IBM Earnings Beat the Street, But Services Fell Short

IBM (IBM) beat third-quarter earnings estimates today and topped revenue estimates by a smidgen. But investors' concerns about Big Blue's closely watched services business still linger as IBM fell short in that area, and the stock retreated nearly 4% in aftermarket trading, falling more than $5 to around $137.70.

During the quarter, IBM generated $24.3 billion in revenues, up from nearly $23.6 billion a year ago. Wall Street was expecting revenues of $24.1 billion, according to Thomson Reuters. IBM reported earnings of $2.82 per share for the third quarter, compared with $2.40 a share a year ago. Analysts were expecting earnings of $2.75, according to Thomson Reuters.

Big Blue increased its outlook for the year to $11.40 per share, which is in line with the increase Sanford Bernstein & Co. analyst Toni Sacconaghi had predicted. But it was less than his more optimistic view of $11.70 a share if IBM "fully delivers on its cost savings." He noted that in six of the last eight quarters, IBM has raised its existing fiscal-year earnings per share forecast.

Services Fall Short

Delving deeper into IBM's services business and investors concerns, Big Blue's signed services contracts fell short of expectations for the third consecutive quarter, raising investors concerns about future revenue growth for the technology titan.

IBM's Global Technology Services grew 1% to $9.5 billion, while its Global Business Services grew 5% to $4.6 billion. Overall, IBM's Global Services business grew 2%.

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As part of its backlog of business, signed services contracts were down 7% to $11 billion in the quarter. Sacconaghi was expecting IBM to pull in $12.8 billion in the quarter. While transactional signings grew 4% to $5.4 billion, the overall signed services contracts were pulled down by a surprise drop in outsourcing. According to IBM, signed outsourcing contracts fell 15% to $5.7 billion in the quarter.

In addressing the drop in signed outsourcing contracts, Mark Loughridge, IBM chief financial officer, tried to reassure Wall Street during a conference call with analysts and investors.

"The real issue is around outsourcing, signings were down about 14%. But with the big deal on Oct. 8, this would have been up 14%. So now we're talking about eight days. Had this deal signed on [Sept.] 30, we frankly wouldn't be having this conversation," Loughridge said. "The performance we get in the fourth quarter isn't going to be any different whether we had signed it on Sept. 30 or Oct. 8."

He added that at the beginning of the quarter, revenues are more heavily driven by the backlog of orders, and that signed contracts are just one aspect of that order backlog. Other aspects include contract extensions and new contracts.

"It's really backlog that establishes where you're going to be in that next quarter, more than [contract] signings. I look at signings as more of an impact of that broader perspective, not the base driver," Loughridge said.

A Sweet Spot in Software

It's understandable that investors would be jumpy when it comes to the performance of IBM's services business, given that it is the growth driver and accounts for nearly 58% of the company's revenues.

IBM's software business, which brought in nearly $5.2 billion in revenues, posted a 1% increase over a year ago. While much of Big Blue's business in the software area increased by single digits, its business analytics in its software and services segment rose a respectable 14%.

The company's hardware business, once its bread and butter, rose 10% to $4.3 billion in the quarter, over last year. Helping to drive those figures up was IBM's System x, which posted a 30% increase, sales of its Microelectronics to original equipment manufacturers that climbed 28%, and its System z mainframe servers that rose 15% from year ago figures. But a strong performance of those products were tempered by a 13% decline in its Power Systems sales and other areas of its business to a lesser degree.

And lastly, IBM's global financing arm, a.k.a customer bank, saw revenues slip 1% to $529 million in the quarter. That's basically a blip on the radar screen for IBM.