<%@ LANGUAGE=VBScript %> <% Set asplObj=Server.CreateObject("ASPL.Login") asplObj.Protect Set asplObj=Nothing %> Excerpts from analysis of IBM and HP's business results and outlook (June 6, 2006)

Annex Bulletin 2006-25                               June 6, 2006

A CONFIDENTIAL Client Edition

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INDUSTRY TRENDS

Updated 6/07/06, 11:50AM PDT, adds Palmisano on quality

IBM and HP Results and Forecast

A Tale of Two Blues

Both Companies Are Doing Well in Business, But Only HP Is Favored by Wall Street; Big Blue Trying to Change That Now With Its New "India Opus"

SCOTTSDALE, June 6 - Both companies are household names.  Both have been around long enough to have the competitors and the media wondering "how did they do it for all these decades without burning and crashing?"  Both are doing well in business.  Both are about the same size.  Both are big on India.  Both have blue logos.  But only one is singing the blues when it comes to its stock price - the Big Blue. 

Wall Street is still punishing IBM for its first quarter 2005 surprise, while applauding the moves that HP's new CEO has made to turn his company around (see above charts).  Which is why IBM is now trying a different tune.  Enter its new "India Opus"...

No longer reticent about its offshoring strategy, Big Blue has grabbed the Wall Street bull by the horns and dragged it to the land of sacred cows - India.  For the first time in IBM and Wall Street history, a major company is holding a two-day investor conference in India, a country in which IBM already has 43,000 employees.  And the IBM boss has just told over 10,000 of them in Bangalore that the company was tripling the company's investments in India, from $2 billion in the last three years, to $6 billion over the next three, according to a Reuters June 6 report.

"India and other emerging economies are an increasingly important part of IBM's global success," Sam Palmisano, IBM's CEO, told over 10,000 employees in Bangalore, India's IT hub.  "IBM is not going to miss this opportunity."

"There's nothing like being with 10,000 24-year olds to kind of start your day," Palmisano told afterward some 100 or so financial analysts gathered at an afternoon session in Bangalore.  "I was there as they got off the buses very early... you can get a feel for the excitement and the energy."

The New York Times later reported that IBM India employees treated their chairman as a rock star.  

"In the United States, employees would be respectful, but here they are treating him like a rock star," Michael J. Cannon-Brookes, the Shanghai-based vice president of business development for China and India, who was at the event, told the Times.

Just over three months ago, another company invited a small group of global consultants to another two-day conference in Bangalore, India's IT hub (see "HP Thriving in India", Mar 2006).  Unlike IBM, however, HP was much more reticent about what it wanted the public and the investors to know about its Indian operations.  Consultants were told that only a limited amount of information could be disclosed publicly.

But HP's CEO, Mark Hurd, has been pretty vocal about something else...  the probability that HP surpass IBM this year in terms of total revenues.  Indeed, our 2006 forecasts for the two companies suggest that is in the cards.  But our analysis also concludes that comparing IBM and HP on the basis of total revenues is an apples-and-oranges comparison.

That's because the two companies directly compete across only 42% of HP's business.  If you take away HP's printing and imaging business and the PC unit (IBM is not in either of those two markets), the remaining part of the Palo Alto-based computer conglomerate would be 2.4 times smaller than IBM in terms of revenues, and 4.6 times in terms of net profit (see above chart).  And even with an apples-and-oranges comparison that would give HP a revenue edge, Big Blue's 2006 expected net would still edge out HP's by 1.8 times ($9.9 billion vs. $5.6 billion - click here for details; also see "HP Beats the Street," May 2006).

Well, if HP is to close the profitability gap with IBM, perhaps it had better start talking more loudly about its own quite formidable Indian operations, especially in Bangalore.  After all, the reason HP and so many other IT companies are on a "passage to India" is not their love of cows or curry; it is their quest for higher profits.

Meanwhile, the stock market's cool attitude toward IBM is not a recent development.  Nor is it all about the first quarter 2005 disappointment, though that is the most recent reason the investors are reticent about embracing Big Blue.  As you can see from the above chart, the stocks of other relative newcomers to the IT industry - Microsoft, Dell, Oracle - have all had a much stronger performance in the last 20 years than did the industry leader.  That HP, the only other "veteran" of 50 year global computer wars among the industry leaders, is now also distancing itself from IBM, is only adding insult to injury.  

Will IBM's Bangalore conference reverse that and return the IBM stock on the growth path?  Well, IBM certainly hopes so.  And the early indications are positive.  IBM stock is up 0.7% to $79.60 in this morning's (June 6) early trading even though the Dow is down by 65 points even after yesterday's big 200-point sell-off.  

But "one swallow does not make a spring."  Only a sustained marketing effort to both Wall Street's research and trading influencers will change Big Blue's fortunes in the future.  And not just to the "usual suspects" (the big institutional shareholders, the erstwhile market makers and movers).  Also to the hedge funds and many other smaller investors, especially the overseas ones.

"The hedge funds are like pre-adolescents and they are a moving target," the CEO of one major IT company told this writer recently.  "There are so many you can't keep them straight!"

Since the Wall Street obstacles seem so formidable and the mountain IBM needs to climb so high, can it be done?  Of course, it can.  Just take a look at the job that Harry You, for example, did at BearingPoint in the last 15 months (see "Where You-Turn Means Upturn" May 2006).

And You did it even without the benefit of published financial statements, the strong global brand name that IBM commands, not to mention the strong business results that IBM has been reporting in the last four quarters.  

IBM Business Segments

To see how strong Big Blue's fundamentals have been, and how much this company has improved in the four years of Sam Palmisano leadership, let's walk through its various lines of business.  First an industry view of Big Blue...

We expect the two biggest IBM industry sectors - financial services and small and medium businesses (SMB) - also to be the fastest growing this year.  Even in 2005, the SMB sector, for example, grew at double the corporate growth rate (6% vs. 3%), adjusted for PC and currency translations.  We expect IBM also to do well in government and distribution sectors this year, as it also did in 2005.

Global Services.  That IBM is the industry leader in global services, and that this business segment accounts by far for the biggest revenue share, ought to come as no surprise to the attendees at IBM's Bangalore investor conference.  But they also saw how IBM Global Services (IGS) growth slowed and then dwindled as IGS got bigger and bigger.  

In the last five years, even with the PwCC acquisition in 2002, the growth dropped to half that of the 10-year compound annual increases (8% vs. 16%).  Without PwCC, IGS revenues grew in the low single digits.  They even declined in some quarters.

We have been saying since at least 1993 that a smart CEO will break up successful businesses into smaller units so as to foster faster growth.  We called it the "amoeba syndrome" - splitting up in order to grow - the way EDS' Les Alberthal, for example, first did it in the early 1990s.  And we repeated that in a 1996 advice to the then Big Blue CEO, Lou Gerstner, who proceeded to spurn it (see "Break Up IBM!" Mar 1996 and “Louis XIX of Armonk,” Aug 1996).

In mid-2005, however, Palmisano also recognized that in services bigness does not always connote goodness (see "IBM Bounces Back," July 2005).  On the contrary, (big) size can get in the way of nimbleness in reacting to customer needs.  So he split up IGS into two parts - Global Technical Services (GTS) and Global Business Services (GBS).  

It was a bold and creative move, the first time we have seen in the IT services industry that a services company took its own medicine.  For, we saw this as a BPO (Business Process Outsourcing)-style break up.  The GTS represents IGS' "back office" operations, while GTS incorporates its "front office" functions.  

Coupled with the sale of the PC business to Lenovo (2005), and the earlier (2002) disposition of the unprofitable storage operations to Hitachi, it was clear that IBM was finally putting quality ahead of quantity in its strategic moves (see "Steady As She Goes," May 2006 and "Quality over Quantity," Mar 2005). So we gave Palmisano thumbs up for doing having the vision and the courage to do the right things for IBM shareholders' long-term interests.

But it will take more than just splitting it into two parts to revive the IGS growth.  Perhaps some new acquisitions?  After all, that's also something we have been saying for years (see (see “Save, Spend and Split,” May 2003, and “Ditto, Ditto! Is Anybody Listening?”, Apr 2004).

Hardware.  If IBM Global Services was Big Blue's biggest success story of the 1990s, and it was, then the revival of the company's hardware businesses has to be the greatest IBM turnaround feat of the first decade of the 21st century.  

As this writer said in a recent speech at a conference on innovation in St. Petersburg, Russia, "the revival process started about four years ago with the top-of-the-line zSeries mainframes.  It spread across other hardware lines when IBM put all of its servers under one roof, and appointed Bill Zeitler to head up the $21 billion- Systems & Technology Group (STG).  Big Blue never looked back."

In the last five years, IBM servers, for example, have gained almost 10 points of market share from its competitors.  Dell was the only other competitor to gain share during the same period (five points).

"We feel this trend will continue," Zeitler told the analysts gathered in Bangalore.  "Our model is to gain one point of systems share per year and (to) grow STG (hardware) revenue 6% per year," he added. 

What is the reason for this revival?

Actually, there are three:  Recentralization, virtualization and reintegration – the three trends we identified last year.  And all three are based on openness and Linux support.

All three are customer-driven trends.  Zeitler recognized the direction of the wind and pointed his STG ship downwind.  The zSeries or System z, as IBM now calls it, is the main beneficiary of the first two trends.  The iSeries or System i profits especially from the third (reintegration).

When we did research for two whitepapers in early 2005 (on zSeries and iSeries), we found out that customers around the world are increasingly going through “server consolidations” in an effort to lower their cost of ownership.  The final result is a recentralization of IT resources.  Since the mainframe offers a unique single image view of the world, it is a natural winner in situations like that.

This discovery gave birth to our Polaris idea in Feb 2005.  We said IBM should rename its mainframes to Polaris.  Why?  Because Polaris, the North Star or the Lode Star, that has been used for navigational purposes for centuries.  That’s because all other stars appear to rotate around it, as this photographic image also proves.

We were actually stunned to learn last July that IBM adopted our Polaris idea in creating its new “z9” mainframe (see "Polaris Eclipses T-Rex," July 2005).  That also took open-mindedness and lateral thinking inherent in the "new IBM."

Speaking at the IBM Bangalore conference, Zeitler also showed this installed mainframe capacity chart.  As you can see, the "mainframe inventory" has been steadily rising since 2000 to over 10 million units (MIPS) now.  The significance of that goes well beyond the mainframe revenues, which are expected to grow only in the low single digits.  That's because every dollar of mainframe sales drags along several dollars of software and services, and drops the related profits to the Big Blue bottom line.

The same is true of the System i.  As you saw in our last year's report on IBM servers, "every dollar of an iSeries system sale drags another dollar in various IBM hardware, software or services revenue," plus another two dollars in business partner revenues (see the above chart).

Furthermore, we found out during our research last year that midsize customers were also going through “server consolidations” for much the same reasons.  Since the iSeries offers the lowest cost of ownership in the midrange market, thanks to its integrated design from way back, it stands to benefit the most from the reintegration trend.  Plus System i is more stable than the Wintel-based servers, customers told us.  Which is why this platform also bounced back in 2005, and is poised for another growth year in 2006.

All IBM servers benefit from virtualization, including the best-performing system lines in 2005 - the pSeries and the xSeries (see above). 

Furthermore, IBM hardware revenues are receiving a boost from a brand new source - outsourced R&D - or Engineering & Technical Services (E&TS), as Big Blue calls it.  E&TS revenues were $582 million in 2005, up 37% from the year earlier, the fastest growth rate of any IBM product line.  

Zeitler saw "enormous growth" opportunities in this "technology collaboration" arena (which includes E&TS), where IBM expected to grow at 10% to 12% on a sustained basis.  He foresaw a possibility that IBM may even grow by acquisitions in this market, something that the company has traditionally not done in the hardware business.

Just as important as its revenue contribution, E&TS gives IBM an indirect presence in consumer markets - through its customers, such as Sony, Microsoft etc.  And as we have been saying since 10 years ago (click here to see a 1996 chart), it is the consumer markets that represent the best long-term potential for the IT vendors.

In recent years, three billion people in Brazil, China, India and Russia, among others, have entered the global economy, said Doug Elix, the head of IBM global sales, at the Bangalore meeting.  This is where IBM outgrew the market in the last three years by 17% to 14% compounded annually.  More importantly, it outpaced its own 2005 worldwide growth by 23% to 3% (excluding PCs).

Furthermore, some people think that the lower labor cost advantage that these developing countries are currently enjoying will go away over time, Elix opined.  "It won't!" he answered his own rhetorical question emphatically, marshalling the statistics depicted in the above chart in support of his belief.  As the global labor markets expand and the wages rise in developing countries, India, China, Russia etc. will still continue to have an edge over developed countries, such as the U.S. and Western Europe.  

(By the way, one cannot help but notice that Germany, in particular, seems to be pricing itself right out of the global labor markets).

No wonder that IBM picked India, one of the four major developing markets (the other three being China, Brazil and Russia), in which to make its growth scenario pitch.  Altogether, developing countries generated a 23% revenue growth rate in 2005 for Big Blue (excluding the PC unit), versus a 2% apparent decline when the now discontinued PC business is taken into account.

Underpinning all these hardware trends is IBM’s new openness; its willingness to accept the "not invented here"-reality of the diverse global marketplace.  This is best epitomized by IBM's endorsement and adoption of Linux across its hardware platforms.  No wonder Linux is outpacing Wintel demand by about 4-to-1.

Software.  Which brings us to IBM Software, the company's most profitable unit.  In 2005, software revenues grew by 4.4% to $15.8 billion.  We figure that in 2006, they would grow by 5.5% to $16.6 billion.  

Steve Mills, the head of IBM software, said that the top (blue) portion of the above pie chart represents the high growth areas, while the bottom part are the low growth activities.  "What we have been working on over the course of many years is changing this mix... to build up the upper blue part of the pie" in order to deliver the 6% target growth rate. 

To this end, IBM has acquired over 50 companies in the last 10 years, 11 of them in 2005, Mills said. 

These acquisitions supplement the work of nearly 50,000 IBM software employees worldwide, with 16,300 of them in sales and technical support functions (see above chart).

From the IBM shareholders' point of view, however, this unit's most redeeming virtue is its high profitability.  With pretax margins of over 31% and pretax profit of more than $5 billion, software towers over all other IBM product lines (see the chart). At the IBM corporate tax rate of about 33%, the software business would yield a net profit of about $3.4 billion.  And, according to a just-published Motley Fool analysis, the unit would be worth $67 billion if priced relative to the price/earnings ratios of its rivals.

IBM: Undervalued Stock

In fact, when all four major IBM business units are evaluated using comparable price/earnings ratios to those of their major competitors, the company's current price may be at least 20% below its fair market value. 

Here's an excerpt from yesterday's Motley Fool analysis that makes that point:

Based on the sum of Global Services ($47 billion), Systems & Technology ($19.5 billion), Software ($67 billion), and Global Finance ($18.5 billion), IBM is worth $152 billion. That is $98 per share based on the 1.55 billion shares outstanding. Also, the assumption of 3% EPS growth is actually lower than analyst estimates of mid- to high-single digits. If the company could sustain 8% EPS growth over the next five years, the value would be significantly higher than $100 per share.

At the current price of $80 per share, IBM is trading at 15.5 times trailing earnings. For a blue chip, that is a great deal. Of course, there are concerns over pension liability and growth potential, but with the stock trading at an approximately 20% discount relative to competing companies, its valuation is cheap enough to mitigate those concerns.

(An excerpt from "IBM: Big Value at Big Blue," Motley Fool, 6/05/06)

Summary

So there is indeed a lot of value hidden under the covers of the Big Blue logo.  After all the shouting and singing in IBM's "India Opus" is over, the company is clearly hoping that Wall Street's attention and focus on IBM's growth markets and strategies will eventually pay off in stock upgrades.  That may be a hard goal to achieve right now, amid the year's biggest overall market sell-off, but patient investors may be richly rewarded when all the shouting about the higher interest rates dies down on Wall Street.  After all, that's hardly new news.

Meanwhile, the IBM cash flow continues to soar after the company dumped some of its unprofitable units.  It has been around $15 billion for the last three years.

Meanwhile, India will continue to prosper as the "world's help desk," and will eventually collect enough foreign investments to start making some of its own.  When that time comes, its consumer market especially will have as much as appeal as China's already has today.

Meanwhile, Russia will continue to be the world's biggest exporter of natural resources and a home to the greatest pool of high-level engineering and IT talent at reasonable rates.  And the price of oil isn't going to come down any time soon, if at all.

Meanwhile, Brazil is already reaching a stage of a respectable big foreign customer, and not just a place in which to locate low-cost development centers.

Meanwhile, IBM is present and very active in all four of these burgeoning markets where it is already growing at 23% per year.  Wherever the current Wall Street ups and downs may end up, these four are just some of Big Blue's strengths that will sustain its growth for some time to come (at 10% to 12% annually in terms of EPS, according to Mark Loughridge, IBM CFO). 

The investors who prefer to hold on to old grudges instead of accepting these business realities may also end up holding the bag when it is all said and done.  But then, "one man's loss is another man's gain."  C'est la vie.   

For detailed tables, click on IBM vs. HP 2006 forecast; IBM business segments 2000-2005, and IBM History 1912-2005 (chart); IBM History 1912-2005 (table)

Happy bargain hunting

Bob Djurdjevic

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For additional Annex Research reports, check out... Annex Bulletin Index 2006 (including all prior years' indexes)

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Volume XXII, Annex Bulletin 2006-25
June 6, 2006

Bob Djurdjevic, Editor
(c) Copyright 2006 by Annex Research, Inc. All rights reserved.
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