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IBM FINANCIAL

Analysis of IBM’s Fourth Quarter Business Results

Hype Exceeds Results

IBM Had a Good Quarter, But Not as Good as Wall Street Gave It Credit

PHOENIX, January 15 – The most remarkable thing about IBM’s just-released fourth quarter business results was that they came early.  Five days early, to be exact, and also early in the morning (8AM EST; IBM normally announces after the markets close at 4PM).  

Was IBM trying to catch Wall Street napping?  If so, it appears the trick worked.  IBM shares went up 6% in early trading, before sleepy traders got the sand out of their eyes, and realized that not everything is as rosy in the Big Blue picture as IBM executives had painted.  So the IBM shares eased later in the day.  They still chalked up a 4% gain at the end of trading, closing at $94.

The second most remarkable thing about IBM’s fourth quarter release was the amount of verbal hype IBM executives spewed out.  We have not heard anything like that in years, not even in the best Gerstner days.

“We enter 2004 with good momentum,” IBM CEO, Sam Palmisano, said in a release.  “The client buying environment is steadily improving.  We are enthusiastic about our prospects for this year and beyond.”

“We feel the environment is steadily improving,” IBM CFO, John Joyce, echoed his boss’s optimism during the teleconference with analysts.  He also (uncharacteristically) offered a bold forecast: “I would characterize 2004 as the year as the year when the industry will begin its next growth cycle.”

If Joyce is right, his outlook bodes well not just for IBM, but also for its competitors.  None of them, however, sounded as bullish.  Accenture, for example, got killed a couple of days ago (stock went down 13%) following its release of very solid results in its latest quarter.  The ostensible reason for the sharp drop in ACN shares was the supposedly conservative and cautious remarks by Accenture executives about the future outlook – the antithesis of the IBM hype today.

So what are we to conclude from these two opposite examples?  Perhaps that Wall Street watches the executive body language more carefully than the numbers.  Analysts and traders evidently pay more attention to hype than to results.  IBM numbers weren’t bad, but they weren’t as good as Accenture’s.  Yet the market rewarded IBM and punished Accenture.  Go figure…

Maybe the $3.1 billion that IBM spent in the quarter on stock buybacks (a record!) had something to do with the Wall Street enthusiasm? (see the chart).

And now, here are the highlights…

Business Segment Analysis

Geographies.  IBM fourth quarter revenues went up 9% as reported, but increased only 1% in constant currency.  In other words, IBM got a big boost from the weakness of the U.S. dollar.

As a result, revenues in Europe, for example, grew by 17% as reported, but were only up 1% in constant currency, matching the equivalent growth rate in Americas.

The Asia/Pacific region also grew in double digits (up 13%) as reported, but only 3% in constant currency.  

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The only segment that declined equally as reported and in constant currency was IBM’s OEM business.  It was down 14%, not matter how you slice it or dice it.

(Why is IBM hanging on to this loser, anyway, especially as it that dates all the way back to Akers’ era?  No takers?)

Services.  IBM Global Services (IGS), the unit that we once dubbed Big Blue’s only “crown jewel,” reported an 8% growth in the fourth quarter.  Alas, the IGS revenue growth translates into a 1% decline in constant currency.  

Worse for the IBM shareholders, the services’ profit margins are also shrinking.  The gross margins of IT services (without maintenance) dropped from 23.7% in 4Q03, to 22.1% in the latest period (they were 24.7% two years ago).  We estimate that the corresponding pretax margins were only 8%, less than even hardware’s (11%), and much less than software’s (34%).

Yet Wall Street analysts who cheered the IBM results, according to this morning’s wire reports, attributed their optimism to the supposedly strong IGS results in the fourth quarter.  Were they sleep-talking?

Some also cheered the supposedly record IGS new contract signings in the fourth quarter.  First of all, even though the $17.3 billion in new business sales is an imposing and impressive figure, it is not a record.  In fact, it is down 4%.  In the quarter a year ago, IGS sold $18.1 billion in new contracts. 

More importantly, even though IBM said its backlog rose to $120 billion, the company is still losing $11 per quarter out of the backlog.  Which means that before any new deals are signed in any quarter, IGS is already starting $11 billion in the hole (see the chart).

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In 2003, for example, IGS sold $55.4 billion in new contracts, yet its backlog went up by only $8 billion.  Cancellations, expirations and “rescoping” evidently amounted for the even more foreboding difference ($47 billion). 

And that’s the reason for optimism about the future growth?  More likely, that may be the reason for the IBM hype.  Is it supposed to distract us from following our noses and common sense?

Servers.  The IBM servers, on the other hand, are a real success story of the fourth quarter, and to a lesser extent, of the year.  The zSeries revenues were up 33% in the quarter (7% for the year), boosted by shipments of the new mainframe models.

The xSeries (Intel/PC) servers also had a strong quarter with a 20% jump in revenues (+17% for the year).  The pSeries (Unix) and storage also had a double-digit growth (+12% and +14% respectively).  And even the iSeries (AS/400), a product line that’s been lagging behind other IBM servers, chalked up a 2% revenue growth, ending the year with a 7% rise.

The server group finished 2003 with an 18% surge in the fourth quarter, and an 11% revenue increase for the year. 

Given that nearly all of these lines are terminal, as are the industry’s hardware businesses in general, their resurgence in 2003 is the third most remarkable thing about IBM’s latest results.

Can that growth be sustained?  Of course, not.  Declining hardware businesses are a global, universal and irreversible trend.  IBM can only stave off the inevitable by playing tough defense.  But as we enter 2004, a number of hungry hardware vendors, some of them comparable in size to IBM (HP, for example), are already sharpening their knives in the hopes of digging into IBM’s lunchbox.  IBM mainframes, for example, seem especially vulnerable.

Which is why the current IBM leaders may end up eating their words of optimism, just as the former CEO had to do when he predicted in March 1994 that the mainframe was about to stage a comeback (see “Mountain Shook, Mouse Was Born,” Mar 1994).

Software.  The IBM software also had a very strong quarter, with revenues growing by 12%, and the gross margin rising from 87% to 89%.  Text Box:

As a result, this IBM business segment topped all others in terms of pretax profit.  Software accounted for $1.46 billion of IBM’s total pretax profit (a 29% margin) on revenues of $4.3 billion.  IGS was second, slightly ahead of servers, with pretax profit of $1.1 billion (including maintenance) on revenues of $11.4 billion. 

So $1 in software sales is roughly equivalent of $3.3 in services revenues - in terms of their respective contributions to the IBM bottom line.  Yet nobody on Wall Street that we’ve heard of cheered this IBM business unit’s results today.  IGS grabbed most of the attention.

PC & Technology.  The PC and Technology units are the other two perennial losers in the IBM product portfolio.  The only difference is that PC is much bigger and consumes that many more resources before delivering red ink to the IBM bottom line. 

In 2003, for example, it took $11.4 billion of PC revenues to produce a $118 million pretax loss.  IBM’s Technology unit was much more “efficient.”  It generated $252 million in pretax losses from only $2.9 billion in revenues. J

Industries.  Last but not least, IBM’s industry report card for the fourth quarter showed a continuation of existing trends.  The financial services sector continues to be the biggest IBM segment ($6.7 billion revenues in 4Q03), but it is now also the fastest growing industry unit (up 17% in 4Q03; up 13% for the year).

The manufacturing sector, perhaps surprisingly, grabbed the second spot after the financial services with a 12% increase in the fourth quarter (14% for the year). 

But growth slowed in two other leading sectors.  The small and medium business (SMB) part of IBM had an 11% revenue rise in the last period, as opposed to 14% for the year.  And the government sector, which had a 15% growth rate for all of 2003, also came in with 11% in the fourth quarter.

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Summary

IBM’s fourth quarter results were right on the money for the most part.  Some business segments exceeded our expectations (servers, software), while others disappointed us (IBM Global Services).  But now that IBM executives have raised the bar for the rest of the year and beyond with their bullish comments, they’ll have to deliver on their promises, or else watch the stock suffer the wrath of disappointed investors. 

IBM may be about to find out that “under-promising and over-delivering” is usually a better marketing approach than “over-selling and under-delivering.” 

But we are also ready to be surprised and corrected.  Miracles do happen... So stand by for some interesting times ahead as we start to compare IBM’s optimism with the reality of quarterly results.

Happy bargain hunting!

Bob Djurdjevic

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

2004: "Hype Exceeds Results" (Jan 15)

2003: "Small Is Now Big at Big Blue" (Oct 15); "A Passage to India" (July 22),  “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), “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 XX, Annex Bulletin 2004-01
January 15, 2004

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

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