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IBM FINANCIAL

Analysis of IBM’s Fourth Quarter Business Results

A Crescendo Finale!

As in Beethoven’s Ninth, Big Blue’s 2004 “Ode de Joy” Ends on High Notes

WESTERN AUSTRALIA, Jan 19 – As in Ludwig van Beethoven’s celebrated ninth symphony’s fourth movement, “Ode de Joy,” IBM’s fourth quarter was a jubilant crescendo finale to a strong year.  By the time the last chords of Big Blue’s version of the “Pastoral” died down in the waning minutes of 2004, members of the “symphony in blue” could be imagined slumping in their seats: exhausted but triumphant; spent but fulfilled… like victorious runners who collapse after the finish line.

It was “a powerful fourth quarter,’ the Big Blue band leader and conductor, Sam Palmisano, said of Armonk’s version of “Ode de Joy.”  “It was IBM’s strongest fourth quarter ever, with earnings exceeding $3 billion for the first time.”

Revenue growth was equally impressive – up 7% from a very strong fourth quarter 2003, and up 18% sequentially from the third quarter, IBM’s best third quarter in years (see Slow Quarter No Longer, Oct 2004).

More importantly from Wall Street’s perspective, IBM beat the consensus estimate of $1.76 a share gathered by Thomson First Call by five cents (earning $1.81 per share).

So you’d think Wall Street would stand up and give the Big Blue orchestra a standing ovation?  Think again.  The Romans had their Ides of March; the Big Blue has its January blues.  Here’s what we said about it two years ago, when we first noted that a real turnaround might be under way at IBM:

PHOENIX, Jan 17, 2003 - Big Blue’s latest report card showed its best growth in four years.  IBM’s fourth quarter business results, released on Thursday (Jan 16) after the markets closed, signaled that a real turnaround may be in the making…

So how did Wall Street react to the most encouraging report card IBM has submitted in years?  It dumped the Big Blue stock.  IBM shares took a 6% dive Friday after its fourth quarter results were released.

It figures… Big Blue’s January blues are upon us once again (also see Up on Rumors, Down on Facts, Jan 19, 1999; A Slam-Dunk of Bunk, Jan 20, 2000; IBM Ends Year with a Bang, Jan 19, 2001; Big Blue Stock to Take a Dive?; Jan 19, 2002).  

(An excerpt from Start of a Real Turnaround?, Jan 2003)

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Well, Wall Street didn’t exactly dump the IBM stock this time, but there was no standing ovation, either.  The Big Blue shares were up a tepid 0.12% to $95.01 in after-hours trading, following the release of its fourth quarter results.  Which means they will probably drop again today.  And the IBM stock is down both for the year, and relative to Dow Jones Industrials, of which IBM is a part (see the chart).

Business Segments Analysis

IBM Global Services.  Moving on from (trading) fluff to (business) substance, IBM Global Services (IGS), now the largest business segment accounting for 49% of total revenues, came through for IBM in the fourth quarter with a 10% surge (6% in constant currency). 

Particularly encouraging was the fact that the consulting segment joined the outsourcing unit’s double-digit growth rates (up 12% each).  As a result, the gross margin improved from 24.8% to 25.1%.  Integration services grew by 6%, while maintenance revenues increased 3%.

On the down side, however, new contract signings were down 27% for the quarter ($12.7 billion vs. $17.3 billion).  They were also down 22% for the year ($43 billion vs. $55 billion). 

The resurgence of consulting deals can be a partial explanation for the drop, as they tend to be smaller in size, but are more profitable, than the outsourcing contracts.  Shorter contract terms is another reason.  But there seems to be more to it…

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The “rescoping,” an old IGS nemesis, appears to be accelerating.  IBM’s backlog at the end of 2004 was down $9 billion relative to that a year before.  Add to it the drop in new business signings, and the average IGS backlog losses added up to about $13 billion per quarter in 2004, as opposed to $12 billion in 2003; $11 billion in 2002 and $9 billion in 2001, and $7 billion in 2000.

And that spells trouble for future IGS revenue growth.  IBM’s biggest unit is selling less and losing more from its backlog every year.  It seems an accounting miracle that such an operation could be having a double-digit revenue growth.  But that’s what IGS has been reporting.  It remains to be seen how long it can keep it up. 

Hardware.  The IBM 2004 server renaissance unfolded first at the top end.  Here’s what we said about the mainframe revival after the first quarter:

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).

(see Going Retro with Mainframes, Apr 2004)

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Since then, the zSeries revenue has gone on to grow by 44% in the second quarter, and by 12% in the third, before declining by 4% in the fourth – relative to a very strong last period of 2003.  And even in the latest and biggest quarter, the mainframe capacity, measured in MIPS, increased by 6% over the corresponding period a year ago.

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As a result, the zSeries revenues for the full year jumped in double digits (up 15%), symbolic of an erstwhile dinosaur that’s now hopping around the marketplace like a springbok (see the chart).

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But the real hero of the fourth quarter was the Intel-based xSeries.  The xSeries revenues surged by 25%, pushing the 2004 total up by 24% over last year’s.  The Unix-based pSeries also had a strong quarter, with revenues rising 15%.  For the full year, the pSeries revenues were up 7%.

Which leads us to the iSeries, the only IBM server line to have experienced a decline, both in the fourth period (down 9%), and for the year (down 17%).  If there is a small consolation for IBM, it is that the rate of decline in the fourth quarter has abated.  In the first quarter of 2004, the iSeries revenues declined by 7%; in the second by 28%; in the third by 26%.

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As we noted in our recent “IBM Server Renaissance” report, the iSeries is due for a marketing facelift this year.  And its new leader, Mark Shearer, who took over as general manager earlier this month, is the man facing the greatest challenge among IBM servers – restoring an IBM erstwhile “crown jewel” and its second-oldest product line to its former glory.

Software.  The IBM software unit continues to excel, especially in terms of profitability.  Although only about a third of the largest IBM unit’s revenues (IGS), IBM software delivered 21% more pretax profit to the company’s bottom line ($1.7 billion vs. $1.4 billion).  That’s because at 89%, its gross margin is among the industry’s highest, as is its 34% pretax margin.

Tivoli, Websphere and DB2 software reported the highest growth rates (up 25%, 18% and 15% respectively), while Lotus and Rational chalked up 8% increases each. 

The total IBM software revenue grew by 7% in the fourth quarter, up 3% in constant currency.  For the full year, software was up 5%, or 1% in constant currency.

Geographies.  The best performing IBM region of 2004 wasText Box:  
 
 
Asia/Pacific which grew 11% as reported, and 5% in constant currency.  Alas, it is the smallest, too, with revenues of $21.5 billion. 

The Asia/Pacific area was followed by the Americas whose $40 billion-revenues represented a 5% increase (4% in constant currency).  Holding up the rear was Europe, traditionally a strong market for IBM, with a 10% increase as reported, but only 1% in constant currency, due to the weak U.S. dollar.

The best performer of the fourth quarter, however, was the Americas region.  It recorded the same increases as for the full year (5% and 4% respectively).  Asia/Pacific was second, with a 6% and 3% growth, while Europe again ended up in the cellar, with 9% and 1% revenue increases.

The fact that the iSeries and Europe seem like IBM’s current “problem children” is probably not coincidental.  Europe has traditionally been the iSeries’ strongest market.  So “as goes Europe, so goes the iSeries…” may be the situation here.  Fix one, and you fix the other?

Industries.  All five major IBM industry segments reported solid growth in 2004, as did the SMB (small and medium business).Text Box:

The world’s laggard industry from not that long ago – communications – is suddenly the biggest spender on IT.  It led all other IBM industry segments in both the fourth quarter and for the full year with 10% increases respectively.

IBM’s biggest industry sector – financial services, which accounts for a quarter of Big Blue’s total business – tied communications in the spending growth for the full year (+10%).  Distribution was third, with an 8% increase, followed by public and industrial sectors with 6% each.

The SMB market, which IBM started to pursue aggressively two years ago (see “Finally Heard!”, Jan 2003), grew at the overall Big Blue growth rate for the fourth quarter.  It was up 7%.  For the full year, however, the SMB grew at a lower rate than IBM as a whole (8% vs. 9%), giving rise to questions if Big Blue’s SMB campaign may be running out of steam.  After all was said and done in the last two years, its share of corporate revenues is still only 23%, the same as it was when the SMB hullabaloo started.

Outlook

IBM’s fourth quarter results were a crescendo finale to a strong year.  But now IBM has to do it all over again in the New Year. 

IBM CFO Mark Loughridge described 2004 in the post-earnings release conference as a year in which the economic environment improved, shifting from recovery to moderate expansion.

"We're encouraged as we go into 2005 in a large part by the improvement we've seen in our organic performance," Loughridge said, adding that 2004 experienced the strongest organic performance seen by the company in years. "We anticipate organic performance to continue to accelerate in 2005."

He said revenue should grow this year about one percentage point faster than the current Wall Street average estimate of 6%, excluding IBM's PC business.

Loughridge also said analysts' consensus earnings forecast of 11% for 2005 to $5.60 a share is "reasonable."  He added that IBM is targeting double-digit earnings growth long-term, fueled by revenue growth in the mid- to high-single digits.

Words like that should be music to investors’ ears.  But not today.  Not on Wall Street.  IBM stock finished the day (Jan 19) down almost two points.  The Romans had their Ides of March; Big Blue has its January blues…

Happy bargain hunting

Bob Djurdjevic

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Volume XXI, Annex Bulletin 2005-01
January 19, 2005

Bob Djurdjevic, Editor
(c) Copyright 2005 by Annex Research, Inc. All rights reserved.
e-mail: annex@djurdjevic.com

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