Comments on IBM’s Q1, 2015 Earnings Report

By Joe Clabby, Clabby Analytics

I’m a technology analyst, not a financial analyst, so take this with a grain of salt…

Last week IBM announced its Q1 2015 earnings – and, despite a 12% revenue decline as compared with Q1 2014, the results were encouraging. A closer look at the company’s earnings shows very strong mainframe revenue (up 118% over Q1 2014); strong performance by IBM’s middleware organization; solid progress in cloud computing (IBM’s cloud business now contributes over $7 billion annually to the company’s earnings); and strong performance in business analytics (up 20%).

On the downside, a closer look at the sources of revenue shows that IBM’s overseas markets are struggling (revenue declined in Europe, the Middle East, and Africa by 19%; in Asia Pacific by 18% – and in the Americas by 3%). A strong U.S. dollar is partially to blame for this – as are other political situations – but it is pretty clear that IBM must fix its overseas performance in order to get back on track (overseas revenues account for two-thirds of IBM’s earnings).

Mainframe Performance

The huge growth in mainframe revenues was to be expected because IBM introduced a new mainframe model (the z13) in January. Traditionally, about a year before the introduction of a new mainframe, z System (mainframe) revenue starts to decline drastically as customers wait for a new model. When the new model is introduced, customers see a huge jump in processing capacity – for about the same price as the previous generation systems. So, waiting for the new generation yields a huge payback for customers who need more processing power. (Note: the new mainframe can now process 2.5 billion transactions per day). IBM has tried new pricing tactics and various packaging approaches in order to smooth out this mainframe peak-and-valley buying behavior, but has been unable to change it. So, expect strong mainframe growth over the next two years, followed by a leveling in year two and a drop in year three when mainframe buyers wait for a new model (mainframes are on a three year life cycle renewal schedule).

Middleware Performance

IBM’s middleware software performance was stellar, accounting for 84% of IBM’s software revenue. (IBM’s middleware products include WebSphere, Information Management, Tivoli, Workforce Solutions and Rational products). Middleware is the infrastructure “glue” that enables systems, programs and databases to communicate with one another – and also helps ensure that service levels (such as availability and security) are met. The curious thing about middleware is that “middleware begets middleware” – in other words, when enterprises commit to a particular middleware approach, they buy more and more of that middleware. As an example, look at the strong financial performance of VMware over time. VMware became the leading middleware choice for x86 virtualization – and has experienced continued positive revenue growth for a decade and a half since being acquired by EMC. I expect that IBM will see the same kind of result, continued solid middleware growth, as information technology buyers expand capacity and purchase more and more IBM middleware to link their systems and data together.

Cloud Performance

IBM reported that its cloud revenue was up more than 75 percent adjusting for currency and divested businesses; up more than 60 percent as reported. This represents the 12th month of cloud revenue growth – with the current run rate at $7.7 billion annually. IBM’s solid and continued growth in clouds shows me that the company now understands the cloud market – and has brought a combination of the right products and services to bear for continued cloud growth.

The way I see it, it took IBM several years to get its cloud computing strategy sorted – to build-out its cloud offerings. Historically, IBM was very slow to adjust to the evolving, heavily x86-based cloud computing marketplace. At first, IBM attempted to build its own x86 virtualization software, but instead decided to partner with other suppliers (such as VMware) to virtualize x86-based servers. Then IBM decided to focus on building private, heterogeneous mainframe/Power System/x86-based cloud environments – when the market clearly wanted more powerful x86-focused solutions and access to public clouds. As IBM dillied and dallied with its heterogeneous clouds, other vendors (Amazon, Google and Microsoft) introduced their highly successful public cloud implementations.

To build heterogeneous private clouds, IBM combined various Tivoli management software products into new “SmartCloud” offerings (SmartCloud has been replaced with products that have a prefix of “IBM Cloud”). These products work well together, as serve as the basis of several IBM cloud service offerings – but still, the market wanted a more strongly focused x86-based server cloud solution (one that could address public cloud needs as well as provide advanced cloud services like bare metal provisioning). In July, 2013, IBM acquired SoftLayer, a maker of x86-based cloud solutions and finally delivered the kind of private/public/hybrid x86 cloud environment that its customers needed.

The SoftLayer acquisition has been wildly successful for IBM. This market momentum continues with IBM working to build out its portfolio of OpenPower based servers running on the SoftLayer IaaS platform. These servers, now billable by the month, give customers an option to better manage data-intensive workloads on public and private clouds. In addition, IBM is looking to build out all new cloud services based on OpenStack. This will give users application portability on the cloud.

Cloud as a Managed Service

IBM also reported that, for cloud delivered as a service, the company is seeing an annual run rate of $3.8 billion compared to $2.3 billion in the first quarter of 2014. This is a very strong growth rate – and may be the tip of an iceberg when it comes to future IBM revenue growth. IBM’s Q1 2015 $3.8 billion run rate represents growth of over a billion and a half dollars when compared to Q1 2014 – and indicates that the company now understands how to sell cloud services. The beauty of cloud services is that they are replicable – IBM can invest in building one type of cloud and then sell its integrated solution to thousands of customers. IBM’s cloud services earnings suggest that the company’s cloud service message is catching on – and enterprises are now turning to IBM to run their clouds. With strong professional services; with a solid software portfolio; with a rich cloud ecosystem – and with unique platform offerings – IBM is very well positioned for strong growth in cloud services.

The last comment about “unique platform offerings” is worth closer scrutiny. It is my belief that IBM has a huge competitive advantage over other cloud makers in that IBM can cost effectively build cloud environments that use three different types of computers (mainframes, Power Systems and x86 servers). I contend that by using the right type of computer to process workloads that can exploit that computer, IBM can process more work for less money than x86-only cloud providers. In fact, it is my guestimate that IBM may be able to process some workloads for 30-40% less than its x86 cloud computing competitors. Accordingly, the ability to offer multi-platform back-end clouds creates a strong competitive advantage for IBM, and has huge upside in terms of profitability. Watch IBM’s cloud services revenue closely over the next several quarters. If that revenue continues to incline, it may become a key contributor to IBM’s return to profitability.

Business Analytics

In business analytics, IBM has the richest and deepest portfolio of data management, database, and analytics offerings of any vendor in the IT industry. IBM reported that its business analytics revenue was up more than 20 percent adjusting for currency and divested businesses – and up 12 percent as reported. Watch this segment closely – IBM’s position as the leader in business analytics combined with growing demand for Big Data and analytics solutions should provide IBM with strong revenue growth in this sector. And, if this growth rate continues, it will contribute greatly to IBM’s return to profitability.

Also Noteworthy

There was one other important buying pattern that I found in IBM’s earning report: IBM’s Power System group showed a 1% increase in revenue versus Q1, 2014. Power Systems revenue started to decline a few years ago as the market started to adopt the Linux operating system for some enterprise-class workloads. IBM had been too busy capturing Unix business from its competitors (Oracle Solaris and HP/UX) – and was not properly prepared to ride the Linux wave on Power Systems. Under new leadership, the Power Systems group built out low-end Linux-based Power Systems to compete with x86 Linux servers, while at the same time keeping its commitments to further AIX (IBM’s Unix) development. Today, IBM’s Linux on Power Systems can support big and little endian Linux applications (meaning it can run tens-of-thousands of Linux applications) – and the POWER eight core processor can process four times the amount of data that Intel’s two core x86 architecture can process. So IBM’s Power Systems group appears to be back on track (although I’d like to see one more quarter of positive growth to confirm this).

Summary Observations

As I looked at IBM’s Q1 2015 earnings report, I’m seeing strong growth in two of IBM’s four focus market segments (cloud and analytics are growing solidly – IBM’s growth in mobile and social is not as strong).

The cloud growth is a real feather in IBM’s cap – IBM was slow to get into the cloud marketplace, and tried to mold a bunch of its infrastructure products into cloud offerings – but eventually got it right when it acquired SoftLayer in July, 2013 (SoftLayer enabled IBM to compete head to head with leading cloud providers such as Amazon, Google and Microsoft in the x86 cloud marketplace). With $7.7 billion in annual revenue, IBM has clearly turned the corner and has become a leader in the cloud marketplace.

I’m particularly interested in IBM multi-platform clouds. If IBM is indeed building multi-platform clouds, then it has a strong competitive advantage over x86-only cloud service providers in that it can offer cloud computing services at a very significantly lower prices (which means it has a huge margin advantage over its competitors). I plan to research this more closely and will report what I find in a future PundIT article.

As for business analytics/data management/database growth, revenue growth has been solid over the past several years – and I expect it to continue to accelerate.

In the final analysis, IBM has had 12 straight quarters of revenue “challenges” – some due to the company’s technology decisions, but many were also the result of unfavorable worldwide economic conditions. The way I see it, the company’s transformation plan (which includes serving its traditional customers while adopting new approaches such as cloud computing service provisioning) is now starting to pay off. The company still has to remedy its overseas sales problems, but with strong growth in its traditional middleware business as well as in cloud and analytics, I think that we’re only a few quarters away from seeing IBM return to profitability.

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