This blog is devoted to helping investors make informed decisions. It will be regularly updated and provide opinions on earnings results. It is not intended to give investment advice and should not be taken as such. Consult your investment advisor.
One of the great IT bellwethers, IBM (NYSE: IBM),
issued mixed results in mid-July. It’s hard to be too critical of a
company that has just raised estimates despite increased currency
headwinds, but a deeper analysis of the company's results reveals some
underlying weakness. It’s been a difficult year for technology, and IBM’s earnings did little to raise investors' spirits.
IBM reports
The two key positives in the report came from the growth in
services backlog (7% at constant currency) and the strength in
higher-margin software sales. In order to demonstrate their impact, here
is a chart of IBM’s segmental growth. All data is sourced from company
accounts.
Growth in the second quarter was better than in the first. Moreover,
IBM’s reported revenue decline of 3% was made to look worse due to
currency headwinds of 2%. Based on its backlog, IBM forecasted that
third-quarter revenues in its global business services segment would be
up by mid-single digits, with global technology services increasing in
the low single digits.
The software segment's bounce back toward growth looked robust, and
management pointed out that its 4% reported revenue increase (5% in
constant currency) was the strongest recorded since the first quarter of
2012. IBM spoke of a very good software pipeline, and referenced good
growth in some important niches like branded middleware (up 10%) and
business analytics (11%).
To put this data into context, here is a graph (sourced from company
accounts) of the segmental revenue share and normalized pre-tax income
share.
Clearly, software is its highest-margin business, and its relative
strength in the quarter helped IBM raise gross margins to 49.7% from
48.3% last year.
With the services backlog up 7%, and higher-margin software returning
to growth in Q2, why aren’t these results as hot as they look?
Four reasons it's still tough out there
First, although software returned to growth in Q2, this was partly due to the weakness in the previous quarter. In fact, growth in the first half
was only 1.9%, which compares unfavorably to 2.6% and 11.5% in the two
previous years. Indeed, a glance at the first chart above demonstrates
that IBM is starting to lap some weaker quarters in 2012.
Second, going back to what IBM said last time around,
$400 million in software and mainframe deals were rolling in to Q2
anyway. When asked about these deals on the current conference call,
management stated that less than half closed in Q2, and, more
importantly, rollovers in higher-margin software are actually larger
going into the Q3. This all sounds good, but there is no guarantee that
rollover deals will get closed. In addition, its main rival Oracle(NYSE: ORCL) also reported some weakness in the quarter.
The third reason is that IBM’s forecast for services
revenue growth in Q3 needs to be put into context. Penciling in growth
of 5% and 2% for business services and technology services,
respectively, would give a total services revenue figure for Q3 of
around $14.9 billion. This compares favorably with the $14.4 billion
recorded last year, but rather less so against the $15.3 billion in
2011.
Finally, the macro commentary wasn’t great. America’s revenues
disappointingly declined 3%. However, the real surprise was within its
growth markets. Revenues in Brazil, India, Russia, and China, were flat
(up 1% in constant currency). In common with Oracle, IBM cited specific
weakness in Russia and China, and it expressed a cautious outlook for
its growth markets for the second half.
Key takeaways for the industry
While the tech market remains weak in 2013, there are pockets of
strength. IBM stated that its cloud revenues were up 70%; Oracle also
reported cloud-based strength. This shows a clear shift in corporate IT
spending towards the cloud and away from legacy on-license/on-premise
software.
Furthermore, the relative strength in IBM's middleware and business
analytics numbers suggests that middleware and data analytics company TIBCO Software(NASDAQ: TIBX) and interactions management provider NICE Systems(NASDAQ: NICE) could do well.
TIBCO finally seems to be sorting out its problems with its sales
force in North America. In addition, its increased focus on big data
analytics solutions, and offering its customers its service both
on-premise and via the cloud, is in line with trends in IT spending. Corporations
may be holding back on discretionary IT spending in general, but they
are still keen to invest in niche areas like social media and customer
engagement. Indeed, TIBCO cited specific strength in sectors such as
financial services and retail.
As for NICE, it has a deal with IBM to
integrate the latter’s analytics within its services. Unlike many areas
of tech spending this year, NICE has been reporting earnings that are
in line with expectations. Moreover, it is seeing strength within sales
of its advanced applications, which allow customers to analyze the data
that its systems capture. Again, this is a sign that in a slow global
economy, corporations are willing to spend on analyzing customer
interactions in order to better manage how they sell into their existing
customers.
The bottom line
In conclusion, IBM and Oracle have both reported earnings, and
neither had particularly good news for the IT spending environment.
Conditions appear to be stabilizing, but the broad-based bounceback in
demand hasn’t really happened yet.
With regards to IBM itself, the company’s story is about its ongoing
paring of lower-margin businesses, and how well it manages its shift
toward more software sales. For longer-term investors, I think the stock
will do fine. If it hits the raised adjusted diluted guidance of $16.90
in EPS for 2013, then it will trade on a forward earnings multiple of
11.4 times, as I write. This is attractive enough, but investors need to
be prepared for potential near-term volatility, because tech spending
remains weak.
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