Will IBM Shift Application Software Strategy?

Yesterday, IBM reported a strong first quarter that beat earnings estimates. Q1 revenues were down 11% to $21.7 billion, short of Street estimates of $22.5 billion. Net income was down 1% to $2.3 billion. However, EPS was up 4% to $1.73 per share, beating Street estimates of $1.69 per share. Let’s take a closer look.

Over the years, IBM has transformed itself, shifting its focus from commodity businesses like PCs and hard disk drives towards software and services. It has spent over $20 billion on over 100 acquisitions in the past decade, and today its portfolio is built around higher-value networked, modularized and embedded technologies, such as service-oriented architecture (SOA), virtualization, business intelligence and analytics. In the earnings call, IBM said its three main initiatives are cloud computing, business analytics and its Smarter Planet strategy, wherein intelligence is applied to key processes like food, healthcare, telecommunications and power.

The focus on its cloud computing initiative led IBM to consider acquiring Sun. However, the deal failed and yesterday Oracle announced that it will be acquiring Sun for $7.4 billion. With the increasing focus on saving costs, cloud computing has become a hot space and more acquisitions will likely follow this year.

The big decision that IBM needs to make is whether it will get back into the application software business, because its infrastructure focused strategy may run out of steam as companies move to adopt cloud computing. In that scenario, while a handful of companies will need intensive infrastructure investment, the larger population of businesses will need very little in terms of large scale servers, middleware, databases, etc. The action is largely going to be in applications, making the SaaS apps companies ripe targets.

Following this logic, the companies that ought to be on IBM’s radar are Omniture, Concur, SuccessFactors, Taleo, Citrix, RightNow, NetSuite, and a host of other smaller, private SaaS companies covered in the Deal Radar series.

Coming back to its financials, IBM reported gross profit margin of 43.4% versus 41.5% last year, mainly as a result of its shift to higher-margin technologies and an 84.2% software margin. It ended the first quarter with $12.3 billion in cash and generated free cash flow of $1.0 billion, up $450 million y-o-y. Debt, including Global Financing, was $31.0 billion, down from $33.9 billion at year-end 2008. Global Financing debt decreased $1.0 billion to $23.4 billion. IBM paid $675 million in dividends and bought back shares worth $1.8 billion in the quarter. Q4 analysis is available here.

By segment, revenues from Software was down 6% to $4.5 billion. Revenues from IBM’s middleware products including WebSphere, Information Management, Tivoli, Lotus and Rational products, were $3.6 billion, down 5%. Systems and Technology revenues were $3.2 billion, down 23%.

Global Financing revenues were down 9% to $578 million. Total Global Services revenues was down 10%, with Global Technology Services revenues at $8.8 billion and Global Business Services revenues at $4.4 billion. Services signings totaled $12.5 billion, including 16 contracts greater than $100 million. Services backlog at the end of the quarter is estimated at $126 billion versus $130 billion at year-end 2008.

By region, revenue from the Americas was down 7% to $9.3 billion, EMEA was down 18% to $7.2 billion and Asia-Pacific was down 6% to $4.8 billion.

Based on its performance, IBM expects to meet its EPS target of $9.20 per share for 2009 and said that it is ahead of its 2010 roadmap of $10 to $11 per share. It is currently trading around $100, recovering well from its 52-week low of $69.50 on November 21. Market cap is about $135 billion.