IBM 2014 Second-Quarter Form 10-Q Summary
Business context and reporting period
International Business Machines Corporation (IBM) reported unaudited results for the quarter and six months ended June 30, 2014, compared with the corresponding 2013 periods. IBM described its strategy as shifting toward higher-value growth areas, particularly cloud, data and analytics, mobile, and security, while addressing secular and cyclical pressure in hardware. Unless noted otherwise, amounts are U.S. dollars.
Financial results and liquidity
| Metric | Q2 2014 | Q2 2013 | Six months 2014 | Six months 2013 |
|---|---|---|---|---|
| Revenue | $24.364B | $24.924B | $46.848B | $48.332B |
| Gross profit | $11.975B | $12.132B | $22.518B | $22.810B |
| Gross margin | 49.1% | 48.7% | 48.1% | 47.2% |
| Income before taxes | $5.171B | $4.144B | $8.151B | $7.750B |
| Net income | $4.137B | $3.226B | $6.521B | $6.258B |
| Diluted GAAP EPS | $4.12 | $2.91 | $6.37 | $5.60 |
| Diluted operating non-GAAP EPS | $4.32 | $3.22 | $6.82 | $6.23 |
- Q2 revenue declined 2.2% reported and 2.5% at constant currency. Six-month revenue declined 3.1% reported and 2.4% at constant currency. IBM said revenue excluding the customer care divestiture declined about 1% at constant currency in both periods.
- Q2 GAAP net income rose 28.2% and diluted EPS rose 41.6%; six-month net income rose 4.2% and diluted EPS rose 13.8%. Share repurchases reduced diluted weighted-average shares by 9.4% in Q2 and 8.4% for the half year. Q2 results also compare with a $1.0B workforce-rebalancing charge in Q2 2013.
- Operating non-GAAP earnings were $4.341B for Q2, up 21.3%, and $6.985B for the first half, up 0.4%. Operating non-GAAP EPS increased 34.2% and 9.5%, respectively. IBM’s operating measure excludes specified acquisition-related and retirement-related items; it is not GAAP.
- Six-month operating cash flow was $6.905B, versus $7.197B. Free cash flow, as defined by IBM, was $3.606B versus $4.382B. IBM attributed the decline primarily to cash taxes, which were $3.545B and $1.188B higher year over year; it said free cash flow excluding the cash-tax impact increased about $400M.
- At June 30, cash and marketable securities were $9.721B, total debt $46.470B, and working capital $5.749B; the current ratio was 1.14, versus 1.28 at year-end 2013. Total debt was up $6.752B from year-end, while equity fell $5.417B to $17.513B, primarily reflecting share repurchases. IBM reported a 56.1% core debt-to-capitalization ratio, excluding Global Financing, and a 72.6% consolidated ratio.
- IBM reported $3.6B of Q2 cash from operations and $3.0B of Q2 free cash flow in its management discussion. These quarterly figures are management-reported measures; the cash-flow statement provides six-month totals.
Material changes and segment performance
- Software revenue increased 1.0% in Q2 and 1.3% for the first half; middleware grew 3.4% and 3.3%, respectively. IBM reported strength in cloud, mobile and security offerings, but declines in operating systems, Workforce Solutions and Rational.
- Global Services revenue declined 1.4% in Q2 and 1.7% for the first half. Excluding the customer care divestiture, IBM said revenue increased about 1% at constant currency in both periods. Global Services backlog was $136B, down 3.2% reported year over year; adjusted for the divestiture it was down 0.5%.
- Systems and Technology revenue declined 11.4% in Q2 and 16.6% for the first half. Six-month gross margin fell 3.7 percentage points, and the segment recorded a $635M pre-tax loss for the half. IBM cited hardware market challenges, while noting sequential improvement in Q2 and the launch of entry-level POWER8.
- Global Financing revenue rose 3.5% in Q2 and 3.1% for the first half. Its Q2 pre-tax income increased 7.7% to $593M, but bad-debt expense rose to $65M from $15M; IBM attributed higher provisions mainly to specific reserves in China.
- IBM repurchased 61.8M shares for approximately $11.8B during the first half and paid $2.086B in dividends. Q2 dividend per share was $1.10, compared with $0.95 a year earlier.
Outlook, management commentary, risks and unusual items
- IBM’s July 2014 full-year guidance was at least $17.00 GAAP diluted EPS and at least $18.00 operating non-GAAP diluted EPS. Guidance excluded any gain from the pending System x sale to Lenovo. IBM expected third-quarter operating EPS growth to be single digit, with no more absolute operating EPS than Q2, and fourth-quarter growth to be double digit.
- IBM expected 2014 free cash flow of approximately $16B, about $1B higher year over year, and expected cash taxes to be a roughly $2B year-over-year headwind. It expected an approximately 20% effective tax rate and 2014 retirement-plan costs of about $2.1B.
- Management expected software revenue growth to accelerate to mid-single digits at constant currency in the second half; Global Services to deliver revenue growth at rates similar to the first half; and continued hardware revenue declines, while targeting full-year profit stabilization in Systems and Technology. IBM’s longer-term roadmap targeted at least $20 operating non-GAAP EPS in 2015.
- IBM announced a proposed $2.3B sale of its x86 server business to Lenovo, subject to regulatory and other closing conditions, with initial closing expected in the second half of 2014. IBM estimated a pre-tax gain of about $1B, with final timing and amount uncertain. It also recognized $121M of Q2 and $219M of first-half pre-tax gain from the customer care divestiture.
- Investment initiatives included $1.2B to expand SoftLayer cloud capacity, $1B for Watson commercialization, and a July announcement of $3B in semiconductor research and early-stage development over five years. IBM also announced an enterprise mobility partnership with Apple. Management said these investments may weigh on short-term results but support its longer-term strategy.
- Key risks include weak hardware demand, economic and client-spending conditions, execution of growth initiatives, currency movements, customer credit and financing risks, cybersecurity and privacy, pension costs, tax examinations, and legal proceedings. IBM said recorded legal liabilities were not material, but it could not estimate reasonably possible losses for certain matters. Significant disclosed matters include a $2.5B damages claim by Iusacell, approximately $710M of Brazilian non-income-tax disputes, an Indian tax assessment valued at $890M, and pension-related proceedings in the UK and Spain. IBM disputed or was contesting these matters.
- IBM said disclosure controls were effective at quarter-end and reported no material change in internal control over financial reporting during the quarter. The filing noted that interim results are not necessarily indicative of full-year results.
Important facts for investors to verify
- Reconcile GAAP EPS growth with the effects of the prior-year $1.0B workforce-rebalancing charge, current-year divestiture gains, and reduced share count; compare with IBM’s non-GAAP reconciliation.
- Track the revenue trajectory in Systems and Technology and Global Services, including the effects of the customer care and proposed System x divestitures.
- Assess whether cloud, analytics, mobile, security and software growth can offset hardware declines and the sharp fall in Global Services signings.
- Monitor cash generation against IBM’s $16B free-cash-flow outlook, the expected tax headwind, substantial repurchases, and rising short-term and total debt.
- Follow the Lenovo transaction’s regulatory approvals, closing schedule, final proceeds and gain, alongside tax and pension contingencies whose ultimate exposure IBM could not clearly quantify.