IBM's pSeries Unix Server Sales Up 15 Percent in Q3

by Timothy Prickett Morgan

IT industry juggernaut IBM reported its financial results for the third quarter this week, and continues to be the brightest spot in the Unix server market. IBM said that the pSeries Unix and Linux server line posted a revenue increase of 15 percent in the quarter, but sales were only up 13 percent when calculated in the local currencies they were sold at around the world. This is pretty good growth, but it is less than IBM's stunning second quarter of 2005, which showed sales up 36 percent. IBM said that is had growth in all of its geographies in the pSeries line.

Wall Street had been a little jittery prior to the announcement, worried that IBM might not make its overall numbers in the third quarter ended September 30. Well, IBM made its numbers, and then it didn't. In terms of sales, Big Blue raked in $21.5 billion in the quarter, down 8 percent because of IBM's divestiture of its PC business, but up 4 percent if you take PCs out of the third quarter 2004 data. It's a victory that IBM grew revenue, of course, but maybe not so much of a victory that it had to sell its PC business to Chinese computer maker Lenovo Group in the first place.

On the profit front, there is more good news than bad news. First, IBM has decided to repatriate $9.5 billion in offshore profits that it had been hoarding back to the United States, which will give it some cash to play with going forward. Last year, the U.S. Congress enacted a law called the American Jobs Creation Act that allows companies with foreign profits to bring them home at a 5.25 percent tax rate in 2005 instead of the normal 35 percent rate. IBM brought about half of its offshore profits home, and took a $525 million tax hit that dropped net earnings to $1.52 billion, down 2.5 percent from a year ago. Excluding this charge and a $320 million settlement payment IBM made in the third quarter of 2004 to employees who had sued the company because it made changes to its pension plans, IBM would have posted net earnings of $1.26 per share, up 22 percent compared to the $1.03 per share. This is some indication of how well IBM has been able to restructure itself after its first quarter surprise, which caused the company to lay off 14,500 employees. Including these two charges, IBM's earnings were up a tiny 2.2 percent to 94 cents a share. With earnings decent in the third quarter--enough to balance against the poor showing in the first quarter--now was clearly the time to do the repatriation of foreign profits.

"IBM had a good quarter. It showed the strength of our business model across hardware, software and services, and we continued to see the benefit of the strategic transitions that we've implemented in past quarters," said Sam Palmisano, IBM's chairman and CEO, in his traditional statement accompanying the financial results. "Our restructuring actions and our streamlined management in Europe are starting to yield results. We saw excellent earnings-per-share improvement this quarter, and many of the businesses that are central to our strategy--including middleware, midrange servers, and Business Performance Transformation Services, especially in our Engineering and Technology Services--performed well, especially in emerging markets around the world. We are encouraged by the client reaction to the new zSeries mainframe, and IBM is well positioned in our microelectronics business as the game console industry moves to its next generation of products."

For once, the brightest spot in the IBM hardware portfolio, at least in terms of revenue growth, was the iSeries Power-based midrange server line, which saw sales improve by 25 percent at constant currency and as reported. Because the dollar has been strengthening somewhat as the year has gone by, the fact that constant currency iSeries sales were up would seem to imply that the iSeries had a particularly nice rebound overseas and very good sales, almost filling in the sales gap IBM had with the iSeries in the year-ago quarter, when revenues were down 26 percent at constant currency. This time last year, the transition from Power4 to Power5 iron had caught IBM a bit flat-footed, but it seems safe to say that after sales were up 1 percent in the first quarter and up 10 percent in the second quarter, the iSeries is building up a head of steam and the transition to i5/OS and Power5 hardware is underway. Because IBM only began shipments of its "Danu" System z9s on September 16, there were not enough shipments to make it a great quarter for the mainframe. Still, revenues were down only 4 percent (7 percent at constant currency, meaning the big U.S. mainframe shops still bought) and MIPS shipped in the quarter were actually up 18 percent. In the second quarter, when companies were anticipating new mainframes, zSeries sales were off 24 percent and MIPS shipments were down 19 percent. The xSeries X86- and X64-based servers were up 11 percent (10 percent at constant currency), boosted by sales of blade servers (up 90 percent) and IBM's pushing of xSeries boxes in emerging markets. IBM's disk and tape storage business was also up 11 percent, driven by midrange TotalStorage disk array sales. As has been the case with servers for years, midrange disk array makers are adding high-end features to their machines, which is changing product mix and putting pricing pressure across all parts of the storage market. IBM's Microelectronics unit saw sales increase by 14 percent, thanks to Sony, Toshiba, Microsoft, and Nintendo all getting the chips for their next-generation of game consoles and electronics from that IBM unit.

This time last year, IBM had sold $2.7 billion in PCs, but having sold off its PC business earlier this year to Lenovo Group, it obviously faced a tough compare. Taking PCs out of the equation, IBM's Systems and Technology Group had sales of $5 billion, up 7 percent (6 percent at constant currency). Because of changes in product mix and the decline in mainframe sales, IBM's gross profits in this unit were actually down $8 million in the quarter, according to Mark Loughridge, IBM's chief financial officer, who spoke to Wall Street analysts after the market closed.

Big Blue's Global Services unit is still, of course, the main engine for revenues at the company, and more so now that IBM is out of the PC business. But it is a tough business to grow, and various parts of the services market are undergoing tough transitions. Still, Global Services booked $11.7 billion in sales, up 3 percent. Loughridge said that strategic outsourcing sales were up 2 percent, with signings up 18 percent. Business consulting services sales were up 6 percent in the quarter, and bookings were also up 18 percent; the much-ballyhooed Business Transformation Outsourcing unit within BCS, which IBM inherited through its acquisition of the tech biz from PricewaterhouseCoopers, was up 45 percent in the quarter, but it is still a relatively small part of the Global Services empire. Integrated Technology Services sales were only up 3 percent, and bookings were down 8 percent. Loughridge said services sales were adversely impacted by sluggishness in federal government sales in the United States as well as general weakness in Germany and Japan. IBM signed $11.7 billion in new deals in the quarter, up 13 percent compared to last quarter, and the services backlog grew by $3 billion to $113 billion, year-on-year. Long-term signings in the quarter accounted for $6.3 billion, while short-term deals accounted for $4.7 billion.

IBM's Software Group boosted sales by 5 percent in the quarter to $3.8 billion, with increases in iSeries sales and that platform's integrated operating system and database being offset by declines in similar mainframe sales. In fact, operating system sales were down 2 percent to $588 million, and middleware sales on IBM's host systems were flat. Overall middleware sales were up 6 percent, but the key software brands--WebSphere, Lotus, Tivoli, and Rational--were up 10 percent. IBM's WebSphere middleware (which has a lot of different products that no one can keep straight) were up 14 percent. Sales of Lotus/Domino groupware rose by 12 percent, and Tivoli systems management and security product sales rose by 8 percent. Sales of Rational development tools rose by 12 percent. The gross profit margin in the complete Software Group portfolio was 87.4 percent, which is just a wonderful profit margin for any company--or any part of any company--to have. If you do the math, IBM's overall gross profit was 40.6 percent, and if you could take Software Group out, it would drop to 30.6 percent. (Actually, the fact that companies have spent untold sums on applications for z/OS, i5/OS, and AIX are what keep an even larger portion of IBM's sales humming along and profits coming, quarter after quarter.)

On a geographical basis, IBM sold $9.6 billion in goods and services in the third quarter of 2005, down 5 percent if you take PCs out of the compare. Sales in the Europe/Middle East/Africa region were $6.9 billion, down 6 percent in the local currencies in that region, but up 5 percent when booked back home in dollars. In the Asia/Pacific region, sales were up 17 percent in local currencies, but were only up 2 percent in U.S. dollars at $4.3 billion. IBM's OEM product sales, which is mostly chips for game machines these days but also includes other electronics and services, were up 12 percent to $814 million.

As for the restructuring that was precipitated by the first quarter miss, Loughridge said that about 90 percent of the 14,500 people had been let go already, with another 10 percent remaining to be dealt with in the final quarter of the year. Loughridge was not too clear in his guidance to Wall Street, but he seemed to be saying that with the momentum IBM has created in the third quarter across its product lines, IBM should be able to do well enough in the fourth quarter to book single-digit revenue growth and double-digit earnings per share growth for the full year. It would not take a spectacular fourth quarter to achieve this, particularly now that the PC boat anchor is gone, mainframes will almost certainly boom in the fourth quarter (but against a very, very tough compare), iSeries and pSeries sales should be up, and xSeries just keeps plodding along nicely. It will, of course, all come down to what Global Services does, since so much of IBM's software sales are for renting mainframe software or are purchases tied to server sales. If IBM sells servers, it will sell a lot of software--just as it always does.