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Oracle Corporation (ORCL), International Business Machines Corp. (IBM): Finding Areas of Strength in a Weak Tech Market

One of the great IT bellwethers, International Business Machines Corp. (NYSE:IBM), issued mixed results in mid-July. It’s hard to be too critical of a company that has just raised estimates despite increased currency headwinds, but a deeper analysis of the company’s results reveals some underlying weakness. It’s been a difficult year for technology, and IBM’s earnings did little to raise investors’ spirits.

IBM reports

The two key positives in the report came from the growth in services backlog (7% at constant currency) and the strength in higher-margin software sales. In order to demonstrate their impact, here is a chart of International Business Machines Corp. (NYSE:IBM)’s segmental growth. All data is sourced from company accounts.

Growth in the second quarter was better than in the first. Moreover, International Business Machines Corp. (NYSE:IBM)’s reported revenue decline of 3% was made to look worse due to currency headwinds of 2%. Based on its backlog, IBM forecasted that third-quarter revenues in its global business services segment would be up by mid-single digits, with global technology services increasing in the low single digits.

The software segment’s bounce back toward growth looked robust, and management pointed out that its 4% reported revenue increase (5% in constant currency) was the strongest recorded since the first quarter of 2012. International Business Machines Corp. (NYSE:IBM) spoke of a very good software pipeline, and referenced good growth in some important niches like branded middleware (up 10%) and business analytics (11%).

To put this data into context, here is a graph (sourced from company accounts) of the segmental revenue share and normalized pre-tax income share.

Clearly, software is its highest-margin business, and its relative strength in the quarter helped International Business Machines Corp. (NYSE:IBM) raise gross margins to 49.7% from 48.3% last year.

With the services backlog up 7%, and higher-margin software returning to growth in Q2, why aren’t these results as hot as they look?

Four reasons it’s still tough out there

First, although software returned to growth in Q2, this was partly due to the weakness in the previous quarter. In fact, growth in the first half was only 1.9%, which compares unfavorably to 2.6% and 11.5% in the two previous years. Indeed, a glance at the first chart above demonstrates that IBM is starting to lap some weaker quarters in 2012.

Second, going back to what IBM said last time around, $400 million in software and mainframe deals were rolling in to Q2 anyway. When asked about these deals on the current conference call, management stated that less than half closed in Q2, and, more importantly, rollovers in higher-margin software are actually larger going into the Q3. This all sounds good, but there is no guarantee that rollover deals will get closed. In addition, its main rival Oracle Corporation (NYSE:ORCL) also reported some weakness in the quarter.

The third reason is that IBM’s forecast for services revenue growth in Q3 needs to be put into context. Penciling in growth of 5% and 2% for business services and technology services, respectively, would give a total services revenue figure for Q3 of around $14.9 billion. This compares favorably with the $14.4 billion recorded last year, but rather less so against the $15.3 billion in 2011.

Finally, the macro commentary wasn’t great. America’s revenues disappointingly declined 3%. However, the real surprise was within its growth markets. Revenues in Brazil, India, Russia, and China, were flat (up 1% in constant currency). In common with Oracle Corporation (NYSE:ORCL), IBM cited specific weakness in Russia and China, and it expressed a cautious outlook for its growth markets for the second half.

Key takeaways for the industry

While the tech market remains weak in 2013, there are pockets of strength. IBM stated that its cloud revenues were up 70%; Oracle also reported cloud-based strength. This shows a clear shift in corporate IT spending towards the cloud and away from legacy on-license/on-premise software.

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