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Analysis of IBM’s Third Quarter Business Results

Slow Quarter No Longer

Solid Growth Across the Board, But Some Challenges Remain

PHOENIX, Oct 19 – What is typically a slow quarter for both IBM and the IT industry turned out to be Big Blue’s best three-month period in a very long time.  Third quarter revenues were up 9%, lead by hardware and services, each of which grew in double digits (12% and 11% respectively).  Net earnings jumped by 15%, if adjusted for a $320 million one-time charge IBM took on account of the pension plan lawsuit settlement. 

Particularly encouraging was the surge in Americas, IBM’s most important geography ($10 billion revenues; 42% of total), within which the U.S. market is by far the largest.  Revenues were up 8% (7% in constant currency), the highest quarterly jump this year.  In recent years, the U.S. has been a slow or no growth area for IBM and other IT industry vendors.  So the latest results herald a turnaround of sorts in customer spending.  

The Asia/Pacific revenue growth was also strong (11% as reported; 6% in constant currency).  It was the third quarter in a row that this region had a 6% revenue increase in constant currency – the most consistent growth of any IBM business segment.

Among various industries, communications, government and distribution revenues grew in double digits (16% and 11% respectively).  Others increased in single digits.  None declined.

As for IBM hardware product lines, the (Intel-based) xSeries and the zSeries (mainframes) servers turned in the best report cards.  Their revenues jumped by 26% and 12% respectively.  IBM PCs also showed strong revenue growth (up 17% to $3.3 billion).  They were even marginally profitable (1.7% pretax margin), something that hasn’t happened very often with Big Blue PCs in the last decade or so.

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The stock market reacted favorably to the IBM third-quarter release, pushing up the stock by over four points today. 

Some Disappointments

But it wasn’t all roses in the Big Blue garden.  There were some weeds, too.  But that’s life… You have to take the bad with the good.

“No one has yet drunk a cup of honey without mixing it with a cup of bile,” noted Njegos (1813-1851), a famed Montenegrin ruler in his “Mountain Wreath” collection of poems.  “A cup of gall needs a cup of bile; they are swallowed the easiest when mixed.”

Services.  Back to real life from poetry and metaphors, the biggest disappointment to us were the new contract sales and backlog numbers that IBM Global Services (IGS) reported.  The “biggest” - because IGS is now IBM’s largest and most important unit. 

In the old days, people used to say, “as goes the mainframe, so goes Big Blue.”  Nowadays, “as go the services, so goes Big Blue” is more appropriate.  IGS’ ups and downs now pretty well shape the Big Blue future, as most of the services contracts are multi-year deals. 

Anyway, IGS’ new contract sales were down 36% in the third quarter from the corresponding period a year ago.  At $9.8 billion, the latest new business signings were the lowest since 3Q02, and only the third time in the last 20 quarters that new business signings were in single digits (i.e., below $10 billion). 

Nor is this just a one-time disappointment.  For the first nine months of 2004, they new contract signings were also down - 40%.  As a result, the IGS backlog is now $10 billion lower than at the start of the year, having dropped $8 billion in the latest period alone.  Which means that $18 billion of the IBM backlog disappeared in various cancelations/expirations/ ”rescopings” during the third quarter – a record decline, compared to $13 billion per quarter average losses this year, and $7 billion only four years ago (see the chart).

So it wasn’t all JP Morgan, the well-publicized $5 billion-IBM loss that some analysts quoted by the media cited as the reason for the backlog decline (see “Outsourcing Boomerang,” Sep 2004).  IGS has been struggling with new business sales and renewals of existing deals even before the latest period (the backlog was down $2 billion in the second quarter, too – see “Old World Renaissance,” July 2004).  The latest results just happen to be the biggest disappointment to-date.

IBM CFO, Mark Loughridge, tried to put a positive spin on it during the conference with analysts that followed the IBM earnings release. 

“Over the last several quarters, in both Strategic Outsourcing and Business Consulting Services, contracts are smaller in size with shorter average duration,” he said. “This leads to higher revenue yields.”

True enough.  But it also leads to increased sales costs and less profitable deals.  Besides, such “spin” can hardly explain why $18 billion disappeared from IBM’s backlog in a single quarter, at least not to analysts with open and alert minds. 

Loughridge seemed to agree, however unwittingly.  “Looking forward, we expect the backlog erosion to return to more typical levels,” he added.

That was an interesting comment. For, backlog “erosion” has been anything but “typical” for IBM.  Its backlog doubled between 4Q99 and 4Q03 from $60 billion to $120 billion.  The fact that the IBM CFO “looking forward” is still thinking “erosion” instead of growth (that has been typical in IGS’ past performance), is yet another reason to worry about the IGS future.

On the plus side, IGS has maintained its gross profit margins at about 23% during the last 12 months, despite growing share of outsourcing revenues - 12% vs. 7% for consulting and 10% for systems integration.  (Outsourcing is typically less profitable than consulting or systems integration).  But the IGS pretax margin has eroded slightly (from 10.9% a year ago, to 10.2% in the latest quarter).  See what we mean about the increased cost of sales?

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iSeries.  The iSeries servers, formerly known as the AS/400s, were another disappointment in the latest IBM quarterly report.  Their revenues were down 26%, after dropping 28% and 7% respectively in the first two quarters of this year. 

“The transition to Power5 (chip technology) is taking longer than previous cycles, as existing customers must transition their operating environment to the new level required,” was IBM CFO’s explanation.

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No kidding (re. “taking longer”).  Such an excuse is already wearing thin.  And the iSeries’ revenue declines stand out like a sore thumb especially now that all other IBM servers are reporting solid growth (also see “Old World Renaissance,” July 2004).

The mainframes (zSeries), for example, grew by 12% in terms of revenues and by 17% in terms of MIPS.  The xSeries revenues soared by 26%.  Even the pSeries (Unix), the servers that share the Power5 technology with the iSeries, eked out a 1% growth, despite a weakness in Europe.

So the new iSeries management had better start delivering real growth real soon instead of the product transition excuses.

SMB Market.  The small and medium (SMB) market was another mild disappointment in the latest period.  After growing by 15% and 7% respectively in the first two quarters of this year, the third quarter growth rate dropped off to only 5%.  That shrank the SMB market share (of IBM total revenues) from 23% to 22%.  And the SMB market is the IBM future! (see “Finally Heard, Part II,” Nov 2003).

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Guess thinking small is hard for Big Blue, just as it’s hard for a leopard to change its spots (re. “Can the Ethiopian change his skin, or the leopard his spots?” - Book of Jeremiah).  IBM has always been the most comfortable with large enter prises.  But the game is changing, and Big Blue must change with it.

About 70% of new jobs in America are created by small and medium size businesses.  The economic growth is from the bottom of the corporate pyramid.  IBM knows it:

"IBM market research indicates medium business spending on integration is growing faster than the market as a whole (emphasis added)," IBM said, adding that, "more than half of midsize companies are making investments in connecting to their customers and suppliers in real time."

(from “Finally Heard, Part II,” Nov 2003)

Since Big Blue seems to be now aware of where the greatest growth opportunities lie, all it needs to do is walk its SMB talk.

Some Other Upsides

Meanwhile, IBM did highlight two other upsides that have developed recently in its business.  Business Process Outsourcing (BPO), or Business Performance Transformation Services in IBM Speak, recorded a 46% year-over-year increase in the latest period.  BPO is now a $2.1 billion business at IBM.  It is a market that IBM and Accenture dominate, although other major competitors, such as HP, EDS and Capgemini, are also trying to play in it.

Emerging markets in four big developing countries was another bright spot highlighted in IBM’s latest financials.  China, Russia, India and Brazil now account for $3 billion of IBM revenues, up 33% from a year ago.  With exception of Russia, those countries are also where much of the labor outsourcing is taking place.

So it looks like “Finally Heard, Part III,” may be in order.  We have been saying since at least 1996 that investing in developing countries, especially in Eastern Europe, was another major growth opportunity (see “Renaissance II,” June 1996).


The latest IBM quarter was better than expected.  The company is firing almost on all cylinders.  The quarter wasn’t without some blemishes, but then there is no such thing as a perfect game (except in baseball).  The most encouraging sign was a pick up in demand in the U.S. market – a laggard until now.  If Big Blue keeps improving its pitching game – both high and low (IGS and SMB) – it stands a good chance of making good quarterly results a habit.

Happy bargain hunting!

Bob Djurdjevic

For additional Annex Research reports, check out... 

2004 IT: 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)

2003 IBM: "IBM vs. HP: Spinning Global Server Market Shares" (Nov 2003);  "Finally Heard, Part II," (Nov 2003), “Small Is Now Big at Big Blue” (Oct 16),  “On the Nose But No Cigar” (July 16), “A Paler Shade of Blue” (June 2), “Save, Spend and Split” (May 8), “Shrunk by the Marketplace” (Apr 17), “Turnaround Continues...” (Apr 15), "Finally Heard!" (Jan 29), “Start of a Real Turnaround?” (Jan 17).

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), 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.]

Or just click on and use appropriate  keywords.

Volume XX, Annex Bulletin 2004-22
October 19, 2004

Bob Djurdjevic, Editor
(c) Copyright 2004 by Annex Research, Inc. All rights reserved.
e-mail: annex@djurdjevic.com

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