Annex Newsflash 2005-23                                  July 18, 2005



Updated 7/19/05, 12:45 PM PDT (adds "IGS Splits Up to Continue Growing")

Analysis of IBM's Second Quarter Business Results 

IBM Bounces Back

Quick Recovery in IBM Global Services, European Results

PHOENIX, July 18 - It is not often that a large company can get practically instant gratification from its remedial actions (see "Tweaking Big Blue," May 2005).  Yet that's exactly what happened when IBM released its second quarter results after the markets closed today (July 18).  The company exceeded Wall Street's expectations in both profits and revenues, bouncing back quickly from a disappointing first quarter (see "IBM: Slammed and Dunked", Apr 2005).

No wonder IBM stock surged by almost five points in after-hours trading.  The Big Blue shares are still trading below the level from which they plunged in mid-April, following the disappointing first quarter results, dragging down much of the IT industry leaders' equities (see "IBM: Slammed and Dunked", Apr 2005).  But IBM has gained much of the lost ground, and it appears poised for an additional upward spurt when the regular trading resumes tomorrow (see the above chart).

Business Segment Analysis

The main reason for the "instant gratification" was that the two "problem children" of the first quarter have both bounced back.  IBM Global Services' (IGS) new contract signings surged by 45% to $14.6 billion, while its backlog increased by $3 billion from the first quarter to $113 billion.  And the European business has stabilized, with some parts of it (e.g., business consulting services) actually showing robust growth.

Hardware.  Furthermore, IBM hardware divisions continue to deliver great results.  The pSeries, xSeries and iSeries servers, as well as storage, all reported double digit revenue growth.  The iSeries' 10% growth was particularly impressive as it represents the first major reversal of its declining trends in 2004 (also see "An iSeries Revival," Mar 2005).

The only exception were the zSeries servers (mainframes).  They suffered a hiatus in demand as customers awaited next week's new product announcements before resuming their buying spree.  And now that IBM is finally rid of its money-losing PC business (see "Lenovo Completes IBM Deal," May 2005, and "IBM 5-yr Forecast: Quality over Quantity," Mar 2005), the hardware profit margins have shot up five points (from 29% to 34%).

But a pause in mainframe acquisitions has not slowed the customer demand for its software, or the implementation of new applications using on web-based mainframe tools and capabilities.  The double digit growth percentages of all mainframe related software attest to that (since software is an annuity for which customers pay over time, it is not subject as much to the vagaries of product cycle changes as is mainframe hardware).  And this bodes well for the mainframe hardware growth in the future.  We expect it to resume in the fourth quarter, after the company starts shipping its new systems in September (also see "A zSeries Renaissance: Poughkeepsie Spring," Apr 2005).

Software.  The key IBM software brands grew by 17% in the quarter, lifting the overall software revenues to a double digit (10%) growth.  The gross margin of 86.7% represented a half point improvement over the corresponding period a year ago.  Given that IGS absorbed the brunt ($1.2 billion) of the $1.7 billion charge IBM took in the quarter, the biggest IBM unit ended up in the red for the first time in its history.  The fact that PC lost money ($149 million) even while singing its Big Blue swan song was par for the course (see "IBM PC: Good Riddance", Dec 2004).

As a result, IBM software unit's pretax profit in the quarter was by far and away the best of all IBM business segments' (see the chart).

IBM Global Services.  "One swallow does not make a spring," goes an old saw.  One quarter of good IGS results does not necessarily portend a return to its old growth rates.  But it is a step in the right direction.  And for that, IBM and the IGS leaders deserve kudos, especially for playing good defense.

Good defense?  Yes.  Stopping the hemorrhaging that John Joyce, the head of IGS, once called "rescoping" (in July 2002, when he was the IBM CFO), was an important a factor in boosting the IGS backlog by $3 billion as was the rebound in new bookings.

As a result, the IGS backlog losses shrank from $13 billion per quarter in 2004, to $11 billion in the first half of this year.  Which means $2 billion of additional revenues down the pike.  It was the first quarter in six that the IGS backlog showed a discernible improvement (see the chart).

IGS Splits Up to Continue Growing

There is perhaps no better time to leave a business than on a high note. That's what the IGS head John Joyce decided to do after the second quarter results were released, according to IBM.  Although only 51, Joyce, whom Lou Gerstner had picked for his CFO, is retiring from IBM to join Silver Lake Partners, a private-equity firm.  The company said leaving was his decision.

But Sam Palmisano, IBM's CEO, wasted no time in using Joyce's departure to reorganize IGS.  Using what we called the "amoeba syndrome" (splitting up in order to continue growing - see below), Palmisano did not replace Joyce, but effectively broke up Big Blue's biggest business unit in two (or three parts, depending on how one looks at it).

Ginni Rometty, who successfully spearheaded the PwCC acquisition in 2002, was promoted to senior vice president, and made the head of Enterprise Business Services (EBS), a new entity that comprises of consulting, business process outsourcing, systems integration, etc.  Mike Daniels, was also promoted to senior vice president and given the helm of Information Technology Services (ITS), that includes strategic outsourcing, eBusiness, maintenance etc.  Daniels has made his claim to fame as the head of IBM Americas unit.

IBM said that in 2006, it would begin to disclose separate financial information for these two units.

IBM also promoted Bob Moffat to senior vice president and head of Integrated Operations.  Moffat, who ran IBM's supply-chain operations, will continued to do that.  But now he will be senior vice president of integrated operations, with a focus on services operations.  All three executives report to the IBM CEO.

As you can see, Palmisano split up IGS in a true BPO (Business Process Outsourcing) spirit - by function, rather than by replicating processes in each unit.  The way we see it, Rometty's EBS unit is the IBM services "front office" that is in charge of present and future customer value creation.  Daniels' ITS operation, on the other hand, handles legacy systems and operations, and is in charge of delivery of the IGS solutions.  Moffat's Integrated Operations function runs IBM and customer infrastructures and supply chain processes.  It includes not just IGS but also other IBM operations.

We find this a clever and thoughtful way to break up a company.  If it succeeds, it may become a new "amoeba model" model for IBM customers and competitors who may also copy it in years to come.


Overall, the second quarter was a strong period for IBM.  The company bounced back from the disappointing first quarter results, thus proving that it can quickly adapt and adjust to the challenges of the marketplace.  And nimbleness is a prerequisite for success in today's fast-changing business environment.  Based on the questions some Wall Street analysts asked at the post-earnings teleconference, there was still some residual skepticism about whether or not Big Blue can go from one good quarter to sustained growth.  

Mark Loughridge, the IBM CFO, was confident the company would do it.  But what we liked the most about his style is that he could have been thumping himself on the chest after such a good quarter (as the Gerstner era CFO's used to do), but did not.  He was confident in a low key manner, coming across as unassuming and modest - like his boss, Sam Palmisano, instead of brash and arrogant - like Gerstner.

It's definitely a new IBM we are seeing under Palmisano.  And we like the new look and feel.  For, it bodes well for Big Blue's future.

Annex Clients: Click here for detailed IBM 2Q P&L

Happy bargain hunting!

Bob Djurdjevic

NOTE: Our term "Amoeba Syndrome" stems from an Austrian sociologist, qLeopold Kohr, who wrote in his 1957 book, ‘The Breakdown of Nations,’ (that’s right - 1957, not 1975!: q‘It is always bigness, and only bigness, which is the problem of existence - social, as well as physical,’ he said. Kohr concluded that the only solution must lie in cutting down of the substances and organisms which have ‘outgrown their natural limits.’  

That's also what the former EDS CEO, Les Alberthal, told us in a 1993 conversation (see Annex Bulletin 93-16, 3/18/93, and "Death of a Corporation," July 1999).

For additional Annex Research reports, check out... 

2005 IT: IBM Bounces Back (July 2005); Accenture: Smashing Records (July 2005); Merrill's New Bull (EDS) (May 2005);  IBM Trumps Trump (May 2005);  Tweaking Big Blue (May 2005); Hurd's First RBI (May 2005); Dell Rings the Bell (May 2005); Stock Buybacks: The Phantom Is Back (May 2005); EDS Misfiring on All Cylinders (May 2005);  HP Surges, Dell Slumps; Lenovo Completes IBM Deal (May 2005);  Capgemini Jettisons Healthcare in N.A. (Apr 2005); HP: From India to Poland (Apr 2005); IBM: Slammed and Dunked (Apr 2005); Hurd Advice: Up Mount Market Cap (Apr 2005); Accenture: Roaring Ahead (Apr 2005);  Fujitsu Unveils New Servers (Mar 2005);  EDS Executive Suite; HP's New CEO (Mar 2005);  An iSeries Revival (Mar 2005); EDS Booster Club Fees Rise (Mar 2005);  An Upside-Down View (Mar 2005);   The Worst of Both Worlds (Mar 2005);  Octathlon 2005: Accenture Wins (Mar 2005);  IBM Global Services: Smaller, Shorter - Better? (Mar 2005);  IBM 5-yr Forecast: Quality over Quantity (Mar 2005); Rumor Lifts EDS', Fujitsu's Shares (Mar 2005); Capgemini: Turning the Corner (Feb 2005);  IBM Servers to Grow Again (Feb 2005);  Carly's Fickle Fans (Feb 2005);  CSC: Gearing Down on Purpose (Feb 2005);  EDS: Grossly Overpriced Stock (Feb 2005);  IBM Historical Update: 2004 Shot in the Arm (Feb 2005); New HeadTurners Series #1 (Feb 2005); IBM: A Crescendo Finale! (Jan 2005); Accenture: Strong Finish, Better Start (Jan 2005); Annex Coverage 2004: IT Services Dominate (Jan 2005)

2004 IT: EDS: The Titanium Stock (and other Wall Street tales) (Dec 2004); IBM PC: Good Riddance (Dec 2004); Fujitsu: Recovery Continues (Nov 2004);  IBM Server Renaissance (Nov 2004);  HP Hits Home Run (Nov 2004); Capgemini: Revenue, Stock Soars (Nov 2004); EDS: Jordan's Swan Song? (Nov 2004);  To Russia with Love and $ (Oct 2004); 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)

Or just click on and use "financial engineering" or similar  keywords.

Volume XXI, Annex Newsflash 2005-23
July 18, 2005

Bob Djurdjevic, Editor
(c) Copyright 2005 by Annex Research, Inc. All rights reserved.

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