Big Blue Red Flags
More one-time gains and unusual items make the quarter for IBM
IBM bulls continue to talk about the company’s cloud-based turnaround. Meanwhile, we believe a thorough look at the financial statements shows a company that would have missed earnings targets the last several quarters without an ongoing parade of unusual, non-operating benefits.
The latest June quarter results were no different. IBM’s adjusted EPS of $2.31 beat by 2 cents. However, we counted several times this amount in unusual benefits that are unlikely to repeat while some look set to reverse into headwinds in upcoming quarters. Below we discuss a few of the concerns we noted for our institutional clients.
Huge jump in “other income”
IBM’s Adjusted Other (Income) and Expense in the 6/22 quarter jumped to $418 million in income from $16 million in the year-ago quarter. IBM pulls out all non-service-related pension costs along with all impacts related to its recent Kyndryl spin-off in its non-GAAP results. We see that it still included a $232 million pretax gain on the divestiture of its healthcare software assets. This is classified as “other” within the Other Income line. This is a one-time item and depending on whether it was taxed at 21% or IBM’s effective tax rate of 16.4% - this added 20-21 cents to EPS.
On the call, IBM noted that it took the opportunity of this gain to book losses on stranded assets for $75 million and noted that the gain offset $100 million of losses to wind down the Russian business. That still leaves $57 million of gain that won’t recur, which is still 5 cents in EPS for a company that beat by 2 cents.
We have discussed the history of IBM’s workforce rebalancing charges in past reviews of IBM As we expected, the company benefitted again in the 6/22 quarter from lower workforce rebalancing in SG&A. This charge declined from $107 million to $28 million year-over-year and that $79 million was worth 7 cents in EPS for 2Q22. It is important to remember that workforce rebalancing is unlikely to be a source of profits in 3Q22 or 4Q22 as IBM reported $0 of rebalancing charges there for 3Q21 and a $60 million credit for 4Q21:
Not only will the tailwind of lower rebalancing charges be gone, but any workforce rebalancing charges recorded in 3Q21 will be an earnings headwind.
We have also pointed out in past reviews how IBM is benefitting from lower R&D expenses. In the 6/22 quarter, IBM’s R&D spending was essentially flat on higher sales causing R&D as a percentage of sales to fall by 77 basis points. If the R&D percentage had remained the same, it would have shaved about 3 cps off earnings. What is noteworthy is the fact that gross margin declined in all of IBM’s divisions which is a clear indication of higher costs everywhere but apparently, we are to believe that there is no cost inflation in the R&D department.
Update on Kyndryl dependence
IBM continues to get a huge portion of its growth from sales to Kyndryl which IBM spun off two quarters ago. However, Kyndryl itself continues to forecast negative sales growth. Here is a snapshot of IBM’s reliance on Kyndryl for the 6/22 quarter:
Software sales up 6%, 11.6% without FX hits, but 7% was from KD. This is the largest division at 41% of sales, with the highest margin – generating 59% of gross profit. It sure looks like KD is the bulk of the growth here. Within Software, transaction processing was up 12%, 19% without FX hits, but 22% was from KD.
Infrastructure looks better with sales up 19%, 25.4% without FX, with only 7% from KD. But, the roll-out of the new Z-cycle within infrastructure’s zSystems drove that unit up 69%, up 77% with no currency and no mention of KD. That really helped juice the full unit’s sales and IBM had a VERY easy comp on zSystem sales which were down 13% in 2Q21. IBM should have a VERY easy comp for zSystem in 3Q22 as 3Q21 saw zSystems down 33% and 3Q20 down 16%. IBM toned down expectations a bit for 3Q22 zSystem sales growth though.
KD isn’t mentioned in the zSystem area, but that strong growth is diluting down the KD impact. If we look at Infrastructure support, IBM said growth was -2% or up 5% without FX but KD was 8% of the gain. We think this along with the software sales shows that KD is having an outsized impact on growth here.
It is also worth noting that of IBM’s retained 19.9% stake in KD – it sold half of it in 2Q to retire a credit line in November. It will either pay cash to settle this if the shares are below $13.95 or will be paid additional cash if KD is above $13.95. That is not a material amount of money – but IBM sure isn’t hanging on to shares in the company it remains very closely aligned with for future growth.
Also of note, IBM lost a lawsuit to BMC Software on May 30 for $718 million. IBM’s comments are that it has no exposure to this because it was related to Kyndryl:
from IBM 2Q22 10-Q:
“As disclosed in the Kyndryl Form 10 and subsequent Kyndryl public filings, in 2017 BMC Software, Inc. (BMC) filed suit against IBM in the United States District Court for the Southern District of Texas in a dispute involving IBM’s former managed infrastructure services business. On May 30, 2022, the trial court awarded BMC $718 million in direct damages and $718 million in punitive damages, plus interest and fees. The judgment will be appealed. IBM does not believe it has any material exposure relating to this litigation. No material liability or related indemnification asset has been recorded by IBM.”
However, Kyndryl believes it wasn’t the party being sued and IBM needs to deal with it.
from Kyndryl 8-K filed May 30, 2022:
“The Company is not directly named as a party to this matter, but has previously included disclosure about the matter in its filings with the Securities and Exchange Commission because the matter raises allegations about IBM’s managed infrastructure business, which IBM contributed to the Company in connection with IBM’s spin-off of the Company.”
On May 30, 2022, the trial court issued an opinion dismissing several of BMC’s claims and awarding BMC $717 million in direct damages and $717 million in punitive damages, plus interest. This judgment is against IBM. IBM has publicly stated that it plans to appeal the judgment because it believes that the judgment is contrary to the facts and the law, and intends to seek a complete reversal on appeal. The Company also understands that IBM plans to seek a stay of any final judgment entered by the court while the appeal is pending. IBM may seek an indemnity from the Company in connection with the matter. Until there is a final and conclusive judgment in the case after appeals and proceedings are concluded, until the amount of any applicable insurance is determined, and until a definitive assessment of Kyndryl’s indemnity obligations (if any) occurs, which in the aggregate will likely take several years, the amount of any indemnity obligation that the Company may owe to IBM is indeterminate.”
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