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Analysis of IBM Global Services 2001 Business Results
Tough Times, Soft Deals
“Swiss Cheese Backlog;” “Crown Jewel’s” Bulk vs. Bottom Line
PHOENIX, Apr. 26 - “When the going gets tough, the tough get going,” claims an old saw. Not necessarily in the global IT services game. That’s where tough times lead to soft deals.
How soft? So soft that even $15 billion of new contract signings, up 50% over the year before, wasn’t enough to prevent the IBM Global Services (IGS) revenue from declining in the first quarter.
Yogi Berra would love to play in a game like this. Remember his immortal truism - “it ain’t over till it’s over?”
Well, in the current tough IT services market, a deal is never a deal. And the game is never quite over, just as George Bush’s “war on terrorism” is never quite either won or lost. But is always fought valiantly - with the U.S. taxpayers’ dollars.
Meanwhile, back to the IT market… how do we know the deals are turning soft?
Well, you’ve seen us scratching our heads for several quarters now trying to explain an apparent dichotomy. IGS keeps announcing record new contract signings, yet its revenues have declined for two quarters in a row now! (see “A Disastrous Quarter,” Apr. 17).
So we figured that IGS must be experiencing an inordinate amount of existing contract cancellations and expirations, which offset the flood of new business.
Well, it looks there is more at play here than just those two factors. Here’s what Doug Elix, the head of IGS, told his employees in an e-mail sent out on Apr. 22, right after praising them for a job well done in new contract sales:
“However, many of our existing customers
have been restructuring their contracts with us in order to help
bring their overall spending down, which offsets our ability to generate
growth from new business. Clearly,
satisfying and meeting the expectations of our current customers is
critical; certainly it is equally important to securing new business.”
In the wide world of business, “restructuring” has become a euphemism for layoffs, a dirty word, especially with public. But now we see “restructuring” being used in a new context - for IT services (outsourcing) deals that are too rich for the vendor, and too hard on the customer. So rather than lose the whole shebang - i.e., have a customer default - vendors are cutting better deals for their clients, part-way through the contracts.
Which means backlog is never a real backlog! Think of it as Swiss cheese, if you wish. It’s a work-in-progress, with much downside risk. IBM’s $108 billion backlog, therefore, will obviously produce much less revenue than that by the time the customer checks are cashed.
How much less? That’s hard to tell. But as you can see from the above chart, IGS seems to have been losing about $8 billion per quarter from the backlog before any new sales are recorded. Since the fourth quarter of 1999, IBM had sold about $121 billion-worth of new contracts, while its backlog increased by only $48 billion. So about 60% or $73 billion went to fill the hole.
And as you saw from the last two quarters, the revenue impact of such deal “restructurings,” along with that of cancellations and expirations, is quite substantial. So, a “Swiss cheese backlog” is another product of tough times and soft deals.
For all of us in the industry watching business, this will mean setting up new yardsticks with which to gauge the health of a business.
Now with that as a current news preamble, back to our original mission… analyzing the IBM Global Services 2001 business results. IBM, of course, does not break out this unit’s income statements (only revenues and pretax profits are reported, but bundled with hardware maintenance). So the figures that you are seeing here are our estimates, based on the same type of analysis that we had used in previous years. Revenue and pretax profits do match up to published data.
In 2001, the IGS “services” unit (without maintenance) came close to reaching the $30 billion revenue milestone. But a more important milestone from an IBM shareholder’s viewpoint was its surpassing the $2 billion mark at the bottom line. We estimate that the IGS services had a net profit of about $2.3 billion in 2001, up 25% from 2000, for a net margin of 7.8%.
Such an improvement in IBM services’ profitability is especially welcome at a time of declining revenues. And given that throughout most of the “Gerstner era” at IBM (1994-2001), hardware maintenance profits were covering up for IBM services’ meager profitability.
During the 1994-2001 period, IBM services and maintenance generated about the same net profit ($9.9 billion and $9.3 billion respectively). But the maintenance did it from only about one-quarter of revenues, which have been declining at that! ($47 billion vs. $197 billion - see the chart).
IBM services (w/o maint.) represented only one-fifth of IBM’s net profit during the last eight years, while accounting for about 29% of its revenues during the same time frame. So the maintenance profitability has made IGS look better (see the chart - pg. 4).
Which suggests that the trend toward services has had a lot more to do with increasing the IBM bulk than the quality of its earnings. In fact, with a net margin of only 5.9% between 1994-2001, one can argue that the IBM services has been a drag on IBM’s net margin. Even at a time of sharply eroding hardware margins, and including the lower services profitability, the IBM aggregate net margin was a much higher 8.3%.
Another long-term trend that the IGS 2001 results have reaffirmed is its declining revenue growth rates. As you can see from the chart, the IGS 10-year growth rate has been 20%; the five-year 13%, one-year 7%, and in the last two quarters, the revenue has actually declined.
So even in terms of adding to the IBM bulk, the IGS unit is not performing as well as in the past. The pressure to do better is evident from the Apr. 22 Elix memo to employees:
“This was another tough quarter for us. In the current environment, our customers continue to curtail their investment in many IT services and this has adversely impacted our ability to grow. Our first quarter performance is therefore disappointing and below expectations.
we grew revenue by 1 percent at constant currency.
Certainly, this growth is better than many of our competitors.
However, this level of growth will not give us the momentum we need to
stay in a leadership position.”
First, the “1 percent at constant currency” growth is actually a 3% decline as reported.
Second, we don’t know what sort of competitors IGS is comparing itself to? But the ones that matter, such as EDS, the No. 2 vendor in global IT services arena, is certainly growing (rather than shrinking!), and mush faster than IBM.
Even as the EDS revenue growth slowed to 7%, which is what it was at in the first quarter, it is still much higher that IGS’s - decline! As the EDS chairman and CEO, Dick Brown, put it when the company released its first quarter results on Apr. 22, the “revenue less than we predicted, but (we are) the best on a muddy track.”
Yet the EDS stock is still down more than 25% since its high in late November!? ($53 vs. $72 per share).
As we’ve said many times before, don’t look always for reason and logic when it comes to Wall Street’s appraisals of the companies’ business fundamentals. The just-released surging (!) first quarter GDP figures are a case in point. Even though the 5.8% GDP growth has by far outpaced the expectations and the gloom and doom stories one hears these days from IT vendors, the stockmarket shrugged off the good news, and the Dow Jones industrials fell anyway.
Is there a way of explaining these dichotomies? Yes, there is.
As we have been saying for almost 10 years now, the growth in the U.S. economy is from the bottom of its business pyramid. It is the small and medium-size enterprises that are generating it. Empowered by the PC and the Internet revolutions, they are taking the business away from giant corporations.
That is why all those who are focusing only on large companies are missing the boat. That is why the 5.8% GDP will do little to bolster the prospects of the Dow Jones 30 industrials, or even of S&P 500 companies. That is why the companies that cater to these industrial era dinosaurs, such as the top global IT services providers, are having trouble growing amid the bursting U.S. economy.
As long as they stay on that course, Wall Street will be (for once) right in shrugging off the good GDP news. It doesn’t matter to those who fish at the high end. They are all feeding at the same trough, which is getting smaller and more crowded year after year.
Happy bargain hunting!
Volume XVIII, No. 2002-11
Editor: Bob Djurdjevic
P.O. Box 97100, Phoenix, Arizona
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