Annex Research| Annex Bulletins| Index 2003 | SearchFeedbackClips| Activism| Quotes|
The copyright-protected information contained in the ANNEX BULLETINS is a component of the Comprehensive Market Service (CMS). It is intended for the exclusive use by those who have contracted for the entire CMS service.

An Open Client Edition

IBM FINANCIAL

Analysis of IBM’s Second Quarter Business Results

On the Nose, But No Cigar

Small/Medium Business Growth - New Strength; Services Backlog, Cashflow - Old Weaknesses

PHOENIX, July 16 - IBM hit our second quarter earnings forecast on the nose ($1.7 billion net profit).  Big Blue’s revenues were actually slightly better than expected ($21.6 billion vs. $21.1 billion - see our “IBM 5-year Forecast,” May 8).  But IBM will probably still get no cigar when the market opens tomorrow. 

Sp don’t expect the Big Blue shares to add to the momentum the IT companies received from yesterday’s Accenture announcement.  They will probably sag in the aftermath of its second quarter earnings release. 

The reason?

Expectations.  Lofty expectations.  Too lofty for an otherwise quite a solid quarterly report card that IBM turned in today.  Wall Street expected slightly more than Big Blue delivered.  And stocks trade on expectations, not facts.

Since we deal in facts, let us tell you about our expectations.  J (We’ll let the facts speak for themselves).

* We expected IBM revenues to be up 7% since a year ago.  They were up 10%.

* We expected IBM Global Services (IGS) to grow by 29%.  It grew by 25%.

* We expected the IGS gross margins to be 23%.  They were 24%.

* We expected the IBM hardware revenues to decline by 5%.  They dropped 1%.

* We expected the hardware gross margins to be 26.3%.  They were 26.9%.

* We expected the IBM software revenue to grow by 5%.  It grew by 6%.

* We expected the software gross margins to be 85%.  They were 86%.

And so on, and so forth… You get the picture: IBM results were anything but disappointing.  Yet the stock will probably drop tomorrow.  Fickle Wall Street… Or is it?  Could there be some other factors that might warrant being cautious about IBM’s near-term prospects?

There could be.  As there are some other things that might warrant rejoicing.  Let’s start with the latter…

Small & Medium Companies.  “It’s funny how IBM is starting to sound more and more like Bob Djurdjevic,” a reporter said this afternoon after listening to the IBM CFO John Joyce rejoice over the revenue growth the company is getting in the small and medium company market.  The reporter was referring to our seven-year pitch that had been falling on deaf years at IBM until the management change at the top last year.  We’ve been that the key to IBM growth lies in how well IBM succeeds in marketing to the small and medium (S&M) enterprises.

It's like a seven-year itch that finally got scratched.,” we said in an earlier Annex Newsflash - see “IBM: Finally Heard! (Jan 29).

Text Box:

And there was indeed something in IBM’s second quarter results worth cheering.  IBM’s S&M segment’s revenues were up 17% in the quarter.  Only the government sector grew faster (+19%).  The S&M market, which IBM defines as companies with less than 1,000 employees, now account for nearly a quarter of Big Blue’s global revenues.  So finally IBM has some facts with which to back up its rhetoric.

“Our revenue from Small and Medium businesses accelerated in the 2nd quarter,” said Joyce.  “This group of customers… is very important to IBM, generating 23% of our geographies’ revenue in the first half.”

Halleluiah!

And now on to some worrisome warts…

IGS Backlog.  Only for the second time ever, IBM Global Services, the MVP of IBM line-up, lost more revenue from its backlog than it sold in a quarter.  As a result, the IGS backlog dropped from $113 billion at the end of the first quarter, to $112 billion. (The IGS backlog also dropped a year ago - see “Ban the Hoarse Whisperers,” July 2002). 

It is not surprising that the IBM CFO, John Joyce, did not dwell on this disturbing trend change during today’s post-release teleconference with analysts.  But it is a disgrace that none of the highly paid Wall Street analysts took him to task over it.

Text Box:

As you can see from the chart, IBM has been losing about $9 billion per quarter in the last four years.  We first noted that trend in 2001, and reiterated on it several times last year.  Fortunately, Big Blue has been able to sell more than that, thus keeping its backlog growing for the most part. 

Until the second quarter of 2002, that is.  That’s when the IBM CFO coined a new English word - “rescoping” (see Analysis of IBM 2Q02 Business Results, July 2002):

It has been coined to depict the old-fashioned customer reneging, or contract renegotiations, coupled with the usual cancellations and expirations.

Earlier this year, the IBM CFO offered some encouraging words about “rescoping” (see “Turnaround Continues…,” Jan 2003):

“Changes in scope of existing contracts continue to decline relative to previous quarters,” said IBM’s Joyce who authored the “rescoping” term in July of 2002.

We weren’t buying it:

Nevertheless, IBM backlog inched forward by only $1 billion (from $112 billion to $113 billion) after the $12 billion-worth of new contract sales was added in.  This puts the first quarter backlog losses at $11 billion - higher than the $9 billion average during the last three years, and the same amount IGS lost in the fourth quarter of 2002.  

So unless the IBM CFO is using some “new math” to back up his claim, maybe IBM had more than the average amount of contract expirations in the first quarter?

Well, now that the IGS backlog is down again, no wonder the IBM CFO remained mum on the “rescoping” subject.  He let the facts speak for themselves, as we do, even if they fall on deaf ears on Wall Street.

Cashflow.  Negative cashflow is another worrywart in the IBM financial statements.  During the first half of 2003, IBM’s negative cashflow was about half a billion dollars.  A year ago, it was a negative $2.9 billion.  So it looks like IBM is doing much better?  Not so fast…

Had IBM continued with its stock buyback programs (which it has not abandoned for all intents and purposes) at the rate it was doing it in the first half of 2002, IBM’s negative cashflow would have been a staggering $3.8 billion.

Now, to put things in perspective, we commented yesterday about Accenture’s strong cashflows as being one of an important positive factor in an IT services company’s financial performance.  You saw that Accenture generated about $1 billion of positive cashflow to-date in its fiscal year. 

So a $12 billion-company is generating $1.5 billion more cash than an $80+ billion-behemoth!  Of course, Accenture doesn’t have the hardware products to drain its cash.  So back to our “IBM Break-up” idea (1996 and 2000 versions), also revisited this year in our five-year forecast, “Save, Spend and Split” (May 2003).

Geographic Segments

Although Europe took the poll position among the IBM geographic regions in terms of its “as reported” growth (up 23%), it was actually the company’s worst performer in constant currency (+3%).  

Text Box:

“Europe remained the weakest geography,” said the IBM CFO.  “Of our major countries there: the UK had the strongest growth, improving on its 1st-quarter performance, and Italy and Germany declined.”

Americas and Asia/Pacific were the strongest regions, based on constant currency (up 6% and 5% respectively).

“Americas’ growth slowed a little due to Latin America and Canada,” Joyce added, “but the U.S. continued to show a little better performance.”

In the Asia/Pacific region, Japan, which is 60% of the area’s revenue, remained flat.  But IBM saw continued strong performance in the ASEAN region.  Joyce said IBM’s business in China also started to pick up

But it was the OEM segment that buried the IBM growth rate in the quarter.  After declining by 15% (down 16% in constant currency) in the first quarter, the OEM business plummeted by 30% (31% in constant currency) in the second period.

Horizontal Segments

IBM Global Services.  As noted earlier, IGS grew by 25% in the second quarter, mostly on the strength of its PwCC acquisition, and the favorable comparisons with the year-earlier period that did not contain any PwCC revenues.

IGS also came in with a 24% gross margin, slightly better than we expected.  But not necessarily better than IBM had hoped.  If you read carefully between the IBM CFO’s lines, you will see that there may be trouble brewing in Europe, especially in terms of this IGS segment’s profitability.

“We will continue to focus on improving margins, particularly in EMEA,” he said (emphasis added).

In other words, the BCS profitability in Europe isn’t up to snuff.  This jibes with some informal input we’ve received from the European consulting market.  In a recent five-year deal, IBM’s BCS unit reportedly offered the customer the first two years’ worth of services basically for free.  No wonder the IBM CFO has some gripes with the BCS profit margins, “particularly in EMEA.”

Text Box:

Meanwhile, Joyce tried to put on a brave face regarding the PwCC integration within the IGS’s Business Consulting Services (BCS).  With the acquisition of PwCC, BCS now represents more than 30% of Global Services revenue, he said. This unit grew 66% for the quarter, or 53% at constant currency.

“We continue to retain about 98% of the partners,” Joyce also said.  “So far, we’ve regained 121 of the 149 accounts that dropped PwC Consulting prior to the acquisition, due to auditor independence issues.”

The Strategic Outsourcing IGS segment, which was 40% of IGS revenues, was up 12% year-to-year, or about 5% at constant currency.

Integrated Technology Services grew 7%, but was flat at constant currency.  ITS was almost 30% of IGS, and includes product support services and maintenance.  Its revenue was negatively impacted by a year-to-year reduction in network installation services in the public education sector, Joyce explained.

Isn’t it ironic that at a time when the government spending is soaring world over, it is actually declining on something as vital to the future of a nation as education?  Welcome to the global war economy!

The second quarter new contract signings were $10.7 billion, slightly above the total a year ago ($10.6 billion).  IBM signed 13 deals greater than $100 million in the latest quarter.  Five deals were greater than $250 million.

As usual, Joyce complained about the “big ones that got away” - the megadeals that slipped from the second to the next quarter.  And he quickly put a positive spin on it.

“We’re off to a very good start in the 3rd quarter,” he said, “with multiple deals totaling almost $3 billion.”

Hardware/Software.  IBM hardware revenues were hurt by the company's inability to ship encryption software with its latest high-end mainframe (the z-Series), which led some customers to delay orders. Total hardware revenues fell 1%t from a year ago, to $6.6 billion (6% in constant currency).

IBM software revenues rose 6% to $3.5 billion (a 2% drop in constant currency). WebSphere, a family of products for online businesses, and DB2, IBM’s major database software product, grew strongly but sales of its Lotus messaging software fell.

IBM also lost $8 million on PC revenues, which declined by 3% to $2.7 billion.

The biggest problem area, though, continues to be the Technology Group.  It lost $111 million on continuing operations on revenues of $896 million.  So stand by for more Big Blue asset sales.  Assuming, of course, IBM can find a sucker to take over its unprofitable business.

In short, it was a solid quarter in which IBM hit the numbers on the nose, but will probably still not get a cigar from Wall Street in tomorrow’s trading.

Happy bargain hunting!

Bob Djurdjevic

P.S. In early morning trading on July 17, the IBM stock was down over 4% to about $83.

For additional Annex Research reports on IBM, check out... 

2003: “A Paler Shade of Blue” (June 2), “Save, Spend and Split” (May 8), “Shrunk by the Marketplace” (Apr 17), “Turnaround Continues...” (Apr 15), “Start of a Real Turnaround?” (Jan 17).

2002 IGS: "Half or Double Trouble?" (Aug. 12, 2002), "IBM to Take $500M Charge" (Sep 3, 2002), IBM-PwCC Update (Oct 2, 2002), Analysis of IBM Second Quarter Results (July 17, 2002), IBM Layoffs Confirmed! (Aug 14, 2002), Analysis of IBM Third Quarter Results (Oct 16, 2002), Boom Amid Gloom and Doom (Oct 10, 2002)

2002 IBM: “Gerstner: The Untold Story”  (Dec 27), "Gerstner Spills the Beans" (Dec 13), "On a Wing and a Prayer" (Oct 21), "IBM-PwC Tie the Knot" (Oct 2), "Half or Double Trouble?" (Aug 12), Wall Street/Main Street Chasm (June 25), “Wall Street Casino,” (June 21), Big Blue Salami (June 19), "Looming IBM Layoffs" (May 14), "IBM 5-Yr Forecast: From Here to Eternity?" (Apr 2002),  “Tough Times, Soft Deals,” (Apr 25, 2002), “Gerstner’s Legacy: Good Manager, Poor Entrepreneur” (Jan 2002), IBM Pension Plan Vapors: Where Did $17 Billion Go? (Mar 2002), "Sir Lou OutLayed Lay!" (Apr 1, 2002).

A selection from prior years: Is IBM Cheating on Taxes, Annex Bulletin 99-17 (May 1999),  IBM 5-year Forecast 2001: An Unenviable Legacy (June 2001) "Break Up IBM!" (Mar. 1996), Fortune on IBM (June 15, 2000), “Smoke and Mirrors Galore,” July 2000), "Slam Dunk of Bunk" (Jan 2000), Annex Bulletin 98-14 ("Wag the Big Blue Dog"), Armonk's Fudge Factory (Apr. 9, 1999)Where Armonk Meets Wall Street, Greed Breeds Incest (November 1998)Stock Buybacks Questioned: Is IBM Mortgaging Its Future Again?, 97-18 (4/29/97),  "Some Insiders Cashed In On IBM Stock's Rise, Buybacks" 97-22, 7/27/97,  Djurdjevic’s Forbes column, "Is Big Blue Back?," 6/10/97;  “Executive Suite: How Sweet!,” (July 1997), "Gerstner: Best Years Are Behind", Aug. 10, 1999), "IBM's Best Years Are 3-4 Decades Behind Us" (July 1999), "Lou's Lair vs. Bill's Loft" (June 1999),  "Corporate Cabbage Patch Dolls," 98-39, 10/31/98; Djurdjevic’s Chronicles magazine October 1998 column, "Wall Street Boom; Main Street Doom", “Louis XIX of Armonk,” (Aug. 1996), "Mountain Shook, Mouse Was Born" (Mar. 25, 1994), “A Nice Guy Who Lost His Compass” (Jan 26, 1993), “Akers: The Last Emperor?” June 1991), Industry Stratification Trend (Mar. 30, 1990) etc.]

Or just click on and use appropriate  keywords.






 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Volume XIX, No. 2003-15
July 15, 2003

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

P.O. Box 97100, Phoenix, Arizona 85060-7100
TEL/FAX: (602) 824-8111

|Annex Research | Annex Bulletins | Quotes | Workshop | Feedback | Clips | Activism | Columns