Annex Bulletin 2012-05                              April 23, 2012

A partially OPEN edition



Oracle Runs Out of Oracles (Analysis of latest quarterly results)



Updated 4/23/12, 12:00AM HST

Analysis of IBM's First Quarter Business Results

Big Blue Feet of Clay

IBM is still solid like the Rock of Gibraltar, but is also stuck like the Rock of Gibraltar in low or no growth enterprise market; Will history repeat itself?

HAIKU, Maui, Apr 23 - "The new Wall Street 'Rock of Gibraltar' stands unscathed by the Japanese earthquakes and tsunamis.  Business is booming across the Big Blue geographies and product lines..."

Oops... wrong film.  That was last year's opening paragraph about IBM's first quarter results. Let's try again. Here's the new reel...

"From a geographic perspective, the growth markets continued to perform well, with double-digit growth again this quarter, while the major markets continued to be weighed down by Japan, and by Public sector, which declined more sharply this quarter," said IBM CFO Mark Loughridge during the Apr 17 teleconference with analysts. "Japan and Public Sector... impacted the overall GBS constant currency growth rate by 6 points... So Japan impacted both our profit growth, and revenue growth in GBS this quarter."

What a difference a year makes. In the first quarter of 2011, Big Blue rode on the crest of the new mainframe wave.  Things were rosy.  The stock soared. IBM looked as solid as the Rock of Gibraltar, we noted in subsequent reports (see Wall Street's New "Rock of Gibraltar" and Big Blue "Rock of Gibraltar" Stands, Apr 2011).

IBM is still solid.  Like the Rock of Gibraltar.  Unfortunately, it is also stuck like the Rock of Gibraltar.  Stuck in the same place.  While the marketplace around the Big Blue is exploding, and the companies like Apple, Facebook  etc. are growing by leaps and bounds, IBM's first quarter revenues were flat.  Its hardware business was down 7% in the first quarter (right chart).

In fact, the only relatively bright light was software. And even software grew only 5%.  Which is below par for the most profitable IBM business segment in recent years (see the chart, right, and Our Initial Reaction below for details).

No wonder the stock market punished Big Blue not only in after-hours markets, but also for the next three days' of trading (right).

And we have a feeling this may be only only the start of a longer-term slide for this erstwhile bellwether stock of the Dow Jones Industrials' index. 

Why the pessimism?

Three simple words: Lack of growth.

No amount of rhetoric and news-spinning by IBM's CFO, Mark Loughridge, could reverse that fact. Not even the desperation of increasing the year-end earnings forecast could persuade investors to keep the faith (to at least $15.00 EPS from $14.85 EPS).  They abandoned Big Blue in big numbers since the first quarter release on Apr 17.

As long as IBM keeps refusing to step out of its comfort zone - the low or no growth enterprise pond - it will remain stuck in it, like that Big Blue whale in the above cartoon.  The only way up the growth curve is to start inventing new markets, and in the process reinventing itself.  With IBM shares down seven points in two days, this would be an excellent time to start that journey.

The new IBM CEO, Ginni Rometty (right), has a chance to give the company a  fresh new look, without worrying about her  predecessor's legacy.  Just like Sam Palmisano did in 2002-2003, when he ascended to the top post.  He waited a year or so for the former CEO to leave before starting to leave his mark on the future of Big Blue. 

Rometty does not have that luxury today. Unlike Palmisano in 2002, when IBM was down in the dumps (left chart), she is starting with the IBM stock close to its all-time high.

That's not an enviable position to be in at a time when radical changes are called for. Because the latter means pain and suffering for a while, before the next spurt up the market cap mountain can occur.  And Wall Street investors and shareholders do not have much patience while the giants, like the Big Blue, try to reinvent themselves.

Still, it's the only way to go if Rometty wants to lead rather than follow.

That's what Apple's Jobs did several years ago.   He proved that a leopard can change its spots.  And look at Apple now (left chart).  Even though IBM shares are still up a respectable 10% for the year, that's only a quarter of Apple's growth this year - without Jobs! 

The story is the same for the last 12 months.  Apple has left both "veterans" of the IT industry - IBM and Microsoft - in the dust, even if all three companies' shares have risen in double digits (right chart) since April of 2011.  In fact, so powerful has Apple become that  it now affects market and economic indices, not just its competitors.' shares.

At the end of last year, the overall earnings for S&P 500 rose about 6% compared from 2010. If Apple's 116% profit surge was excluded, S&P earnings would have risen only 3%.  So we must be careful when it comes to averages.

But Apple is not the only apple worth picking...

Facebook, for example, an upstart founded in 2004 which is expected to go public next month, may hit $12 billion in revenues next year and will be worth $137 billion, according to Wall Street estimates.  That's about the size of Intel or Oracle, the companies that have been around for 44 and 35 years respectively.  And neither has been a slouch when it comes to growth, either.  Facebook's spectacular ascent makes even Google look like a laggard, let alone establishment companies, like IBM.

It's not that IBM hasn't tried to reinvent itself. It has.  The "On Demand," "Smarter Planet" and "business analytics" are some examples of it from the Palmisano era.  Here's what the IBM CFO Loughridge said about it in his latest teleconference:

"Total cloud revenue doubled over last year, with strong contribution from all areas, private cloud, public cloud, and our industry-based solutions. This all comes together in our Smarter Planet solutions. With over 25 percent growth this quarter, Smarter Planet continues to deliver strong growth driven by our new Smarter Cities solutions and continued strength in smarter commerce offerings."

"When you look at our offerings in business analytics, cloud, and Smarter Planet, about half of the revenue is software. So the success we’re having in our growth initiatives is improving our business mix and our margin."

Alas, that's not enough as the company's flat revenues show.  That's all just fishing on the periphery of the same enterprise fond.  We recommended to the Big Blue in 2006 that it should create a "Baby Blue" and aim at blowing the lid off the SMB market (see From Little Acorns Big Oaks Grow, Nov 2006).  The idea fell on deaf ears in Armonk.

In the meantime, the company spent more than five years spinning its wheels in the enterprise market hoping to get better traction.  It has not.

It may be time for Rometty to remind her Big Blue crew of what President Eisenhower said to his White House staff in the 1950s: "I think we've flogged this horse enough. Let's get a new one."

Translated into IBM-ese, this means look for new greener pastures outside the corporate arena.  Or languish and eventually whither for lack of new food sources.

Check out what we said in our Mar 15 update on Apple vs. IBM:

Apple's phenomenal growth has served as an  embarrassing mirror to all those "establishment" companies, like IBM, who ignored consumer markets, preferring to do business with their peer-shrinking Fortune 500 dinosaurs.  They ignored our estimates to the contrary, wpe2.jpg (31149 bytes)such as, for example, this chart (left), published in 1996, which predicted that Consumer will be king by 2010, not an enterprise czar (see Louis XIX of Armonk).

Don't get me wrong. Big Blue has done an outstanding job in its own right.  And the $206 record high stock price reflects it.  But Apple's earnings are now more than double that of the world's oldest computer company ($33 billion vs. $15.9 billion).  So they are not even in the same league anymore.  Nor will they be in the future. (Annex Bulletin 2012-04, 3-15-12)

As you can see from our forecast below, expect IBM to grow at about 2% and 4% over the next two years, while Apple is forecast to surge by about 46% and 17% respectively in the same time frame.  So the gap will only get wider. Unless IBM changes its tack.

We know that's easier said and done.  Corporate graveyards are filled with corpses of companies that tried to reinvent themselves in a different market.  A year ago, the New York Times carried an excellent story about it (see Wreckage at the Intersection of Corporate and Consumer Markets, Apr 2011).  Here's an excerpt:

The record of powerful companies charging into the consumer marketplace, only to retreat in humiliation later, is long and distinguished. Cisco’s announcement last week that it would shut its Flip video camera division, two years after buying Flip for $590 million, is just the latest chapter in a story that could be titled “The Consumer Marketplace: Destroyer of Dreams.”

So why try? For starters, the stock market rewards sexy consumer products. Their makers are not just companies — they become cultural movements. Apple’s stock trades at a price of about 18.5 times earnings per share, Cisco Systems at 13 times. No one ever waited in line to buy a Cisco networking solution. Cisco’s share price fell about 3.5 percent last week; it is down almost 16 percent so far this year.

“To enterprise companies, the consumer market is the Afghanistan of business,” said Andrew Zolli, consultant and director of the PopTech, an annual technology conference. “Lots of companies take a turn there and no one leaves satisfied — and they all leave eventually.”

Sadly, IBM's been at such crossroads before.  More than once.  In this writer's first ever public speech, delivered to an international business audience in Mallorca, Spain in June 1984, I talked about the "Jolly Blue Giant" being challenged by the then upstarts - the "PCM" vendors. If you click on "The PCM Syndrome" (below), you can see an excerpt from that speech.

IBM failed that challenge.  It refused to change.  It believed the "mainframe were forever," like the diamonds. Turned out they were not.  The company almost bit the dust in the early 1990s because of its feet of clay.  It took a wrecking ball called Lou Gerstner to start changing things at Big Blue. 

Will Ginni Rometty allow history to repeat itself?  Or will she kick 434,000 IBM employees out of their comfort zone and into ozone of 24/7 creative action?

That is the question for Big Blue again: "To be or not to be."

IBM Forecast

And now, for what it's worth, here is our IBM revenues and earnings forecast through 2015.  Consider it the best case scenario.

As for the IBM stock, now that some of the hot air has been taken out of it following the first quarter release, Big Blue shares appear about fairly priced relative to other IT leaders. 

Top 10 IT Cos. Mkt Cap Trail P/E Change   Mkt Cap Trail P/E
  20-Apr-12    (annlzd) 01-Dec-11  
Apple $534.23 16.31 116% $360.55 14.01
Microsoft $272.03 11.75 67% $212.66 9.19
IBM $231.27 15.28 9% $223.29 14.93
Google $193.90 18.06 -6% $198.80 20.90
Oracle $143.68 15.13 -24% $159.76 18.01
Cisco $107.23 15.26 18% $99.88 16.04
Intel $137.97 11.68 21% $126.89 10.79
SAP $77.63 17.07 21% $71.39 20.09
EMC $58.58 24.07 57% $47.27 23.05
HP $48.46 8.58 -33% $56.13 8.50
Avg Top 10 IT $180.50 15.32 38% $155.66 15.55
IBM stock on 4-20-12 $199.60      
IBM @ Top10 P/E  2% $203.10 $13.06  (EPS)  
IBM stock on 12-01-11 $189.45      
IBM @ Top8 P/E  -3% $183.52      
22-Apr-12    Source: Annex Research      

But averages can be deceiving.  Kind of like the fate of that statistician who believed in them and then went to drown in a lake with an average depth of three feet.  Notice the sharp declines  in HP and Oracle shares (interestingly the two companies that are embroiled in a bitter fight with each other at the executive level).  Google is also down, though not by as much.

As for the companies whose share have risen in the last five months since we took the "market temperature" reading of the Top 10, IBM's 9% annualized growth is the lowest.  Apple's 116%, of course, is through the roof.

IBM's current multiple of 15.28 is also on a par with the average for Top 10 IT stocks (15.32).  So overall, at the current price of about $200, we feel that IBM shares are priced fairly relative to the market and the Top 10 IT stocks.

The question is, what happens when the market starts to cool off?  Clearly, a 38% average annualized increase for these stocks is not sustainable in the long run, especially on top of an already huge run-up in the last 12 months.  It's pure emotion.  And as HP and Oracle shareholders have found out, that could mean here today, gone tomorrow.

Happy bargain hunting

Bob Djurdjevic

Our Initial Reaction

HAIKU, Maui, Apr 17 - "Sell on rumor, buy on fact" - seems to be an appropriate tactic when it comes to trading in IBM stock.  It is the flip side of the "up on rumor, down on fact"-stock price fluctuations.  Big Blue shares gave up all of their gains from the regular trading today in the first 11 minutes of after-hours trading, following the start of the IBM teleconference of analysts:

International Business Machines Corporation (IBM)


207.45 Up 4.73(2.33%) 4:00PM EDT|After Hours: 202.80 Down 4.65 (2.24%) 5:11PM EDT - Nasdaq Real Time Price


As the conference progressed, the after-market stock price continued to slide...

International Business Machines Corporation (IBM)


207.45 Up 4.73(2.33%) 4:00PM EDT|After Hours: 202.68 Down 4.77 (2.30%) 5:30PM EDT - Nasdaq Real Time Price

What happened? Three simple words: Lack of growth. No amount of rhetoric and news-spinning by IBM's CFO, Mark Loughridge, could reverse that fact. Not even the desperation of increasing the year-end earnings forecast could persuade investors to keep the faith (to at least $14.27 from at least $14.16; and operating (non-GAAP) diluted earnings per share to at least $15.00 from at least $14.85).

Sure, IBM profit is up.  But its first quarter revenues were flat overall, with software being the only major growth segment.  During the teleconference with analysts the IBM CFO said he expected the IBM hardware businesses to regain revenue growth in the second half of the year. But that's a bird in the bush. Here's what the 1Q performance looks like (see above chart).

As you can see, most lines point downward.

Meanwhile, what the investors also see in today's IBM results is that the lifeblood of Big Blue's business - the Services backlog - was down 2 percent to $139 billion.  Considering that the new contract sales were $11.8 billion, actually up 12% from a year ago, suggests that the main reasons for the backlog decline must be coming from expirations,  cancelations and rescoping.  And that does not bode well for future revenues.

Software was the only relatively bright light in IBM's 1Q report. But even software revenues only rose 5%, not enough to lift up the rest of the growth laggards.

* * *

     The PCM Syndrome

      Once upon a time in a not-so-distant land, there lived a giant. 


      The Giant always dressed well, spoke lucidly and acted confidently.  His favorite color was blue, his motto "THINK".  As the Giant grew, he trimmed off excess fat through vigorous exercises.  To ensure every part of his body was functioning perfectly, the Giant kept moving things around.  And so, arms became legs, toes became fingers,  shoulders became hips...  Except for the head, of course.  The head had to think up new ways of organ mutations.  [PAUSE & SMILE]  

        People of this land, at first apprehen­sive of the Giant's strange ways, slowly came around to liking it.  They saw dis­placed organs functioning well, some even better than before.  Fondly, people began interpreting the Giant's three-letter acronym as "I've Been Moved".  [PAUSE & SMILE] 

      After a while, the Giant's power was beginning to resemble his size.   


      "Let there be rent", the Giant would say.  And people would start renting.  "Let there be SYSTEM/360", the Giant would test them some more.  And people would throw away their 1401's to start afresh again.   

     And so it went until some of the wise old men among the people of this land, started looking in the ancient scriptures to see if there had ever happened such a thing before.  They found but one reference to it.  It was Lord Acton who wrote:   


            "Power tends to corrupt and ABSOLUTE POWER CORRUPTS ABSOLUTELY".

     The wise men went to the Giant and asked if he would change some of his ways for the good of all people.  But, the Giant was so preoccupied with his own body-building that he he scarcely paid any attention to what the old men were saying.  So, the people began interpreting his three-letter acronym's as "I've Been Misled".  [PAUSE & SMILE] 

        It was then that the wise men counseled the people to take the Giant to court.  And so they did, claiming he became too big for his britches.  Thousands of pages of legal briefs changed hands.  The trial transcript alone was 104,400 pages long.   

      The Giant bled, but so did the govern­ment of the land.  Some people estimated that the Giant's lawyers were costing him about $15 million per year.  The peoples' own legal costs averaged over $3.8 million per year.  In the end, 13 years had gone by before the Giant succeeded in outspending and outmaneuvering even the peoples' government. 

(see  "Is Antitrust Dead?" article itself is a synopsis of the book project "In IBM We Trust" (1984)

      But, what the courts and the government failed to do, someone else accomplished at least partially.  Since 1975, a new force entered the scene.  Plug-compatible challengers began disturbing the Giant's rose garden.  So badly were the Giant's roses in need of attention, that the first new mainframe competitor reported a profit in the first quarter after it started shipping its computers.  

      This was accomplished, in part, thanks to its "purchase only" strategy.  The competition, albeit still an infant-size, reentered the marketplace.  This extra­ordinary event became known as "The PCM Syndrome".   

      History tends to repeat itself.  Actors change, as does the stage, but the play is still the same as it was in ancient times. 


      "David versus the Goliath" was staged in its n-th edition when in 1975 the first Amdahl mainframe hit the market.   

        It took a courageous man to buy a V/6 then.  No less courageous than was David when he took the Giant on.  

It took a man of vision, or perhaps one driven to despair through his helplessness against the Giant's power.  Desperate men do desperate things.  If things work out, they become men of vision.  And so it was with the first plug-compatible purchasers. [TURN SLIDE OFF] 

     Yet, the Giant could have prevented his partial demise. 

      "Tempt not a desperate man", Shake­speare wrote four centuries ago. 

      But, the Giant did not read Shakespeare.  So, he drove David to despair.  That's when David struck back.  Later, others, also joined the fray with their own plug-compatible mainframes.  

      By 1977, the Giant started paying atten­tion.  His new mainframes were priced well below the previous price/performance levels.  In the ensuing years more price reductions followed.  The Giant also went on a diet, began exercising again.  He started to listen to the people he had scorned before.   

      Today, the Giant is singing "let there be purchase"-song, pretending it was his original tune.  "Purchase is a natural order of things", one of Giant's apostles hailed recently.  While most people are still doing what the Giant wants them to, more or less, some have become more cautious.  They still remember the time when "let there be rent" was the Giant's favorite tune, and are sus­picious of his motives for change.   

      But, even if they are not aware that it was the PCM's who forced the change -- the Giant is.  And that is the peoples' best insurance policy.   [PAUSE] 

      Today, all people of this happy land are better off because of the Giant's reincarnation. 


Volume XXVIII, Annex Bulletin 2012-05
April 23, 2012

Bob Djurdjevic, Editor

(c) Copyright 2012 by Annex Research, Inc. All rights reserved.
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Annex's 33rd Birthday (May 15, 2011)


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