IBM Needs More Than Buybacks for EPS Growth

International Business Machines (IBM -0.89%) has always had one of the largest share buyback programs. The company has bought nearly 40% of its total outstanding shares in the last decade.

IBM has been aggressively buying back its shares primarily to boost its earnings from multiple segments, including a worrying revenue slump in its leading server division. The company bought shares worth $8.2 billion in the last-quarter, or 14% of IBM shares traded during the quarter. That was more than three times what it spent on buybacks in the first quarter of fiscal 2013, and the largest amount spent by the company on share repurchases in a single quarter since 2007.

But, IBM chief executive Virginia Rometty announced that the company would slam the brakes on its buyback splurge for the remaining nine months of the year. The company plans to spend just $5.8 billion on share repurchases for the remaining three quarters of the current fiscal year.

Revenue cliff
IBM has seen revenue decline for eight straight quarters. The company reported revenue of $22.48 billion in the first quarter of fiscal 2014, the lowest quarterly revenue in five years, or a 3.9% year-over-year decline. Its net income fell a jaw-dropping 21.4% to $2.38 billion, while its diluted GAAP EPS declined 15.4% to $2.29.

IBM's hardware business, including servers and systems storage, seems to be disintegrating. Revenue from the segment fell 23% to $2.4 billion. Practically all the company's server segments fared badly -- System-Z revenue tumbled 40%, Power Systems revenue declined 21%, and System-X revenue fell 17%.

Although IBM's System-Z mainframe business still commands a strong market position, it is, unfortunately, in the final stages of its product cycle, hence the huge revenue decline. The Power Systems business serves high-end Unix and Linux computing customers. These customers have been migrating to bladed white-box data center environments, which has impinged on the sector's growth. Meanwhile, the performance of the low-end System-X business has been faltering with the planned sale of the x86 server business to Lenovo.

The only reprieve for IBM's server division will come when the sale of the unprofitable x86 division is completed, leaving a leaner and more profitable unit.

IBM's core software division looks like one of the company's few bright spots, but is simply not growing fast enough to offset declines in other major segments. Revenue for the segment improved 1.6% to $5.66 billion, which was a slowdown compared to the previous quarter's growth of 2.8%.

According to Gartner, Oracle (ORCL -2.25%) recently leapfrogged IBM to become the world's second-largest software vendor after Microsoft (MSFT -1.84%). IBM's software sales for fiscal 2013 grew 1.4% to hit $29.1 billion, considerably slower than Microsoft's 6% growth, or Oracle's 3.4% growth. Worldwide software sales grew 4.8% in fiscal 2013.

Betting big on the cloud
IBM's cloud business is, by far, the most promising of all its businesses. The company's cloud revenue expanded 50% in the first-quarter, with the annual run rate of cloud-delivered-as-service growing 100% year-over-year to $2.3 billion. That revenue was almost as big as that from the company's server division.

It's important to note that IBM's SoftLayer cloud service did not participate in the recent cloud cuts by Amazon, Microsoft, and Google. IBM has been ramping up its SoftLayer cloud business and plans to spend a further $1.2 billion to expand its web-based software products.

The company announced several new cloud platforms this year alone. SoftLayer got special features such as bare-metal cloud capabilities that set it apart from its competitors. The company has been using this edge to maintain its current pricing structure. It's margins from the business are, therefore, quite likely to remain intact.

A lot of growth in IBM's cloud service is inorganic growth from acquisitions. The company spent $3.1 billion last year to acquire ten cloud companies. But, the overall cloud market is growing at a brisk pace, and grew 20% last year to $131 billion. IBM Market Intelligence estimates that the cloud market will reach $200 billion by 2020.

IBM's cloud business grew 69% in fiscal 2013 to $4.4 billion. Even allowing for a modest 25% growth through 2020, the business will reach annual revenue of $16.8 billion by 2020, or close to 17% of its current annual revenue.

In the short-term, it might take about three years for growth in the sector to balance out declines in the company's overall revenue, assuming that it holds steady at the current rate of 5% per annum.

Foolish bottom line
IBM might see revenue declines for another three years or so, after which growth in its cloud business should be able to offset the shortfall. The company has been using share buybacks to boost its earnings, but will now have to depend on organic growth to do that.