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Will 2016 Be International Business Machines Corporation's Best Year Yet?

By Leo Sun - Jan 20, 2016 at 6:30PM

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Will Big Blue’s investors see red or green returns this coming year?

IBM (IBM -1.14%) recently reported its fourth quarter earnings, narrowly beating expectations on both the top and bottom lines. Revenue slipped 8.5% annually to $22.06 billion, but beat estimates by $20 million. Non-GAAP earnings from continuing operations fell 17% to $4.84, but also topped expectations by three cents. However, those earnings were boosted by a non-GAAP tax rate of 14.7%, which was lower than a 21.8% rate a year earlier.

For fiscal 2016, IBM expects earnings of "at least" $13.50, which would represent a 9.5% decline from 2015, partially due to stronger currency headwinds. Analysts had expected earnings of $15.

IBM CEO Ginni Rometty. Source: IBM.

Big Blue's investors, who have endured a near 20% decline in its stock price over the past 12 months, have likely grown accustomed to these lackluster reports. The company's sales have now fallen for 15 consecutive quarters, and earnings growth remains tepid. But looking ahead, could IBM's fortunes reverse this year with fresh top and bottom line growth?

Focusing on strategic imperatives
At first glance, IBM's sales growth looks disastrous. Tech services revenue fell 7.1% annually to $8.1 billion, business services revenue dropped 9.9% to $4.3 billion, software revenue plunged 10.7% to $6.8 billion, and hardware revenue slipped 1.4% to $2.4 billion.

However, revenue from its five "strategic imperatives" businesses -- cloud, analytics, mobile, social, and security -- rose 10% annually. However, that still represents a sequential decline from 17% growth in the third quarter and 20% in the second quarter.

For the full year, strategic imperatives revenue rose 17% to $28.9 billion and accounted for 35% of IBM's top line. Last year, IBM declared that those businesses could generate $40 billion in revenues by fiscal 2018. That goal seems achievable -- if sales climb at least 17% in both 2016 and 2017, the businesses will generate $40 billion in sales by the beginning of 2018.

Big battles in the cloud
IBM's cloud business must keep growing for the company to hit that target. For the full year, IBM's total cloud revenue rose 43% annually to $10.2 billion, but much of that total came from its slower-growth hybrid and private cloud businesses. Its higher-growth "cloud as a service" revenues grew 50% to $4.5 billion with an annual run rate of $5.3 billion -- up from $3.5 billion in the prior year quarter.

IBM's cloud growth looks solid, but it still trails behind market leaders Amazon (AMZN -1.13%) and Microsoft (MSFT 0.71%). Amazon's AWS, which is a hybrid PaaS (platform as a service) and IaaS (infrastructure as a service) platform, had an annual run rate of $7.3 billion as of last October. Microsoft's cloud business -- which consists of SaaS (software as a service) solutions Office 365 and a PaaS/IaaS platform called Azure -- had an annual run rate of $8.2 billion last October.

Azure, which directly competes against AWS, has an estimated annual run rate of $1.6 billion, according to Forrester Research. The firm estimates that IBM's direct cloud platform competitor, Bluemix, only had a run rate of $600 million. Falling behind in this race could throttle the growth of IBM's cloud-dependent strategic imperatives. To gain ground, IBM will need to invest more heavily in new technologies like machine learning and the Internet of Things, and possibly engage its rivals in a costly price war. Both moves could drag down IBM's earnings growth.

"Powering up" the hardware business
Another bright spot is IBM's hardware business. Sales of mainframes and Power systems respectively rose 16% and 4% annually last quarter, but those gains were offset by an 11% decline in storage hardware.

IBM's Power Systems. Source: IBM.

However, sales of IBM's Power Systems could continue rising thanks to its OpenPower Foundation, which "open sources" IBM's hardware designs to third-party manufacturers that use IBM's Power processors. Sales of Power Systems have grown for four consecutive quarters, with sales of low-end Linux-based systems offsetting slower sales of Unix ones. The growth of that ecosystem has already helped it gain a foothold in Chinese servers, and has turned it into Intel's (INTC -2.43%) unlikely rival in data centers. To counter IBM, Intel recently partnered with Oracle (ORCL 0.39%) to produce Oracle-Intel servers, which run Oracle's database software on Intel's Xeon chips.

But huge challenges remain
IBM has made promising progress with the growth of its strategic imperatives and its Power ecosystem, but big challenges remain. It's still unclear how IBM will turn around its sluggish IT services and middleware businesses, which remain dead weights on its top line growth.

For now, IBM's P/E of 9 and its 3.9% dividend will likely prevent the stock from falling too much further. However, it's also hard to see its stock bouncing back in the near future. I believe that 2016 will be more of the same for Big Blue -- decent growth at its higher-growth businesses will be offset by weak growth at its older businesses.

Leo Sun owns shares of The Motley Fool owns shares of and recommends The Motley Fool owns shares of Oracle. The Motley Fool recommends Intel. 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.

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Stocks Mentioned

International Business Machines Corporation Stock Quote
International Business Machines Corporation
$129.47 (-1.14%) $-1.49
Microsoft Corporation Stock Quote
Microsoft Corporation
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Oracle Corporation Stock Quote
Oracle Corporation
$76.77 (0.39%) $0.30
Intel Corporation Stock Quote
Intel Corporation
$34.52 (-2.43%) $0.86

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