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International Business Machines Corp. (IBM - Analyst Report) reported modest fourth quarter 2011 results with earnings per share (EPS) surpassing the Zacks Consensus Estimate by 9 cents but revenues falling shy of our expectation of $29.74 billion.

IBM posted non-GAAP EPS of $4.71 in the fourth quarter, up 10.8% on a year-over-year basis and representing double-digit growth in 18 of the last 20 quarters. The significant upside was primarily driven by solid revenue growth (7 cents), margin growth (13 cents) and share repurchases (26 cents).

Revenue Details

Total revenue increased 1.6% year over year (1.0% adjusted for currency) to $29.49 billion. The upside was driven by continued strength across its growth markets, which  accounted for 22.0% of IBM’s total geographic revenue in the fourth quarter. IBM’s key initiatives such as Business Analytics, Smarter Planet and Cloud offerings also maintained the growth momentum in the fourth quarter.

Revenues by Segment

Services– Total Global Services revenue grew 2.7% year over year to $15.33 billion, driven by an upside of 2.8% (3.0% at constant currency) in Global Technology Services revenues to $10.45 billion and 2.5% (2.0% at constant currency) in Global Business Services revenues to $4.88 billion.

The estimated services backlog, as of December 31, 2011, was $141.0 billion, up $4.0 billion (flat at constant currency) from the year-ago quarter.

Total transactional revenue jumped 3.0% to $6.2 billion. Total outsourcing revenue stood at $7.2 billion, up 4.0% year over year.

Software– IBM reported a year-over-year increase of 11.0% (11.0% at constant currency) in its branded key middleware products including WebSphere, Information Management, Tivoli, Rational products and Lotus products.

Accordingly, revenues from the company’s Software segment grew 8.7% (9.0% at constant currency) year over year to $7.65 billion.

Operating systems revenue of $710.0 million, upped 3.0% year over year (3.0% at constant currency). Revenues from the WebSphere suite of software products shot up 21.0% year over year. Information Management software revenues escalated 9.0%. Revenues from Tivoli software rose 14.0%. Revenues from Lotus software decreased 2.0%, while the same from Rational software crept up 4.0%.

Hardware– Systems and Technology revenues decreased 8.0% (8.0% at constant currency) year over year to $5.80 billion. Systems revenues fell 7.0% (7.0% at constant currency), primarily attributed to a 31.0% decline in System z revenues. Total delivery of System z computing power, as measured in MIPS (millions of instructions per second) plunged 4.0% in the quarter.

Revenue from POWER Systems leaped 6.0% year over year while revenues from System x mainframe server products decreased 2.0%. Revenues from System Storage decreased 1.0% while revenues from Retail Store Solutions increased 1.0% year over year. Revenues from Microelectronics OEM plunged 11.0%.

Financing– Revenues from Global Financing fell 12.7% (13.0% at constant currency) year over year to $548.0 million.

Revenue by Region

From a geographic perspective, fourth quarter 2011 revenues were up 3.0% (3.0% at constant currency) in the Americas while the same in the Asia-Pacific region grew 2.0% (declined 1.0% at constant currency). Europe, Middle East & Africa (EMEA) revenues inched up 1.0% (1.0% at constant currency) during the quarter.

IBM witnessed a growth of 10.0% (11.0% at constant currency) in the reported quarter from Brazil, Russia, India, China and South Africa (BRICS), reflecting the company’s strength in the emerging countries. Revenues from the growth markets, which include South Africa, Vietnam and the Czech Republic, increased 7.0% (8.0% at constant currency).

Operating Performance

Gross profit on a non-GAAP basis increased 3.5% year over year to $14.72 billion. Gross margin rose 90 basis points (bps) on a year-over-year basis to 49.9%. The year-over-year growth in gross margin was driven by strong margin expansion in services segment and improvement in revenue mix.

Total operating expense & other income increased 2.4% year over year to $7.45 billion in the quarter, primarily due to higher acquisition costs and selling, general & administrative expense (up 2.1% year over year).

Pre-tax income on a non-GAAP basis came in at $7.27 billion, up 4.6% year over year. Pre-tax margin increased 70 bps to 24.7% in the quarter. Net profit on a non-GAAP basis improved 4.4% year over year to $5.49 billion. Net margin increased 50 bps year over year to 18.6%.

Balance Sheet

IBM ended the quarter with $11.92 billion in total cash and marketable securities, compared with $11.30 billion in the previous quarter.

At the end of the third quarter, total debt was $31.32 billion compared with $30.36 billion in the prior quarter. Global Financing debt totaled $23.3 billion versus $22.8 billion at the end of December 2011, resulting in a debt-to-equity ratio of 7 to 1.

Non-global financing debt increased $600.0 million since September 30, 2011 to $8.0 billion and resulted in a debt-to-capitalization ratio of 32.0% compared with 27.8% at the end of the third quarter.

The company reported cash flow from operations (excluding Global Financing receivables) of $10.0 billion versus $4.47 billion in the previous quarter. In the reported quarter, IBM generated free cash flow of $9.0 billion, up from $3.5 million in the prior quarter.

Guidance

IBM expects fiscal 2012 operating EPS of at least $14.85. GAAP EPS is expected to be around $14.16. Currently, the Zacks Consensus Estimate for fiscal 2012 is pegged at $14.81, which is slightly below management’s guided range.

Our Take

IBM’s top-line grew a modest 2.0% in the reported quarter, which primarily reflects a slowing IT spending environment, in our view. Although software continued to grow strongly, sluggish growth in the services segment and decline in hardware make us cautious on the overall IT spending environment. We believe that macroeconomic concerns will continue to hurt IBM’s growth in the first half of 2012.

We believe that IBM remains well positioned for long-term growth based on its four key growth initiatives: smarter planet, growth markets, business analytics and cloud computing, which are expected to deliver at least $50 billion in revenues by fiscal 2015. We believe that IBM’s strong product pipeline, expansion into emerging markets and continuous acquisitions will help it to achieve this target going forward.

Moreover, a strong patent portfolio and accretive acquisitions will provide IBM a competitive edge over other prominent vendors, including Oracle Corp. (ORCL - Analyst Report), Hewlett-Packard Co. (HPQ - Analyst Report), Microsoft Corp (MSFT - Analyst Report) and EMC Corp (EMC - Analyst Report)), in our view.

We have a long-term (6-12 months) Neutral recommendation on IBM. Currently, IBM has Zacks #3 Rank, which translates into a short-term Hold rating.

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