IBM Profits Up Some as Sales Decline Some in Q2

by Timothy Prickett Morgan

Thanks to the sale of its PC business and an antitrust settlement with Microsoft and despite restructuring charges relating to layoffs and other reorganizations, IBM, still the dominant player in the IT market, was able to pull off a decent second quarter. Specifically, IBM pushed net income up 5.4 percent to $1.82 billion, with revenues down 3.6 percent to $22.3 billion. That's a tough trick, and one only made possible because IBM wrangled $775 million in monopoly money out of Microsoft--without even suing--at exactly the right time, which was before the second quarter closed.

If you think the timing of the announcement of the antitrust settlement between IBM and Microsoft was not exactly accidental and was settled as IBM knew its mainframe sales were lagging because the market was expecting new zSeries machines, you are not alone. But the timing could just be fortuitous. The settlement with Microsoft came about because of disparities in Windows pricing among Microsoft's resellers and through the antitrust lawsuit that Microsoft lost in early 2000 when it was sued by the U.S. Department of Justice. IBM and a number of other players were due to collect some money after that case went to appeal and settled. IBM not only got $775 million in cash, but also $75 million worth of credits on Microsoft software for its own consumption as part of its settlement. The two companies made the deal on June 30, which was the last day that a statute of limitation extension the two negotiated in November 2003 and the last day of IBM's second quarter. No matter how it happened, the deal has saved IBM's financial cookies in the quarter because mainframe sales plummeted in advance of the expected machines.

How far? zSeries MIPS shipments in the second quarter were down 19 percent and revenues were off 24 percent as reported and off 25 percent on a constant currency basis (which means in the local currencies where the machines were sold). The drop in mainframe sales was one of the factors that caused IBM's sales in the financial services sector to drop by 3 percent in the quarter, explained Mark Loughridge, IBM's chief financial officer, in a conference call with Wall Street analysts on Tuesday.

He went to great lengths to explain that the zSeries is coming to the end of a long product cycle, but that the uptake of mainframe processing capacity to run Linux, Java, WebSphere, and other non-legacy workloads on mainframes still accounted for 60 to 70 percent of sales. Loughridge said that the new zSeries mainframes would be announced next week, and that shipments would come "at the back-end of the third quarter." When asked how the new mainframes would impact the trend in mainframe sales, Loughridge said that IBM expected to have sustained single-digit mainframe revenue growth over the long haul--consistent with its general trend in the past few years.

The Power5-based pSeries Unix and Linux server line was also a big boost in the second quarter, with sales up 36 percent in the quarter. Loughridge said that IBM saw double-digit revenue growth in its pSeries line in its Americas, EMEA, and Asia/Pacific geographies, and also had unit shipment growth compared to a year ago across its entry-, midrange-, and enterprise-class pSeries machines. Because of these numbers, the pSeries line is expected to post market share gains in the Unix market when Gartner and IDC tally up report cards for Q2. The iSeries server line, which runs IBM's OS/400 operating system as well as its AIX Unix variant and Linux, was a relatively bright spot for a change, with sales up 10 percent as reported (up 9 percent at constant currency). Loughridge said that the high-end of the iSeries line sold particularly well, and that the iSeries experienced growth in all geographies.

Rounding out the server lines, IBM's xSeries X86 and X64 servers (with a smattering of Itanium) posted revenue growth of 11 percent in the second quarter (up 8 percent at constant currency). xSeries sales were helped by new four-way Xeon boxes that were announced in the first quarter, but adversely affected by the new eight-way machines that were announced late in the quarter. Interestingly, Loughridge said that sales of blade servers were up 65 percent in the quarter, and that blade-based servers account for nearly one-fifth of total xSeries sales. Overall sales in the Systems and Technology Group at IBM, which includes storage, printers, chips, and retail systems, increased 5 percent to $4.9 billion. Disk and tape storage was up 19 percent as a combined category, with external disk and SAN product sales up 16 percent and tape drive and array sales up 28 percent. IBM's Microelectronics Division dropped by 5%, but Loughridge said that the company was focused on its Power-based gaming console and electronics chips to turn that business around in the second half of the year.

Because of the sale of the PC business to Chinese vendor Lenovo, which netted IBM $1.1 billion in cash, and the decline in mainframe sales, IBM's overall hardware sales were down 25 percent in the quarter, to $5.6 billion. IBM stopped selling PCs in April, however, and if you take PC sales out of the comparison, the hardware sales were up 5 percent to $5 billion.

If anyone is still worried, it is probably the 14,500 employees who have either voluntarily retired or have been sacked by Big Blue as part of the restructuring that was announced after its first quarter miss. Loughridge said that the workforce reduction was higher than the 10,000 to 13,000 it had estimated, and was driven predominantly because of good acceptance of the severance offers IBM is making in Europe, where 70 percent of the cuts will be made. IBM booked a pre-tax charge of $1.7 billion to cover these layoffs, including $200 million in charges related to office reorganizations. Loughridge estimated that the layoffs and restructurings would deliver savings of about $500 million in costs in the second half of 2005 and about $1.3 billion in all of 2006. IBM started the layoffs at the end of June, and 8,000 people have already left the company.

IBM's Software Group posted sales of $3.8 billion, up 10 percent as reported and 7 percent at constant currency. Gross profits in the software unit were 86.7 percent, which shows you why IBM stays in the zSeries and iSeries business and why it has been expanding into software for all major platforms. Sales of the WebSphere Portal and WebSphere Application Server were up 36 percent and 24 percent, respectively, and IBM believes that it gained share in the middleware business in the quarter. Sales across all WebSphere products were up 18 percent in the second quarter. IBM's DB2 database sales were up 14 percent, with double-digit growth both on zSeries and iSeries host machines and on so-called distributed platforms, by which IBM means Windows, Unix, and Linux. Sales of Lotus-branded groupware, messaging, and middleware products increased 17 percent in the quarter. Sales of Notes middleware were driven by new licenses as well as upgrades, and Loughridge said that IBM is gaining traction with its Workplace middleware, which doubled compared to last year (albeit on a very small base). Tivoli-branded security and management middleware sales increased 28 percent, and Rational development tool sales were up 8%. Overall middleware sales were up 11 percent, while operating systems sales--helped by rebounding iSeries sales and exploding pSeries sales and hurt by zSeries sales--was up 3 percent in the quarter.

On a geographic basis (and taking PCs out of the mix), IBM's sales in the Americas region for the second quarter were $9.4 billion, down 3 percent as reported (but up 5 percent at constant currency, thanks to the relatively strong local currencies compared to the historical exchange rate with dollars in Central and South America). Sales in EMEA were flat at $7.5 billion (up 4 percent at constant currency) and in Asia/Pacific were down 10 percent (but up 2 percent at constant currency). IBM's OEM product sales were flat at $702 million in the quarter.