International Business Machines (NYSE:IBM) is set to report its third quarter results after market close on Monday, Oct. 19. The company has been suffering from big revenue declines over the past few years, mostly driven by selling off underperforming businesses and foreign exchange headwinds, and that trend is unlikely to change during the third quarter.
IBM's second quarter was mixed, with the company beating analyst estimates for earnings while coming up short on revenue. Its strategic imperatives, which are businesses where most of IBM's future growth is expected to come from, have grown quickly during the first half of the year, with revenue increasing by 30% year-over-year on an adjusted basis. Other parts of the company haven't performed as well, and the result has been lower revenue and profits.
What analysts are expecting
Analysts are expecting both revenue and profits to decline for IBM during the quarter. The average analyst estimate for revenue is $19.61 billion, down 12.5% compared to the same quarter last year. During the second quarter, IBM revenue declined by 13% year-over-year. Neither of these numbers are adjusted for currency or divestitures -- on an adjusted basis, IBM revenue was down just 1% during the second quarter.
Analysts expect IBM to report non-GAAP earnings per share, what IBM calls operating EPS, of $3.30, down about 10% year-over-year. Operating EPS excludes both acquisition-related and retirement-related items but does not exclude stock-based compensation, a rarity among tech companies. For this reason, operating EPS is a better indication of IBM's earnings power than GAAP EPS.
While IBM hasn't provided guidance for the third quarter, it does expect full-year operating EPS to be between $15.75 and $16.50. Analysts on average expect just $15.70 of operating EPS for the full year. IBM reaffirmed this guidance when it reported its second quarter results.
What investors should look for
IBM's numbers are still being skewed by currency and divestitures, so the headline revenue decline isn't as bad as it seems. However, the company is not growing, even adjusted for these items, which means the strategic imperatives have yet to reach critical mass.
Investors should look for continued growth in these areas, which include cloud, analytics, mobile, and social, during the third quarter. Cloud revenue jumped by 70% year-over-year last quarter on an adjusted basis, with $8.7 billion in revenue over the past 12 months. This includes hardware, software, and services, so it may not be directly comparable to cloud revenue from other cloud companies. The portion of IBM's cloud revenue that's delivered as a service reached an annual run rate of $4.5 billion during the second quarter, up from $2.8 billion during the year-ago period.
Meanwhile, revenue from business analytics most recently rose by 20% on an adjusted basis, with mobile revenue quadrupling and social revenue rising by 40%. Strategic imperatives accounted for $25 billion of the top line in 2014, so double-digit growth is adding a meaningful amount of revenue to IBM's total.
Beyond strategic imperatives, one key thing investors should focus on is the services backlog. Services accounted for about 60% of IBM revenue during the second quarter, and the backlog provides an indication of what the services business will look like going forward. At last count, the backlog stood at $122 billion, up 1% year-over-year on an adjusted basis, with total signings rising 17% in the second quarter. This suggests the services business is doing fine, and investors should pay attention to how the backlog evolves during the third quarter.
Revenue from hardware has grown during the past couple of quarters, driven by the launch of the z13 mainframe earlier this year. IBM mainframe revenue tends to spike following a product refresh, driven by client upgrades, and this has helped IBM prevent revenue from falling even further. The company did announce a new line of mainframes, LinuxONE, based on both the z13 and an older model, in August, with the goal of pushing the mainframe as a Linux system. This could help give IBM mainframe revenue a boost going forward, but I would expect mainframe revenue to start to normalize in the coming quarters.
It will be the details that matter when IBM reports earnings. The headline numbers will, once again, look downright awful, but the company will eventually lap its major divestitures, and currency issues are ultimately a temporary problem. Investors should focus on the performance of the core of IBM, as well as the growth of its strategic imperatives, to get a sense of where the company is headed.
Timothy Green owns shares of International Business Machines. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.