IBM 2014 Third-Quarter Form 10-Q Summary
Reporting period: Three and nine months ended September 30, 2014. Unless otherwise stated, financial amounts are in U.S. dollars; figures are in millions. Comparative results were reclassified to present Microelectronics as discontinued operations.
Business context and results
IBM reported lower revenue and weaker continuing-operations earnings in the quarter, while strategic offerings in areas such as cloud, analytics, mobile and security continued to grow. Management said results fell short of expectations, citing software sales execution, insufficient Global Services productivity, currency movements and delayed client decisions.
| Metric | Q3 2014 | Q3 2013 | Change |
|---|---|---|---|
| Revenue | $22,397 | $23,338 | Down 4.0% reported; down 3.6% at constant currency |
| Gross profit margin | 48.6% | 49.0% | Down 0.4 percentage points |
| Income from continuing operations | $3,455 | $4,139 | Down 16.5% |
| Diluted continuing-operations EPS | $3.46 | $3.77 | Down 8.2% |
| Operating (non-GAAP) diluted EPS | $3.68 | $4.08 | Down 9.8% |
| Net income | $18 | $4,041 | Down 99.6%, chiefly reflecting the Microelectronics disposal charge |
For the first nine months, revenue was $68,680, down 3.2% (down 2.7% at constant currency); continuing-operations income was $10,237, down 4.0%. Diluted continuing-operations EPS was $10.09, up 5.1%, while operating diluted EPS was $10.76, up 2.1%. Net income fell 36.5% to $6,539, including a $3,698 after-tax discontinued-operations loss.
Segments and material changes
- Systems and Technology: Q3 revenue fell 15.0%; gross margin fell 5.9 points, and the segment recorded a $99 pre-tax loss. Management cited the System z product cycle and declines in Power, Storage and System x.
- Global Services: Q3 revenue declined 2.7%; pre-tax income fell 12.6% and margin declined 1.9 points. Management cited inadequate productivity and slower-than-planned contract transitions.
- Software: Q3 revenue declined 1.6%; pre-tax income fell 3.2%. Management cited sales execution issues, although cloud, security and mobile offerings showed growth.
- Global Financing: Q3 pre-tax income declined 3.7% to $475, as higher credit-loss provisions and SG&A partly offset higher gross profit. Nine-month pre-tax income rose 5.2% to $1,664.
- Global Services backlog was $127.9 billion, down 9.3% year over year (down 6.7% excluding customer care divestiture, as reported). Nine-month signings fell 27.3%.
Cash flow, liquidity and debt
- Q3 operating cash flow was $3.9 billion, up $145 year over year; free cash flow was $2.2 billion. Q3 gross share repurchases and dividends totaled $2.8 billion.
- For nine months, operating cash flow was $10.8 billion versus $11.0 billion; free cash flow was $5.8 billion versus $6.6 billion. The filing attributes much of the free-cash-flow decline to cash taxes, which rose $1.5 billion year over year.
- Cash and marketable securities were $9.6 billion at September 30, down $1.5 billion from year-end 2013. Working capital was $4.9 billion versus $11.2 billion; the current ratio was 1.14 versus 1.28.
- Total debt was $45.7 billion, up $6.0 billion from year-end; short-term debt rose to $12.9 billion. IBM reported a 61.9% “core” debt-to-capitalization ratio, excluding Global Financing debt and equity, and a 76.0% consolidated ratio.
- IBM reported access to a $10 billion global credit facility and compliance with significant debt covenants. It repurchased $13.5 billion of stock and paid $3.2 billion in dividends during the first nine months.
Unusual items, outlook and risks
- Microelectronics: IBM recorded a $4.7 billion pre-tax disposal charge in Q3, including a $2.4 billion asset impairment, $1.5 billion of expected cash consideration to GLOBALFOUNDRIES and $0.8 billion of other costs. The business was classified as held for sale and discontinued operations. The deal, announced October 20, remained subject to closing conditions; IBM said estimates could change and additional charges could arise. Cash consideration is expected over three years, with working-capital adjustments.
- Other divestitures: IBM’s sale of its industry-standard server business to Lenovo had an initial closing on October 1, 2014, with further closings expected into 2015. IBM expected a net Q4 gain of about $0.75 per share, while warning of lost revenue and profit. It also expected a Q4 workforce-rebalancing charge of up to $600 million.
- 2014 outlook: Management expected full-year GAAP continuing-operations EPS to be flat to down 2% from $15.30 in 2013, and operating continuing-operations EPS to be down 2% to down 4% from $16.64. Expected full-year free cash flow was $12–13 billion, including an estimated $0.5 billion cash use in Q4 related to the Lenovo transaction and a further $0.5 billion in 2015. Management withdrew its prior expectation of $20 operating EPS in 2015.
- Management expected an approximately 21% 2014 effective tax rate and approximately $2.0 billion of retirement-plan cost. It described near-term revenue pressure but expected portfolio changes and productivity actions to improve the margin profile over time.
- Credit quality bears monitoring: Global Financing’s allowance coverage rose to 1.8% from 1.2% at year-end; bad-debt expense rose to $66 in Q3 from $12 and to $164 for nine months from $35. Non-accrual financing receivables increased to $285 from $191 at year-end.
- Contingencies include a $2.5 billion damages claim by Iusacell, pension-related litigation in the UK and Spain, environmental claims, and Brazilian non-income-tax matters with approximately $650 million of potential assessments. IBM said it could not estimate reasonably possible losses for certain proceedings; it believes it will prevail in the Brazilian matters.
- Other disclosed risks include currency and client-spending weakness, cybersecurity and privacy, customer credit and financing risks, pension funding, tax examinations, litigation, and execution of acquisitions and divestitures. IBM stated its disclosure controls were effective and reported no material quarterly change in internal control over financial reporting.
Important facts for investors to verify
- Whether the GLOBALFOUNDRIES transaction closes on expected terms, and whether the recorded charge, estimated costs and cash consideration require adjustment.
- Whether IBM achieves its full-year EPS and free-cash-flow outlook, especially given currency headwinds, divestiture effects and the anticipated Q4 restructuring charge.
- Whether software execution, Global Services productivity, Systems and Technology performance, backlog and signings stabilize or continue to weaken.
- Whether rising credit-loss provisions, non-accrual receivables and financing-portfolio exposures lead to further losses.
- How debt growth, reduced working capital, large buybacks and dividends affect liquidity and leverage, and whether the announced additional $5.0 billion repurchase authorization is used.
- Developments in the significant legal, tax and pension matters, including whether any outcomes create material charges or cash requirements.