IBM Closes 2002, Glad It Ditched Some Units and Hopeful for 2003

by Timothy Prickett Morgan

Unless you are obsessed about economics or are an investor in Big Blue's stock, you probably don't much care how IBM does financially as each quarter winds down. Except, that is, if you happen to be in the IT business in a direct or indirect way. Then, how IBM is doing matters a great deal. If IBM and its equally large behemoth competitor, Hewlett Packard are seeing the IT market stabilize, that is good news for all of us.

I'm never sure if I should call IBM a bellwether of IT spending, which in one way or another affects whether or not we can pay our mortgages, car payments, and such. IBM accounts for about one-tenth of all IT spending worldwide, and with its partner channel added in, what IBM sells probably comes to about a quarter of the $1 trillion or so that goes into IT budgets a year. Anything with that much influence in a market is setting the market as much as being affected by it. That said, if IBM is hinting that the decline in IT spending that we have all suffered through since late 1999 might have finally found a floor, this is cause for a certain amount of celebration. IBM's chief financial officer, John Joyce, did not come right out and say this to Wall Street analysts when IBM announced its results two weeks ago, mainly because he doesn't want to say anything that will get Big Blue's stock in a bind if the IT market takes a turn for the worse. But Joyce was certainly peppier than he has been in many a quarter, which is all the more remarkable considering how competitors Microsoft, Sun Microsystems, and Oracle have been getting more cautious because of specific competitive pressures they are under.

IBM's worldwide sales across all products was up 7 percent in the fourth quarter of 2002 to $23.7 billion and down 2.3 percent for the year to $81.2 billion. Net income per share for the fourth quarter was down 24 percent in the quarter to $1.11, not counting a 52 cent hit against earnings for discontinued operations, and was down 53 percent for the year to $2.06 a share after a $1.01 hit for those discontinued operations (mostly chip, hard disk, and display businesses that have been sold or closed.)

The economy in the United States seems to have improved in the quarter, with sales in the Americas up 5 percent as reported (7 percent at constant currency) to $10.3 billion. In local currencies, sales in Europe, the Middle East, and Africa were only up 1 percent in the fourth quarter, but when translated to dollars and brought back to IBM's New York headquarters, EMEA sales grew by 13 percent to $7.8 billion. Joyce said that the economies in Germany and the United Kingdom continued to be weak and dragged down sales. Within the Asia/Pacific region, sales in local currencies were up 4 percent, but increased 7 percent when brought back to the U.S. to $4.8 billion. Japan accounts for 60 percent of sales in the AP region, and Joyce said the economy there remains fragile and doesn't have any momentum. Sales in China and Korea were growing nicely, however, and helped buoy the rest of the area. IBM breaks out OEM deals separately from its geographical data, and the remaining OEM businesses --mostly custom chip manufacturing and engineering services--shrank by 11 percent to $828 million in the fourth quarter.

While not the big money maker that it used to be the server business is still a primary driver of IBM's software and services businesses, so how it does is important. Server and storage sales were down 1 percent (at constant currency) to $4.2 billion. In the fourth quarter, zSeries mainframe sales were down 4 percent, pSeries sales were flat, iSeries sales were down 13 percent, and xSeries sales were up 14 percent. Joyce said the aggregate amount of zSeries MIPS shipped were up 13 percent, and Linux MIPS shipments were up 45 percent compared to this time last year. He said iSeries sales were impacted by an upcoming announcement, which was a bit of a stretch, since no one knew outside of IBM that new machines were coming until 2002 had ended. The iSeries business was down because customers were wary of spending money and hopeful of new machines with better pricing sometime in 2003. The machines came in earlier than expected, because IBM doesn't want to see the iSeries decline further in 2003. pSeries Unix server sales were flat because of the intense competition in the market and a glut of processing capacity among many of the core financial services, telecoms, service providers, and other companies who love Unix machinery. The xSeries line was propped up mightily by the xSeries 440 line of high-end machines, which are adversely affecting sales of other eServer brands at IBM accounts. These very powerful machines, which run Windows or Linux, offer great bang for the buck and are offered as adjunct machines for iSeries customers.

IBM doesn't provide a breakdown of its various server sales, but Steve Milunovich at brokerage house Merrill Lynch does have a model that shows such a breakdown. He reckons that for the fourth quarter of 2002, IBM sold $619 million in iSeries server hardware that was booked in the $4.2 billion in Server Group's system and storage sales for the quarter. For the full year, he believes the iSeries represented just under $1.7 billion in sales, of a total of $12.6 billion. IBM's systems sales (servers plus storage) declined by 8 percent for the year, while he estimates iSeries sales shrank by close to 21 percent. zSeries sales for the fourth quarter were just over $1 billion, and hit $2.9 billion for all of 2002 (down 8 percent from 2001). Merrill Lynch figures pSeries sales were $882 million in the fourth quarter and $2.7 billion for all of 2002 (down 16 percent from 2001). The xSeries Intel-based server line blew by the iSeries and pSeries line to become IBM's second-biggest revenue maker, with more than $2.8 billion in sales for 2002 (up 14 percent), but IBM only sold $863 million worth of machines in the fourth quarter. Merrill Lynch's model for 2003 indicates xSeries will account for about $3.4 billion in sales, outstripping zSeries, pSeries, and iSeries lines individually that will, Milunovich expects, only bring in about the same sales in 2003 as they did in 2002. This model, we must add, was created before the iSeries line was revamped, and it is hard to believe that the iSeries will not, despite deep price cuts, stimulate enough demand to do better in 2003 than it did in 2002.

IBM's Global Services unit, which has absorbed the consulting unit of accountancy PricewaterhouseCoopers, saw sales grow to $10.6 billion, up 13 percent at constant currency in the quarter. While maintenance revenues were flat in the fourth quarter, services revenues were up 15 percent and IBM had its second biggest quarter for services contract signings in the fourth quarter, with $18 billion in signings. IBM's backlog continues to grow, with $112 billion in services in the pipe for future revenue recognition as these services are provided. While IBM's outsourcing and integration businesses were essentially flat, business-consulting services (driven by the PwC biz) were up 52 percent in the quarter. Buying PwC seems to have saved IBM's services cookies, so to speak. IBM's Personal and Printing Systems business, which is a persistently smaller portion of IBM's overall business, accounted for $3 billion in sales. IBM's PC business made a profit in the quarter and for the full year, mostly thanks to its outsourcing of manufacturing. On the software side, sales were flat at $3.8 billion, and down 2 percent at constant currency, reflecting the intense competition IBM feels in the database and middleware markets and the difficulty it has growing software sales when its zSeries and iSeries units are not doing as well as they might. Operating system sales were off 2 percent in the quarter, and middleware sales (including databases, WebSphere, transaction monitors, and so forth) were down 1 percent. Host-based middleware sales, which is mostly mainframe stuff, is about half of IBM's total software sales, and it was down 1 percent in the quarter. Middleware sales on Unix and Windows platforms was down 2 percent in the quarter. WebSphere sales in the quarter only grew at 4 percent (they were up 21 percent for the full year), and DB2 sales were up 11 percent in the quarter (but up only 9 percent for the year). Lotus groupware sales were flat in the quarter, down 5 percent for the year, and IBM believes that it lost market share against its competitors.

The thing that everyone on the conference call wanted to know about was what IBM expected for 2003. Here's what Joyce had to say:

"A year ago, we all looked ahead to 2002 and said it was going to be another demanding year, and a tough one to forecast. You will recall that strategists and security analysts were quite undecided about when to expect a turn in the market as a whole, and in the technology sector in particular. But we pointed to our business model's three fundamental strengths that served us well in a challenging economic environment. As we start the year, we already have about half of our earnings under contract. We expected to benefit from improvements in our cost structure. And we expected to gain share in key segments like s, services, storage, and servers, just as we had the year before. Few competitors could point to these strengths. So what's different a year later? Strategists and analysts are still undecided about the timing of a turn, but there is greater confidence that the tech sector has steadied. Now the question seems to be more one of how strong the recovery will be. And for IBM, those three fundamentals that helped us in a difficult 2002 will continue to help us while the market remains tough in 2003. 2003 will still have its challenges for us:

• We expect continued pricing pressure
• We've already pointed to reduced net income from our pension plans due to lowering our return · assumptions from 9.5 percent to 8 percent
• The market for intellectual property will continue to slow
• We will have more shares outstanding due to our pension funding
• Industry analysts are not expecting demand to pick up until the second half of 2003 at the earliest

For IBM's first quarter, the current Street average has nearly 10 percent revenue growth and 9 percent EPS growth. I would not get ahead of the curve and expect more than that. But the actions we took last year, the acquisitions, the rebalancing of capacity, the focus on total supply chain management, will more than offset the challenges. 2003 will be the reverse of conventional wisdom about IBM. It will be growth, aided by the acquisitions, and profit improvements that will offset weakness in pension and IP income. IBM can grow revenue and earnings in 2003 without growth in IT spending. However, as I also said back in November, most analysts in fact are forecasting modest growth in IT spending."

Sponsored By SNAP-E BOOKS

Snap-eBooks is a new publishing company dedicated to the principle that great products and tools do not have to cost a lot! Snap-eBooks completely disagrees with the current industry practice that says that you should charge whatever the market will bear for AS/400 related products. We believe that keeping the prices of our products low makes them accessible and affordable for everyone in our industry including programmers, operators, administrators, managers, and pretty much anyone else. After all, why should a book cost $89? At that price, only companies or corporations can afford them. Our low prices also mean that you can purchase however many eBooks you need, and get them when you need them. Each eBook is full of step-by-step information that you can use to immediately learn a given topic in a short amount of time. Download the Lightning-Guide eReader and then take a look at our sample eBook, called Introduction to Visual Age for RPG, and check it out for yourself just how useful our products really are.