International Business Machines (IBM), Earnings Expectations Are Not Justified!

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International Business Machines Corporation (IBM) is an American leading technology company. The Company operates through five segments: Cognitive Solutions, Global Business Services (GBS), Technology Services & Cloud Platforms, Systems, and Global Financing. The Cognitive Solutions segment delivers a spectrum of capabilities, from descriptive, predictive, and prescriptive analytics to cognitive systems. Cognitive Solutions includes Watson, a cognitive computing platform that has the capability to interact in natural language, process big data, and learn from interactions with people and computers. The GBS segment provides clients with consulting, application management services, and global process services. The Technology Services & Cloud Platforms segment provides information technology infrastructure management services. The Systems segment provides clients with infrastructure technologies. The Global Financing segment cover activities like client financing, commercial financing, remanufacturing, and remarketing.

What is the problem with IBM?

Recently International Business Machines reported $1.84 in adjusted earnings per share for Q1 2020, exactly in line with analyst estimates. Sales dropped by more than expected, as did sales of its largest legacy segment, Global Technology Services. IBM is trying to pivot to a more cloud-focused strategy after its purchase of Red Hat. However, the sales of most of IBM’s other businesses have continued to decrease, dragging down the rentability of the company’s overall business even as cloud sales grow. IBM’s stock fell slightly in after-hours trading.

What to Look for?

During the first week of April, International Business Machines Corp. (IBM) welcomed company veteran Arvind Krishna as its new chief executive officer (CEO), just as both his company and the global economy were entering a period of global change. Krishna, the principal architect of IBM’s $34 billion acquisition of software giant Red Hat, wants to conduct tradition-bound IBM to a cloud-computing-oriented business model.1 But he now must do that when global markets are shrinking due to the coronavirus pandemic. IBM investors will focus attentively on how the giant is weathering the pandemic, and also on whether Krishna’s strategy will be justified when IBM reports earnings on April 20 after the market close for Q1 2020.2

Key metric investors will focus on is the health of IBM’s legacy Global Technology Services (GTS) business and how much it’s likely to be hurt by the expected sharp economic downturn. For Q1 of 2020, analysts estimate that IBM’s adjusted earnings per share will drop sharply while corporate revenue and revenue at Global Technology Services will see moderate declines.

Over the past 12 months, IBM has underperformed the broader market. The company’s shares have posted a total return of -10.5% compared to the S&P 500’s -3.1% total return. All figures are as of April 10, 2020.

One Year Total Return for S&P 500 and IBM
Source: TradingView.

IBM’s shares rose after the company posted earnings that faintly beat expectations for Q4 2019.3 While adjusted earnings per share (EPS) fell 3.5% year-over-year (YOY), revenue was generally flat, growing 0.1%.4 The growth in revenue, nevertheless small, was the first increase since Q2 2018, thus ending a five-quarter continuity of revenue decrease. It was a sign that the Red Hat acquisition may be starting to pay off.

That quarter also was advantageous with an improvement from Q3 2019 when the company reported YOY adjusted EPS and revenue declines of 21.7% and 3.9%. The drop in adjusted EPS was the biggest since Q2 2016.4 Even the slight earnings beat was not enough to keep the stock on pace with the rest of the market, which it had been doing during the first half of 2019.3

After the initial boost following the Q4 2019 earnings report, IBM’s stock started to fall and then rallied on the January news of Krishna’s promotion to CEO.5 1 That was just before the stock got crushed along with the rest of the market on fears of the spread of COVID-19. Due to the economic turmoil caused by the virus, analysts expect IBM’s adjusted EPS and revenue to decline by 18.3% and 1.0%, respectively, in Q1 2020.4

IBM KEY METRICS
 Estimate for Q1 2020 (FY)Q1 2019 (FY)Q1 2018 (FY)
Adjusted Earnings Per Share ($)1.842.252.45
Revenue ($B)18.018.219.1
Global Technology Services Revenue ($B)6.87.27.6

As mentioned, major metric investors will focus on is revenue growth in IBM’s giant Global Technology Services unit. The business has been a major drag on the company, posting falling revenue during 11 of the last 13 quarters, including the estimated Q1 2020 drop. Notwithstanding, GTS remains IBM’s long-standing information technology (IT) infrastructure and platform services business. Strengthened with an experience of decades , GTS is seen as crucial to enabling IBM to pivot more aggressively toward the cloud. It’s also IBM’s largest source of revenue, generating about 35% of total revenue in 2019.6

However, that revenue share has been falling. GTS comprised nearly 37% of IBM’s total consolidated revenue in 2018.6 The segment posted YOY revenue declines of 4.7% and 5.3% in Q4 and Q3 of 2019, respectively. Analysts are expecting another decline of 5.3% for Q1 2020.4

One of the main reasons International Business Machines’s consolidated revenue numbers haven’t fallen sharply is due to the significant growth in the company’s Cloud & Cognitive Software segment, which grew 4.5% during 2019.6 The challenge for Krishna and the rest of the executive management team will be to get the Cloud segment and Global Technology Services growing in tandem.

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