Long-suffering shareholders of International Business Machines (NYSE:IBM) were beginning to have hope that its long-awaited turnaround was finally taking hold. After enduring 22 consecutive quarters of year-over-year revenue declines, the company had cobbled together three successive quarters of improving revenue. Unfortunately, each came with an asterisk, the result of favorable foreign exchange rates and a strong refresh cycle for IBM mainframes that would inevitably slow.
The first of those issues came home to roost last quarter, as the strengthening U.S. dollar hit exchange rates, removing the tailwinds that had helped boost previous results.
IBM is expected to report its fourth-quarter and full-year 2018 results after the market close on Jan. 22. Let's look at the details from last quarter and some recent developments to see if they provide any insight into the company's upcoming earnings release.
For the third quarter of 2018, IBM reported revenue of $18.8 billion, a decline of 2% from the prior-year quarter. Exchange rates dragged on the results, which would have been flat were it not for the effect of currency changes. The metric missed analysts' consensus estimates, which called for sales of $19 billion. The bright spot was the rising profitability, as earnings per share of $3.42 marked a 5% increase year over year, and topped expectations of $3.40.
The biggest surprise was the performance of IBM's strategic imperatives -- the company's newer, high-growth businesses, which include analytics, cloud computing, security, and mobile. Over the trailing 12 months, strategic imperatives grew to $39.5 billion, an increase of 13% year over year, and up 11% when adjusting for currency differences. Unfortunately, the current quarter lagged. Revenue from the group climbed to $9.3 billion, up just 7% compared to the prior-year quarter, and sinking below the important 50% benchmark the strategic imperatives achieved in the second quarter.
A big announcement
Big Blue announced in October that it would acquire open-source cloud software provider Red Hat (NYSE:RHT) in a deal valued at about $34 billion -- the company's largest acquisition ever. IBM said the deal would be accretive to free cash flow and gross margin within 12 months, and to operating earnings per share by the end of year two. The company also said that it planned to suspend its share-repurchase program in 2020 and 2021 to help fund the deal, but would continue to return capital to shareholders via dividend increases.
This is a big move for IBM, but the cost is high. The company is paying a 63% premium to Red Hat's stock price prior to the announcement -- a high price for a company that produced revenue of just $2.9 billion and adjusted net income of $698 million in fiscal 2018.
To help limit the amount of new debt on the books, IBM announced in December that it would be selling a bundle of flagging software products to Indian tech company HCL for $1.8 billion.
A look ahead
IBM has resolutely held fast to its full-year guidance. The company expects at least $13.80 in adjusted operating earnings per diluted share, and diluted earnings per share of at least $11.60. Big Blue is also anticipating free cash flow of about $12 billion, with a realization rate of more than 100%.
We can look to Wall Street to get a feel for investor sentiment and expectations, though it's important not to get caught up in its short-term mindset. For the fourth quarter, analysts' consensus estimates are calling for revenue of $21.8 billion, a decline of 3.3% from the prior-year quarter. Earnings per share (EPS) are expected to be $4.84, a decline of 5.8% year over year, putting IBM's full-year EPS in line with analysts' expectations.
What to watch for from IBM
This is an important quarter for IBM. Investors will be looking for reassurances that the company can get its revenue growth back on track, and will be looking for additional details about the Red Hat deal. Based on the volatility of the past few quarters, I suspect IBM's earnings report on Jan. 22 will produce either a big relief rally for the stock or send the shares sharply lower once again.
Check out the latest IBM earnings call transcript.