[EN] IBM Profit Margins Shrink Again in Shift to Cloud Computing
While headline numbers show a revenue and EPS beat, the quality will be an issue with earnings per share helped by the unexpected boost in intellectual property income and lower tax rates.
October 17, 2016
International Business Machines Corp. said profit margins shrank for the fourth quarter in a row, underscoring the technology company’s challenge in shifting to more subscription-based software and cloud services.
Operating gross profit margin in the third quarter was 48 percent, down 2.1 percentage points from the same period a year earlier. This missed the average analyst estimate of 50.1 percent.
Sales were $19.23 billion, down 0.3 percent from the previous year, beating the average analyst estimate of $19 billion. While this is the closest IBM has gotten to revenue growth in more than four years, it’s still the 18th quarter of sales declines.
Profit, adjusted for certain items, was $3.29 a share, better than the average analyst estimate of $3.23, according to estimates compiled by Bloomberg.
The strategic imperatives group -- which includes businesses such as artificial intelligence, cloud computing and data analytics -- reported revenue of $8 billion in the quarter, up 16 percent from a year earlier.
IBM shares fell 3 percent in extended trading to $150.21. They closed little changed at $154.77.
The Big Picture
Since Chief Executive Officer Ginni Rometty took the top post in 2012, investors have been waiting for her to turn the computer services company around and find growth in newer businesses -- like cloud and artificial intelligence -- to offset declines in legacy hardware, software and services units. The move is taking longer than some investors would like. IBM has been spending more on infrastructure and development, as well as on acquisitions, which has dented profitability in recent quarters. The company now has 49 data centers, having added two new ones in the third quarter in South Korea and Norway, Chief Financial Officer Martin Schroeter said on a conference call.“We have some pretty heavy investment levels going into the cloud and cognitive businesses, and we’ll continue to make those,” Schroeter said in an interview. Less-profitable businesses accounted for more of IBM’s total revenue in the third quarter, which pressured margins, according to Schroeter. The data center investments and this change in revenue sources accounted for more than three-quarters of the margin decline in the quarter, he said.
Revenue in cognitive solutions, which includes much of IBM’s software sales and artificial intelligence products under the Watson brand, increased 4.5 percent to $4.24 billion. Margins narrowed in this segment, due to continued high investment levels, Schroeter said.
Sales from technology services and cloud platforms, which include infrastructure software and networking tools, was $8.75 billion, up 2.4 percent.
Global business services booked $4.19 billion in revenue, a slight decline of 0.4 percent from the previous year. This sector includes older services, such as business process outsourcing.
Sales in the systems segment, which includes mainframes and the operating software that helps run them, declined 21 percent to $1.56 billion.
Income from intellectual property increased by $340 million from the previous year, lifting earnings per share by 30 cents, Schroeter said on the call.
IBM reaffirmed its full-year profit forecast of at least $13.50 a share, suggesting fourth-quarter profit will be at least $4.30 a share.
“While headline numbers show a revenue and EPS beat, we note the quality will be an issue,” with earnings per share helped by the unexpected boost in intellectual property income and lower tax rates, RBC Capital Markets analyst Amit Daryanani wrote in a note. Those two factors aren’t good indicators for fundamental business health. With revenue, the concern is that organic growth in newer businesses is stagnating and is buoyed by acquisitions, the analyst also said.
“Margins were a little off. You’re going to have that bumpy road when it comes to margins making this shift,” said Dan Morgan, senior portfolio manager at Synovus Securities Inc., which holds IBM stock.
IBM third quarter revenue falls, but tops forecasts on cloud, analytics growth
"We're building cloud data centers which don't come online at 90 percent utilization, you build utilization as you ramp"
By Narottam Medhora and Nayyar Rasheed
International Business Machines Corp posted better-than-expected third-quarter revenue on Tuesday, helped by growth in the company's cloud and analytics businesses.
Under Chief Executive Ginni Rometty, the technology services company has shifted toward more profitable areas, such as cloud services, artificial intelligence, analytics, and security while trimming its traditional hardware and services businesses.
Revenue from those areas, which the company calls "strategic imperatives," rose 16 percent to $8 billion in the third quarter. Cloud revenue jumped 44 percent compared with a 30 percent rise in the second quarter, it said.
However, shares of IBM, which reported its 18th straight quarter of declining revenue, were down 3.1 percent at $150.60 in after-market trading.
IBM has made a string of acquisitions focused on elements of its strategic imperatives business, including The Weather Company and Truven Health, spending $5.45 billion so far this year. In comparison, the company spent $821 million on acquisitions in the same period last year.
IBM's operating gross margin fell 2.1 percentage points to 48 percent in the quarter, as a result of higher investments in the company's cloud business and the shift to a subscription-based as-a-service model.
"We're building cloud data centers which don't come online at 90 percent utilization, you build utilization as you ramp," said IBM Chief Financial Officer Martin Schroeter in an interview with Reuters.
Schroeter added that IBM would continue its pace of investments due to demand for the company's as-a-service offerings.
"Gross margins declined 210 basis points and that was due to - probably - product mix and a higher level of overall investment for some new higher-margin products," said David Holt, an analyst at CFRA Research.
The Armonk, New York-based company maintained its full-year adjusted earnings forecast of at least $13.50 per share.
The company's revenue marginally fell to $19.23 billion in the quarter ended Sept. 30 from $19.28 billion a year earlier, but beat the average analyst estimate of $19 billion, according to Thomson Reuters I/B/E/S.
Net income fell to $2.85 billion, or $2.98 per share, from $2.95 billion, or $3.01 per share.
Excluding items, IBM earned $3.29 per share, beating analysts' average estimate of $3.23 per share.
Recent investments in cloud services has provided a boost in revenue
18 Oct, 2016
IBM has posted a higher than expected third-quarter revenue today, boosted by strong growth in cloud services and analytics.
Revenue in those areas rose overall by 16% to $8 billion, with revenue in cloud climbing 44% compared to 30% in the second quarter.
The US IT firm has focused on more profitable ventures under chief executive Ginni Rometty and has invested over $5 billion in areas such as cloud services and security while reducing their commitment to hardware and services. The shift to these "strategic imperatives" has generated almost $32 billion over the last 12 months.
"IBM's third-quarter performance, led by continued double-digit growth in our strategic imperatives, is a testament to our leadership in cognitive solutions and cloud," said Ginni Rometty.
"Our ability to apply deep expertise and breakthrough technology, led by Watson and the IBM Cloud, to massive amounts of data is enabling us to build new markets and transform industries," added Rometty.
IBM's total cloud revenue for the year now stands at $12.7 billion, the largest of any provider.
"We're building cloud data centres which don't come online at 90% utilisation, you build utilisation as you ramp," said IBM chief financial officer Martin Schroeter, speaking to Reuters.
IBM recently started a $3 billion plan to connect the super-computer Watson to IoT networks. From this, the firm announced a $200 million investment in a new global headquarters based in Munich, in response to growing demands from businesses that want to restructure using AI and IoT.
It is the job of the chief financial officer and the rest of the top brass of every public company in the world to present the financial results of their firms in the best possible light every thirteen weeks when the numbers are compiled and presented to Wall Street for grading. Money is how we all keep score, and how we decide we will invest and therefore live in our old age, hopefully with a certain amount of peace.
Starting this year, IBM has been presenting its financial results in a new format, which helps it emphasize its cognitive computing and cloud businesses. IBM uses those terms pretty generously – a flat file database running on a mainframe is a cognitive solution, for instance, which is funny if you think about how close it is to semi-structured data that is coming to dominate data processing. As we have complained in the past, the new categorization by Big Blue obfuscates as much as it illuminates, and that is why we spend some time each quarter picking apart the figures and trying to reassemble what IBM’s underlying systems business looks like and how healthy it is – or is not.
The good news is that IBM actually breaks its systems hardware (meaning servers and storage arrays with a smattering of switches that it resells) and its related operating systems software businesses out separately with the new categorization of its financial results. In the third quarter ended in September, IBM sold $1.56 billion in its System z and Power Systems servers as well as its various storage arrays to external customers and another $176 million worth of gear to other IBM divisions that create more complete stacks based on the IBM hardware. Those figures include operating systems, too.
That is down by half from when Big Blue still had its System x X86-based server business, which it sold off to Lenovo Group two years ago not so much because this business was unprofitable (as it claimed, which if you looked carefully it was not) but because it was going to get unprofitable as intense competition and volume economics pushed down margins to laser sharp, razor thin bits of cash. IBM may have been the number three peddler of X86 iron in the world two years ago, but Dell had a big lead and IBM was never going to catch up without radically changing the company and possibly acquiring one of the ODMs in Asia or Supermicro, its server partner for the SoftLayer cloud. (That would not have been the stupidest thing IBM ever did, but it did not do that.)
Rather than go wide with the X86 server business, IBM has instead gone deep with its Power Systems business and the OpenPower Foundation that it seeks to cultivate as an alternative to X86 machinery in the datacenter. And by X86 machinery, we really mean Intel Xeon machinery because AMD Opterons don’t really sell, although there is a good chance we could see them enter the field late next year for the Epic Battle Of Datacenter Processing that is brewing. The OpenPower Consortium is getting some traction, and Martin Schroeter, IBM’s chief financial officer, said on a call with Wall Street analysts that “one of the world’s largest Internet providers based in China” had chosen Power-based systems for its hyperscale datacenters. He did not elaborate on who this was, how many systems them have, and whether they were using IBM’s Power8 chips or those made by Suzhou PowerCore, which is now calling itself PowerCore Technology and which has created its own SP1 variant of the Power8.
IBM wants and needs to make money with its own Power Systems iron, which is why it has been contracting out its manufacturing to Tyan and Wistron with its first generation of Power Systems LC Linux-only boxes and has added Supermicro with its second generation of the Power Systems LC iron. The Linux-based Power machines include regular Power Systems, which do not have some of the discounts on processors and memory available on the Linux-only machines that make them more competitive with X86-based systems running Linux, as well as the Power Systems LC setups, and together these now represent 15 percent of revenues for the Power Systems business and grew by “double digits” in the third quarter. That is up from a nominal point or two before IBM got serious with OpenPower three years ago, and that was after more than a decade of shipping Linux on its Power and System z mainframe machinery. Linux has been a huge success on the IBM mainframe – the relative low cost of the software and IBM’s aggressive pricing on the hardware running it basically saved the System z business from oblivion – and IBM is trying to pull off that trick again on the Power Systems line.
Schroeter said that IBM’s margins for its biggest NUMA-based Power iron, which is called the Power Systems scale-out models and which have from four to sixteen sockets in a single system image, held up well in the third quarter, but that margins in the midrange of the line (machines with one, two, or four sockets) were down, and that overall margins for Power Systems were down.
While IBM still sells Power iron running AIX and IBM i, the Power8 machines that support these two IBM operating systems are looking a little long in the tooth at two and a half years old, and customers know that entry and midrange Power9 machines are coming next year. The System z13 generation of mainframes has pretty much had its run, after being in the market for seven quarters, and while IBM has not said anything, it stands to reason that a z14 processor complex will be announced next year around the same time that the Power9 chip is shipping. In both cases, Power and z customers who can wait are gonna wait, or demand very steep discounts on current iron to make up for the price/performance improvements that are coming with the future Power9 and z14 machines. IBM is very enthusiastic about using Blockchain in commercial transaction processing settings, and has 40 clients testing it out on mainframes, but this workload will take a long time to grow. Presumably, IBM will also push Blockchain on Power as well.
We wonder how much IBM is taking in licensing Power technology through the OpenPower Consortium, and similarly wonder how IBM will be keeping track of the revenue in the Power ecosystem as it grows outside of its walls. ARM Holdings has the same problem when talking about the uptake of ARM server chips in the datacenter from its half dozen server partners.
IBM’s operating system business is on the wane, following down hardware sales, and re estimate that Big Blue had $434 million on operating revenues in Q3. The good news is that this part of the IBM systems business is very profitable, with gross profits of $385 million, or 88.3 percent of revenues. The systems hardware business brought in $1.2 billion, and had gross profits of $440 million, 36.9 percent of revenues. The systems business overall had gross profits of $891 million and pre-tax income fell to $136 million. That is a 45 percent decline, and it looks like that Systems business took some cost hits for taxes and other charges. IBM’s overall revenues of $19.23 billion were off a smidgen compared to last year, gross profits were off 4.5 percent to just over $9 billion, and pre-tax income was down 11.2 percent to $3.9 billion. So, like we said, the IBM Systems group took a hit.
But this is not the “real” IBM systems business, as we have pointed out before. IBM sells integration and transaction processing software for its machinery that drives around $2.5 billion a quarter in Q2 and Q3 and that is very profitable. On top of this, IBM gets various software and hardware support fees, and also makes a good living as a bank financing the installation of its wares through its Global Financing arm. We allocate all of the transaction processing software, 90 percent of the integration software, and 75 percent of the tech support revenues streams to IBM’s homegrown systems business, and when you add it all up, it looks like this:
In the third quarter, that works out to $1.63 billion servers, storage and operating systems (and probably a few hundred million dollars in storage software like Spectrum/GPFS that don’t get counted here), plus $1,57 billion in transaction processing software (CICS transaction monitors and such), $924 in integration software (think WebSphere in its many forms), $1.39 billion in tech support, and $573 million in financing. Add it all up, and it is a tad over $6 billion, and down 11.9 percent from the year-ago period, but still comprising 31.3 percent of Big Blue’s overall revenues. The real systems business is still a big part of what Big Blue does, and if you wanted to be honest about it, all of the higher level services and cloud and application software and databases it sells are also part of a systems business, too.
But you will never hear IBM talk about it that way. Some days, it is like IBM forgot that it is International Business Machines. . . .