Annex Newsflash 2005-32                            October 17, 2005

  IBM FINANCIAL

Updated 10/17/05, 7:30 PM PDT (adds Client Tables)

Analysis of IBM's Third Quarter Business Results

Springboard Quarter

iSeries: New Server Star; SMB, E&TS Markets Also Strong

PHOENIX, Oct 17 - IBM came through with good results in what is normally a tough summer quarter for Big Blue.  Revenues were up 4% after adjusting for the divested PC business, while earnings were $1.26 per share, up 22% compared to the year-ago quarter.  That easily surpassed the $1.13 per share EPS that Wall Street was expecting.

Furthermore, finally free of the burden of its low-margin PC business, and bolstered by the layoffs and expense cutbacks in the second quarter, IBM's operating income surged 40%, while its pretax profit jumped 33%.  

In short, the third quarter was a solid springboard for the tail winds that IBM will be enjoying in the fourth quarter (the volume "z9" shipments and the seasonally strong year-end demand, among others).

"IBM had a good quarter," said Sam Palmisano, IBM's CEO, in a statement that accompanied the earnings release.  "We are encouraged by the client reaction to the new zSeries mainframe."  Palmisano also praised the performances of IBM's streamlined operations in Europe, that of the midrange servers, the BPO (business process outsourcing) and the E&TS (Engineering and Technology Services) unit, among others.

iSeries: The New iStar

The star of the third quarter was the iSeries.  Last year's laggard became this quarter's leader among IBM server product lines.  The iSeries revenues shot up 25% from the third quarter of 2004.  The recovery that IBM set in motion a year ago is finally starting to bear fruit.  Big time.  After a small (+1%) increase in the first quarter, and a bigger one in the second (+10%), the iSeries is finally beginning to reclaim its past glory.  And you can expect the momentum to carry on in the fourth quarter.

No surprise there.  Check out our "An iSeries Revival" research paper, written and published in February, at a time when there were many more Doubting Thomas's than there are iSeries boosters.  Even among some IBMers, let alone Wall Street or the media.  Here's what the IT Jungle said about it in August:

Bob Djurdjevic, president of Annex Research, reminded me recently that he predicted at the end of 2004 that this would happen, and indeed, it did. "And I expect it to continue," he says. "My prediction last year was that the iSeries would end this year in upper single-digit growth, and I still believe that." In fact, Djurdjevic has put together a 37-page report called "An iSeries Revival," which you can read by clicking here.

(see "Is the iSeries Really on an Upward Trend?," IT Jungle, Aug 2005).

Among other IBM servers, the pSeries revenue jumped 15% in the quarter, the xSeries and storage were up 11%, while the zSeries declined 4%, as expected, since the new "z9" mainframes started shipping only in late September.  You can expect the z9 to join others in double-digit growth in the fourth quarter, when the z9 hits volume shipments.

E&TS: The New eStar

IBM's E&TS (Engineering and Technical Services) unit, the new "eStar," is continuing to burn the track.  The 68% jump in its third quarter revenues was its eighth quarter of double digit growth in a row.  As we've noted in our earlier reports (see "Tweaking Big Blue," May 2005), picking up the R&D outsourcing contracts from clients such as Microsoft and Sony, among others, gives IBM chance for an indirect play in consumer markets.  And to do it without the high risk and big marketing expenses.

No wonder the IBM unit was also featured in a recent Associated Press report on outsourcing R&D.  "If you're doing R&D, and if you're not world-class, then you'd better let it go," Irving Wladawsky-Berger, IBM's vice president for technical strategy and innovation, told AP.  

Indeed.  Guess E&TS growth rates suggest its stuff is world class.

Business Segment Analysis

Industries.  It took taking away the PC business to show how successful IBM is becoming in the SMB (small and medium size business) market.  Although its share of the total IBM revenues dropped from 22% to 19%, the SMB business was the only sector to grow in double digits in the second quarter (see the charts).

And since Europe represents the world's biggest SMB market, and the European revenues also increased 5% in constant currency, an IBM turnaround on both fronts is evident.

Geographies.  Europe and the U.S. were also the best geographic markets in the third quarter.  Without the PC business, both of them were up 5%.  The Asia/Pacific region, on the other hand, weighed down by the sluggish performance in Japan, declined in double digits as reported, and by 2% without the PC revenues.

But IBM continues to derive significant revenue growth from the world's largest emerging markets.  The growth in Russia, a country that we predicted a year ago would be the next big global investments opportunity (see "Global Investments: New "Drang Nach Osten", Sep 2005), is nothing short of explosive (up 88% in the third quarter).  IBM revenues in India and Brazil also soared, up 51% and 26% respectively (without the PC business).  Only China lagged behind in terms of non-PC revenues,  which declined 1% in the latest period.

Services.  Which brings us to another relative laggard, IBM Global Services (IGS).  Although this unit signed $11 billion in new contracts in the third quarter, a "feat" that IBM executives lauded and some analysts applauded (as being up from the quarter a year ago), the figure is actually quite troubling.  

First, because it is down 25% sequentially from the second quarter.  But more importantly for IGS' long term health, because the biggest IBM unit dropped as much business from its backlog, leaving the latter flat with that in the second quarter at $113 billion (see the chart).  Which means that IGS will have to sell a lot more than that of new business if it is to show anything more than the anemic 3% revenue growth that it reported in the third quarter.

Summary

Overall, IBM's third quarter results were slightly better than expected, both in terms of our forecast, and compared to that of most Wall Street analysts.  No wonder the stock rose more than two points in after-hours trading this evening.  But the main reason for investor optimism isn't so much what has already happened (the first nine months of 2005).  It is what lies ahead for Big Blue in the fourth quarter.

And what is that?  First, the volume shipments of the "z9" mainframe, of course, which will also drag along additional sales of highly profitable software and services.  Second, continued strength in both SMB, Europe and iSeries markets (all three are intertwined).  Third, a new boost to pSeries (Unix) demand, thanks to the new p5 processors that IBM has just introduced.  And fourth... a wild card; a hope that IGS will get off the mark and have a good sales quarter.  Being the year-end, the time when many large corporations make most of their major purchases, chances of that happening are not great, but are better than at any other time this year.

So for all those reasons, we see upside to the IBM stock and its business performance.

Annex Clients: Click on Table 1 (P&L) or on Table 2 (Pretax profit) for detailed IBM 3Q05 results

Happy bargain hunting!

Bob Djurdjevic

For additional Annex Research reports, check out... 

2005 IT:  IBM: Springboard Quarter (Oct 2005); Top Wall St Firms Bump Up Investments  (Oct 2005); Accenture: A Whopper Quarter  (Oct 2005);  Global Investments: New "Drang Nach Osten" (Sep 2005);  HP: Sweet Turnaround (Aug 2005);  Dell Spooks Street (Aug 2005);  EDS Ups Its Forecast (Aug 2005);  Capgemini Beats Forecast (July 2005);  Fujitsu: Losses Reversed; Forecast Upgraded (July 2005);  IBM: Polaris Eclipses T-Rex (July 2005);   IBM Bounces Back (July 2005); Accenture: Smashing Records (July 2005); Merrill's New Bull (EDS) (May 2005);  IBM Trumps Trump (May 2005);  Tweaking Big Blue (May 2005); Hurd's First RBI (May 2005); Dell Rings the Bell (May 2005); Stock Buybacks: The Phantom Is Back (May 2005); EDS Misfiring on All Cylinders (May 2005);  HP Surges, Dell Slumps; Lenovo Completes IBM Deal (May 2005);  Fujitsu Revenues Flat, Lower Net (Apr 2005); Capgemini Jettisons Healthcare in N.A. (Apr 2005); HP: From India to Poland (Apr 2005); IBM: Slammed and Dunked (Apr 2005); Hurd Advice: Up Mount Market Cap (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 2005-32
October 17, 2005

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

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