Shares of International Business Machines Corp. (IBM) plunged 4.30% ($8.90) in after hours trading on the heels of dismal first-quarter earnings of $3.00 per share, which missed the Zacks Consensus Estimate by 6 cents per share (2.0%).

Revenues

IBM’s first-quarter revenues of $23.41 billion missed the Zacks Consensus Estimate of $24.59 billion. Revenues declined 5.1% from the year-ago quarter and 20.1% on a sequential basis. Unfavorable foreign currency movement, particularly in yen, had a negative impact of 2.0% on first-quarter revenues.

None of the major segments achieved growth in the quarter. Software declined a modest 0.5% year over year but a huge 29.6% quarter over quarter to $5.57 billion (up 1% on a constant currency basis).

IBM achieved growth in some of the key areas that include smarter commerce, social business, security and storage management. However, IBM’s inability to close certain software transaction (worth approximately $400.0 million) fully offset this strong growth in the reported quarter.

Revenues from IBM’s middleware products [WebSphere, Information Management, Tivoli, social workforce solutions (prior Lotus) and Rational products] increased 1.0% year over year (up 2.0% on a constant currency basis) to $3.5 billion. Operating system revenues declined 2.0% on a year-over-year basis to $578.0 million.

Services revenues decreased 4.0% year over year and 6.1% sequentially to $14.08 billion. Global technology services revenues fell 4.3% from the year-ago quarter and 6.6% from the fourth quarter of 2012 to $9.61 billion. Global business services revenues were $4.48 billion, down 3.3% from the year-ago quarter and 5.0% on a sequential basis.

Backlog at the end of the first quarter increased 1.0% year over year to $141.0 billion (up 5% on a constant currency basis). IBM won 22 service agreements worth more than $100.0 million in the reported quarter.

Total outsourcing revenue decreased 5.0% year over year, while transactional revenues declined 3.0% year over year in the quarter. GTS outsourcing declined 6% from the year-ago quarter, while GBS outsourcing decreased a modest 1.0% year over year in the reported quarter.

Total signings amounted to $16.9 billion during the quarter, up 44.0% on a year-over-year basis. Outsourcing signings surged 97% year over year to $10.7 billion, while transactional decreased 2.0% from the year-ago quarter to $6.2 billion. Outsourcing backlog remained flat on a year-over-year basis to $91.0 billion at the end of the last quarter.

Hardware/System & Technology revenues (including effect retail store solutions divestiture) plunged 17.2% year over year and 46.1% quarter over quarter to $3.11 billion. Revenue growth was negatively impacted by product transitions and lack of execution.

Systems revenues decreased 13.0% from the year-ago quarter. System z revenues increased 7.0% year over year, which was fully offset by weak performances from Power Systems, System X and Storage, which were down 32.0%, 9.0% and 11.0%, respectively. Revenues from Microelectronics OEM decreased 16.0% year over year in the reported quarter.

Global Financing revenues increased 1.8% year over year but decreased 6.7% sequentially to $499.0 million in the reported quarter.

Region wise, revenues declined 7.0% year over year (down 1.0% on a constant currency basis) to $5.7 billion in Asia-Pacific. Revenues from Americas declined 4.0% year over year (down 3.0% on a constant currency basis) to $10.0 billion. Revenues from Europe/Middle East/Africa declined 4.0% (down 4.0% on a constant currency basis) from the year-ago quarter to $7.3 billion.

Revenues from IBM’s growth markets decreased 1.0% from the year-ago quarter. IBM revenues from BRIC (Brazil, Russia, India & China) countries declined 1.0% year over year (up 3% on a constant currency) in the reported quarter. Revenues from major markets declined 6.0% year over year in the reported quarter.

Margins

Gross margin expanded 100 basis points (“bps”) from the year-ago quarter. The improvement in gross margin was primarily driven by favorable revenue mix and productivity improvements. However, on a sequential basis gross margin contracted 560 bps due to lower revenue base.

Total operating expense & other income decreased 4.4% from the year-ago quarter and 5.0% sequentially to $6.85 billion. The decline was primarily due to lower selling, general & administrative expense (down 6.7% year over year and 7.2% sequentially). This was partially offset by a higher research & development expense (up 1.4% year over year and 2.6% sequentially).

Higher gross margin base and lower-than-expected increase in operating expenses drove pre-tax income as a percentage of sales, which jumped 70 bps on a year-over-year basis in the quarter.

In the reported quarter, net income was $3.38 billion or 14.4% of sales compared with $3.27 billion or 13.2% in the year-ago quarter and $6.13 billion or 20.9% in the previous quarter.

Earnings jumped 7.9% from the year-ago quarter driven by margin expansion (23 cents) and aggressive share repurchase (13 cents), which fully offset weak revenue growth (negative impact of 14 cents). On a sequential basis, earnings plunged 44.3% primarily due to lower revenues.

Balance Sheet & Cash Flow Details

IBM ended the quarter with $11.99 billion in total cash and marketable securities, compared with $11.13 billion in the previous quarter. At the end of the first quarter, total debt was $33.40 billion compared with $33.27 billion in the prior quarter.

IBM reported cash flow from operations (excluding Global Financing receivables) of $2.43 billion versus $2.87 billion in the year-ago quarter. In the reported quarter, IBM generated free cash flow of $1.70 billion, significantly down from $1.87 billion in the year-ago quarter.

IBM paid dividends worth $950.0 million and bought back 12.3 million shares in the quarter for $3.5 billion. At the end of Mar 31, 2013, IBM had $6.2 billion remaining under its share buyback program.

Positive Outlook

IBM forecasts fiscal 2013 operating earnings of at least $16.70 per share, an estimated 9.5% increase from $15.25 reported in 2012. Tax rate is expected to be approximately 25% for the next three quarters.

IBM expects to report a strong second quarter from the rollover of the pending mainframe and software deals. The company expects growing contributions from smarter planet (up 25% year over year in the last quarter), business analytics (up 7% year over year in the last quarter) and SaaS & Mobile (up more than 50% year over year in the last quarter) to drive top-line growth going forward.

IBM expects second-quarter operating earnings growth to be similar that of the first quarter. However, workforce rebalancing activity in the second quarter is expected to have a negative impact on earnings.

Our Take

Although IBM reported a dismal first quarter, we believe strong backlog, improving outsourcing signings and new contract wins will boost the top line going forward. However, sluggish IT spending and continuing weaknesses in the domestic market and Euro zone are the major concerns in the near term.

Additionally, deteriorating results in the hardware segment remain a major concern going forward. IBM continues to expand its Power systems into the Linux market. IBM is also focusing on further developing its flash technology and storage business. We believe that these improvements will boost hardware top-line growth going forward.

Moreover, this will also help it to counter strong competition from Oracle (ORCL), Hewlett-Packard (HPQ) and EMC Corp. (EMC) going forward.

Currently, IBM has a Zacks Rank #3 (Hold).

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