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IBM FINANCIAL

Annex Research’s Five-Year Forecast for IBM

An Unenviable Legacy

New IBM CEO to Inherit Sluggish Giant; Milking the Pension Fund - New LOB

PHOENIX, June 19 - “The king is dead; long live the king!”, goes an old saw.  Well, the IBM “king” (“Louis XIX of Armonk”) is neither dead, nor gone yet from his Armonk “Versailles,” yet the industry is already abuzz about the kind of a legacy Lou Gerstner will be leaving to his hand-picked successor (Sam Palmisano). Text Box:

So what kind will it be?  We try to answer that question in this special report that contains our five-year forecast for IBM.  And our answer is in a word - an unenviable legacy.

Unenviable, because IBM is still a sluggish, monolithic colossus trying to compete with smaller, nimbler fish in an increasingly crowded and swiftly changing market. 

Unenviable, because IBM’s illusion of prosperity has been created by financial and accounting trickery, such as stock buybacks, tax reductions, or the milking of the IBM pension fund, which we jointly dubbed several years ago as Big Blue’s new “financial engineering” line of business (see Annex Bulletin 98-36, Oct. 20, 1998, or “Armonk Fudge Factory,” May 28, 1999, or “Fortune on IBM,” June 15, 2000).

Unenviable, because empires built on such shaky grounds tend to creak and quake rather than make their enemies quake in their boots.

Unenviable, because IBM is unlikely to achieve the elusive $100 billion-revenue milestone in the next five years.  Or, for that matter - ever! 

Unenviable, because IBM’s “smoke and mirrors”-aided profits are likely to decline over the next five years.

Unless, of course, the company undergoes some radical restructuring equivalent of a corporate lobotomy under its new leader.

And how likely is that under Sam Palmisano?  Not very.  For, if Palmisano were a “hell bent for leather”-type of a radical leader, he would have been long gone from a “kiss the boss’s posterior”-type of Armonk.  As are now so many other former IBM “radicals” who were at one stage or another considered candidates for the top Armonk job (e.g., Jim Cannavino, Ellen Hancock, Bob LaBant, etc.).  

Of course, Palmisano may still surprise us all once he does take the reigns of IBM.  After all, he has never been a Numero Uno so far.  A former John Akers’s (an ex-IBM chairman and CEO) executive assistant, Palmisano apprenticed in Asia/Pacific under Ned Lautenbach and Mike Armstrong (now AT&T’s chairman and CEO).  He learned the ropes of the IT services business under Dennie Welsh.  And he ran the PC unit under the tutelage of his present boss.

In short, Palmisano has proven himself to be an outstanding executive when it comes to toeing the boss’s line.  But we are yet to find out how good he is when casting his own line.

Milking the Pension Fund

Either way, Palmisano, the ultimate IBM insider who served directly under two last Big Blue CEOs, will not be allowed any excuses for the transgressions of his former bosses.  After all, he was in the kitchen when the Armonk broth was being prepared.  Which includes the “financial engineering” finaglings, such as the stock buybacks, tax reductions or milking of the IBM pension fund.

Speaking of the latter, what was a cause of some raised eyebrows in 1999, grew into a full-fledged bonanza last year.  IBM’s 2000 pretax profit was padded by over $1.1 billion, or 10% of pretax earnings, from this non-operating “line of business” (LOB).  That’s up from 6% in 1999 and 5% in 1998. 

If the current trends continue, the milking of the IBM pension fund may account for nearly $2 billion or 19% of IBM 2001 pretax profit.  And that would make this “financial LOB” bigger than the profit IBM earns from all of its servers; and more than double the pretax earnings from technology, PCs or global financing.

Nor is IBM alone in this accounting scam.  According to a June 15 Wall Street Journal story, 100 largest companies that are components of the S&P 500 index got a 6% boost last year from earnings generated by their pension funds.  And just think, all this happened during the time of a supposedly depressed stockmarket!?

How is that possible?  Easy.  Once again, the accounting “black magic” comes to fore.  

“Pension accounting is designed to smooth our the bumps in recognizing pension costs and investment returns,” explains the Journal article.  “That means it can take years before Text Box:  the effects of declines in pension assets are fully reflected in corporate earnings.”

By which stage, “Louis the XIX of Armonk” will be off to greener pastures, of course, such as perhaps some Florida golf links.

Making it easier for the corporate executives and boards to pull the wool over the general shareholders’ eyes is that the pension plan manipulations are a relative obscure notion to most ordinary investors.  Once again, the Journal explains:

“(The) effects (of pension plan schemes) are buried deep in the footnotes of the companies’ annual reports.  This area of accounting is still widely ignored and little understood by the investing public.”

Worse, the assets from which the companies, like IBM, claim hefty profit contributions don’t even belong to them.  “Pension assets belong to pensioners, not stockholders, even though the earnings produced by these assets show up in companies’ income statements,” Jack Ciesielski, publisher of Analysts’s Accounting Observers, told the Journal.

So “buyers beware,” the Journal seems to be cautioning the “investing public” - without ever even mentioning IBM!? (the story did mention by name Unisys, Lucent, Verizon, and Allegheny, however, among the 100 large companies surveyed for pension plan manipulation).

Five-year Forecast

Over the next five years, we expect the IBM revenues to increase at a compound annual rate of less than 1% per year.  Barring some radical restructuring that we mentioned earlier in this report which could boost the growth, after peaking in 2002 at $95.7 billion, we expect the Big Blue’s revenues to decline gradually to $91.7 billion in 2005.  

The company’s net earnings are likely to decline slowly from the $8 billion-peak set last year, to a $5.5 billion- to $6 billion-level in 2005.  Of course, that’s pretty much the best case scenario.  Things could get a lot worse if the global economic conditions deteriorate; or if the “investing public” figure out Armonk’s financial engineering scams, and take a flight away from the IBM stock.

Among the IBM business segments, services (excluding maintenance) will continue to be the only real growth activity.  Yet even the growth of this one-string IBM violin will have been more than halved in the next five years.  We expect the services’ revenues to increase at a compound annual rate of 8% as compared to 16.5% in the 1995-2000 period.   

Maintenance revenues, on the other hand, are likely to drop at 5% per year between 2001 and 2005, matching the rate of decline during the previous five-year period.  This means that a combined services plus maintenance revenues of the IBM Global Services (IGS) unit will increase at 4.4$% compounded annually between 2001 and 2005, reaching $45 billion at the end of the five-year period.

The heavily server-centered (read mainframe-centered) IBM software revenues are likely to decline at 2% compounded annually during the next five years, accelerating the drop-off in business which was already evident in the 1995-2000 period.

Finally, we expect the IBM hardware revenues to shrink at 4.3% compounded annually, dropping to $35 billion by the end of the five-year period.  This means that in 2003, the IGS revenues will likely surpass for the first time those of IBM hardware product units ($40.9 billion vs. $38.7 billion).

And that’s all she wrote… for now.

Happy bargain hunting!

Bob Djurdjevic






 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Volume XVII, No. 2001-13
June 19, 2001

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

P.O. Box 97100,      Phoenix, Arizona 85060-7100
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