After dropping about 1% in early trading, IBM (NYSE:IBM) shares rallied throughout Friday to end the day virtually unchanged. It seems the longer that the market had to digest the company's quarterly earnings, the more positive it got. After examining these results, this optimism does make some sense. IBM is clearly still a company in transition, extricating itself from commoditized hardware businesses to higher margin software offerings. IBM's transition is far from complete, but this quarter showed some momentum in some units. Nonetheless, hardware continues to be a drag, and overall revenue growth is likely some time away. While it seems the worst is behind IBM, valuation is a bit of a concern and could temper share performance over the next twelve months.
In the second quarter, IBM earned $4.32 on $24.36 billion in sales compared to consensus of $4.29 on $23.23 billion in revenue (all financial and operating data available here). The revenue beat is more impressive than the earnings beat as the company has been able to manufacture earnings beats in past quarters by accelerating buybacks, deferring taxes, or taking gains. For instance, IBM's tax rate came in at 20% rather than 22% a year ago. While a company like IBM has the capacity to move EPS several pennies to ensure a close beat when necessary, revenue can obviously not be managed as well as accounting wizardry is far less useful. This beat is indicative of firming customer demand, though revenue was still off by 2.2% year over year. Unsurprisingly, management reaffirmed its full year EPS target of at least $18. IBM is now trading 10.7x 2014 earnings. The only major disappointment in the quarter was a 1% drop in IBM's service backlog to $136 billion.
Unsurprisingly, hardware was IBM's weakest unit with sales dropping 11% year over year. However, this was a tremendous sequential improvement as sales fell 23% in the previous quarter. However, part of this improvement is due to the fact Q2 2013 was a lot worse than Q1 2013, making it an easier comparison. Storage remains a challenged space due to increased competition and lower pricing, sending revenue down 12%. IBM's chip business also dropped 18%, which is why the company has been shopping the unit. Mainframe was only down 1%. Investors should expect continued revenue declines in this unit through the end of the year before hopefully finding a bottom in 2015.
While hardware is weak, it is not an IBM problem, but a market problem as other companies like Cisco (NASDAQ:CSCO) and Oracle (NASDAQ:ORCL) have reported lousy hardware numbers. This segment has just seen tremendous competition, and IBM is making a wise strategic decision to de-emphasize these offerings and focus R&D dollars on cloud and service products.
IBM's performance in emerging markets continues to be very disappointing. Ironically, the press release refers to them as "growth" markets even though they have done nothing but decline lately. Revenue in these countries dropped 7% year over year while BRIC nations saw a decline of 2%. Globally, Asia-Pacific was the clear laggard, down 9% while the Americas were down 1% and Europe/Middle East/Africa reported a 1% gain. Ever since the NSA spying revelations, IBM has faced increased problems in emerging markets as some countries have avoided US tech companies, fearing complicity in the NSA's efforts. For instance, Chinese revenue dropped 11% in the quarter, though this is a bit better than past quarters. This suggests we may be nearing a bottom in NSA-related business losses and US companies are exiting the penalty box. If so, we could see some growth in growth markets before the end of the year, though currency will likely continue to be a headwind.
In keeping with a slightly lower backlog, service revenue was down 1%, which is nothing to write home about, though layoffs helped to boost margins a bit. Software is showing some growth with sales up 1% and pre-tax profits up 10% thanks to cost cutting. IBM's cloud products are starting to gain some traction, though weakness in servers has been offsetting much of these gains. Cloud as a service was up 100% in the quarter and should account for about 3% of revenue in the coming 12 months. With the expansion of Watson's capabilities, IBM is working feverishly to further grow cloud service revenue and offset weakness in legacy units. Overall, IBM is still a challenged company with no revenue growth, but we seem to be nearing a turn with hardware and growth sales closing in on a bottom while software and cloud are generating some growth.
Now, IBM continues its laser-like focus on shareholder returns. IBM bought back $3.7 billion in stock. Its dividend cost another $1.1 billion. While sequentially lower, this pace of returns is unsustainable as IBM only generated $3 billion in free cash flow. IBM is adding debt to fund a portion of its buyback program. Excluding its financing unit, IBM carries about $17 billion in debt, so the company has very little leverage. Still, investors should note that these capital returns are slowly increasing leverage and are not justified by operations alone.
IBM uses these capital returns and one-time maneuvers to meet its EPS target, and often, I feel like the company would do better focusing on managing the business and not EPS. When valuing the company, I believe it is better to focus on free cash flow, which can't be as easily managed and is indicative of the sustainable pace of capital returns. While IBM's worst revenue declines are likely in the past, I struggle to see a path for meaningful near term growth. I expect the company to generate $15 billion in free cash flow in 2014, and an about 8% free cash flow yield translates to around $175-$180. I would wait for shares to reach this level before buying as the turnaround is not complete and growth is still uncertain.
Disclosure: The author is long CSCO. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.