Guild Companies - IBM Posts a Good Second Quarter

IBM last week reported what can only be characterized as a good second quarter in an IT spending environment that continues to be difficult on a worldwide basis. Big Blue reported overall sales of $21.6 billion, up 10.1 percent from last year's second quarter, with net income of $1.7 billion and earnings of 97 cents per share. Because IBM was getting out of the disk drive business and restructuring its chip businesses this time last year, charges against earnings brought net income down to a measly $56 million, or three pennies per share. This is obviously a big improvement on the bottom line, which explains why IBM ditched the disk and chip businesses.

IBM's Global Services continues to be the juggernaut for revenue growth at the company, with sales of $10.6 billion in the second quarter of 2003. That is a year-on-year increase of 23 percent as reported, up 14 percent at constant currency in all the regions around the globe that IBM does business. (Currency exchange rates had a net negative effect of about 7 percent in the quarter, just as it did in the first quarter of the year, as the dollar weakens and the euro gains strength.) IBM booked $10.7 billion in signings during the quarter, and has a backlog (including long-term maintenance contracts) of $112 billion in the pipeline. Perhaps most significant, according to IBM's chief financial officer, John Joyce, IBM has already booked $3 billion in signings in the third quarter, which is only three weeks old. (IBM just signed big deals with Quest and the state of California.) Joyce said that the pipeline of opportunity in services was strong for the third quarter. IBM's Business Consulting Services sector, within Global Services, represents more than 30 percent of the company's services sales, and it grew by 66 percent (53 percent at constant currency) in the second quarter. Strategic outsourcing is about 40 percent of the Global Services pie, and it grew by 12 percent in the quarter (5 percent constant currency). Integrated technology services (which includes technical support and maintenance) was just under 30 percent of the Global Services pie and grew by only 7 percent during the quarter (it was flat at constant currency).

IBM's Software Group is the real profit engine of the company, and sales were up by 6 percent as reported to $3.5 billion (down 2 percent at constant currency). Operating system sales were held back by falling zSeries sales in the quarter because IBM moved up the "T-Rex" zSeries 990 machines to a May announcement, rather than shipping them in the second half of the year. And while iSeries sales were up, they did not grow enough to bolster operating systems sales enough to offset the mainframe decline. IBM's middleware sales--which include databases, transaction monitors, systems management tools, groupware, and development tools--grew by 7 percent as reported. Host-based middleware for mainframes and OS/400 servers were up by only 2 percent as reported, while sales of middleware for Windows, Linux, and Unix platforms were up by 17 percent during the quarter. Host-based middleware is still about two-thirds of IBM's overall middleware sales, however. Joyce said that sales of WebSphere products were up by 14 percent and that Tivoli systems management products were up by 9 percent, while Lotus sales declined by 3 percent. (These are as reported figures.) Other middleware product sales were flat, and IBM did not include Rational sales in its breakdown of financial results.

On the server front, IBM's Systems Group booked $3.2 billion in sales during the second quarter, up 10 percent as reported and up 3 percent at constant currency.

Sales of xSeries servers were up 25 percent as reported (16 percent at constant currency), and Joyce did not elaborate on what was driving sales of Intel-based machines, and for an obvious reason: the desire to acquire inexpensive servers is what is driving this business. He did say that IBM shipped 9,000 BladeCenter and HS20 blade servers in the quarter, and that he expected IBM to soon surpass Hewlett-Packard as the volume leader in this market. (We'll see about that.) He said that when the math was done by IDC and Gartner, he expected that the xSeries line would see over a point of market share gains in the second quarter of 2003.

Revenues from the pSeries line were up 20 percent in the quarter (13 percent at constant currency). Joyce said that both the low-end and the high-end parts of IBM's Unix server line were selling well, and that pSeries 630 machines actually sold out in the quarter. (Whether this was due to pessimistic planning assumptions by IBM or a big increase in demand from new customers is unknown.)

Sales of the iSeries midrange line, which runs IBM's own OS/400 operating system as well as Linux, were up by 6 percent as reported and down 2 percent at constant currency. Joyce elaborated a little, saying that iSeries sales were strong in the Americas and the Asia/Pacific regions, and the iSeries was once again struggling with weak sales in Europe. He said further that a shift in the sales mix toward bigger, more richly configured iSeries machines was making this box a profit engine for IBM, and that Big Blue expected to see a strengthening in demand as customers with older AS/400 and iSeries servers migrated to the new boxes.

The amount of MIPS shipped on the zSeries platform was down 7 percent in the quarter, and sales dropped by 5 percent. Joyce said that the primary reason for this shortfall was the product transition from the "Freeway" zSeries 900 to the T-Rex zSeries 990 servers. Toward the end of the third quarter, IBM will begin shipping integrated encryption features for the T-Rex machines, which are not currently available and which are key to the financial services organizations that are IBM's largest mainframe customers. Later this year, IBM will boost the number of channels supported on the T-Rex mainframes, which will allow companies to cram even more virtual Linux machines on the boxes than is currently possible.

Storage is now a part of the Systems Group, and sales of all storage were up by 12 percent in the second quarter, driven by 40 percent growth in FAStT midrange products and steady sales of high-end Shark arrays and midrange LTO tape units.

IBM's sales in the Personal Systems Group, which includes printers, were down by 3 percent as reported, to $2.7 billion, with a loss of $8 million. Joyce said that ThinkPad laptops and portables now accounted for 55 percent of PC sales, and that the company was surfing the wave of a shift from desktop to laptop machines.

On a geographic basis, IBM's sales in the Americas were $9.5 billion in the second quarter, up by 5 percent at constant currency and as reported. Sales in Europe, the Middle East, and Africa were up by 23 percent as reported, but were up by only 3 percent in the local currencies of all the countries in that region. Sales in Asia/Pacific were up 12 percent as reported (6 percent at constant currency), to $4.6 billion. At $588 million and a decrease of 30 percent, IBM's OEM sales are so miniscule by comparison that they don't really merit further discussion, unless IBM starts raking in profits here.

What everyone wants to know, of course, is how well IBM expects to do in the second half. IBM and HP are without a doubt the bellwethers of the IT market, and if they think things are getting better in the IT market, they probably are. But Joyce clearly didn't want anyone to order champagne yet. "I don't need to remind investors that second-half economic recoveries were expected back in 2001 and again in 2002," he cautioned. "And while some may argue it's more likely this year, we're going to take a very pragmatic view. We have increased our focus on execution within our on demand strategy, and if the economy does pick up, we will benefit from that as we continue to gain share. Our business model continues to buffer us on the downside, while enabling us to take advantage on the upside." He added that IBM expected to meet the average consensus among Wall Street analysts for revenue and profit for 2003.

In his usual prepared statement accompanying the financial results, IBM chairman and CEO Sam Palmisano echoed these sentiments. "We believe the industry will continue to evolve where business process insight combined with technology leadership will be what customers want, to ensure the success of their companies," he said. "And while it is difficult to predict the certainty of an economic rebound, IBM is in the best position to benefit further from any upturn in the market or the economy overall."

Joyce would not comment on the investigation into IBM's revenue recognition practices by the Securities and Exchange Commission, nor would he comment on a separate investigation by the Schools and Libraries Universal Service Support Mechanism, commonly called E-rate, which is questioning some contracts that IBM and other ISPs have signed to bring low-cost telecom and Internet access to schools for violations on competitive bidding practices. None of the Wall Street analysts on the call brought up the $3 billion lawsuit that The SCO Group has filed against IBM, which must have been a relief to Joyce. There's not much he can say about this anyway.