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IBM FINANCIAL

An Analysis of IBM’s First Quarter Business Results

Going Retro with Mainframes

But Mainframe Bonanza Fails to Boost Big Blue; Services Growth Sluggish

PHOENIX, April 15 – Big Blue customers seem to be “going retro.”  They are once again gaga over mainframes.  That’s as if “Beatlemania” were back, and “I Wanna Be Your Man” were once again climbing the pop charts.

At least that’s the impression one would get from a 34% surge in IBM’s first quarter mainframe revenues.  The zSeries business, as the mainframes are called nowadays, was up 28% in constant currency.  Not bad for a 40-year old (see “Mainframe at 40!”, Apr 2).

Alas, if only these were the good old IBM days when the adage “as goes the mainframe, so goes IBM” applied.  Nowadays, mainframes account for a mere 5% of Big Blue’s revenues.  Thus, their (temporary) resurgence could do little to offset some more worrisome news from the company’s biggest business segment – IBM Global Services (IGS – which now accounts for more than half of IBM revenues).

What was the IGS worrywart?  Well, there were several…

First, the revenues grew by 1% in constant currency (up 9% as reported).  That’s not surprising (to us and to you, our clients), but it seems to be catching the ever-bullish-about-IBM Wall Street analysts by surprise.  We’ve told you that in 2004, IGS won’t have the benefit of favorable year-over-year comparisons that its PwCC acquisition gave it last year.  As a result, the biggest IBM unit would have to find new markets and new ways to grow in the future (see “Crown Jewel” Restored?”, Mar 22).

Well, that evidently isn’t happening.  At least not yet; not in the first quarter.

Second, IGS’ new contract signings were down 13% from $12 billion a year ago, to $10.5 billion in the latest quarter.  And they were down sequentially, too (from $17.3 billion in the fourth quarter).

IGS Backlog Losses

The third piece of bad news about IGS is that its backlog erosion continues.  At the year-end 2003, the IGS backlog stood at $120 billion.  Three months and $10.5 billion of new business later, its backlog was still $120 billion. 

In other words, the “rescoping,” expirations and cancellations ate up all of the new business that IBM had signed in the first quarter. 

Nor is this a new phenomenon.  Since March 31, 2003, IGS has closed $54 billion of new business, while its backlog went up by only $7 billion.  So it took $47 billion of new contracts just fill in the big black hole of contract terminations and/or “rescoping.”

Again, no surprise there…

“So what will it take to restore IBM’s biggest “crown jewel” to its former luster?” we asked rhetorically in our “Crown Jewel” Restored?” Annex Bulletin (Mar 2004). 

“Well, a lot more than marketing slogans (such as the OnDemand concept),” we replied.  “Stopping the hemorrhaging that the ‘rescoping’ is causing, for example, is much more important.  So is finding new markets to grow the business, such as SMB (small and medium business market).”

Interestingly, the IBM CFO, John Joyce, asserted twice during this afternoon’s teleconference with analysts that IBM’s efforts to reduce the “rescoping” of its IGS deals have resulted in a fifth consecutive quarter of improvements.

Beg your pardon?  When we first voiced our concern over “rescoping” (in 2000, well before IBM coined the word), the average quarterly backlog losses were $7 billion.  In 2001, they were $9 billion.  In 2002, when IBM started talking about it, they were $11 billion.  And in 2003, they were $12 billion per quarter (see the chart).

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Now, does the preceding suggest that the “rescoping” problem is getting worse, or that IBM is making progress?  The former is true, of course. 

So is the IBM CFO lying?  Let’s assume that he is not.  Let’s say that IBM is making improvements in reducing the “rescoping” of the IGS contracts.  That leaves expirations or cancellations as the only other two possible causes of the widening IBM backlog black hole. 

Expirations are unlikely to be much of a factor, as there is nothing that IBM has disclosed to us that suggests that the terms of the IGS contracts have changed substantially in the last two-three years.  

Which leaves cancellations as the most likely culprit.  If IBM is making progress with “rescoping,” then cancellations must be going through the roof (or through the floor and into the black hole).  And that’s worse than “rescoping!”  At least with “rescoping” the vendor gets to keep some of the business.

Consider the following facts – all based on IBM published figures.  Since 1999, IGS has sold $224 billion in new contracts.  During the same period, the IGS backlog increased by only $60 billion.  So $164 billion of IGS’ new business in the last four years has gone into the backlog black hole.

Perhaps now you can see why we said last month that, “stopping the hemorrhaging that the ‘rescoping’ is causing, for example, is much more important” than spewing out marketing slogans, such as OnDemand.

Business Segment Analysis

Hardware. Hardware was the unexpected “hero” in IBM’s latest financial release.  Lead by strong sales of zSeries (up 34%), pSeries (up 15%) and xSeries (up 28%) servers and storage (up 16%), IBM hardware revenue surged by 16% in the first quarter (up 10% in constant currency).

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Of course, not all hardware products did well.  IBM’s two perennial losers – Technology and PCs – once again bled red ink to Big Blue’s pretax profit line.  So IBM did what it always does with its losers.  It hid them.  The company merged the Technology business with its newly refreshed and growing Systems Group for the first time in this quarter, while relegating its $10 billion-PC unit to the bottom line of the hardware chart. 

Only uninitiated would be fooled by such cheap financial cosmetics, but that’s IBM for you.  Some of Lou Gerstner’s legacy is still evident at Armonk (see “financial engineering” in our past Bulletins).

Software. If hardware was an unexpected “hero” in the latest quarter, IBM software was a predictable winner.  Software revenues rose in double digits (up 11% as reported; up 3% in constant currency) to $3.5 billion.

Best of all for IBM shareholders, the software gross margins jumped to 86%.  That’s almost like having the license to print money!  And so, even after cross-subsidizing the company’s less successful products, the IBM software still managed to drop an 18% pretax margin to the profit line.

Industries. After almost eight years of paying lip service to its best growth opportunity, IBM’s small and medium business (SMB) market is now leading all other vertical segments in revenue growth.  In the first quarter, it went up by 15% to $4.9 billion. 

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Only the financial services sector (at $5.5 billion, up 13%) is now bigger than the SMB market.  Manufacturing and communications segments also increased by the same amount.

Geographies. Asia/Pacific topped all IBM geographic segments in the first quarter revenue increase (up 16% as reported to $5.2 billion; up 6% in constant currency).

European revenues also surged in double digits as reported (up 15% to $7.3 billion), but real growth in constant currency was only 1%.

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Perhaps the most encouraging sign, however, came from the Americas market (read mostly the U.S.), IBM’s largest.  Its revenues went up by only 6% as reported, but that translated into a 4% real growth in constant currency.  Here comes that mainframe again...

The OEM business predictably continued to erode (down 3%).  What’s left of it now represents only 3% of IBM’s revenues.

Summary

Just as was the case in the first quarter (see “IBM Hype Exceeds Results,” Jan 2004), the IBM executives sounded bullish, both in person (John Joyce), and in print (Sam Palmisano, CEO).

“Because we anticipated these (strategic IT industry) changes (that are supposedly stymieing Big Blue competitors) – in computing and in how enterprises apply technology – we made significant investments and repositioned IBM during the downturn,” Palmisano was uncharacteristically self-congratulatory in a statement that accompanied its financial release.

“Those strategic moves are now beginning to pay of for our clients and shareholders,” he asserted.  “We remain enthusiastic about our prospects for 2004.”

Well, IBM executives get paid, and handsomely at that, for being enthusiastic.  But the market place wasn’t so sure.  The Big Blue shares dropped 3% in after-hours trading, and can be expected to be down when the market opens tomorrow.

So “going retro” with mainframes may be the fad of the moment with IBM’s largest customers.  And it may bring back nostalgic memories to those who created the most successful computer product line the world has ever seen.  But it does little to boost the IBM top and bottom lines. 

Resuming the growth of IBM Global Services is a “sine qua non” (a condition without which recovery won’t work, loosely translated from Latin).  It starts with stemming the IGS backlog losses, i.e., reducing the cancellations and “rescoping.”  It continues with some new strategic acquisitions.

Until that happens, look for the IBM stock to tread water, at best.

Happy bargain hunting

Bob Djurdjevic

For additional Annex Research reports, check out... 

2004: Going Retro with Mainframes (Apr 8); IBM: Five-year Forecast (Apr 8);  Mainframe at 40! (Apr 2);  Accenture: Burning the Track (Mar 2004); "Crown Jewel" Restored? (Mar 2004); "Cap Gemini: Another, Smaller Loss" (Feb 2004);  "CSC: Good Quarter Gets Boos" (Feb 2004); "Hot Air Jordan" Flaunts Flop as Feat (Feb 2004); "Hype Exceeds Results" (Jan 2004);  "Cronyism Is Alive and Well at EDS" (Jan 2004);  "Five Most and Least Likely Forecasts for 2004" (Jan 2004)

2003 IGS:  "IBM OnDemand: Different Strokes for Different Folks" (Dec 2003); "Investing in Growth" (Apr 2003)

2003 IBM: "IBM vs. HP: Spinning Global Server Market Shares" (Nov 2003);  "Finally Heard, Part II," (Nov 2003), “Small Is Now Big at Big Blue” (Oct 16),  “On the Nose But No Cigar” (July 16), “A Paler Shade of Blue” (June 2), “Save, Spend and Split” (May 8), “Shrunk by the Marketplace” (Apr 17), “Turnaround Continues...” (Apr 15), "Finally Heard!" (Jan 29), “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), 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 XX, Annex Bulletin 2004-11
April 15, 2004

Bob Djurdjevic, Editor
(c) Copyright 2004 by Annex Research, Inc. All rights reserved.
e-mail: annex@djurdjevic.com

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