<%@ LANGUAGE=VBScript %> <% Set asplObj=Server.CreateObject("ASPL.Login") asplObj.Protect Set asplObj=Nothing %> CLIENT VERSION - Analysis of IBM 2002 Annual Report (Apr 17, 2003)

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

   Confidential Annex Research Client Edition


Analysis of IBM’s 2002 Annual Report

Shrunk by the Marketplace

What Former CEO Thought Was a “Dumb Idea,” the Marketplace Is Now Doing to Big Blue; IBM Pension Plan Woes Continue

PHOENIX, Apr 17 - Over seven years ago now, we proposed to the former IBM CEO, Lou Gerstner, that he break up and shrink the Big Blue if he is to achieve the kind of growth Wall Street was expecting (see "Break Up IBM!", Mar 20, 1996).  Here are headlines from that report:

And Now on to Next Phase for “Big Blue” Under Gerstner:  How to Grow IBM?  Make It Smaller, Better!

Break Up IBM!

A Blueprint for a $180 IBM Stock: Spinning-off and Selling-off Certain Businesses Could Generate $43 Billion of Additional Shareholder Value

Gerstner thought it was a “dumb idea” (see “Louis XIX of Armonk,” Aug 1996).  Over the next six years, he chose to squander nearly $50 billion on stock buybacks instead of investing in acquisitions and new products and services, and divesting the loser units.

Well, the marketplace is now doing to IBM what the former CEO didn’t have the foresight to do.  It is downsizing the company.  IBM’s 2002 Annual Report, released last month, revealed that Sam Palmisano’s Big Blue of 2002 was about the same size as Gerstner’s IBM was five years ago ($81.3 billion in revenues).  Text Box:  
Sir Louis of Armonk

Ever since 1999, the year we said Gerstner’s best years were behind (see "Gerstner: Best Years Are Behind", Aug 1999), IBM has been “growing” by shrinking.  Which is another sad legacy of its former CEO (also check out “Gerstner’s Legacy: Good Manager, Poor Entrepreneur”, Jan 2002).

As you have seen from our last two Annex Bulletins on IBM, Big Blue’s new leader and his lieutenants have been trying to reverse the damage Gerstner has inflicted on IBM shareholders (see “Turnaround Continues...”, Apr 15 and “Start of a Real Turnaround?”, Jan 17).  But they have a long way to go.  Just how long can be seen, from continued woes of the IBM pension plan, and from ongoing problems with IBM’s PC and Technology units - two IBM business units we said back in 1996 that Gerstner should sell (see Step 2 below):

Six Steps to Riches: How Should IBM Be Split Up?

Step 1: Spin off and report separate financial results for the IBM Global Services, including the Integrated Systems Solutions Corp., its outsourcing subsidiary, as well as maintenance.

Step 2: Sell the PC Division and the other low-margin hardware operations, such as OEM, and/or other such hardware products.


Step 3: Consolidate the remaining high-margin product businesses - S/390, AS/400 and RS/6000 into a single IBM Server company.  It should include the respective OS software (OS/390, OS/400 and AIX).


Step 4: Evaluate the feasibility and desirability of spinning off the non-OS software into a separate business, such as the network-related (Lotus+), or other IBM software (e.g., middleware; VisualAge, systems management tools/Tivoli, etc.).


Step 5: Aggressively market the new IBM market value proposition - “smaller is better” to some Wall Street “stoneagers.”


Step 6: Increase the IBM dividend as the financial benefits rise (i.e., the shareholders’ value).

What Would It Take?


What would it take for Gerstner to make our six-step blueprint a reality?

Courage and humility.  

Courage - because he would have to act more boldly than any other IBM chairman since Tom Watson’s Jr. “betting the company” S/360-project (in the early 1960s). 

Humility - because Gerstner would have to give up the empire-building, and concentrate on creating wealth for the shareholders, including himself, of course.

Well, now in hindsight, we all know that Gerstner had neither the courage nor the humility to carry out such a major restructuring.  But the marketplace did it for him.  So let’s start our 2002 business segment analysis with the two units that we said seven years ago that IBM should get rid of.

Segment Analysis

Personal Systems.  Back in 1996, the PC division was a $14 billion business.  In 2002, it was an $11 billion-operation, on its way to $10 billion or less per year, after having peaked at $15 billion in 1998.

Despite having been shrunk by the marketplace, this IBM unit may actually seem fairly impressive judged by its bulk alone.  During the last 10 years (1992-2002), it contributed about $150 billion in revenues to IBM’s top line.  

Text Box:

Unfortunately for IBM shareholders, it has also been a money-losing operation for most of those years, sometimes to the tune of $1 billion or more per year.  Which is why we recommended that Gerstner sell it.

Here’s an excerpt about IBM’s refusal to do it from our last year’s business segment analysis:

What is less understandable, however, is why the top IBM executives have hung on to this money-losing product line, especially since it has not done much for them even in terms of growth.  To keep those factories churning?  Which would par for the course, we suppose, for a company that had been led by a CEO who, upon taking the IBM helm in 1993, declared “the last thing this company needs is a vision statement” (see Annex Bulletins 93-40, 7/27/93 and “Mountain Shook, Mouse Was Born,” 94-12, 3/25/94).

So should IBM sell its PC business now?  Sure.  But who would be foolish enough to buy this huge money-losing operation now?  HP has had enough challenges digesting its Compaq acquisition.  Dell is too busy trying to keep up with HP.  And the Japanese vendors are up to their necks in home-grown alligators to be looking for some new and bigger overseas ones with which to wrestle.

So the most likely fate for IBM PC operation in the next few years is shrinking and coasting.  And bleeding some more “red ink.”  Unless, of course, the Armonk sellers can locate the buyer of that London bridge that’s now attracting crass tourists in Lake Havasu City, Arizona.

Technology. The IBM Technology division is another money-losing unit that we suggested back in 1996 that Gerstner ought to shed.  He didn’t.  So the losses kept mounting… a few hundred million one year, a few hundred next.

Finally, last year, his first at the Big Blue helm, IBM’s new CEO took some action.  Palmisano sold the (hard disk) part of this unit to Hitachi.  The resulting $1.2 billion Technology pretax loss in 2002 should serve as a good reminder about how important timing is in everything.  It makes it seem almost as if IBM paid Hitachi to “buy” this operation from Big Blue.  Seven years ago, when hard disk storage was still a profitable business, it would have been an entirely different story.

Overall, the pretax losses from IBM’s discontinued operations amounted to over $2 billion.

Worse, the losses continue even in the remaining part of the Technology unit.  As you say in our latest report, this hardware operation lost $11 million on revenues of $916 million in the first quarter.

The Technology unit’s revenue also keeps shrinking rapidly.  After reaching a peak in of $12 billion in 1998, it dropped to only $3.7 billion in 2002.  The discontinued operations’ revenue alone was $3.3 billion at the 2000 level.  And following the completion of the Hitachi deal, the Technology unit’s first quarter 2003 revenue was merely one half of that a year ago. 

In other words, this is another example of the marketplace doing to IBM what its former CEO didn’t have the foresight to do (shrink the company while the getting out of some businesses was still good).

Ironically, even the very birth of the OEM business was due to correct the judgment errors of the IBM leaders of the yesteryear.  The $65 billion-IBM Technology segment was born in 1992 to help cover up a $116 billion-blunder that the John Opel-John Akers Armonk administrations made in the early 1980s.  As Akers took over as IBM CEO in 1985, he predicted his company would be a $180 billion company by the end of 1994.  IBM was a “mere” $64 billion corporation in 1994, thus the $116 billion difference.

But Opel and Akers kept spending money on new plants and equipment in line with their $180 billion-vision for the company.  Which meant that IBM entered the 1990s with oodles of extra manufacturing capacity.  The story of layoffs and charges that eventually sank Akers is well known.  Perhaps less well know is his effort in the last year of his tenure as IBM chairman and CEO (1992) to ameliorate the situation by entering into the OEM business for the first time in IBM’s history. 

Text Box:

Today’s Technology segment, which produced some $53 billion in revenues in the last 10 years, is what the original IBM OEM business has morphed into.  After a fairly quick start in 1992-1995, this unit pretty much coasted in the second half of the decade, before starting to decline sharply in the last five years. 

Global Services.  IBM Global Services (IGS) unsurprisingly accounted for the largest share of IBM’s revenues in the last 10 years - $303 billion or 34% of the total. 

Text Box:

In the latest full year (2002), IBM’s only “crown jewel” of the 1990s accounted for $36 billion or 45% of the total, up 8% from the year before.  Both sets of figures include maintenance revenues.

Led by a surge in outsourcing in the mid-1990s, IBM services (excluding maintenance) also topped all other segments in terms of growth.  Outsourcing grew at 19% compounded annually in the last five years (1997-2002), while the overall services revenues increase at 8% per year during the same time frame.

But that’s down from 13% annual growth in the 1996-2001 five year-period, and the 20% and higher growth rates in the early and mid-1990s.

Maintenance, now also a part of IGS, has been declining steadily at an annual rate of 4% during the 1992-2002 period, although its revenue has now stabilized around the $5 billion level.

Enterprise Systems.  IBM Enterprise Systems, now renamed to just ”Systems,” was the second largest segment in the last 10 years.  Its aggregate revenues of $175 billion represented 20% of IBM’s total during that period.  Unfortunately for IBM, this segment has also been shrinking throughout the period at a rate of 3% compounded annually.

Within that total, the S/390 servers led the decline with an 11% compound annual rate between 1992 and 2002.  Furthermore, the rates of decline for the S/390 line seem to be accelerating.

The AS/400 revenues shrank at a rate of 5% per year, while the RS/6000 sales grew at 12% annually.  One should keep in mind, however, that the RS/6000 did not exist as a product prior to 1990, so it started the decade from zero.

Software.  The IBM Software unit was the third largest revenue contributor in the 1992-2002 period, with a $166 billion, or 19% of total.  Unfortunately for IBM, this stellar performer from the 1980s, that regularly chalked up growth rates of 20% to 30% per year back then, stalled in terms of its growth in the last 10 years.  The compound annual growth of software revenues was only 2% during the last 10 years.

There were two main reasons for it. First, a decline in the mainframe and other proprietary systems’ fortunes also led to a drop in operating systems software revenues (-4% compounded annually 1997-2002).  The S/390 and the AS/400 OS revenues declined in the second half of the 1990s at compound annual rates of -6% and -12% respectively.  The RS/6000 eked out a meager growth of 4% per year, thanks to a continuing demand for UNIX.

The so-called Middleware, the largest IBM software segment (42% of total in 2002), grew at a compound annual rate of 3% during 1997-2002.  The Distributed software grew at 9% compounded annually during the same period.

Summary.  The only IBM real growth segment in the 10 years has been the IBM Global Services operation.  Yet even that unit, despite an outstanding sales record in 2000-2002, has dropped down to only a single digit revenue growth rate. 

In short, Gerstner’s IBM was worse than even John Akers’ growth record.

Pension Fund Woes

One year ago, in a story about IBM’s sudden pension fund deficits, we wondered “Where Did $17 Billion Go?” (Mar 21, 2002).  This year, however, the same question would have read: “Where did $24 billion go?”

Yes, for the first time ever, both IBM U.S. and non-U.S. pension plans are under water - to the tune of $6.4 billion (the amount by which the obligations exceed the pension fund assets).  Of that total, $1.4 billion is attributable to the U.S. plan, with the balance ($5.1 billion) representing the non-U.S. shortages.  Yet at the end of 1999, the two sets of plans yielded a $17.2 billion surplus (of assets over obligations).  That’s a $24 billion downward swing in just three years!

The negative swing in terms of the “net actuarial gains/losses” is even greater.  Back in 1999, the IBM pension plan had a $11.6 billion gain.  At the end of 2002, however, it is showing a $21.2 billion loss.  That’s a $33 billion downward swing in the same three-year period! (see the chart).

Text Box:

IBM has now lowered its assumptions for the long-term return on its U.S. pension plan assets from 10% in the 2000-2001 period, to 9.5% in 2002, to 8% in 2003.  For non-U.S. plans, the equivalent assumptions have been reduced from 5%-11% % in 2000-2001, to 5%-9.25% in 2002.

Keep in mind that the above statistics reflect the status of the IBM pension plan after the company had already made a $4 billion contribution to it (in Dec 2002).  In other words, things would have been even worse without it.

As the new IBM CEO Palmisano put it in his letter to the shareholders, “one of the most important investments we made in 2002 was to contribute just under $4 billion, in cash and in IBM stock, to fully fund the accumulated benefit obligation of our U.S. pension fund.”  Palmisano added that the plan was underfunded “mainly due to low interest rates and continued weakness in capital markets.”

The most important unspoken reason, of course, was the bad investment decisions that the fund’s managers have made.  A small consolation to IBM employees may be that Big Blue’s pension fund managers weren’t alone in misreading the market tea leaves (also see "Money Can Buy Longer Life", May 6).

Happy bargain hunting!

Bob Djurdjevic

For additional Annex Research reports, check out...

2003: “Turnaround Continues...” (Apr 15), “Start of a Real Turnaround?” (Jan 17)

2002: “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. 2003-07
April 17, 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