International Business Machines Corp. (IBM) reported earnings of $2.78 per share in the first quarter of 2012, which surpassed the Zacks Consensus Estimate by 15 cents. Earnings increased 15.4% on a year-over-year basis, representing double-digit growth in 19 of the last 21 quarters. The significant upside was primarily driven by margin growth (21 cents) and share repurchases (15 cents).

Revenue Details

Total revenue of $24.67 billion was flat on a year-over-year (1.0% adjusted for currency) basis in the first quarter. Healthy revenue growth in the software segment was fully offset by flat global services and decline in hardware revenues during the quarter.

Total revenue was positively impacted by strong performance of the growth markets (up 9.0% both on a reported and constant currency basis). IBM continued to witness strong growth from BRIC (Brazil, Russia, India & China) countries (up 10.0% reportedly/11.0% at constant currency basis) during the first quarter. On a combined basis, BRIC and growth markets were up 11.0% year over year in the reported quarter.

The better-than-expected performance of growth & BRIC markets continued to offset sluggish results from the major markets (down 1.0% reportedly/flat at constant currency basis). The weak result was primarily attributed to a difficult Japan market and a sharp decline in public sector spending. IBM lost two major contracts in Japan, which significantly hurt its overall results during the quarter.

The significant revenue upside in the Americas (up 1.0% reportedly/2.0% at constant currency) was primarily driven by strong revenues from Canada, which fully offset a flat performance in the U.S. Europe, Middle East & Africa (EMEA) revenues declined 2.0% (up 1.0% at constant currency), primarily due to weak results in France and Italy, partially offset by good performance in U.K. and Spain during the quarter. However, Asia Pacific increased 4.0% year over year (1.0% at constant currency) during the quarter.

Revenues by Segment

Services– IBM reports services revenue in two segments: Global Technology Services (GTS) and Global Business Services (GBS). In the first quarter, GTS revenue increased 1.7% year over year to $10.04 billion, primarily driven by stable performance from GTS outsourcing and integrated technology services, partially offset by flat revenue growth from maintenance.

GBS revenue declined 1.5% year over year to $4.64 billion, primarily due to weak GBS outsourcing and consulting & systems integration revenue. Sluggish performance from Japan and public sector (1/3 of GBS) had a negative impact on GBS revenue growth during the quarter. Within GBS, business analytics grew 16.0% and smarter planet climbed 18.0%, respectively, in the reported quarter.

Total outsourcing revenue increased 1.0% year over year (2.0% at constant currency), while transactional revenue remained flat year over year (up 1.0% at constant currency). Total signings amounted to $11.8 billion during the quarter. The estimated services backlog, as of March 31, 2012 was $139.0 billion, down $3.0 billion (up $1.0 billion at constant currency) from the year-ago quarter.

Software– Software segment grew 5.5% (7.0% at constant currency) year over year to $5.60 billion. IBM reported a year-over-year increase of 7.0% (8.0% at constant currency) in its branded key middleware products including WebSphere, Information Management, Tivoli, Rational products and Lotus products.

Revenues from operating systems, WebSphere suite of software products, Information Management software, Tivoli and Rational software increased 9.0% (10.0% at constant currency), 16.0%, 5.0%, 5.0% and 1.0%, respectively, during the quarter. Lotus software revenues were flat in the quarter.

Systems and Technology (Hardware)– Revenues decreased 6.7% (6.0% at constant currency) year over year to $3.75 billion. Systems revenues fell 6.0% (6.0% at constant currency), primarily attributed to a 25.0% decline in System z revenues. Total delivery of System z computing power, as measured in MIPS (millions of instructions per second) plunged 5.0% in the quarter.

Revenue from POWER Systems remained flat (up 1.0% at constant currency) on a year-over-year basis. IBM gained significant market share during the quarter, primarily driven by 250 new contracts from customers previously associated with Hewlett-Packard (HPQ) and Oracle (ORCL).

Despite increasing 17.0% at constant currency in the growth markets, revenues from System x mainframe server products were flat in the quarter. Revenues from hardware storage decreased 4.0% while software storage increased 18.0% year over year. Revenues from Retail Store Solutions fell 13.0% year over year. Revenues from Microelectronics OEM also plunged 13.0% annually.

Financing– Revenues from Global Financing fell 5.0% (4.0% at constant currency) year over year to $490.0 million in the reported quarter.

Operating Performance

Gross profit on a non-GAAP basis increased 3.0% year over year to $11.28 billion. Gross margin expanded 120 basis points (bps) annually to 45.7%. The year-over-year growth in gross margin was driven by strong margin expansion in the services segment and improvement in revenue mix.

Total operating expense & other income increased 2.8% year over year to $7.17 billion in the quarter, primarily due to higher acquisition costs and selling, general & administrative expense.

Pre-tax income on a non-GAAP basis came in at $4.11 billion, up 3.2% year over year. Pre-tax margin increased 50 bps to 16.7% in the quarter. Net profit on a non-GAAP basis improved 9.2% year over year to $3.27 billion. Net margin increased 110 bps year over year to 13.2%.

Balance Sheet

IBM ended the quarter with $12.34 billion in total cash and marketable securities, compared with $11.92 billion in the previous quarter. At the end of the first quarter, total debt was $32.05 billion compared with $31.32 billion in the prior quarter.

Global Financing debt totaled $23.6 billion versus $223.3 billion at the end of December 2011, resulting in a debt-to-equity ratio of 7 to 1. Non-global financing debt increased $469.0 million since December, 2011 to $8.5 billion and resulted in a debt-to-capitalization ratio of 32.7% compared with 32.0% at the end of the fourth quarter.

The company reported cash flow from operations (excluding Global Financing receivables) of $2.87 billion versus $10.0 billion in the previous quarter. In the reported quarter, IBM generated free cash flow of $1.87 billion, down significantly from $8.97 billion in the prior quarter.

In the first quarter, IBM repurchased 15.5 million shares for $3.0 billion and paid dividends worth of $900.0 million. IBM acquired five companies during the first quarter for $1.3 billion.

Guidance

IBM expects fiscal 2012 operating EPS of at least $15.00 (up from the previous guidance of $14.85). GAAP EPS is expected to be around $14.27 (up from the previous guidance of $14.16). Management expects a strong second half of 2012 based on stable services business, strong performance from software, product update in the hardware segment and an improving Japanese macro environment. Currently, the Zacks Consensus Estimate for fiscal 2012 is pegged at $14.87, which is below management’s guided range.

Our Take

IBM’s modest top-line growth over the last two reported quarters primarily reflects a slowing IT spending environment, particularly from the public sector, in our view. Although software continued to grow strongly, sluggish growth in the services segment and decline in hardware make us cautious on the overall IT spending environment. Moreover, unfavorable foreign currency, sluggish environment in Japan and stiff year-over-year comparisons in the hardware segment may hurt profitability in the near term.

We believe that IBM remains well positioned for long-term growth based on its four key growth initiatives: smarter planet, growth markets, business analytics and cloud computing, which are expected to deliver at least $50 billion in revenues by fiscal 2015. We believe that IBM’s strong product pipeline, expansion into emerging markets and continuous acquisitions will help it to achieve this target going forward.

We have a long-term (6-12 months) Neutral recommendation on IBM. Currently, IBM has Zacks #3 Rank, which translates into a short-term Hold rating.

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