IBM's Third Quarter Is Decent; iSeries Sales Down but Improving

by Timothy Prickett Morgan

IBM is holding up a little bit better this year than most IT vendors. And like the other vendors, the company is taking it one quarter at a time in 2004. Having had three solid quarters this year, and one of its best third quarters in the past decade, IBM is looking forward to a good showing in the final 13 weeks of the year.

Say what you will about Louis Gerstner, IBM's former chairman and CEO, who is now chairman of The Carlyle Group (yes, the politically connected investor in defense and electronics companies), but he taught IBMers how to run the company in an aggressive manner that would have made founder Tom Watson proud. But he also taught cooperation inside IBM, which Watson would have been adamantly against, since he liked to have ideas to compete and win. IBM's current chairman and CEO, Sam Palmisano, has spent two years basking in the benefits of the IBM product and marketing system that Gerstner created, fueled in large part by the company's focus on services, on having a broad product portfolio that feeds into services, and on getting new hardware and software technologies out of the labs and into products much more quickly than it could before Gerstner arrived. If there is any reason why IBM has been able to ride out the downdraft in IT spending, Gerstner's revamping of the company is it.

For the third quarter, IBM booked sales of $23.4 billion, up 8.9 percent. Gross profits were $8.65 billion, up 10.7 percent. As the company rolled out new servers, storage, and software in the quarter, its sales, research, and development costs rose, putting pressure on profits. IBM had income from operations of $1.8 billion, up 1 percent. Income in the quarter would have been even higher if the company had not paid $237 million to settle a class-action lawsuit over its pension plan. Thanks to stock buybacks, IBM was able to boost earnings per share by 3.9 percent, to $1.06.

IBM has a broad product mix, so there is always something that is not selling well. As was the case in the second quarter, the iSeries did not do so well, with sales down 26 percent. Mark Loughridge, who took over as IBM's chief financial officer a few quarters ago, initially skimmed over the iSeries in his presentation, blaming the decline in sales on the transition to i5/OS V5R3. In a conference call with analysts, he offered a few more thoughts on what was going on with the iSeries, especially with respect to the small and midsized business market, which IBM pushes the iSeries into when it cuts its revenues across industry sectors. In the first nine months of 2004, IBM sold $15 billion in hardware, software, and services to small and midsized businesses, which represented 22 percent of the company's $68.8 billion in total sales for those months. Obviously, all of that SMB sales is not from the iSeries (IBM sells lots of Windows boxes to SMB shops), and I am reasonably certain that all of the iSeries sales do not end up in this category. (Maybe they do? IBM is quite vague.) IBM also breaks out financial services, public, industrial, distribution, and communications sectors as separate revenue segments in its financial presentations, as if small and midsized businesses were not in these other industry sectors. This presentation seems to show that 80 percent of IBM's sales come from the top five, 10, or 20 percent of its customers, while at least half of its installed base comes from smaller customers, which do not seem to buy a lot of stuff from Big Blue.

"Aside from iSeries, our SMB performance was reasonable, especially across software and services," said Loughridge. "The iSeries transition is taking longer than I think we expected, although as we look forward into the fourth quarter, we see significant improvement from the third to the fourth quarter." Loughridge was alluding to the recent product announcements, which have been coming out since May. "This customer set is now absorbing what is an extremely powerful offering for them on a price/performance basis. We're confident in the long-term capability and we will see improvement going forward."

IBM's overall hardware business was dragged down by iSeries sales being sluggish, and so were its software sales, since OS/400 and its integrated DB2/400 database are sold under perpetual licenses. Even with the iSeries drag, IBM's hardware sales were up 12 percent, to $7.5 billion. The Systems and Technology unit, which is comprised of servers, storage, chips, and other technology, had sales of $4.1 billion in the quarter, up 9 percent, while the Personal Systems unit (which includes PCs, laptops, retail systems, and printers) saw sales rise 17 percent, to $3.3 billion. ThinkPads and desktops had double-digit revenue growth, while store system sales boomed and were up 50 percent.

Sales of zSeries mainframes were up 12 percent, with MIPS shipped in the quarter up 17 percent, compared with this time last year. Sales of pSeries Unix servers were up only 1 percent in the quarter, thanks to the same product transition the iSeries is dealing with as it moves from Power4 to Power5 chips. Loughridge also said that sales of Unix kit in Europe was down 17 percent, and he attributed the decline to the product transition as well. Unix server sales in the Americas were up 9 percent, and sales in Asia/Pacific were up 8 percent, Loughridge said. Why the transition to Power5 is affecting Europeans and Asians more than Americans is a bit of a mystery. Only IBM really knows what it going on, and Loughridge's statements raised more questions than they answered. Why is the transition not affecting Unix sales in the Americas? The xSeries servers, which are based on Intel and Advanced Micro Devices X86 processors, exploded by 26 percent; and this was the tenth consecutive quarter of double-digit growth for IBM's xSeries line. Loughridge said that blade server sales were up 140 percent in the quarter and that blade products are now a significant contributor to profits in the xSeries line.

Storage sales, including disk and tape together, were up 5 percent in the quarter, and were similarly muted by product transitions. Overall disk sales were down 1 percent in the quarter as midrange disk sales climbed by 27 percent. Loughridge said that, on the technology front, chip yields at the 300mm fab in East Fishkill, New York, had doubled again in the third quarter and that IBM expected yields to improve by another 40 percent in the fourth quarter.

Loughridge also said that server sales in emerging markets like Russia, China, India, and Brazil were up 30 percent or more in all of those regions in all of the three quarters of 2004, and this appears to be one of the primary drivers of big iron sales for IBM. This presumably includes the company's core server brands, including the iSeries. Think about it. If IBM were not seeing booming sales in these areas, iSeries sales would have been a lot lower, and even pSeries sales would have gone south. Take out those four booming markets, and even zSeries sales might have flatlined this year.

IBM's Global Services business, which accounts for just under half of total sales, accounted for $11.4 billion in sales, up 10 percent. IBM's long-term booking declined by roughly half in this quarter, and Loughridge explained that the average term for both long-term contracts (spanning years to a decade) and short-term contracts (running a year or less) is contracting as customers negotiate for shorter terms, in order to give themselves more flexibility. IBM's backlog declined by about 3 percent, to $110 billion (that's after the removal of the giant contract it lost with JPMorganChase, which is taking its IT back in-house), and it had bookings of about $10.5 billion in the quarter. Loughridge was at pains to explain that the shortening of contracts was good news, in that it allows IBM to recognize revenues on contracts in a shorter term, and he said that IBM believes it can continue to grow revenues in services in the coming year, even as this change ripples into its services business.

For the third quarter, the Software Group had sales of $3.6 billion, up 5 percent, due mostly to currency effects. Operating system sales were $600 million, down by 2 percent (again, blame the iSeries for the decline), and middleware sales were up 6 percent, to $2.9 billion. Host-based middleware sales increased 5 percent, while middleware for Unix, Linux, and Windows servers increased 7 percent in the quarter. WebSphere family products were up 14 percent, but Lotus middleware sales declined 6 percent. DB2 sales across all platforms increased by 15 percent, and DB2 tools grew by 34 percent. IMS database sales were a lot lower, and other legacy middleware products saw sales decline, said Loughridge. Tivoli systems management products grew by 21 percent in the quarter, aided by the acquisition of Candle, and Tivoli security product sales were up 47 percent.

From a geographical perspective, sales in the Americas were up 8 percent (up only 7 percent at constant currency within the countries in the region), to $10.1 billion. In Europe, the Middle East, and Africa, sales were $7.3 billion, up 8 percent as booked back at IBM headquarters in New York but flat in the local currencies, where IBM actually sold the gear. In the Asia/Pacific region, IBM booked sales of $5.3 billion, up 11 percent as booked, but only up 6 percent in constant currency. IBM's OEM revenues (which span all geographies) were up 13 percent, to $726 million.