Annex Bulletin 2007-36                             October 16, 2007

Recent...

On the Button Again -  Analysis of IBM 3Q07 results [Annex clients click here]

Seedlings Sprouting Stronger Limbs - Update to "IBM State of the Union" [Annex clients click here]

IBM FINANCIAL

Updated 10/16/07, 7:50PM PDT

Analysis of IBM's Third Quarter Business Results

On the Button Again

Services Exceed Expectations, But Financial Sector, Mainframe and High-end Software Disappoint

SCOTTSDALE, Oct 16 - IBM hit the third quarter numbers on the button again (in line with Wall Street's expectations), but the financial services sector, mainframe and high-end software growth slowdowns disappointed analysts and investors.  As a result, the IBM stock gave up in after-hours trading most of the gains it had accumulated earlier in the day in anticipation of a better third quarter.

After dropping by as much as 2%, IBM shares stabilized around $118 in after-hours trading, down 1.3% from their today's closing price of $119.6 (see the chart).

IBM earnings were up 6% to $1.68, a tad higher than the $1.67 Wall Street had expected, while revenues hit the average analyst estimates on the nose at $24.1 billion, up 7% from the year before.

Asia/Pacific Continues to Grow Fastest

Geographies. The Americas revenue growth was 3%, same as the U.S. market.  IBM cited the weakness in Financial Services sector as the main reason for its relatively slow growth. Europe had a slightly better  performance, rising 11% as reported, and 4% in constant currency.  Germany and Spain turned in the best results.

Asia/Pacific again had the best performance at constant currency, up 9% as reported and 6% at constant currency.   India, ASEAN, China and Australia, New Zealand all made "solid contributions," according to IBM.  Japan's revenue, at approximately a half of A/P business, was essentially flat.

Emerging markets are leading the growth in the global economies, IBM said.  The combined BRIC countries (Brazil, Russia, India and China) revenues grew 19% as reported and 10% in constant currency. Three of the four countries continued very strong growth, but Brazil declined in the period in constant currency.

Strong Services Growth

Services. Offsetting some hardware and software disappointments were the stronger-than-expected IBM Global Services growth rates.  The GTS (Global Technology Services - mostly outsourcing) revenues were up 13%, while its profits rose 26%.  The GBS (Global Business Services - mostly consulting) business performed even better.  Its revenues were up 16%, while profits surged by 29%.

Both increases, which the IBM CFO, Mark Loughridge characterized as "exceptional services performance" during a teleconference with analysts, were due mostly to the strong new contract signings in 2006 and in the first half of 2007, he explained.  Especially big was the fourth quarter of last year, when IBM closed $17.8 billion of new business, its best sales performance since 4Q02.

The third quarter 2007 new contract bookings came in about expected at $11.8 billion, up 12% from a year ago, but the corresponding amount of losses due to "rescoping," expirations and cancellations left the backlog sequentially flat at $116 billion.

What should further moderate enthusiasm about IBM's services outlook in the future is not just the huge mountain of new contract signings that the company will have to scale in the current quarter, just to stay flat with a big final period of 2006, but also continued high rates of outflow from its backlog.  For the first nine months of 2007, average outflows have equaled the inflows of new contracts ($11.5 billion each).  Which suggests flattening of revenue growth in the future, even without the possible derogatory impact of the credit crunch on IT spending of the financial services sector.

Furthermore, despite a relative improvement in the services' profitability, the strong services revenue growth ironically helped drag down the overall IBM profitability (by 0.7 of a point).  How is that possible? Well, the metrics of the services business are such that they carry lower gross margins that the IBM average (23% to 30% vs. 41% to 42%).  And considering that services now account for more than half of Big Blue's total revenues, they are the driving force behind Battleship IBM.

So the best thing IBM should to do offset the negative effects of its services resurgence is to boost its highly profitable software growth.

Slower Software Growth, Lower Margins

Software: Alas, IBM software's profitability has also come under pressure in the third quarter.  Gross margins are down 1.1 points from a year ago.  But at 84.2%, this Big Blue segment is still hugely profitable.  That is why a slowdown in its revenue growth rates has been particularly unwelcome at this time when IBM could have used a boost.

Loughridge blamed several large deals, particularly in the financial sector, that had slipped into the fourth quarter.  As a result, software revenues were $4.7 billion, an increase of only 7% (3% in constant currency) from a year ago.  Just how much of a slowdown that was can be seen from the relative growth rates of various IBM software segments.

Revenues from IBM's middleware products, for example, such as WebSphere, Information Management, Tivoli, Lotus and Rational, were $3.6 billion, up 6% from the third quarter of 2006.  They grew by 12% a year ago, double the current growth rate. Operating systems revenues (564 million) dropped 2% (vs. down 6% a year ago).

As for the individual software brands, WebSphere revenues increased 10% (vs. 30% a year ago).  Information Management software was up 9% (vs. 12% a year ago).  Tivoli infrastructure management software rose 5% (vs. 44% a year ago)  Lotus software, which is more ubiquitously used in SMB as well as large enterprise accounts, increased 9% (vs. 8% a year ago). Rational software, integrated tools to improve the processes of software development, was up 3% (vs. 2% a year ago).

Slowing Mainframe Demand, Financial Sector Woes

Hardware: We figure that the lower growth rates of the IBM software brands are probably related to a slowdown in mainframe demand.  After all, mainframes pulls over $14 billion in revenues for IBM, almost five times the actual hardware server sales.  And slowed the System z revenues did in the third quarter - down 31% as reported and down 34% in constant currency.  MIPS shipments also dropped by 21% since a year ago.

IBM blamed a "tough compare" (mainframe revenues surged by 25% in last year's third quarter) and the weak sales in September, again decisions being delayed, especially in the financial sector that consumes about half of the IBM mainframe shipments.  IBM's CFO said that 70% of the deferred deals occurred in the financial sector, especially in the U.S.

The good news for IBM is that the profitability of most of its servers, including the mainframe, actually improved, according to Loughridge.

Given that the financial services sector was uncharacteristically the poorest performing segment of the six (up only 1% in constant currency), and that they are big consumers of both mainframes and enterprise-class software, there is at least a hint that the credit crunch may have affected the demand in the third quarter.  So the fourth quarter will be the tell-tale sign of that.  For, IBM will no longer have the excuse that a number of large transactions did not close on time, as Loughridge kept repeating this evening.

Other IBM servers turned in a mixed performance.  The System p continued to excel despite a generally shrinking Unix market, rising 6% in the latest quarter.  The System x similarly turned in excellent results under adverse circumstances, rising 6% while awaiting deliveries of Intel's first quad processors.  The System i disappointments continued.  This product's revenues were down 21%.  The high-end of this product line will be merging with the System p, thus easing the pain at least in a financial sense.

Microelectronics revenue also declined (by 15%), while storage products' rose slightly (up 1%).  But the Engineering and Technical Services returned to growth (up 10%), in part due to its major win at Nokia Siemens Networks (see "Seedlings Sprouting Stronger Limbs", Oct 2007).  Similarly, Retail Store Solutions, a unit that we called in the above report "one of IBM's best kept secrets," is continuing with its explosive growth, surging by 29% in the latest period.

"Hardware did not meet our expectations," Loughridge summed it up.  "We are disappointed with the third quarter results."

Summary

Overall, however, it was a good quarter for IBM, right on the money as far as Wall Street expectations are concerned.  But some of the above disappointments may negatively affect the IBM stock that had risen in anticipation of strong third quarter results.  Furthermore, a possibility that the financial credit crisis may spread and affect IBM's high end results is also likely to be on the back of investors' minds.

As if anticipating such worries, the IBM CFO tried to assure the analysts that the company expects to meet the average of earnings per share estimates on the Street for the fourth quarter of a 15% growth.  Loughridge said that analysts' full year estimates were "consistent with our full-year objectives." 

Which means $6.91 per share earnings on revenues of $97.4 billion.  Our own estimate is pretty close to that - $6.82 EPS and $97.2 billion revenues.  So we'll see if the universe unfolds as it should in the fourth quarter.

 Happy bargain hunting!

Bob Djurdjevic

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