IBM Comes Up Short in Q1 After March Fall Off

by Timothy Prickett Morgan

IBM pulled a Carly Fiorina last Thursday and gave Wall Street something of a surprise as it closed its first quarter a bit lower than the street had expected. And that is why IBM also surprised the street by moving up its announcement of financial results from this week to Thursday--there's no sense in sitting on bad news, especially when you can run your numbers in the same news space as Sun Microsystems, which reported its financials that evening, too.

Mark Loughridge, IBM's relatively new chief financial officer, cut right to the chase in his conference call with Wall Street analysts to explain IBM's financial results for the first quarter ended March 31. "This quarter did not play out as we expected," he explained. "We had a good start to the quarter, consistent with the way we exited 2004. In fact, we had revenue growth of over 6 percent through the end of February. However, we had a significant drop--primarily in small transactions at the end of the quarter, and March revenue was down."

Specifically, IBM's sales in the quarter were $22.9 billion, up 3.3 percent, and IBM brought $1.4 billion to the bottom line, an increase of 2.9 percent over last year's first quarter. That worked out to 85 cents a share, and because of IBM's share buyback and other financial engineering, earnings per share increased by 7.6 percent to 85 cents a share in the quarter. Analysts polled by Thomson/First Call had been expecting, on average, for IBM to rake in 90 cents a share on sales of $23.65 billion. Loughridge tried to cushion the earnings shock by saying that without an increase in pension costs that IBM had to book in the quarter, it would have posted earnings per share growth of 20 percent, a lot higher than the 8 percent it posted in the first quarter. While this shows the impact of IBM's needing to more fully fund its pension, the fact remains that maybe it should have been more fully funding its pension all along, and has in effect overstated its past earnings by having not done so already. The pension issue cuts both ways, as do IBM's share buybacks for the past 15 years.

Loughridge said that IBM had a disappointing quarter in services, with a decline in short-term signings, which tend to be very profitable for IBM because they involve putting employees who have just finished working on projects right back to work where they are experts. IBM's Global Services unit, which is the biggest money maker for the company, reported sales of $11.7 billion in the quarter, up 6 percent as reported but up only 3 percent in the many currencies that IBM actually books sales in around the globe. IBM's strategic outsourcing was up 8 percent, with double-digit growth in Europe and decent growth in Asia, but sales were off in this sub-sector of IBM's services business in the Americas region. Contract extensions were high in strategic outsoucing, but because services contracts are front-loaded, renewals do not boost revenue in the current quarter. IBM's business consulting services was only up 5 percent, with the much-touted business transformation services business (primarily the result of the PricewaterhouseCoopers acquisition) nearly double from this time last year to $1 billion. Integrated technology services sales were only up 4 percent. IBM had about $10 billion in services signings in the quarter, and IBM's services backlog didn't grow at all in the quarter, holding steady at about $110 billion. While sales were off in the current quarter, Loughridge said that the services pipeline in 30 to 40 percent better than it was as IBM entered the first quarter; of course, some of that pipeline strength comes from the fact that many deals Big Blue had hoped to sign got pushed to the second quarter or beyond.

IBM's hardware sales came to $6.7 billion in the first quarter, flat compared to last year's first quarter and down 2 percent at constant currency. Personal Systems sales were down 3 percent to $2.7 billion, and were adversely impacted by the pending sale of IBM's PC business to Chinese IT company Lenovo Group. IBM's zSeries mainframes ran out of gas in the quarter, after some surprisingly good quarters, with revenues down 16 percent and MIPS shipments down 11 percent. While Loughridge didn't say this, the surprisingly good mainframe sales in the final quarter of 2004 looks like IBM was eating into Q1 2005's sales. IBM's pSeries Power-based Unix servers grew by 12 percent in the quarter, and Loughridge said that the company was through the transition from Power4 to Power5 processors. Even the iSeries business, which had declined throughout 2004, showed a little life and grew by 1 percent in the quarter. xSeries servers, which use Pentium, Xeon, Itanium, and Opteron X86 processors, grew by 8 percent, and IBM's blade server business grew by 90 percent. (Blade sales a very small in terms of revenue, however.) He said that xSeries products grew by double-digits in Americas and in Asia, but because of competitive pressures, Europe had revenue declines. IBM's storage sales were up 5 percent across all categories, with enterprise disk array sales up 20 percent, tape products up 3 percent, but SAN sales declining.

IBM's Software Group posted sales of $3.6 billion in the quarter, up 2 percent as reported and flat at constant currency. Operating system sales were off 2 percent to $590 million, brought down by mainframe declines and sluggish iSeries sales, and middleware sales were up 8 percent in the key non-mainframe brands, but off 4 percent on predominantly mainframe-based software. WebSphere and Lotus products both grew 11 percent, Tivoli products were up 15 percent, but information management products (including tools, transaction monitors, and databases) were only up 5 percent (again, dragged down by zSeries and iSeries machines). DB2 database sales across all platforms was up 9 percent.

On a geographic basis, sales on the Americas region were up 2 percent to $9.3 billion, but only up 1 percent in constant currency. Sales in Europe were up 2 percent in local currencies, but thanks to the weak dollar, came in to IBM HQ in New York as $7.7 billion, up 7 percent. Sales in the Asia/Pacific region were down 2 percent in local currencies, but up 1 percent to $5.2 billion as reported in dollars. IBM's OEM technology sales--including chips, intellectual property, and other components--were $691 million, up 3 percent.

Loughridge said that IBM is aware of the execution issues it is facing, and that it has already instituted restructuring changes to its organization that it was planning for the future. Because of the softness in sales that IBM saw in March, the company is stepping up those restructurings immediately, which he says should bear fruit in the second half of 2005. He was pretty vague about what these restructurings were, and just as vague about what the problems they were designed to solve actually were, except to say that there were sales execution issues across hardware, software, and services lines and that IBM would be moving decision making close to the customer and increase the speed of sales execution--what he referred to as "lowering the center of gravity" of the sales process. It is an interesting string of words, but how you increase the speed of sales execution in a market with ever-lengthening sales cycles without using price as a lever is a bit of a mystery. He confirmed that analysts' current estimates for the second half "remain reasonable," and closed by saying that IBM was "driving to get there a different way, on lower revenue and more cost and expense savings."

As we went to press on Friday, IBM's stock was off 8.1 percent to just under $77; at the beginning of April, before Wall Street started wondering about how IBM would do in the quarter, the stock was trading in the low $90s and Wall Street was pegging it to shoot to around $105 to $110. So either Wall Street reacted very badly to IBM's Thursday Surprise, or analysts and investors believe IBM is facing something a little more drastic than a hiccup in a quarter.