iSeries Sales Down 18 Percent in Q4 as Users Await i5s and V5R4

Last week, IBM reported its financial results for the fourth quarter and full year in 2005, and as is usually the case for a large, multinational corporation with a complex set of product lines, Big Blue had plenty of ups and downs in the quarter and is finding it hard to generate revenue growth even as it manages to squeeze profits out of those products. But, the company, with over $88.3 billion in sales (excluding its divested PC and disk drive businesses) and $8.7 billion in net income for 2005, is still by a smidgen the largest IT supplier in the world, just ahead of Hewlett-Packard.

While size matters to both IBM and HP, profits are beginning to matter more, which is why both companies have been gradually shifting their emphasis in many of their business lines. In IBM’s case, it is getting out of commodity hardware businesses like PCs and disks and focusing more on high-end services and software where the margins are fatter. Even as these two behemoths of the IT industry try to tune their products, marketing strategies, and sales channels, local economic and competitive conditions in the 140 or so countries they do business confound their abilities to get balanced performance. Whenever a company is so broadly and so deeply entrenched in so many market sectors in so many geographies, there is always a lot going wrong even if a lot is going right. That’s the price any company pays for being large.

In the fourth quarter of 2005, IBM’s software and services businesses were under pressure, as were its iSeries Power-based and xSeries X64-based server lines, but the zSeries mainframe and the Power-based pSeries Unix server lines went a long way to propping up sales. Any IBM system sale has a drag-along effect for peripherals, software, and services, so it is difficult to isolate the effect of server product transitions on sales in these areas from generic sales.

During the final quarter of 2005, IBM had sales of $24.4 billion across all of its product lines, down 1 percent as reported (but up 3 percent at constant currency, which means when measured in the local currencies where IBM sells its gear). Net income, including the effect of a $267 million pension charge, came to $3.2 billion, which worked out to $2.01 per share, which was an increase of 29 percent if you exclude the PC business.

IBM’s sales in the Americas region totaled $10.5 billion, up 3 percent at constant currency without the PC business. IBM’s business in Europe, the Middle East, and Africa–where IBM initiated layoffs last year in an effort to change the way it sells and to cut costs–accounted for $8.3 billion in sales, up 2 percent at constant currency excluding the PC business. In the Asia/Pacific region, which is still dominated by Japan but which is increasingly represented by the emerging markets in China, India, and ASEAN nations, IBM booked sales of $4.5 billion, but a poor showing in Japan nonetheless drove overall sales in the AP region down 3 percent at constant currency and not including the PC business. (Sales were down 22 percent including PCs and as reported, which is why I am taking out PCs in this analysis.) IBM’s OEM product sales, which is mostly driven by PowerPC chip sales to game console and embedded device makers, totaled $1.1 billion, up 35 percent.

Mark Loughridge, IBM’s chief financial officer, said in a conference call with Wall Street analysts last week that the Americas region exhibited “solid execution” and that the performance was “broad-based, with growth across all key brands and all regions.” In Europe, Loughridge said that sales in the Nordic countries and Spain was up, but that sales in Germany and Italy continue to decline. He noted that even in these two countries, however, as well as across Europe, IBM had “good growth” in hardware sales. Japan still accounts for 60 percent of IBM’s sales the AP region, and with that area in decline, it is hard to get good numbers for Big Blue. For all of 2005, the emerging markets of China, India, Russia, and Brazil accounted for $3.8 billion in sales (not including PCs), with growth in China of 8 percent, in India of 55 percent, in Russia of 29 percent, and in Brazil of 7 percent.

In terms of hardware sales, the heroes of the fourth quarter for IBM were the zSeries mainframe and the pSeries Unix servers. Not including PCs, IBM’s hardware sales were $6.9bn in the quarter, up 6 percent as reported (but up 9 percent at constant currency). IBM launched the “Danu” System z9 mainframes at the end of July and rolled out shipments throughout the fall, and that allowed Big Blue to crank up mainframe sales by 5 percent (10 percent at constant currency). Loughridge said that IBM shipped 28 percent more mainframe MIPS in Q4 2005 than it did in the year-ago quarter, making this the largest amount of MIPS IBM has ever shipped and the highest revenue in a fourth quarter since 1998, besting even the impressive $1+ billion quarter of 2004. Loughridge said that IBM expected to see continuing growth in mainframe sales through the first half of 2006 as customers absorb the bigger Danu boxes and their associated software, with a tapering off in the second half of the year. He added that 60 percent of mainframe revenues–not MIPS, but revenues–were driven by new workloads, such as Java and Linux, which is up considerably from the 15 percent level in 1998.

And Loughridge had nothing but praise for the pSeries Unix server line, which saw sales grow by 4 percent in the fourth quarter (7 percent at constant currency). For the year, the pSeries business grew by 15 percent as reported, nailing double-digit growth in all geographies and demonstrating that IBM’s Power chip is a serious contender even if it doesn’t support the X86 instruction set. Loughridge said that pricing pressure was intense at the low-end of the Unix server market, but that pricing pressure was not as intense at the high-end. This stands to reason, since Opteron-based servers are setting the price pace along with IBM’s Power5 and Power5+ machines at the low-end, whereas IBM’s own Power boxes are setting the pace at the high end of the Unix market. IBM is already aggressively priced on big Unix boxes. IBM’s CFO hinted that the Power5+ chip, which debuted in the fall of 2005 would make its way into more pSeries during 2006, and he attributed a surprising 18 percent decline in iSeries sales to customer expectations for new Power5+ hardware and the new i5/OS V5R4 operating system in the first quarter. Other IBMers have tried to dissuade me from getting the impression that the iSeries line would change radically in 2006, so this comment was a bit surprising. On a brighter note, he said that IBM had added about 2,500 new customers to the iSeries line in 2005, about the same number of new customers it added in 2004.

Sales of xSeries servers, which are based on Xeon and Opteron processors, were flat in the quarter. Loughridge explained that pricing pressure in Europe and Asia/Pacific was particularly intense with X86 and X64 servers and particularly on single- and dual-socket servers that make up the bulk of the volume in the X86 and X64 server business. He said that because of that pricing pressure, IBM’s xSeries sales volumes were up 13 percent in the quarter–IBM’s highest volumes ever in the X86 market–but revenues were only up 3 percent. And, finally, Loughridge conceded that Big Blue had some “operational issues,” where IBM had “undercalled demand on some products.” BladeCenter blade server sales grew by 41 percent in the quarter, but fell short of the 65 percent growth IBM had in this area for the full year.

Rounding out hardware sales, IBM’s TotalStorage showed 24 percent revenue growth in the quarter, driven by midrange and high-end disk arrays. Overall disk sales were up 32 percent, with enterprise disk array sales up 46 percent and midrange disk arrays up 40 percent. IBM’s Microelectronics Division saw sales spike by 48 percent in the quarter, with sales of 300mm chips up 250 percent thanks to sales of PowerPC-derived chips to Microsoft and Sony for their game machines.

IBM’s Software Group had sales of $4.6 billion in the quarter, flat as reported and up 3 percent at constant currency. While IBM is one of the largest providers of software on the planet, customers are not adding workloads to their z/OS and i5/OS platforms as fast as they are on other platforms–even if they are adding Java and Linux workloads to their zSeries and iSeries boxes. IBM is caught in the vice of trying to make its legacy application platforms more competitive, which hurts revenues, as it also peddles competitive (and increasingly open source) technologies, which adds further to the pricing pressure. This is why IBM’s Software Group has not seen the kind of explosive growth as its service business and has not, of late, even kept pace with its hardware business.

As reported, the WebSphere family of middleware products saw sales increase by 4 percent, with WebSphere Application Server sales up 16 percent in the quarter. Sales of CICS transaction monitors and other middleware was off 4 percent, and operating system sales declined by 6 percent. Information management products–including the various implementations of the DB2 database as well as IMS databases for mainframes–also grew by 4 percent, half the growth rate IBM booked in this category for the full 2005 year. Lotus groupware products had modest growth of 2 percent, also tapering off in the fourth quarter and significantly lower than the growth IBM had for the full year, which was 10 percent as reported. Loughridge said that Domino 7 enjoyed “strong customer response” and that there was “high interest” in the WorkPlace groupware products, which are built atop WebSphere middleware; he added that WorkPlace sales more than doubled in Q4 compared to Q3. The question you have to ask is how WorkPlace might be cutting into Lotus Domino sales. Rational-branded software development tool sales declined by 2 percent in the quarter, with some customers in the Americas region delaying their purchases. Sales of Tivoli-branded management and security software were up 3 percent, with storage virtualization software sales a bright spot with 17 percent growth. And, the main thing you need to know about Software Group: gross profit margins were 89 percent in the quarter, which is the main reason why IBM is a profitable company at all.

If Software Group brings in more than its share of the bottom line, IBM’s Services Group brings in more than its fair share of the top line. But as has been the case for the past few quarters, as IT shops transition from long-term outsourcing and system integration contracts to shorter-term contracts and various new kinds of services such as business process reengineering, IBM is finding to tough to grow its services sales. Revenues at the Global Services unit fell by 5 percent as reported (and 1 percent in constant currency) to $12 billion. IBM’s signings in the quarter were $11.5 billion at constant currency, which included $5.3 billion in short-term deals and $6.2 billion in long-term deals. IBM’s backlog of services deals was $111 billion as it left the fourth quarter–the same as last year–but more significantly, it was lower than at the end of the third quarter of 2005 by $2 billion. This has Wall Street nervous.

Strategic outsourcing bookings were down 32 percent in the quarter, and Loughridge warned that revenues in this area–formerly the lion’s share of IBM’s services business–are being affected by the cumulative effect of lower signings that started in 2004 and went through the first quarter of 2005. Integrated technology services signings were down 10 percent, and IBM has rebalanced its portfolio, adding more sales people and training existing employees in growth markets. Business consulting services signings were up 23 percent in the quarter, but sales were down 6 percent (with double-digit declines in AP and Italy). Within the BCS category, IBM’s consulting and systems integration business saw signings grow by 4 percent, helped significantly by spending by the U.S. government. IBM said that its business transformation outsourcing business had a 144 percent increase in signings in the fourth quarter and had revenue growth of 28 percent to $4 billion for all of 2005. However, as exciting as this is, it is tiny compared to the $47.4 billion in services sales IBM had last year.