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Shares of International Business Machines Corp. (IBM - Analyst Report) surged 4.11% ($8.06) in after-hours trading on the heels of strong fourth quarter earnings, which beat the Zacks Consensus Estimate by 14 cents per share (2.7%).

Revenue

After two consecutive misses, IBM’s fourth quarter revenue of $29.30 billion succeeded in beating the Zacks Consensus Estimate of $29.18 billion. However, revenue declined 1% from the year-ago quarter. Adjusting for favorable foreign currency, revenue growth was almost flat on a year-over-year basis in the reported quarter. Revenue jumped 18.4% on a sequential basis.

Software was the only segment that witnessed year-over-year growth in the quarter. Revenue climbed 3.5% year over year (up 4% due to favorable foreign currency) and 37.3% sequentially to $7.92 billion. Revenue from IBM’s middleware products (WebSphere, Information Management, Tivoli, Lotus and Rational products) increased 5.0% year over year, while operating system revenue remained flat on a year-over-year basis.

Services revenue decreased 2.1% year over year but increased 3.7% sequentially to $15.00 billion. Global technology services revenue fell 1.6% from the year-ago quarter but climbed 3.6% from the third quarter to $10.28 billion. Global business services revenue was $4.72 billion, down 3.2% from the year-ago quarter but up 3.9% on a sequential basis. Backlog at the end of fourth quarter remained flat at $140.0 billion.

Total outsourcing revenue decreased 3.0% year over year, while transactional revenue also declined 1.0% year over year in the quarter. GTS outsourcing declined 3% from the year-ago quarter, while GBS outsourcing plunged 4.0% year over year in the reported quarter.

Total signings amounted to $17.9 billion during the quarter, down 12.0% on a year-over-year basis. Outsourcing signings plunged 28% year over year to $8.3 billion, while transactional increased 9.0% from the year-ago quarter to $9.5 billion. Outsourcing backlog declined 3% year over year to $89.0 billion at the end of the last quarter.

Hardware/System & Technology revenue declined a modest 1.0% year over year but surged 48.0% quarter over quarter to $5.76 billion. Excluding the negative impact from the divestiture of Retail Store Solutions (“RSS”), revenue increased 4.0% from the comparable prior-year quarter. Revenue in the growth markets soared 68% year over year in the fourth quarter.

Systems revenue except RSS increased 4.0%, primarily due to a 56.0% year-over-year jump in System z revenues. This fully offset weak performance from Power Systems, System X and Storage, which were down 19%, 2% and 5%, respectively. Revenue from Microelectronics OEM increased 4% year over year in the reported quarter.

IBM gained significant market share during the quarter, primarily driven by 350 new contracts from customers previously associated with Hewlett-Packard (HPQ - Analyst Report) and Oracle (ORCL - Analyst Report).

Global Financing revenue declined 2.4% year over year but increased 13.3% sequentially to $535.0 million in the reported quarter.

Region wise, revenue grew only in Asia-Pacific, up 4.0% (5.0% including favorable currency) year-over-year to $7.0 billion. Revenue from Americas (“US and Canada”) was flat year over year (up 1.0% including favorable currency) at $12.5 billion. Revenue from Europe/Middle East/Africa declined 5.0% (down 3.0% including favorable currency) from the year-ago quarter to $9.1 billion.

Revenue from IBM’s growth markets increased 7.0%. IBM continued to witness strong growth from BRIC (Brazil, Russia, India & China) countries, which were up 11% year over year (14% including favorable impact of foreign currency) in the reported quarter.

Margins

Gross profit on a non-GAAP basis increased 3.6% year over year and 28.9% sequentially to $15.33 billion. However, gross margin expanded 210 basis points (“bps”) from the year-ago quarter and 420 bps from the previous quarter. The improvement in gross margin was primarily driven by favorable revenue mix and productivity improvements.

Total operating expense & other income decreased 2.3% from the year-ago quarter but increased 13.2% sequentially to $7.22 billion. The year-over-year decline was primarily due to lower selling, general & administrative expense (SG&A) (down 3.3% year over year). Sequentially, both SG&A and research & development expense (R&D) increased in the reported quarter.

Higher gross margin base and lower-than-expected increase in operating expenses drove pre-tax income, which jumped 9.5% year over year and 47.0% from the previous quarter to $8.11 billion in the fourth quarter. Pre-tax margin increased 250 bps from the year-ago quarter and 540 bps sequentially to 27.7% in the reported quarter.

Net profit on a non-GAAP basis increased 9.5% year over year and 47.5% sequentially to $6.13 billion in the reported quarter. Earnings per share (“EPS”) jumped 14.4% from the year-ago quarter and 48.9% from the previous quarter to $5.39. Earnings growth was driven by margin expansion (47 cents) and aggressive share repurchase (24 cents), which fully offset weak revenue growth (negative impact of 3 cents).

Balance Sheet & Cash Flow Details

IBM ended the quarter with $11.13 billion in total cash and marketable securities, compared with $12.25 billion in the previous quarter. At the end of the fourth quarter, total debt was $33.27 billion compared with $33.67 billion in the prior quarter.

IBM reported cash flow from operations (excluding Global Financing receivables) of $10.50 billion versus $4.19 billion in the previous quarter. In the reported quarter, IBM generated free cash flow of $9.52 billion, significantly up from $3.14 billion in the prior quarter.

Positive Outlook

IBM forecasts fiscal 2013 operating earnings of at least $16.70 per share, an estimated 9.5% increase from $15.25 reported in 2012. IBM continues to expect effective tax-rate to be around 25% for 2013.

Our Take

Although IBM reported a better-than-expected fourth quarter, revenue growth was disappointing. We expect software to grow strongly in the near term, although stiff competition from Oracle remains a concern. However, sluggish growth in the services and hardware segment makes us cautious on the stock.

Moreover, volatile macro-economic environment, continued weakness in the domestic market and Euro zone, declining outsourcing signings and increasing competition from other outsourcing service providers such as Accenture (ACN - Analyst Report) are the major headwinds in the near term.

Currently, IBM has a Zacks Rank #4 (Sell).

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