It didn't take long for International Business Machines (NYSE: IBM) CEO Arvind Krishna to shake up the century-old tech giant. Just six months after Krishna took the helm, IBM announced that it would spin off its gigantic managed infrastructure services provider business into a new company. The move will allow IBM to concentrate its efforts on hybrid cloud computing, artificial intelligence, and other growth areas.
IBM will report its third-quarter results after the market closes today. The numbers won't be a surprise -- along with announcing the spinoff, IBM provided preliminary third-quarter results. The company expects to produce revenue of $17.6 billion and adjusted earnings per share of $2.58. That revenue estimate is slightly ahead of analyst expectations, while the EPS estimate was in line.
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Revenue and earnings will be down compared to the same period last year as the COVID-19 pandemic continues to negatively affect portions of IBM's business . In the second quarter, total revenue slumped 5.4% while adjusted EPS plunged 31%. IBM saw some clients delay projects, defer purchases, and reduce capital spending, with demand for perpetual software licenses and project-oriented services hit the hardest.
The good news is that the cloud business continued to grow at a strong double-digit rate despite the pandemic. Total cloud revenue was up 34% year over year adjusted for currency in the second quarter, bringing trailing-twelve-month cloud revenue to $23 billion. IBM's cloud revenue includes some hardware and services sales, so it isn't directly comparable to cloud computing infrastructure providers like Amazon Web Services.
Revenue from Red Hat, which IBM acquired last year for $34 billion, grew 18% on a normalized basis in the second quarter. Red Hat's software is now a key component of IBM's hybrid cloud strategy. Also performing well was the mainframe business, which saw sales soar 68% as clients continued to upgrade to the most recent z15 system.
Sales will be down by about 2.4% in the third quarter based on IBM's preliminary results. That's a smaller decline than the second quarter, but it indicates that the parts of IBM that felt pain from the pandemic last quarter are still under some pressure.
The spinoff makes sense
Shares of IBM have not participated in the rally that has propelled many large cap tech stocks to new heights this year. The stock is down around 6% in 2020, and it's off roughly 20% from its pre-pandemic high.
Based on the average analyst estimate for 2020 adjusted earnings, which will be depressed due to the pandemic, IBM stock trades at a price-to-earnings ratio of just 11. The managed infrastructure business, which makes up most of IBM's global technology services segment, is less profitable than the company as a whole, and much less profitable than the cloud and cognitive software segment.
In the second quarter, the global technology services segment managed a gross margin of just 34.2%. That compares to a companywide gross margin of 48%, and a cloud and cognitive software gross margin of 77.1%. The spinoff will boost IBM's gross margin while removing a business that's been dragging down the company's growth rate.
IBM will probably have more to say about the spinoff during its third-quarter conference call. Slow-growing legacy business have acted as anchors for the company for years as it's tried to transform itself into a cloud computing company. The spinoff will remove one of those anchors, which may make the stock more attractive to investors and lead to a higher earnings multiple.
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