IBM Hit by Financial Services Slowdown in Q3

Published: October 22, 2007

by Timothy Prickett Morgan

Financial services companies, particularly among large enterprises based in the United States, slammed the brakes on IT spending in the third quarter and nearly gave IBM a financial haircut. Thanks to very strong bookings in past quarters for services that were delivered between July and September and to the continually weakening U.S. dollar, IBM's financial cookies were saved despite the weakness in the financial services sector. IBM's sales were up 6.6 percent to $24.1 billion and net income rose by 6.3 percent to $2.4 billion; earnings per share, thanks to an accelerated share repurchasing funded by debt earlier this year, rose by 15.9 percent to $1.68 per share.

The news that the financial services sector was experiencing a slowdown, at least for IBM's business groups, was probably not a big surprise to Wall Street analysts. The Dow Jones Industrial Average has recovered (for now at least) after a wild ride in the past couple of months thanks to the housing market woes in the United States, and IBM's stock is hitting nearly $120 a share (a level Big Blue's stock hasn't seen since the dot-com boom). So long as Wall Street analysts were calling IBM shares a good buy, then their end-of-year bonuses seem to be secure for the coming holiday season. The question now is will the markets hold together long enough for the business fundamentals to catch up, or will the underlying economy in the United States take a dive and bring the rest of the world down with it. At that point, we can all kiss our sweet bonuses goodbye. . . .

Mark Loughridge, IBM's chief financial officer, said repeatedly in a call with Wall Street analysts on Tuesday that by his reckoning, this was not the beginning of a more general slowdown in IT spending. "I would not look at this and say it was a general economic decline," he said in a conference call with Wall Street analysts. "I would say that we have a financial services sector slowdown, mostly localized to the U.S."

The sharp decline in System z mainframe sales and a number of deferrals of very large software deals in the third quarter were to blame for IBM not doing better, and Loughridge insinuated that these were mostly due to decisions at banks, mortgage providers, insurance companies, and other financial services firms to halt their spending. Loughridge said that of the software deals deferred in the quarter, 70 percent were from the financial sector. This is IBM's biggest sector for doing business, and even with the deferrals of mainframe and software purchases, IBM's sales to financial services firms rose by 5 percent to $6.6 billion in the quarter (but rose only 1 percent at constant currency). That flagging growth knocked about 1 percent off IBM's overall revenue in the quarter, according to Loughridge, who said further that at the beginning of the quarter sales were rising by 9 percent in July. But then the subprime mortgage crisis hit, and financial services companies started closing their purses.

IBM's hardware business, which was helping it get through a rough patch in the services business last year, was relying on the services business to help it get through its own rough patch in the third quarter. IBM's Systems and Technology Group reported sales fell by 10 percent to $4.9 billion--a drop of 13 percent at constant currency. System z mainframe sales, which have been growing for eight consecutive quarters, took a dive, with sales down 31 percent (34 percent at constant currency, showing how the dive was steeper in the United States) and MIPS shipments falling by 21 percent in the quarter. Transitions to Power6 processors and a new user-based pricing model for System i machines didn't help in this business, and sales fell by 21 percent; the single Power6-based server that IBM is selling helped out the System p midrange Unix server business, which rose by 26 percent in the quarter, according to Loughridge, but overall System p server sales only grew by 6 percent. "I think System p had a pretty good quarter," he said.

Both the System i and the System p server lines would probably be having much better quarters if the Power6 processors and their related servers were already to market. IBM has been dodging questions about where the Power6 revamp is. But clearly customers had expected a full line of Power6 machines by now. One machine with two labels--the Power6-based System i 570 and System p 570--and the promise of a Power6-based blade server by the end of the year does not constitute a product line.

Loughridge blamed relatively weak System x X64 server sales on the transition to quad-core processors, but some of IBM's System x machines have had quad-core chips since early this year. So that can't be the only issue. Competition probably is, and Hewlett-Packard and Dell have done a good job competing against Big Blue in entry and midrange X64 servers. IBM's midrange disk sales were weak, but tape products and high-end disk arrays helped overall storage sales increase by 1 percent. IBM's OEM chip business, mostly for game consoles, fell by 15 percent in the quarter.

IBM's Global Services group not only filled in the revenue gaps left by the hardware business, but cost controls allow the services business to drive a 25 percent increase in profits. (When is the last time this happened? When was the first time, in fact?) Global Technology Services had sales of $9.1 billion in the quarter, up 12.8 percent, while Global Business Services had sales of $4.6 billion, up 15.9 percent. Total services sales were up 14 percent to $13.7 billion in the third quarter. Telecommunications firms, small businesses, wholesale and retail distributors, and governments were the strongest areas for IBM in the quarter for its GBS division, and Loughridge said in the conference call with Wall Street analysts that IBM had growth in all geographies and all sectors within the GBS division, which provides business process transformation and outsourcing services, among other things. On the GTS side, which includes outsourcing, systems integration, and hardware and software maintenance for IBM and other products, signings for short-term contracts fell by 3 percent in the quarter to $1.8 billion, but long-term signings (which will help future quarters) rose by 19 percent to $5.3 billion. GBS signings are more of a short-term affair, and short-term signings fell by 6 percent to $3 billion and long-term signings rose by 80 percent to $1.6 billion. Total services contract signings rose by 12 percent to $11.8 billion in the quarter, and IBM had an estimated services backlog of $116 billion, up 6 percent over the backlog in the year-ago quarter.

Loughridge explained that the improvement in the Global Services group was the result of a lot of hard work, which IBM started two years ago. "The result has been consistent improvements in utilization, better contract quality, and increased profit margins," Loughridge said. "And as we've seen in the past few quarters, profitable growth. We feel great about how this business is now positioned. This is the best all-around services performance that we've seen in a long time."

Software Group could have done better than it did in the quarter, but being tied as heavily as it is to IBM's mainframes and to customers in the financial services sector, software sales of $4.7 billion, up 7 percent, is not so bad. IBM's key branded middleware products had modest growth, with WebSphere middleware up 10 percent, DB2 and related databases up 9 percent, Lotus groupware up 9 percent, Tivoli systems management tools up 5 percent, and Rational development tools up only 3 percent. When you knock off currency effects thanks to the weak dollar, growth is in the single digits for these businesses. Despite the slowdown in server sales, IBM managed to increase operating system sales by 2 percent, which is a neat trick.

Looking ahead, Loughridge said that he was pretty confident IBM would close many of the software deals that had been deferred in the third quarter, and that initiatives to get mainframe shops with older iron to move up to newer System z9 machines would help bolster hardware sales. He said that IBM expected hardware sales to be flat in the fourth quarter compared to last year, which would be a big improvement over this quarter, and was confident that IBM could boost software sales and profits by double-digit percentages compared to last year as well.

On a geographical basis, IBM's sales in the Americas region came to $10.2 billion in the third quarter, up 4 percent (up 3 percent at constant currency), while sales in EMEA were up 11 percent to $8.1 billion (but only up 4 percent in local currencies). The Asia/Pacific region seems to be flagging a bit thanks mostly to Japan, with sales up only 9 percent (6 percent at constant currency) to $4.9 billion. IBM's OEM technology business, which is mostly chips for game consoles, brought in $890 million in the quarter.

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