<%@ LANGUAGE=VBScript %> <% Set asplObj=Server.CreateObject("ASPL.Login") asplObj.Protect Set asplObj=Nothing %> Analysis of IBM 2Q09 Business Results (July 16)

Annex Bulletin 2009-14                            July 16, 2009

A partially OPEN edition



Less Than Meets the Eye - Analysis of HP's 3QFY09 results


Big Blue Blows Lid Off Forecasts - Analysis of IBM's 2Q09 results



Updated 7/21/09, 6:00PM HIT, adds MARKET UPDATE

Analysis of IBM's Second Quarter Business Results

Big Blue Blows Lid Off Forecasts

IBM Surpasses Wall Street's Earnings Expectations by Wide Margin Despite Lower Revenues, Appears Recession-proof

HAIKU, Maui, July 16 – Big Blue blew the lid off Wall Street earnings estimates with its second quarter release.  IBM reported net profit of $2.32 per share, up 18% over the second quarter of 2008, significantly exceeding average analyst expectations of $2.02 per share.  The company also raised the full year 2009 earnings estimate to $9.70 per share, up 50 cents from $9.20 per share.

What’s especially important about these numbers, however, is that IBM’s excellent bottom line results came in the face of a bigger-than-expected revenue decline (down 13% or 7% in constant currency) to $23.25 billion.  So Big Blue is showing the world what can happen when a company puts Quality over Quantity as the backbone of its strategy, and learns how to do more with less.

Recession?  Evidently not in Armonk (IBM’s HQ in New York).  By contrast to recent disappointing results by HP (Suddenly, All Lines Point South) and Accenture (Revenues, Earnings Drop), some of IBM’s major global rivals, the company is also demonstrating how its strategy of focusing on software and services and emerging markets is paying dividends.  Even though all major lines of business revenues declines, and its hardware business plummeted 26% since a year ago, IBM managed to increase its bottom line in double digits.

In short, a smaller Big Blue appears recession-proof.  No wonder its shares are already soaring in after-hours trading (up over 2% to $113 as we write this - left chart). 

“We expect both software and services PTI (pretax profit) to grow double-digits this year,” said Mark Loughridge, IBM’s CFO, in a post-earnings teleconference with analysts. 

Over a longer haul, that meant that software’s pretax contribution increased from $2.8 billion in 2000 to about $8 billion this year, while the services’ share went from $4.5 billion to approximately $8 billion (right chart).

As a result, IBM's pretax margins as well as net earnings have been growing much faster than the revenues (see left chart).

"We are well ahead of pace for our 2010 roadmap of $10 to $11 per share," said IBM CEO, Sam Palmisano.

It is also interesting to contrast the market reaction to Google’s earnings which came out simultaneously with IBM’s.  Google shares are down nearly three points to $430, even though Google reported increases in both revenues and earnings.  Which speaks volumes about the art of investor relations, something IBM has been lacking before.  This time around, the company had set the bar low enough so as to exceed it by a wide margin.  And the stock market’s loud applause was a result.

Business Segment Analysis

Software.  IBM software was the "hero" of the quarter.  Its pretax margin expanded 8.3 points to 32%, while the gross margins shot up 1.2 points to 85.9%.  Which means that software threw $1.85 billion of pretax profit to the bottom line.  And to achieve such results in the midst of the current global recession is nothing short of extraordinary.

IBM's "key branded middleware," which is what the company calls its most profitable products that now account for 58% of IBM's software revenue, even managed to grow its revenues 5% in constant currency (it was down 2% as reported). 

Within these brands, the corporate web management software, Websphere, grew 8% as reported and 17% in constant currency.  Tivoli, Rational and Information Management products also grew in single digits in constant currency, while declining in low single digits as reported.  Lotus was the only major brand that saw its revenues shrink both as reported (-14%) and in constant currency (-8%).

Overall, software revenues were down 7% as reported, or flat in constant currency.

Services.  IBM Global Services (IGS), the company's largest business segment that operates in two components - Global Technology Services (GTS - outsourcing) and Global Business Services (GBS - consulting & SI) - also had a strong quarter.  Its combined pretax contribution was $2 billion, exceeding in absolute terms even that of software.  But the IGS pretax margins were, of course, much lower (14.9% and 13.3% respectively for GTS and GBS vs. 32% for software). 

Nevertheless, compared to the profitability of its global services rivals, GTS' 34.8% and GBS' 27.2% respective gross margins, up 3.2 and 1.3 points respectively since a year ago, speak volumes about how annuity business can thrive even in recessionary times.  And, IBM's outsourcing new contract signings in constant currency were up 38% in the quarter. 

The reason?  As we have said before, in good times, services companies help their clients grow faster.  In lean times, they save them money by performing the IT functions more efficiently.  Again, "doing more with less" is the name of the game in the services business as it is in IBM as a whole.

IGS also improved its overall sales and portfolio management record.  Even though the new contract signings of $14 billion were down 5% in the second quarter from the year before, a more significant indicator of future revenues - backlog - was up $6 sequentially (since the first quarter of 2009) to $132 billion. 

This means that IGS has been playing tough defense (i.e., protecting the outflow of revenue from existing contracts) in addition to selling lots of new business.  As a result, for the first time since 2007, in the first half of this year, IGS has sold more that it had lost from the backlog (see above charts).  And that's obviously good news for future revenues and earnings.

Hardware.  Which brings us to hardware, once upon a time the core of IBM's business, now a relative laggard compared to software and services.  The Systems & Technology Group's (STG) revenue was down 26% as reported, down 22% in constant currency.  Perhaps surprisingly, the mainframe revenues declined the most among the major product lines - down 39% as reported, and down 35% in constant currency.

Loughridge, the IBM CFO, blamed that in part on what he called "a tough compare."  In a year-ago quarter, the System z (IBM's name for its mainframes) experienced a real bonanza, surging by 34%.  Now, that was a tough mountain to climb.  And the mainframe folks ended up short.

But the System z was up 17% in constant currency in "growth markets" (up 2% as reported).  Which suggests that most of the weakness is in the biggest market of North America.  The relatively small impact of currency translations on this product line also hints at that.

All other IBM hardware lines also declined but at lower rates than the mainframes.

Loughridge also said that he expected IBM to start stabilizing and returning to profit growth by the fourth quarter.

Geographies & Industries.  All four major IBM geographic segments reported revenue declines, but actual and in constant currency.  The Americas region was down 9% as reported, down 7% in constant currency.

Europe dropped the most - 20%, but 13% of that total was eaten up by currency translations.  Asia/Pacific declined the least - down 7% as reported, and down 5% in constant currency.  The major downward factor was the biggest country in that region - Japan - whose revenues slumped 11% in constant currency and 4% as reported.  Without Japan, Asia/Pacific grew 1% in constant currency, but was down 10% as reported.

IBM's public sector reported the best results in the second quarter - up 7% in constant currency, and flat revenues as reported.  All other segments experienced declines both as reported and in constant currency.

The Small and Medium Business (SMB), which IBM now called "General Business," continues to disappoint.  This is an area that was supposed to be a key part of Big Blue's growth engine, according to IBM CEO's prediction at a business partner conference in May of 2007 (see IBM Lowering Center of Gravity).  In the latest period, SMB revenues were down 14% as reported, and 7% in constant currency.  Which means they dropped more than the company's business overall (which shrank by 13% and 6% respectively).

Summary & Outlook

Putting its mouth where its money is, IBM raised its earnings outlook for the year from $9.20 to $9.70 per share.  As you saw earlier, both IBM CEO and CFO reassured the analysts and investors that the company is well ahead of its goal of the $11 per share 2010 profit which the company executives promised to deliver at an analyst meeting in May 2007 (see right chart and "BRIC by BRIC... to Top Line Growth").

Loughridge also said economic conditions remained tough and held off of sounding an all-clear, but said he saw further room for the company to improve its profitability.  And he added that he expects the U.S. government's stimulus plans to begin encouraging customers' discretionary spending, and forecast a weaker dollar to provide tailwind.

This will obviously buoy the investors when the markets open tomorrow, and will likely propel the Big Blue shares to greater heights than those achieved in after-hours trading this evening.  The best way to build credibility with investors is to "underpromise and overdeliver."  Which is exactly what IBM has been doing lately. The fact that Big Blue's investor relationship game suddenly appears better than even Google's, one of the recent Wall Street darlings, is evidence that one is never too old or too big to learn even from younger upstarts.

Click here for detailed tables and charts (Annex clients only)

Happy bargain hunting!

Bob Djurdjevic

Click here for PDF (print) version


Big Blue Stock Towers over Rivals' Shares

HAIKU, Maui, July 21 – The IBM stock has now moved up over 12% since the company released its second quarter results last Thursday.  That's over $18 billion in new shareholder value gained in just three trading days.  No surprise there.  We said the same evening (July 17) that, "this (IBM results) will obviously buoy the investors when the markets open tomorrow, and will likely propel the Big Blue shares to greater heights than those achieved in after-hours trading this evening."  Which is what did happen.

But what is perhaps less obvious is that the Big Blue stock outperformed the shares of most of the IT highflyer companies' since Thursday night.  How often will you see Google at the bottom of any stock market rankings?  Or Apple in the middle, even after it rose 3% tonight following its second quarter report?  Why did HP shares rise so much on new recent news, especially considering that IBM reported far superior business results in the last quarter?  Why didn't Accenture shares increase more?

Those are some of the questions investors with some logic and commons sense might be pondering after looking at the above chart.  Alas, Wall Street has never been big on logic and common sense.  Which is why Yahoo, the company that just disappointed investors this evening with its latest results (shares down over 3% in after-hours trading), appears like a highflyer on the above chart, second only to IBM. 

The reason, of course, is not logic and common sense but the old rumor mill.  The same evening IBM reported its second quarter results, Carl Icahn, a major Yahoo shareholder, reportedly said he would like to see the Microsoft takeover of Yahoo resume and go forward.  And that kind of speculation, not business results, pushed the Yahoo shares up even higher than IBM's for a day or two, before some sanity and a sense of reality returned to the trading floor.

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Volume XXIII, Annex Bulletin 2009-14
July 16, 2009

Bob Djurdjevic, Editor
e-mail: annex@djurdjevic.com

Tel/Fax: +1-602-824-8111

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