Slowing U.S. Sales Hurt IBM's First Quarter

Published: April 24, 2007

by Timothy Prickett Morgan

IBM reported its financial results for the first quarter of 2007 last Tuesday, kicking off the earnings season for the year for the major players in the IT market. Big Blue's sales were just a hair over $22 billion, up 6.6 percent, with net income of $1.8 billion, up 8 percent. The interesting news is that sales were flat in the United States, and as you might expect, sales in the booming Asia/Pacific region helped give IBM growth. Europe, which is often a problem area when it comes to growth for IBM, helped out this time, too, thanks in large part to the strength of the euro against the dollar.

"IBM's good results in the quarter demonstrate the breadth of our global capabilities, the advantages of our business model, and our focus on profitable growth," said Sam Palmisano, IBM's chairman, president, and chief executive officer in a statement. "We continued to grow in the higher-value products and services that help our clients transform their businesses. We again grew gross profit margins and earnings, and continued to generate significant cash from operations. This gives us considerable financial capability to strengthen our position in the profitable growth segments and create further value for our investors." Palmisano does not attend quarterly conference calls with Wall Street analysts, and his comments in the quarterly financial statements, like those of Louis Gerstner, his predecessor, are an exercise in trying to say the same exact thing every quarter using new words. (I know the feeling.)

Of course, every quarter is a little different, and in this one, IBM's sales to large enterprises in the United States ran out of gas in March, according to Mark Loughridge, the company's chief financial officer, who does take questions from Wall Street. Loughridge said that sales were humming along okay in January and February, but tapered off, which meant that sales in the U.S. were actually flat compared to the first quarter of 2006. This pulled down sales in the Americas region, which grew by only 1 percent to $9.1 billion in the quarter, compared to 13 percent growth in EMEA to $7.6 billion (8 percent of that was currency) and 10 percent growth in Asia/Pacific to $4.5 billion (only 1 percent of that growth was due to currency).

Loughridge did not want to make a big deal about this miss in the United States, and he did not give a lot of detail about what went wrong. He said that some deals did roll over into the second quarter in the States, and said further that IBM had a "pretty good" pipeline in the second quarter and that he expected to see "modest growth" and said that he "was not going to make an economic forecast" for the United States based on IBM's Q1 results. At the end of the call, when pressed by callers to explain the situation a little more and how it might affect the rest of the year, Loughridge said that the good growth in Europe and Asia were going to help IBM meet its growth projections for 2007. Germany, which is IBM's third biggest country for sales, was up 10 percent in the quarter, which he said was a "huge rebound."

IBM may be a services and software company, but its systems are still the products that tie customers to IBM and its software and services to a large extent. (Big Blue will never admit this, of course, since it would be admitting that the shift from hardware to software and services in the 1990s was mostly a means of charging for services and expertise that used to come as part of IBM systems back in the 1970s and 1980s.) IBM's Systems and Technology Group had sales of $4.5 billion in the quarter, up only 2 percent and flat at constant currency. Sales for this group actually fell in the United States, but Loughridge did not say by how much.

The company's System z mainframe line saw revenues go up by 12 percent in the quarter, with MIPS shipments (an ancient measure of the aggregate performance of a mainframe) up 9 percent. This marked the seventh consecutive quarter of year-on-year MIPS shipment growth. Mainframe sales in Europe and Asia grew in the double digits.

The System i family of Power-based servers, which run its i5/OS operating system and DB2/400 database, had weak sales again, down 13 percent, but that was better than the 22 percent decline a year ago. The high-end of the System p Power-based servers, which run AIX, had a good showing, and helped drive sales up 14 percent. (Of course, System p sales declined by 9 percent a year ago.) System x X64-based servers, which mostly run Windows and Linux, grew by 7 percent in the quarter, and sold well across all geographies, according to Loughridge. Interestingly, blade server unit shipments were up 12 percent, but revenues were flat, and Loughridge said this was due to "an unusual amount of operating lease activity."

As for other hardware, game processor sales were off in the quarter, so IBM's Microelectronics division had a 7 percent sales slump and OEM sales fell by 5 percent to $800 million. On the storage front, disk sales were off 2 percent and tape sales were flat, driving IBM's overall storage business down 1 percent in the quarter. Sales of POS terminals and related retail systems were up 7 percent, but printers fell by 11 percent and engineering and technology services fell by 6 percent.

IBM's Software Group, which is the profit engine for the company, posted sales of $4.3 billion, up 9 percent. IBM's middleware brands--WebSphere application servers, DB2 databases, Tivoli systems management, Lotus groupware, and Rational development tools--accounted for 51 percent of total software sales in the first quarter of 2007, and grew by 17 percent. Lotus was the growth laggard, at 7 percent, but the others clustered around that 17 percent figure. Other middleware products--mostly stuff that runs on mainframes--accounted for 25 percent of IBM's overall software sales, and declined by 2 percent. Operating systems accounted for 12 percent of that $4.3 billion, and were flat, and other software and services from the Software Group made up the remaining piece.

If systems are the IBM foundation and software is the IBM profit engine, then its Global Services unit is the revenue-getter. Global Services had sales of $12.4 billion in the first quarter, up 8 percent. IBM booked $11.1 billion in services deals in the quarter--about the same as a year ago--and had a services backlog about $115 billion as it exited the quarter. IBM's services oriented architecture (SOA) full-court press is resonating with customers and helped drive its Global Business Services unit up 9 percent to $4.2 billion in sales. The company's Global Technology Services unit, which is the largest piece of the company and which does outsourcing, systems integration, and system and software maintenance, came in at $8.3 billion in sales in the quarter, up 7 percent.

IBM's long-term plan for the past decade has been high single-digit revenue growth and low double-digit net earnings growth. In the first quarter of 2007, IBM's revenues were up 8 percent, despite the difficulties in the U.S., and net income was up 8 percent. More importantly, after share buybacks of $3.4 billion, IBM pushed up earnings per share by 12 percent to $1.21 per share.

Today, you could argue that there are two bellwethers of the global IT economy. One is, of course, IBM, and the other is now Hewlett-Packard. When IBM dwarfed HP some years ago and participated in many other markets--including PCs, hard disk drives, networking, and printers--you could say that IBM alone was the best indicator of the health of the IT market. But with IBM having a focus on services--which accounts for more than half of its sales--and on software--which drives its profits thanks to its monopoly on mainframes and System i platforms--Big Blue alone is perhaps only half the story. HP, which dominates printers, PCs, and X64 servers, is the other half of the IT story.

If you add IBM and HP together, you get approximately one-sixth of the global IT sales in any given quarter. HP will generate more IT revenues during calendar 2007 than IBM will, particularly after IBM divests its remaining high-end printer business to Ricoh.

It will be interesting to see what happens with HP's U.S. business.

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