Business context and reporting period
IBM’s unaudited Form 10-Q covers the three months ended March 31, 2017, compared with the first quarter of 2016. IBM reported across Cognitive Solutions, Global Business Services, Technology Services & Cloud Platforms, Systems, and Global Financing. Management emphasized growth in cloud, analytics, mobile, social, and security while transforming traditional businesses.
Financial results
| Metric | Q1 2017 | Q1 2016 / comparison |
|---|---|---|
| Revenue | $18.155 billion | $18.684 billion; down 2.8% reported and 2.2% at constant currency |
| Gross profit margin | 42.8% | 46.5%; down 3.7 percentage points |
| Income before taxes from continuing operations | $1.424 billion | $1.034 billion; up 37.7% |
| Income from continuing operations | $1.753 billion | $2.016 billion; down 13.1% |
| Net income | $1.750 billion | $2.014 billion; down 13.1% |
| Diluted GAAP EPS | $1.85 | $2.09; down 11.5% |
| Operating non-GAAP earnings / diluted EPS | $2.255 billion / $2.38 | $2.270 billion / $2.35; earnings down 0.7%, EPS up 1.3% |
| Operating cash flow | $3.955 billion | $5.530 billion |
| Free cash flow, as defined by IBM | $1.088 billion | $2.323 billion |
The effective tax rate was negative 23.1%, primarily reflecting a $582 million discrete tax benefit from an intra-entity asset transfer, partly offset by a $99 million foreign-audit charge. The prior-year negative 95.1% tax rate primarily reflected a roughly $1.0 billion Japan tax refund, plus interest. These unusual tax effects materially affect period comparisons.
Financial position, liquidity, and debt
At March 31, 2017, cash and cash equivalents were $10.096 billion and marketable securities were $599 million. Total assets were $117.495 billion, total liabilities $99.047 billion, and equity $18.448 billion. Working capital was $6.408 billion and the current ratio was 1.18, versus $7.613 billion and 1.21 at year-end 2016.
Total debt was $42.781 billion, up $613 million from year-end; approximately $28.475 billion supported Global Financing. Short-term debt was $8.340 billion and long-term debt $34.441 billion. IBM reported a consolidated debt-to-capitalization ratio of 69.9% and a core ratio excluding Global Financing of 48.3%. It was in compliance with significant debt covenants and had a $10.25 billion global credit facility.
Material changes and business performance
- Strategic imperatives revenue was $7.8 billion, 43% of IBM revenue. Cloud revenue was $3.5 billion, up 33% reported; cloud as-a-Service revenue grew 59%, with an $8.6 billion exit run rate.
- Cognitive Solutions revenue increased 2.1% reported; Global Business Services decreased 3.0%; Technology Services & Cloud Platforms decreased 2.5%; Systems decreased 16.8%, reflecting product-cycle declines in z Systems and Power Systems.
- Systems pre-tax loss widened to $186 million from $10 million. Global Financing pre-tax income fell 19.5% to $311 million.
- Lower workforce-rebalancing and real-estate charges, together with higher intellectual-property income, helped reduce reported expenses. IP and custom development income rose to $445 million from $217 million, including one transaction with period income above $100 million.
- Operating cash flow fell by $1.575 billion year over year, primarily because the prior-year period included the Japan tax refund; strong collections partly offset the decline. Investing activities provided $350 million, compared with a $1.886 billion use in Q1 2016, principally because of lower acquisition spending.
- IBM repurchased $1.293 billion of shares and paid $1.321 billion of dividends during the quarter. The Board subsequently approved a quarterly dividend of $1.50 per share, payable June 10, 2017.
Outlook, risks, contingencies, and unusual items
IBM maintained its 2017 outlook: GAAP continuing-operations EPS of at least $11.95 and operating non-GAAP EPS of at least $13.80, including stated adjustments of $0.75 per share for acquisition-related charges and $1.10 for non-operating retirement items. It expected free cash flow to be essentially flat year over year and free-cash-flow realization above 90%. Management expected operating pre-tax income growth, gross-margin improvement from Q1, and a decline in GAAP pre-tax income due to higher non-operating pension expense. It expected the second-half Systems and Technology Services & Cloud Platforms profit trends to improve; Q2 revenue growth faced an estimated two-point currency headwind, plus or minus one point.
Management forecast 2017 retirement-related plan costs of approximately $2.9 billion, including about $1.5 billion of non-operating costs, and total retirement-plan contributions of approximately $2.5 billion. Legal and regulatory matters include an SEC investigation concerning revenue recognition, a DOJ investigation involving alleged foreign bribery and FCPA compliance, and multiple contract and employment disputes. An adverse outcome in the UK pension matter could require an estimated one-time pre-tax charge of approximately $290 million plus ongoing accruals. Potential Brazilian non-income-tax matters were approximately $1 billion; IBM said it believes it will prevail and that the amount is not a meaningful indicator of liability. The filing says loss estimates for many matters cannot be made reliably; recorded legal liabilities were not material.
Other risks identified include economic and client-spending weakness, execution of growth and productivity plans, cybersecurity and data privacy, currency movements, pension and tax matters, customer credit and financing risks, and the ability to manage acquisitions and legal proceedings. IBM said its disclosure controls were effective and that no material change in internal control over financial reporting occurred during the quarter.
Important facts for investors to verify
- How much of reported earnings and EPS reflects the $582 million Q1 tax benefit, and how comparable operating non-GAAP results are to GAAP results.
- Whether strategic-imperative growth can offset declines in Systems and traditional services, and whether projected margin improvement materializes.
- Progress toward the 2017 EPS and essentially flat free-cash-flow outlook, given Q1 free cash flow was below the prior-year period.
- Debt maturity and refinancing needs, liquidity access, and the performance and credit quality of Global Financing receivables.
- Developments in the SEC revenue-recognition inquiry, DOJ investigation, UK pension litigation, and tax disputes, including potential financial exposure.