3 Key Takeaways From IBM's Earnings Report

International Business Machines reported another revenue decline, but this masks the fact that the rest of the business is growing. Here are three important points from IBM's earnings report.

Apr 23, 2014 at 10:30AM

Another quarter, another revenue decline for International Business Machines (NYSE:IBM). Hardware was once again the culprit, with a 23% year-over-year decline in revenue in the segment. However, this also includes the x86-based server business that IBM has agreed to sell to Lenovo. While continued revenue declines are certainly not a good thing, investors that focus only on revenue are ignoring the big picture. Here are the three key takeaways from IBM's first quarter earnings report.

Everything other than hardware is doing fine
Software and services, which made up about 87% of IBM's revenue in the first quarter, not only grew in terms of revenue (adjusted for currency), but also grew in terms of gross margin. Operating margin decreased across the board, but this was due to a $900 million charge related to workforce restructuring. Excluding this charge, the pre-tax profit margin for every segment except hardware actually increased.

IBM's non-hardware businesses are doing fine, and this success is being masked by the weakness in hardware. I mentioned in my IBM earnings preview that the key things to watch were growth in software and services, particularly regarding the cloud. IBM delivered on those fronts. Cloud revenue grew by 50% year-over-year, and while it represents a small part of IBM's total revenue, it also represents a significant opportunity for growth.

Hardware is weak, but mainframes are here to stay
The most important part of IBM's hardware business is System z, where revenue declined by 40% in the first quarter. System z is IBM's mainframe business. It may come as a shock to many that the mainframe computer, which recently celebrated its 50th anniversary, is still relevant today. But it is, and that's not going to change.

The System z revenue decline is due to where the business is in the product cycle . Gross margin was actually up in the quarter, so mainframes aren't facing the same issues that normal servers are facing. Mainframe computers are very good at processing enormous numbers of transactions securely, which is applicable to the banking industry, for example, and IBM's mainframes remain critical to the operation of many businesses worldwide. Switching costs are high, and there's little chance that a mass exodus away from mainframes is going to happen. Selling mainframes, and more importantly selling software and services that run on mainframes, remains a lucrative business for IBM.

While the hardware business looks like it's in shambles, IBM's mainframe business is not facing the same secular issues that the server market is facing. While x86 servers are increasingly becoming a commodity, mainframes provide IBM with an important competitive advantage.

IBM is an expert capital allocator
Very few tech companies have lasted as long as IBM, and very few tech companies have a product like the mainframe that has remained relevant for 50 years. IBM has succeeded not by always being in front of the next big thing, but by expertly allocating capital in a way that maximized long-term profits.

IBM's strategy has been unchanged for the past decade. Businesses that become commoditized, where IBM can't achieve acceptable margins, are discarded in favor of businesses where IBM has competitive advantages. The sale of the PC business a decade ago, the sale of the x86 server business earlier this year, and the expected sale of the foundry business all fit within this strategy.

Along with these divestitures, IBM is investing in areas with the greatest potential for high returns on investment. Watson, IBM's Jeopardy-winning computer system, has a $1 billion investment behind it. IBM is looking to revolutionize big data with the system. Investments in the cloud, including $1.2 billion to expand its global cloud footprint through recently acquired SoftLayer, gives IBM a better ability to deliver its high-value software and services via the cloud.

In a sense, IBM is always in a state of transition, moving capital to where it needs to be in order to maximize long-term profits. This is why the company has survived as long as it has, and this is why the company will continue to survive and thrive into the future.

The bottom line
The story at IBM hasn't changed. The parts of the business that matter, software and services, are both growing and becoming more profitable. Meanwhile, the mainframe business is suffering from cyclical issues, unlike the server market as a whole. IBM allocates capital in order to maximize long-term profits and long-term shareholder returns, not short-term revenue growth. The revenue declines of the past few quarters don't mean much in the grand scheme of things.

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Timothy Green has no position in any stocks mentioned. The Motley Fool owns shares of 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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