Editor’s note: IBM’s latest earnings report topped Wall Street expectations but generated little in the way of positive reaction as revenue fell again. But Technology Business Research analyst Andrew Smith sees a bright spot beyond Watson and cognitive computing: IBM’s software business.

IBM Software’s revenue declines slowed in 1Q16, and it will rely on its Solutions Software capabilities to capture market opportunities, says Smith.

HAMPTON, N.H. – IBM’s (NYSE: IBM) software business faces ongoing revenue and margin declines due to lower demand for its legacy, on-premises middleware solutions. As a result, the vendor will reorient its middleware intellectual property (IP) under the Bluemix, SoftLayer and Watson brands and apply it to higher-value, hybrid cloud deployments.

TBR expects this transition to pressure IBM Software’s revenue and margins during 2016, as legacy enterprise license agreements (ELAs) decline and customers look to replace transactional, one-time payments with longer-term cloud subscriptions.

IBM has taken several measures to combat this challenge. During IBM’s 4Q15 earnings presentation, CFO Martin Schroeter made a clear link between IBM Middleware and cloud, positioning Middleware solutions as essential enablers of hybrid cloud environments. This was a new approach for IBM; the vendor had not previously tied its cloud and middleware messaging together in such an explicit manner. TBR believed this shift foreshadowed additional organizational and strategic changes across IBM’s software business.

Months later, during IBM’s annual Investor Briefing event in February, the vendor announced a new segment reporting structure that separates the legacy software reporting lines of Key Branded Middleware, Other Middleware and Operating Systems and distributed them across new reporting lines Solutions Software, Transaction Processing Software, Integration Software and Operating Systems.

This change is significant because the new reporting lines provide a different view of IBM’s performance and how contributions from key products and platforms such as Watson, Bluemix and SoftLayer relate to the growth of the vendor’s Strategic Imperatives.

TBR also believes the reporting change is an accurate reflection of how IBM has marketed and sold software solutions over the past year. We believe internally, IBM has been operating under a similar structure to effectively deliver software and cloud solutions to customers. Changing financial reporting lines was a final step in the reorganization process. We expect IBM to prioritize the growth of critical IP within the Solutions Software segment, which contains some of the most strategic software solutions in the IBM portfolio. TBR believes the performance and growth of this subsegment will be a key indicator of IBM Software’s success over the next two years.

During conversations with TBR over the past 12 months, IBM Software has demonstrated an understanding of the financial and business model shifts facing its organization and the changes needed to adapt to cloud consumption preferences. To take advantage of increasing adoption of DevOps tools and practices, containerized applications and microservices, and hybrid cloud solutions, we expect IBM to reassemble its management and middleware IP into smaller services that provide easier automation and integration for customers within a Bluemix-based environment. Recent acquisitions such as Gravitant and Optevia will help establish this strategy. TBR believes IBM is successfully positioning its organization to deliver solutions and services for customers looking to implement hybrid cloud solutions, which have quickly become the next frontier of opportunity in the enterprise technology space.

Reorienting people, products and business units will help IBM better align with customer preferences and quickly leverage acquired assets

IBM Software’s revenue declined 3% year-to-year to $5.4 billion in 1Q16, as demand for the vendor’s legacy middleware offerings continued to wane. Under the new reporting structure, Cognitive Solutions declined 2% year-to-year to $4 billion. Within Cognitive, Solutions Software grew 1% year-to-year to $2.7 billion and Transaction Processing Software declined 8% year-to-year to $1.3 billion. Technology Services & Cloud Platforms declined 2% to $8.4 billion but grew 2% in constant currency. Within the segment, Integration Software declined 4% year-to-year to $1 billion. The Operating Systems segment declined 9% year-to-year to $400 million.

During IBM’s 1Q16 earnings call the vendor also released dollar and growth figures for its strategic imperatives, including the amount of strategic imperatives — as well as cloud — revenue attributed to each of the new reporting segments. All strategic imperatives grew revenue year-to-year in constant currency, with the exception of social, which declined 1% year-to-year. Analytics and cloud imperatives grew 9% and 36% year-to-year, respectively. IBM reported strategic imperatives and cloud revenue growth year-to-year within all reporting segments except Systems, where strategic imperatives declined 6% and cloud grew 1% year-to-year.

Despite growth across its strategic imperatives, IBM’s Software portfolio remains in transition. Declines across the software portfolio overall indicate IBM is still working to help customers migrate legacy workloads to the cloud while retaining as much business as possible under new purchasing, deployment and billing structures. We expect IBM to continue reorienting people and products internally to promote efficiency and quickly scale the amount of revenue from Strategic Imperatives across new business lines. Software solutions will continue to play a central part in the growth of IBM’s Analytics Imperative, and we expect the performance of IBM’s Solutions Software segment to be a bellwether of that success. IBM expects the Solutions Software segment to grow year-to-year in 2Q16, spurred by the performance of recently acquired assets.

IBM sustained its aggressive pace of partnerships and acquisition activity in 1Q16 to drive adoption and revenue growth in higher-value markets for hybrid cloud and analytics

During IBM’s 1Q16 earnings call the vendor reported acquisitions added two points of growth to software revenue overall. IBM continues to invest heavily in software-oriented partnerships and acquisitions, which benefit its strategic imperatives. IBM will manage the decline of noncore businesses, including its Transaction Processing Software portfolio, while aggressively pursuing growth of the Solutions Software segment.

Most recently, IBM acquired Bluewolf, a cloud and applications integrator with specialization in Salesforce. Although Bluewolf will be integrated into GBS, the acquisition allows IBM to leverage an expanding pool of cloud integration expertise that can cross-sell its analytics, security and social solutions. This strategy contrasts with IBM’s Transaction Processing Software segment, where the vendor will invest less and manage the decline of the segment as opportunities for traditional middleware solutions wane.

IBM completed several other tuck-in acquisitions during 1Q16 to fill strategic gaps in its evolving software portfolio. Recent acquisitions including Bluewolf, Optevia and Resilient Systems help improve IBM’s software and cloud IP and can be applied to the vendor’s portfolio of financial, banking and healthcare offerings. IBM’s pace of acquisition will pressure the vendor to sustain margin expansion, particularly given ongoing currency headwinds and macroeconomic conditions, which we expect will result in margin declines throughout 1H16. However, we believe IBM is willing to sacrifice margin performance in the short term to generate long-term growth opportunities in emerging markets. Details on some of the acquired companies include:

  • Iris Analytics: Iris Analytics is a real-time analytics solution designed to prevent fraud and money laundering. Iris solutions will integrate with the Counter Fraud Management and IBM Payments portfolios to bolster IBM’s financial services analytics capabilities.
  • Truven Health Analytics: Truven Health Analytics is a provider of cloud-based healthcare data, analytics and insights. The acquisition expands IBM’s data corpus, which pulls from repositories across Twitter and The Weather Company. Data from Truven will help IBM’s Watson Health unit continue to expand its accessibility to patient data and records across cost, claims, quality and outcomes.
  • Resilient Systems: Resilient Systems is a provider of incident response solutions. Acquiring the Resilient Systems Incident Response Platform will immediately expand IBM Security’s ability to help clients respond to breaches, and the vendor plans to quickly provide integration with other security solutions across its QRadar portfolio.
  • Optevia: Optevia is a SaaS systems integrator specializing in Microsoft Dynamics CRM solutions for public sector organizations. The acquisition brings IBM valuable integration skills based on a SaaS delivery model and provides another avenue for IBM to deliver hybrid cloud infrastructure and management capabilities underlying critical enterprise application workloads such as CRM.