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Market Update

Not Changing Long-Term Outlook for IBM...Yet

Despite IBM's very weak 1Q results, Morningstar's Grady Burkett is closely watching for any further worsening before adjusting his long-term forecast for the tech firm, though is making 2013 changes.

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 International Business Machines(IBM) first-quarter results came in well below our expectations, as the firm's hardware and software results disappointed. Overall revenue declined 5% year over year to $23.4 billion, while free cash flow declined to $1.7 billion, versus $1.9 billion generated in last year's first quarter. We expect to adjust our 2013 forecast to reflect this quarter's weakness. Still, we are not yet inclined to lower our longer-term forecasts or fair value estimate, and this quarter's miss has no bearing on our economic moat rating.

Hardware was particularly weak, falling 13% from the year-ago quarter. Mainframe revenue did grow 7% year over year to approximately $650 million, but this is a poor result given IBM's recent refresh of its System z portfolio. Management blamed the weakness in mainframe sales primarily on execution and deal push-outs, and we expect a stronger second quarter. 

The rest of IBM's hardware portfolio performed abysmally, with proprietary Power servers, x86-based servers and storage arrays declining 32%, 9%, and 11% respectively. Management called out solid adoption of its integrated systems as a bright spot, but we have yet to see data that suggests IBM is gaining meaningful traction in the converged system market. Broadly, the hardware industry is becoming increasingly challenging, and IBM appears to be ceding some ground. Rumors surfaced on Thursday that IBM is considering a sale of its x86 server business, which wouldn't be surprising given IBM's focus on software, services, and noncommodity hardware.

Although IBM's service revenue declined 4% year over year to $14.1 billion, backlog grew 1% to $141 billion, and we expect service revenue to stabilize here. Software revenue came in at $5.6 billion, roughly flat from the year-ago quarter, as decent results across the majority of IBM's branded middleware portfolio was offset by a slight decline in revenue relating to database and analytics software. We expect software results to improve sequentially as slipped deals close, and we are maintaining our long-run forecast for IBM's software revenue. Still, IBM's database and analytics businesses are strategic for the firm and key sources of competitive advantage, and further weakness in this specific software category would be cause for concern. 

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Grady Burkett does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.