Guild Companies--Bellwether IBM Sees Stabilization in Third Quarter

The economies of the world are not in great shape, but with a steady sales pitch and a steady hand on the cost controls, IBM managed to grow its revenues and profits in the third quarter. Big Blue is still not firing on all cylinders, to be sure, but with the many countries and states dealing with huge budget deficits, and with millions of companies trying to steer through rickety economies, IBM is doing about as well as any titan of the IT industry could do.

IBM's chairman and CEO, Sam Palmisano, provided the traditional overview for IBM's third quarter results in a statement accompanying the numbers, saying that IBM has done well in a challenging environment. And he took on the question to which everyone wants an answer: what does the future of IT spending look like? "We are beginning to see signs that the economy has stabilized," Palmisano said in the statement. "As we look to 2004, more customers are expected to increase their investments in information technology. While demand is not yet across the board, it is strongest in the areas where we have positioned the company and strengthened our capabilities." Specifically, he said that IBM would need to fill some 10,000 positions in key areas such as middleware, Linux, Wintel and Lintel servers, and unspecified "high value" services. He said further that $200 million of the company's $700 million in annual training and education budget would be spent on gearing up some 100,000 existing employees to go after the highest-demand IT products and services. But don't count on a recovery in 2004 just yet, because Palmisano does not want to be the one to first call a recovery in IT spending, and therefore to be lionized for calling it wrong if a recovery does not materialize. "Although it is too early to say that a rebound is at hand, we are confident that we will benefit from both a pick up in IT spending and an economic recovery."

IBM's chief financial software, John Joyce, reiterated that sentiment in his conference call with Wall Street analysts after the results were announced. "Overall IT spending remains good, but not robust," he said. "Customers remain cautious with capital spending." He said later in the call that IBM was comfortable with an average of Wall Street's estimates for sales and profits in the fourth quarter. The financial services sector seems to be perking up (which has accounted for 25 percent of IBM's sales in the first three quarters of 2003), and IBM is also making some headway into the small and midsized business market (which accounts for about 23 percent of its total sales so far in 2003).

IBM's total worldwide sales in the quarter were $21.5 billion, up 8.6 percent. Net income was up 35.9 percent, to $1.8 billion, thanks in large measure to Big Blue's exit from its unprofitable hard disk drive and aluminum chip making businesses. Earnings per share in the quarter came to $1.04, up 33.3 percent from the 78 cents it posted this time last year.

Currently, 65 percent of IBM's sales come from services and software, and half of its sales come from services alone. The annuity-like nature of these products means that IBM does not have to continually sell products to many of its customers. IBM's Global Services unit booked $10.4 billion of sales in the quarter, up 17 percent as reported (up 11 percent at constant currency in each of the regions where IBM does business). The company had $15.4 billion in new services signings in the third quarter, and grew its backlog to $115 billion. Joyce said that the services pipeline looks to be up sequentially for the fourth quarter, and that it is seeing services growth in all geographies and products. IBM's maintenance businesses grew by 7 percent, while outsourcing grew by 13 percent, business consulting services grew by 53 percent, and integrated technology services (which include maintenance and tech support services) fell by 2 percent. In local currencies, these growth percentages shift down by 5 to 8 percent.

IBM's Software Group, which sells operating systems, databases, middleware, systems management, and development tools, had sales of $3.5 billion in the quarter, up 11 percent compared with the third quarter of 2002 (5 percent at constant currency). Operating systems accounted for $610 million in sales in the quarter, up 6 percent as reported and flat at constant currency. Other products, which IBM lumps into a generic "middleware" category, accounted for $2.7 billion in sales. In the quarter, WebSphere middleware sales were up 12 percent, DB2 database sales were up 14 percent, Tivoli systems management sales were up 25 percent (helped by an easy compare), and Lotus groupware and messaging sales were up 9 percent as reported. The acquisition of the Rational tools contributed to 37 percent of the growth in the "middleware" piece of IBM's software pie, or about 5 points of growth as reported.

Across all of its hardware units, IBM sold $6.7 billion in kit of various types, down 1 percent as reported and down 5 percent in local currencies. For the three quarters of 2003 completed, hardware accounted for 30 percent of total sales, so don't think IBM is not a hardware company anymore. It is.

In the Systems Group, which sells servers and storage, sales were $3.2 billion, up 6 percent (flat at constant currency). Intel-based xSeries server sales were up 16 percent in the quarter, with high-end sales of xSeries 440, and 445 "Summit" servers were up 40 percent compared with the third quarter of 2003. Margins for this line improved despite intense pricing pressures, no doubt helped by the xSeries 440, which is less costly than a Unix server but is a loss more expensive for a unit of processing capacity than an entry Wintel or Lintel box.

Sales of pSeries and iSeries Power-based server platforms were each up 5 percent as reported, and it looks like sales in the pSeries line were impacted by shortages of Power4 and Power4+ processors and possibly other components. Joyce said that the pSeries line was in strong demand during the third quarter and that it would post its fifth consecutive quarter of market share gains in the Unix server market once the analysts tallied up their estimates. He also said that Linux use on the iSeries is on the rise, that 25 percent of new iSeries machines shipped in the quarter had at least one Integrated xSeries Server, Intel-based coprocessor installed, and that $10 million of on-demand excess capacity was activated on installed iSeries machines in the quarter.

Sales of the zSeries were up 1 percent as MIPS shipments rose by 30 percent, driven in part by shipments to IBM's Global Services for outsourcing contracts and Global Financing for operating leases. (It would be interesting to see what these two units pay for a unit of mainframe processing capacity, since IBM could make it anything it wants.) Nonetheless, IBM had to cut prices on mainframe hardware in the quarter to make it more competitive, which impacted sales.

While sales of "Shark" storage arrays declined by 10 percent, Joyce said that IBM expected to regain lost share in the fourth quarter and that sales of cheaper FAStT storage arrays were up 85 percent, driving up midrange storage sales by 33 percent. IBM's tape product sales were up 18 percent (13 percent at constant currency).

Over in its Personal Systems Group, which sells printers and PCs, sales were up 2 percent as reported, to $2.8 billion, with ThinkPad notebooks up 8 percent and desktops down 6 percent. Pricing pressures on desktop machines pushed the Personal Systems Group to a $50 million loss. Joyce said IBM's goal was to reach profitability in the Personal Systems Group in the fourth quarter. IBM's Technology Group, which used to sell disk drives and aluminum chips, is now focused on selling copper chips and intellectual property. Sales at the Technology Group were $882 million in the quarter, down 30 percent, and it lost $96 million. Yields at IBM's new 300mm wafer copper chip plant in East Fishkill, New York, continued to improve, and Joyce said that IBM could now do 350 wafer starts a day. While this is well below its full capacity, he said that IBM is only going to tool up as its chip customers demand it. He also said that he expected the Technology Group would book about $1 billion in sales in the fourth quarter; the unit is at break-even, at $1.1 billion in sales.

On a geographic basis, the Americas region posted $9.4 billion in sales, up 4 percent as reported, with the United States having a tough compare and sales in Latin America and Canada picking up. IBM's revenues in the EMEA (Europe, Middle East, Africa) region saw sales blossom to $6.8 billion, up 19 percent as reported and 7 percent at constant currency. Sluggish sales in Europe have been hurting IBM, and this must be a relief. Joyce attributed this to "better execution" by the sales teams in this area. Sales growth across Europe was highest in the United Kingdom, up 16 percent when measured in pounds sterling. Sales in Germany were up 3 percent, and sales were flat in Italy; Germany and Italy were in decline in the second quarter of 2003. The Asia/Pacific region booked $4.8 billion in sales, up 11 percent in constant currency. Profits in this region were under pressure, said Joyce, because one of its largest competitors was engaging in market-share protection through price wars. IBM's sales in Japan were flat as measured in yen, which translated into a small gain when booked in dollars back at Big Blue's Armonk, New York, headquarters. Sales in Korea, Australia, New Zealand, China, and the ASEAN region (which includes Brunei, Cambodia, Laos, Indonesia, Malaysia, Myanmar, the Philippines, Singapore, Thailand, and Vietnam) all experienced double-digit revenue growth compared with the third quarter last year.