International Business Machines Corp (IBM - Free Report) reported third-quarter 2016 results wherein both non-GAAP earnings of $3.29 per share and revenues of $19.23 billion comfortably surpassed the respective Zacks Consensus Estimate of $3.21 and $19.01 billion.
After declining for 17 consecutive quarters, revenues were almost flat on a year-over-year basis driven by strong growth from strategic imperatives and cloud. However, earnings declined 1.5% from the year-ago quarter due to a lower gross margin base and higher research & development expenditure.
IBM has been moving away from its traditional businesses to newer (read lucrative) business avenues like cloud and data analytics. Though IBM’s strategic imperatives are performing well, third-quarter results showed that these are not sufficient to compensate for the weakness in its traditional businesses yet.
Segment Revenue Details
Total software revenue increased 3% year over year to $5.7 billion.
Cognitive Solutions (solutions software and transaction processing software) revenues grew 4.5% year over year to $4.24 billion. Software solutions registered growth of 8%, driven primarily by analytics (Watson platform, Big Data, Information Integration). Cloud was up an impressive 74%. Acquisitions continue to cushion growth.
Revenues at the Global Business Services (includes consulting, global process services, application management) segment were $4.19 billion, roughly in line with the year-ago quarter. Segmental revenues pertaining to strategic imperatives were up 13%.
Revenues at Technology Services and Cloud Platforms (includes infrastructure services, technical support services, integration software) grew 2.4% to $8.75 billion. Segmental revenues pertaining to strategic imperatives surged 45% driven by robust performance of hybrid cloud.
Revenues at Systems (systems hardware and operating systems software) fell 21% on a year-over-year basis to $1.56 billion. Hardware revenues tanked 25%, while operating systems slumped 11%.
Global Financing (includes financing and used equipment sales) revenues declined 7.8% to $412 million.
IBM’s strategic imperatives (cloud, analytics, mobility and security) revenues surged 16% on a year-over-year basis to $8.3 billion in the quarter. Cloud revenues jumped 44% while Analytics revenues increased 15% during this period. Revenues from mobile and security increased about 19% and 11%, respectively.
Per IBM, strategic imperatives now represent 40% of the company's top line and have delivered revenues of almost $32 billion over the last 12 months.
IBM continues to expand its cloud footprint by announcing new cloud centers in South Korea and Norway during the quarter. The company now has 49 cloud centers.
During the quarter, IBM entered into a partnership with Workday and an extended relationship with VMware (VMW - Free Report) . Workday will now use IBM cloud for software development and testing purposes, while the extended relationship with VMware will enable easy hybrid cloud adoption.
Expanding Watson Offerings
IBM continues to expand its Watson offerings. During the quarter, the company introduced Watson Conversation Service and Watson Virtual Agent for Customer Service. The service has already been selected by the likes of The Royal Bank of Scotland Group plc (RBS - Free Report) .
Additionally, IBM launched Watson for Drug Discovery and Watson Health Core. The company also entered into a partnership with Siemens to help healthcare providers deliver value-based care to patients with chronic conditions such as heart disease and cancer.
IBM believes that the partnership with Siemens will accelerate adoption of Watson’s Population Health Management offerings in the U.S. Further, the company noted that it has won customers in China, South Korea, Finland and the United Kingdom.
IBM is focused on developing capabilities around th Blockchain technology. It is now working with almost 300 clients including the likes of CLS and Bank of Tokyo-Mitsubishi. Moreover, the company announced a Blockchain innovation center in Singapore. (Read More: IBM to Focus on 'Fintech' with Blockchain Center in Singapore)
Non-GAAP gross margin contracted 200 basis points (bps) to 48% from the year-ago quarter. Pre-tax margin from continuing operations also contracted 160 bps on a year-over-year basis to 19.1%.
Segment-wise, Cognitive Solutions gross and pre-tax margin contracted almost 400 bps and 280 bps, respectively. The year-over-year contraction reflected increased investment levels and expenditure related to SaaS ramp.
Global Business Services gross and pre-tax margin contracted 90 bps and 270 bps respectively, mainly due to weakness in Consulting.
Technology Services and Cloud Platforms gross and pre-tax margin contracted 20 bps and 70 bps, respectively. Per IBM, margin expansions in Infrastructure Services were fully offset by decline in Technical Support Services that impacted margins in the quarter.
Systems gross and pre-tax margin contracted 480 bps and 270 bps, respectively, primarily due to weakness in Power and Storage, which entirely neutralized margin expansion in z systems.
Balance Sheet & Cash Flow Details
IBM ended third-quarter 2016 with $10 billion in total cash and marketable securities as compared with $10.6 billion at the end of second-quarter 2016. Total debt (including global financing) was $42.5 million, which declined from $44.5 billion at the end of last quarter. Core (excluding global financing) debt was $16.4 billion, which fell from $18 billion.
IBM reported cash flow from operations (excluding Global Financing receivables) of $3.3 billion and generated free cash flow of $2.4 billion in the quarter. The figures were better than cash flow and free cash flow of $3.1 billion and $2.1 billion generated in the previous quarter, respectively.
In the quarter, IBM returned $2.2 billion to shareholders — $1.3 billion as dividends and $0.9 billion through share repurchases. The company has $3 billion left for share repurchase.
For full-year 2016, IBM continues to project non-GAAP earnings to be at least $13.50. Further, the company continues to anticipate generating free cash flow at the high end of the earlier expected range of $11 billion to $12 billion.
IBM is having a tough time, given the ongoing and heavily time-consuming business model transition to cloud. Further, sluggish IT spending particularly on on-premise and data center hardware and foreign exchange volatility remain concerns. Moreover, intensifying competition in the cloud is a major headwind.
Nevertheless, IBM's strategic growth initiatives, including its Big Data & business analytics, cloud computing, mobile and social business are expected to drive growth. In addition, the company’s policy of making strategic acquisitions will lead to incremental revenues, strengthening its technology leadership and resulting in a more favorable mix of business.
The acquisitions have also increased its scale of operations globally. This year, IBM has made 12 acquisitions so far, worth over $5 billion. Strong cash flow generation is also expected to provide the financial flexibility required for strategic investments in a changing business environment.
Zacks Rank & a Key Pick
IBM has a Zacks Rank #4 (Sell).
Amazon.com AMZN, with a Zacks Rank #1 (Strong Buy) is a better-ranking stock in this sector. The company’s domination in the cloud computing market is a major headwind for IBM. You can see the complete list of today’s Zacks #1 Rank stocks here.
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