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As Good As It Gets Still Not Good Enough - IBM 1Q10 results analysis

Between Rock and Hard Place - Analysis of IBM 2Q10 business results

IBM FINANCIAL

Updated 7/20/10, 2:00PM HIT

Analysis of IBM's Second Quarter Business Results

A Mixed Bag of Goodies

Investors Focus on the Bad, Ignore the Good, Stock Drops as Result

HAIKU, Maui, July 20 – When IBM released its second quarter results after the markets closed last night, Wall Street ignored the good and focused on the bad, sending the Big Blue shares down over four points in after-hours trading.  The second quarter brought a mixed bag of goodies in which IBM exceeded the earnings expectations, but came up short on revenues and new services contract signings. 

Why would investors choose the bad over the good?  Because they can.   Because as hard as IBM brass try to appeal to Wall Street with logic and reason, quarter after quarter, year after year, they end up hitting their heads against the wall of emotion.  On Wall Street, emotion is king.  And marketing to investors is an art, not an MBA class.   One has to appeal to their right brain senses, not to the left brain rationality.

After an exuberant reception which greeted Intel's results on Wall Street on Friday, it was time for cooler heads to prevail.  The Street looked for an excuse to cool off, to calm its ebullience.   IBM and Texas Instruments, which also reported last night, were convenient scapegoats.  Or was Big Blue a scapegoat?

The Wall Street reaction was not completely irrational.  Investors had some valid causes for concern. IBM eked out a meager 2% revenue growth (left chart), while increasing net earnings 9% (right), partly due to aggressive share buybacks (which accounted for about two points).   The slow revenue growth in this quarter suggests that a recovery may be stalling.  Lest we forget, IBM revenues were DOWN 13% a year ago.  Which means that they are now still below the 2008 business volumes.  In fact, they are a tad lower than even the second quarter 2007 numbers.

So renewed concerns about the rate of business spending on IT raises legitimate questions.

Services New Contract Signings, Backlog Down

Just as importantly for IBM, which now generates more than 56% of its business from services (left chart), new contract signings in that business segment were down 12% from the year ago quarter.  The outsourcing signings were down 19%.

Furthermore, the IBM services backlog also declined by $3 billion since a year ago (although IBM now claims it is down by only $2 billion in the press release, while the IBM CFO told the analysts last evening that the "backlog remains steady at $129 billion, up $1 billion adjusted for currency"). 

Best not to go there, either.  For, currencies are like the wind.  Sometimes they are at your back, at other times in your face.  So unless business executives want the market to start discounting their results whenever they get a tailwind from foreign currency translations, it's better not to use them as an excuse when they diminish the results, as was the case with IBM in this quarter.

The $129 billion backlog as of June 30 was also down by a whopping $5 billion since March 31, when IBM said in a first quarter release that it stood at $134 billion.  The company said at the time in a release that the backlog was up $8 billion from $126 billion in 1Q09 at actual exchange rates (it was up only $1 billion adjusting for currency... see what we mean with "best not to go there?"). 

Why does backlog matter?

Because backlog is a sum total of all pluses and minuses in a services business.   As such, it is a gauge of future revenues and earnings.  New contracts  and renewals are the pluses.  Expiration, cancelations and "rescoping" (downward contract renegotiations) are the minuses.  In IBM's case, the minuses outweighed the pluses by $4 billion in the the first half of 2010 ($16.3 billion vs. $12.3 billion - left chart).  Which raises a legitimate concern that no analyst focused on during the Q&A session.  Instead, they dwelled only on the less important new contract signings shortfall.

The IBM CFO tried to explain the disappointing signings by saying that not all new contract signings are equal; that this quarter's total would produce more short-term revenue that a bigger number a year ago. 

"We will actually get more revenue over the next 12 months from this quarter’s outsourcing signings of $6.5 billion than we did from last year’s second quarter signings of $8 billion," IBM CFO Mark Loughridge told the analysts during the teleconference.

Maybe so.  But such finer points were lost on an already downcast audience.  It was like trying to justify a baseball team's meager current results with promises of a better season next year.  Best not to go there, either.  It brings back unwelcome memories of the John Joyce and Lou Gerstner era at IBM (see "Slam Dunk of Bunk", Jan 2000).  It's best to let the chips fall where they may. 

Wall Street has a way of overreacting and then overcorrecting the overreaction.  Ultimately, investors tend to end up where they were supposed to be if they used logic and reason in the first place.  Which is probably why some of them had second thoughts today, when the IBM shares dropped precipitously at first, and then started to rise.  They ended down only $3.24 at $126.55.

Some Bright Spots

Meanwhile, a sharp selloff of Big Blue shares did create a buying opportunity.  For, there is indeed much to cheer about in IBM's second quarter results. 

Bottom Lines.  Let's start with the bottom lines...

• Net income of $3.4 billion, up 9%

• Pretax income of $4.6 billion, up 7%

• Pretax margin of 19.3%, up 1 point

The foregoing results conclude 30 consecutive quarters of EPS growth, 12 of last 14 at double digits.  We don't know of any other major company that can boast that kind of bottom line stability.  "Steady As She Goes" - we also noted in our five-year forecast for IBM in 2009.

Software. Investors could also get a lift if they looked at the IBM software.  They would see not only a faster rate of growth (up 6% from last year on an apples-to-apples basis), but also an amazing 87.1% gross profit and a 33.3% pretax margin.   Again, we are not aware of many businesses Wall Street trades that can generate that kind of gross profit.  Microsoft, the software juggernaut and a monopolist in the PC market, for example, had a pretax margins of 34% in its last full fiscal year.  And Big Blue is far from being a monopolist in its software business.

Revenues from the WebSphere, for example, which delivers capabilities that enable clients to integrate and manage business processes across an enterprise, increased 17% year over year.  Tivoli software, which helps clients manage technology and business assets by providing visibility, control and automation across the organization, increased 18%, while revenues from Information Management software rose 7%.   Even the operating systems business increased 3%.  A year ago, operating systems revenues were down 11%.

Hardware.  If investors wanted to find for a real IBM turnaround story, they should look at Big Blue's hardware sector.  A year ago, Systems and Technology Group's revenues were down 26%, with all of its product lines declining in double digits.  Mainframes were down 39%, for example, while Retail Store Solutions led the precipitous drops with a 41% decline.

What a difference a year can make.  In the latest quarter, IBM's hardware revenues were up 3% (4%, adjusting for currency).  Systems revenues increased 1% (2%, adjusting for currency), while Storage business rose 5%,.  Meanwhile, revenues from Retail Store Solutions and Microelectronics OEM surged by 31% and 23% respectively, a 72% and 46% turnaround respectively in one year.

Furthermore, revenues from the System x (x86-Wintel servers) increased 30%.  A year ago, they were down 22%.  That's a 52% swing in performance in just one year.

Revenues from System z declined 24% from a year ago.  It is probably the last double-digit decline the market is likely to see in IBM's mainframe business for a while.  Later on this week, Big Blue is expected to unveil its "latest and greatest" mainframe solution whose capabilities will reach far beyond the scope of traditional mainframe applications.  Think of it as sort of a new "IT Czar."  It will run and control practically everything that an enterprise-class customer considers information technology.  And it will do that for a fraction of the cost of traditional computing.

So we should consider the second quarter System z results as the last lull before the spurt which will occur on the fourth quarter, the first full three-month period of the new IBM "system of systems" shipments.  No surprise there (see Big Blue Poised for Growth Again, Jan 2010).

"I expect this (STG) growth rate to improve in the third and the fourth quarters, and to deliver double-digit pre-tax income growth for the second half of the year," IBM's Loughridge told the analysts.

Growth Markets.  Another IBM success story in the second quarter was what the company now calls "growth markets" (we used to refer to this global sector as "emerging markets").  Check out these highlights...

• Growth markets revenue was up 14%;

• Frst-half revenue as large as total Euro zone revenue (i.e., the "Old Europe")

• BRIC countries revenue up 22%;

BRIC, of course, stands for Brazil, Russia, India and China - the world's largest "emerging" economies.  And double-digit growth occurred in each of the four countries. But IBM's strong performance extended beyond the BRIC countries. 

"In fact we had double-digit growth in over 35 countries this quarter, up from 30 in the first quarter," said Loughridge, the IBM CFO, during the teleconference with analysts.

So the growth momentum is clearly there, though not visible as much in the places where Wall Street usually looks first - in the U.S. and Europe's majors.  In fact, IBM's growth markets outpaced the majors by nine points in this quarter.

The pick up in the growth of IBM's SMB business (small and medium size businesses which IBM now calls "General Business) is also a reflection of the increased importance of the company's overseas operations in smaller markets (right chart).

Summary

IBM delivered a mix bag of goodies in the second quarter.  Declines in services backlog and new contract signings are a worry.  High profitability and good growth of software, coupled with a big turnaround in Big Blue's hardware business, are major pluses.  Double-digit growth in emerging markets, a steady new growth engine for IBM for several years now, continues to boost the overall corporate performance.

So on balance, it looks like there is more upside than downside for IBM as we look ahead to the second half of this year.  Maybe that's why the company also raised its outlook yesterday for the full year EPS (earnings per share) to $11.25. If Big Blue were to achieve it, it would reach the first step on the steep trail to $20 (operating) EPS goal in 2015.

Happy bargain hunting!

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