<%@ LANGUAGE=VBScript %> <% Set asplObj=Server.CreateObject("ASPL.Login") asplObj.Protect Set asplObj=Nothing %> Analysis of IBM 1Q06 business results (Apr 19, 2006)

Annex Bulletin 2006-15                               April 19, 2006

A CONFIDENTIAL Client Edition

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IBM FINANCIAL

Updated 4/19/06, 9:00AM PDT; updates Outlook

Analysis of IBM First Quarter Business Results

On the Button!

Big Blue's First Quarter Blues Are a Thing of the Past ; Revenues, Profits Hit the Mark This Year

SCOTTSDALE, Apr 19 - Big Blue's first quarter blues are a thing of the past.  By contrast to a disappointing quarter a year ago (see "Slammed and Dunked," Apr 2005), IBM's first quarter 2006 results were on the button.  Revenues hit the mark while profits exceeded Wall Street expectations.  Some parts of the business emboldened investors, others left them cold.  But overall, it was a solid quarter, another step forward in IBM's slow but steady turnaround march.

"We are beginning to see the expected turnaround in our services business, driven by long-term signings growth over the past four quarters," IBM CFO Mark Loughridge said in a post-release teleconference. "We see good opportunities there over the long term."

Investors and traders agreed.  After having bid up the IBM stock by more than two points in advance of its first quarter earnings release on Apr 18, they tacked on another $1 in after-hours trading.

Net Profit.  IBM net earnings were up 22% to $1.71 billion in the first quarter, or $1.08 per share, on revenue of $20.7 billion.  Wall Street consensus estimates were for earnings of $1.05 a share and $20.7 billion in revenue, according to Thomson Financial.

Gross Profit.  IBM's gross profit margin was 39.1%, up more than three points from the same quarter last year.  Its surge illustrated how much of a drain on IBM's bottom line the PC business had been for years.  But eve excluding the divested PC business, the gross margin was up half a point. 

Business Segment Analysis

Services.  IBM Global Services (IGS) unit reported a 1% drop in revenue, although it rose 3% gain in constant currency.  IGS signed $11.4 billion in new services contracts in the quarter, up 14% from $10.0 billion a year ago.  Since new bookings portend future revenues and earnings, this bodes well for IGS in the second half of the year.

IGS' profit margin gain of 2.3 percentage points, to 26.6%, was another encouraging indicator.  It suggests that the streamlining and restructuring actions that IBM took in the second quarter of last year are taking hold, and beginning to deliver positive results.  Just to remind you of what those actions were...

Global Technology Services (GTS), a $7.7 billion segment in 1Q06, up 2% in constant currency, primarily delivers infrastructure services, including outsourcing,  integrated technology Services and maintenance.  Think of it as a "back office" operation, if you will.  

Global Business Services (GBS), on the other hand, a $3.8 billion segment in 1Q06, up 4% in constant currency, delivers professional services, including consulting, systems integration, and application management services.

In the first quarter, GTS accounted for $7.2 billion of IGS' new contract sales, while GBS contributed $4.1 billion to it. 

BPO continues to be the fastest-growing sub-segment IGS and GTS, up 51% in the latest period in constant currency.

Hardware.  In Big Blue's two other major units, hardware and software revenue each rose 6% if the sold-off PC business and currency fluctuations were excluded.  IBM's best hardware results came in some of its lowest-margin segments, including Microelectronics and lower-end servers.

Systems and Technology Group revenue of $4.4 billion grew 3% year-to-year, and 6% in constant currency. Growth was led by Microelectronics, System x servers (Intel-based), storage, and retail store solutions, a leftover from the PC sale to Lenovo.

While gross margin was up for hardware overall, excluding the PC business in 2005, it was down year-to-year.  And a meager pretax profit from 1Q05 ($40 million) turned into a pretax loss of $18 million in the latest period. 

IBM said that product mix negatively impacted Systems and Technology profitability because strong growth emanated from lower margin businesses.

System x servers, for example, grew 10% since the first quarter of 2005 (13% in constant currency), with growth reported in all geographies.  Especially strong was the performance in blades servers, that grew over 45% in both volumes and revenue. 

Meanwhile, System z revenue declined 6% year-to-year at actual currency, and was also down 2% in constant currency.  IBM said that the workload mix, together with new midrange mainframe that will be unveiled later this month, will help to drive improved performance in the second quarter.

System p UNIX servers, the best of breed among IBM servers last year, also declined (9% in the quarter, down 6% in constant currency).  IBM said that the System p volumes were up 9%, but a mix toward lower end offerings reduced the revenues.  The company is expecting to have its first full quarter of shipments of the new 570s and quad core 560 midrange models in the second quarter. The System p will complete its transition to POWER5+ in the third quarter.

Finally, the System i ended up in the cellar among the IBM servers for a second quarter in a row, with revenues declining 22% (19% in constant currency).  If one swallow does not make a spring, then two swallows might.  But rather arriving, the swallows are departing, signaling a possible autumn, not spring.  In System i's case, the second declining quarter in a row may suggest a reversal of the 2005 turnaround that saw three growth quarters in a row (first to third).  

IBM once again blamed the product transition for the decline.  But such an excuse is starting to wear thin.  The System i obviously needs a marketing shot in the arm, in the form of a concerted push into the SMB space, especially in emerging markets, where the growth opportunities are the best.

IBM storage was another strong hardware performer, rising 6% (9% in constant currency). 

Software.  IBM software unit also did relatively well in the quarter with a 6% revenue increase in constant currency (up 2% as reported), mostly on the strength of IBM's middleware brands - WebSphere, DB2, Tivoli, Lotus and Rational products.  Operating systems revenues declined by 12%.  

Particularly encouraging for IBM future mainframe revenues was a 26% jump in WebSphere revenues, and a 24% surge in Tivoli software.  Both products run on System z platform, among others. Their rapid growth is an indication that customers are implementing web-based projects that will eventually start to use up more mainframe MIPS (processing power).

Geographies. At a 6% increase, the Americas delivered its best growth rate in six quarters, led by software and services performance.  All America's sub-regions grew, too.

Growth in Europe accelerated to 3 percent.  France and Spain showed solid growth, and Italy returned to growth. The UK was also up, but Germany declined.  Europe's biggest IBM country and the continent's largest economy evidently continues to be a Big Blue "problem child."

Asia/Pacific revenue declined 2% this quarter, mostly due to a continued weakness of IBM Japan, which represents about 60% of the region's revenue base.  In all other sub-regions growth improved, with the strongest revenue rise in India and China (61% and 15% respectively in constant currency).

"Were building capability in these emerging countries, especially in India and China," Loughridge said during the teleconference with analysts. "In these two countries alone we ended the first quarter with 45,000 people."

In other two major emerging markets, Russia's revenues grew by 48% while Brazil's rose only 1% in constant currency.

Stock Buybacks Ease Somewhat

After a torrid pace of stock buybacks throughout most of 2005, IBM seems to have pulled back in a little in the last two quarters.  To be sure, the first quarter's total share repurchases of $2.5 billion are still bigger than the three previous quarters, but are down 26% from the first quarter a year ago.

The likely reason for the boost in he first quarter stock buybacks is the abundance of cash that IBM generated in the latest period.

"In the first quarter, we had outstanding cash generation," boasted Loughridge, the CFO. "Our cash from operations excluding Global Financing receivables was the strongest first quarter we have seen in the last five years, driven by our earnings and accounts receivable performance."

In the first quarter, Net Cash Provided from Operations, excluding the change in Global Financing Receivables, was over $700 million, an increase of over $1.6 billion from last year.

Last year, in the first quarter, IBM contributed $1.7 billion to the U.S. pension fund, while this year it made a $1 billion pension contribution to the U.K. pension fund.  Excluding the pension funding from both years, the company generated over $900 million more cash from operations year-to-year.

Business Outlook

Sam Palmisano, IBM chairman and chief executive officer, said in a release that "IBM had a good quarter with excellent earnings-per-share results. We continued to improve our profit performance with our strategic focus on higher-value segments of the marketplace, as well as with our emphasis on productivity and global integration."

For the current second quarter, Thomson First Call analysts predict, on average, that Big Blue will make $1.28 a share on sales of $22.05 billion.  For the full year, we estimate IBM earnings to be $9.9 billion, or $6.32 per share, on revenues of just over $91 billion, virtually flat with 2005 (but up without the PC).  That's an 11% net margin, something IBM shareholders have not seen in years.

But Wall Street isn't buying it.  Not this time.  Not even after its positive initial reaction to the first quarter report.  By the end of today's trading (Apr 19), the IBM stock had slipped right back where it was last week, before the earnings announcement hype - down almost two points for the day.

So what will it take to spruce up the stock and spark investors' interest in IBM?

In a word, growth.  Sustainable growth.  Not a spurt here, a spurt there-type that IBM has demonstrated in the last couple of years.  And to do that, IBM has to do better in SMB and the emerging markets, especially in Russia and Eastern Europe, where the company is barely scratching the surface of growth opportunities.

Investors have short memories when it comes to successes, but long ones in terms of pain.  IBM's disappointing first quarter of last year inflicted a lot of pain on a lot of wealthy people and corporations.  They don't forgive and forget.  Not easily.  Not quickly.  Not without assurances that they would not be let down again if they hopped on board again (see "Slammed and Dunked," Apr 2005).

The IBM stock performance in the last 12 months has proven that.  Even though the company's fundamentals have been substantially and steadily improving, the stock market is not giving Big Blue credit for it.  Common sense and reason would suggest that it eventually will.  Sooner or later.  Which is why the stock may be a good buy now.

Click here for detailed IBM 1Q06 P&L and for other IBM 1Q Pretax Profit and for a 2006-2007 P&L forecast

Happy bargain hunting!

Bob Djurdjevic

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Volume XXII, Annex Bulletin 2006-15
April 19, 2006

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