IBM 2019 Third-Quarter 10-Q Summary
Business context and reporting period
International Business Machines Corporation reported for the quarter and nine months ended September 30, 2019. The quarter includes Red Hat results from its July 9 acquisition. Red Hat is included in Cloud & Cognitive Software. Prior-year segment figures were recast to reflect IBM’s 2019 organizational changes.
Key financial metrics
| Metric | Q3 2019 | Nine months 2019 |
|---|---|---|
| Revenue | $18.0 billion, down 3.9% | $55.4 billion, down 4.3% |
| Gross margin | 46.2%, down 0.7 points | 45.9%, up 0.5 points |
| Income from continuing operations | $1.7 billion, down 37.8% | $5.8 billion, down 14.8% |
| Diluted GAAP EPS from continuing operations | $1.87, down 36.4% | $6.46, down 12.2% |
| Operating diluted EPS (non-GAAP) | $2.68, down 21.6% | $8.10, down 9.6% |
| Operating cash flow | $3.6 billion | $11.3 billion |
| Free cash flow (company-defined) | $1.8 billion | $5.9 billion |
Q3 GAAP net income was $1.7 billion versus $2.7 billion a year earlier. Nine-month net income was $5.8 billion versus $6.8 billion. Q3 operating cash flow declined $0.6 billion year over year; nine-month operating cash flow increased $0.2 billion. The company’s free cash flow definition excludes changes in Global Financing receivables and subtracts net capital expenditures, including software investment.
At September 30, cash, restricted cash and marketable securities totaled $11.0 billion. Total debt was $66.3 billion, up $20.5 billion from year-end 2018; $23.1 billion supported Global Financing. Current assets were $38.1 billion against current liabilities of $35.1 billion, yielding working capital of $3.1 billion and a 1.09 current ratio. Total assets were $149.6 billion and equity was $18.1 billion.
Material changes versus prior periods
- Red Hat was acquired for approximately $34.8 billion in cash consideration; total consideration recorded was $35.1 billion. IBM funded the transaction with cash and debt, including a $20 billion May debt offering. The acquisition added $23.1 billion of goodwill and $13.5 billion of identifiable intangible assets in the preliminary allocation.
- Q3 Cloud & Cognitive Software revenue increased 6.4% (8% adjusted for currency), including 17.2% growth in Cloud & Data Platforms. Global Business Services grew 1.0%. Global Technology Services declined 5.6%, and Systems declined 14.7%, reflecting lower client business volumes and the z14 product-cycle downturn.
- Q3 total cloud revenue was $5.0 billion, up 11%; trailing-12-month cloud revenue was $20.0 billion, up 5%. Remaining performance obligations were $115 billion, down from $124 billion at year-end 2018.
- Q3 expense and other income increased 17.3%, while interest expense rose to $432 million from $191 million, principally reflecting acquisition-related spending and debt. Results also included Red Hat purchase-accounting effects and acquisition costs; a $2.2 billion deferred-revenue fair-value adjustment will reduce reported revenue after closing.
- Working capital fell from $10.9 billion at year-end, primarily reflecting the wind-down of OEM IT commercial financing and lower financing receivables. IBM said the wind-down is expected to reduce revenue with nominal profit impact.
Outlook, commentary, and risks
Management maintained 2019 expectations of at least $10.58 GAAP diluted EPS from continuing operations, at least $12.80 operating diluted EPS, and approximately $12 billion in free cash flow. For Q4, IBM expected revenue to rise $3.5–$3.7 billion sequentially, citing the z15 launch and the seasonally larger transaction quarter. Management said it expects a sustainable revenue-growth trajectory in 2020.
IBM expects Red Hat to be free-cash-flow accretive in its first 12 months, with an estimated $0.5 billion and $1 billion added to IBM free cash flow in 2020 and 2021, respectively. Management targeted a mid-to-high-single-A leverage profile within a couple of years, while maintaining the dividend. Share repurchases were suspended after the acquisition to prioritize debt reduction; IBM reported reducing debt by $6.7 billion since June 30.
Management cited ongoing cloud, software, security and systems investment, but noted weaker-than-expected GTS performance, lower client business volumes, a strengthening U.S. dollar and competitive pressures. 2019 tax-rate expectations were approximately 8–9% GAAP and 9–10% operating, including estimated discrete tax events. A change in the U.S. pension plan’s actuarial-loss amortization period reduces 2019 non-operating pension expense, but IBM said it affects free-cash-flow realization.
Risks include acquisition integration and execution, elevated debt and financing costs, revenue declines in some segments, foreign-exchange exposure, client credit risk, cybersecurity and privacy matters, pension funding, tax examinations and litigation. IBM reported no material recorded legal liabilities, but stated that it cannot estimate reasonably possible losses for many matters. Brazilian non-income tax disputes involve approximately $900 million in potential assessments; IBM believes it will prevail and says the amount is not a meaningful indicator of liability. Net unrecognized tax benefits were $6.3 billion after specified offsets.
Important facts for investors to verify
- Progress on Red Hat integration, hybrid-cloud growth, expected synergies and the timing of deferred-revenue replenishment.
- Debt reduction, leverage trajectory, interest expense and the implications of the Moody’s long-term rating downgrade to A2.
- Whether weakness in GTS and Systems improves, and whether cloud growth offsets declines elsewhere; monitor backlog and signings alongside recognized revenue.
- Delivery against 2019 EPS and free-cash-flow guidance, noting IBM’s non-GAAP definitions and the stated pension-related cash-flow effect.
- Developments in tax examinations, the Brazilian assessments and other legal proceedings, for which loss estimates may be unavailable.