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Morningstar | IBM Updated Forecasts and Estimates from 05 Apr 2019

Our expectations leading into IBM’s fourth quarter were anything but stellar, but the company managed to surprise us with slightly better-than-expected revenue growth. The fourth quarter result wrapped a topsy-turvy year in which the firm was able to resurrect top-line growth only to lose momentum in the back half of the year. Still, a couple of bright spots were apparent in the fourth quarter with global business services, or GBS, outperforming sales expectations and systems managing to decline slower than we had forecast. We think the performance from GBS was notable and supports our opinion that IBM, as well as Accenture, remain the premier global IT services firms. We believe IBM’s consulting and digital transformation skills are key assets for the firm and we continue to see midterm growth tailwinds for this business (albeit low-single-digit growth) after prior years of restructuring and repositioning. To that end, it was significant to see IBM’s consulting top line up 10% year over year within GBS, which indicates the firm’s digital services prowess. The firm provided an in line outlook for fiscal 2019, and while it was a solid end to the fiscal year, our fair value estimate, which was revised in October 2018, remains unchanged at $158 per share for this narrow economic moat name. Even so, with shares up about 7% in afterhours trade but remaining in 4-star territory, we believe there is still some value in this global IT behemoth for risk-seeking investors.

For the quarter, IBM’s reported revenue fell 3% year over year to $21.8 billion (dipped 1% in constant currency). In constant currency and on a year-over-year basis, revenue from cognitive solutions increased 2%, GBS rose 6%, technology services & cloud platforms was flat, and systems fell 20%.

Analytics and artificial intelligence software helped boost cognitive solutions, and as we look at the next year and beyond, we think IBM’s recent software product sales to HCL will help to lessen IBM’s legacy exposure and subsequent growth profile in this business.
GBS saw broad-based revenue growth with application management, global process services, and consulting all posting decent growth. We believe the firm can continue its consulting and digital transformation services success in this business and the shift to higher value services has helped to buoy the segment’s gross margin profile.

Technology services & cloud platforms remains mixed and we think this will be the case for at least the near term with IBM looking to exit lower value infrastructure work. Additionally, support services linked to this segment are likely to face some cyclical pressure given some hardware product cycle issues. While the firm touts the IBM Cloud and new customer acquisition, we retain our also-ran assessment of its positioning relative to other cloud infrastructure providers and don’t see anything in the foreseeable future that would make us change that opinion.

Finally, within systems, revenue was down significantly but this was to be expected due to the highly cyclical nature of this business and the fact that the z14 mainframe is now at the tail end of its cycle. Nevertheless, the adoption and success of the z14 platform remains is a positive sign for the oftentimes neglected technology. With the success of the z14, we believe IBM will continue to redesign and support the mainframe platform for some time.

On the margin front, IBM’s non-GAAP gross margin expanded 10 basis points to 49.5% and its non-GAAP pretax income margin grew 50 basis points to 23.1% year over year. The better margin performance was fueled by higher value services across IBM’s portfolio, particularly in GBS. This margin expansion was dampened, however, by an expected decline in systems margins as the business goes through its cyclical lull. We expect IBM to be laser focused on operational efficiencies over our explicit financial forecast and assume modest year-over-year pretax margin expansion.