Shares of International Business Machines (NYSE:IBM) were hit hard following the company's mixed second-quarter earnings report. Revenue declined for the 13th quarter in a row, and profits fell substantially, with strong growth in IBM's strategic imperatives, like cloud and analytics, unable to make up for falling revenue elsewhere.
IBM's quarter wasn't nearly as bad as it seems, however, and the numbers don't tell the whole story. On the company's conference call, CFO Martin Schroeter provided some additional details on IBM's second quarter. Here are five things that investors need to know.
Currency is doing a number on IBM's results
The strong U.S. dollar is wreaking havoc on the results of companies that count on International markets for the bulk of their sales. Schroeter explains the impact on IBM's revenue:
Our overall revenue performance includes the continued translation impact from a strong dollar and the impact of divested businesses. Together, these reduced our reported revenue growth by 12 to 13 points, both for the quarter and the half.
While IBM's reported revenue fell by 13% year over year, about nine percentage points of this decline was due to currency effects. On top of that, the divestiture of the System x server business last year contributed another four percentage points to the decline. Adjusting for these items, revenue fell by just about 1% year over year, hardly a disaster.
IBM doesn't expect currency issues to subside any time soon. In response to an analyst's question, Schroeter stated that the company was expecting the negative currency impact to be slightly worse during the second half of the year compared to the first half. This means that investors should be prepared for more big declines in revenue during the next two quarters.
Ultimately, currency is a temporary issue, and IBM's business in most international markets, excluding the BRICs, is doing just fine. Adjusted for currency, revenue in IBM's major markets was flat year over year, and revenue in its growth markets excluding the BRICs rose 5%.
IBM's cloud business is growing fast
The cloud is one of IBM's strategic imperatives, and it grew rapidly during the second quarter:
Our cloud revenue was up over 70% year-to-year in the first half. And over the last 12 months, our cloud revenue was $8.7 billion. We had strong growth in both our private foundations revenue and our as a service offering, and we exited the second quarter with an annual as a service run rate of $4.5 billion. Our cloud business is substantial and growing rapidly. The market continues to evolve beyond pure infrastructure toward higher value process, data and analytics as a service engagements. In the same way the Internet evolved from browsing to a full transactional business platform.
IBM's cloud revenue includes hardware, software, and services, spanning public, private, and hybrid clouds, so it's not directly comparable to cloud revenue from cloud infrastructure companies like Amazon. While Amazon has built its cloud business on providing public cloud infrastructure, essentially renting computing resources, IBM's approach is geared toward what the company is good at -- helping clients make their businesses work better.
The services business is doing fine
The Global Business Services and Global Technology Services segments are a major part of IBM's business, accounting for about $12.4 billion of revenue during the second quarter, roughly 60% of the total.
GBS revenues fell 12% year over year during the quarter, while GTS revenues declined by 10%. However, adjusting for currency and divestitures, GBS was down just 3%, while GTS actually grew by 1%. The backlog, which contains services that IBM has yet to deliver, looked healthy:
From a segment perspective, we saw an increase in demand in our services business with 22 deals over a $100 million this quarter the highest number in over two years, this contributed to a backlog that is up year-to-year for the first time since the end of 2013 which is certainly an encouraging data point.
The backlog sits at $122 billion, and it grew by 1% year over year, adjusted for currency. All of this points to a services business that is quite a bit better than the headline numbers seem to indicate.
Debt is actually declining
IBM is often accused of financial engineering, taking on debt in order to fund buybacks and drive up per-share earnings. But IBM's debt has two parts: global financing debt, which is backed by receivables, and corporate debt. This corporate debt declined significantly during the second quarter:
Our non-financing debt of $12.6 billion is down $4.5 billion from a year ago.
Despite the billions spent on both dividends and share buybacks during the past year, IBM was still able to reduce its non-financing debt. Cash was down less than $1 billion year over year, so most of this debt reduction was driven by IBM's robust free cash flow.
OpenPOWER is making progress
IBM is a member of the OpenPOWER foundation, a group created in an effort to build a data center ecosystem around IBM's POWER architecture. IBM now allows third-party hardware to be powered by its POWER chips, and it even licenses the POWER architecture itself. Other companies that are part of the group include Google, NVIDIA, Micron, and Samsung, along with roughly 100 others.
According to Schroeter, the OpenPOWER strategy is making progress:
Our open power strategy continues to take hold globally. In June, the UK government joined the United States as the second major government to turn to open power for its high performance computing priorities. The UK government will utilize IBM's latest open power high performance computing and Watson based cognitive technologies to obtain valuable insights from a variety of data sources to boost productivity and drive growth. This is a similar class of IBM open power system that the United States Department of Energy selected for the Lawrence Livermore Oak Ridge National Laboratories.
OpenPOWER systems are an alternative to those built with Intel's x86 processors, and in certain cases, IBM's POWER8 processors perform far better than comparable Intel-based systems. The U.S. Department of Energy chose IBM, along with NVIDIA, to build two new supercomputers based on OpenPOWER last year, and the new UK government partnership is another step in the right direction.