Don't Panic Over International Business Machines Corp.'s Earnings

Shares of International Business Machines slumped after the company reported its fourth-quarter earnings, with declining revenue and weak guidance spooking the market. On the surface, the 12% year-over-year revenue decline appears downright awful, but IBM sold off three major businesses in 2014, and adjusting for those divestitures improves the picture significantly. There's an awful lot of pessimism surrounding the company and the stock right now, but IBM is in a much stronger position than the recent stock performance suggests.

A look at the resultsWhile the headline revenue decline may seem like a good reason for investors to panic, the situation at IBM is a lot better than it seems. Here's how IBM's various segments performed during the fourth quarter, including both the reported revenue growth and the revenue growth adjusted for the major divestitures IBM made throughout the year:

Source: IBM.

After backing out IBM's sale of its x86 server business, its semiconductor manufacturing business, and its customer care outsourcing business, revenue declined by just 2%. Global Technology Services, the largest segment, actually posted growth, and the only truly large decline was in the Systems and Technology segment. However, with a refresh of IBM's mainframes recently announced, this decline was partly due to customers who held off on mainframe upgrades until the new system is available.

While revenue declined, margins rose. Gross margin jumped by 0.9 percentage points, helped by the sale of the commodity x86 server business, and operating margin jumped to 29.4%, up from 25.9% during the fourth quarter of 2013. Billions in buybacks throughout the year counteracted a higher tax rate, with EPS down just 4% year over year.

IBM expects GAAP EPS to be between $14.35 and $15.10 for 2015, with non-GAAP EPS between $15.75 and $16.50. That range is well below the $20 target IBM was recently forced to abandon, and it points to another tough year for the company. However, the progress IBM made during 2014 provides a foundation for future growth, and while this year will a difficult one, there's really nothing wrong with IBM's business that can't be fixed.

Stronger than it appearsIBM provided a useful slide in its earnings presentation that sums up the business:

Source: IBM.

The bulk of IBM's revenue is recurring, with long contracts ensuring a stable source of future revenue. Any weakness should be visible well in advance, particularly in the services business, in the form of a declining backlog or reduced signings. During the fourth quarter, adjusted for the divested business, IBM's services backlog was flat at $128 billion. The company also signed $18.4 billion of new business, a 13% jump year over year. No problems there.

Future growth for IBM will come from the businesses that it calls Strategic Imperatives. This segment includes anything related to the cloud, business analytics, mobile, and security, and it tends to be heavily weighted toward software, the highest-margin portion of IBM's business. During 2014, cloud revenue grew by 60% to $7 billion. Business analytics grew 7% to $17 billion, mobile revenue tripled, and security grew by 19%. Overall, IBM's strategic imperatives grew by 16% in 2014, and they now make up about 27% of IBM's total revenue.

These businesses include SoftLayer, IBM's infrastructure-as-a-service offering, BlueMix, its platform-as-a-service running on top of SoftLayer, and a slew of analytics software, including Watson, which can be delivered as a cloud service. IBM's annual run rate of software-as-a-service delivered through the cloud has now reached $3.5 billion. Despite IBM's late entry into the cloud business, it seems to be doing a pretty good job catching up.

Now, declining earnings are never a good thing, and 2015 certainly isn't going to be a bumper year for IBM. But any company that's been around for a century inevitably goes through rough patches. Expecting unrelenting earnings growth, year in and year out, is unrealistic. At the same time, an earnings decline isn't the end of the world. IBM's operating income declined in the early 2000s, a decade after a huge collapse in the 1990s nearly killed the company. But IBM, on each occasion, adjusted its strategy, moving toward higher-value, higher-margin businesses. That strategy has paid off.

IBM Operating Income (Annual) data by YCharts

The challenges that IBM faces today appear no different. The company is in much better shape compared with the 1990s, when the low-end mainframe market was overtaken by the PC and server. Today, hardware is only a small part of IBM's business, even smaller now that the x86 server business is gone. IBM is a top-three software vendor, and its global services business appears to be stable.

The sky isn't falling. IBM's business is not collapsing. There's no reason to panic.

The article Don't Panic Over International Business Machines Corp.'s Earnings originally appeared on Fool.com.

Timothy Green and The Motley Fool own shares of IBM. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.