What Investors Need to Know About International Business Machines Corp.'s Earnings

By Markets Fool.com

Another quarter, another revenue decline for IBM. The company recently reported that revenue fell 12% year over year during the first quarter, marking the 12th straight quarter of revenue declines.

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But focusing on revenue is the wrong way to look at IBM. Over the past decade, while Big Blue's revenue has remained essentially flat, profits have nearly doubled as the company has steadily shifted away from low-margin businesses. That shift continues, and while IBM certainly faces plenty of challenges as it transitions its business, the company's earnings report contained a lot more good than bad.

Don't judge a book by its cover
On the surface, IBM's first quarter looks like a train wreck. Revenue fell in every segment on a year-over-year basis, with global technology services down 10.9%, global business services down 13%, software down 8.2%, hardware down 22.6%, and financing down 9.9%.

But these revenue declines include the effects of both currency fluctuations anddivestments that IBM made throughout the past year. IBM sold off a few major businesses in the recent past, including its x86 server division and its microprocessor manufacturing segment.

On a constant currency, divestiture-adjusted basis, IBM's revenue was flat year over year. Most of the company's segments still shrunk, but by low single-digit percentages, and hardware actually grew by 30%, boosted by the mainframe refresh cycle. The portion of IBM's business that it calls "strategic imperatives," including cloud and analytics, grew by 30%.

IBM's generally accepted accounting principles earnings per share was flat from the same period a year ago, but non-GAAP EPS, what IBM calls operating EPS, grew by 9%. Share buybacks helped things along, but non-GAAP net income still grew by 4% year over year on its own. For the full year, IBM maintained its previous guidance for non-GAAP EPS between $15.75 and $16.50.

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Out with the old, in with the new
IBM's strategic imperatives accounted for a little more than a quarter of company revenue during 2014. A 30% year-over-year growth rate for these businesses during the first quarter is impressive given their size, but given that total revenue was flat, this means all of IBM's other businesses are shrinking at a substantial rate.

This shouldn't be all that surprising The market for information-technology products and services is constantly evolving, and IBM needs to evolve with it. The company is shifting resources toward the areas with the most potential, including the cloud, analytics, mobile, and security, and as these businesses become larger, growth will eventually follow.

The key thing to understand is that, despite the upheaval at IBM, profitability has remained strong. IBM gets a lot of flak for not growing revenue, but adding a bunch of low-margin revenue to satiate impatient investors wouldn't make much sense. Profits drive the stock price, not revenue.

IBM's core businesses, like the mainframe, are still very profitable, and there's no reason to believe this will change. An enormous number of organizations rely on IBM hardware, software, and services, including 90% of the top 100 banks in the world. While these businesses may not be growing, they still generate plenty of cash for IBM.

As IBM's strategic imperatives continue to grow, becoming a larger part of the overall revenue mix, profit margins have the potential to improve. The strategic imperatives are more software-heavy than the rest of the company, and software carries extremely high margins. During the first quarter, for example, IBM's software business managed a 31.4% pre-tax margin, compared to 18.4% for the company as a whole.

IBM is not a company that tries to grow revenue as fast as possible, and when it returns to revenue growth, it will undoubtedly be slow. The main takeaway from IBM's first-quarter results is not that revenue continued to shrink, but that profitability remained intact despite the transition under way at the company.

The article What Investors Need to Know About International Business Machines Corp.'s Earnings originally appeared on Fool.com.

Timothy Green owns shares of International Business Machines. The Motley Fool owns shares of International Business Machines. 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.