International Business Machines (IBM -0.69%) reported its second-quarter earnings on July 20 after market close. The company beat analyst estimates for earnings but came up short on revenue, with significant revenue declines in all of its major segments. The quarter was a mixed bag for IBM, with fast-growing parts of the company's business unable to counteract falling revenue elsewhere. Here's what investors need to know about IBM's earnings.
IBM reported quarterly revenue of $20.8 billion, down 13% year over year. This big decline is a bit deceptive, though: Currency effects accounted for 9 percentage points of the decline, while the sale of the System X server business accounted for another 4 percentage points. Adjusted for these items, IBM's revenue fell by just 1% year over year. It's still not a good result, but it's not nearly as bad as it first appears.
The Global Technology Services segment recorded $8.1 billion of revenue, down 10% year-over-year, or up 1% on an adjusted basis. The Global Business Services segment recorded $4.3 billion of revenue, down 12% year over year, or down 3% on an adjusted basis. The services backlog stood at $122 billion, up 1% year over year adjusted for currency.
Software revenue fell 10% year over year, or down 3% on an adjusted basis, to $5.8 billion. Hardware revenue declined by 32% year over year but was up 5% on an adjusted basis, with much of the discrepancy due to the sale of the System X business. Mainframe sales rose 15% year over year on an adjusted basis, driven by the new z13 mainframe launched earlier this year.
IBM reported net income of $3.5 billion and EPS of $3.58, down 17% and 15% year-over-year respectively. Non-GAAP EPS, which excludes a few non-cash items, fell 13% to $3.84, six cents better than analysts were expecting. IBM's gross margin was down slightly to 49.9%, and while operating expenses decreased year over year, revenue fell faster than costs could be cut.
IBM reaffirmed its earnings guidance for the full year. The company expects non-GAAP EPS to come in between $15.75 and $16.50, and it now expects its free cash flow to increase modestly compared with 2014.
Progress on strategic imperatives
Despite the mixed results, certain parts of IBM's business are performing well. The company's strategic imperatives, which are businesses that IBM expects to grow rapidly in the coming years, continued to grow during the second quarter. Unfortunately, it wasn't enough to make up for declines elsewhere.
Overall, revenue from strategic imperatives was up 20% year over year, or up 30% on an adjusted basis. Cloud revenue, which includes hardware, software, and services, rose 50% year over year, or up 70% on an adjusted basis. Over the past 12 months, $8.7 billion has come from the cloud, with $4.5 billion delivered as a service. Business analytics revenue grew by 10% year over year, or 20% on an adjusted basis. Mobile revenue quadrupled, and social revenue rose by 30%, or 40% on an adjusted basis.
A mixed quarter
As I said in my IBM earnings preview, the company's quarterly results are going to be volatile as it transitions its business. The reported numbers, which include the effects of currency and divestitures, paint a grim picture, but in reality, things aren't nearly as bad as they seem.
There are a few pieces of good news. IBM's services backlog rose 1% on an adjusted basis, and service signings jumped 17% year over year. Sales of key branded middleware, which accounts for more than two-thirds of IBM's software revenue, was flat on an adjusted basis, and free cash flow rose compared with the same period last year.
Many of IBM's initiatives, like the cognitive computing system Watson, are long-term projects. Watson is being used in a variety of industries, such as healthcare, but the nature of the machine learning system means that it can take years for it to become useful and generate meaningful revenue.
IBM clearly still has a lot of work to do, and it will take time for high-growth areas of its business to become large enough to drive revenue and earnings growth. But the long-term strategy appears sound, and I believe that patient investors will be rewarded in the long run.