Some Servers Take a Dive in IBM’s Third Quarter

October 20, 2008 Timothy Prickett Morgan

When IBM preannounced its revenues and earnings as the market was swooning two weeks ago in an effort to calm a staggering and falling Wall Street, the company’s overall numbers gave the impression that Big Blue was nonetheless weathering the financial storm. While this may be true in the aggregate, to IBM’s credit (don’t say credit) as an IT supplier, certain portions of its business–particularly certain server lines–didn’t do so well. Decide for yourself if this is some kind of leading indicator for the rest of 2008 and maybe 2009.

IBM’s sales for the third quarter came to $25.3 billion, up 4.9 percent, with net earnings of $2.8 billion, up 19.6 percent, driven in large part by ongoing cost-cutting efforts and a shift away from pension plans as well as some growth in margins on products; earnings per share came in at $2.05, up 22 percent and boosted a bit (4 cents a share) by share buybacks.

Growth in services and software, once again, saved IBM’s financial cookies, as did high-end servers. While IBM tries to pitch itself as a services and software company, the truth is that systems–meaning the combination of servers, systems software, and services relating to those platforms–are really what drive a lot of Big Blue’s sales each quarter. And servers are the foundation of that business, so what happens here matters.

IBM’s Systems and Technology Group, which makes and markets servers, storage, processors, and other hardware, saw sales decline by 10 percent in the quarter to $4.4 billion. The ramp of quad-core System z10 mainframe sales helped out in a big way in Q3, with aggregate MIPS shipments for mainframes up 49 percent and revenues up 25 percent. Mark Loughridge, IBM’s chief financial officer, said in a conference call with Wall Street analysts last Thursday that specialty (and lower cost) mainframe engines for running Linux, Java, and DB2 algorithms experienced a 120 percent growth in MIPS shipped during the quarter. Loughridge said that the mainframe line exhibited double-digit revenue growth in all geographies.

The so-called Converged System p line–which means any System p or Power Systems AIX or Linux box regardless of processor technology and any Power6-based server running the proprietary i5/OS or i operating system–had 7 percent growth, according to Loughridge, while the Legacy System i business–which means any Power5 or Power5+ server running i5/OS or i–crashed down by 82 percent. This was not unexpected since IBM is about ready to withdrawn the older gear, which was replaced in April, from its catalog. The way IBM is breaking down Power Systems sales is completely asinine, except that it helps IBM create the illusion that its System p-Power Systems business is growing when it probably was not in the first quarter of the year and maybe not in the third quarter, either. The high-end Power Systems server line grew by 19 percent, Loughridge said, and the midrange of the line saw sales rise by 21 percent. Some of that is just what happens when you move what would have been System i sales last year into the System p product line. Some of it is real growth, driven by virtualization and server consolidation, as well as workload growth among some of IBM’s Power Systems customers.

What was clear from IBM’s numbers is that there was no way to cover up the fact that its System x X64-based rack, tower, and blade servers business took it on the chin, with sales down 18 percent in the quarter. IBM’s BladeSystem blade server sales fell by 8 percent as well. Loughridge did not offer much of an explanation, except to say that there was a slowdown in the X64 server market in the quarter and that IBM had sales execution issues; he also said that the company was looking to turn the business around in the next two quarters. If this sounds a lot like the IBM PC business to you, which is now owned by Lenovo, you are not alone.

On the storage front, IBM saw disk and tape storage decline in aggregate by 3 percent, but Loughridge said the first half of 2008 was good for storage sales. Disk array sales fell by 1 percent overall, but high-end DS8000 arrays were a bright point, up 2 percent and driven in part by mainframe sales. Tape drive, array, and library sales in aggregate were off 11 percent as companies pulled back on spending. The Microelectronics division within STG, which makes chips for IBM and its partners, had a 27 percent decline in the quarter, dragging down the group.

On the software side of the IBM house, where a significant part of quarterly revenues come from monthly licensing fees for mainframe platforms, Software Group’s sales rose by 12 percent to $5.2 billion. Sales in the quarter were bolstered by the acquisitions of Cognos and Telelogic. WebSphere middleware tools were fairly weak at 4 percent growth, but database and related products were up 26 percent thanks to Cognos. Tivoli systems management tools had a 2 percent boost in sales in Q3, while Lotus groupware and related application software saw 10 percent growth. Rational development tool sales rose by 23 percent, boosted mainly by Telelogic.

What IBM wants to talk about–especially in a rough economy–is services. When the economy gets bad, as it has from time to time, companies call up Big Blue and other service providers to cut costs and to re-engineer their businesses, often asking companies like IBM to host and code their applications. Such services have been more than half of IBM’s sales for a long time now, and this quarter it was more so. IBM’s Global Technology Services (that’s the hosting, app development, and maintenance part) accounted for $9.9 billion in sales, up 8 percent, while Global Business Services (that’s the business re-engineering part) posted $4.9 billion in sales, up 7 percent. Short-term signings in both areas jumped and long-term contracts fell, just as you would expect for a customer set looking for a quick return; IBM has $114 billion in future services revenues backlogged, by the way. Pretax income for the services business in aggregate at IBM was 23 percent in the quarter–the highest IBM has seen in six years–and Loughridge said that IBM was definitely walking away from deals that didn’t make sense in terms of profit and that the company was not looking to boost revenue figures for the sake of showing larger numbers.

Given the edginess of Wall Street these days, Loughridge wanted to make sure everyone understood that IBM was liquid. The company ended the quarter with $9.8 billion in cash (although down from $16.1 billion a year ago thanks to acquisitions and an accelerated share repurchase program), just floated $4 billion in term financing last week, and has a $10 billion credit facility if things get tight. IBM has debts of $9.9 billion, if you don’t include all the gear it finances for customers and resellers, which stands at $24.5 billion. IBM’s Global Financing currently has assets of $32.8 billion, larger than the debts on its books, and it brought in $600m in revenues during Q3.

Looking ahead to the fourth quarter, Loughridge reaffirmed what IBM said in a statement two weeks ago: that it can make its numbers and bring in earnings of at least $8.75 per share. IBM did not provide revenue projections, but it seems likely that sales in Q4 will be flat to down.

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