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IBM Slides After Warning Software Sales Are Coming Under Pressure

Though its Q1 revenue was roughly in-line with expectations, IBM cautioned that software and services deal activity took a hit late in the quarter.
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Like many other U.S. multinationals, IBM  (IBM) - Get International Business Machines Corporation Report is opting not to provide any formal guidance as it contends with the COVID-19 pandemic.

However, Big Blue did signal through its earnings call that some of its businesses have been hit hard in recent weeks.

On Monday afternoon, IBM reported Q1 revenue of $17.57 billion (down 3% annually) and non-GAAP EPS of $1.84 (down 18%). Revenue, which both benefited from IBM’s $34 billion acquisition of open-source software giant Red Hat and was hurt by asset sales, was nearly in-line with a consensus analyst estimate of $17.59 billion. EPS slightly beat a $1.81 consensus.

With COVID-19 lockdowns having begun impacting IBM’s operations in March, the company is withdrawing its full-year guidance, while adding it will “reassess this position” at the end of Q2. IBM had guided in January for 2020 EPS of “at least” $13.35 (up from 2019 EPS of $12.81), and for 2020 free cash flow of roughly $12.5 billion (up 5%).

IBM’s stock fell 3.1% in after-hours trading to $116.70. Shares were down slightly over 1% going into IBM’s call, but added to their losses after CEO Arvind Krishna and CFO James Kavanaugh provided some color on how business has trended since COVID-19 began having a major impact in March.

A Changing Software Deal Environment

“In the last few weeks, we faced a shift in client priorities towards the preservation of capital,” said Krishna, who officially replaced Ginny Rometty as CEO two weeks ago. He added that this shift “disproportionately” impacted IBM’s software operations, which account for a large percentage of its gross profit.

Kavanaugh said that IBM’s software transactions “stalled nearly overnight,” and that many “transformational” applications software deals were paused, particularly among retail industry clients. He also mentioned that IBM’s transaction processing software business, which saw revenue drop 16% annually in Q1 following 3% growth in Q4, was hurt as clients opted to defer license purchases late in Q1.

And in comments that could be particularly relevant for some of IBM’s software peers, Kavanaugh said that IBM’s Global Business Services (GBS) began seeing “a pullback” in deal activity in the second half of March, including for projects involving software from the likes of SAP  (SAP) - Get SAP SE Report, Oracle  (ORCL) - Get Oracle Corporation Report and Workday  (WDAY) - Get Workday, Inc. Class A Report.

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At the same time, Kavanaugh noted that IBM’s top line is protected some in the near-term by the fact that about 60% of its revenue now comes from recurring sources, such as software subscriptions and services contracts. He added that the lion’s share of IBM's services revenue in a given quarter comes from its backlog, which stood at $107.8 billion (down 3% annually) at the end of Q1.

IBM’s Q1 Performance

With the help of recurring revenue streams and its performance during the first two months of Q1, IBM’s Cloud & Cognitive Software unit, which covers much of its software operations, saw revenue rise 5% in Q1 to $5.2 billion. 

Red Hat accounted for $716 million of this revenue following accounting adjustments. On a normalized basis, the open-source software giant’s revenue rose 18% to $1.07 billion, a slowdown from Q4’s 24% growth. However, with the help of IBM's sales resources, the number of large deals closed by Red Hat rose about 50%.

GBS’ revenue was roughly flat at $4.1 billion, while the Global Technology Solutions (GTS) segment’s revenue fell 6% to $6.5 billion. Kavanaugh said that a “significant portion” of the nearly $900 million worth of restructuring charges taken by IBM in Q1 involved GTS, which recorded revenue declines throughout 2019.

IBM’s Systems segment, which covers hardware and OS sales, saw revenue grow just 3% to $1.4 billion, after having grown 16% in Q4. IBM Z mainframe revenue (benefiting from an upgrade cycle related to last September’s launch of the z15 mainframe) rose 59% and storage revenue rose 18%, but Power server revenue fell 33%.

Kavanaugh admitted that the current deal environment is expected to impact the Systems unit’s close rates. But he insisted there would be “less of an impact” for the mainframe and storage businesses, given the mission-critical nature of many hardware purchases and customer needs for additional capacity.

One similarity between Q1 and many prior IBM quarters: A favorable tax rate gave a boost to earnings. Though the aforementioned restructuring charges weighed on IBM’s GAAP and non-GAAP earnings, this was more than offset by “a non-cash discrete tax benefit, associated with the intercompany transfer of intellectual property.”

As a result, the tax line in IBM’s income statement actually served to boost its non-GAAP earnings by $961 million to $1.65 billion.