International Business Machines Corp. (IBM) reported stellar second quarter 2011 results, with earnings per share (EPS) comprehensively beating the Zacks Consensus Estimates by 8 cents (2.7%). IBM shares also rose modestly (1.69%) in after hours trading.
Operating Performance
IBM posted non-GAAP EPS of $3.09 per share in the second quarter, up 18.0% on a year-over-year basis and representing double-digit growth in 16 of the last 18 quarters. The significant upside was primarily driven by solid revenue growth (33 cents) and share repurchases (18 cents), which fully offset weak margins in the quarter.
Net profit on a non-GAAP basis improved 11.0% year over year to $3.78 billion. However, net margin decreased 10 basis points (bps) year over year to 14.2%. Pre-tax income on a non-GAAP basis came in at $5.04 billion, up 9.9% year over year. Pre-tax margin declined 40 bps to 18.9% in the quarter.
Higher operating expenses and hedging losses ($220.0 million) hindered margin expansion in the quarter. Total operating expense & other income increased 19.5% year over year to $7.44 billion in the quarter, primarily due to higher acquisition costs, research & development expense (up 5.7% year over year) and selling, general & administrative expense (up 18.4% year over year).
Gross profit on a non-GAAP basis was $12.48 billion, up 15.4% year over year. Gross margin rose 120 bps on a year-over-year basis to 46.8%. The year-over-year growth in gross margin was driven by Systems and Technology (up 5 bps) resulting from improvements in every systems brand, and an improving mix.
Revenues
Total revenue increased 12.4% year over year (5.0% adjusted for currency) to $26.67 billion, surpassing the Zacks Consensus Estimate of $25.4 billion. The year-over-year growth was driven by strong performance from the transactional businesses in hardware and software.
IBM’s key initiatives such as Business Analytics, Smarter Planet and Cloud offerings reported strong growth in the first half of 2011. Business Analytics revenues rose more than 25.0%, whereas Smarter Planet increased more than 50.0%. IBM management expects to double revenue from cloud computing in 2011.
Revenues by Segment
Services– Total Global Services revenue grew 10.1% (2.0% on a constant currency basis) year over year to $15.11 billion, driven by an upside of 11.0% (3.0% at constant currency) in Global Technology Services revenues to $10.24 billion and a 8.5% (1.0% at constant currency) rise in Global Business Services revenues to $4.87 billion.
The estimated services backlog, as of June 30, 2011, was $144.0 billion, an increase of $15 billion ($2.0 billion constant currency) from the year-ago quarter.
Total transactional revenue jumped 9.0% (1.0% at constant currency) to $6.1 billion. Total outsourcing revenue was $7.1 billion, up 12.0% (3.0% at constant currency) year over year.
Total signings in the quarter were up 16.0% (8.0% at constant currency) to $14.3 billion. Signings in Transactional Services (Consulting, Integrated Technology Services and Application Management Systems Integration) increased 15.0% (7.0% at constant currency) year over year to $7.1 billion.
IBM’s total Outsourcing Services signings (GTS Outsourcing and Application Management Outsourcing) increased 15.0% (7.0% at constant currency) to $7.1 billion.
Software– IBM reported a year-over-year increase of 21.0% (14.0% at constant currency) in its branded key middleware products including WebSphere, Information Management, Tivoli, Rational products and Lotus products.
Accordingly, revenues from the company’s Software segment grew 17.0% (10.0% at constant currency) year over year to $6.17 billion.
Operating systems revenue of $630.0 million, increased 16.0% (9.0% at constant currency) compared with the prior-year quarter. Revenues from the WebSphere suite of software products shot up 55.0% year over year. Information Management software revenues escalated 18.0%. Revenues from Tivoli software rose 9.0%. Revenues from Lotus software jumped 12.0%, while Rational software spiked 4.0%.
Hardware– Systems and Technology revenues increased 17.5% (12.0% at constant currency) year over year to $4.68 billion. Systems revenues grew 20.0% (13.0% at constant currency), attributable to an increase in System z revenues (up 61.0%).
Revenue from POWER Systems leaped 12.0% year over year. Revenues from System x mainframe server products surged 15.0% while MIPS (millions of instructions per second) shot up 86.0% on the back of new product launches.
Revenues from System Storage escalated 10.0% while revenues from Retail Store Solutions increased 8.0% year over year. Revenues from Microelectronics OEM ascended 4.0%.
Financing– Revenues from Global Financing fell 4.6% (11.0% at cc) year over year to $519.0 million.
Revenue by Region
From a geographic perspective, second quarter 2011 revenues were up 10.0% (8.0% at constant currency) in the Americas while the same in the Asia-Pacific region grew 14.0% (3.0% at constant currency). Europe, Middle East & Africa (EMEA) revenues were up 16.0% (3.0% at constant currency) in the quarter.
IBM witnessed a growth of 27.0% (21.0% at cc) in the reported quarter from Brazil, Russia, India and China (BRIC), validating the company’s strength in the emerging countries.
Revenues from the growth markets, which include South Africa, Vietnam and the Czech Republic, increased 23.0% (13.0% at constant currency). This was driven by strong growth in hardware (up 24.0% year over year) and websphere (up 40.0% year over year).
IBM continues to expand in the growth markets of Africa and the Asia-Pacific. During the first half of 2011, IBM expanded its footprint in Eastern and Western Africa by opening new branches in Dar es Salaam, Tanzania and Dakar, Senegal. IBM already serves a number of clients in key sectors spanning the telecommunications, oil & gas, finance and government verticals in East and West Africa.
Moreover, the company has been selected by many government agencies from different countries in the Asia-Pacific to provide services and technical support for their operations, thus ensuring a steady flow of orders and market share gains across various regions.
In the first quarter of 2011, OEM revenues were $700 million, flat year over year.
Balance Sheet
IBM ended the quarter with $11.76 billion in total cash and marketable securities, compared with $13.25 billion in the previous quarter.
At the end of the second quarter, total debt was $29.03 billion compared with $30.25 billion in the prior quarter. Global Financing debt totaled $23.4 billion versus $23.7 billion at the end of June 2010, resulting in a debt-to-equity ratio of 7 to 1.
Non-global financing debt decreased $1.0 million since March 31, 2011, to $6.4 billion and resulted in a debt-to-capitalization ratio of 24.3% compared with 25.1% at the end of the first quarter.
The company reported cash flow from operations (excluding Global Financing receivables) of $4.31 billion versus $1.86 billion in the previous quarter. In the reported quarter, IBM generated free cash flow of $3.4 billion, up from $800.0 million in the prior quarter.
IBM returned $4.9 billion to shareholders through dividends ($0.9 billion) and share repurchases ($4.0 billion) in the quarter. At the end of the second quarter, IBM had $8.7 billion remaining under its existing share repurchase authorization.
Guidance
Based on the strong first half of 2011, IBM raised its fiscal 2011 operating EPS estimate to at least $13.25 from its previous guidance of at least $13.15. GAAP EPS guidance was also raised to $12.87 from the earlier projection of at least $12.73 for the same period.
Currently, the Zacks Consensus Estimate for fiscal 2011 is pegged at $13.23, which is slightly below management’s guided range.
Recommendation
We believe IBM’s growing initiatives in the smarter planet, business analytics and cloud computing will drive long-term growth. IBM remains a heavyweight in the cloud computing market and its strong cash balance enables the company to acquire companies with high intellectual property (IP), which will drive further growth in the upcoming quarters.
IBM is experiencing strong revenue growth across all geographical regions, coupled with robust growth in emerging markets worldwide. IBM expects these growing markets to drive revenues and growth in 2011 and beyond.
Besides, the ability to generate strong free cash flow and improve the already robust balance sheet makes the stock attractive over the long term. However, weak margins will remain an overhang on the stock going forward.
Moreover, increasing competition from Oracle Corp. (ORCL), Hewlett-Packard Co. (HPQ), Microsoft Corp. (MSFT) and EMC Corp. (EMC), will hurt profitability going forward.
We believe the strong second quarter results are already priced into the stock and hence expect it to remain range bound in the near term.
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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