Annex Newsflash 2005-13                          April 14, 2005

IBM FINANCIAL

Editor's Note:  This writer was literally in the air, enroute to New York, when IBM made this surprise announcement.  So this Annex Newsflash is only our first cut at the news.  Stand by for a more in-depth analysis of IBM's first quarter results.

Annex clients click here to view our detailed IBM 1Q05 P&L.

Updated 5/04/05, 2:30 PM PDT (adds "Restructuring")

Analysis of IBM's First Quarter 2005 Business Results

Slammed and Dunked

Stock Drops 5% in After-Hours Trading Even Though Revenues, Profits Rise

NEW YORK, Apr 14 – It was supposed to be a slam-dunk quarter.  At least that's the way things looked two-thirds of the way through.  Instead, it was IBM that got slammed and dunked.  By Wall Street - tonight, with more to come tomorrow...

Big Blue surprised everyone, including itself it seems, with an early and a disappointing first quarter earnings release after the markets closed today.  The announcement came four days early and was six pennies short of the "street consensus" (84 vs. 90 cents per share).  Never mind that the first quarter income from continuing operations was $1.41 billion compared with $1.36 billion a year ago, an increase of 3%, and that the revenues were $22.9 billion, also up 3%.  One must never confuse facts with perceptions.  And perceptions, not facts, rule on Wall Street.

As a result, the Big Blue stock dropped five points in after-hours trading this evening, accelerating a steep two-week slide in advance of the announcement that erased about 10% of its market cap (see the chart).  And if Accenture's experience last week is any indication, that's only the first strike of a lashing IBM can expect from Wall Street tomorrow and next week.  

The price decline that left the IBM stock this evening at a 20-month low could not have come at a worse time for the stock market.  The Dow Jones Industrials, of which IBM is a part, also set a five-month low today after its second consecutive 100+ point-drop.  But the stock market's overall decline has not been nearly as precipitous as IBM's (about 2% vs. about 15% in the last three months).  

What IBM executives said in a hurriedly-called teleconference that followed the earnings' release, only exacerbated the matter.

"This quarter did not play out as we expected," were the first words out of the IBM CFO Mark Loughridge's mouth.  "We had a good start to the quarter, consistent with the way we exited 2004.  In fact, we had revenue growth of over 6% through the end of February."

And then the bottom fell out in March.  "Beware the Ides of March," goes an ancient Roman warning.  IBM said it had a significant drop-off,  primarily in small transactions at the end of the quarter, and March revenue was down. 

"Given our skew of business within the quarter, the March shortfall significantly impacted the first quarter’s overall growth rate and profitability," Loughridge explained.

And boom... the stock started to plummet.  The after-hours trading was halted at one stage due to imbalance of orders.

Business Segment Analysis

IBM Global Services.  IBM's biggest unit reported a 6% revenue growth in the first quarter (3% in constant currency).  Which was not bad as far as it went.  But it was evidently far less than IBM had expected.

"We had a disappointing quarter in services," Loughridge did not mince words in expressing his dissatisfaction.  "Contributing to the shortfall was a decline in short term signings, that impacted not only the total reported signings, but also our revenue and profit performance."

As a result, the IGS pretax profit margin also dropped by 0.8% to 7.6%.

But even more disappointing was IGS' continued slump in new sales, coupled with a an on-going "rescoping" problem that is shrinking its backlog.  In the first quarter, IGS sold $10 billion of new business but its backlog still declined by a billion to $110 billion at the end of the period.  Which suggests that "rescoping" amounted to about $11 billion.

And that does not bode well for IGS' rapid growth in the future.

Servers.  Among the IBM servers, a yesteryear's star turned into a pumpkin (see "Going Retro with Mainframes," Apr 2004).  The zSeries servers, that celebrated the mainframe's 40th birthday a year ago with a 34% surge in revenues, dropped back with a 16% decline in the first quarter of this year.  Of course, that's relative to a very strong first quarter of last year.  

"But one swallow does not a spring make," as they say.  The second quarter results will show if this is just a temporary setback, or a start of a longer downturn.

The iSeries servers, on the other hand, did return to growth, eking out a 1% increase.  The xSeries servers and storage products grew by 8% and 5% respectively.  The pSeries (Unix) servers, on the other hand, among the laggards of 2004, were the only ones to grow in double digits (up 12%).  

Overall, IBM's Systems & Technology business grew by 2%, while the company's PC unit's revenues declined by 3%.

Software.  IBM software also showed a respectable (2%) growth in what is normally the slowest quarter of the year.  But WebSphere, Lotus and Tivoli products all grew in double digits (between 11% to 15%), implying a solid demand among the big corporate buyers.  

The sales of these three products are typically linked to the zSeries (mainframe) demand.  So their growth is an encouraging sign for those who are betting that the mainframe's stumble in the first quarter is just that - a stumble, rather than a crash.

SMB Push Continues

Industries.  Some 30 months ago, IBM launched its big push into the small and medium (SMB) business market (see "Finally Heard!", Jan 2003).  Big Blue's success in this sector will pretty well make or break its growth strategy, we have been saying for almost nine years now.  As of the third quarter of 2004, however, IBM's SMB push seemed to be sputtering (see "Slow Quarter No More," Oct 2004).  In the fourth quarter, it merely kept pace with the rest of the business (see "IBM: A Crescendo Finale!", Jan 2005).

But now, in the first quarter, the growth is accelerating again.  The SMB segment was up 7% as the fastest-growing IBM market.  The second fastest-growing industry segment distribution, which increased 5% in the first quarter.  

The financial sector and government, the two largest vertical IBM markets, also outgrew the company as a whole, rising 4% in the period.

Geographies.  Some of the biggest overseas countries were IBM's biggest first quarter disappointment.  Revenues declined 5% in France, Germany, Italy and Japan.  So even if the business in emerging markets surged in double digits (up 18%), it was not enough to make up for the shortfall.

When it was all said and done, Europe still ended up the fastest growing geographic region (up 7% as reported, and up 2% in constant currency), followed by the Americas ( 2% and 1% growth respectively).  The Asia/Pacific region held up the rear with a 1% rise as reported and a 2% decline in constant currency.

Stock Buybacks Continue

IBM set a new all-time record in first quarter stock buybacks of $3.4 billion.  

Evidently the company feels that that is its preferred way of rewarding its shareholders (rather than through universal distributions, such as dividends, that are now taxed at slightly higher rates than capital gains).  The fact that by definition it is only rewarding its former shareholders does not seem to trouble anyone at Armonk.  Nor does it seem concerned that that capital might be better used if invested in the business.  The fact that the company is no longer getting any "bang for the buck" in terms of stock price increases makes the continuation of this wasteful practice one of Armonk mysteries.

IBM Unleashes Financial Tsunami on U.S. Tax Day

NEW YORK, Apr 15 - And then the tsunami hit... As expected, Big Blue did get slammed and dunked today, giving up over $11 billion of its market cap, most of it in the first hour of trading.  But not just IBM.  All of the IT sector was awash in a bloodbath unleashed by a financial tsunami whose epicenter was in Armonk.  The top 18 IT firms we follow lost $28 billion of their market value in a single day; $27 billion of it before noon today (EDT).  

There were no exceptions.  We do not ever recall a day like this.  Wall Street took no IT prisoners today.  And not just IT.  The Dow Jones Industrial average dropped 191 points, the third successive 100+ point-loss this week.

Being an innocent bystander was a dangerous thing on this Friday April 15.  Microsoft lost more than $4 billion of its value.  HP and Oracle each retreated by over $2 billion.  Dell wasn't far behind, either (down $1.5 billion).  SAP lost about $1.2 billion.  Sun Micro and EMC shareholders coughed up about $1 billion.  And so on... 

Even IBM's overseas competitors got clobbered.  Capgemini stock lost 4.2% of its value, while Fujitsu's dropped 3.2%.

People used to say when IBM sneezes, the rest of the industry catches a cold.  Let us revise that.  When IBM sneezes, the rest of the industry gets pneumonia.  And IBM didn't even sneeze very loudly.  As you saw from our last night's report, most of the numbers looked good.  Just not good enough for Wall Street's taste.

And as if that weren't bad enough, the IBM tsunami hit on the U.S. tax day.  Ouch!  It's a good thing the week is over...

Beware of Knee-Jerk Reactions

At a time like this, it is always instructive to take a longer-term view.  Wall Street tends to think in quarterly increments.  Which often leads to knee-jerk reactions and false readings.  Life and business are continuous.  The following chart depicts IBM's growth for the last 92 years.

And the following chart shows IBM revenues in the last two decades, and our forecast for the next five years.  As you can see, all bars point... UP!

By the time all is said and done, therefore, the March 2005 revenue drop will probably end up looking like a drop in a bucket.  Imperceptible; a blip, not a trend change.  

Panicked traders and customers should keep these charts in mind before continuing to run for the hills and thus hurt themselves even more than they already have.  Shedding $28 billion of market value in one day doeth seem a little excessive, especially on the news that IBM revenues and profits actually INCREASED!

IBM to Lay Off 10,000 to 13,000, Mostly in Europe, Take a $1.3 Billion to $1.7 Billion Charge

PHOENIX, May 4 - IBM announced this afternoon after the markets closed a new round of major layoffs that are intended to address its major problem area during the first quarter - Europe.  The company will cut between 10,000 and 13,000 jobs, and will take a charge between $1.3 billion and $1.7 billion.

IBM said it plans to improve the efficiency of its services operations by consolidating much of the service delivery workload into fewer locations by using standard job roles, processes and tools.

IBM Europe reported a disappointing 2% growth in the first quarter (in constant currency), following similarly anemic performances earlier quarters of 2004.   The problem was especially acute in some of the major European countries, and particularly troublesome compared to the growth other IT industry leaders (see the chart).

So now IBM has taken out pan-European layers of management created in 1993, in the hope of streamlining decision-making and bringing its people closer to customers.  The company has not quantified the savings it expects from the cutbacks.  But it is clear that improving profitability is the major reason behind them.

Happy bargain hunting!

Bob Djurdjevic

P.S. Annex clients click here to view our detailed IBM 1Q05 analysis.

For additional Annex Research reports, check out... 

2005 IT:  IBM: Slammed and Dunked  (Apr 2005); Accenture: Roaring Ahead (Apr 2005);  Fujitsu Unveils New Servers (Mar 2005);  EDS Executive Suite; HP's New CEO (Mar 2005);  An iSeries Revival (Mar 2005);  EDS Booster Club Fees Rise (Mar 2005);  An Upside-Down View (Mar 2005);   The Worst of Both Worlds (Mar 2005);   Octathlon 2005: Accenture Wins (Mar 2005);  IBM Global Services: Smaller, Shorter - Better? (Mar 2005);  IBM 5-yr Forecast: Quality over Quantity (Mar 2005); Rumor Lifts EDS', Fujitsu's Shares (Mar 2005); Capgemini: Turning the Corner (Feb 2005);  IBM Servers to Grow Again (Feb 2005);  Carly's Fickle Fans (Feb 2005);  CSC: Gearing Down on Purpose (Feb 2005);  EDS: Grossly Overpriced Stock (Feb 2005);  IBM Historical Update: 2004 Shot in the Arm (Feb 2005); New HeadTurners Series #1 (Feb 2005); IBM: A Crescendo Finale! (Jan 2005); Accenture: Strong Finish, Better Start (Jan 2005); Annex Coverage 2004: IT Services Dominate (Jan 2005)

2004 IT: EDS: The Titanium Stock (and other Wall Street tales) (Dec 2004); IBM PC: Good Riddance (Dec 2004); Fujitsu: Recovery Continues (Nov 2004);  IBM Server Renaissance (Nov 2004);  HP Hits Home Run (Nov 2004); Capgemini: Revenue, Stock Soars (Nov 2004); EDS: Jordan's Swan Song? (Nov 2004);  To Russia with Love and $ (Oct 2004); IBM: Slow Quarter No Longer (Oct 2004); Accenture: Revenues, Profits Up, Stock Down (Oct 2004); Capgemini: A Takeover Target? (Oct 2004); Sellout of America (Oct 2004); Spy Wars (Sep 2004); Outsourcing Boomerang (Sep 2004); EDS to Cut Up to 20,000 More Jobs (Sep 2004); Capgemini Stock Plummets on Unexpected Loss (Sep 2004); HP Savaged by Wall Street (Aug 2004); Moody's Lowers the Boon on EDS (July 2004); HP: Delivering Value Horizontally (June 2004); Accenture: Revving Up a Notch (June 2004); Beware Your CFO! (May 2004)IBM: Changing of the Guard (May 2004); Capgemini: Texas-size Home Run (May 2004); Following the Money (May 2004);  EDS: On a Wink and a Prayer (Apr 2004); HPS Wins by a Nose! (Octathlon 2004); Accenture: Burning the Track (Mar 2004);  IGS: "Crown Jewel" Restored? (Mar 2004); HP: Still No Cigar (Feb 2004); Cap Gemini: Another, Smaller Loss (Feb 2004); CSC: Good Quarter Gets Boos (Feb 2004); EDS: "Hot Air Jordan" Flaunts Flop as Feat (Feb 2004); IT Industry: Whither Goeth It? (Jan 2004); Cronyism Is Alive and Well at EDS" (Jan 2004)

Or just click on and use "financial engineering" or similar  keywords.

Volume XXI, Annex Newsflash 2005-13
April 14, 2005

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

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