IBM Defies Financial Gravity No Longer, Server Sales Down

by Timothy Prickett Morgan

Joyce told Wall Street that revenues for the first quarter would be in the range of $18.4 billion to $18.6 billion, down about 12 percent from the $21 billion in sales IBM posted in the first quarter of 2001. The consensus among Wall Street analysts, according to those surveyed by market data firm First Call/Thompson, was that IBM would hit $19.7 billion in sales, despite the tough economic climate. Joyce said that IBM is expecting pre-tax earnings in the range of $1.65 billion to $1.7 billion, down about 33 percent from the $2.49 billion pre-tax earnings from the first quarter of 2001. Earnings per share, said Joyce, is expected to be down in the range of 66 cents to 70 cents, which is down about 31 percent from the 98 cents IBM brought to the bottom line in the first quarter of 2001.

Joyce said that, as IBM has warned in the past year, business conditions remain difficult. He said that customers were continuing to delay hardware, software, and services purchases because they were not confident in the supposed economic recovery underway in the United States. He said that IBM is seeing across-the-board weakness among its business units, and singled out its OEM business from the Technology Group as one of the reasons for the decline. Joyce said that IBM expected Technology Group's revenues, which come from sales of custom logic chips, hard disk drives, and displays, among other things, would be down around 35 percent in the quarter and would lose about $200 million on a pre-tax basis, accounting for about 8 cents per share in IBM's earnings decline.

Although IBM didn't say it, one of the things that has contributed to its diminished sales and profits at Technology Group is the significant engineering problems IBM has had with its 10K RPM disk drives, which have been failing in the field at higher rates than expected for more than a year, as well as its lateness in bringing out 15K RPM disk drives. IBM has reportedly gone to rival Seagate Technology for the disks its uses in its enterprise servers, after relying almost solely on its own units in some product lines. This would have the double-whammy effect of reducing Technology Group's revenues and reducing IBM's profits because it is not getting disks at cost in its server lines.

The speculation on Wall Street is that IBM's new CEO, Sam Palmisano, is setting the bar low so he can look like a hero next year when the IT sector rebounds. He can say out loud, and honestly, that he inherited a bad IT market, and whisper that IBM is changing its ways in the aftermath of the closer scrutiny that all public companies are getting with so many high-flying companies going bust. IBM is reportedly telling analysts that Palmisano is now managing expectations and that sales at the end of the first quarter were disappointing, according to Steve Milunovich, the lead IBM-watcher at Merrill Lynch.

Milunovich has revised downward his revenue and earnings numbers for Big Blue for calendar 2002 and 2003. Milunovich says that he expects IBM's server revenues to be down 14 percent in the first quarter, to $2.7 billion. According to Merrill Lynch's IBM sales model, sales of iSeries and AS/400 servers and integrated storage would be down 21 percent, to a meager $325 million. So you can see why IBM is considering moving up the iSeries Regatta and OS/400 V5R2 announcements--there is no point in waiting on such announcements when customers are waiting to buy the new stuff (see "Are iSeries Regatta and OS/400 V5R2 Announcements Imminent?" for more on the iSeries Regatta announcements). IBM's mainframe revenues for the first quarter will be down 7 percent, to $600 million; pSeries sales will be down 17 percent, to $690 million; and xSeries sales will be down 20 percent, to $460 million, says Milunovich.

Milunovich figures that pSeries and xSeries sales won't do much better in the second and third quarters of 2002, and that they won't surge enough in the fourth quarter to compensate for flagging mainframe and zSeries sales and give IBM the same $4.1 billion server sales for the fourth quarter that it saw in 2001. For calendar year 2002, Milunovich reckons that IBM will bring in $13.15 billion in server sales, down 8 percent compared with last year. And iSeries sales revenues will drop to $1.58 billion, according to Merrill Lynch's IBM sales model, down 25 percent from last year's $2.1 billion. Milunovich also figures that mainframe sales will drop 8 percent, to $2.88 billion, but that xSeries sales for the year will be flat, at just over $2.43 billion, and that pSeries sales will be up 4 percent, to $3.34 billion. Mulinovich believes that each of IBM's zSeries, iSeries, and xSeries server lines will experience single-digit growth in 2003, with the pSeries line experiencing growth possibly as high as 12 percent.

The basic idea that such an economic model makes clear is that not only is the earnings bar going to be a lot lower at IBM, but so will the bar for server sales. Of course, this can change--if IBM acts boldly and immediately. With some 550,000 aging AS/400 servers and probably around 10,000 aging mainframes out there in the world, IBM could aggressively cut prices to churn and modernize those customer bases. Such a strategy would drive secondary sales of other IBM hardware, software, and services, and would make it harder for alternative suppliers to get into these IBM accounts. But as long as IBM maintains the status quo--"the iSeries offers the lowest TCO in the midrange"--and doesn't give OS/400 and OS/390 shops substantial incentives to upgrade their machinery, Merrill Lynch's model is probably on target. Moving the pSeries 670 and iSeries Regatta announcements forward two quarters doesn't solve IBM's problems. It just shifts revenues from the third and fourth quarters to earlier in the year and shifts sales slumps to later in the year. But the bigger picture will not change unless IBM changes its strategies and tactics.

IBM's general managers in Somers, New York, would do well to consider these numbers from Merrill Lynch as the Ghost of Quarters Future. A change of heart could change IBM's future. This Tiny Tim, for one, would sure like to be around in an iSeries business that is more generous, in an enlightened self- interest manner, and therefore thriving.