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Analysis of IBM’s Third Quarter Business Results

IBM Stock Gets Trashed!

IBM Runs Out of Tricks as Wall Finally Loses Patience with Big Blue

PHOENIX, Oct. 18  The IBM stock got trashed again on Wednesday (Oct. 18) following the release of its third quarter results.  Just like one year ago.  It’s just that the reasons differed. 

Last year, Wall Street bought IBM’s warnings about the supposed upcoming Y2K impact, and promptly expunged about $37 billion-worth of hot air out of the IBM market capitalization in just one day (see “Big Blue Sings Y2K Blues,” Oct. 21, 1999).

This year, however, Wall Street finally saw through IBM’s dwindling bag of tricks, and trashed between $33 billion and $42 billion of IBM’s market value, again in just one day.  And that despite the fact that Big Blue’s third quarter business results weren’t really all that bad.

“This was a solid quarter, with earnings per share up 20%, and an acceleration of revenue growth relative to the first half of the year,” Lou Gerstner, the IBM chairman and CEO, said in a statement.

But Wall Street wasn’t buying it anymore.  After four years of gulping down such IBM explanations for Armonk’s game of financial smoke and mirrors, using the stock buybacks as a multi-billion dollar “chaser,” traders and investors finally focused on some cracks lurking behind IBM’s illusion of prosperity.

First and foremost, it was the company’s continued lack of GROWTH!  Revenues were up only 3%.  Yet when IBM reported an abrupt slowdown in growth one year ago, supposedly due to the Y2K issue, it implied it was just a one-time, passing phenomenon.

We said that was a lame explanation; that IBM’s lack of sustainable growth was an endemic problem that has been plaguing the company for at least the last six years (see “Big Blue Sings Y2K Blues,” Oct. 21, 1999).  Few people bothered to listen, however.  And so by the end of August 2000, a euphoric Wall Street had pushed the IBM stock back up to $132, close to its all-time high of $139, reached in July 1999.

Text Box:

But the third quarter 1999 slowdown did have its good points.  It should have made for a much easier relative comparison to this year’s results.  At least that’s what the IBM executives promised (as late as July of this year), when they predicted a much stronger second half of 2000.

It didn’t happen.  IBM’s growth was still anemic, just as we predicted a year ago.  The decline was led by its S/390 and AS/300 servers, and accompanied by a surprising drop in software revenue (-3%), and a double-digit (-19%) decline in Enterprise Investments.  Even IBM’s much ballyhooed Global Services business went up by less than 4% without the hardware maintenance revenues.

Which is probably why the IBM stock finally got trashed today, plummeting from $113 on Tuesday, to $90 in the early morning trading on Wednesday, before rising slightly to close at $95. 

At the trough of this wild day’s ride, the IBM stock had lost some $42 billion of its market value in a matter of hours.  Such is the price of gullibility and greed.

Business Segment Analysis

Hardware.  Gerstner’s IBM wouldn’t be IBM - the financial engineering company, if it didn’t try to slip a few fast ones by Wall Street analysts while putting a positive spin on the bad or mediocre news. 

We’ve already said that IBM reported anemic (3%) growth in the third quarter.  The biggest disappointment was probably hardware revenues, which were up only 4% from the already depressed third period in 1999.  Yet even that 4% growth was probably an overstatement of the actual performance, due to some fancy financial footwork by the Armonk smoke and mirror artists.

Why?  Because $225 million of last year’s third quarter revenue was “restated” - read transferred - from the Enterprise Investments category into the hardware segment.  Obviously, this boosted the hardware results at the expense of the obscure money-losing category that few people care about, and which we had dubbed “Lou’s Kitty” in one of our last year’s reports about it (see “Armonk’s Fudge Factory”, Apr. 9, 1999).

And why did the hardware need such a boost?  Because the big iron sales stank.  Not only did the S/390 revenues drop for God Text Box:  only knows which quarter in a row, but for the first time in years, the MIPS shipments also dropped 2%. 

IBM blamed it on the usual product transition woes.  Wishful thinking.  Even veteran mainframe warriors, such as Amdahl/Fujitsu, have forsaken the race with IBM for the next generation S/390 servers (see a Wall Street Journal Oct. 19 article), which IBM calls the “z900 eServers.” So the Big Blue may have just reached for “a bridge too far,’ sinking several hundred million dollars into a bygone era. 

“Some existing orders were even deferred,” and not just new ones, Armonk’s financial spinmaster, John Joyce, the IBM CFO, was forced to admit in his comments about the third quarter.

Similarly, “for God only knows which quarter in a row,” the AS/400 hardware revenues also declined (-6%).  IBM blamed its “supply constraints” for that disappointment.

Overall, the Enterprise Systems revenues declined 7%, and its pretax margins dropped to only 11.8%, lower than even that of services (12.9%). 

Two bright spots in IBM’s hardware lineup were the low-margin PCs and the Unix servers (RS/6000).  Their revenues increased 12% and 15% respectively.  But the PC pretax margin was only 1.5%, while the RS/6000 volumes are too small to have made a difference for a company of IBM’s size.

The obvious demise of IBM’s biggest hardware businesses notwithstanding, the IBM chairman also tried to put on an optimistic spin on the news.  “We expect our broad portfolio will be even more important as we go forward, especially compared to the single-segments companies in our industry.’

Yeah, right.  Before the ink was even dry on this Gerstner statement, Sun Microsystems, one of these “single segment” companies, shattered all records with its third quarter results.  Revenues surged by 60%, while Sun’s met soared by 88% over the same period last year.

Someone on the IBM Board ought to suggest to this Armonk “has been” that the IBM chairman is probably about five years past due on his retirement plans.

Services.  IBM Global Services (IGS) had “another strong quarter” in terms of new contract signings, IBM said.  Indeed, the impressive $13.3 billion total was second only to the all-time record of $20 billion that IGS set in the second quarter of this year.

About two-thirds of the $13.3 billion were outsourcing deals.  Fourteen of them were contracts worth over $100 million; two were over $1 billion.  Yet by the time all was said and done, the IGS revenue growth in the third quarter was a mere 3.8% (excluding hardware maintenance, which went up by 6%). 

How is that possible?

Just ask EDS.  In our report on EDS Second Quarter Results (July 28, 2000), we commented about the extensive “pruning” the Plano, TX-based IT services company was doing with some of its non-profitable contracts. 

Text Box:  Well, if what EDS was doing was “pruning,” then the Big Blue’s services unit must have been burning off entire forests of its low-margin or unprofitable contracts in the last several quarters.  For there is no other way one can explain how the company managed to blunt the positive effect of all its new contract signings, and reduce it to low-single digit growth in revenues.

Boy oh boy… the tricks Armonk magicians don’t tell us about, and the Wall Street analysts don’t look for!  But they finally got it right anyway, for whatever non-reasons and however belatedly, when they trashed the IBM stock today.

At $95, however, IBM has still outperformed the Dow Jones growth by 3.7-fold since July 1996 - roughly the time the Big Blue went on its stock buyback binge.  Meaning, even after this one-day bloodletting, the IBM stock is still overpriced.  At least judging by its business fundamentals.

Oh, yes, in the third quarter, IBM recycled another $1.4 billion of the Big Blue shareholders’ money into share repurchases, contributing to a negative $2.4 billion cashflow during the first nine months of this year.  No wonder the equity dropped by another $1 billion (or 5%), while its debt increased by about the same amount during the nine-month period.

 Happy bargain hunting!

Bob Djurdjevic

NOTE: The print edition of this report, of course, contains additional charts and tables not included here.

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Volume XVI, No. 2000-23
October 18, 2000

Editor: Bob Djurdjevic
Published by Annex Research;
e-mail: annex@djurdjevic.com

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