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IBM FINANCIAL

Analysis of IBM’s Third Quarter Business Results

Small Is Now Big at Big Blue

IBM Continues to Stress Importance of Small/Medium Market, Up 16%?

PHOENIX, October 15 – Small is now (finally) big at Big Blue.  For the third time in the last three quarters, IBM has stressed the importance of the small and medium market.  So if “one swallow does not a spring make,” maybe three will?

Speaking during a teleconference with analysts following the release of the third quarter financial results, IBM CFO, John Joyce, said that, “this chart reflects our five worldwide industry sectors, as well as our important small and medium business customers…(emphasis added).  Our small and medium business sales organization continued to show good growth”

Joyce’s chart indicated this market to have grown faster than any other Big Blue vertical segment.  Revenues from small and medium size companies, which IBM defines as enterprises with less than 1,000 employees, were up 16% in the third quarter as reported (up 10% in constant currency).  

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During the first two quarters of the year, they were up 13% and 17% respectively (as reported).  This market now accounts for 23% of IBM’s business.  Joyce’s emphasis on “importance” of this customer set to IBM echoed his remarks on the same topic three months ago, when he spoke about the second quarter results.

So it looks like we’ve been finally heard.  As we said in a January 2003 reported titled “Finally Heard!”, “it's like a seven-year itch that finally got scratched.”

It took seven years of harping about it (see below), but finally a major IT vendor has heard us. And it is the most unlikely computer provider - the biggest and the bluest of them all (IBM) - that made the first major move toward reaching out to small and medium size enterprises in the hopes of fueling its own growth.

(Annex Newsflash, Jan 29, 2003)

But there is just one problem with the latest IBM numbers.  Joyce’s chart showed the S&M market’s third quarter revenue as $4.8 billion, and the year-over-year growth of 16%.  But one year ago, when IBM released such a vertical market breakdown for the first time, Joyce said the S&M third quarter 2002 revenues were $4.4 billion.

Which would make the annual growth 9%, not 16%, as Joyce has just claimed.

Oh well… what’s a little inconsistency here, a little discrepancy there, if you’re trying to draw a big picture with a giant paintbrush.  The Bush administration spokespeople can relate to that problem when describing their “successes” in Iraq.  J  And with the depth of the security analysts’ kind of “scrutiny,” Joyce’s little secret is likely to remain a secret on Wall Street, for now.

Other Third Quarter Results

Other highlights of IBM’s third quarter report card read almost exactly the same as those from the second quarter (see “On the Nose, But No Cigar,” July 16).  The company hit the Wall Street numbers on the nose, yet it is being punished for not exceeding them.  The Big Blue stock was off 3% in after-hours trading today.

IBM also met or exceeded our expectations for the quarter.

* We expected IBM revenues to be $21.4 billion.  They were $21.5 billion.

* We expected the IBM gross profit to be $7.8 billion.  It was $7.8 billion.

* We expected IBM net earnings to be $1.79 billion.  They were $1.79 billion.

Get the picture?  Once again, IBM hit our major numbers on the nose.  Once again, there was no cigar on Wall Street.  Good is no longer good enough in a stock market thirsting for upside surprises.

Horizontal Segments

Once we started to peel the Big Blue financial onion, however, we did find some small upside and downside surprises, too.

IBM Global Services.  IBM’s “crown jewel” gained a little more luster in the third quarter with its outstanding new contract sales record.  It also lost a little luster with its slower-than-expected revenue growth, and shrinking profit margins.

New contract sales were $15.4 billion, the best ever for the third quarter.  The backlog was also up, from $112 billion to $115 billion, the highest it has ever been.

This reversed a dangerous trend that saw the IGS backlog drop or stagnate in the last four quarters, despite the $10 billion+ of quarterly new contract sales.  But how long can IGS keep it up?

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With the backlog seeping $11 billion on average per quarter in the last two years (see the chart), IGS sales organization is now on a treadmill.  If it doesn’t sell at least $11 billion per quarter, it jeopardizes the future growth of the business. 

This is another case where good is no longer good enough.  Only excellent will do.  To understand why, one only needs to look at the latest IGS revenue and profit numbers.

As this is the last quarter in which the PwCC revenues did not figure last year, we expected IGS’s IT services revenue to surge by 26% to $9.6 billion, and the maintenance to decline by 1% to $1.25 billion.  Instead, the IT services revenue went up by “only” 18%, while maintenance rose by 7%. 

This yielded an overall IGS revenue growth of 17% as reported; 11% in local currency – the lowest growth so far this year.  With the PwCC starting to figure in the next period, the comparison to last year’s revenues will be even more difficult in the fourth quarter.

We figure that the slowdown in the revenue growth rates was due to IGS’s shrinking backlog in the previous quarter, and continued “rescoping” of its contracts, the term the IBM CFO first coined in July of 2002 (see Annex Bulletin 2002-17, July 17, 2002).

IGS’s profit margins have been another shrinking item this year.  In the latest quarter, the gross margins were down 1.4 points to 25.1%.  They were also down 0.4 and 1.1 points respectively in the first two quarters of the year.

“The key driver was an increased mix of our lower-margin Business Consulting Services,” said Joyce, trying to explain the drop. “We also had lower margins in Europe, due to utilization, although improving BCS margin in Americas offset part of that.  Outsourcing gross profit margins also contributed to the decline, due primarily to the early stages of a new contract.”

What Joyce didn’t say, however, was that some of IGS’s outsourcing wins may have also contributed to its lower margins.  We are talking about its “megadeals,” of course, as they are always hotly contested and typically carry lower margins.

In the latest period, for example, IBM signed 14 deals valued at more than $100 million, of which three were over $1 billion.  Guess one could call IGS’s declining mar gins the “curse of a megadeal.”

Hardware.  All IBM server product lines showed improved revenue performances in the third quarter.  The mainframes, or zSeries as IBM calls them now, recorded the slowest growth (1% as reported; down 5% in local currency).  That’s mostly due to price cuts that IBM implemented, particularly in the Asia/Pacific market, intended to gain share from its Japanese mainframe competitors (e.g., Fujitsu).

The midrange servers – the pSeries (UNIX) and iSeries (AS/400) – reported a faster growth – 5% each as reported (up 1% and flat in local currency).

But the xSeries (PC) servers stole the show in the third quarter.  Driven by a strong global demand for PCs, their revenues surged by 16% as reported (up 11% in constant currency).

Alas, if only IBM shareholders were to benefit from it!  The IBM’s PC unit once again lost money in the quarter ($50 million).  Its only consolation may be that the Technology division lost even more money ($96 million), on sharply declining revenues (down 30%).

Software.  IBM Software unit provided another upside surprise in the third quarter.  Both its revenue and growth and its profit margins exceeded our expectations.  Revenue increased in double digits (11%), while its gross margin went up by 1.5 points to 85.8%. 

The strong performance of the software unit was fueled by the double-digit growth in its Tivoli and WebSphere brands (25% and 12% respectively).  Lotus also turned in a solid performance with a 9% revenue growth.

Geographic Segments

Once again, Europe continued to be IBM’s fastest growing geographic segment.  And even though the growth rates on the Old Continent have slowed somewhat (from 23% in the first two quarters to 19% in the third), IBM’s success was a little more “real.”  For, revenues in local currency grew at 7%, as compared to only 3% in the first half of the year.

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IBM CFO seemed especially buoyed by the turnaround in two major European markets – Germany and Italy.  Both countries reversed the declines from the previous period.  Germany was up 3%, while the business in Italy was flat.  Not bad for a period in which Europeans take vacations.  And they take them very seriously. J

The Asia/Pacific region also reported solid results.  Revenues grew at 11% as reported, 7% in local currency.

The revenues in the Americas market, of which the U.S. is by far the biggest, grew by 4% as reported, 3% in local currency.

The OEM business, on the other hand, continued to slump.  It was down 26% both as reported and in local currency.

Buybacks Back in Vogue

Another downside surprise in today’s release was a resumption of IBM stock buybacks.  Just as we thought that sanity had returned to Armonk (IBM had virtually ceased squandering its capital by lining Wall Street’s pockets about a year ago), here we go again… Armonk has gone back to it.  

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In the latest period, IBM spent about $1.2 billion on share repurchases.  To be sure, that’s quite a bit less than the company used to waste under the former CEO’s leadership (see the chart).  But it is nevertheless a waste of money that could be more productively used for acquisitions or product development.  Or even by increasing the dividends, which would benefit all shareholders, not just some.

Oh well, maybe saner heads will prevail at some point in the future.

Happy bargain hunting!

Bob Djurdjevic

P.S. In early morning trading on Oct 16, the IBM stock was down over 4% to $89.

For additional Annex Research reports on IBM, check out... 

2003:  “On the Nose But No Cigar” (June 2), “A Paler Shade of Blue” (June 2), “Save, Spend and Split” (May 8), “Shrunk by the Marketplace” (Apr 17), “Turnaround Continues...” (Apr 15), “Start of a Real Turnaround?” (Jan 17).

2002 IGS: "Half or Double Trouble?" (Aug. 12, 2002), "IBM to Take $500M Charge" (Sep 3, 2002), IBM-PwCC Update (Oct 2, 2002), Analysis of IBM Second Quarter Results (July 17, 2002), IBM Layoffs Confirmed! (Aug 14, 2002), Analysis of IBM Third Quarter Results (Oct 16, 2002), Boom Amid Gloom and Doom (Oct 10, 2002)

2002 IBM: “Gerstner: The Untold Story”  (Dec 27), "Gerstner Spills the Beans" (Dec 13), "On a Wing and a Prayer" (Oct 21), "IBM-PwC Tie the Knot" (Oct 2), "Half or Double Trouble?" (Aug 12), Wall Street/Main Street Chasm (June 25), “Wall Street Casino,” (June 21), Big Blue Salami (June 19), "Looming IBM Layoffs" (May 14), "IBM 5-Yr Forecast: From Here to Eternity?" (Apr 2002),  “Tough Times, Soft Deals,” (Apr 25, 2002), “Gerstner’s Legacy: Good Manager, Poor Entrepreneur” (Jan 2002), IBM Pension Plan Vapors: Where Did $17 Billion Go? (Mar 2002), "Sir Lou OutLayed Lay!" (Apr 1, 2002).

A selection from prior years: Is IBM Cheating on Taxes, Annex Bulletin 99-17 (May 1999),  IBM 5-year Forecast 2001: An Unenviable Legacy (June 2001) "Break Up IBM!" (Mar. 1996), Fortune on IBM (June 15, 2000), “Smoke and Mirrors Galore,” July 2000), "Slam Dunk of Bunk" (Jan 2000), Annex Bulletin 98-14 ("Wag the Big Blue Dog"), Armonk's Fudge Factory (Apr. 9, 1999)Where Armonk Meets Wall Street, Greed Breeds Incest (November 1998)Stock Buybacks Questioned: Is IBM Mortgaging Its Future Again?, 97-18 (4/29/97),  "Some Insiders Cashed In On IBM Stock's Rise, Buybacks" 97-22, 7/27/97,  Djurdjevic’s Forbes column, "Is Big Blue Back?," 6/10/97;  “Executive Suite: How Sweet!,” (July 1997), "Gerstner: Best Years Are Behind", Aug. 10, 1999), "IBM's Best Years Are 3-4 Decades Behind Us" (July 1999), "Lou's Lair vs. Bill's Loft" (June 1999),  "Corporate Cabbage Patch Dolls," 98-39, 10/31/98; Djurdjevic’s Chronicles magazine October 1998 column, "Wall Street Boom; Main Street Doom", “Louis XIX of Armonk,” (Aug. 1996), "Mountain Shook, Mouse Was Born" (Mar. 25, 1994), “A Nice Guy Who Lost His Compass” (Jan 26, 1993), “Akers: The Last Emperor?” June 1991), Industry Stratification Trend (Mar. 30, 1990) etc.]

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Volume XIX, No. 2003-17
October 16, 2003

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

P.O. Box 97100, Phoenix, Arizona 85060-7100
TEL/FAX: (602) 824-8111

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