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1 Headwind IBM Will Face This Year

International Business Machines' (NYSE: IBM) return to growth after five years of declining revenue has been driven by a few different things. A weakening U.S. dollar has boosted the top line thanks to currency translation effects, the continued double-digit expansion of IBM's growth businesses has offset slumping sales in some legacy businesses, and the launch of the newest z14 mainframe system has provided a boost to the hardware business.

The timing of the new mainframe system was just about perfect, coming when IBM absolutely needed to prove that it could grow. A 71% jump in mainframe sales during the fourth quarter of 2017 was enough to push IBM's total revenue, adjusted for currency, about 1% higher. Momentum continued for the mainframe in the first quarter of 2018 with 54% growth, but currency-adjusted total revenue was just about flat.

An employee working on a z14 mainframe system.
An employee working on a z14 mainframe system.

The z14 mainframe. Image source: IBM.

Unfortunately, this strong mainframe growth probably won't last. The initial spike in sales following a mainframe launch typically gives way once that launch is lapped. The z14 started shipping toward the end of the third quarter of 2017, so the second half of 2018 will likely feature a mainframe headwind that will test IBM's ability to produce revenue growth.

The mainframe cycle

IBM refreshes its mainframe lineup every few years. The z14 was announced in July 2017, about two and a half years after the launch of the z13. Each new mainframe triggers some existing customers to upgrade. This creates a swell in mainframe sales, often lasting a few quarters.

After that initial surge, mainframe sales start to slump as the launch is lapped. That slump lasts until the next mainframe refresh, which starts the process over again.

Here's how IBM's mainframe business has performed since 2006:

A chart showing year-over-year quarterly mainframe sales growth.
A chart showing year-over-year quarterly mainframe sales growth.

Data source: IBM. Chart by author.

It's hard to tell whether the mainframe business is growing or shrinking from this chart. IBM doesn't disclose actual mainframe sales, just year-over-year growth each quarter. The company did win new mainframe customers during the first quarter, including at least one that's using one of IBM's smaller mainframe systems for blockchain applications. But it also expects its overall systems business to be stable (adjusting for product cycles) in the long run.

A second-half headwind

What we can say from this chart: Mainframe sales will likely grow during the second quarter but decline during the second half of the year. A swing of a few hundred million dollars during the third and fourth quarters could be in the cards. With IBM producing around $20 billion of quarterly revenue, this mainframe headwind could knock off a couple percentage points from IBM's revenue growth.

And because a portion of IBM's systems business is included in both its strategic imperative revenue and its cloud revenue, both of those numbers will be affected as well. During the fourth quarter of 2017, about 19% of strategic imperative revenue and 31% of cloud revenue came from the systems business. This includes Power servers and storage as well as mainframe systems, but a steep decline in mainframe sales would likely put a dent in the growth rate of IBM's growth businesses.

IBM may be able to make up for this expected mainframe sales decline with growth elsewhere. Its cloud as-a-service business, which doesn't involve the systems segment at all, has reached a $10.7 billion annual revenue run rate and grew by 25% year over year during the first quarter of 2018. IBM expects as-a-service revenue to grow by 15% to 20% annually as part of its long-term model.

The mainframe gave IBM a much-needed boost to end its long streak of revenue declines last year. In the second half of this year, the mainframe will be working in the opposite direction. IBM will need to muster growth in other parts of its business to offset that headwind.

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Timothy Green owns shares of IBM. The Motley Fool is short shares of IBM. The Motley Fool has a disclosure policy.

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