What to Expect When IBM Reports Earnings

A recovery in IBM's hardware business could boost the company's top line after a disastrous third quarter, but profit growth will continue to be driven by software and services. Look for continued growth in cloud revenue as IBM expands its cloud offerings in 2014.

Jan 13, 2014 at 7:00PM

International Business Machines (NYSE:IBM) is set to release its fourth-quarter earnings after market close on Jan. 21. Shares of IBM got crushed after its last earnings report, with revenue widely missing estimates as hardware sales plummeted. I pointed out at the time that the hardware business doesn't matter nearly as much as the software and services business, and that those businesses were doing just fine. Here's what to expect this time around from IBM's earnings report.

What analysts are expecting
Even though revenue missed estimates last quarter, IBM still managed to grow the bottom line by 6% year-over-year. This quarter, analysts expect revenue to decline by 3.7% year over year to $28.22 billion, likely reflecting lowered expectations for the hardware business. Revenue fell by 4% last quarter, so analysts are expecting a slight improvement on that front.

Even with this expected revenue loss, analysts still think that IBM will be able to boost its earnings considerably compared to last year. The average analyst estimate for EPS is $6.01 for the quarter, up from $5.39 for the same quarter last year. This 11.5% expected EPS growth may be a little too optimistic, nearly doubling the EPS growth of last quarter, but it's certainly within the realm of possibility.

Of course, analyst estimates don't mean much when they are as far off the mark as they were last quarter, so all of these expectations should be taken with a grain of salt.

Look for a hardware recovery
The main reason why IBM's hardware business declined by so much last quarter was weakness in nearly every emerging market. China was down 22%, BRIC countries collectively fell by 15%, and the Asia Pacific region declined by 15% as well. Another big American tech company to see terrible results in emerging markets last quarter was Cisco, so this weakness may not be an IBM-specific problem.

Competitor Hewlett-Packard (NYSE:HPQ) managed to steal away server market share from IBM last quarter amid this collapse. HP's server revenue grew by 2% year over year in its fourth quarter even as the server market contracted, a significantly better result than IBM managed. HP's operating profit from servers did fall, however, suggesting that the company had to accept lower margins in order to claim that market share.

If last quarter's hardware problems were caused by temporary issues, then IBM's server sales may have recovered to some degree during the fourth quarter. This could lead to IBM beating revenue estimates significantly, although servers don't contribute all that much to the bottom line compared to software and services. If server sales continue to be weak, this could point to more serious, IBM-specific, problems.

Growth in software and services
Software and services have become IBM's main business as it has shifted away from low-margin commodity businesses over the past decade. Last quarter, software and services grew by 2% and 1% respectively, with the service backlog jumping by 6% to $141 billion.

One specific area to focus on in the earnings report is revenue generated from the cloud. IBM acquired cloud-infrastructure company SoftLayer last year, and the company plans to launch a slew of cloud-based products in 2014. While IBM's cloud revenue grew by 70% last quarter, IBM has fallen behind the rapidly expanding Amazon (NASDAQ:AMZN) in the cloud.

IBM's and Amazon's cloud businesses aren't quite the same. While Amazon provides basic compute and storage, a commodity that companies like Microsoft also offer, IBM is looking to deliver high-value, high-margin services over the cloud. One example is Watson, the Jeopardy winning system in which IBM recently invested $1 billion. Watson is part of the business analytics division, a business that grew by 8% last quarter, and IBM believes that Watson alone could eventually become a $10 billion business.

While the fruits of the Watson investment and the expanded cloud offerings won't be apparent in the upcoming earnings report, investors should look to the conference call for details regarding IBM's plans for the cloud in 2014.

The bottom line
The hardware business is a wild card going into IBM's earnings report, and better-than-expected sales could boost IBM's top line above analyst estimates. This shouldn't really affect the bottom line, though, as software and services are the main profit drivers. If analysts prove to be correct about earnings, then software and services should grow faster than last quarter, putting IBM closer to its long-term goals.

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Timothy Green has no position in any stocks mentioned. The Motley Fool recommends Amazon.com. The Motley Fool owns shares of Amazon.com and International Business Machines. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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