IBM Corp.'s Strategy Shift Is Starting to Pay Dividends

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Enterprise computing giant IBM (NYSE: IBM) reported third-quarter results Tuesday night. The company delivered strong results in key markets such as cloud computing and mainframe systems, and share prices surged in Wednesday's early trading session.

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IBM's third-quarter results: The raw numbers

Metric

Q3 2017

Q3 2016

Year-Over-Year Change

Revenue

$19.2 billion

$19.2 billion

(0.4%)

Net income

$2.73 billion

$2.85 billion

(4.2%)

GAAP earnings per share (diluted)

$2.92

$2.98

(2%)

IBM tracks and reports an adjusted profitability metric known as operating earnings. This non-GAAP item backs out costs related to acquisitions and employee retirement plans, and Big Blue sees this as a better measure of day-to-day operating results. Operating earnings stopped at $3.30 per diluted share in the third quarter, essentially flat compared to $3.29 per share in the year-ago period.

What happened with IBM this quarter?

  • IBM's strategic imperatives continued to show muscular growth. Revenues in this category, which includes operations such as cloud computing, data security, artificial intelligence, and mobile technologies, increased 11% year over year while sales of so-called core technologies decreased by 8%. Strategic imperatives accounted for sales of $8.8 billion in the third quarter, or 46% of the company's total revenues.
  • Within the strategic imperatives bundle, cloud service sales led the way with a 20% year-over-year revenue boost. That category produced sales of $4.1 billion, or 21% of IBM's total revenue stream.
  • There's still life in the old-school product category of mainframe server systems. A new generation of the Z Systems mainframe lineup made its debut in September, driving 62% growth in third-quarter mainframe sales compared to the year-ago quarter. All told, revenues from the systems division rose 10% year over year to $1.7 billion.
  • The company generated $2.5 billion of free cash flow in the third quarter, up from $2.4 billion a year earlier. Shareholders got paid $1.4 billion in the form of dividends and IBM bought back another $900 million of its own shares. That adds up to a total shareholder-facing cash return of $2.3 billion, or 91% of IBM's free cash flows.

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Big Blue updated its full-year guidance as follows:

  • Operating earnings guidance was unchanged at approximately $13.80 per diluted share. Having achieved $8.64 per diluted share in the first three quarters, that works out to a fourth-quarter target near $5.16 per diluted share. As a reminder, IBM reported operating earnings of $5.01 per diluted share in the fourth quarter of 2016, so we're looking at a 3% year-over-year earnings growth ambition.
  • Free cash flows should remain "relatively flat" compared to fiscal year 2016. That would be roughly $11.6 billion, leaving room for approximately $5.4 billion in the fourth quarter.

What management had to say

In a conference call with analysts, CFO Martin Schroeter indicated that IBM's long-awaited turnaround gained significant traction in the third quarter:

Ninety days ago, I talked about planting the flag to mark the beginning of an improvement of the trajectory of our business, which would result in a second half that was improved over the first. Now in the third quarter, we've improved our year-to-year revenue and margin trajectory. Last year, we increased revenue by $2.5 billion dollars from the third to fourth quarter. This year we'd expect stronger sequential performance, due in part to the mainframe cycle, so perhaps three to four hundred million more, and of course that quarter to quarter will depend on currency too.

Looking ahead

IBM is incorporating the Watson platform for cognitive computing into many of its products and services, and management likes to think of their business as "a cognitive solutions & cloud platform company." And Big Blue isn't afraid of exploring new technologies that can be paired up with Watson in efficient ways. For example, cryptocurrency and blockchain transaction systems might be the next big thing, so IBM is testing the waters there.

"In the third quarter, we continued to launch new blockchain partnerships and networks, including an initiative with a group of leading food retailers and suppliers including Walmart, Kroger, Dole, Nestle and Unilever to address food safety," Schroeter said. "And we're partnering with UBS and several global banks to build a blockchain-based platform to support trade finance."

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Anders Bylund owns shares of IBM. The Motley Fool owns shares of and recommends Unilever. The Motley Fool has a disclosure policy.