IBM Turns In Its Best Second Quarter in Six Years

Published: July 24, 2007

by Timothy Prickett Morgan

IT industry bellwether IBM had a tough first quarter in 2007, with its business in the United States slowing down. But in the second quarter, Big Blue's U.S. unit rebounded as much as IBM said it might earlier this year, while overseas markets continued to grow as the U.S. dollar continued to be weak. The upshot is that IBM has turned in its best second quarter in revenue and profit growth since 2001, when the bloom was just coming off the dot-com rose.

In the second quarter, IBM had sales of $23.8 billion, up 8.6 percent, with three of its four major divisions having double-digit revenue growth. IBM's net income, helped by the divestiture of printer and PC businesses that were not particularly profitable, rose by 11.8 percent to $2.3 billion. Earnings rose by 19.8 percent to $1.57 per share. That EPS was helped hugely by a $12.5 billion accelerated share buyback maneuver that IBM did in the quarter, taking 9 percent of its shares off the market. The buyback also invoked the ire of the Internal Revenue Service and compelled the tax authority to close a loophole allowing so-called Killer B transactions that allow U.S. companies to use cash from foreign units to buy back shares and dodge income taxes on that cash. IBM has spent $18 billion on its own stock this year.

IBM's chairman and chief executive officer, Sam Palmisano, commenting on the results for IBM's quarter in a statement accompanying the company's financial results, bragged about Big Blue's broad product line, as he usually does. He did not attend the conference call with Wall Street analysts last Wednesday, as he never has.

"This quarter's strong revenue growth--our best since 2001--underscores IBM's global capabilities, as well as the higher value that clients place on our expanding software product line and wide range of services offerings that are helping them transform their businesses," said Palmisano. "Our overall results again demonstrate the strength of our business model and our ability to achieve profitable growth and strong cash generation. Earlier this year we described to our investors IBM's objective for earnings per share growth through 2010. While this is a long-term goal, our first-half results represent solid progress on major elements of this roadmap, including earnings growth, margin expansion, and revenue growth in key areas: emerging markets, acquisitions and service oriented architecture opportunities."

Mark Loughridge, IBM's chief financial officer, was more bubbly than he has been since he took over the job. "I think every CFO waits for a quarter like this," he said. "It was a great quarter."

IBM's Global Services division, which is its biggest revenue generator, had sales of $13.1 billion, up 10.1 percent; and both pieces of the Global Services behemoth grew by the same amount, with the Global Technology Services unit rising to $8.8 billion and the Global Business Services unit rising to $4.3 billion. "We have never been in such a strong position in both of these services businesses since I have been in this job," said Loughridge. IBM had signings of over $11.7 billion in the quarter, up 22 percent, and a services backlog of $116 billion, up 6 percent. IBM has some pretty tough compares in the second half of 2007, since the services business ran aground in early 2006. But clearly, IBM has adjusted to the shift by customers to shorter-term contracts and is, according to Loughridge, leveraging the acquisitions IBM has done and the internal investments it has made to provide services around service-oriented architecture and other kinds of IT and business transformation. Long-term signings were also up in the quarter, up 27 in Global Technology Services and up 70 percent in Global Business Services.

By region, the Asia/Pacific market showed the largest growth rates for services for IBM in the quarter, up by double digits. India led the growth in the ASEAN area, with growth up 50 percent; strategic outsourcing in India grew by 150 percent in the quarter, too. Loughridge said that domestic services sales inside India have been up 50 percent or more for seven of the past eight quarters.

In the Systems and Technology Group, which creates and peddles IBM's servers, storage, chips, and other gadgetry, had sales of $5.1 billion, up only 2 percent and flat at constant currency. IBM's sale of the high-end printer business to Ricoh knocked about 2 percent off this units growth, and going forward Loughridge said that STG would be dealing with about $250 million a quarter in lost sales. However, looking at just the systems part of the STG business, Loughridge said that system sales across all architectures rose by 4 percent, which is within IBM's business model of getting 4 percent to 5 percent revenue growth from its four server lines in aggregate.

IBM will have to meet those revenue goals for servers in aggregate, since for now, the Power-based and proprietary System i server division saw a revenue decline again, this time falling by 15 percent in the quarter. Loughridge confirmed rumors that IBM would be introducing Power6-based System i machines in the third quarter, but did not specify what products IBM would launch. So far, only the midrange System p 570 server, which was designed for the Power5 and Power5+ servers has been retrofitted to support the Power6 chip, and the actual Power6 server line, bearing either the System i or System p labels, has yet to surface.

The System p servers, of course, are Power-based machines aimed predominantly at running the AIX or Linux operating systems. Sales of System p boxes rose by 7 percent in the quarter, and were somewhat affected by the launch in May of that retrofitted Power6 machine and its delivery to customers in June. Despite the fact that IBM's Unix server sales growth has slowed (only 4 percent at constant currency in the quarter), the company nonetheless believes that when the market statistics come out for the quarter, IBM will gain market share in the Unix server space.

IBM's System z mainframe line only saw 4 percent revenue growth in the quarter (and only 1 percent at constant currency), but shipments of mainframe processing capacity, measured in MIPS, rose by 45 percent in the quarter. MIPS shipments of specialty mainframe engines that are restricted to running Linux, Java, or accelerating DB2 database transactions rose by over 130 percent in aggregate, with Linux-related MIPS shipments up 80 percent compared to the year-ago quarter. This is the eight consecutive quarter of MIPS shipment growth for IBM, and the longest product cycle since IBM sold water-cooled mainframes back in the 1990s. The question is, can it last?

"We're seeing a different kind of cycle, and I expect to see a longer and less volatile product cycle," explained Loughridge. "As I try to predict this, it is hard to use the old metrics for the mainframe. It's a different business, and a different value proposition."

Server consolidation and the efficiency of using mainframes that can run at close to 100 percent utilization is good for the mainframe, and clearly cutting prices on those specialty engines has been good, too, since they cost about a quarter of a mainframe engine running IBM's flagship z/OS mainframe operating system.

IBM's System x server business was up 16 percent in the quarter, riding the same wave of technology shifts to 64-bit and virtualization-enabled X64 processors that the rest of the industry is riding. IBM had growth in this line across all geographies, but sales of BladeCenter blade servers slowed to 15 percent--less than IBM's overall growth. For all the talk about blades, so far, they remain a niche product except at very large companies with hundreds or thousands of servers.

Sales of disk arrays were flat in the quarter, while tape sales, bolstered by products that support encryption, rose by 19 percent. IBM's Microelectronics Division, which is part of STG, had a sales slump as demand for game consoles fell.

Over at Software Group, IBM's steady stream of acquisitions continues to pay off in terms of revenue growth and profit growth. Software Group had sales of $4.8 billion, up 13 percent (9 percent at constant currency). IBM's key branded middleware products--WebSphere, DB2, Tivoli, Lotus, and Rational--represented 53 percent of Software Group's sales, or about $2.5 billion, up 23 percent (19 percent at constant currency). Other middleware, running mostly on mainframes and System i platforms, grew only by 4 percent and comprised 24 percent of software sales at IBM for the quarter. Operating systems accounted for 12 percent of sales, growing at 2 percent (and declining by 1 percent at constant currency), while other software represented 11 percent of Software Group's sales in the quarter and also grew by 2 percent.

"This software portfolio, you have got to remember, is the result of more than 30 years of investment," said Loughridge. "We didn't just ramp this up yesterday. It provides much of the foundation for business infrastructure, and this software is found in virtually all aspects of the middleware marketplace. In recent years, our investment in this portfolio has increased and operational execution has improved. Software is our largest provider of IBM profit and our most stable source of growth."

On a geographical basis, IBM's sales were also pretty balanced in the second quarter. The Americas region had sales of $10.1 billion, up 6 percent (5 percent at constant currency), and Loughridge said the IBM sales team and partner channel executed well as the U.S. economy strengthened. The EMEA region posted sales of $8.2 billion, up 13 percent (but only 6 percent at constant currency), lead by Germany, which was strong for the second quarter in a row, but also helped by the United Kingdom, Spain, and Eastern Europe. Asia/Pacific is growing like crazy, and IBM is benefiting. Sales in the Asia/Pacific region rose by 10 percent in the quarter to $4.6 billion (up 10 percent at constant currency). OEM sales were down 9 percent to $852 million.

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