International Business Machines (NYSE: IBM) is set to report its first-quarter results after the market closes on Tuesday, April 16. Currency headwinds, divestitures, and an aging mainframe product cycle will conspire to knock down revenue, and earnings will take a hit as well. But the company expects per-share earnings to grow this year, and its mega-acquisition of Red Hat will add fuel to the fire starting in 2020.
What happened last time
While IBM grew revenue in 2018, the company's fourth-quarter results were hurt by an expected drop in hardware sales. Revenue in the systems segment plunged 20% year over year adjusted for currency, the result of a 44% decline in mainframe sales and a 7% decline in storage sales.
A steep decline in mainframe sales is normal at this point in the product cycle. IBM started shipping its latest z14 mainframe in the third quarter of 2017, and it enjoyed five quarters of growth. It was the strongest mainframe cycle in many years, but that strong growth is now being lapped.
IBM's other segments performed better. Cognitive solutions revenue was up 2%, global business services revenue was up 6%, and technology services and cloud platforms revenue was flat. Margins also improved, with gross margin up 10 basis points and operating margin up 50 basis points year over year. While the systems segment saw gross margin decline, IBM's two services segments enjoyed margin expansion.
Along with its fourth-quarter results, IBM guided for adjusted earnings per share of at least $13.90 in 2019, up from $13.81 in 2018. Full-year free cash flow is expected to be about $12 billion, flat compared to 2018.
What analysts are expecting
While IBM expects earnings to grow this year, the first quarter will be a different story. Analysts expect a year-over-year decline in both revenue and earnings.
IBM expects to realize about 16% of its full-year adjusted EPS in the first quarter, which works out to $2.22. A combination of the mainframe product cycle and discrete tax items will push more of IBM's earnings out of the first quarter this year. On the revenue front, less mainframe revenue and a currency headwind will hurt IBM's results.
IBM will be changing its reporting segments starting in the first quarter. The new segments will be cloud and cognitive software, global business services, global technology services, systems, and global financing. IBM will also report results for its announced divestitures under an "other" category. The company sold off some stand-alone software businesses in recent months.
A lot of moving parts
The mainframe cycle and a significant currency headwind are going to make IBM's first-quarter revenue look pretty bad. The company expects a currency headwind of roughly 4 percentage points, and divestitures will also reduce the top line.
The good news is that IBM's cloud strategy, which is heavily focused on hybrid cloud, is looking like the correct strategy more and more with each passing quarter. Other cloud computing providers are starting to embrace hybrid cloud, an admission that an all-in public cloud solution won't work for many companies. IBM's hybrid cloud focus and its acquisition of Red Hat puts it in a great position to benefit from this trend.
While IBM's revenue and earnings are set to decline in the first quarter, the picture looks better when you zoom out and look at the full year. IBM expects to grow earnings per share despite the mainframe product cycle, and it expects to keep free cash flow right around $12 billion. In 2020 and beyond, the addition of Red Hat should boost the company's cloud growth.
Shares of IBM are up about 27% so far this year, partly due to decent fourth-quarter results and partly because the stock sold off toward the end of 2018. Based on the company's earnings guidance, the price-to-earnings ratio sits just above 10. IBM's results aren't going to blow anyone away this year, but such a huge discount for a company with key competitive advantages doesn't make much sense to me.
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Timothy Green owns shares of IBM. The Motley Fool is short shares of IBM. The Motley Fool has a disclosure policy.
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