a point to GTS revenue growth in the reported quarter. As part of its $1.2 billion investments aimed at building 15 data centers worldwide, IBM opened a cloud data center in Hong Kong and, most recently, in London.

Per its growth initiatives, IBM plans to invest $1.0 billion in Watson group, which will focus on developing cloud delivered Big Data services to the market. During the second quarter, IBM launched BlueMix, a platform-as-a-service (PaaS), based on its open architecture in the market.

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.

GBS outsourcing revenues fell 9.0% (down 9.0% at cc) from the year-ago quarter. Consulting & Systems Integration revenues increased 1.0% (flat at cc) on a year-over-year basis. IBM is set to invest $100.0 million to expand its consulting services capability with 10 new IBM Interactive Labs.

The recent partnership with Apple (AAPL - Analyst Report) that aims at offering software and services to enterprise users of iOS, will boost IBM’s consulting revenues in the long run.

Services backlog at the end of the second quarter declined 1.0% year over year (down 3.0% on cc) to $136.0 billion. Outsourcing backlog decreased 6.0% year over year to $85.0 billion.

Total signings amounted to $11.0 billion during the quarter, down 33.0% on a year-over-year basis (down 33.0% on cc). Outsourcing signings plunged 46.0% year over year to $4.8 billion, while transactional decreased 17.0% from the year-ago quarter to $6.2 billion.

Software revenues increased 1.0% (flat on cc) year over year to $6.49 billion. The segment benefited from growth in key branded middleware (up 1.0%) that comprises of WebSphere (up 5.0%) and Tivoli (up 4.0%) partially offset by Workforce solutions (down 7.0%), Information Management (down 1.0%) and Rational (down 9.0%).

IBM’s mobile revenues soared 100.0% on a year-over-year basis in the second quarter.

IBM’s cloud revenues jumped 50.0% from the year-ago quarter. Software delivered as service (SaaS) revenues increased 40.0% year over year in the second quarter. Business Analytics revenues increased 7.0% 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.

Hardware revenues plunged 11.4% year over year (down 12.0% at cc) to $3.33 billion. 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 28.0%, 1.0%, 3.0% and 12.0%, respectively.

In June, IBM launched entry-level POWER8 processor. The company expects to launch POWER8 for the mid-range and high-end over the rest of the year.

IBM’s new initiatives that include the expansion of OpenPOWER ecosystem added a number of new members bringing the total to 36 at the end of reported quarter. The company recently announced that it will invest $3.0 billion over the next five years on research and development of next generation chip technologies.

Global Financing revenues increased 3.5% on a year-over-year basis to $504.0 million in the reported quarter.

Geographic Revenue Details

Region-wise, revenues declined 1.0% year over year (up 1.0% at cc) to $10.6 billion in the Americas, due to strong growth in System Z mainframe in the United States. Revenues from Europe/Middle East/Africa increased 1.0% (down 3.0% at cc) from the year-ago quarter to $7.9 billion, driven by growth in Germany and Italy.

Revenues from Asia-Pacific declined 9.0% year over year (down 6.0% at cc) to $5.3 billion. Revenues outside Japan declined at a double-digit rate. Revenues in China declined 11.0% in the reported quarter.

Revenues from IBM’s BRIC (Brazil, Russia, India & China) markets declined 2.0% (up 1.0% at cc). Revenues from growth markets decreased 7.0% (down 4.0% at cc) year over year in the reported quarter. Brazil increased more than 20.0% year over year due to large deals in the financial sector.  

Revenues from major markets declined 1.0%, while growth markets fell 7.0% from the year-ago quarter. Original Equipment Manufacturer (OEM) revenues plunged 19.0% year over year to $433.0 million.

Margins

Gross margin (including adjustments related to acquisition and retirement) expanded 10 basis points (bps) from the year-ago quarter. The improvement in gross margin was primarily driven by favorable revenue mix and productivity improvements.

Total operating expense & other income as percentage of revenues decreased 380 bps from the year-ago quarter to 27.5%. The sharp decline was primarily due to lower selling, general & administrative expense as percentage of revenues (down 360 bps) and research & development expense (down 10 bps).

Lower operating expense base positively impacted segmental pre-tax income margin, which surged 460 bps from the year-ago quarter. Global services pre-tax margin expanded 410 bps, while software jumped 340 bps year over year in the reported quarter.

Hardware reported a pre-tax income of $25.0 million compared with a loss of $141.0 million in the year-ago quarter. Global financing pre-tax income increased 7.8% year over year to $593.0 billion.
 

 

Net income was $4.34 billion or $4.32 per share compared with $3.58 billion or $3.22 per share in the year-ago quarter.

Balance Sheet & Cash Flow Details

IBM ended the quarter with $9.72 billion in total cash and marketable securities, compared with $9.70 billion in the previous quarter. At the end of the second quarter, total debt was $46.47 billion compared with $43.98 billion in the prior quarter.

IBM reported cash flow from operations (excluding Global Financing receivables) of $2.98 billion versus $1.52 billion in the year-ago quarter. In the reported quarter, IBM generated free cash flow of $2.98 billion, significantly up from $0.6 billion in the year-ago quarter.

IBM bought back shares worth $11.8 billion in the second quarter, which lowered its shares outstanding float to below $1.0 billion. The company raised dividend payout in April by 16.0%. IBM has spent $2.1 billion on dividend payment during the quarter.

Guidance

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 $17.93 for 2014.

IBM expects the software and services segment to grow aggressively (mid single-digit) in the second half of 2014. Services segment profitability is expected to grow in mid single-digit range, while hardware profit is expected to stabilize over the rest of 2014.

Management expects EPS in single-digits and double-digits in the third and fourth quarters, respectively, driven by better performance across all the segments.

Our Take

IBM reported much-better-than-expected second quarter, as the modest decline in revenues was fully offset by stringent cost control and higher profitability from mix improvement. Hardware continues to remain a concern while modest software growth will be discomforting for investors in the near term.

Sluggish revenue growth from the growth markets will continue to impact hardware revenue growth. A resurgent major market will partially offset this decline, in our view.

However, intensifying competition from the likes of Oracle (ORCL - Analyst Report), Hewlett-Packard, SAP and Microsoft remains a major headwind. Further, sluggish IT spending particularly on 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 on chip development are positive for the company over the long term.

IBM’s revenue growth will continue to benefit from its strong backlog. The recent partnership with Apple will also help it to further expand its software, services and consulting business in the enterprise market, going forward.

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

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