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IBM Needs an Earnings Win Next Week

By Timothy Green – Jul 14, 2017 at 3:00AM

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After a disappointing first-quarter report that sent the stock tumbling, Big Blue has to deliver.

After surging 20% in 2016, shares of International Business Machines (IBM 1.45%) fell back into a funk this year. The stock is down about 7.5% year to date, driven lower by a disappointing first-quarter report in April. While IBM beat expectations for earnings, the delayed closing of a few major services deals led the company to miss on revenue.

IBM will have a chance to redeem itself when it reports its second-quarter results after the market closes on July 18. At least one of those delayed deals, a $1.7 billion cloud services pact with a major U.K. bank, was completed during the second quarter, as was a high-profile deal with seven European banks to build a trade finance platform based on blockchain, the technology that underlies cryptocurrencies like bitcoin.

Another quarterly revenue decline is likely, which will extend IBM's infamous streak to 21 consecutive quarters. IBM has beaten the average analyst estimate for earnings for 10 straight quarters, though, and another beat would provide some good news for investors. IBM will also likely reiterate its full-year earnings and free cash flow guidance, which calls for adjusted earnings per share of at least $13.80 and flat free cash flow compared to 2016.

IBM's Global Center for Watson IoT in Munich, Germany.

Image source: IBM.

What analysts are expecting

The average analyst estimate calls for second-quarter revenue of $19.47 billion, a 3.8% year-over-year decline. That's even steeper than the 2.8% decrease IBM reported during the first quarter, so it seems a little too pessimistic to me. For the full year, analysts expect a 2.1% revenue slip.

Adjusted EPS of $2.75 is expected, down from $2.95 in the prior-year period. IBM expects about 37% of its adjusted EPS to be generated during the first half, with the rest coming during the second half. The average analyst estimate would put the first-half total right at 37%, assuming IBM hits its full-year guidance.

One thing that will drive this second-half skew for IBM is the expected launch of a new mainframe system. Increased mainframe sales and reduced systems development spending during the second half will provide a boost to both the top and bottom lines. It's possible, although far from guaranteed, that the launch of the new mainframe system could put an end to IBM's streak of quarterly revenue slides.

At least one analyst only sees things getting worse for IBM. An analyst at Jefferies maintained his underperform rating on the stock earlier this week, knocking down his price target by $10 to $125 per share. AI adoption issues, as well as intense competition for AI talent, were the main reasons given for the gloomy outlook.

Cloud growth

One area investors should keep an eye on is IBM's cloud business. At the end of the first quarter, IBM's trailing-12-month cloud revenue reached $14.6 billion, and its cloud as-a-service annual revenue run rate was $8.6 billion, up 59% year over year.

Growth in the cloud business, as well as IBM's other "strategic imperatives," isn't yet enough to offset declines in IBM's legacy businesses. Exactly when that tipping point will be reached is unclear. The new mainframe later this year will provide a temporary boost, but the typical spike in mainframe sales will fade away after a few quarters.

IBM's big opportunity in the cloud is working with large enterprises. The $1.7 billion cloud services deal IBM signed during the second quarter is a quintessential example of how IBM will grow its cloud business going forward. Lloyds, the U.K. bank in question, has a long-standing relationship with IBM, and the deal represents an expansion of that relationship. IBM's existing customer base of large organizations will be a major asset as those organizations look to move workloads to the cloud.

Like every recent IBM quarterly report, there will be good and bad news on July 18. The cloud business will likely show robust growth, but overall revenue will almost certainly decrease as legacy weakness overwhelms the newer growth businesses. Long-term investors who have been waiting for IBM to return to growth for years will need to wait a bit longer.

Timothy Green owns shares of IBM. The Motley Fool recommends Lloyds Banking Group. The Motley Fool has a disclosure policy.

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