International Business Machines Corp. Slashes Guidance as Revenue Slumps

International Business Machines (IBM 1.38%) reported some ugly third-quarter results on Oct. 19. In my IBM earnings preview, I said that the numbers were going to look awful, and indeed, they did. IBM missed analyst estimates for revenue, posting a 13.9% year-over-year decline, and while it beat earnings estimates, slashed guidance for the full year means that profits are going to decline considerably compared to 2014. That abandoned $20 EPS target is starting to look comical.

Once again, IBM's results are being dragged down by both currency and the effects of divested businesses. Things look better on an adjusted basis, but all of these adjustments make it more difficult to tell exactly how IBM's business is really performing. Let's dive into IBM's results and see if we can make sense of things.

Earnings rundown
IBM reported quarterly revenue of $19.3 billion, down 13.9% year over year, and $340 million short of the average analyst estimate. On an adjusted basis, revenue declined by just 1%, with nine percentage points of the decline attributed to currency and four percentage points attributed to divestitures. This still isn't a good result, but it's a lot better than the reported revenue decline.

IBM reported non-GAAP EPS of $3.34, down 9% year over year but $0.04 better than analysts were expecting. Non-GAAP gross margin increased slightly to 50%, while non-GAAP pre-tax margin was flat year over year at 20.7%. A decline in spending and a lower tax rate compared to the same quarter last year helped IBM beat on earnings.

Geographically, here's how IBM performed during the quarter:

Source: IBM earnings report.

Currency is wreaking havoc on IBM's results, plain and simple. This is something that's out of IBM's control, and out of the control of all of the companies facing similar issues. Eventually, the currency situation will stabilize, but when that happens is anyone's guess.

Here's how IBM's various segments performed during the quarter:

Source: IBM earnings report.

Services were a mixed bag, with GTS growing on an adjusted basis and GBS shrinking, while the services backlog came in at $118 billion, up 1% year over year on an adjusted basis. Software was weak even adjusted for currency, with IBM's Key Branded Middleware, which accounts for two-thirds of software revenue, slumping by 2% year-over-year. Hardware sales were buoyed by continued strong sales of System Z mainframes, which grew by 20% year-over-year, but hurt by a 14% decline in storage sales.

IBM's strategic imperatives continued to grow rapidly during the third quarter, with revenue jumping 27% year-over-year on an adjusted basis. Cloud revenue has risen 65% year-to-date, with total cloud revenue, including hardware, software, and services, reaching an annual run rate of $9.4 billion. Cloud delivered as a service is at an annual run rate of $4.5 billion, flat compared with the second quarter but up from $3.1 billion during the third quarter of 2014. Business analytics revenue rose 19% year-to-date on an adjusted basis, while mobile revenue more than quadrupled, security revenue increased by 12%, and social revenue increased by 40%.

What it all means
On top of a disappointing quarter, IBM lowered its earnings guidance for the full year. The company now expects non-GAAP EPS to be between $14.75 and $15.75 for the full year, down from a previous range of $15.75 to $16.50.

Shares of IBM have been hammered over the past few years as the company has continually disappointed investors. But every great company, at one point or another, is forced to make decisions that hurt short-term profitability for the sake of long-term success. Short-term, quarter-to-quarter results aren't all that important in the grand scheme of things, at least for long-term investors. What matters is what IBM looks like five, 10, or 20 years from now.

IBM's stock is doing exactly what Warren Buffett wanted it to do when he first invested in the company in 2011: it's languishing. The falling stock price means that every dollar that IBM spends on buybacks goes further, and it means that long-term investors can add to their stakes at lower prices. At noon on Wednesday, the stock was down 5.4% from the previous close.

It's difficult to be an IBM investor when the pessimism surrounding the company seems to keep growing. But then again, you can't expect an above-average return if you invest based on popular opinion. IBM's transformation has been messy, and messiness breeds uncertainty. But uncertainty is not the same thing as risk, and the odds that IBM will completely fall apart, given how entrenched the company is in various industries, are vanishingly small.

IBM's third quarter was not good, and its guidance was even worse. There's no guarantee that IBM succeeds in transforming its business, and it's certainly playing catch-up in some areas. The only guarantee is that IBM investors will need to be patient.