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IBM FINANCIAL

Analysis of IBM’s Second Quarter Business Results

Smoke and Mirrors Galore II

Revenues in Five of Seven Business Segments Are Down, Yet IBM Boasts

MOSCOW, July 19 - One year ago to the day, we published the Annex Bulletin 2000-18, “Smoke and Mirrors Galore.”  “IBM Continues to Woo and Wow Gullible Wall Street Analysts,” read our sub-heading.  That’s because IBM tried to spin a bad news quarter as good news.  And Wall Street bought it - hook, line and sinker.

Today, we witnessed “Smoke and Mirrors Galore II.”  And Wall Street fell for it again.  IBM shares were basically unchanged at $104 following its second quarter financial release, despite a disclosure that revenues in five of Big Blue’s seven business segments were down, and that the overall revenues declined by 0.4%.  And just remember, that’s compared to a relatively weak quarter a year ago!

“Our services business continued its explosive growth, increasing its revenue by 15 percent, excluding maintenance, and signing $16 billion of new business,” said Lou Gerstner, IBM’s CEO and chairman, in a release. 

What the IBM chairman neglected to say, however, is that the 15% growth is in constant currencies, and that the actual revenue increase of the IT services portion as officially reported was a mere 8.7%.  Furthermore, when maintenance is included, as it is in IBM’s actual financial statements, the IBM Global Services (IGS) revenues were up only 6.8% over the second quarter 2000.

Is 6.8% what one would term “explosive growth?”  Perhaps only in the land of smoke and mirrors.

And then there was the old IBM trick of quietly restated last year’s results to make this year’s look better.  As we analyzed the company’s latest financial release, we spotted that last year’s gross profit was $80 million lower than reported in July 2000.  That made this year’s growth appear slightly better than warranted. 

Upon closer scrutiny, we discerned that IBM must have transferred that amount from Other Expenses in the 2000 financial statements, into Global Financing, thus reducing its gross profit by $80 million.  The restated second quarter 2000 Other Expenses were $84 in the latest version, versus $164 million one year ago.  

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Most unusual for Armonk “accounting magic” artists, even some accounting typographical errors appear to have crept into IBM’s second quarter release.  A $34 million second quarter 2001 loss was shown as income in the Other Income category.  And a $130 Other Income from a year ago in the same category was reported as a $130 million loss. 

The bottom line IBM math did jibe, however, when adjusted for these errors.  And it showed that IBM second quarter per share net profit was $2.0 billion, up 5% to from a year ago (up 4.4% when adjusted for tax rate and outstanding shares fluctuations).

Business Segment Analysis

Geographies.  All three IBM geographic sectors were down, according to the “as reported” figures.  North America and Europe (EMEA) declined by 1%, while business in Asia/Pacific dropped by 2%.  In constant currencies, however, North America was flat, Europe was up 7% and Asia/Pacific revenues increased by 10% (see the chart).

But IBM’s OEM business showed few signs of erosion due to currency translations.  Revenues were up 11% as reported, and 12% in constant currencies.  

This suggests that although this operation is theoretically global in nature, most of IBM’s customers must be U.S. computer vendors.  The OEM transactions thus seem to be only marginally affected by the fluctuations of the U.S. dollar relative to other currencies.  But since the OEM sector is by far the smallest - less than one-tenth of the geographic revenues ($1.9 billion vs. $19.7 billion) - its strong performance had only a marginal effect on IBM’s overall results.

Services.  As noted earlier in this Annex Bulletin, IBM Global Services (IGS) was one of the two growth segments among the IBM lines of business.  With $16 billion in new contract signings, the second quarter of this year was second only to the same period in 2000, when IGS closed $20 billion in new business (see Annex Bulletin 2000-18).  The fact that revenues (including maintenance) were up only 6.8%, despite such outstanding sales results, suggests that contract cancellations and expirations have also continued at a brisk pace. 

This conclusion is also supported by the fact that IGS backlog increased by only $20 billion since a year ago (from $75 billion to $95 billion) despite surging new contract sales.  In fact, since 1999 (i.e., during the last six quarters), IGS has sold $81 billion in new contracts, while this IBM unit’s backlog increased by only $35 billion (see the chart).

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Furthermore, while much more profitable than IT services alone (46% vs. 24% gross margins), maintenance is a declining business.  Which means that IGS needs to sell almost twice as much of the new IT contracts just to make up for the corresponding drop in maintenance profits.

As for the IGS business sub-segments, outsourcing revenues, including the so-called eSourcing, increased by 15% in constant currencies since a year ago.  We figure that this would put the outsourcing “as reported” business growth at about 10%.  And considering that e-business services alone jumped by 30% since the second quarter of 2000, the actual outsourcing revenue growth was probably only in the single digits.  But that’s a “mystery” that IBM chose not to disclose, for obvious reasons: It would show IGS to be less than omnipotent in its biggest and the most important segment, which is the way Armonk likes to portray its services unit.

Integrated Technology Services sub-segment, on the other hand, put in a much better performance in the second period.  Revenues here were up 19% in constant currency (up about 14% “as reported”).  Demand for systems integration was strong across all geographies, IBM noted in its presentation to analysts.

Business Innovation Services sub-segment, on the other hand, experienced only a 13% growth in constant currencies (about 8% “as reported”).  But its supply chain management business nearly tripled, and the e-business integration services rose by 24%, IBM said.

Hardware.  Led by a sharp (-22%) decline in the money-losing PC business, and in the marginally profitable Technology segment (-14%), IBM’s overall second quarter hardware revenues dropped by 5.5% to $8.65 billion.  But the Enterprise Systems products - formerly known as mainframes - experienced a temporary renaissance.  Their revenues were up 25% to $3.5 billion.  We say “temporary,” because this another declining IBM business segment.  

Back in 1990, for example, the S/390 mainframes alone generated $13.4 billion in revenues and about $2.7 billion in pretax profit.  Today, the second quarter Enterprise Systems renaissance contributed $526 million to IBM’s pretax earnings.  That’s only 40% of IGS’ pretax profit share ($1.3 billion), and is less than that of IBM software.

Software.  Speaking of software, its second quarter revenue was down 5% (flat in constant currencies).  But given software’s much higher profit margins, its pretax contribution was quite a bit bigger than that of the Enterprise Systems’ ($711 million vs. $526 million).

WebSphere and database software grew in the double digits (up 44% and 19% respectively since the second quarter of 2000), while Tivoli’s revenues declined, due to “product transitions,” IBM said.

Summary

So what will be a likely Wall Street reaction to such a mixed second quarter performance by the Big Blue?  If the past is to be our guide, stand by for the IBM shares to rise (just as we predicted a year ago in the Annex Bulletin 2000-18).  Yes, rise!  That’s because rhyme and reason have long since ceased to apply to the way Wall Street looks at business fundamentals. 

Happy bargain hunting!

Bob Djurdjevic

P.S. Belgrade, July 20: Indeed, IBM shares rose on July 20, closing at $105.70.





 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Volume XVII, No. 2001-15
July 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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