IBM 2018 Q3 Form 10-Q Summary
Business context and reporting period
International Business Machines Corporation reported unaudited results for the quarter and nine months ended September 30, 2018. Comparisons are to the same 2017 periods unless stated otherwise. IBM adopted the new revenue-recognition standard on January 1, 2018; management said its impact on current-period results was not material. Dollar amounts are in U.S. dollars.
Financial results and key metrics
| Metric | Three months ended September 30 | Nine months ended September 30 |
|---|---|---|
| Revenue | $18.756 billion, down 2.1% reported and approximately flat adjusted for currency | $57.830 billion, up 2.2% reported and 0.4% adjusted for currency |
| Gross profit / margin | $8.803 billion / 46.9%, flat margin | $26.249 billion / 45.4%, down 0.4 percentage points |
| Continuing-operations income | $2.692 billion, down 1.3%; diluted EPS $2.94, up 0.7% | $6.770 billion, down 0.6%; diluted EPS $7.36, up 1.7% |
| Net income | $2.694 billion, down 1.2% | $6.777 billion, down 0.5% |
| Operating income and diluted EPS (non-GAAP) | $3.134 billion and $3.42; EPS up 4.9% | $8.241 billion and $8.96; EPS up 4.9% |
| Cash from operating activities | $4.2 billion, per management discussion | $11.128 billion, versus $10.991 billion |
| Free cash flow (non-GAAP) | $2.2 billion, per management discussion | $5.415 billion, versus $6.176 billion |
Q3 operating (non-GAAP) gross margin was 47.4%, approximately flat year over year; nine-month operating gross margin was 45.9%, down 0.5 percentage points. The reported nine-month effective tax rate was 2.0%, reflecting tax audit resolutions and discrete tax benefits. Weighted-average diluted shares declined 2.1% year to date, supporting EPS growth despite slightly lower GAAP income.
At September 30, cash, restricted cash and marketable securities totaled $14.662 billion. Total debt was $46.921 billion, up $97 million from year-end 2017; approximately $30.367 billion supported Global Financing. Current liabilities were $36.822 billion versus current assets of $48.257 billion (current ratio 1.31). Short-term debt was $10.932 billion and long-term debt $35.989 billion. IBM reported compliance with significant debt covenants and no borrowings under its committed credit facilities.
For the first nine months, operating cash flow was largely stable, while free cash flow declined $761 million, which management attributed mainly to higher capital spending and cash taxes. Net capital expenditures were $2.839 billion. Dividends paid were $4.250 billion and common-stock repurchases were $2.393 billion.
Material changes and business trends
- Q3 revenue weakness was concentrated in Cognitive Solutions, down 5.7%, and Global Financing external revenue, down 9.0%. Global Business Services grew 0.9%; Systems grew 0.9%; Technology Services & Cloud Platforms fell 1.9% reported but was approximately flat adjusted for currency.
- For the first nine months, Systems grew 11.3% reported, reflecting IBM Z and Power Systems demand. Cognitive Solutions was flat, Global Business Services grew 2.4%, and Technology Services & Cloud Platforms grew 1.8% reported.
- Management emphasized strategic offerings: Q3 cloud revenue was $4.6 billion, up 11% reported; security grew 33%. Nine-month cloud revenue was $13.5 billion, up 17%, and security grew 57%. Q3 as-a-Service annual exit run rate was $11.4 billion, versus $9.4 billion a year earlier.
- Services backlog was $112.8 billion, down 5.4% reported and 2.9% adjusted for currency. Services signings fell 22.7% in Q3 and 1.1% year to date. Remaining performance obligations were $119 billion; approximately 60% was expected to be recognized over the next two years, subject to stated exclusions and estimates.
- Retirement-related plan cost rose 9.7% to $2.300 billion year to date, including higher non-operating costs. Workforce-rebalancing charges in SG&A were $590 million year to date, versus $188 million in 2017.
Guidance, outlook, risks and unusual items
- IBM reaffirmed 2018 guidance of at least $11.60 GAAP diluted EPS from continuing operations, at least $13.80 operating diluted EPS, and approximately $12 billion free cash flow. Management expected full-year revenue growth and fourth-quarter GAAP and operating pre-tax margin expansion; full-year currency was expected to benefit revenue growth by 0–1 percentage point, with a roughly 2-point Q4 headwind.
- Management expected a 2018 operating tax rate of 16%, plus or minus 2 percentage points, excluding discrete items. The final U.S. tax-reform accounting charge remained provisional and was expected to be finalized in Q4 2018.
- On October 28, 2018, IBM announced an agreement to acquire Red Hat for $190 per share in cash, valuing the transaction at approximately $34 billion, subject to customary approvals. IBM obtained a $20 billion bridge-loan commitment, said it intended to fund the purchase with cash and debt, and expected rating downgrades. S&P lowered IBM and IBM Credit long-term ratings one notch to A; IBM also said it intended to suspend share repurchases in 2020 and 2021. This is a post-quarter event.
- IBM’s significant disclosed exposures include litigation, tax examinations, environmental proceedings, pension funding, customer credit and currency risks. Brazilian non-income tax disputes had a stated potential amount of approximately $900 million; IBM said it believed it would prevail and that the amount was not a meaningful indicator of liability. The Indiana contract dispute had a $78 million award to the state affirmed on appeal, with both parties appealing further. IBM said it could not estimate reasonably possible losses for certain other matters. Its SEC revenue-recognition investigation closed in May 2018 without enforcement action.
- Other items: IBM reported no material goodwill impairments. It expected the 2019 lease-accounting standard to materially affect the balance sheet; operating lease commitments were $6.6 billion at December 31, 2017. The company cited economic and client-spending conditions, execution of growth and productivity plans, innovation, cybersecurity and data privacy, intellectual property, acquisitions, legal proceedings, pensions, taxes, currency, and financing-receivable credit quality among forward-looking risks.
Important facts for investors to verify
- Reconcile GAAP and non-GAAP earnings, including the exclusions for acquisition-related costs, non-operating retirement items and tax-reform impacts.
- Track revenue and margins in cloud and other strategic offerings against declines in legacy software, support and services; review backlog and signings for evidence of future demand.
- Assess cash conversion, capital-expenditure growth, dividend commitments, debt maturities and the allocation of debt to Global Financing.
- Monitor the Red Hat transaction’s approvals, financing, rating effects, closing costs and the planned share-repurchase suspension.
- Check the final U.S. tax-reform charge, outcomes of tax audits and litigation, pension assumptions and the quantified or unquantified contingencies disclosed in the filing.