Tech giant International Business Machines (IBM +1.93%) will report its fourth-quarter results after the market closes today. The company was able to return to growth in the first half of 2018, but that revenue resurgence petered out in the third quarter. Another decline is likely in the fourth quarter as the mainframe cycle shows its age.
With the stock falling 26% in 2018, pushing IBM's price-to-earnings ratio into the single digits, expectations couldn't be lower. Still, the company will need to prove that it can consistently grow again before the market changes its mind on the stock.
Image source: IBM.
What happened last time
IBM reported a decline in revenue in the third quarter, but not because of the mainframe. Mainframe revenue grew by 6% year over year, marking the fifth consecutive quarter of growth and cementing this mainframe product cycle as the strongest in recent memory.
Instead, it was certain legacy software products that led IBM to miss estimates for revenue. The company was able to produce more per-share profits than expected, though, thanks to margin improvements in the services business.
|
Metric |
Q3 2018 |
Change (YOY) |
Compared to Average Analyst Estimate |
|---|---|---|---|
|
Revenue |
$18.8 billion |
(2.1%) |
Miss by $330 million |
|
Adjusted earnings per share |
$3.42 |
4.9% |
Beat by $0.02 |
Data source: IBM. YOY = year over year.
IBM's cognitive solutions segment houses some of IBM's growth businesses, as well as legacy software. That segment suffered a 5% revenue decline on a constant currency basis in the third quarter, driven by the timing of large transaction-processing deals and weakness in collaboration, commerce, and talent management software.
The company has since sold off a portfolio of its trouble-making software, taking $1.8 billion from Indian tech company HCL for seven software products. This deal will help bolster the balance sheet ahead of the Red Hat acquisition, and it removes some of the products that were hurting IBM's results.
What analysts are expecting
Analysts expect both revenue and adjusted earnings to fall in the fourth quarter, although currency as well as divestitures will be responsible for part of that revenue decline.
|
Metric |
Average Analyst Estimate |
Change (YOY) |
|---|---|---|
|
Revenue |
$21.75 billion |
(3.5%) |
|
Adjusted earnings per share |
$4.84 |
(5.8%) |
Data source: Yahoo! Finance.
It's highly unlikely that the mainframe business will be able to put up a sixth consecutive quarter of growth. The z14 mainframe has reached the part of the cycle where steep sales declines are common as the initial launch is lapped. That's normal, but it creates a revenue headwind for IBM.
IBM expects to produce at least $13.80 in per-share adjusted earnings for 2018. The company has already booked $8.96 per share through the first nine months of the year. If IBM hits the average analyst estimate on the nose, its full-year adjusted earnings will be exactly $13.80.
Strategic imperatives
IBM's "strategic imperative" growth businesses now accounts for nearly half of total revenue. The category has been growing at a double-digit rate, with the cloud portion growing even faster. Maintaining those kinds of growth rates will be tough. Cloud computing is now a $19 billion business, and cloud delivered as a service is now at a $11.4 billion annual revenue run rate. IBM expects that as-a-service business to grow by 15% to 20% annually as part of its long-term plan, but overall strategic imperative growth will likely continue to slow down.
But even slower strategic imperative growth can lead to a return to revenue growth if the rest of IBM stabilizes. IBM generally doesn't give revenue guidance, so it may not have much to say about revenue expectations in 2019. The Red Hat deal will add some revenue once it closes in the second half of the year, but investors will be looking for organic revenue growth from IBM after years of declines and a short-lived return to growth. Whether the company can deliver remains to be seen.
IBM has made some noise recently with a couple big cloud deals. But only a sustainable return to growth will allow the stock to recover after a brutal 2018.
Check out the latest IBM earnings call transcript.
