International Business Machines is set to announce its Q3 earnings Thursday, October 16th. In the second quarter of 2014, the company reported a marginal decline in revenues due to currency headwinds and divestment of the customer care outsourcing business. This decline was further accentuated by weak performance of the server and storage division, which is facing decreasing sales, product transitions, market disruptions, as well as the pending divestment of a major product line (x86 servers).
During Q2, IBM’s total revenue declined by 2% year on year to $24.4 billion. However, the company reported 28% rise in net income to $4.1 billion, largely due to base effect of lower earnings a year ago arising from workforce rebalancing that impacted the bottom-line by $1 billion. While its core software business witnessed low-single-digit growth, due to 3% year-over-year growth in middleware revenues, its Global Technology Services revenues declined by 1%, primarily due to the negative impact of the sale of the customer care Business Process Outsourcing services business in Q4 2013. However, cloud computing and analytics initiatives buoyed Global Business Services division revenues, which grew by 2% year over year to $4.5 billion in Q2.
We expect that IBM will continue to report growth in revenues for both the software segment and the GBS division in Q3. Trends in IT spending indicate that it will continue to grow, albeit at a slower pace. According to Gartner, Worldwide IT spending is on pace to total $3.7 trillion in 2014, a 2.1 percent increase from last year. While most of the growth is expected to come from developed countries such as the U.S., we expect the company to report growth in revenues from emerging economies, which reported a lackluster performance in the previous quarters. Furthermore, we expect order backlog to improve, which will boost revenues in the future. However, we are closely watching the GTS revenues, which have declined due to contract restructuring and pricing pressure. We also expect its server and storage division to report another quarter of disappointing results as the company is refreshing its product offering, and demand for its product remains low.
Middleware and OS Revenues
The Middleware and the Operating Systems divisions are the biggest contributors to IBM’s stock value, together making up nearly 47% of our estimate. This division continues to report good growth on the back of strong brand recognition of its suite of software such as Tivoli, Rational and Websphere, etc. Additionally, demand for enterprise software remains healthy, which should boost demand for middleware software. Furthermore, these solutions cater to the growing markets that include mobile, social and security tools. Therefore, we expect software division to post growth in Q3 as well as in the near future. However, in this earnings announcement, we are closely monitoring the growth in new licenses for the different middleware products as it will help us to ascertain software demand in today’s market in greater detail.
Revenues From GTS To Remain Tepid
According to our estimates, the global technology service division makes up 21% of IBM’s stock value. Revenues from this division have declined over the past few quarter as a result of contract restructuring and a decline in outsourcing backlog. Furthermore, discretionary IT spending from clients remains weak, which is negatively impacting outsourcing revenues. We expect this trend to have continued in the third quarter, which likely produced a decline in revenues. However, contract restructuring will help the division to post higher profit margins in Q3
GBS Revenues To Post Another Quarter Of Growth
The global business services division contributes over 11% to IBM’s stock value according to our estimates. In Q2 2014, GBS reported a 2% year-over-year growth in revenue to $4.5 billion, buoyed by growth in Business Analytics (7% growth) and Cloud (50% growth). We expect this trend to power GBS revenues in Q3 and contribute more to the top line performance going ahead.
Server Revenues To Decline
Server and storage division, which was once the cash cow of the company, is witnessing a continuing decline in revenues. The company announced the sale of its x86 server business to Lenovo in Q1, in a transaction that is to close in increments over the remainder of the year. The x86 division caters to the blade and rack server market, which is facing intense competition from white box (i.e., unbranded) and better positioned server manufacturers. We expect to get a better understanding of the divestiture process on the earnings call. The remaining server businesses – z-Systems mainframes, the Power line, and its range of high performance computing platforms – each face specific issues. Mainframes are at the trailing end of product cycle and Power systems are confronting severe disruptions in the Unix server market, albeit with the new and open Power 8 architecture. High end platforms retain a strong market position and are benefiting as well from the new Watson initiatives. In short, this challenged division is experiencing a range of issues, though the trends may well be on the cusp of more meaningful improvement.
We currently have a $227 Trefis price estimate for IBM which is about 20% higher than the current market price.