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Volume 2, Number 3 -- January 20, 2005

IBM Ends 2004 with Most Profitable Quarter in Its History

by Timothy Prickett Morgan

If you were wondering why IBM has been shedding business units in recent years, the title of this article sums it up. The Big Blue of old, from the 1950s, 1960s, and 1970s, was interested in controlling the IT market and wringing huge profits from that control. In the 1980s and 1990s, IBM learned the hard way that it cannot control the IT market and that it needed to focus on profit. In the 2000s, IBM has shed poorly profiting businesses, shored up vintage but profitable product lines, and launched itself into areas it believes will be profitable, even if they are today a bit esoteric.

If the rein of IBM chairman and CEO Sam Palmisano can be characterized in any way, it is in its relentless pursuit of profits, even if it means pushing Linux or ditching the disk drive or PC businesses, as IBM has recently done. His predecessor, Louis Gerstner, was responsible for knocking IBM's business units into shape and getting it focused on how it must relate to the new IT market of the 1990s. Now that IBM is through its painful transition from a hardware supplier with some software and services businesses to a services and software supplier with some hardware business, the expectations for profits are pretty high for Palmisano--about as high as they were for Gerstner during the Y2K and dot-com bubbles. This is a much tougher IT market than that 1998 and 1999 market, and yet, discounting the effects of inflation, in the fourth quarter of 2004 IBM turned in its most profitable quarter in its 94-year history.

In the fourth quarter, IBM booked $27.7 billion in worldwide sales, up 6.8 percent, and brought $3.04 billion to the bottom line, up 12.2 percent. This is the first time IBM's profits broke $3 billion, and the black ink would have been deeper had IBM not had to pump $320 million in pretax money into settling claims against its pensions. If IBM is trying to convince people that it doesn't have the money to properly fund its pension, it is not making a good case by throwing off so much cash--particularly after spending $7.3 billion in stock buybacks in all of 2004 ($2.9 billion of that was used to buy IBM stock in the fourth quarter). Perhaps this is why IBM pumped $700 million into its pension fund in December and will put another $1.7 billion into it in January. IBM ended 2004 with $10 billion in cash, after distributing its dividends, which is the most cash IBM has had on the balance sheet in a long time.

IBM's Global Services unit, which Wall Street was a little worried about, grew 10.1 percent, posting $12.6 billion in sales in the quarter. Hardware sales for the company increased a more modest 4.1 percent, to $9.5 billion. Software Group's sales were up 7 percent, to $4.5 billion, and financing operations were down 10.4 percent, to $657 million.

Mark Loughridge, IBM's chief financial officer, said in a conference call with Wall Street analysts that IBM's business transformation outsourcing, engineering and technology services, strategy and change consulting, and business performance management software units--the leading edge products of the evolving IBM--had sales of over $3 billion for all of 2004, an increase of 45 percent. You can see now why IBM decided to focus on these areas and ditch various commodity hardware businesses. In the fourth quarter, Global Services had about $14.7 billion in services contract signings, substantially lower than the $17.3 billion in signings in the final quarter of 2003. Loughridge says IBM will continue to be selective in the services deals it inks, mainly because it is just as concerned with profits as it is with revenue growth. IBM's long-term bookings are what took the hit in 2004's fourth quarter, and IBM has explained in the past that companies are more interested in signing short-term services deals than long-term deals. Companies want to date IBM Global Services, not marry it, it would seem. IBM ended 2004 with a services backlog of $11 billion, quite a bit lower than the $120 billion backlog at the end of 2003. Loughridge says IBM is focused on going back into its services client base and getting additional--and profitable--sales.

On the hardware front, sales growth was not nearly as high as in the server units, but Wall Street sometimes forgets that the proprietary server businesses drives a lot of IBM's software sales--and its most profitable software, to boot. IBM can afford to be patient with growth in hardware sales, particularly as it is gaining market share in the X86 and RISC/Unix server markets. By exiting the hard disk and now the PC business (which has not effected IBM's financials yet), IBM's overall hardware sales numbers will drop, but profits should go up modestly and, more importantly, not take hits because of the volatile PC business, which lost $1 billion at IBM in the past three and a half years.

Within its Systems and Technology Group, sales of zSeries mainframes started to turn south in the fourth quarter, with zSeries sales down 4 percent and aggregate MIPS shipments only growing 6 percent. IBM said the transition in the Power-based iSeries OS/400 server business was down 9 percent compared to this time last year, but said part of the reason for this decline is the transition to the new eServer i5s, which have a different pricing model compared to the prior generation of iSeries machines. The good news for the iSeries line is that even though sales were down in the final quarter of 2004, sequential sales were up 80 percent in the fourth quarter, which means midrange shops have digested the i5 announcements and are starting to buy. IBM's Power-based pSeries and p5 server lines experienced 15 percent sales growth in the fourth quarter, driven by the same Power5 "Squadron" servers that underlie the eServer i5 line. Unix shops, by the nature of their workloads, tend to always need more processing capacity, so it stands to reason that Unix shops would pull Power5 boxes off the shelves faster than the more conservative and penny-pinching OS/400 shops. IBM's xSeries X86-based server business grew by 25 percent in the quarter, with blade servers up 150 percent both in the quarter and for the full year.

On the storage front, IBM said sales were off 11 percent, with disk array sales down 15 percent and tape sales down 3 percent. Loughridge said storage sales would rebound in the first quarter of 2005 as IBM shipped its new DS6000 and DS8000 disk arrays in volume. IBM said PC sales started tapering off in December, when it announced the sale of the PC unit to Lenovo Group.

Within its Software Group, Loughridge said operating systems sales were up only 1 percent, held back by diminished sales in iSeries and zSeries servers. However, he said software demand continued to recover in the quarter, with IBM's biggest customers buying more of its wares. IBM's middleware sales, which includes legacy mainframe products such as DB2 and IMS databases and the CICS transaction monitor as well as all the new-fangled WebSphere products, were up 8 percent in the final quarter of 2004. Sales of IBM's broad WebSphere middleware product family were up 18 percent in the quarter, with the application server portion of that business up 33 percent. IBM's overall database management product sales were up 8 percent, with DB2 database sales on Windows, Unix, and Linux up 25 percent and up 15 percent across all platforms (including mainframes and the iSeries). Lotus groupware sales were up 5 percent, with Domino sales up 2 percent. IBM says it is still adding Notes clients, but the fact that it is not bragging about the number is the best indicator this installed base has hit a plateau. Tivoli systems management software sales (including those from the newly acquired Candle) were up 25 percent, and Rational development tool sales up 8 percent. The entire collection of IBM software had an impressive 89 percent gross margin.

On a geographical basis, sales were $11.1 billion in the Americas region, up 5 percent as reported and 4 percent in the local currencies in the countries that make up the region. In the Europe, Middle East, and Africa region, sales were $10 billion flat as reported in American dollars, up 9 percent thanks to the falling dollar, but up only 1 percent at constant currency. (In other words, Europe is only really growing because of currency effects, and the strong euro is hurting IBM locally even as it is helping it back in its Armonk headquarters.) In the Asia/Pacific region, revenues were $5.8 billion, up 6 percent (3 percent at constant currency). IBM's OEM product sales to other vendors, which are booked in dollars, were $787 million, up 10 percent.

For the full year in 2004, IBM had revenues of $96.5 billion, up 9.1 percent, and net income of $8.4 billion, up 11 percent. Not including discontinued operations, earnings were $4.94 per share, up 13.8 percent thanks to those share buybacks. Looking forward, Loughridge said IBM's own models of its business indicate that for every 5 percent in revenue growth, it can drive 10 percent in earnings per share growth going forward. IBM has for the past few years looked for revenue growth in the high single digits each year, but Loughridge is now saying that for 2005, the mid-to-high single digit range is probably a better estimate.

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Editor: Timothy Prickett Morgan
Managing Editor: Shannon Pastore
Contributing Editors: Dan Burger, Joe Hertvik, Kevin Vandever,
Shannon O'Donnell, Victor Rozek, Hesh Wiener, Alex Woodie
Publisher and Advertising Director: Jenny Thomas
Advertising Sales Representative: Kim Reed
Contact the Editors: To contact anyone on the IT Jungle Team
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