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IBM Tops Q2 Earnings & Revenue Estimates, Acquires Red Hat

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International Business Machines Corp (IBM - Free Report) delivered second-quarter 2019 non-GAAP earnings of $3.17 per share, which surpassed the Zacks Consensus Estimate of $3.06. Further, earnings per share (EPS) increased 9 cents from the year-ago quarter

Revenues of $19.16 billion outpaced the Zacks Consensus Estimate of $19.11 billion but declined 4.2% on a year-over-year basis. At constant currency (cc), the metric dipped 1.6%. The year-over-year revenue decline can primarily be attributed to currency fluctuation and headwinds from IBM Z product cycle.

Notably, IBM stated that signings declined 14% on cc basis in the second quarter to $9.7 billion. Services backlog fell 4% year over year and totaled $111.2 billion.

IBM Closes Red Hat Acquisition

IBM has completed the acquisition of Red Hat for $34 billion in cash. The deal is part of the company’s efforts to bolster Open Hybrid Architecture Initiative.

The deal marks IBM’s largest acquisition ever and the combined company is likely to alter the dynamics of “the cloud market for business.” Specifically, IBM hopes to leverage Red Hat to help it become the world’s largest hybrid cloud platform provider.

The company anticipates Red Hat buyout to improve revenue growth approximately by a CAGR of two points over a five-year period. Following the buyout, Red Hat will join IBM's Cloud and Cognitive Software segment and will function as a separate entity.

Geographic Revenue Details

Revenues from Americas decreased 3% on cc basis and came in at $8.8 billion. The same from Europe, Middle-East and Africa increased 1% year over year to $6.1 billion, while Asia-Pacific revenues declined 2% on a year-over-year basis and came in at $4.2 billion.

Structural Changes

Starting from first-quarter 2019, IBM combined Cloud business and Cognitive Software in one segment.  Further, the company merged security services with security software.

IBM also integrated all divested business to the other categories in order to provide enhanced transparency to the software and GBS segments. The divested business includes pending sales of seven software products to HCL, the sale of IBM’s marketing platform and commerce software offerings to Centerbridge, and the recently concluded sale of Seterus mortgage servicing business.

Cloud & Cognitive Software Segment

The Cloud & Cognitive Software segment’s revenues-external improved 5.4% year over year (on cc basis) to $5.6 billion. Revenues at Cloud & Cognitive Software (including cloud and data platform, Cognitive application and transaction processing) increased primarily due to growth in application driven by security and solutions, improvement in data and analytics, and growth across hybrid cloud and data portfolio.

Segmental revenues pertaining to Cloud increased 8%. Cloud as-a-service revenue annual run rate was $2.1 billion.

Revenues from cloud and data platforms increased 7% year over year.

IBM’s attempt to bolster hybrid cloud business with Red Hat Acquisition is likely to pave the way for the company’s growth prospects.

Notably, IBM witnessed growth in industry verticals like health, key areas of analytics and security in the reported quarter. Watson Health witnessed broad-based growth in Payer, Provider, Imaging and Life Sciences domains.

Revenues from Cognitive Applications were up 5% year over year, driven by security, health, supply chain and weather. Security growth was backed by offerings in orchestration, data security and endpoint management.

Further, robust sales of Resilient and QRadar, which address areas like endpoint protection, incident response and security intelligence, were other positives.

Transaction Processing Software includes software that runs mission-critical workloads, leveraging IBM’s hardware platforms. Revenues were up 4% year-over-year basis.

Global Business Services Segment

Revenues from Global Business Services-external segment totaled $4.2 billion, up 3.4% from the year-ago quarter. The year-over-year increase in the top line can primarily be attributed to growth across all three business areas namely consulting, application management and global process services.

Cloud revenues surged 17% year over year. Cloud as-a-service revenue annual run rate was $1.7 billion.

Application Management revenues were up 2% year over year. Global Process Services revenues climbed 3%. Moreover, Consulting revenues increased 5% year over year on solid performance of IBM’s digital business.

Notably, IBM recently announced that IBM Garage is enabling approximately 500 enterprises to implement robust business transforming strategies. IBM Garage leverages AI, machine learning, blockchain, IoT, DevOps tools and robust cognitive capabilities to provide clientele with end-to-end workflows.

Moreover, IBM Garage is enabling ADP to integrate AI capabilities across business processes to bolster customer engagement.

Global Technology Services Segment

Revenues from Technology Services-external decreased 3.5% from the year-ago quarter to $6.8 billion. Segmental revenues pertaining to cloud advanced 5% from the year-ago quarter. Cloud as-a-service revenue annual run rate was $7.4 billion.

Infrastructure & Cloud Services’ revenues decreased 4% from the year-ago quarter. Moreover, Technical Support Services revenues declined 2% from the year-ago quarter.

Notably, IBM recently expanded partnership with AT&T Inc. (T - Free Report) . According to the new multi-year agreement, IBM's cloud and IT infrastructure services will be leveraged by AT&T Communications. This will facilitate migration of “AT&T Business Solutions' internal software applications” to IBM Cloud.

AT&T deal is a major win for IBM as it bodes well for expanding presence in North America. Additionally, IBM and AT&T intend to develop robust technologies pertaining to edge computing platforms to assist enterprises in harnessing the benefits of 5G, IoT devices and smart sensors and edge compute platforms.

Systems Revenues

Systems revenues decreased 18% on a year-over-year basis to $1.8 billion, primarily owing to the decline in the IBM Z product cycle and storage. Segmental revenues pertaining to Cloud revenues declined 16%.

IBM Z revenues decreased 41% year over year.

However, Power revenues increased 3% from the year-ago quarter. The upside can primarily be attributed to Linux and robust adoption across the latest POWER9-based architecture.

During the reported quarter, IBM has made IBM Power Systems Virtual Servers accessible via IBM Cloud.

IBM’s Power Systems Virtual Servers will provide a platform to assist AIX and IBM i workloads for public or private clouds or on premises in order to simplify business processes and expand operational efficiencies. IBM Cloud capabilities will aid the company in upscaling business operations in North America.

Meanwhile, storage hardware revenues declined 21% year over year on weak performance in both high end and mid-range and stiff competition. IBM stated that pricing pressure in the immensely competitive storage market is hurting revenues.

While Operating Systems Software revenues increased 3%, Systems Hardware slumped 23% from the year-ago quarter.

Finally, Global Financing (includes financing and used equipment sales) revenues decreased 11% year over year and 8.5% at cc to $351 million.

Operating Details

Non-GAAP gross margin increased 90 bps from the year-ago quarter and came in at 47.4%. The gross margin benefited primarily expansion in services margin and shift to high value, services productivity and cloud scale efficiencies.

Non-GAAP operating expense (research & development expenses and selling, general and administration expenses) increased 9.9% year over year. On a GAAP basis operating expenses were flat year over year on realization of acquisition synergies and improving operational efficiencies. Currently, IBM continues to invest in rapidly growing fields like hybrid cloud, AI, security and blockchain.

Pre-tax margin from continuing operations expanded 140 bps on a year-over-year basis to 14.5%.

Non-GAAP operating margins from continuing operations contracted 10 bps and came in at 13%.

Balance Sheet & Cash Flow Details

IBM ended second-quarter 2019 with $45.4 billion in total cash and marketable securities compared with $18 billion in the previous quarter (which includes around $34 billion cash which was used in July to close Red Hat acquisition). Total debt (including current portion) was $73 billion (which includes $25 billion from Global Financing debt), up from $49.9 million from the previous quarter.

The company reported cash flow from operations (excluding Global Financing receivables) of $2.8 billion and generated free cash flow of $2.4 billion in the quarter under review.

Moreover, the company returned $1.8 billion to its shareholders through dividends and share repurchases. However, the company suspended its share repurchase program on Jul 9, post Red Hat acquisition.

Guidance

For 2019, IBM continues to expect non-GAAP EPS to be at least $13.90. The Zacks Consensus Estimate is currently pegged at $13.89.

IBM still anticipates 2019 free cash flow of $12 billion.

Notably, the above expectations exclude the impact of Red Hat acquisition.

Zacks Rank & Stocks to Consider

IBM currently carries a Zacks Rank #3 (Hold).

Some better-ranked stocks worth considering in the broader sector are Alteryx (AYX - Free Report) and Rosetta Stone (RST - Free Report) , both sporting a Zacks Rank #1 (Strong Buy).  You can see the complete list of today’s Zacks #1 Rank stocks here.

The long-term earnings growth rate for Alteryx and Rosetta Stone are pegged at 13.7% and 12.5%, respectively.

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