Zacks_Analysts' Blog : Mixed 3Q for IBM - Analyst Blog

International Business Machines Corp. (IBM) reported mixed third quarter 2011 results with earnings per share (EPS) surpassing the Zacks Consensus Estimate by 6 cents (2.0%) but revenues falling shy of the estimate of $26.24 billion. IBM shares declined $7.44 (3.99%) in after hours trading.

IBM posted non-GAAP EPS of $3.28 in the third quarter, up 15.1% on a year-over-year basis and representing double-digit growth in 17 of the last 19 quarters.  The significant upside was primarily driven by solid revenue growth (22 cents), margin growth (3 cents) and share repurchases (18 cents).

Operating Performance

Gross profit on a non-GAAP basis was $12.25 billion, up 11.3% year over year. Gross margin rose 140 bps on a year-over-year basis to 46.8%. The year-over-year growth in gross margin was driven by Systems and Technology (up 3 bps) resulting from improvements across all systems brand.

Total operating expense & other income increased 12.3% year over year to $7.08 billion in the quarter, primarily due to higher acquisition costs, research & development expense (up 4.9% year over year) and selling, general & administrative expense (up 9.7% year over year).

Net profit on a non-GAAP basis improved 9.0% year over year to $3.95 billion. However, net margin increased 20 basis points (bps) year over year to 15.1%. Pre-tax income on a non-GAAP basis came in at $5.18 billion, up 9.9% year over year. Pre-tax margin increased 40 bps to 19.8% in the quarter.

Revenues

Total revenue increased 7.8% year over year (3.0% adjusted for currency) to $26.16 billion. The upside was driven by continued strength across growth markets, which was 23.0% of IBM’s total geographic revenue in the third quarter. Strong performance from the growth markets fully offset the sluggish performance in the major markets (up 5.0%, flat at constant currency) during the third quarter.

IBM’s key initiatives such as Business Analytics, Smarter Planet and Cloud offerings maintained the growth momentum in the third quarter. As of September 30, 2011, Business Analytics revenues rose more than 19.0%, whereas Smarter Planet shot up more than 50.0%. Revenue from Cloud computing has doubled compared with fiscal 2010 revenue at the end of the nine months of fiscal 2011.

Revenues by Segment

Services– Total Global Services revenue grew 7.7% (2.0% on a constant currency basis) year over year to $15.15 billion, driven by an upside of 8.7% (3.0% at constant currency) in Global Technology Services revenues to $10.32 billion and 5.7% (flat at constant currency) in Global Business Services revenues to $4.83 billion.

The estimated services backlog, as of September 30, 2011, was $137.0 billion, up $2.4 billion ($2.3 billion constant currency) from the year-ago quarter.

Total transactional revenue jumped 7.0% (1.0% at constant currency) to $6.1 billion. Total outsourcing revenue was $7.1 billion, up 9.0% (3.0% at constant currency) year over year.

Total signings in the quarter increased 12.0% (6.0% at constant currency) to $12.3 billion. Signings in Transactional Services (Consulting, Integrated Technology Services and Application Management Systems Integration) jumped 8.0% (3.0% at constant currency) year over year to $6.5 billion.

IBM’s total Outsourcing Services signings (GTS Outsourcing and Application Management Outsourcing) increased 16.0% (10.0% at constant currency) to $5.8 billion.

Software– IBM reported a year-over-year increase of 17.0% (12.0% at constant currency) in its branded key middleware products including WebSphere, Information Management, Tivoli, Rational products and Lotus products.

Accordingly, revenues from the company’s Software segment grew 13.0% (8.0% at constant currency) year over year to $5.82 billion.

Operating systems revenue of $598.0 million, increased 9.0% year over year (4.0% at constant currency). Revenues from the WebSphere suite of software products shot up 52.0% year over year. Information Management software revenues escalated 12.0%. Revenues from Tivoli software rose 8.0%. Revenues from Lotus software jumped 6.0%, while Rational software spiked 7.0%.

Hardware– Systems and Technology revenues rose 3.6% (1.0% at constant currency) year over year to $4.48 billion. Systems revenues grew 6.0% (2.0% at constant currency), despite a 5.0% decrease in System z revenues.

Revenue from POWER Systems leaped 15.0% year over year. Revenues from System x mainframe server products spiked 1.0% while MIPS (millions of instructions per second) declined 11.0% in the quarter.

Revenues from System Storage escalated 8.0% while revenues from Retail Store Solutions increased 14.0% year over year. Revenues from Microelectronics OEM plunged 6.0%.

Financing– Revenues from Global Financing fell 2.0% (6.0% at cc) year over year to $520.0 million.

Revenue by Region

From a geographic perspective, third quarter 2011 revenues were up 7.0% (6.0% at constant currency) in the Americas while the same in the Asia-Pacific region grew 10.0% (1.0% at constant currency). Europe, Middle East & Africa (EMEA) revenues leaped 9.0% (flat at constant currency) during the quarter.

IBM witnessed a growth of 17.0% (13.0% at constant currency) in the reported quarter from Brazil, Russia, India and China (BRIC), reflecting the company’s strength in the emerging countries. Revenues from the growth markets, which include South Africa, Vietnam and the Czech Republic, increased 19.0% (13.0% at constant currency).

Balance Sheet

IBM ended the quarter with $11.30 billion in total cash and marketable securities, compared with $11.76 billion in the previous quarter.

At the end of the third quarter, total debt was $30.16 billion compared with $29.03 billion in the prior quarter. Global Financing debt totaled $22.8 billion versus $23.4 billion at the end of September 2011, resulting in a debt-to-equity ratio of 7.1 to 1.

Non-global financing debt increased $1.0 million since June 30, 2011, to $7.4 billion and resulted in a debt-to-capitalization ratio of 27.8% compared with 24.3% at the end of the second quarter.

The company reported cash flow from operations (excluding Global Financing receivables) of $4.47 billion versus $4.31 billion in the previous quarter. In the reported quarter, IBM generated free cash flow of $3.5 billion, up from $3.4 million in the prior quarter.

IBM returned $4.3 billion to shareholders through dividends ($0.9 billion) and share repurchases ($3.4 billion) in the quarter. At the end of the reported quarter, IBM had $5.2 billion remaining under its existing share repurchase authorization.

Guidance

IBM raised its fiscal 2011 operating EPS estimate to at least $13.35 from its previous guidance of at least $13.25. GAAP EPS guidance was also raised to $12.95 from the earlier projection of at least $12.87.

Currently, the Zacks Consensus Estimate for fiscal 2011 is pegged at $13.31, which is slightly below management’s guided range.

Our Take

IBM has been one of the most consistent performers in the tech industry over the last 12 months. IBM shares have surged 26.5% year to date compared to a 5.6% decline in S&P 500. However, we believe that lower-than-expected revenue and a sequential decline in total backlog ($137.0 million in the third quarter versus $144.0 million in the prior quarter) reflect a weak IT spending environment. We believe this will remain an overhang on the stock in the near term.

Moreover, IBM is facing stiff competition from Oracle Corp. (ORCL), Hewlett-Packard Co. (HPQ), and Accenture plc (ACN) in most of its business segments. IBM intends to boost its research & development spending and continue its acquisition spree in order to sustain its market leadership position, which can hurt profitability going forward, in our view.

However, we believe IBM’s growing initiatives in the smarter planet, business analytics and cloud computing will drive long-term growth. IBM remains a heavyweight in the cloud computing market and its strong cash balance enables the company to acquire companies with high intellectual property (IP), which will drive further growth in the upcoming quarters.

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.