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IBM FINANCIAL

Analysis of IBM Second Quarter Business Results

“Old World” Renaissance?

zSeries Growth Lifts Hope, But Mainframe “Recovery” May Be Short-lived

PHOENIX, July 16 – If someone told you that railroads and ocean liners are back in vogue on Wall Street, would you jump up and down for joy and invest in them?  If not, then you may be one of the few investors who are not susceptible to IBM’s hype.  The Big Blue stock got a boost this morning from its second quarter report – read, from its “old world” revenues and profit growth.

It was the zSeries, the modern-day name for the 40-year old mainframes, that again provided the biggest boost to IBM in the latest period.  Its 44% growth helped push IBM’s second quarter revenues above Wall Street’s expectations - to $23.2 billion, up 7% as reported, up 4% in constant currency. 

IBM hardware was certainly the biggest upside surprise in the quarter.  Their revenues surged by 12% to $7.4 billion, the second quarter of double-digit growth in a row. By contrast, IBM’s “new world” growth engine - IBM Global Services (IGS) - had a lackluster quarter. It produced only a 2% growth in constant currency, while its new contract sales and backlog declined.

Meanwhile, IBM software results, a downside surprise, were “disappointing” even in the words of the company’s smooth new CFO, Mark Loughridge.  Revenues declined 4% in constant currency.  Yet software still managed to drop a 28% pretax margin to the IBM bottom line.

IBM’s net profit from continuing operations was up 15% to $2 billion - a strong performance by any measure, especially in light of the disappointing recent results of some of Big Blue’s rivals (e.g., Unisys). So all seems well at Armonk. 

But the question is… how long will the “old world” bonanza last?

The answer… until the customers overhaul their creaky tracks and rusty engine rooms (continuing our opening railroad and ocean liners metaphor). 

Mainframes have been the engine of the IBM growth in the last two quarters.  Their resurgence is largely due to replacements of older technology with new models.  So being bullish about IBM’s long-term prospects at this point in time is like cheering a replacement parts manufacturer in the rust belt.  Eventually, the job will be done, and the customers will return to the “same old, same old”… What IBM will do for growth then - is the $64 million-question.  Alas, no one asked it last night during IBM’s teleconference with analysts.

Will Big Blue go back to its “new world” growth engine – IBM Global Services?  If so, get ready for a sputtering ride… For, a question that no analyst asked was, “what’s wrong with IGS?”  There seems to be much to worry about, and plenty that IBM’s new CFO so skillfully swept under the rug…

Services’ Growth Woes

Take the backlog, for example.  Answering an analyst question, Loughridge said that IGS backlog was up $6 billion since a year ago.  True enough.  What he didn’t say, however, is far more relevant… It was down $2 billion since three months ago!  Why?

Again, no one asked that question, letting the IBM CFO off the hook.  But we suspect that something is seriously broken in this erstwhile IBM growth engine.  We think that the main cog in its wheels is “rescoping,” a term the former IBM CFO, John Joyce, now the head of IGS, coined two years ago (see “Ban IBM Hoarse Whisperers,” July 2002). 

IGS is losing more business than it is winning.  That’s why its backlog has shrunk.  That’s what’s worrisome about IGS’ future.

In the latest period, IBM signed $10.6 billion in new contracts, down 1% from a year ago.  Which means that it lost $13 billion from its backlog in the quarter.  That’s higher than the $12 billion per quarter average losses in 2004 and 2003, and much higher than $11 billion average in 2002, the $9 billion average in 2001, or the $7 billion average in 2000 (see the chart on page 2).

And that suggests that the spread of the “rescoping” malaise is accelerating, not subsiding, as Loughridge hinted at one stage during the teleconference, echoing the IBM CEO, Sam Palmisano (from May 2003).

A 7% decline in new contract sales in the first six months of 2004 exacerbates the “rescoping” problem.  As long as a company sells more than it loses, its backlog rises, and everybody is happy.  But that’s not the case at IGS.  Not anymore.

Since 1999, IGS has sold $235 billion-worth of new contracts.  Yet, it’s backlog increased by only $58 billion.  Which means that $177 billion went into a “black hole” comprised of “rescoping,” cancellations and expirations.  

No wonder the IGS revenues grew by only 2% in the quarter, and would have been pretty well flat-lining in the last three years, had it not been for the PwCC acquisition (in 2002), and the foreign exchange boost.

Software Growth Stalls

IBM software is the company’s most profitable business segment, with gross margins in excess of 86%, and pretax margins around 22%.  In the last 3-4 years, it has also been a growing business.  That ended in the second quarter.  Software revenues were down 4% in constant currency.

Now, that’s not the end of the world, especially as the latest software gross margins actually slightly improved to (86.3%), while its pretax margins shot up to 28%.  Yet uncharacteristically, IBM termed the results “disappointing,” and blamed “numerous transaction deferrals” for it.

That sounds like a strange explanation, especially considering the strong mainframe sales (over two-thirds of IBM software is mainframe-based), and the fact that software license fees are like an annuity (revenues are earned over time).  

The only way IBM mainframes revenues and MIPS could be up 44% and 75% respectively, while the related software revenues decline 4%, is if there is no increase in the number of mainframe footprints!  In fact, the software decline hints at a probable decrease in the number of mainframes installed - a result of customer data center consolidation projects that IGS and other IT services vendors have been spearheading.

In short, the IBM software decline at a time of booming mainframe sales only serves to confirm the temporary nature of such a “recovery.”

Other Business Segments

“And then there were six Indians,” a nursery rhyme counts down the number of Indians.

How do you deal with a money losing business?  You sweep it under the rug.  In IBM’s case, the money-losing Technology unit has disappeared from the charts, having been merged with the now increasingly profitable Systems group in the latest IBM release.

As a result, the new Systems & Technology segment grew its revenues by 10%, while increasing its pretax profit by 111%.  Bingo!  The problem unit disappears from the public view.  Now, that’s investor relations marketing/management… perceptions over facts.

As for IBM’s PC unit, another perennial money loser, it managed to eke out a meager profit ($27 million) on revenues of $3.2 billion in the latest quarter.  Nothing to write home about, especially compared to the profits Dell, for example, makes on PCs.  But it beats bleeding “red ink.”

Summary

IBM’s new CFO, Mark Loughridge, delivered a flawless performance in his first “on stage” appearance on behalf of Big Blue.  He was as smooth as silk.  Whenever he addressed a problem area, it was something that other competitors were also experiencing.  Whenever he talked about an IBM strength, Big Blue was the only vendor doing so well.  The Wall Street analysts lapped it up, judging by their tepid questions.

Loughridge’s pep talk about IBM’s growth initiatives was a case in point.  He highlighted Business Process Transformation Services and the Emerging Countries as two areas that would supposedly help IBM grow in the future.  He said the first one has grown 40% per year, while the second one amounted to a 35% annual surge.

Sounds impressive… but only for the uninitiated.  For, the some total of the first initiative is represents only 3.1% of IBM revenues, while the second one amounts to only 4.2% of the total.  So Loughridge would have us believe that a fast growth in a 7.4% segment of its business would countervail the flat or declining trends in the remaining 92.6% of the total? 

Hm… Maybe on Wall Street such math would work, but not where common sense prevails.

In summary, IBM’s second quarter was a very good period for Big Blue.  Unfortunately, it was largely driven by a temporary resurgence in an “old world” business.  When that trend blows itself out, which may well happen before the end of the year, IBM will probably return to its old anemic growth, coupled with occasional declines.  Unless the company quits wasting money on stock buybacks, and adopts our “save, spend and split” recommendation, 2005 may be the first of such declining years.

2004: Moody's Lowers the Boon on EDS (July 2004); HP: Delivering Value Horizontally (Jun 2004); Accenture: Revving Up a Notch (Jun 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); Going Retro with Mainframes (Apr 8);  IBM: Five-year Forecast (Apr 8); Mainframe at 40! (Apr 2);  Accenture: Burning the Track (Mar 2004); "Crown Jewel" Restored? (Mar 2004); "Cap Gemini: Another, Smaller Loss" (Feb 2004);  "CSC: Good Quarter Gets Boos" (Feb 2004); "Hot Air Jordan" Flaunts Flop as Feat (Feb 2004); "Cronyism Is Alive and Well at EDS" (Jan 2004);  "Five Most and Least Likely Forecasts for 2004" (Jan 2004)