Mainframe Sales Fuel Growth at IBM

Jing Cao (Bloomberg) -- IBM managed to increase sales for the first time in almost six years, but that growth wasn’t fueled as much by cloud computing and other new products as some analysts had projected, causing shares to tumble.

“The bulls were hoping for a beat on that segment,” said Daniel Ives, chief strategy officer at GBH Insights. Revenue in the newer businesses “missed whisper expectations,” which disappointed the most bullish scenarios, he said. 

IBM reported fourth-quarter sales of $11.1 billion in “strategic imperatives” -- those newer products and services in cloud, analytics, security and mobile. While that was up 17 percent from a year earlier, it was just in line with the average estimate and many were hoping for more, Ives said.

IBM shares were down 3.3 percent at 7:16 a.m. in pre-market trading in New York Friday.

Much of the growth fueling IBM’s $22.5 billion in fourth-quarter revenue came from its new mainframe servers. Customers from banks to health-care companies are buying the hardware and accompanying software for their own data centers to run large applications -- from financial transactions to customer billing. That should help keep pumping up revenue over the next couple of quarters, analysts said. But IBM will have to show that gains in its newer software and services will help it keep growing even when the bump from hardware sales fades.

“It’s possible that organic growth may be back to flat in the second half of this year, once the benefit from the mainframe refresh cycle goes away,” said Bloomberg Intelligence analyst Anurag Rana. “If you exclude the contribution from mainframes, growth would be flat to negative, which is in line with the past few quarters.”

Sales, which increased 3.6 percent in the period, topped the average analyst estimate of $22.06 billion.  International Business Machines Corp. had forecast the growth in October. IBM said it took a one-time charge of $5.5 billion as a result of the new U.S. tax law, which weighed on profit. In addition, the company said it expects its tax rate to rise in 2018 as a result of the bill, which includes a lower corporate tax rate offset by a broader tax base and reduced foreign tax credit utilization.

Tax Headwinds

The tax headwinds, combined with the one-time charge, threw “one big wrench in the wheel” and could also be why investors are reacting negatively, said David Holt, an analyst at CFRA Research.

Profit, excluding some items, was $5.18 a share in the quarter. Analysts projected $5.17. IBM fell 1 cent short of the average analyst estimate of $13.81 a share for the full year. Under generally accepted accounting principles, IBM reported a loss for the quarter including the tax charge. The shares fell as much as 4.8 percent to $161 in extended trading.

Over the last six years, Chief Executive Officer Ginni Rometty assured investors that she would refocus IBM’s business on emerging technologies -- such as cloud and artificial intelligence -- and stem the revenue decline. She shed units, invested in cloud data centers and bought a number of companies to boost sales, bolster technology offerings and add troves of data to help train AI algorithms. But those investments have yet to pay off, and analysts have said that IBM’s turnaround is still in the works. 

The shares took a beating last year, after the company missed sales estimates in the first half. The stock then rallied the most since 2009 after the company forecast revenue would increase in the fourth quarter. Analysts have said that shows investors care most about getting back to sales growth. One quarter of expansion doesn’t a successful turnaround make, and it’s now critical for IBM to sustain improving revenue this year.

“Revenue growth has been what investors have been wanting to see,” Holt said. “When you pull back the layers, all the segments are churning, and fundamentals are pointing in the right direction.” 

The company projected revenue growth in 2018, regardless of currency trends. New Chief Financial Officer  Jim Kavanaugh said that will be achieved in part by gains in software-as-a-service as well as IBM’s global business services operations -- an area that has struggled in recent years. 

Strategic Imperatives Goal

Rometty had set a goal for IBM to reach $40 billion in strategic imperative revenue this year, which would mean those newer products would make up more than half of the company’s business. Kavanaugh said the company will achieve that goal and continue to increase strategic imperative sales at least at a percentage in the the double digits.

Should IBM increase revenue in global business services as promised by the end of the year, that would reverse continuous declines of more than a year, Holt said. This is an area IBM has invested heavily in to shift the focus and skills of its employees onto projects in digital and cloud-based technologies.

Gross margins were 49.5 percent, missing the average analyst estimate of 50.9 percent, in part because measures to cut expenses took longer to pay off, the company said. While margins improved sequentially as promised, this is the ninth straight quarter that they shrank compared with the same period the prior year. Gross margins will stabilize this year, helped by the expense cutting, higher sales in more profitable products and increased scale on the cloud business, Kavanaugh said. However, currency hedges and plans to continue investing will offset some of that benefit, he said.

Revenue from the systems unit, which houses hardware and operating systems software, grew 32 percent. Typically an area of decline, sales of mainframe servers, as well as accompanying software, helped boost the group.

Sales in the cognitive solutions unit, which houses analytics software and the AI products branded under Watson, grew 2.5 percent to $5.4 billion. Technology services and cloud platforms, the unit that includes IBM’s cloud infrastructure and platform offerings as well as its consulting business, posted a revenue decline of 1.2 percent, in part because some of its legacy software sales with bigger upfront revenue shifted to the cloud.

Last week, IBM named Kavanaugh to be the new CFO, while Martin Schroeter will be taking on a new role as the senior vice president of global markets. Kavanaugh has been at IBM for two decades and previously oversaw real estate and chief information officer budgets.