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IBM FINANCIAL

Analysis of IBM’s Third Quarter Business Results

On a Wing and a Prayer

Facts and Reason Do Not Support IBM CFO's Bullish Outlook for Fourth Quarter and 2003

TUCSON, Oct 16 - IBM CFO, John Joyce, sounded optimistic in his comments to analysts this afternoon, following IBM's third quarter earnings report, released after the markets closed today. He said he was "comfortable" with analysts' estimates for the fourth quarter and predicted double-digit earnings growth next year.

Yet even some heretofore bullish Wall Street analysts sounded skeptical about it. And with good reason.  IBM's optimism seems to be founded more on prayer and hope than on facts and reason.  Kind of like that WW II pilot song, "On a Wing and a Prayer."

CNN Money was among the first among the media to discern some contradictions in IBM CFO comments.  Here's an excerpt:

NEW YORK (CNN/Money, Oct 16) - IBM on Wednesday said its third-quarter profit from continuing operations was 99 cents per share, beating most analysts' expectations.

At the same time, there was some confusion about the business forecast executives provided for the fourth quarter. At issue was whether the company would need the revenue and earnings from PwC Consulting, which it bought earlier this month, in order to meet Wall Street's consensus estimate for revenue growth of about 12 percent.

John Joyce, IBM's chief financial officer, said on a conference call that with the PwC Consulting purchase complete, the company will begin to benefit from its added revenue, expected to be about $1 billion in the fourth quarter.

However, he noted that most analysts' had not taken that additional revenue into account when they formulated their estimates. "After adjusting for that revenue and earnings impact, I am generally comfortable with the range of expectations for our performance in the fourth quarter," Joyce said. [...]

But an IBM spokeswoman, when asked for clarification of the company's guidance following the call, told CNN/Money that the anticipated 12 percent increase includes the additional $1 billion in revenue from PwC Consulting.

Bob Djurdjevic, president of Annex Research, a market research and consulting firm that does not trade the stocks or take short positions in any of the companies it follows, said he had expected IBM's services and consulting business would show a decline this year had it not been for the acquisition of PWC Consulting.

"What he is saying is we expect to meet the expectations thanks to this additional source of revenue, not from our existing ongoing operations," Djurdjevic said.

Even with the additional revenue from PwC, Djurdjevic said the company's outlook is dubious because it hinges largely on revenue growth in consulting and services, an industry that recently has shown signs of weakness. […]

Djurdjevic said that many customers also appear to be reneging on some existing deals with IBM and asking for others to be renegotiated, putting the company's outlook, which is tied largely to growth in services, at risk.

"It's an optimistic outlook based on hope and prayer rather than fact and reason," he said. etc [...]

To read the rest of the CNN story, click here....

So Joyce being "comfortable" meant he agreed with the First Call number, which excluded the $1 billion of PwC Consulting revenue that IBM will count in the fourth period (Joyce acknowledged that during the Q&A). Yet answering a question by an analyst, Joyce also said his fourth quarter figures included PwCC's $1 billion.

That's like being asked if something were black or white, and answering the question with "yes."

In other words, it's talking out of both sides of one's mouth. Which has been typical of IBM's black magic accounting wizards about whom we've written tomes in the past (see “Smoke and Mirrors Galore,” July 2000, "Slam Dunk of Bunk", Jan 2000, and other links at the bottom of this report).

No wonder IBM acknowledged for the first time that it will have to start pumping money into its depleted pension fund (see IBM Pension Plan Vapors: Where Did $17 Billion Go?, Mar 2002). Joyce said IBM is planning to put in $1.5 billion through 2005. Which would take a $700 million toll on IBM's earnings and cashflow next year. No wonder IBM finally and severely cut back its stock buybacks (down to $600 million in the current quarter, from $1.8 billion in the quarter a year ago). IBM's acquisition of PwCC was also a factor in depleting the company's cash (see "IBM-PwC Tie the Knot", Oct 2).

Services Key to Recovery?

The IBM CFO virtually acknowledged that IBM was a one-string violin, as we put it in our five-year forecast for Big Blue, when he said that his optimistic 2003 forecast was predicated on the growth in IBM Global Services (IGS) revenues and profits.  “Services is our most profitable business,” Joyce said.

Yet even that one-string is starting to fray, as we also noted in our April report (see "IBM 5-Yr Forecast: From Here to Eternity?", Apr. 2002).  This has not been lost on Wall Street analysts who, for the first time, showed some skepticism.  Several analysts asked the IBM CFO to explain just how he expected IBM to achieve that double-digit growth in earnings, given the slowdown in its services business.

Indeed, IBM’s new contract signings have again contracted.  They were $9 billion in the quarter, down from $10 billion a year ago, and well below the $15 billion IGS claims to have sold in the first quarter.

Far more damaging, however, is the process that the IBM CFO termed “rescoping” in his July conference with analysts.  That’s when customers request that their deals be renegotiated, resulting in lower rates and a loss of revenue for IBM.

How important is that?  In a word - very!  Just take a look at the IGS backlog.  It shrank again this quarter to $103 billion, for the second time ever (the first time was in the previous quarter).

For the last two quarter, therefore, IBM sold $10 and $9 billion dollars of new business while losing $12 and $13 billion respectively from the backlog!  Since 1999, the outflow from the IGS backlog was an aggregate $97 billion!  

As you can see from the chart, IGS sold $140 billion of new business, while its backlog went up by only $43 billion.  And it’s the backlog from whence the revenue comes.  And the profit. And that’s supposed to give us cause for optimism in 2003?  Hm…

Of course, not all of the IGS backlog depletion is due to “rescoping.” Some of it is a natural attrition as a result of expirations or cancellations of the contracts.  But we estimate that during the last two quarters, at least $5 billion per quarter has been wiped out from the backlog due “rescoping.”  

Add to it that PwCC, IGS’s new “knight in shining armor,” has already acknowledged severe declines in its revenues even prior to the IBM acquisition.  So IGS may not end up getting nearly the revenue boost from this deal in 2003 that it had hoped for based on PwCC’s historical results. And it will certainly get no profit boost in the first half of 2003; in fact, just the opposite - PwCC will be a drain on earnings.  Even the IBM CFO acknowledged that today. 

Put it all together, and you can see why we think that IBM’s optimism is based more on prayer and hope than fact and reason.  Nevertheless, stand by for the IBM stock to rise tomorrow (Thursday).  After today’s sharp drop, the market will be thirsting for good news.  So even absence of bad news is likely to be interpreted as good news.  

Business Segment Analysis

Industries.  As if finally listening to our six-year “sermon” about the importance of diversifying away from the Fortune 500-type accounts to the small and medium-size enterprises (see “Louis XIX of Armonk,” Aug 1996), IBM provided today for the first time an industry breakdown of its quarterly revenues.

As it turns out, the small and medium companies account for 23% of total revenues.  But this percentage includes all of the hardware sales, too, not just services and software.  Which means that most of the iSeries (formerly AS/400) revenues, and some of the pSeries (Unix) and xSeries (PC) server sales, are also included in the $4.4 billion total.  Which probably leaves the IGS’ (services) share at a practically negligible percentage.

That’s something that the IBM CFO neglected to point out to analysts during the conference.  And none of the participants appear to have been wise enough to spot this new revelation and ask IBM to elaborate on it some more. 

Nor did they wonder how these figures compare to some of the prior year’s statistics, which would help put IBM’s penetration into the small and medium company market in historical perspective.  Well, at least from now on, we’ll have something to which we can compare future results.

Services.  IBM Global Services revenues were flat in constant currency.  That is the first pause this year in a declining trend that began in the fourth quarter of 2001.  Maintenance revenues were actually up 1%, an unusual reversal of a downward spiral caused by the IBM hardware drop.  But the IGS pretax profit dropped 8%, in part, due to the “rescoping” of deals about which we’ve already commented.

Also for the first time ever, IBM provided a breakdown of what it called “long-term” vs. “short-term” new contract signings over the last seven quarters - without offering a definition of either.  From what we could surmise, “long-term” deals seem to be synonimous with megadeals pursued in the large company market.  The “short-term” contracts are the rest (probably also including some deals with large companies).

The message IBM was trying to convey was that the slowdown in sales was taking place at the high end - as the “long-term” contract signings dropped off precipitously, while the “short-term” sales remained basically flat through the last seven quarters.

Since IBM’s expectations of a turnaround are based on resumption of these “long-term” deals, and since they are typically done with the beleaguered Fortune 500 companies, chances of that happening in the long run are between slim and none.  The decline of large business is an irreversible trend.  It has been with us for over a quarter of a century now, and it is unlikely to change in 2003.

Servers.  The IBM server revenue dropped 3% in the latest quarter (in constant currency).  But that’s actually good news in our books.  For, it means a slowdown in the rate of decline.  IBM is evidently milking its drying hardware cash cows more successfully than in the past.

Mainframes (zSeries) dropped 6% in the quarter and 8% for the year.  The AS/400 (iSeries) declined 2% in the quarter and 20% for the year.  And the Unix (pSeries) and PC (xSeries) server revenues actually went up! (13% and 3% respectively for the quarter, and 1% and 15% respectively for the year).

Nevertheless, hardware continued to bleed red ink on IBM’s bottom line, if the discontinued operations (read hard disk business, being sold to Hitachi) are taken into account. 

The PC unit also lost money again, although its loss has narrowed from the earlier period ($20 million vs. $50 million).

Software.  Perhaps the biggest negative surprise was a drop in software revenues (down 3% as reported and down 5% in constant currency).  All large customer-related segments were down - middleware (-5%), operating systems (-2%), data management (-5%), Tivoli (-16%) and Lotus (-15%).

Nevertheless, software pretax profit, making it again the most profitable business segment (assuming hardware maintenance is taken out of IGS).

Summary

So where does leave us with respect to the outlook for IBM?  Right on course of our five-year forecast.  Notwithstanding any temporary upticks in the IBM stock that may result from a “tide lifts all boats” stockmarket syndrome, we expect IBM’s business to continue to erode slowly in 2003, as it has been in 2002.

 Happy bargain hunting!

Volume XVIII, No. 2002-21
October 16, 2002

Editor: Bob Djurdjevic
Published by Annex Research
e-mail: annex@djurdjevic.com

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