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Annex Bulletin 2010-07                            April 19, 2010

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Updated 4/19/10, 4:30PM HIT

Analysis of IBM's First Quarter Business Results

As Good As It Gets Still Not Good Enough

Schizophrenic Market Behavior Continues Even after IBM Exceeds Wall Street's and Our Expectations

HAIKU, Maui, Apr 19 – IBM's first quarter results exceeded everyone's expectations, ours as well as Wall Street's.  Yet even "as good as it gets"-quarter was not good enough for schizophrenic Wall Street traders.   As we write this, the IBM stock is down nearly three points in after-hours trading (to $129.41).

Ironically, that's not surprising.  Erratic market behavior is becoming a norm.  Here's what we told our clients and the media they can expect from Big Blue before IBM released its first quarter results after the markets closed today:

Last week, Google and Intel blew the lid off the Wall Street expectations.  Consumer markets are heating up again, was the message.  Today, we will find out if the early spring fever will have also extended to the big boys in business. 

We see from this today’s trading action that the market does expect good news from Big Blue, too.  IBM shares are up $1.25 to almost $132 as I write this, dragging the Dow Jones upward as well. 

But Big Blue shareholders should be wary.  And not just because that old Wall Street saw – “buy on rumor, sell on fact.”  This is a schizophrenic market.  Google’s earnings were up 38% but its stock got slammed anyway.  It was down 7% following its 1Q release on Friday.  Just because.  No reason that we could see.  Intel, on the other hand, has kept its 1Q announcement gains.  Go figure.  “What’s good for a goose is good for a gander?”  Not on Wall Street Wow..

After IBM did release its outstanding first quarter results, the market's negative reaction to them confirmed that old adage - "buy on rumor, sell on fact."  Here was our first off-the-cuff comment, filed before the IBM teleconference with analysts:

We told you that IBM may blow the lid off Wall Street forecasts.  And we had said back in early January that Big Blue will be poised for growth again in the new year (see Big Blue Poised for Growth Again).  But holy-moly… we never expected the comeback to be so fast and furious.  ALL IBM lines are growing again, including the hardware. 

And software, well… it’s out of this world – an 85% gross margin and a double digit growth.  It doesn’t get much better than that.  No wonder IBM raised its earnings outlook for the year to “at least $11.20.” 

HIGHLIGHTS OF IBM’S 2010 FIRST-QUARTER RESULTS

o Diluted earnings per share of $1.97, up 16 percent;
o Revenue of $22.9 billion, up 5 percent, flat adjusting for currency;
o Net income of $2.6 billion, up 13 percent;
o Pre-tax income of $3.5 billion, up 13 percent;
o Pre-tax margin of 15.4 percent, up 1 point;
o Gross profit margin of 43.6 percent, up 0.2 point;
o Free cash flow of $1.4 billion, up about $400 million;
o Software revenue up 11 percent;
o Systems and Technology (hardware) revenue up 5 percent;
o Services revenue up 4 percent;
o Services signings of $12.3 billion, down 2 percent (incl. AMS*);
o Consulting services signings up 18 percent (excl. AMS);
o Strategic Outsourcing signings up 6 percent (excl. AMS);
o Services backlog of $134 billion, up $8 billion year to year;
o Full-year 2010 earnings-per-share expectations raised to at least $11.20.

*NOTE: AMS (Application Management Service) is IBM’s low-margin activity, akin to body shop work that India-based companies provide.  In 2009. AMS had a big year last year, up 14%.  So it is a tough compare.  This work also tends to be “lumpy” (sporadic).  Without AMS, IBM’s new business contract signings would have been up 4%.

Still, Wall Street ignored all the positive traded down the IBM shares after the release.  Predictably, as you can see. 

Strange, isn't it, how even illogical can become normal.  Socrates and Hegel would feel right at home on Wall Street these days (see Socratic and Hegelian Dialectic).

Business Segment Analysis

Software, STG, SMB... Standouts

Products & Industries. Meanwhile, IBM's growth in the first quarter impressed by both its breadth and depth.  Nearly all geographies and product lines contributed to it. 

The greatest improvement was evident in the STG (Systems and Technology Group) results.  IBM's hardware unit more than doubled its growth from the fourth quarter (up 11 points - see right chart).  The STG revenues were also up 5% relative to a year-ago quarter despite sharp declines in its System z and p server businesses.  Both product lines experienced a typical hiatus in customer buying before major new product announcements.

Among the vertical markets, the SMB (small and medium size business) performance was a standout, exceeding the growth of the corporation by a factor of two (up 10% vs. IBM's 5% growth).  The distribution sector also impressed by a similar double-digit increase (left chart).

And, as you've already seen, the IBM software topped all major lines with an 11% annual surge.

Geographies.  From a geographic perspective, the Americas’ first-quarter revenues rose 2% since a year ago. Revenues from Europe were up 5% (down 2% in constant currency).  The Asia-Pacific business jumped 10% (up 1%, adjusting for currency).

OEM revenues surged 18% compared to last year's first quarter.

Revenues from the company’s growth markets organization increased 20% (8%  adjusting for currency) and represented 19% of geographic revenues.

Driving the improvement in the major markets growth rate, IBM showed a better performance in each of the G7 countries. The best growth came from the UK, which was up 8% over last year's first quarter.

Services. If there was a relatively weak spot in IBM's quarter results, that would be the Global Business Services (consulting), the smaller of the two IBM services segments.   Its revenue of $4.4 billion was flat as reported (down 5% in constant currency).  But even here there was a bright light.  The GBS new business signings were up 18%, suggesting revenue growth is likely to follow.

The Global Technology Services unit, on the other hand, more than double the size of GBS with revenues of $9.3 billion, reported a 6% revenue growth in the first quarter (flat in constant currency).

What may have legitimately spooked some of the investors, however, was a decline in overall IBM services signings (down 2% since a year ago).  Yet the footnote you have seen above explains even that.  The AMS signings decreased 23%, or approximately $700 million. Without it, total services signings would have been up 4% year-over-year.

But investors rarely read footnotes.  They needed an excuse to sell off the IBM stock after bidding it up first based on speculative expectations.  And so the IBM services became a scapegoat, notwithstanding the fact that the total IBM Global Services revenues increased 4% (down 2%, adjusting for currency).

To us, a more disturbing fact was a drop in the backlog, from $137 billion at the end of the fourth quarter, to $134 billion as of Mar 31 (right chart).  Coming on the heels of a recovery in 2009, which suggested IBM services were playing solid defense amid the global recession, the first quarter sequential decline is not a great sign. 

Yet IBM CFO, Mark Loughridge claimed the "backlog erosion (was) at the lowest level in two years. "

"Within the backlog, we saw improved stability in our base accounts," Lioughridge also said, as he cited the backlog growth relative to the first quarter of 2009, while ignoring the sharp decline since the latest backlog figures as of the fourth quarter of last year.

If that's so, we just don't see it in the published IBM figures (left chart).

"The estimated services backlog at March 31 was $134 billion at actual rates compared with $126 billion in the first-quarter 2009."

Software. Revenues in the IBM Software unit, Big Blue's most profitable segment, were $5.0 billion, an increase of 11% (up 5%, adjusting for currency).  Websphere, Information Management and Tivoli all recorded double digit growth (up 13%, 11% and 23% respectively).  They contributed to a double digit increase in IBM's middleware revenues (up 13% for five major brands).

"Software had a terrific quarter," the Loughridge, the CFO, said on a teleconference with analysts.  "Organic investments, complemented by strategic acquisitions, have enabled us to deliver unique capabilities and tremendous value for our customers."

Operating systems revenues also rose (up 1%; down 3% adjusting for currency) compared wth the prior-year quarter.

Summary

It was not a perfect quarter for Big Blue, but it was "as good as it gets," a period the company returned to growth across the board, as we predicted at the start of the year.   As a result, IBM increased its expectations for the year, "to at least $11.20 of earnings per share," the IBM CFO said.

"Given what we see in the short term and our work with the business units, we expect a return to revenue growth at constant currency in the second quarter," Loughridge summed up his outlook for the current three-month period.

He added that he expected the Services to deliver "modest" revenue growth, "hardware to improve to a mid-single digit" increase, and Software to "continue its strong performance. "

You would think that such an o ptimistic outlook might have given the IBM shares a boost, wouldn't you?  Well, not today; not in the midst of a schizophrenic market behavior.  Maybe "tomorrow?" (by "tomorrow," we mean at some point in the future not necessarily literally tomorrow).

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

Happy bargain hunting!

Bob Djurdjevic

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Volume XXVI, Annex Bulletin 2010-07
April 19, 2010

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

(c) Copyright 2010 by Annex Research, Inc. All rights reserved.
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