Big Blue down on all fronts in its third quarter

Retail system divestiture can't save profits

Its third financial quarter was not an easy one for IBM, with sales down across most product lines and in many geographical regions, and profits down even after selling off its retail-store systems business to Toshiba.

Total sales in the quarter were off 5.4 per cent to $24.75bn, and every part of IBM, including the Software Group, took a revenue hit. Expenses were on the rise for sales and general administration, up 4.3 per cent to $5.91bn, and even while cutting other expenses and holding taxes relatively steady, IBM still saw net income fall by four-tenths of a per cent to $3.82bn.

The culprit in the quarter, explained IBM CFO Mark Loughridge in a conference call with Wall Street analysts after the market closed, was big software deals in emerging markets that slipped out into the fourth quarter.

The revenue and profit dip in the third quarter was also driven by anticipated upgrades in the System z mainframe and Power Systems lines, said Loughridge, who added that he was hopeful that those software deals would get done and that the new System z EC12 and Power7+ servers announced in August and October, respectively, would help bolster the Software Group and Systems and Technology Group in the fourth quarter.

The System z mainframes were only shipping for 11 days in the quarter, and he said that revenues for mainframes should be up 20 to 30 per cent in Q4, pulling up Systems and Technology Group revenue, combined with a much smaller Power Systems bump, to yield 5 per cent revenue growth.

Loughridge quickly added that the divestiture of the RSS business to Toshiba, which netted IBM $420m in the third quarter and kept its profits from taking a big dive, would cut back revenue by 4 per cent in the current quarter.

Still, Loughridge put a stake in the ground, saying that "as always, we need to execute," and that the Software Group had to close those big deals that slipped and build on that momentum, and that the hardware sales teams had to push the new systems and storage that Big Blue has announced in recent months. If they do, then hardware and software could grow revenue in the mid-single digits and profits by double digits – which is all that Big Blue has cared about since about 1993.

The Systems and Technology Group took the biggest haircut of IBM's major business units in the third quarter, with sales down 15.9 per cent to $43.9bn. Pre-tax income fell by 61.1 per cent to $124m for STG as high-end system sales stalled due to the impending announcements of new iron.

System z mainframe sales were off 20 per cent, but shipments of total capacity shipped to customers during the quarter fell by only 2 per cent as customers did capacity-on-demand upgrades of existing systems. These CoD upgrades don't yield as much top-line revenue as a new system, but considering that they are just a turn of the golden screwdriver, they are profitable as all get out.

IBM's Power Systems line took a 2 per cent hit, understandable given that everyone knew Power7+ chips were coming, but perhaps avoidable if IBM had made it clear that it was only planning to make announcements in October for two relatively large systems that account for a fairly small portion of shipments but a much larger share of revenues and profits for the Power Systems line.

IBM is not going to launch any more Power7+ systems until 2013, and it has not been clear about what the plan is. This could have a similar effect on Power System sales in the coming quarters as customers decide to wait to see what new gear Big Blue has in store using its Power7+ chips.

Loughridge did say that the company closed 260 competitive deals against Oracle and HP, which brought in over $200m in new business and helped drive its 18th consecutive quarter of revenue share gains in the Unix server racket. While this is all well and good, the Unix server business is in decline and IBM has to do better outside of Unix.

That didn't happen this quarter with its x86 server business. IBM's System x and BladeCenter server sales were off 5 per cent, and with all of the new Xeon E5 processors out the door already and inside of Big Blue's gear, there's really no excuse here at all for a decline other than competitive pressure. It is not clear if IBM is losing sales to Dell, HP, and others in the x86 arena, or if it is cutting price to win deals.

IBM's disk and tape storage sales were off 10 per cent in the quarter, and again it is hard to say if that's because IBM is losing out to the competition, cutting price to win deals, or a little of both.

Loughridge said that IBM sees "value shifting to software" in the storage area, which is reported in Software Group underneath the Tivoli brand. That may be true, but then maybe IBM should create an accounting category called "storage" with a software and hardware component and track the business the way storage is sold, not based on some arbitrary brands it has slapped on things.

The same would hold true for mainframes, Power Systems, and x86 boxes. Put the software and hardware back together, as they are sold, and show us what the Business Machines are actually doing. In any event, IBM is hopeful that its new DS8870 disk arrays will help pump up sales in Q4 and beyond.

Software goes limp, services with a frown

Loughridge did not elaborate much about the big software deals that got pushed out into the fourth quarter, but he did say that they were in growth markets outside of North America and Europe.

Software Group, the profit engine of the Big Blue Empire, decline nine-tenths of a point to $5.76bn in the third quarter, but gross margins held more or less steady at 88 per cent. (Good business if you can get it, and to get it you have to go back in a time machine to 1964.) Software Group brought in $2.36bn in pre-tax income, up 6.3 per cent, so whatever bits IBM is peddling, they are more profitable ones.

The key branded middleware at IBM – WebSphere, DB2, Tivoli, Lotus, and Rational products – accounted for 63 per cent of sales, or $3.63bn in revenues. Operating systems made up another 10 per cent of the total, or $576m, while other middleware – mostly CICS and other mainframe stuff with a smattering of things for OS/400 and IBM i proprietary platforms – comprised another 19 per cent or $1.09bn.

WebSphere middleware sales were up 2 per cent and database products were down 1 per cent. Tivoli storage, security, and systems management products had a 5 per cent sales bump, while Lotus groupware declined 10 per cent and Rational development tool sales plummeted 16 per cent.

Over in the two-headed Global Services behemoth, revenues were off 4.6 per cent to $14.46bn, and pre-tax income fell by 1.4 per cent to $2.43bn.

Yup, it takes three dollars of services revenue to make the same profit as one dollar of software revenue. And IBM's hardware business makes no money at all, if you look at it the way IBM does its books. But as we all know, if there is no mainframe, there is no software or services, so this accounting presentation is largely a Numberwang.

Anyway, Global Technology Services, which does break-fix maintenance, traditional system outsourcing, and integrated technology services (which is not systems integration), accounted for $9.92bn in sales, down 1.6 points, and just under $1.7bn in pre-tax income, essentially flat.

Global Business Services, which does application outsourcing, consulting, and system integration (which is not integrated technology services) posted sales of $4.54bn, down 6 per cent, and pre-tax income of $738m, down 4.8 points. By the way, GBS gets all the credit for those Smarter Planet, business analytics, and SmartCloud engagements that IBM is always going on about, and these represent about a third of GBS sales, or about $1.5bn in the third quarter collectively.

IBM does not report financials for each part of its services business, but does provide a pie chart showing their slices, so you can do the math to figure it out. System outsourcing sales were around $5.79bn, down 5 points, while application outsourcing was just over $1bn but off 7 per cent. Maintenance was $1.88bn of that, down 5 per cent. Integrated technology services was $2.31bn, off one point, and consulting and system integration was $3.47bn, off six points.

The Global Services group had a services backlog of $138bn as September came to a close, up 1 per cent from the year-ago period.

IBM does not provide revenue or profit guidance for future quarters, but Loughridge said that he believed IBM was well on track to post $15.10 of earnings per share on an operating basis (not as reported), and that the company was also on track towards its goal of hitting at least $20 per share EPS on an operating basis by 2015.

Loughridge did not say anything about wanting to grow revenues, which is something that more than a few IBMers are eager to hear from their new CEO, Ginni Rometty, and Big Blue's CFO. They are going to wait a long time to hear that.

In 20 years, after so many share buybacks – IBM did another $3bn in the quarter and $9bn so far this year – Big Blue could be a privately held company making a tidy $50bn in annual revenues with much higher gross margins. That scenario is a lot more likely than an IBM with $200bn in yearly sales trying to do too many things and not making any money anywhere. IBM has been down that road before and ain't going back down it – even if it means not becoming the next Apple. ®

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