Troubled IBM? — 3Q14 Earnings Disappoint

As IBM continues to divest itself from its pesky, low margin hardware businesses, the company has seen revenues continually shrink, and this quarter profits and outlook did not meet Wall Street expectations. And the stock got hammered, now down $20 a share. IBM reported revenues of $22.4 billion, which generated $3.5 billion in profit, down 17% where IBM had reported $4.1 billion in profit only last quarter. This reflects an EPS $3.46 before the charges made in the quarter. These figures are based upon continuing operations as a result of the fact that IBM has decided to discontinue their microelectronics manufacturing business in addition to selling their x86 server business to Lenovo. Consolidated results, including a net loss on discontinued operations of $3.4 billion put IBM’s net income at $18 million on the quarter and an EPS of $0.02. As IBM enters this time of uncertainty, we all have to ask, are we about to see the reemergence of a troubled giant of the 80’s or are we getting a front seat to another miraculous turnaround like Gerstner performed in the 90’s? It’s important not to jump to conclusions as these things take time.

Divesting From Hardware

IBM already announced earlier this year that they would be divesting from their x86 business and selling it to Lenovo, which further removes IBM from the hardware business after selling their PC business to Lenovo in 2004. IBM has stated that they will continue to maintain a strategic reseller relationship with Lenovo to provide their customers with support and unique services. This division represented nearly $4 billion in revenue for IBM but generated virtually no profit, which is the reason the company gives for IBM’s divestiture. I have high hopes for Lenovo’s IBM-branded x86-based server business now that is out from the IBM mother ship where to Lenovo’s PC P&L, it looks like a really good business.

The announcement to sell (pay) their fab to GlobalFoundries could be looked at as another nail in IBM’s hardware coffin, showing the company’s accelerated commitment to move towards software and services. This deal results in IBM taking a onetime charge of $4.7 billion pre-tax and $3.3 billion net of tax. This includes a $1.5 billion cash consideration to be paid to GlobalFoundries over the course of three years. As a result, IBM will join the ranks of the fabless semiconductor industry and will continue to manufacture their processors with GlobalFoundries. They also will be giving GlobalFoundries thousands of patents, strengthening GlobalFoundries’ patent portfolio and also giving them a lot of IBM’s fab brainpower as well through employee transfers.IBM-logo

Business Unit Performance

The Global Services segment revenues saw a decrease of 3% and  IBM says they are flat, adjusting for divestments from their customer care outsourcing business and currency fluctuations. IBM reported $13.7 billion on the quarter. The company saw Global Technology Services also decrease 3% to $9.2 billion, once again saying that the division was actually up 1% with adjustments made to the divestment of the customer care outsourcing business. Global Business Services revenues were also down 2% to $4.5 billion, with IBM once again claiming currency impacted them by a percent.

The worrying figures for IBM, which drove their stock downward sharply were the fact that their Global Technology Services division saw pre-tax income decrease 11% and pre-tax margin decreased to 17.7%. Global Business Services also saw pre-tax income decrease 15% and margins decrease to 17.5%. In addition to all of that, the estimated services backlog was $128 billion, down 7% y-o-y.

For IBM’s Software division, the company reported $5.7 billion in revenue, down 2% when compared with the same quarter a year ago. Software pre-tax income decreased 3% and pre-tax margin decreased to 35.5%. IBM’s reported $513 million in operating systems revenues, down 11% year over year. The company’s middleware products fared better only reporting a 1% decrease to $3.7 billion for the quarter.

For a company banking their future on services and software, it appears that IBM is in reverse course. I must note that IBM is a long way away from fulfilling their potential destiny with Watson, public clouds or SoftLayer and may need new dollars from dumping the hardware units to get the altitude to make a financial difference.

IBM’s System and Technology hardware division took the hardest hit, reporting $2.4 billion in revenue for the quarter, down 15% year over year and an increased pre-tax loss of $99 million. Revenues from power systems were down 12% compared to the same period a year ago and revenues from System x were also down 10%. This is the last quarter that IBM will be reporting System x revenue as the division will officially be divested to Lenovo. Revenues from System z mainframe servers decreased a whopping 35% compared to the same period a year ago, but simply represents the continued industry move away from mainframes. IBM also reported that revenues from system storage decreased 6%.

On the bright side, declines in Power Systems are flattening, and it appears that IBM has the chance to greatly improve its performance by getting its higher end Power Systems online and out the door.

Hardware performance at IBM isn’t pretty but is getting better. One key for them here is to convince enterprises that the combination of proprietary Power Systems hardware plus an open Linux equals an open system, but as HP and Dell embrace Intel’s more open and accepted Xeon E7 V2 platform, this will be an IBM challenge.  Another key to future IBM hardware success can be to make the software, let’s say Watson, so incredibly useful that customers don’t care what it runs on. That’s what I really think IBM is banking on here as going toe to toe with HP, Dell and for that matter Lenovo, on “open” isn’t a high probability win. The wildcard here is OpenPower, which I wrote about here, but that doesn’t come online in a full, open way for years.

IBM’s Bright Spots

IBM, even with all of their doom and gloom in the third quarter, showed some serious promise in what IBM calls their “strategic imperatives”. Strategic Imperatives as a whole showed double digit revenue growth, with half of that coming from software.

For the year, IBM’s business analytics revenue saw an 8% increase over the same period last year and their cloud business revenue saw an increase of over 50% of the year to date compared to last year. Cloud-as-a-Service alone saw an 80% increase over the same period as well, and exited the quarter at an annual run rate of $3.1 billion. IBM’s mobile revenue more than doubled over the same period a year ago and their security revenue saw an over 20% increase marking the 8th consecutive quarter of double digit growth in security.

IBM Adjusts Outlook

IBM also updated their expectations for the full year of 2014. As a result, they expect their operating EPS to be down 2 to 4% compared to $16.64 earnings per share in 2013. They also believe that their long-term plan to deliver $20 operating EPS in 2015 to investors is no longer possible and will have to provide a new EPS outlook for 2015 in January.

Overall, 2014 does not look like it will be ending on a good footing for IBM, even though it was supposed to be the year where IBM pivoted from 2013 and moved forward.

I’m glad IBM got off the $20 EPS bandwagon. Yeah, I get that Wall Street loves consistency, but I believe EPS “Babe Ruth’s” drive poor long-term decision making. It’s way too easy to take those end of quarter deals to make that EPS than stick to your guns. Selling strategic assets off is easy, too.

Where to Go From Here?

IBM is really a company that placed itself inside the center of the IT industry for many years for many reasons and now they appear to be at a crossroads. Will they repeat the rise and glory of the Gerstner 90’s, will they follow the relics of the 50’s and lose relevance like NCR, or something in the middle? IBM has a lot of new and high growth businesses that could improve growth and profitability, but the reality is that they are currently struggling to move their customers to newer products and services at a needed pace that aligns with their prior business drop off.  Frankly, there’s a big gap.

Additionally, in their hardware businesses they have been seeing continually increasing competition specifically in their server businesses and as a result, IBM has been hemorrhaging in hardware for years. IBM’s solution to competition in hardware is to simply divest from it and either sell it to their competitors or in Globalfoundries’ case, pay them to take it from them. As I learned from some painful days in the PC industry, after seeking the high ground over and over, you sometimes run out of places to go. I often think of the analogy of someone stranded on a tropical island, consistently scurrying farther and farther up the coconut tree to find higher ground. I don’t know if it’s fair yet to place IBM in this category, but it’s no longer out of the question, either.

IBM has been cutting and cutting for years and trying to trim the company to a point where their bottom line would satisfy investors. And over the course of the past 5 years, that has worked for the company. But the reality is that IBM is now coming dangerously close to the top of the coconut tree by selling off so many businesses so quickly and laying off employees at the same time.

While it’s too soon to say if IBM is at the top of the coconut tree, what I do know is that time is running out, and it’s imperative for IBM to quickly show results else risk losing the hearts of IBM, it’s employees.  Now that would be a real disaster.