Shares of International Business Machines (NYSE:IBM) fared poorly following the company's third-quarter earnings report. Revenue slumped for the 14th quarter in a row, falling 14% year over year, and the company slashed its EPS guidance for the full year, predicting a significant decline in earnings.
But the numbers don't tell the whole story. During IBM's earnings conference call, CFO Martin Schroeter provided a deeper look at the company's performance. Here are five key points that investors need to know.
The strategy is working
IBM is in the process of transforming its business, shifting resources into areas with long-term growth potential. Schroeter explained IBM's strategy:
So as we transform our business, we invest where we see higher value over the longer term. We drive growth in the areas where we're investing, while other areas decline as we shift the business and we expect to expand margins in our move to higher value. This is how we transform from one era to the next.
IBM's strategic imperatives, which include cloud, analytics, mobile, and social, are growing rapidly, and IBM expects this growth to eventually balance out declines in revenue elsewhere in the business. During the third quarter, revenue from the strategic imperatives jumped 27% year over year on an adjusted basis.
Despite the overall revenue and profit declines during the quarter, gross margin expanded compared with the same period last year, and the net income margin was flat. A lower tax rate helped the latter figure, but the growing importance of these strategic imperatives played a role as well. About 50% of strategic imperative revenue came from software in 2014, higher than the software mix of the overall company. With software by far the most profitable segment, IBM's margins should expand as its transformation continues.
Currency is a problem
While the 14% revenue decline during the third quarter looks awful, most of it was due to two factors that have little to do with the business itself. Schroeter explains: "Our revenue trajectory continues to reflect significant impacts from currency movements [and] our divested businesses, in fact over 12 points of growth in total."
More than half of IBM's revenue comes from outside of the United States, with Europe in particular being a major market for the company. A stronger U.S. dollar compared with the same period last year means that the same amount of foreign currency translates into fewer dollars, leading to a revenue decline.
Adjusted for currency, as well as for the sale of IBM's x86 server business, total revenue declined by just 1% year over year during the third quarter. In the Europe/Middle East/Africa region, revenue actually increased by 1% on an adjusted basis. Currency is something that's out of IBM's control, and the big headline revenue decline should be viewed with that in mind. On an adjusted basis, IBM's third quarter was far from a disaster.
Earnings are going to decline
A strong U.S. dollar also has the effect of reducing the portion of IBM's expenses that are denominated in foreign currencies, but the revenue decline still drives earnings lower. In addition to currency issues, weakness in the software business toward the end of the third quarter, as well as lower-than-expected demand for IBM's disc-based storage products, led the company to reduce its earnings guidance for the full year.
"Taking all of this into consideration, we believe it is prudent to update our expectations for full year operating earnings per share to $14.75 to $15.75, while our view of free cash flow remains relatively flat year to year." Schroeter said.
Any guidance cut is disappointing, especially considering that IBM reaffirmed its previous guidance at the end of the second quarter. With 2014 non-GAAP EPS of $16.53, a significant earnings decline this year is now essentially guaranteed. At the low end of IBM's guidance, EPS will decline by about 11%.
IBM is not falling apart
With the persistent revenue declines and lowered guidance for the full year, at a glance it would seem like IBM's business model is falling apart. But according to Schroeter, that's simply not the case: "But as we head into next year, what's really important from a currency impact, yes, there will, at least at this point based on where the spots are today, there will be an additional impact because we will wrap on hedges, but importantly, we are not losing competitiveness in the marketplace because of currency."
IBM's revenue declines are not the result of a struggle to remain relevant. You could certainly argue that the growth of cloud computing has forced IBM to reinvent itself, and that has caused some issues as the company shifts resources to high-growth areas. But the vast majority of IBM's revenue problems are related to currency, not a lack of competitiveness.
Growth at all costs is not in the cards
While the stock market seems to reward tech companies that put revenue growth and market share ahead of profitability and sustainability, IBM isn't one of those companies. In an answer to an analyst's question about IBM's scale, Schroeter had this to say: "You know, it's a good question, David, and it is one that we think about not from the perspective of size or scale, because as you know, we're not trying to be the largest of something. What we are, though, is trying to be the highest value, so as we move to value, that has, that plays a large influence in how we think about deploying capital and where we think about putting our dollars to work and so at this point, when we look at our businesses and the way they work together, and I would argue that the world is moving more toward bringing solutions together in front of a client."
It's kind of strange how much attention is being given to IBM's revenue, because IBM has never been a company that has put revenue growth first. The strategy for many years has been to go after the highest-value portions of the IT market, and that strategy persists today. That's the reason IBM sold off its PC business in 2004, and its x86 server and semiconductor manufacturing businesses last year.
The IT landscape is certainly in flux, with many organizations seriously considering cloud computing in one form or another. IBM is positioning its business to be the provider of high-value solutions, and while it's certainly giving up possible revenue growth as a result, profits are what ultimately matter in the long run.