IBM 2017 Third-Quarter 10-Q Summary
Reporting period: Quarter ended September 30, 2017; comparisons are with the 2016 comparable period unless noted. IBM reports Cognitive Solutions, Global Business Services, Technology Services & Cloud Platforms, Systems and Global Financing. Management’s strategic imperatives include cloud, analytics, mobile, social and security. Financial statements are unaudited.
Financial results
| Metric | Q3 2017 | Nine months 2017 |
|---|---|---|
| Revenue | $19.153 billion, down 0.4% reported (1.0% adjusted for currency) | $56.597 billion, down 2.7% reported (2.2% adjusted for currency) |
| Gross margin | 45.9%, down 0.9 percentage points | 44.8%, down 2.3 points |
| Income from continuing operations | $2.726 billion, down 4.5% | $6.811 billion, down 7.7% |
| Diluted GAAP EPS | $2.92, down 2.0% | $7.24, down 5.6% |
| Operating income / diluted EPS (non-GAAP) | $3.079 billion / $3.30; EPS up 0.3% | $8.125 billion / $8.64; EPS up 0.6% |
| Operating cash flow | $3.6 billion | $10.991 billion, down $2.114 billion |
| Free cash flow (company-defined) | $2.5 billion | $6.176 billion, down $0.793 billion |
Q3 GAAP pre-tax income was $3.065 billion, down 6.1%; continuing-operations income margin was 14.2%, down 0.6 points. Q3 operating (non-GAAP) gross margin was 47.6%, down 0.4 points. Management attributed margin pressure principally to investment, business mix and higher retirement-related costs, partly offset by productivity. Non-GAAP measures exclude specified acquisition-related and non-operating retirement items; they are not GAAP results.
For the first nine months, reported net income was $6.807 billion versus $7.371 billion. The effective tax rate was 1.7%, compared with a benefit-driven negative rate of 0.4% in 2016. The 2017 rate reflected discrete tax items, including a $582 million first-quarter benefit from intra-entity asset-transfer accounting; the 2016 comparison included a Japan tax refund and interest.
Business trends and changes
- Q3 strategic-imperatives revenue was $8.8 billion, up 11% reported; total cloud revenue was $4.1 billion, up 20%, and security revenue rose 51% reported. Nine-month strategic-imperatives revenue grew 9%; cloud revenue of $11.6 billion grew 22%.
- Q3 Cognitive Solutions revenue grew 3.9% and Systems grew 10.4%, including 63.8% growth in z Systems following the z14 launch. Global Business Services revenue fell 2.3%; Technology Services & Cloud Platforms fell 3.3%; Global Financing pre-tax income fell 31.4%.
- IBM reported nine-month revenue declines across the overall business despite growth in strategic imperatives. Q3 revenue performance improved sequentially year over year, but management noted continuing declines in traditional services and infrastructure areas and pricing pressure in parts of services.
- Q3 operating income and diluted operating EPS were below and slightly above their respective prior-year levels. The gap between GAAP and operating results included acquisition-related and retirement-related adjustments.
Financial position, cash and capital
- At September 30, cash and cash equivalents were $10.915 billion; cash plus marketable securities was $11.515 billion. Working capital was $13.045 billion and the current ratio was 1.41, versus 1.21 at year-end 2016.
- Total debt was approximately $45.625 billion, up $3.457 billion from December 31, 2016; about $29.390 billion supported Global Financing. Consolidated debt-to-capitalization was 69.8%; IBM’s core measure excluding Global Financing was 49.6%. IBM said it was in compliance with significant debt covenants.
- Nine-month cash uses included $3.674 billion of share repurchases and $4.119 billion of dividends. The quarterly dividend was $1.50 per share. The board later authorized an additional $3.0 billion for repurchases; $1.5 billion remained under the then-current authorization at September 30.
- Operating cash flow declined year over year, mainly reflecting the prior-year Japan tax refund and lower cash from financing receivables; improved working capital partly offset the decline. Investing cash use was lower largely because 2016 included substantially greater acquisition spending.
Outlook, unusual items and risks
- IBM maintained its 2017 outlook: GAAP continuing-operations EPS of at least $11.95 and operating EPS of at least $13.80. It expected full-year free cash flow to be relatively flat versus 2016 and cash-flow realization to remain consistent with its longer-term model.
- For Q4, management expected sequential revenue performance stronger than the typical Q3-to-Q4 increase, potentially by $300–$400 million, depending on currency and partly reflecting the mainframe cycle. It expected the usual seasonal gross-margin improvement of approximately 2.5–3.5 points. These are management expectations, not guarantees.
- Management expected 2017 operating tax rate of approximately 15%, plus or minus 3 points, excluding discrete items; it cautioned that tax reform, business mix and uncertain discrete items could affect the rate. It forecast approximately $2.9 billion of retirement-plan costs for 2017, including elevated non-operating costs.
- Unusual items included the $582 million tax benefit from the intra-entity transfer and a $91 million gain following a final UK pension litigation ruling. Retirement-related plan cost for the first nine months rose 39.8% to $2.097 billion, principally reflecting lower expected asset returns and higher actuarial losses.
- Legal and tax exposures include an Indiana contract dispute in which IBM appealed a net $78 million award to the state, and Brazilian non-income-tax disputes with approximately $1.1 billion in potential assessments; IBM said it expects to prevail and considers the amount not a meaningful measure of liability. IBM was cooperating with an SEC investigation into revenue recognition for certain transactions. The filing says loss estimates for many proceedings cannot be provided; recorded legal liabilities were not material.
- Other risks identified include customer spending and credit conditions, competition and execution of growth initiatives, cybersecurity and data privacy, currency movements, pension funding, tax examinations, litigation, and acquisition and integration risks. Moody’s and S&P had downgraded IBM’s senior debt ratings in May 2017; IBM reported investment-grade ratings and no rating-trigger default provisions.
Important facts for investors to verify
- Whether strategic-imperatives growth, particularly cloud and security, can offset declines in traditional services, infrastructure and other businesses.
- Progress against full-year EPS and free-cash-flow outlook, including the effects of currency, taxes and the Q4 mainframe cycle.
- Debt growth, financing-business leverage, refinancing needs and the sustainability of dividends and share repurchases.
- Changes in pension costs and funding requirements, and the extent to which non-GAAP adjustments affect comparisons with GAAP performance.
- Developments in the SEC revenue-recognition investigation, the Indiana appeal, Brazilian tax matters and other contingencies.