IBM 2019 Q2 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, 2019, compared with the corresponding 2018 periods. In the first quarter, IBM reorganized its reportable segments; prior-year segment figures were recast for comparability. IBM completed its acquisition of Red Hat on July 9, 2019, after quarter-end.
Key financial metrics
| Metric | Q2 2019 | Q2 2018 | Six months 2019 | Six months 2018 |
|---|---|---|---|---|
| Revenue | $19.2B | $20.0B | $37.3B | $39.1B |
| Gross margin | 47.0% | 46.0% | 45.7% | 44.6% |
| Income from continuing operations | $2.5B | $2.4B | $4.1B | $4.1B |
| Diluted continuing-operations EPS | $2.81 | $2.61 | $4.58 | $4.42 |
| Operating cash flow | $2.9B | $2.3B | $7.7B | $6.9B |
| Free cash flow (company-defined, non-GAAP) | $2.4B | Not stated here | $4.1B | $3.2B |
- Q2 consolidated revenue fell 4.2% reported (1.6% adjusted for currency); first-half revenue fell 4.4% reported (1.2% adjusted for currency). Q2 net income rose 3.9%; diluted EPS rose 7.7%, supported in part by a 3.1% lower diluted weighted-average share count.
- Q2 operating diluted EPS was $3.17, up 2.9%; first-half operating diluted EPS was $5.42, down 2.0%. These are non-GAAP measures and exclude specified acquisition-related, retirement-related and tax-reform items.
- At June 30, cash, restricted cash and marketable securities totaled $46.4B. Total debt was $73.0B, up $27.2B from year-end 2018, largely reflecting financing raised for Red Hat. Current assets were $77.5B and current liabilities $42.4B (current ratio 1.83).
- IBM reported $45.4B cash and cash equivalents on the balance sheet; the $46.4B liquidity figure also includes restricted cash and marketable securities. IBM said approximately $34B cash was used to close Red Hat on July 9.
- H1 dividends paid were $2.8B and common-stock repurchases were $1.2B. IBM suspended its repurchase program upon Red Hat’s closing, earlier than previously planned, to reduce debt.
Material changes versus the prior comparable period
- Growth was concentrated in Cloud & Cognitive Software: Q2 external revenue increased 3.2% reported (5.4% currency-adjusted). Global Business Services revenue rose 0.5% (3.4% currency-adjusted).
- Global Technology Services revenue declined 6.7% reported in Q2 (3.5% currency-adjusted); management attributed declines partly to its decision to deemphasize lower-value contracts and third-party content. Systems revenue declined 19.5% reported (18.0% currency-adjusted), including a 41.8% decline in IBM Z revenue amid product-cycle effects.
- Q2 GAAP gross margin improved 1.0 percentage point to 47.0%. Management cited software growth, services productivity and cloud scale efficiencies. H1 margin also improved 1.0 point to 45.7%.
- Q2 GAAP interest expense rose to $348M from $173M, primarily reflecting higher debt and rates associated with Red Hat financing. H1 interest expense was $558M versus $338M.
- Services backlog was $111.2B at June 30, down 4.5% year over year; Q2 services signings fell 16.0% to $9.7B.
Outlook, management commentary, risks and unusual items
- Before incorporating Red Hat, IBM said it remained on track for 2019 GAAP continuing-operations EPS of at least $12.45, operating EPS of at least $13.90, and free cash flow of approximately $12B. The EPS outlook excluded specified acquisition-related, non-operating retirement and tax-reform items; these expectations did not include Red Hat or related activity other than pre-closing financing costs. IBM planned to update full-year expectations at an August 2, 2019 investor briefing.
- Management expected Red Hat to be accretive to free cash flow in its first year and operating EPS by the end of the second year after closing. Noncash purchase-accounting adjustments were expected to reduce reported revenue after closing, and make the acquisition dilutive to full-year 2019 EPS.
- IBM said its OEM IT commercial-financing wind-down would reduce revenue with a nominal profit impact and would not change 2019 EPS or free-cash-flow expectations. Red Hat debt and the repurchase suspension were intended to support a return to target leverage ratios within a couple of years; IBM reaffirmed its commitment to investment-grade ratings and a growing dividend.
- Unusual Q2 items included $578M of gains from two software divestitures, approximately $500M of workforce-rebalancing charges, and a charge related to an unfavorable legal ruling. Management said the gains and charges were essentially neutral to total expense and profit for the quarter. The software divestiture gain and its estimates may change, though IBM did not expect material changes.
- IBM expected 2019 retirement-plan contributions of approximately $2.3B, including about $400M to non-U.S. defined-benefit and multi-employer plans. A change in the U.S. pension-plan actuarial-loss amortization period was expected to reduce 2019 non-operating expense by about $900M; IBM noted an effect on free-cash-flow realization.
- Legal and tax exposures include ongoing IP, employment, contract, environmental and other proceedings. IBM said recorded legal liabilities were not material, but it could not estimate reasonably possible losses for many matters. Potential Brazilian non-income-tax assessments and litigation were approximately $950M; IBM said it believed it would prevail and that the amount was not a meaningful indicator of liability. The Indiana contract dispute remained pending after a state supreme court ruling; IBM sought rehearing.
- Other stated risks include economic and client-spending weakness, execution of growth and productivity plans, cybersecurity and privacy, currency and customer-credit exposures, pensions, taxes, litigation, and acquisition integration and higher debt. IBM reported effective disclosure controls and no material change in internal control over financial reporting during the quarter.
Most important facts for investors to verify
- Updated 2019 guidance after Red Hat’s closing, including the impact of purchase-accounting deferred-revenue adjustments and the stated EPS and free-cash-flow targets.
- Post-acquisition debt, cash, interest expense, credit-rating developments and progress toward IBM’s target leverage ratios.
- Whether cloud and software growth can offset continued weakness in Systems and Global Technology Services; track backlog and services signings as demand indicators.
- How much of reported earnings and cash flow reflects divestiture gains, pension-accounting changes, tax items, currency movements and other nonrecurring effects.
- Developments in material legal and tax matters, including the Indiana dispute and Brazilian assessments, and any changes to recorded provisions or estimated exposure.