A Messy Earnings Beat for International Business Machines Corp.

Image Source: IBM.

IT giant International Business Machines (IBM 0.06%) beat analyst estimates for both revenue and earnings when the company reported its first-quarter results, but the numbers were noisy. A one-time tax benefit and significant restructuring costs complicated IBM's results, and new reporting segments made comparisons between past periods difficult.

Nonetheless, IBM's quarter was better than analysts expected, in part due to currency having a lower negative effect compared to previous quarters. Here's what you need to know about IBM's first-quarter results.

Earnings rundown
IBM reported quarterly revenue of $18.7 billion, about $400 million higher than the average analyst estimate. Revenue was down 4.6% year over year, but down just 2% adjusted for currency. The negative effect of currency on revenue was far less severe compared to the fourth quarter of 2015, when currency knocked off 7 percentage points of revenue growth.

Non-GAAP EPS, what IBM refers to as operating EPS, came in at $2.35, down 19% year over year, but $0.26 higher than analysts were expecting. On an GAAP basis, EPS was $2.09, down 14% from the prior-year period. These numbers include some extraordinary items that are worth mentioning.

First, IBM received a $1 billion refund of previously paid foreign taxes, for a total benefit of $1.2 billion including interest. This tax benefit more than offset taxes for the quarter, creating a net tax benefit of $983 million. This is compared to a $585 million tax provision during the prior-year period. Both GAAP and non-GAAP figures include the effect of this tax benefit, thus boosting IBM's earnings.

However, there's another item that moved the company's earnings in the opposite direction. IBM's operating expenses rose substantially year over year, knocking down operating income. GAAP operating income for the quarter was just $1.03 billion, down two-thirds compared to the prior-year period. This decline was due to $1.5 billion of charges related to workforce transformation, real estate actions, and actions in Latin America. Neither GAAP nor non-GAAP figures back out these presumably one-time charges.

The net result of these two items is basically null. Adjusted for IBM's true tax rate, backing out the charges would essentially cancel out the tax benefit, leaving roughly the same non-GAAP EPS as reported. IBM really did beat analyst estimates.

Some new segments
The first quarter marked the beginning of a new reporting structure for IBM. Here's how each of the segments performed:

Source: IBM earnings report.

Systems segment revenue, which includes hardware and operating systems software, plunged during the quarter, but this was due to the mainframe product cycle. IBM launched new System Z mainframes early last year, which drove hardware revenue higher for a few quarters. The decline during the first quarter was inevitable and expected.

IBM also breaks out the performance of what it calls strategic imperatives, which are the growth areas that the company is heavily investing in. These include cloud, analytics, mobile, social, and security, and they're spread throughout IBM's reporting segments. Overall, the strategic imperatives generated $7 billion of revenue during the first quarter, up 17% year over year adjusted for currency.

Source: IBM earnings report.

Analytics is the largest strategic imperative, and it's still growing at an impressive rate despite its size. Cloud, which includes public, private, and hybrid cloud, is also growing quickly. IBM's as-a-service cloud annual run rate, which includes IaaS, PaaS, and SaaS, reached $5.4 billion during the first quarter.

One thing that this new reporting structure accomplishes is to spread out the old software segment. Thankfully, IBM provided figures for software in its earnings slides. During the first quarter, total software revenue was $5.4 billion, down 1% year over year adjusted for currency. Cognitive Solutions software accounted for $4 billion of this total and was flat year over year.

Final words
IBM's first quarter results were messy, but the company did indeed perform better than analysts expected. IBM also reiterated its guidance for Operating EPS of at least $13.50 during 2016, and raised its free cash flow guidance to the high-end of its previous $11 billion to $12 billion range.

The story at IBM hasn't really changed. Strategic imperatives keep growing fast, the rest of the business keeps declining, and the end result is a small decline in adjusted revenue and lower earnings. The first quarter marks the 16th quarter of year-over-year revenue declines in a row, and it may still be a while before that streak is finally broken.

Still, the picture that those bearish on IBM paint, one of a company in an irreversible decline, isn't borne out by the numbers. IBM's transformation has been a slow and frustrating process for shareholders, but the company's long-term strategy makes sense, and progress is being made in the most important parts of the business.