After years of revenue and profit declines, International Business Machines (NYSE:IBM) expects 2017 to be a turning point. The company's guidance calls for the first earnings increase since 2013, and with its growth businesses close to accounting for half of total revenue, a return to revenue growth shouldn't be far behind.
IBM CFO Martin Schroeter broke down the company's results during the quarterly conference call, providing additional details for investors. Here are five quotes investors need to see.
IBM's AI advantage
Watson, IBM's cognitive computing system, has been the face of the company's artificial intelligence efforts for years. While other companies are focusing on building virtual assistants, such as Amazon.com's Alexa or Microsoft's Cortana, IBM is putting its efforts into solving problems for its enterprise customers. Schroeter explains:
We're moving into a new phase. The debate about whether artificial intelligence is real is over, and we're getting to work to solve real business problems. As we move into this new era, it's important to understand what enterprise clients are looking for. They need a cognitive platform that turns vast amounts of data into insights, and allows them to use it for competitive advantage. They need access to a cloud platform not only for the capability, but for speed and agility. And they need a partner they trust, and who understands their industry work and process flows.
IBM is building solutions for specific industries, such as healthcare and financial services. Acquisitions in those areas have built up IBM's industry expertise and data sets, allowing the company to better understand the needs of its clients. Watson Health, for example, has 7,000 employees, including doctors, nurses, and data scientists. This deep focus on using Watson to solve specific problems, coupled with IBM's vast base of existing enterprise customers, makes the company a potent force in the world of A.I.
A new source of income
One reason IBM was able to hit its guidance for earnings in 2016 was a significant increase in intellectual property and custom development income. This shows up as a reduction in expenses on the income statement, totaling $521 million during the fourth quarter and $1.6 billion for the full year. That's up 170% and 140%, respectively. Schroeter explains the increase:
Our expense dynamics also reflect the success we've had in rebuilding our intellectual property income base through IP partnerships. This is a model we've developed for some of our high value technologies that are more mature, but not necessarily in a priority investment area for us. So it made sense to work with partners who will invest and build businesses around some of these software assets. It's good for them and it's good for IBM.
Profitability deteriorated in most of IBM's reportable segments during 2016, with this IP income helping to offset those declines. IP income is expected to remain significant this year, with Schroeter pointing to a pipeline of deals for 2017. But IBM will need to stabilize and grow its segment margins to successfully return to earnings growth.
Watson is picking up steam
IBM's Watson exists in many forms, ranging from versions created for specific applications to a variety of services available through IBM's cloud platform. The company hasn't disclosed how much revenue Watson is bringing in, but Schoeter did point out that usage has been growing rapidly:
Our Watson platform, which underpins our cognitive strategy, continues to gain momentum in the marketplace. Natural language processing has long been at the core of Watson. Last quarter, we added new cognitive capabilities for conversation and the demand has been strong. We've seen significant growth in our API calls this year, especially around conversational services, where API calls increased 50 fold year to year.
Without absolute numbers, it's impossible to say how big of a business Watson has become. A slew of partnerships and initiatives have been announced in the past few months alone, and late last year IBM CEO Ginni Rometty predicted that 1 billion people would be using Watson, either directly or indirectly, by 2018. It's clear that Watson is gaining momentum, but investors remain in the dark regarding the details.
Mainframes are alive and kicking
While IBM has sold off various parts of its hardware business over the years, the mainframe business continues to be a source of profits for the company. The last major mainframe refresh came in early 2015, but IBM is still picking up new clients:
Eight quarters into the cycle, we added eight new clients in the quarter, 29 for the year and 80 since inception. New client adoption at this stage in our cycle further validates our clients' perceived value and their ongoing commitment to the IBM platform. Clients are investing heavily to meet the demands for future growth.
IBM will be due to refresh its mainframe product line sometime this year, but Schroeter pointed out that this won't have any impact on the company's financials until late in the year. Still, a new mainframe could help IBM hit its earnings guidance in 2017.
A return to revenue growth is coming soon
With IBM's strategic imperatives still growing at a double-digit rate, the point when these new businesses more than offset declines in the legacy businesses shouldn't be too far away. Schroeter said in response to an analyst's question that pre-tax margin expansion is the focus this year, but that IBM was closing in on that crossover point:
And our margins in the strategic imperatives continue to be higher than overall IBM and higher obviously than the core, so our focus on delivering value hasn't changed. And whenever that crossover point happens to be, yes, we're already close. So when you say wouldn't it imply, yes, we're close, we were close in the fourth. But we're focused on delivering value, and for 2017 we're focused on obviously PTI margin expansion.
IBM's revenue has declined for 19 quarters in a row, in part because of divestitures and a strong U.S. dollar. Returning to earnings growth this year is an important step, but IBM will need to return to revenue growth to convince the market that its turnaround is for real.