Earnings Outlook: IBM earnings: Security is growing fast, but is it enough money to matter?

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In the continuing story of International Business Machines Corp.’s attempt to transform itself for the new age, one large focus will be how the tech company is taking advantage of a heightened security climate, and if IBM’s offerings will make enough money to move a heavy needle.

IBM’s IBM, -0.38%  “Strategic Imperatives” group — which includes the security business — has been driving growth, with the company expecting the segment to account for more than 40% of revenue by the end of the year. When IBM reports earnings Wednesday after the market closes, security is once again expected to the fastest-growing area in IBM’s fastest-growing segment.

Through the first quarter, IBM’s security business had generated $3.4 billion in revenue in the previous 12 months, for growth of 66% year over year, the company told MarketWatch. In the first quarter, security brought in $800 million with growth of 65% from the year-ago period, compared with SI’s 15% growth overall.

That is just a fraction of IBM’s $19.07 billion in reported revenue, however, and may not be enough to truly move the needle as other segments grow much slower. Analysts expect technology services and cloud-platform revenue to rise 2.6%, to $8.63 billion and cognitive-solutions revenue to rise 4.4% to $4.76 billion from the year-ago quarter. Technology services and cloud-platform includes IBM Cloud, formerly known as Bluemix, while cognitive solutions includes IBM’s Watson AI.

Read also: IBM broke a long losing streak thanks to some of its oldest technology

Global business services revenue is expected to rise 1.7% to $4.17 billion, and systems revenue is forecast to rise 5.7% to $1.85 billion from the year-ago period. Global business services includes consulting for modernizing business design and enterprise and cloud applications, while the systems business includes operating-systems software and the company’s mainframe business, including IBM’s z14 line of servers. IBM does not break out security revenue contributions from their other respective business segments.

How IBM is taking advantage of the growing wave of network security spending, should give investors a clue as to how the company is executing on the ripest opportunity in its turnaround. Not only is the first anniversary of the Equifax Inc. EFX, -1.21%  breach disclosure approaching, but Goldman Sachs said in a recent note that cybersecurity stocks should get a short-term boost given concerns of meddling in the coming midterm elections in November.

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Of chief information officers surveyed by Goldman Sachs, security was their top spending priority, with 45% responding they planned to boost spending in the next 12 months, beating out other spending priorities like Software-as-a-Service and cloud, as security breaches become more costly to businesses.

A data breach costs an organization an average $3.9 million, according to an IBM Security-sponsored report from the Ponemon Institute. That gets somewhat reduced to $2.9 million when security automation is deployed, but when the breach is large enough, a so-called “mega breach,” those averages skyrocket to $40 million when one million records are compromised and $350 million when 50 million records are compromised, according to Ponemon.

What to look for

Earnings: Of 20 analysts surveyed by FactSet, IBM on average is expected to post adjusted earnings of $3.04 a share. Estimize, a software platform that uses crowdsourcing from hedge-fund executives, brokerages, buy-side analysts and others, calls for earnings of $3.06 a share.

Revenue: Wall Street expects revenue of $19.87 billion from IBM, according to 17 analysts polled by FactSet. Estimize expects revenue of $19.74 billion.

Stock movement: IBM shares suffered one of their worst tumbles in five years back in April following the previous earnings report, dropping 7.5% in one day even though results exceeded Wall Street expectations. Since April, IBM shares have traded below their 200-day moving average, and until recently, their 50-day moving average.

From last quarter: IBM earnings show AI is not paying off yet

Shares have yet to recover and are down 9.3% since IBM’s last earnings report, compared with a 1% gain on the Dow Jones Industrial Average DJIA, +0.38% a 3.5% gain on the S&P 500 index SPX, +0.11% and a 7.5% gain on the tech-heavy Nasdaq Composite Index COMP, +0.03%

What analysts are saying: Of the 25 analysts who cover IBM, 10 have buy or overweight ratings, 13 have hold ratings and two have sell or underweight ratings, with an average price target of $167.09.

First and foremost to analysts is how is the SI transition story unfolding. GBH Insights analyst Daniel Ives, who has an “attractive” rating and a $180 price target on IBM, said SI will be the “clear focus” of Wall Street and will be the primary driver of the stock for the next six to nine months.

“The challenges and headaches remain clear for IBM heading into the rest of 2018 as the lack of consistent execution, the ability to successfully transition to a next-generation-software-driven/Strategic Imperative model that has failed to truly materialize yet, massive competition from all angles, and legacy hardware headwinds remain the anchor on the ship,” the analyst said.

“That said,” Ives continued, “this quarter its all about taking a positive step in the right direction and we believe this will also be a good signal for broader enterprise tech spending trends that we saw in 2Q, with healthy momentum overall on analytics, security and cloud heading into [the second half].”

Expect software growth to be volatile seeing the June and December ending quarters are typically the most “transactional” quarters of the year, said Stifel analyst David Grossman, who has a buy rating and a $182 price target on IBM.

“Transactional software sales (Cognitive) are seasonally strongest in 2Q and 4Q, which makes them the most volatile from a growth perspective,” Grossman said. “The company is in the midst of a multiyear process of unbundling pricing of its software portfolio in addition to migrating certain customers to a SaaS revenue model (SaaS 11.5% of revenue today versus 7.5% two years ago). Consequently, software comparisons are most difficult in the seasonally strong 2Q and 4Q.”

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