Tech giant International Business Machines Corp. (IBM) reported third quarter 2010 earnings that beat the Zacks Consensus Estimate. The current quarter profitability was fueled by margin expansion due to a shift to the higher-margin software business, increased sales in emerging and growth markets and higher development in the hardware, software and services businesses.
Revenues came in slightly above the Zacks Consensus Estimate with the strongest performance coming from its hardware business. IBM reported gains across all of its business units.
Global spending on information technology (IT) is expected to grow 2.4% in 2010 to $2.4 trillion and 3.1% in 2011, according to research firm Gartner. We expect IBM to benefit from the growth in corporate spending on information technology.
IBM raised its earnings forecast for fiscal 2010, the fifth time in a row, since the third quarter of 2009 as itstands to benefit from its increased focus on software and services.
Despite upbeat third quarter results and encouraging profit guidance, IBM’s shares fell 3.3% or $4.73 to $138.10 in after hours trading due to lower technology services and outsourcing deals signed in the quarter, a key indicator of future revenue growth.
Operating Performance
IBM’s quarterly earnings exceeded the Zacks Consensus Estimate of $2.75 per share by 7 cents, posting a surprise of 2.6%. Net profit improved 11.7% year over year to $3.59 billion, while earnings per share rose 17.5% to $2.82. This compares with a profit of $3.21 billion or $2.40 per share in the year-ago quarter. Net margin upped 120 basis points year over year to 14.8%. The company cited that it has posted earnings per share growth in the last 31 consecutive quarters with double digit growth in the 13 of the last 15 quarters.
The company benefited from an increased Other income and a lower effective tax rate of 23.3% in the quarter.
Gross profit margin grew marginally to 45.3% from 45.1% in the year-ago quarter, led by improved margins in all segments except the Global Technology Services and Other segment. IBM has benefited from the growing focus on high-margin segments, such as Services and Software businesses.
Operating expense grew year over year on a dollar basis in the third quarter due to a higher SG&A expense (21.2% of total 3Q 2010 revenue versus 21.3% of total 3Q 2009 revenue), which grew 2.7% to $5.15 billion and a higher RD&E expense (6.0% of total 3Q 2010 revenue versus 6.1 % of total 3Q 2009 revenue), which increased 1.2% to $1.46 billion from the year-ago quarter. Operating margin inched up to 18.1% in the quarter from 17.7% in the year-ago quarter.
Revenues
Total revenue in the quarter was $0.2 billion above the Zacks Consensus Estimate of $24.1 billion. Revenues of $24.27 billion in the third quarter were up 3.0% (up 4% when adjusted for currency) compared with the year-ago quarter. Overall, sales were down in one of its five segments. Services, Software and Systems and Technology revenues were higher, while Financing fell from the year-ago quarter.
Revenues by Segment
Services — Total Global Services revenue grew 2% (up 2% adjusting for currency) year over year to $14.07 billion, driven by an increase of 0.7% in Global Technology Services revenues to $9.5 billion and a 5.4% increase in Global Business Services revenues to $4.6 billion.
The estimated services backlog on September 30 was $134 billion, an increase of $5 billion (down $2 billion, adjusting for currency) sequentially and flat year over year at actual rates and adjusted for currency. Signings in Transactional services (Consulting, Integrated Technology Services and Application Management Systems Integration) increased 4% year over year (up 4%, adjusting for currency) to $5.4 billion.
Signed services contracts (accounting nearly 60% of total revenue)dropped 7% to $11.0 billion. Analysts had been expecting signings of more than $12 billion in the quarter. Including an agreement signed on October 8, the company would have reported outsourcing signings of $12.7 billion or a growth of 14%, when adjusted for currency.
IBM signed 10 contracts in the quarter, which amounted to greater than $100 million. IBM’s total outsourcing services signings (GTS Outsourcing and Application Management Outsourcing) decreased 15% (down 14%, adjusting for currency) to $5.7 billion.
Software — IBM reported improved revenues from its branded key middleware products that include WebSphere, Information Management, Tivoli, Rational products and Lotus products, which rose 7% (up 8%, adjusting for currency) year over year to $3.1 billion. As a result, the company’s Software segment increased 1% (up 2%, adjusting for currency) to $5.2 billion from the year-ago quarter.
Excluding the first-quarter divestiture of the Product Lifecycle Management operations (PLM), Software revenues grew 4% (6%, adjusting for currency) year over year. Operating systems revenues of $550 million increased 6% (7%, adjusting for currency) compared with the prior-year quarter.
Revenues from the WebSphere family of software products upped 14% year over year. Information Management software revenues increased 5%. Revenues from Tivoli software rose 9%. Revenues from Lotus software and Rational software were flat year over year.
Revenues from Business Analytics operations within Global Business Services and Software climbed 14%, which was encouraging. We believe that IBM will benefit from its spate of new initiatives such as smarter planet, business analytics and optimization and cloud computing.
Hardware — Systems and Technology revenues increased 10.4% (11.0%, adjusting for currency) year over year to $4.33 billion. Systems revenues were up 8%, attributable to an increase in System x revenues, which grew 30%. This was partially offset by a decrease of 13% in revenues from POWER Systems. Revenues from System z mainframe server products soared 15% while MIPS (millions of instructions per second) climbed 54.0% riding on new product launches. Revenues from System Storage escalated 7% while revenues from Retail Store Solutions were flat year over year. Revenues from Microelectronics OEM ascended 28%.
Financing — Revenues from Global Financing decreased 1.3% (down 1%, adjusting for currency) year over year to $529 million.
Revenue by Geography
From a geographic perspective, third quarter 2010 revenues were up 3% (up 2%, adjusting for currency) in the Americas and grew 14% (up 7%, adjusting for currency) in the Asia-Pacific region. Europe, Middle East & Africa (EMEA) revenues were down 6% (up 1%, adjusting for currency) in the quarter. IBM witnessed a growth of 29% (up 26%, adjusting for currency) from Brazil, Russia, India and China (BRIC), validating the company’s strength in emerging countries.
Year-over-year revenues from OEM customers upped 27% and revenues from the growth markets — which include South Africa, Vietnam and the Czech Republic — increased 16% (up 13% adjusting for currency) and represented 21% of total geographic revenue. Growth markets revenues for both servers and storage increased by more than 20% in the quarter. To date, IBM recorded 103 sales offices in the growth markets.
Balance Sheet
IBM ended the quarter with $11.10 billion in total cash and marketable securities, compared with $12.24 billion in the previous quarter. The company reported cash flow from operations (excluding Global Financing receivables) of $4.18 billion versus $3.99 billion in the previous quarter. In the reported quarter, IBM generated free cash flow of $3.17 billion, up from $3.02 billion in the previous quarter. The company returned $4.5 billion to shareholders through $0.8 billion in dividends and $3.7 billion in share repurchases.
At quarter end, Global Financing debt totaled $22.0 billion versus $21.2 billion in the previous quarter and $22.4 billion at year-end 2009, resulting in a debt-to-equity ratio of 7.1 to 1. Non-global financing debt totaled $5.5 billion, an increase of $1.7 billion since year-end 2009, resulting in a debt-to-capitalization ratio of 22.1%, down from 16.0% in the fourth quarter of 2009.
Guidance Raised
Historically, IBM’s earnings have consistently surpassed the Zacks Consensus Estimate, and IBM has raised its guidance for almost every quarter over the last three years. For fiscal year 2010, the company again raised its earnings forecast to at least $11.40 per share from the previously projected $11.25 per share. Earnings expectation is well ahead of the Zacks Consensus Estimate of $11.28.
IBM also expects to double its profit by 2015 to at least $20 per share and it plans to spend around $20 billion in acquisitions over the same period. IBM expects growth to pick up, attributable to the new product cycles in the hardware division. Moreover, the new mainframe computers and high-end servers will lead to further growth in hardware sales in 2010.
Over the long term, we remain positive on IBM, and thus maintain our Neutral rating on the stock. IBM is a Zacks #3 Rank (Hold).
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