Cost Controls Boost IBM Earnings on Flat Q1 Revenues

Published: April 20, 2006

by Timothy Prickett Morgan

If this were a decade ago, and IT industry juggernaut IBM told Wall Street that its mainframe business was off 6 percent, its proprietary midrange server business was off 22 percent, its Unix server business was off 9 percent, its services business was off 1 percent, and its software business was only up 3 percent, Big Blue would have had its corporate head handed to it. But, this is 2006, and what matters more than revenue growth for the largest IT company in the world is improving profits, which IBM did manage to get in the first quarter of 2006.

IBM has been selling off commodity IT businesses over the past few years, and in 2005, Big Blue ditched the PC business, selling it off to Chinese PC maker Lenovo Group, which is pulling a Lexmark and very quickly turning what looked like a bad business and into something interesting and perhaps market changing as a former IBM unit gets out of the Big Blue bureaucracy. A year ago, IBM surprised Wall Street with a miss in the first quarter, missing both revenue and earnings targets that it carefully nudges analysts toward as they make their predictions. That miss was the major reason why IBM gave 14,500 of its employees pink slips last year, and the improved profitability in this year's first quarter is why IBM gave those people the sack.

IBM booked $20.7 billion in sales in the first quarter of 2006, down 10 percent as reported but flat if you take the effect of the PC business out of the comparison. If you count the money in local currencies rather than converting every sale to U.S. dollars--what IBM calls constant currency--and take PCs out of the picture, Mark Loughridge, IBM's chief financial officer, said in a conference call with Wall Street analysts that sales for the company were actually up 4 percent. IBM was able to put $1.7 billion to the bottom line from continuing operations during the quarter, up from $1.4 billion a year ago. This cash was after IBM spent $2.5 billion on share buybacks, which took 31 million shares off the market and helped to boost earnings per share. IBM posted net earnings of $1.08 per share in Q1, up 27 percent from the 85 cents that IBM brought to the bottom line in the year ago quarter.

The Global Services unit, which Wall Street has been watching like a hawk for a decline like the one that hit last year, performed a little better than many people might have been expecting, despite the revenue decline of 1 percent to $11.6 billion. In March, IBM broke the Global Services group into two different business units. The first is the Global Technology Services unit, which posted sales of $7.7 billion in the first quarter and which is comprised of its strategic outsourcing, business transformation outsourcing, integrated technology services, and maintenance products. The other unit is the Global Business Services unit of Global Services--and yes, if your eyes are glazing over from these names, that is a perfectly normal reaction--posted sales of $3.8 billion in the quarter. This unit is where IBM parked its consulting, systems integration, and application management services. Both of these units saw sales decline by 1 percent in the first quarter compared to reclassified figures from Q1 2005. IBM's backlog of services contracts was steady at $111 billion, said Loughridge, with short-term signings for Q1 2006 up 3 percent and accounting for $4.8 billion, and long-term signings up 20 percent to $11.3 billion. Long-term deals for the GBS unit (the systems integration and consulting unit) were down 27 percent to $1.2 billion in the quarter. Loughridge downplayed the issue, saying that the short-term deals lead to long term money. "We see good opportunities out there over the long haul," he said.

Over in the Systems and Technology Group, server and storage sales were up 3 percent to $4.4 billion, and up 6 percent at constant currency, despite the declines in System z mainframe and System i and System p midrange server sales. Loughridge said that System z MIPS shipments were up 22 percent in the quarter, with over 35 percent of the MIPS shipped coming from specialty Java (zAAP) and Linux (IFL) engines. These engines cost about one quarter of regular mainframe engines, which is why a boost in MIPS didn't translate into more revenue. Of course, the mainframe base also knew that a new System z box is coming at the end of April, something which Loughridge confirmed in the call. This may have also impacted mainframe sales. IBM refreshed the System i server line at the end of January with the Power5+ processors, which slowed down sales for that product line, and continued its refresh of the System p line with the Power5+ chip, too. Loughridge said that the Power5+ chip would be rolled into larger System p machines in the third quarter, completing the revamp of that line that began last fall.

He also cautioned Wall Street into reading too much into the revenue declines for these servers or thinking it is pricing pressure. "I don't think we saw increased pricing pressure in the quarter," he said. "This is normally a light quarter for hardware, and we foresee a normal mix for the year." Having said that, he conceded that there were some pricing issues in the belly of the System i market, as well as modest pricing pressure in the fast-growing Asia/Pacific and Eastern European markets for IBM's Unix server line. The System x line, which saw sales increase by 10 percent in the quarter thanks to big boxes and blades, had price pressure in the United States. System x server volumes were up 20 percent, and blade server revenues and shipments were both up 45 percent. Loughridge added that pricing was very aggressive in enterprise arrays and storage area networks, too. IBM's storage sales across disk and tape products was up 6 percent in the quarter. The Microelectronics Division, which makes Power chips for game console makers, car makers, and other embedded uses, saw sales spike by 37 percent in the quarter, which basically saved Systems and Technology Group's cookies for the quarter.

The third wheel on the cart that takes IBM's money to the bank is, of course, Software Group, which saw sales grow by 2 percent in the first quarter to hit $3.9 billion. WebSphere middleware sales, which includes a dizzying array of products, boomed 26 percent in the quarter, and Tivoli systems management and security products similarly rose by 24 percent in the quarter. Database products (which IBM called information management) rose by 6 percent, while Lotus groupware sales were flat and Rational development tools were down 8 percent. These five key brands accounted for 11 percent revenue growth together in the quarter, and other middleware sales (mostly stuff for mainframes) declined by 1 percent. IBM's operating system sales, which are tied very tightly to System i, p, and z sales, dropped by 12 percent in the quarter.

By geographical region, IBM's sales in the Americas were $9 billion as reported, down 3 percent but up about 6 percent if you take out the PC business and use constant currency. Using the same math, sales in Europe, the Middle East, and Africa were $6.7 billion, down 14 percent as reported and up 3 percent at constant currency, while the Asia/Pacific region, which is still dominated by Japan, saw sales decline by 21 percent to $4.1 billion as reported back in U.S. dollars, but down only 2 percent if you take out PCs and think in local currencies. If you take out PCs and look at the so-called BRIC economies--that is Brazil, Russia, India, and China--these areas grew at a combined 27 percent excluding PCs. Again, without PCs, IBM's sales in China were up 17 percent, similar to the 23 percent growth in Brazil, but paling compared to the 48 percent growth in Russia and the 58 percent growth in India.

While Sam Palmisano, IBM's chairman and chief executive officer, never talks during these Wall Street calls and never says much in the company statements other than IBM has a strong business model that is underscored by its "balanced portfolio," he will be heading out to Bangalore, India, to talk about the wonders of the emerging economies in June. As always, IBM remains committed to its goal of low double-digit earnings per share growth for that business model, a point Loughridge reiterated again in the call. It would be nice to get at least some of those earnings from increased sales to companies in the Western economies, not just through aggressive sales in these emerging BRIC markets and the offshoring of research and development to China and India.