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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.

[snip]

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…

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.

[snip]

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?

[snip]

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).

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?

[snip]

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.

[snip]

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

[snip]

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

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.  

[snip]

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).

[snip]

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.

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