International Business Machines Corp. (IBM) delivered strong first quarter 2011 earnings, beating the Zacks Consensus Estimate by 11 cents (4.78% upside). The solid result was primarily driven by robust revenue growth, continued margin expansion and share repurchases in the said quarter.
Operating Performance
IBM posted non-GAAP earnings per share (EPS) of $2.41 per share in the first quarter. This was up 20.5% on a year-over-year basis, primarily due to solid revenue growth (15 cents), margin expansion (11 cents) and share repurchase (15 cents).
Net profit on a non-GAAP basis improved 13.3% year over year to $2.99 billion. Net margin increased 70 basis points (bps) year over year to 12.2%. The company cited that it has posted EPS growth in the last 33 quarters with double-digit growth in 15 of the last 17 quarters.
Gross profit on a non-GAAP basis was $10.95 billion, up 9.6% year over year. Gross margin rose 80 bps on a year-over-year basis to 44.5%, primarily attributable to strong margin performance by the Systems and Technology segment.
Total operating expense & other income increased 8.2% year over year to $6.97 billion in the quarter, primarily due to higher acquisition costs, research & development expense (up 4.4% year over year) and selling, general & administrative expense (up 2.0% year over year).
Pre-tax income on a non-GAAP basis was $3.99 billion, up 12.1% year over year. Pre-tax margin went up 60 bps to 16.2% in the quarter.
Total revenue increased 7.7% (5.0% adjusted for currency) year over year to $24.61 billion, surpassing the Zacks Consensus Estimate of $24.04 billion. This was driven by strong growth in the transaction and outsourcing business. Strong contribution from growth markets (approximately half of the quarter’s revenue) and solid performance from System z, Power, System x and Software were also responsible for the upside.
IBM’s key initiatives such as Business Analytics, Smarter Planet and Cloud offerings reported strong growth in the quarter. Business Analytics were up 20.0%, with 15% contribution to software, and contributing more than 30% in Global Business Services. Smarter Planet increased 20.0%, while Cloud offerings achieved a growth of 5.0% in the quarter. IBM management expects to double cloud revenues in 2011.
Revenues by Segment
Services – Total Global Services revenue grew 6.2% (3.0% on a constant currency basis/ cc) year over year to $14.57 billion, driven by an upside of 6.0% (3.0% cc) in Global Technology Services revenues to $9.86 billion and a 6.8% (3.0% cc) rise in Global Business Services revenues to $4.71 billion.
The estimated services backlog as of March 31, 2011 was $142.0 billion, an increase of $8 billion ($1.5 billion cc) year over year.
Total transactional revenue jumped 6.0% (3.0% at cc) to $5.9 billion. Total outsourcing revenue was $6.8 billion, up 7.0% (4.0% at cc) year over year in the quarter.
Total signings in the quarter plunged 14.0% (18.0% at cc) to $10.5 billion. Signings in Transactional Services (Consulting, Integrated Technology Services and Application Management Systems Integration) inched down 1.0% (5.0% at cc) year over year to $5.8 billion.
IBM’s total Outsourcing Services signings (GTS Outsourcing and Application Management Outsourcing) plummeted 27.0% (30.0% at cc) to $4.7 billion.
Software – IBM reported a year-over-year rise of 16% (14% at cc) to $3.3 billion 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 6.0% (4.0% at cc) year over year and stood at $5.3 billion. Excluding the first quarter 2010 divestiture of the Product Lifecycle Management operations (PLM), Software revenues climbed 10.0% (8.0% at cc) over the prior year, driven by strong performance from business analytics, storage management and business integration. Netezza (acquired in late 2010) contributed significantly to the revenue growth (transaction volumes up 50.0% year over year).
Operating systems revenue of $542.0 million increased 9.0% (7.0% at cc) compared with the prior-year quarter. Revenues from the WebSphere suite of software products shot up 51.0% year over year. Information Management software revenues increased 13.0%. Revenues from Tivoli software rose 8.0%. Revenues from Lotus software increased 1.0%, while Rational software increased 5.0%.
Revenues from Business Analytics operations within the Global Business Services and Software climbed an encouraging 20.0%.
Hardware – Systems and Technology revenues increased 19.0% (16.0% at cc) year over year to $4.0 billion. Systems revenues were up 18.0% (16.0% at cc), attributable to an increase in System x revenues, which grew 13.0%.
Revenue from POWER Systems leaped 19.0% year over year. Revenues from System z mainframe server products surged 41.0% and MIPS (millions of instructions per second) also climbed 34.0%, on the back of new product launches.
Revenues from System Storage escalated 10.0% while revenues from Retail Store Solutions increased 18.0% year over year. Revenues from Microelectronics OEM ascended 23.0%.
Financing – Revenues from Global Financing fell 4.0% (6.0% at cc) year over year to $516.0 million.
Revenue by Region
From a geographic perspective, first quarter 2011 revenues were up 9.0% (8.0% at cc) in the Americas and grew 12.0% (4.0% at cc) in the Asia-Pacific region. Europe, Middle East & Africa (EMEA) revenues were up 3.0% (2.0% at cc) in the quarter.
IBM witnessed a growth of 26.0% (22.0% at cc) in the reported quarter from Brazil, Russia, India and China (BRIC), validating the company’s strength in the emerging countries. Revenues from the growth markets, which include South Africa, Vietnam and the Czech Republic, increased 18.0% (12.0% at cc).
In the first quarter of 2011, OEM revenues were $600 million, up 13% year over year.
Balance Sheet
IBM ended the quarter with $13.25 billion in total cash and marketable securities, compared with $11.65 billion in the sequentially preceding quarter.
At the end of the first quarter, total debt was $30.25 billion compared with $28.62 billion in the prior quarter. Global Financing debt totaled $23.7 billion versus $22.8 billion at year-end 2010, resulting in a debt-to-equity ratio of 7 to 1.
Non-global financing debt totaled $6.5 billion, an increase of $712.0 million since year-end 2010, resulting in a debt-to-capitalization ratio of 25.1% compared with 22.6% at year-end 2010.
The company reported cash flow from operations (excluding Global Financing receivables) of $1.86 billion versus $2.34 billion in the year-ago quarter. In the reported quarter, IBM generated free cash flow of $798.0 million, down from $1.43 billion in the year-ago quarter.
This decline was credited to higher income tax settlement payments in the quarter.
IBM returned $4.8 billion to shareholders through dividends ($0.8 billion) and share repurchases ($4.0 billion) in the quarter. At the end of the first quarter, IBM had $4.7 billion remaining under its existing buyback authorization.
Guidance
Based on the strong first quarter 2011 results, IBM raised its fiscal 2011 operating EPS estimate to at least $13.15 from its previous guidance of at least $13.00. GAAP EPS guidance increased to at least $12.73 from at least $12.56 for the same period.
Currently, the Zacks Consensus Estimate for fiscal 2011 is pegged at $13.07, which is below management’s guided range.
Recommendation
We believe that IBM will continue to benefit from its spate of new initiatives like smarter planet, business analytics and optimization and cloud computing over the long term.
IBM reported strong first quarter results, witnessing growth across all sectors and segments. However, sluggish new services signing will remain a concern going forward.
Moreover, IBM continues to face stiff competition from a number of companies, including Hewlett Packard Co. (HPQ), Microsoft Corp. (MSFT), Oracle Corp. (ORCL) and EMC Corp. (EMC).
We remain Neutral over the long term (6-12 months) based on the belief that the shares are fairly valued at current levels.
Currently, IBM has a Zacks #3 Rank, which implies a short-term Hold rating on the stock.
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