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July 15, 2004

IBM Boosts Earnings As Sales Come In a Bit Shy

by Timothy Prickett Morgan

Given the choice between having lower sales and higher profits or higher sales and lower profits, Wall Street would prefer that any vendor choose profits. And that is what IBM's new chief financial officer, Mark Loughridge, said Big Blue did in the second quarter. IBM reported revenues of $23.2 billion, up 7 percent compared with this time last year, and net earnings of just under $2 billion, up 16.6 percent.

Despite tough product transitions in the Power-based iSeries and pSeries server lines and stagnant software sales (like so many other software players in the second quarter), IBM had decent hardware sales and continues to wring costs out of all aspects of its businesses (particularly services) to drive profits. But IBM clearly has its eyes on turning its $1 billion investment in the consulting business of PricewaterhouseCoopers into a powerhouse. Loughridge finished his presentation to Wall Street analysts by reminding everyone that IBM is chasing after a market it calls Business Process Transformation Services (BPTS), which he said accounted for $1.4 billion in sales in the second quarter for IBM and which is growing at 40 percent. Strictly speaking, BPTS is only partially in the IT business, as it seeks to outsource business processes, engineer new systems, consult with customers on their business strategies, and monitor the performance of companies as they try to reach their goals. Taken to their extreme, the BPTS services that IBM wants to sell effectively turn Big Blue into a chief operating officer for hire.

But until BPTS grows to become the dominant service that IBM offers (if it ever does), IBM has to continue to generate sales and make money by pushing hardware, software, and more traditional services such as IT outsourcing, hosting, and systems integration.

In the second quarter, IBM's hardware sales were $7.42 billion, up 12 percent as reported and 10 percent at constant currency. (The weakness of the U.S. dollar hasn't helped IBM as much in hardware as it has in other units, it seems.) The Systems & Technology unit, IBM's main hardware group, which is comprised of the former Systems Group (which makes servers and storage) and Technology Group (which makes chips and used to make disks), had sales of $4.2 billion, according to Loughridge, and posted over $600 million in profits--about a third of IBM's total for the quarter. Those profits were unquestionably driven by strong sales of the company's zSeries mainframes, which posted a 44 percent gain in sales and a very high 75 percent gain in the aggregate MIPS shipped over the second quarter of 2003. Loughridge said that 70 percent of the MIPS shipped in the quarter were for new workloads, which means not traditional COBOL and CICS applications, and which increasingly means Linux-based infrastructure workloads that mainframe shops are consolidating from out in their networks back into their mainframes.

The iSeries line was hammered, with a 28 percent decline in sales, as customers more or less stopped buying iSeries machines as they awaited the Power5-based eServer i5 machines, which started shipping June 11. Sales of the i5 line were impacted at the high end, as customers awaited the new 16-way Model 570 machines announced on July 13. Loughridge said that while sales of older iSeries boxes were down substantially, i5 sales were on plan.

The pSeries Unix server line was just starting its transition to the Power5 machines on July 13, but sales were nonetheless down by 3 percent as some customers at the end of the quartered caught wind of the Power5 announcement and deferred acquisitions. Loughridge said that sales of high-end systems continued to grow "in the double digits," which stands to reason, since no one is expecting the 64-way "Squadron" Power5 servers until late September or early October.

When Apple reported its financial results yesterday, it zinged IBM yet again for not getting enough PowerPC 970 "G5" processors out the door from its 300 mm wafer chip plant in East Fishkill, New York. When questioned about this, Loughridge said that IBM had doubled the yield at the plant from the first to the second quarter, and was on its way to double the yield again in the third quarter. He said that the ramp curve at the chip plant was exactly what IBM had planned, albeit pushed out somewhere between one and two quarters. While Apple continues to complain about G5 supplies, Loughridge assured Wall Street and customers today by saying that IBM was not supply constrained for its own Power5 chips. He also said that he believed IBM is pretty much through the transition with the i5, having launched the Model 570s, and is well on its way with the eServer p5 machines.

The xSeries server sales, which use a mix of Intel and Advanced Micro Devices processors, were up 18 percent, with growth across the product line. Loughridge singled out IBM's BladeCenter blade servers, saying that these boxes were bringing some customers into the IBM fold for the first time. Storage sales were up 5 percent, with midrange disk arrays up 7 percent and low-cost FastT arrays growing by 36 percent. IBM's tape business grew by 13 percent, the fourth quarter of double-digit growth for this line. IBM's Personal Systems unit, which sells notebooks, PCs, workstations, and printers, booked sales of $3.2 billion, up 16 percent. IBM said that the unit was profitable, too, bringing $27 million to the bottom line.

Despite the mostly good news on hardware, software and services continue to be the twin engines of profit and revenue for Big Blue. Software sales were flat at $3.5 billion, with operating system sales down 2 percent at constant currency, thanks in large part to slumping iSeries sales. Middleware sales were flat, with sales of middleware on mainframe and iSeries systems up 2 percent and down 3 percent on Unix, Windows, and Linux systems. Sales were down a few points in IBM's Lotus, Tivoli, and Rational units, while WebSphere sales were up 2 percent. "Consistent with many of our pure-play competitors, we encountered a difficult sales environment," said Loughridge. "The number of large deals was down from the past quarters, and there were a significant number of deferrals at the end of the quarter." He said, however, that he believed the majority of those transactions remained opportunities for the third quarter.

The Global Services unit raked in $11.3 billion in sales during the second quarter, up 7 percent as reported, but only 2 percent at constant currency, reflecting the large amount of overseas sales this part of IBM has, and the weakness of the U.S. dollar in many foreign companies. IBM had $10.6 billion in new services signings in the quarter and increased its backlog to $118 billion. The signings were almost a carbon copy of the short-term and long-term signings that IBM had in the first quarter, and were down a bit from the second quarter of 2003. Loughridge said that IBM improved the gross profit margin across its services businesses by 7 percent in the quarter, and that every unit within Global Services contributed to profit improvement.

On a geographic basis, sales were up 2 percent in the Americas region to $9.7 billion. In the Europe/Middle East/Africa region, sales were also up 2 percent in local currencies, but when translated into dollars, back at IBM headquarters in Armonk, New York, EMEA sales were booked at $7.5 billion, up 7 percent. In the Asia/Pacific region, sales were up 13 percent as reported, to $5.2 billion (although up only 6 percent at constant currency). IBM's OEM sales, which are booked in dollars, were up 19 percent, to $701 million.

As for the future, Loughridge said that he did not expect anything different from what his predecessor as CFO, John Joyce, has been saying for several quarters. "We continue to see the IT industry growth around 4 to 5 percent, which is the best it has been since 2000. Customer spending continues to improve, though not uniformly across all segments and regions. This is nothing new. Demand is not entirely predictable or consistent, and it evolves with customer requirements."

Editors: Dan Burger, Timothy Prickett Morgan, Alex Woodie
Managing Editor: Shannon Pastore
Publisher and Advertising Director: Jenny Thomas
Advertising Sales Representative: Kim Reed
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