Confidential Client Edition

IBM CORPORATE

Updated 3/10/05, 8:30AM MST (adds IBM Forecast Update)

Annual Update to Annex Research’ Five-year Forecast for IBM

Quality over Quantity

Our “Save, Spend & Split”-Strategy Now Being Partially Implemented

PHOENIX, Mar 2 – Our harping over the last two years seems to be finally paying off – for IBM shareholders.  Looks like Big Blue is partially implementing our recommended “Save, Spend & Split”- growth strategy.  We first annunciated it two years ago, and reiterated it last April (see “Save, Spend and Split,” May 2003, and “Ditto, Ditto! Is Anybody Listening?”, Apr 2004).

IBM is spending some money on some (small) acquisitions in the services arena[1], and it has split off a major chuck of its unprofitable hardware portfolio (see “Good Riddance, Finally?,” Dec 2004).  What is hasn’t implemented as yet is the “save” part – eliminating or curtailing the financial drain resulting from stock buybacks. 

In fact, the company spent a record $7.3 billion on share repurchases in 2004, up 63% over 2003, even though its stock has actually declined since a year ago!?  And it has been down since three years ago even compared to the Dow Jones Industrial's Index of which it is a part (see the charts).

Oh well, can’t win them all, we suppose… 

Spinning off the IBM PC business, however, will have a major beneficial impact on the company’s business results.  Assuming the deal closes as planned in the second quarter, in 2005, for example, we expect the IBM revenues to decline by 4% to $92.7 billion.

How can a drop in revenue be beneficial?  It can.  Because we expect the operating, pretax and net earnings to rise by 2% to 3% despite the revenue decline.  Which means that Big Blue’s profit margins will actually improve. 

The net margins, for example, will rise from an already enviable 8.8% in 2004, to 9.3% this year.  Which means that the expected 2005 net earnings of $8.65 billion will be another new all-time high for IBM.

That’s putting quality over quantity - a refreshing change from the Gerstner administration’s approach to running a business when bigness connoted goodness.

Long Lasting Benefits

The benefits of such a change in strategy will be long lasting.  In 2006, for example, we expect the IBM revenues to rise modestly (up 2% to $94.2 billion).  But the net margins are expected to surge to 10.5%, with net earnings just a shade under $10 billion, another all-time record. 

If this forecast comes to pass, 2006 will be the first year in more than two decades that IBM net margins reach a coveted double-digit range.  Unlike in 1985, however, when IBM earned $6.6 billion on revenues of $50 billion, the 2006 earnings will not be padded by a one-time sale of assets that boosted the company’s 1985 profits (see "Akers: The Last Emperor…Great IBM Lease Base Sale," Annex Bulletin 91-31, 6/12/91).  

And if IBM gets rid of its on-and-off money-losing Technology unit, the company’s profit margins will improve even more.

Linux, Recentralization and SMB Reintegration Trends

As we noted in our recent IBM revenue forecast (see “IBM Servers to Grow Again,” Feb 2005, incorporated into this five-year forecast by reference), the company will also benefit from the new Linux, recentralization and reintegration trends.  Here’s an excerpt:

Who would have thought that a cute little penguin could end up doing what multi-billion software giants have failed to – shake, rattle or break some Windows; cause a Solar(is) eclipse or two; and stir up the pot in the PC server business.  In short, Linux is creating new tectonic movements in the IT industry.  A fringe is becoming mainstream. [snip]

IBM servers are also getting a shot in the arm from two customer-driven trends.  One is recentralization.  Another is reintegration.  The zSeries is the main beneficiary of the former trend.  The iSeries will profit from the latter.

(see IBM Revenue Forecast, Feb 2005)

The upshot of all this has been and will be renewed organic growth of the IBM hardware segment. 

Despite the appearances (in 2005 and 2006 hardware revenues are likely to decline 21% and 6% respectively due to the sale of the PC unit to Lenovo), the continuing IBM hardware businesses will probably grow faster than the company’s erstwhile “crown jewel” – IBM Global Services (IGS).  As you saw in our revenue forecast, we expect the latter to grow by only 4% this year and next.  Unless, of course, IGS’s new contracts sales record improves dramatically, as does its management of the “rescoped” deals.

The software revenue growth, on the other hand, is likely to accelerate slightly.  We expect it to rise 6% in 2005, and 7% in 2006.

Five-year Outlook

The expected hardware and software growth spurts are likely to put the IBM revenues on track to reach the elusive $100 billion-mark by 2008.  In 2009, they are likely to be $104 billion.  That’s about the same five-year forward growth rate as that in the last five years (1999-2004), a little less than 2% compounded annually between 2005 and 2009.

Within this composite, we expect the IGS to grow at about 3% compounded annually during the same period, less than half the rate of growth in the last five years.

The IBM software should grow at 7% compounded annually (versus 4% in the past), while the hardware should decline by 3% per year, as it has in the past.  But the hardware revenues will actually grow at a 3.5% annual rate between 2006 and 2009, after the comparative effect of the PC sale to Lenovo wears off.

While these revenue growth rates may seem pretty anemic, much more important to the IBM shareholders, however, is the expected net earnings growth.  The net is likely to increase at 6% compounded annually over the next five years, ending up at over $11 billion in 2009 for a net margin of 11%.

That’s triple the revenue rate of increase.  And if IBM were to achieve it, that would be another proof of its putting quality over quantity.

By the way, any of these growth rates could change significantly up or down with any major acquisition or asset sale, in accordance with our “Save, Spend and Split”-strategy recommendation.

IBM Forecast Update

PHOENIX, Mar 10 - Up until now, we have been assuming in our IBM revenue and profit forecasts that the IBM PC business sold to Lenovo would be a part of the Big Blue's results only in the first quarter of 2005.  Well, now that it is evident that the second quarter business would also be conducted under the IBM label, we have updated our 2005 numbers.

The upshot is that we expect IBM 2005 revenue to be $94.9 billion, down 1.5% from 2004, while the corresponding net profit is likely to rise 5% to $8.8 billion or $5.43 per share, for a 9.3% net margin.

In 2006, we are picking IBM to earn just shy of $10 billion, or $6.18 per share, on revenues of $96.3 billion, up 1.5% over 2005 (see the updated charts).

Happy bargain hunting!

Bob Djurdjevic

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