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Morningstar | IBM’s Strategic Imperatives Give Way to Cloud Messaging; Scrappy Quarter; Shares Near FVE

As we’ve become accustomed to, IBM’s first quarter was a scrappy affair with the firm’s growth impacted by mixed results across its broad portfolio. On the one hand (in constant currency), the cloud & cognitive software and global business services, or GBS, businesses performed satisfactorily, while the global technology services, or GTS, and systems businesses struggled. Reading between the lines, we see some long-term bright spots for the firm especially in the services businesses such as GBS and GTS, where digital transformation services and portfolio optimization remain key levers. Additionally, the significant decline in the systems business is more cyclical in nature and isn’t indicative of a notable deterioration in this business. However, the ongoing struggle to reposition IBM’s complex and slow-moving business remains a concern against a backdrop of fierce and agile competition.

Given the competitive environment, we remain confident on our narrow economic moat rating and negative moat trend rating. With management reiterating their full-year outlook and our view unchanged, we retain our $158 fair value estimate for IBM. Even with shares modestly below our fair value, we’d suggest a slightly larger margin of safety as shares remain in 3-star territory.

For the quarter, reported revenue fell 4.7% year over year to $18.2 billion (dipped 0.9% in constant currency). The company’s long-standing “strategic imperatives” nomenclature ended in the quarter and the firm now points to “Cloud” and “As-a-service” growth to signify the success of their higher value propositions. To that end, on a year-over-year constant currency basis, cloud revenue grew 12% to $4.5 billion, while the as-a-service business increased 15% to $11.7 billion (on a trailing 12-month basis).

Cloud offerings associated with consulting and application management in the GBS business were a standout, growing 25% year over year, and supports our confidence in IBM’s leading IT services business. Systems revenue was the notable laggard, which was impacted by the mainframe sales cycle after the z14 was released mid way through calendar 2017. Still, we do expect a better midterm performance from the systems business as IBM is likely to releases a new mainframe platform over the next couple of years.

On the margin front, IBM’s non-GAAP gross margin expanded 90 basis points to 44.7% and its non-GAAP pretax income margin rose 320 basis points to 12.3%. The margin uplift was supported by healthy margin growth in the GBS and GTS businesses where pretax margins rose 450 and 300 basis points, respectively. Higher value services combined with productivity and global scaling efforts aided this margin expansion and we believe there is more room for improvement. As a result, from an overall firm perspective, we see a midterm opportunity to improve the profitability of IBM.