IBM Closes 2008 on a High, i Sales Unclear

Published: January 21, 2009

by Timothy Prickett Morgan

Wall Street got a chance to catch its breath a little yesterday after the market closed when IBM announced its financial results for the fourth quarter, a quarter that was impacted by the economic crisis last summer and fall but one in which Big Blue nonetheless was able to pull out of the fire profit-wise by cutting costs. More importantly, perhaps, IBM's top brass reaffirmed that they were on track, despite the state of the global economy, to meet aggressive profit targets.

In the fourth quarter, which bore the brunt of the economic meltdown and which saw 1.53 million layoffs of full-time workers in the United States, IBM did see a decline in sales. But aggressive cost cutting and margin management allowed the company to actually beat the estimates Wall Street was making about IBM's possible profits in the quarter. (As if we trust even a tenth of what Wall Street says these days.) IBM's sales worldwide actually declined by 6.4 percent to just a hair over $27 billion, but despite that decline, IBM held gross margins and actually boosted net income by 12 percent to $4.43 billion. And because IBM buys back buckets of its own shares each quarter "to return value to its shareholders," er, to financially engineer its earnings per share growth, IBM was still able to show a 17.1 percent increase in EPS to $3.28 in the quarter. While not a miracle, this is nonetheless a fine piece of piloting in some pretty rough waters. No question about that.

I know that IBM is mostly a services and software company these days, but as I have said before, take away IBM's platforms and you remove the foundations for those services and software sales. So I like to talk about servers first when I talk about Big Blue.

To that end, the Systems and Technology Group had a rough quarter, with sales down 20 percent to $5.4 billion; sales fell 16 percent when measured in local currencies before revenues were brought back to New York and converted into U.S. dollars, so this steep decline is not a trick of currency fluctuation, but some real declines. System z mainframe sales were a bright point, but still declined by 6 percent (but rose 1 percent in constant currency), with MIPS shipments up 12 percent. Loughridge said that mainframe sales in the Americas was strong, and that financial services and industrial companies (I think he meant manufacturers) were particularly strong. Which sounds weird to me given where the economy is hurting, but that's the mainframe business for you.

Power Systems, as gauged by the grouping IBM calls Converged System p (which means everything Power but legacy entry iSeries machines using Power5 processors), posted sales up 8 percent as reported and up 14 percent at constant currency. This latter category is showing real growth for Power Systems sales, not just the effect of IBM reclassifying iSeries sales as was the case in 2007's first quarter. It is not clear if Power System machines running the i5/OS and i 6.1 operating system did well or poorly because IBM doesn't provide any numbers on this any more, but the company did say that legacy System i (that's those Power5 entry boxes) sales fell by 92 percent (91 percent at constant currency). As I have been saying for a year now, this is an artificial distinction in server types that is meant to make IBM's Unix business look good, but it has the side effect of making the i business look bad. I will be putting together an estimate of i and p platform sales, as usual, to give us all some sense of what has happened out there.

The real story on the server front was a very steep decline in System x sales at Big Blue in the quarter. Mark Loughridge, IBM's chief financial officer, said in a conference call with Wall Street analysts yesterday after the market closed that System x sales (which also include the BladeCenter blade chassis and presumably all X64-based blade servers) fell by 32 percent in Q4 (down 28 in constant currency). BladeCenter sales, he said, fell by 27 percent. Storage sales were also hit hard, declining 20 percent for both disk and tape products, with disk array sales falling 16 percent and tape sales down 31 percent.

Clearly, something bad is going on with the X64 and storage areas. Storage purchases, particularly tape, can be deferred for a while then the economy gets bad, but that steep drop in X64 server sales--after a drop in the third quarter--is something of a worry. Loughridge tried to explain it away as a shift toward virtualized mainframe and Power boxes, a story that Wall Street might buy, but I don't until I see some more data.

"This reflects a significant slowdown in the X86 market, as customers are virtualizing and consolidating workloads into more efficient platforms such as Power and mainframe," Loughridge said in explaining the X64 decline in Q4. "So as you look at these results, you can see that the industry standard hardware is\r\nclearly more susceptible to an economic downturn."

We won't know that for sure until we see numbers from Hewlett-Packard and Dell, but even still, I don't think the situation is likely to be as simple as that which Loughridge is offering in his explanation. I think it is just as likely that IBM, which has always sold relatively heavy X64 server configurations, is not only seeing a dropoff in sales, but is also seeing the virtualization effect (which has already compressed sales of mainframe, i, and p platforms) take its toll on X64 boxes. Bigger boxes tend to get virtualized first, so you would expect IBM, with its large enterprise focus across most of its servers, to get hit by the uptake of server virtualization sooner than Dell or HP, which have large businesses selling small machines to SMB shops as well as selling some big iron.

IBM's Global Services behemoth, which was broken into two bits somewhere to make its size less embarrassing compared to the company's hardware and software units, posted sales of $14.3 billion in the fourth quarter of 2008, down 4 percent. Global Technology Services fell by 3.7 percent to $9.62 billion, and Global Business Services fell by 4.5 percent to $4.17 billion, more or less in line with IBM's overall declines. However, IBM was able to boost gross margins on services by nearly 5 points, and that made a huge difference in the bottom line in Q4. IBM's services groups have done a masterful job staying relevant throughout a tumultuous 2008, and the company exited the year with a $117 billion backlog in services, actually $2 billion more than it had as 2007 came to a close. Global Financing, which is kept separate from the services unit, had sales of $609 million, down 1.3 percent, but again, gross margins increased by 4.5 points, which means it contributed more to profits. (By comparison, gross margins in the Systems and Technology Group fell by nearly 6 points, meaning it cut into profits.)

IBM's Software Group was the one unit that actually had a real increase in sales in Q4, and if general manager Steve Mills were a little bit younger, he would probably be on deck to replace Sam Palmisano as chairman and chief executive officer. (As it is, the two are close enough in age that this will probably not happen, unless IBM bucks tradition when Palmisano retires at age 60.) In any event, Software Group had sales of $6.4 billion in the quarter, up 3 percent as reported and up 9 percent in constant currency. This growth came in large part from IBM's so-called Information Management product line, which includes DB2, other databases, and related tools and which had an 18 percent spike in sales in the quarter (up 25 percent at constant currency). That kind of growth rate in this kind of economy for these kinds of products is impressive. The question now: is this sustainable or a one quarter push?

IBM's results for its other software units seemed more like what you'd expect. WebSphere middleware had a 1 percent decline, Tivoli systems management tools fell by 4 percent, Lotus groupware was flat (probably impacted by the impending launch of Notes/Domino 8.5), and Rational application development tools fell by 1 percent. But databases brought up the class average for key branded middleware so they, as a group, showed a 6 percent increase in sales. Operating system and other software sales declined by about 1 percent by my math, which stands to reason given the decline in mainframe sales and the possible decline in Power System i sales. That this number wasn't bigger means the hit was not big. Moreover, host-based middleware sales were down around 2 percent or so by my math, which also suggests the i platform didn't do as badly as we might expect.

By geography, sales in the fourth quarter in the Americas fell 2 percent as reported, but were up 2 percent at constant currency. (Gotta love Brazil and Canada, man.) Sales for Big Blue in Europe, the Middle East, and Africa fell by 12 percent (but were down only 1 percent in constant currency) and Asia/Pacific sales fell by 1 percent to $5.5 billion (down 1 percent at constant currency). You can see how the strengthening of the U.S. dollar compared to the euro and a number of other currencies used in Europe, Africa, and the Middle East took its toll on IBM's books. But, this is just the flip side of a weak dollar, which for years has made IBM look stronger than it really was. IBM's OEM sales, which is mostly chips for game consoles, fell by 31 percent to $615 million and are booked in U.S. dollars from the get-go.

For all of 2008, IBM had $103.6 billion in sales (still well behind HP), up 4.9 percent. The company brought $12.3 billion to the bottom line, 18.4 percent more dough than in 2007, and had $8.93 per share of earnings, up 24.4 percent thanks to those share buybacks.

Looking ahead, IBM did not provide revenue guidance for 2009, but did say that it expected to be able to meet or exceed $9.20 per share in earnings, putting it on track toward its long-term goal of hitting even higher levels of profits by 2010. Something that Palmisano was happy to brag about in the statement accompanying the financial results released yesterday:

"A strong fourth quarter capped an outstanding year," Palmisano said. "In 2008, IBM performed well in an extremely difficult economic environment. Clearly our strategic transformation--migrating to the more profitable segments of the industry, investing in growth regions of the world, and driving productivity through global integration--is continuing to pay dividends. With our strong financial position, solid recurring revenue and profit streams, and global reach, we are confident about 2009 and, based on our 2008 performance, we are ahead of pace on our roadmap for $10 to $11 per share."

Well, that's one of the Global 2000. Let's hear it from the other 1999. . . .

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