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IBM Reports Mixed 2Q, Outlook Up

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International Business Machines Corp. (IBM - Free Report) reported earnings of $3.51 per share in the second quarter of 2012, striding ahead of the Zacks Consensus Estimate by 9 cents. Earnings increased 13.6% on a year-over-year basis, representing double-digit earnings growth in 20 of the last 22 quarters. The significant upside was primarily driven by margin growth (35 cents) and share repurchases (17 cents).

Revenue Details

Total revenue declined 3.3% year over year to $25.78 billion (up 1.0% adjusted for currency) in the second quarter and missed the Zacks Consensus Estimate of $26.31 billion. Revenue decline was witnessed across most of the segments, partially offset by strong performance from the growth markets (up 2.0% on a reported and 8.0% on a constant currency basis).

IBM continued to witness strong growth from BRIC (Brazil, Russia, India & China) countries (up 5.0% reportedly and 12.0% at constant currency basis) during the second quarter. On a combined basis, BRIC and growth markets were up 12.0% year over year in the reported quarter.

The better-than-expected performance of growth & BRIC markets continued to offset sluggish results from the major markets (down 4.0% reportedly and 1.0% at constant currency). The weak result was primarily attributed to a difficult Japan market and sluggish IT spending.

Revenue in Americas (down 1.0% on a reported basis and up 1.0% at constant currency) was primarily driven by strong revenues from Canada, which fully offset a flat performance in the U.S. Europe, Middle East & Africa (EMEA) revenues declined 9.0% (flat at constant currency), primarily due to weak results from France and Italy, partially offset by good performance in U.K. and Spain during the quarter. However, Asia Pacific increased 2.0% year over year (4.0% at constant currency) during the quarter.

Revenue Segment Details

Services– IBM reports services revenue in two segments: Global Technology Services (GTS) and Global Business Services (GBS). In the second quarter, GTS revenue decreased 2.4% year over year to $9.99 billion primarily attributed to declining revenue growth in GTS outsourcing and maintenance. Revenue growth was flat in the integrated technology services segment.

GBS revenue declined 4.1% year over year to $4.67 billion, primarily due to weak GBS outsourcing and consulting & systems integration revenue. Sluggish performance from Japan had a negative impact on GBS revenue growth during the quarter. Within GBS, business analytics grew 28.0% and smarter planet climbed 15.0%, respectively, in the reported quarter.

Total outsourcing revenue decreased 3.0% year over year (up 1.0% at constant currency), while transactional revenue also declined 3.0% year over year (up 1.0% at constant currency). Total signings amounted to $13.7 billion during the quarter, down 4.0% on a year-over-year basis. The estimated services backlog, as of June 30, 2012, was $136.0 billion, down $8.0 billion (up $1.0 billion at constant currency) from the year-ago quarter.

Software– Software segment remained flat (4.0% at constant currency) year over year at $6.17 billion. IBM reported flat year-over-year revenue growth (4.0% at constant currency) in its branded key middleware products including WebSphere, Information Management, Tivoli, Rational products and Lotus products.

Systems and Technology (Hardware)– Revenues decreased 9.0% (7.0% at constant currency) year over year to $4.23 billion. Systems revenues fell 7.0% (5.0% at constant currency), primarily attributed to an 11.0% decline in System z revenues. Total delivery of System z computing power, as measured in MIPS (millions of instructions per second), plunged 8.0% in the quarter.

Revenue from POWER Systems decreased 7.0% (4.0% at constant currency) on a year-over-year basis. IBM gained significant market share during the quarter, primarily driven by 320 new contracts from customers previously associated with Hewlett-Packard (HPQ - Free Report) and Oracle (ORCL - Free Report) .

System x mainframe server product revenue declined 8.0% year over year (5.0% at constant currency) in the quarter. Revenues from hardware storage decreased 4.0% due to continuing shift to software storage in the quarter. Revenues from Retail Store Solutions fell 4.0% year over year. Revenues from Microelectronics OEM also plunged 22.0% annually.

Financing– Revenues from Global Financing fell slightly ($2.0 million year over year) to $517.0 million in the reported quarter.

Operating Performance

Gross profit on a non-GAAP basis decreased slightly to $12.44 billion. However, gross margin expanded 140 basis points (bps) annually to 48.2%. The year-over-year growth in gross margin was driven by strong margin expansion in the services segment and improvement in revenue mix.

Total operating expense & other income decreased 5.9% year over year to $7.00 billion in the quarter, primarily due to lower selling, general & administrative expense (down 3.9% year over year).

Pre-tax income on a non-GAAP basis came in at $5.44 billion, up 7.9% year over year. Pre-tax margin increased 220 bps to 21.1% in the quarter. Net profit on a non-GAAP basis improved 7.9% year over year to $4.08 billion. Net margin increased 160 bps year over year to 15.8%.

Balance Sheet & Cash Flow Details

IBM ended the quarter with $11.19 billion in total cash and marketable securities, compared with $12.34 billion in the previous quarter. At the end of the second quarter, total debt was $32.25 billion compared with $32.05 billion in the prior quarter.

Global Financing debt totaled $22.6 billion versus $23.6 billion at the end of March 2012, resulting in a debt-to-equity ratio of 7 to 1. Non-global financing debt increased $933.0 million since December, 2011 to $9.8 billion and resulted in a debt-to-capitalization ratio of 36.0% compared with 32.7% at the end of the first quarter.

IBM reported cash flow from operations (excluding Global Financing receivables) of $4.94 billion versus $2.87 billion in the previous quarter. In the reported quarter, IBM generated free cash flow of $3.66 billion, up significantly from $1.87 billion in the prior quarter. IBM acquired eight companies in the second quarter for $2.0 billion.

Outlook Up

IBM expects fiscal 2012 operating EPS of at least $15.10 (up from the previous guidance of $15.00).

Our Take

IBM’s top-line decline in the reported quarter 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 overall IT spending environment. Moreover, unfavorable foreign currency, sluggish environment in Japan 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 Zacks #3 Rank, which translates into a short-term Hold rating.

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