IBM Corp (IBM) Q1 Earnings Top Estimates, Revenues Miss

International Business Machines Corp (NYSE:IBM) reported first-quarter 2016 non-GAAP earnings of $2.38 per share, which increased 1.3% from the year-ago quarter and beat the Zacks Consensus Estimate by 4 cents (1.7%).

Revenues of $18.16 billion missed the Zacks Consensus Estimate of $18.49 billion and decreased 2.8% year over year and 16.6% sequentially. Strong U.S. dollar impacted revenues by $300 million.

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, the revenue decline reflected that these are not sufficient to counter the weakness in traditional businesses yet.

Shares fell 5.37% in after-hour trading following the first-quarter announcement. Despite the quarterly beat we do not expect shares to rebound in the near term due to the weakness in revenue growth rate.

We note that IBM has underperformed the S&P 500 over the last couple of years. While the S&P 500 generated gains of 10.8%, IBM shares increased 2.3%.

Strategic Imperatives

In the first quarter, IBM’s strategic imperatives (cloud, analytics, mobility and security) revenues increased 12% (up 13% at constant currency) to $7.8 billion. Cloud revenues increased 35% to $3.5 billion. The annual exit run rate for cloud as-a-service revenue increased 59% (up 61% at constant currency) on a year-over-year basis to $8.6 billion.

Revenues from analytics (largest of the company’s strategic imperatives) increased 7%. Revenues from mobile increased 20% (up 35% at constant currency) and from security increased 10% (up 14% at constant currency).

Segment Revenue Details

Cognitive Solutions (solutions software and transaction processing software) revenues grew 2.1% on a year-over-year basis (up 2.8% at constant currency) to $4.06 billion. IBM reported that solutions software revenues grew 5%, while transaction processing software declined 1%.

Solutions software growth was driven primarily by analytics (Watson platform, Big Data, Information Integration). The company stated that good growth in on-premise databases and data warehousing, which includes DB2, Informix and Netezza drove growth in analytics. Content and integration offerings were also up in the quarter.

Segmental revenues pertaining to Strategic Imperatives and Cloud grew 7% and 45%, respectively.

Revenues from Global Business Services (includes consulting, global process services, application management) segment were $4 billion, down 3% (down 1.9% at constant currency). Segmental revenues pertaining to Strategic Imperatives grew 13%. Cloud practice surged 57%.

Revenues from Technology Services and Cloud Platforms (includes infrastructure services, technical support services, integration software) decreased 2.5% (down 2% at constant currency) to $8.21 billion. Segmental revenues pertaining to Strategic Imperatives advanced 31%, on the back of robust performance from hybrid cloud (up 42%).

IBM now has more than 50 cloud centers globally. Both Infrastructure services and technical support services declined 2%. Integration software dipped 3% this quarter, owing to lower on-premises DevOps tools and IT services management software revenues. IBM noted that the Bluemix platform continued to expand in the reported quarter.

Systems (systems hardware and operating systems software) segment fell 16.7% on a year-over-year basis (down 12.1% at constant currency) to almost $1.40 billion. The decline primarily reflects lower z Systems and Power revenues.

IBM added seven new z systems clients in the quarter. The company anticipates launching a new mainframe late in 2017.

Power revenues declined due to IBM’s transition to a growing Linux market from declining UNIX. Workloads on Linux grew double-digit, outpacing the market in the quarter. The company noted that it has 3% market share, which presents significant growth opportunity.

Storage hardware was up 7% backed by double-digit growth in all-flash array offerings. Software defined storage revenues grew double-digit. Storage software now represents more than 40% of total storage revenue.

Global Financing (includes financing and used equipment sales) revenues slipped 1.2% (down 2.1% at constant currency) to $405 million.

Expanding Watson Offerings

IBM continues to expand Watson offerings. During the quarter, IBM entered into partnerships with the likes of Visa (NYSE:V) , Samsung (KS:005930), H&R Block (NYSE:HRB), AT&T (NYSE:T) , Harry & David, Charlotte Russe, Performance Bicycle and others. The company added 50 new clients to Watson IoT Platform in the quarter.

The company has inked a partnership with salesforce.com (NYSE:CRM) , which will result in integration of Watson-Einstein. The collaboration will provide an insight on huge amount of data specifically related to the fields of health care, financial services and retail, which will boost its footprint in the rapidly growing artificial intelligence (AI) market. (Read More: IBM, Salesforce Collaborate to Strengthen Presence in A.I.)

IBM Watson on Cloud is a key growth driver in IoT, healthcare and financial services end-markets. IBM Watson is anticipated to reach more than 1 billion people by the end of 2017. Per the IBM Investor Briefing 2017, the company estimates the market for Watson on Cloud as a decision making support system to be worth nearly $2 trillion by 2025. (Read More: IBM's Prospects Bright on Watson's Increasing Popularity)

During the quarter, IBM signed a collaboration agreement with China’s Wanda Internet Technology Group to provide Infrastructure-as-a-Service (IaaS) and Platform-as-a-Service (PaaS) to Chinese enterprises and businesses through a new company. Reportedly, IBM will have a share in revenues.

We also note that Blockchain initiatives, Quantum computing and Containers are some of the other catalysts that will support IBM’s growth trajectory going ahead. Notably, in Blockchain, IBM won 40 new contracts in the quarter. The company is now working on more than 400 Blockchain processes with customers like Maersk, Northern Trust (NASDAQ:NTRS) and others.

IBM announced the first commercial quantum systems during the quarter. The company also launched new cognitive offerings such as Watson Imaging Clinical Review. Further, cognitive capabilities were added to applications like Watson Care Manager.

Margins

Non-GAAP gross margin contracted 300 basis points (bps) to 44.5% from the year-ago quarter. However, pre-tax margin from continuing operations expanded 410 bps on a year-over-year basis to 11.4%.

Segment wise, Cognitive Solutions, Global Business Services and Technology Services and Cloud Platforms pre-tax margin expanded 590 bps, 270 bps and 530 bps, respectively.

Systems pre-tax loss was $186 million much wider than loss of $10 million reported in the year-ago quarter.

Balance Sheet & Cash Flow Details

IBM ended first-quarter 2017 with $10.70 billion in total cash and marketable securities compared with $8.53 billion at the end of fourth-quarter 2016. Total debt (including global financing) was $42.8 million, which increased from $42.2 billion at the end of last quarter. Core (excluding global financing) debt was $14.3 billion, flat on a sequential basis.

IBM reported cash flow from operations (excluding Global Financing receivables) of $4 billion and generated free cash flow of $1.1 billion in the quarter. The free cash flow figure was lower than free cash flow of $2.4 billion generated in the previous quarter, which included Japan tax refund. However, cash flow from operations increased slightly from $3.2 billion reported in the previous quarter.

In the reported quarter, IBM returned $2.6 billion to shareholders through dividends ($1.3 billion) and share repurchases ($1.3 billion). At the end of the quarter, the company had $3.8 billion remaining under its current buyback authorization.

Guidance

IBM reiterated forecasts for full-year 2017. Non-GAAP earnings are expected to be at least $13.80. The company continues to anticipate generating free cash flow in excess of 90% of GAAP net income.

IBM expects profitability to improve in second-half 2017 based on a number of factors. New system product launches are anticipated to boost gross profit. Further, lower spending on systems development will boost profitability.

Moreover, less dilutive effect of acquisitions, closure of pending contracts in the Global Technology Services segment, improving outlook for the Global Business Services segment and cost savings are expected to drive results in the latter half of 2017.

Zacks Rank

IBM currently carries a Zacks Rank #3 (Hold). You can see the complete list of today’s Zacks #1 (Strong Buy) Rank stocks here.

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