IBM Powers Through The Second Quarter

July 25, 2011 Timothy Prickett Morgan

The comparisons are getting a little bit harder as 2011 rolls along, but the Power Systems business at IBM pulled its weight and then some in the second quarter ended in June. Big Blue’s mainframe business is enjoying the best upgrade cycle it has had in five years, raking in the bucks as companies in emerging markets buy mainframes for the first time and established companies in the financial services and insurance industries do long-overdue upgrades to their big iron.

IBM’s overall revenues in the second quarter were up 12.4 percent, to $26.7 billion, while net income rose by 8.2 percent to $3.66 billion. IBM cares about net income inasmuch as this is the cash it blows on dividends, stock repurchases, and acquisitions, But, as has been the case for the past decade and a half, what IBM measures itself for is earnings per share growth, and on that front diluted EPS hit $3 flat in the quarter, up 14.9 percent. Having EPS grow faster than revenue growth is what the Big Blue Machine has been designed to do, and that’s what it usually does when it is working properly. That EPS growth is what drives the stock and bonuses and other compensation among IBM’s top brass, too. It is a stupid metric right up to the point where you are a millionaire or billionaire because of it.

In a conference call with Wall Street analysts last week, Mark Loughridge, IBM’s chief financial officer, said that the Systems and Technology Group, a little less than half of the merged Systems and Software Group that is under the control of general manager Steve Mills, had double-digit revenue growth across its three major server lines and, based on IBM’s own estimates, took at least three points of revenue market share from competitors in the quarter based on the strength of Power Systems and System z sales.

Specifically, Loughridge said that Power Systems revenues rose by 12 percent as reported; at constant currency, meaning as gauged in their local currencies, aggregate Power Systems sales by geography were up 7 percent. IBM’s CFO said that high-end Power Systems sales–which he continues to call “pSeries” many years after the marketeers made that name illegal in the wake of the convergence of the System i and System p platforms back in April 2008–said on the call that high-end Power Systems revenues were up 23 percent in the quarter, and most encouragingly for the shops running the IBM i operating system, revenues had more than doubled for entry Power Systems machines in the first quarter. Granted, it was an easy compare for the entry machines, which were stalled this time last year awaiting a refresh with the Power7 processors.

The big winner this quarter in terms of systems growth was IBM’s mainframes, with sales up 61 percent (only 53 percent at constant currency) and aggregate MIPS shipped into the mainframe base (including new systems and capacity upgrades) rising by 86 percent. System x and BladeCenter sales were up 15 percent as reported (up 9 percent at constant currency). IBM didn’t talk about how BladeCenter sales were doing–or were not doing–in the quarter. And that is probably because Cisco Systems and Dell are continuing to take share away from both IBM and Hewlett-Packard as they did in the first quarter of this year. IBM doesn’t want to talk about it, or else Loughridge would have done so in his comments.

With storage revenues up 10 percent, OEM chip sales up 4 percent and retail store solutions up 8 percent, Systems and Technology Group turned in one of the best quarters in recent memory, with overall revenues up 17.5 percent to $4.68 billion and gross margins improving by five points to 40.6 percent.

Global Services, which has very little to do with most IBM i shops except that is where the bills for system maintenance come from, had a 10.1 percent bump in sales in the quarter, to $15.1 billion. Loughridge said that IBM had $160 million in layoffs–what Big Blue calls “workforce rebalancing”–in the quarter, and that most of the layoffs were within Global Services and more specifically, within the services operations in Europe. IBM’s services backload grew by $15 billion in the quarter, to a staggering $144 billion, but it only booked $2 billion in real incremental business; the remainder is the future value of services contracts on the book for future quarters as reckoned in now weakened US dollars. (That’s $13 billion in incremental revenue just because the US economy sucks. Easy money, if you can get it.) IBM’s maintenance business, which generated just under $2 billion in the quarter, was up 7 percent. Strategic outsourcing generated just over $6 billion, up 12 percent, while application outsourcing accounted for just over $1 billion, rising 12 percent. IBM is trying to cloudwash its Global Services business, but in a lot of cases, it is just virtual hosting.

The profit engine of Big Blue, Software Group, turned in a decent quarter, as it usually does, and thanks in part to expanded mainframe software sales being dragged along by sales of System zEnterprise 196 mainframes. Software Group had sales of $6.17 billion in the second quarter, up 16.9 percent. Gross margins in Software Group are a succulent 88.4 percent, up a bit from a year ago, and not just because of that mainframe software but also because of that key branded middleware IBM is always talking about and that accounts for nearly two-thirds of IBM’s overall software sales at this point. WebSphere middleware sales were up 55 percent in the quarter (revenue figures were not divulged as usual), while IBM’s database and related tool products showed 18 percent growth. Lotus groupware posted 12 percent growth and apparently gained market share, according to Loughridge, while Tivoli systems management and security products posted 9 percent growth. Rational development tools had a relatively weak 4 percent growth in the second quarter, and operating system sales were up 10 percent.

IBM spent $3 billion on share buybacks in the quarter to help pump up that earnings per share, which was a bit less than the $5 billion that it took to do the job in the first quarter. IBM still has authorizations from its board of directors to spend $8.7 billion, and will likely blow through that all and then some in 2011 to make its EPS goals. IBM exited the quarter with $11.8 billion in cash, and not including the $23.4 billion in financing debt it has for its Global Financing unit (which gives business partners loans on gear they keep in inventory as well as financing on gear for customers), IBM still has $6.4 billion in debt on its books. So that is only $5.4 billion in net cash, and that means you shouldn’t expect IBM to do any big acquisitions. Not if it needs to boost EPS, which it believes it needs to do.

IBM didn’t say much about the rest of the year, but did raise its guidance for operating EPS by a dime to $13.25 per share. IBM wants to push that above $20 a share by 2015, and everything, everything, everything it does and does not do is related to hitting that $20 figure.