IBM 2017 Second-Quarter Form 10-Q Summary
Reporting period: Quarter and six months ended June 30, 2017. Results are unaudited and compare with the corresponding 2016 periods. Amounts are in U.S. dollars; financial statement figures are in millions unless stated otherwise.
Business context and performance
IBM reported continued growth in strategic offerings, particularly cloud, alongside declining consolidated revenue. Management described a shift toward cognitive, cloud and other strategic businesses while restructuring and investing in traditional services and systems operations.
- Second-quarter revenue was $19.289 billion, down 4.7% reported and 3.3% adjusted for currency. First-half revenue was $37.443 billion, down 3.8% reported and 2.8% adjusted for currency.
- Strategic imperatives revenue grew 11% over the trailing 12 months to $34.1 billion, representing 43% of IBM revenue. Second-quarter cloud revenue was $3.9 billion, up 15%; cloud as-a-Service revenue rose 30%.
- Second-quarter segment revenue declined across Cognitive Solutions (2.5%), Global Business Services (3.7%), Technology Services & Cloud Platforms (5.1%), Systems (10.4%) and Global Financing external revenue (2.2%). Systems weakness reflected product-cycle dynamics; the z Systems launch was expected in the third quarter.
Financial results and liquidity
| Metric | Q2 2017 | Q2 2016 | Six months 2017 | Six months 2016 |
|---|---|---|---|---|
| Revenue | $19.289B | $20.238B | $37.443B | $38.923B |
| Gross margin | 45.6% | 47.9% | 44.2% | 47.2% |
| Income from continuing operations | $2.332B | $2.505B | $4.085B | $4.521B |
| Diluted GAAP EPS | $2.48 | $2.61 | $4.32 | $4.69 |
| Operating diluted EPS (non-GAAP) | $2.97 | $2.95 | $5.35 | $5.30 |
- Second-quarter net income was $2.331 billion, down 6.9%; first-half net income was $4.082 billion, down 9.7%. First-half GAAP results included a $582 million tax benefit from a first-quarter intra-entity asset transfer; second-quarter results included $170 million of discrete tax benefits.
- Second-quarter GAAP pre-tax income was $2.443 billion, down 19.9%, with a 12.7% pre-tax margin. The GAAP effective tax rate was 4.5% for Q2 and negative 5.6% for the first half. Management’s non-GAAP operating measures exclude specified acquisition-related and retirement-related items.
- Operating cash flow for the first half was $7.421 billion, compared with $8.988 billion. Management-defined free cash flow was $3.644 billion, versus $4.538 billion. Q2 operating cash flow was approximately $3.5 billion and free cash flow approximately $2.6 billion.
- Cash and marketable securities totaled $12.295 billion at June 30. Working capital was $9.048 billion and the current ratio was 1.25.
- Total debt was $45.673 billion, up $3.504 billion from year-end 2016; approximately $29.045 billion supported Global Financing. Current and long-term debt on the balance sheet were $8.061 billion and $37.612 billion, respectively. Consolidated debt-to-capitalization was 71.1%; IBM’s “core” ratio excluding Global Financing was 52.1%.
- For the first half, IBM returned $5.449 billion through dividends and gross share repurchases. It repurchased 16.3 million shares and had $2.4 billion remaining under its authorization at June 30. The quarterly dividend was $1.50 per share.
Material changes versus the prior comparable period
- Revenue and GAAP earnings declined, while strategic offerings expanded. Operating diluted EPS rose 0.7% in Q2 and 0.9% for the first half, despite lower GAAP EPS.
- Gross margin fell 2.3 percentage points in Q2 and 3.0 points for the first half. Management attributed pressure to business mix, investments and growth in as-a-Service offerings; Systems also faced a shift away from high-margin z Systems during its product transition.
- First-half operating cash flow fell $1.567 billion, primarily because the prior-year period included a Japan tax refund. First-half investing cash outflow was much lower than in 2016, largely because acquisitions were lower; financing outflow increased with greater share repurchases and lower net debt funding.
- Retirement-related costs rose to $1.444 billion for the first half from $1.014 billion, mainly due to lower expected returns on plan assets and higher actuarial losses. Non-operating retirement costs were $759 million, up from $306 million.
- Long-term debt ratings were lowered in May 2017: Moody’s to A1 from Aa3 and S&P to A+ from AA-. IBM reported that it remained investment grade and compliant with significant debt covenants.
Outlook, risks and unusual items
- Management maintained 2017 guidance for at least $11.95 GAAP diluted EPS and at least $13.80 operating diluted EPS. It expected full-year free cash flow to be essentially flat with 2016 and cash-flow realization to exceed 90% of continuing-operations income.
- Management expected improved revenue-growth, gross-margin and expense trends in the second half. It cited the z14 mainframe launch and new services contracts as potential contributors, with the z14 and contracts expected to benefit fourth-quarter results more substantially. The forecast included an expected third-quarter seasonal revenue decline, partly mitigated by an estimated $200–$300 million from those factors.
- IBM expected 2017 pre-tax retirement plan costs of approximately $2.9 billion, including about $1.5 billion of non-operating costs, and total contributions to retirement plans of approximately $2.5 billion. About $500 million of non-U.S. contributions were expected to represent legally mandated minimums.
- Legal matters include an SEC investigation into revenue recognition for certain U.S., U.K. and Ireland transactions; IBM said it was cooperating. By contrast, the DOJ and SEC closed their investigations into specified foreign public-sector matters in June 2017 without enforcement action. IBM also reported potentially significant claims and proceedings, but generally could not estimate reasonably possible losses. A U.K. pension appeal, if unsuccessful, could require reversal of plan changes and an estimated one-time pre-tax charge of approximately $300 million, plus ongoing accruals.
- IBM cited approximately $1 billion of potential Brazilian non-income-tax assessments and litigation, while stating it believed it would prevail and that the amount was not a meaningful indicator of liability. It also reported $570 million of prepaid income taxes in India related largely to disputed assessments.
- Other risks identified include economic and client-spending conditions, execution of growth and productivity plans, cybersecurity and privacy, currency, customer credit, pension funding, litigation, tax matters, acquisitions and competition. IBM stated that estimates of potential losses for many legal matters were not clear or reasonably determinable.
- IBM adopted new accounting guidance for intra-entity asset transfers in 2017, recording the $582 million first-quarter tax benefit. The company expected the 2018 lease standard to materially affect its balance sheet; it expected the new revenue standard to have no material transition adjustment.
Most important facts for investors to verify
- Whether cloud and other strategic-imperative growth can offset ongoing declines in legacy services and systems revenue, and whether second-half improvement materializes.
- Whether gross margins and cash generation stabilize as IBM scales cloud and as-a-Service offerings; compare GAAP results with management’s non-GAAP measures and their exclusions.
- Debt growth, upcoming maturities, credit ratings and the distinction between consolidated leverage and the company’s core leverage measure.
- Progress and outcome of the SEC revenue-recognition investigation, the U.K. pension appeal, and tax disputes in Brazil and India.
- Whether 2017 EPS, free-cash-flow and pension-cost expectations remain achievable given the tax effects, pension assumptions and business seasonality.