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International Business Machines (NYSE: IBM) reported its second quarter results on July 18, beating analyst estimates while reporting yet another decline in revenue. There were signs of progress in the company's numbers, and commentary from management during the conference call shed some additional light on IBM's performance. Here are five quotes from management that investors need to see.
A growing cloud business
One major area of focus for IBM is cloud computing. The company's cloud strategy is centered on enterprise customers and hybrid clouds, although it's also a player in the public cloud market dominated by Amazon.com Web Services. IBM's vast software business is also shifting toward an as-a-service model, with products like Watson delivered via IBM's cloud.
IBM CFO Martin Schroeter discussed the progress of IBM's shift to cloud delivered as-a-service:
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We said we'd continue to build as-a-service capabilities. Our cloud-as-a-service revenue was up 50%, and we exited the quarter with an annual run rate of $6.7 billion in our cloud-as-a-service businesses. That's up from $5.4 billion last quarter. Certainly we have a benefit from the acquisitions recently closed, but we had solid organic growth as well.
More than half of IBM's cloud revenue is now delivered as a service. Schroeter made it clear that this portion of the cloud business is growing organically, but acquisitions are certainly helping. IBM has made a slew of cloud-related acquisitions recently, with the company spending a total of $5.4 billion on acquisitions during the first half of 2016 alone. IBM has completed 20 acquisitions over the past year, and the company will likely continue this trend as it grows out its cloud business.
The impact of currency
Because the majority of IBM's revenue is derived outside of the United States, shifting exchange rates can have a dramatic effect on IBM's reported revenue. This was a major problem in 2015, when currency knocked off eight percentage points of revenue growth.
While the Brexit vote, which sent the British Pound plunging relative to the U.S. dollar, occurred during IBM's second quarter, the net effect of currency translation was minimal, according to Schroeter:
While there was a lot of movement in individual currencies in total, currency translation had a 20 basis point impact to revenue growth.
While currency translation effects were minimal, the roll-off of currency hedges are still negatively affecting IBM's profits. Schroeter said that IBM's pre-tax income was reduced by about $250 million during the second quarter due to the combined effects of these two currency-related items. With IBM reporting pre-tax income of $3.5 billion, a $250 million reduction is significant.
Don't worry about mainframes
IBM's systems segment, which includes its mainframe systems, Power Systems, storage, and operating systems software, had a rough quarter. Revenue fell 23% year-over-year, and pre-tax profit slumped 58% year-over-year. Mainframe sales fell hard, but Schroeter explained why it's not a big deal:
Revenues for our z Systems declined 40% in the second quarter while margins improved, consistent with where we are in the product cycle. We're continuing to expand the z client base, adding 13 new clients in the quarter and nearly 70 since the beginning of the cycle.
IBM launched its latest line of mainframes, the z13, in January of 2015. The launch triggered an upgrade cycle from IBM's mainframe clients, leading to major increases in sales. During the first quarter of 2015, for example, mainframe sales rose 130% year-over-year. The standard pattern for mainframe sales is a spike following a refresh, followed by an eventual drop in sales once much of the upgrade cycle has played out. IBM is now on the tail end of that cycle.
According to Schroeter, IBM is picking up additional mainframe customers, growing its customer base during the current product cycle. IBM has been attempting to broaden the appeal of its mainframe systems, launching Linux-only systems last year and allowing customers to pay based on usage. It's unclear what effect these initiatives are having on the mainframe business at this point, but investors shouldn't be worried about the steep decline in sales.
Return to growth in software
Following nearly two years of slumping software sales, IBM managed to grow its software business during the second quarter compared to the prior-year period. Schroeter explains:
Our total software revenue was up 1%, driven by an acceleration in the annuity content. Subscription and support revenue was up, reflecting increased deployment by our clients and steady renewal rates.
Revenue from subscription-based software rose 7% year-over-year during the second quarter, counteracting weakness in transactional software and driving the net increase in sales. Acquisitions were no doubt responsible for much of this growth, with many of the companies added to the software business recently being software-as-a-service providers such as Ustream, Cleversafe, and Compose.
IBM's software business is still in transition, and it will need to return to organic growth to fully convince investors that the company's shift to subscription software will pay off in the long run.
Cost savings will drive a big fourth quarter
IBM expects to generate at least $13.50 in non-GAAP earnings per share this year. Through two quarters, the company has delivered 39% of this total, and it expects to achieve another 24% during the third quarter. That leaves 37%, or about $5.00, for the fourth quarter. That would represent growth compared to the fourth quarter of 2015.
Schroeter explained one factor that will help drive earnings during the fourth quarter:
As we've said, this is about rebalancing skills more than capacity reduction, and so these actions free up spend that can be reinvested to build capabilities as well as contributing to the bottom line. We started to see some savings already, but the majority of the gross savings we'll see in 2016 will come in the fourth quarter.
IBM initiated a "workforce rebalancing" earlier this year as part of its transformation. The goal of the program, according to Schroeter, was to shift labor from legacy businesses to IBM's growth businesses. One result will be lower costs, but the bulk of these cost savings will be delivered during the fourth quarter. This is what will allow IBM to generate such a high proportion of its annual earnings toward the end of the year.
IBM has now reiterated its full-year earnings guidance twice. If the company comes up short, faith in the turnaround will likely evaporate.
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