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International Business Machines Corp. (IBM - Analyst Report) reported sluggish third quarter 2012 results. Although earnings of $3.62 per share were in line with the Zacks Consensus Estimate, revenue of $24.75 billion missed the consensus mark.

Operating Details

Total revenue declined 5.4% year over year to $24.75 billion. Unfavorable foreign currency impact was approximately $1.0 billion and the divestiture of the retail store solutions (“RSS”) point-of-sale business to Toshiba negatively impacted revenue by 1%.

Revenue decline was witnessed across all the operating segments. Services, Software, System & Technology (“Hardware”) and global financing declined 4.6%, 0.9%, 13.1% and 9.2% respectively.

Region wise, revenue contribution from Americas (“US and Canada”) and Europe declined 4.0% and 9.0%, respectively in the third quarter. Asia continues to remain the bright spot, with revenue increasing 1.0% from the year-ago quarter. Japan revenue stabilized in the quarter, as per management’s earlier forecast.

IBM continued to witness strong growth from BRIC (Brazil, Russia, India & China) countries, which were up 4% year over year in the reported quarter. Strong performance from China, India and Russia, which jumped 19%, 13% and 11% respectively, fully offset a 3% decline in Brazil.

Although growth markets declined 1.0% in the quarter, 35 countries grew at a double-digit rate, reflecting strong ongoing growth momentum in the region. However, major markets continued to disappoint with revenue down 6.0% from the year-ago quarter.

Gross profit on a non-GAAP basis decreased 2.9% year over year to $11.89 billion. However, gross margin expanded 130 basis points (“bps”) annually to 48.1%. The year-over-year growth in gross margin was driven by favorable revenue mix and productivity improvements.

Total operating expense & other income decreased 9.9% from the year-ago quarter to $6.37 billion, due to lower research & development expense (down 1.8% year over year) and higher other income ($611.0 million versus $111.0 million in the year-ago quarter).

Lower operating expenses drove pre-tax income, which jumped 6.6% year over year to $5.52 billion in the third quarter. Pre-tax margin increased 250 bps to 22.3% in the reported quarter.

Net profit on a non-GAAP basis was $4.16 billion or $3.62 per share compared with $3.95 billion or $3.28 in the year-ago quarter. The earnings growth was driven by margin expansion (34 cents) and aggressive share repurchase (17 cents), which fully offset weak revenue growth (negative impact of 17 cents).

Operating Segment Details

Services– In the reported quarter, Global Technology Services (“GTS”) revenue decreased 3.9% year over year to $9.92 billion. Global Business Services (“GBS”) revenue declined 6.0% year over year to $4.54 billion. The decline in services results was primarily due to lower volumes across all the regions.

Total outsourcing revenue decreased 5.0% year over year, while transactional revenue also declined 4.0% year over year in the quarter. GTS outsourcing declined 5% from the year-ago quarter, while GBS outsourcing plunged 7.0% year over year in the reported quarter.

Total signings amounted to $13.3 billion during the quarter, up 8.0% on a year-over-year basis. Outsourcing signings improved 26% year over year to $7.3 billion, while transactional declined 8.0% from the year-ago quarter to $6.0 billion.

The estimated services backlog, as of September 30, 2012, increased 1% year over year to $138.0 billion. Outsourcing backlog declined 1% year over year to $89.0 billion at the end of the third quarter 2012.

Software– Software segment declined 1.0% year over year to $5.76 billion. IBM reported 2% year over year revenue decline in its branded key middleware products including WebSphere, Information Management, Tivoli, Rational products and Lotus products.

Systems and Technology (Hardware)– Revenue plunged 13.1% year over year to $3.90 billion. Systems revenues fell 8.0%, primarily due to a 20.0% decline in System z revenues. Total delivery of System z computing power, as measured in MIPS (millions of instructions per second), plunged 2.0% in the quarter.

Revenue from POWER Systems decreased 1.0% on a year-over-year basis. IBM gained significant market share during the quarter, primarily driven by 260 new contracts from customers previously associated with Hewlett-Packard (HPQ - Analyst Report) and Oracle (ORCL - Analyst Report).

System x mainframe server product revenue declined 5.0% year over year in the quarter. Revenues from hardware storage decreased 10.0% due to continuing shift to software storage in the quarter. Revenues from Microelectronics OEM also plunged 25.0% annually.

Financing– Revenues from Global Financing decreased 9.2% year over year to $472.0 million in the reported quarter.

Balance Sheet & Cash Flow Details

IBM ended the quarter with $12.25 billion in total cash and marketable securities, compared with $11.19 billion in the previous quarter. At the end of the third quarter, total debt was $33.67 billion compared with $32.25 billion in the prior quarter.

Global Financing debt totaled $23.3 billion versus $22.6 billion at the end of June 2012, resulting in a debt-to-equity ratio of 7 to 1. Non-global financing debt increased $2.3 billion since December, 2011 to $10.3 billion and resulted in a debt-to-capitalization ratio of 36.0%.

IBM reported cash flow from operations (excluding Global Financing receivables) of $4.19 billion versus $4.94 billion in the previous quarter. In the reported quarter, IBM generated free cash flow of $3.14 billion, down slightly from $3.66 billion in the prior quarter.

Outlook Reiterated

IBM continues to expect fiscal 2012 operating earnings of at least $15.10 per share.

Our Take

IBM’s top-line decline in the last two quarters primarily reflects slowing IT spending environment, in our view. Although software is expected to continue to grow strongly, sluggish growth in the services segment and decline in hardware make us cautious on the stock. Moreover, unfavorable foreign currency, increasing competition and stiff year-over-year comparisons in the hardware segment may hurt profitability in the near term.

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.

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

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