What to Make of IBM's Earnings Guidance

International Business Machines (IBM 1.05%) reported last week that it grew revenue in the fourth quarter, putting an end to a five-year streak of declines. The IT giant also guided for higher revenue in 2018, along with stabilizing margins. That's good news for a company trying to convince investors that its turnaround is on track.

But the stock tumbled on Friday, the day following the report. While the top line finally started moving in the right direction, the bottom line is stalling. IBM expects to report at least $13.80 in adjusted earnings per share in 2018, flat compared to 2017. Both revenue and earnings are going to need to grow in tandem to truly convince the market that IBM stock shouldn't be trading at a depressed valuation.

Image source: IBM.

A currency and tax problem

IBM enters 2018 in a relatively strong position on the revenue front. It started shipping its latest z14 mainframe system in September, and it launched the first systems powered by its new POWER9 processor late last year. Both of these will provide a tailwind for IBM.

Another tailwind is currency. A weakening U.S. dollar boosted IBM's revenue growth by about 3 percentage points in the fourth quarter, and that trend will likely continue in 2018. This isn't "real" revenue growth, but it does help the numbers look a bit better.

While currency is boosting the top line, it's hurting the bottom line. Currency hedges and translation effects knocked down profits during the fourth quarter by boosting expenses by 4 to 6 percentage points. New CFO James Kavanaugh expects this to continue in 2018, one reason for IBM's lackluster earnings guidance.

Taxes are another problem. IBM took a big one-time $5.5 billion charge related to the Tax Cuts and Jobs Act in the fourth quarter, but it also expects its effective tax rate to rise this year. IBM's effective tax rate in 2017 was 12%, the low end of its guidance range. The company expects this effective rate to grow to 16%, plus or minus 2%, in 2018. A lower U.S. corporate rate will be offset by a broader tax base and reduced foreign tax credit utilization. The result is a significant headwind that will wipe out any earnings growth.

Kavanaugh views the tax bill as a positive even though it hurts IBM's near-term results. "Tax reform provides additional flexibility over the longer term," he said during the earnings call. But for investors betting on IBM's transformation, it's yet another bump in the road.

Does any of this matter?

For long-term investors, these currency and tax-related headwinds aren't the real story. Both will eventually pass. What really matters is the performance of IBM's various businesses.

Margins in all of IBM's segments slumped during the fourth quarter. That's a legitimate concern for investors.

Data source: IBM. YOY = year over year.

These margin declines reflect high levels of investment in areas related to the company's transformation, as well as a negative impact from currency.

IBM expects margins to stabilize in 2018. In the services businesses, Kavanaugh sees three things driving the improvement: "One, continued scale of our cloud business; two, improvement in yield of our services productivity as we wrap around some of those completed [lower-margin] contracts I talked about; and three, just getting operating leverage from returning this business and portfolio back to growth."

Margins are what investors should be watching in 2018. If IBM reports flat earnings but manages to keep margins stable, or even grow them, that's a win. The currency and tax stuff is temporary. Stabilizing margins would show that IBM's transformation is on track, regardless of what the headline earnings numbers suggest.

IBM continues to work its way through a long and difficult transformation. The market may not give the company credit for its turnaround until it starts impressing on all fronts. Based on IBM's guidance, that won't be in 2018.