IBM Slapped Hard in First Quarter by Economic Downturn

by Timothy Prickett Morgan

How bad is it? Well, I am certainly no barometer, but this week I got not one call, but two calls, from IBM sales reps offering to sell me a Unix server. Considering that I am the president of a publishing company dedicated to the OS/400 platform and run my Web publishing business on that machine, I was just a little bit insulted by this. The last time this happened to me was in 1991, during the last Bush recession. At that time, The Four Hundred was being published by Technology News, and we were running our subscription systems on a System/32. IBM's sales reps showed up one day and tried to convince me to port our BRADS (similar to RPG) applications to C and run them on the RS/6000. I showed them The Four Hundred and then showed them the door. During any other time, IBM's marketing staff doesn't care if I exist; in fact, my guess is that they wish I would just drop dead, or at least come down with a severe case of lock jaw or carpal tunnel syndrome. When IBM starts trying to sell me Unix servers, I get a little worried.

But not enough to keep me from being optimistic, despite IBM's problems. Business never stops, even though a slowdown can feel like it. IBM's external server and storage sales in the first quarter of 2002 were down 21 percent, to just under $2.5 billion. According to a breakdown of server sales created by Steve Milunovich, the lead IT analyst at Merrill Lynch, the iSeries server business was down 37 percent in the first quarter, to an incredible $260 million; sales were down 33 percent in the first quarter of 2001, when they hit $412 million for the OS/400 platform. (The second, third, and fourth quarters were better in 2001, so don't panic.) Those percentages are different from the official IBM PR, in that they are based on what IBM booked in U.S. dollars, not in local currencies.

I got the distinct impression from the IBM executives I spoke with at COMMON that sales were off in the first quarter of this year because of product transitions. We hear this all the time. People expect new machines more or less every year, and nobody wants to buy last year's model until he sees this year's new model. But there are other forces at work, too. The iSeries processing capacity prices have not dropped substantially over the past several years, even as bang for the buck has improved. The only logical conclusion as to why the iSeries accounted for only $2.1 billion in sales in 2001 and might only hit $1.6 billion in sales in 2002, by Merrill Lynch's reckoning, is that companies are being stingy about what workloads they put on those beloved OS/400 servers.

Perhaps OS/400 shops are buying Model 270 servers instead of upgrading their AS/400 Model 6XX and 7XX machines to iSeries Model 820s or 830s. Perhaps they are putting more and more workloads on external Windows, Unix, and Linux machines. This would, more than anything else, explain IBM's rapid change of heart when it comes to Linux on the iSeries and its desire to position the iSeries as a Windows and Linux (and Unix by extension) server consolidation platform. Consolidation sells bigger boxes, which have a lower cost of sales (fewer calls and fewer feet are necessary), and hence increase profits. Higher profits on bigger boxes gives IBM and its resellers the money to chase new customers, who typically start out at the low-end. This is a good strategy, and, provided IBM makes the right incentives, it will work. The simple fact is that those existing 250,000 OS/400 server customers out there in the world buy a heck of a lot of server capacity. They just aren't buying enough iSeries capacity, and they are the easiest people to convince to do so.

Merrill Lynch reckons that zSeries mainframe sales were off 22 percent, to $505 million; pSeries Unix servers were down 25 percent, to $625 million; and xSeries Wintel-Lintel servers were down 4 percent, to $559 million. IBM's disk array and tape storage businesses were down 19 percent, to $535 million. (This is not IBM's OEM disk business, but Shark and Fast disk arrays.) IBM's overall Enterprise Systems pretax profits (all servers, their internal storage, and all external storage products) were down 55 percent, to a wafer-thin $177 million. If zSeries and iSeries sales were profitable, as I assume they were, then the pSeries and xSeries lines must be hemorrhaging red ink like harpooned whales. No one is talking about this on Wall Street, except for Sun Microsystems.

Overall hardware sales--including raw disk drives, custom chips, servers, PCs, workstations, and printers--fell by 25 percent, to $6.4 billion, in the second quarter. Software sales were down a bit, to $2.9 billion, driven lower by flagging sales of iSeries and pSeries operating systems, according to IBM's chief financial officer, John Joyce. Operating systems revenues were off 7 percent in the quarter, and middleware sales, driven mostly by WebSphere and the inclusion of Informix Unix databases to the IBM product mix, were up by 6 percent. Sales of middleware products on Unix and Windows servers were up 13 percent in the quarter, while sales of similar software on zSeries and iSeries machines were up only 3 percent. (All of these percentages are at constant currency.) Middleware sales--mostly software rentals on mainframe systems software--account for about two-thirds of IBM's overall middleware sales. Middleware--which includes DB2, IMS, and Informix databases, various transaction monitors, WebSphere application servers and add-ons, Domino messaging, and other similar software--accounts for 80 percent of IBM's software sales now.

Sales at Global Services were down 3 percent, to $8.2 billion, but gross profit margins were up 26 percent, to just over $1 billion. IBM booked a record $15 billion in services deals in the quarter, the best first quarter the company has ever had for services, with an increase of over 50 percent. IBM has an absolutely enviable backlog of $108 billion in services deals. This amounts to more than a year's worth of revenue for IBM, and is second only to the cash hoard of Microsoft.