System i Sales Drop Again in Q3, IBM Says Little

October 22, 2007 Timothy Prickett Morgan

Another financial quarter’s results have been reported by IBM, and it is yet again another quarter of revenue declines for the i5/OS platform. With a Power6 refresh of the System i and System p lines not in the works until early next year–the latest rumor is that the high-end System p boxes have now slipped into 2008–it is hard to imagine that the fourth quarter will be any better for the System i than the third quarter was. Which is probably why IBM’s chief financial officer, Mark Loughridge, didn’t say too much about the System i in his conference call with Wall Street last week.

“In the third quarter, many of our servers were impacted by product transitions,” Loughridge said. “System z is well into a very successful product cycle, Systems p and i are transitioning to Power6, and System x awaits new quad-core processors from Intel and AMD.”

As I point out elsewhere in this issue in detailed coverage of IBM’s financial results for the third quarter of 2007 (see IBM Hit by Financial Services Slowdown in Q3), the latter claim is a bit weak, since Intel has been shipping quad-core processors for nearly a year now and has used its “Kentsfield” Core 2 and “Clovertown” Xeon 5300 processors to beat the tar out of Advanced Micro Devices in the server market. To be sure, AMD’s “Barcelona” quad-core chips are only now shipping, and Intel’s high-end “Tigerton” Xeon 7300 processors for high-end X64 servers are only a few weeks ahead of Barcelona. But this just shows how IBM’s revenues from X64 servers are driven disproportionately by high-end boxes. And, by the way, this is exactly the same problem IBM has in the System p and System i lines as far as I can tell.

For years, IBM has engineered, priced, and packaged its Power-based server line more for high-end customers than for entry server customers. Because IBM’s Unix systems have been very aggressively priced at the high end and IBM is well-regarded in the largest data centers of the world, IBM has been able to spend the past seven years eating a huge amount of market share and has come to dominate the high-end of the Unix server market. This is a great accomplishment. But this feat, and IBM’s focus on margins and iron that fulfills this goal has meant that IBM has not engineered or priced the iSeries and System i machine to correctly target its very different customer base. The unified Power-based server line has been a boon for high-end OS/400 and i5/OS customers, who have powerful iron, lots of room to grow, and relatively attractive overall system pricing (provided they get the normal steep discounts, of course.) This has been a boon for IBM, too, which can bring fat profits on hardware and software to the bottom line. That’s why IBM is in the server game, after all.

The user-priced System i 515 and 525 servers announced in April and tweaked over the summer were designed to help boost shipments and revenues for the System i at the low-end of the market and to help the box better compete against the Windows platforms that rule this space. But it has taken some time for resellers to absorb these products, and IBM’s pricing has changed several times as customers complained about the way user-based pricing was implemented. To its credit, IBM reacted quickly when there were complaints, but to my chagrin and to that of many others cheering on the i5/OS platform, this user-based product line should have been to market years ago. I know I was banging the drum like a madman for it, year in and year out.

Perhaps more importantly, IBM should have had Power6-based servers to market in late 2006 or early 2007, and had this happened, IBM would be able to offer a lot more performance per user than a comparable X64 server. But at this point, the raw computing power in the quad-core X64 processors from Intel and AMD is significantly higher than the dual-core Power5+ processors IBM is using in entry System i and System p products. IBM has said nothing about what is delaying its Power6 systems, and equally significantly, won’t even cop to the fact that these servers are late to market. The Power6-based System p 570 machine helped drive midrange System p box sales up 26 percent in the quarter, and it is very likely that System i customers also saw the great price/performance benefits of the i5/OS variant of this box, which started shipping in mid-September. That box may yet help System i sales in the fourth quarter, but it was clearly too late to help the third quarter. Which is why you get a chart like this:

That’s a lot of red, isn’t it? And now that the System i division has been split into two bits, the Business Systems division at the low end with 515, 520, 525, and 550 machines, and 570 and 595 machines being rolled into the AIX business as the Power Systems division, who is responsible for that red ink? Mark Shearer, who was general manager of the System i division is no longer a general manager, but rather in charge of marketing and strategy for the combined Power Systems.

IBM never gives out precise revenue figures for its server lines, but Wall Street analysts take a stab at figuring out the numbers from time to time. In a recent report on VMware‘s effect on the server market, Citigroup Global Markets Equity Research, which is the analyst arm of Citigroup that has been separated from its Citi Smith Barney stock brokerage unit, provided some guidance on IBM’s various server lines that allows us to get an estimate on where IBM’s sales for the System i and System p lines were in the third quarter. The report provided quarterly sales for IBM from the third quarter of 2004 through the second quarter of 2007, and using the percent growth or decline figures given by IBM in its report last week against the third quarter revenue figures estimated by Citigroup, you can calculate that System i sales declined by 21 percent to $237 million in the third quarter while System p sales rose by 6 percent to $859 million. But here’s the important thing you always have to remember: overall Power-based server sales. When you add these lines together, sales in the third quarter fell by only 1.3 percent, to $1.096 billion. Not a big change. And when the pSeries line hit a rough patch (which seems pretty easy compared to the rough patch it is in now) in the third quarter of 2006, iSeries sales were $385 million, according to Citigroup, up 25 percent, while pSeries sales were only up 16 percent to $739 million. Total Power-based server sales were down 1.2 percent, to $1.11 billion in the third quarter of 2006. Of course, the third quarter of 2005 was a great one for IBM, with total Power server sales up 19.2 percent to $1.124 billion; System i sales were up 25 percent and System p sales were up 16 percent. It is not a coincidence that this is when IBM launched very aggressively priced entry i5 520 machines and lowered prices on i5 570 machines.

I want to say something else about System i shipments. As I told you three months ago when IBM’s second quarter financial results came out, even though revenues were down in the quarter, Shearer, who had just lost his general manager job in the wake of the splitting of the System i division, said that shipments were up. (See Shearer Talks About System i Sales, Server Reorganization for that.) Shipments were up in the double digits, in fact, and I would take a stab in the dark and say that even though revenues have been down, aggregate CPWs of processing power shipped has been flat or rising over all of these years of revenue decline. (I am going to start building a model to test this idea, and as I go to press with this story I am waiting for some feedback from Shearer about shipments in Q3.) Mainframe MIPS shipments have been growing quarter to quarter for many years, except when IBM comes to an end of a product cycle, as it did abruptly in the third quarter of this year. Mainframe revenues were down 31 percent and MIPS shipments were off 21 percent. You can blame some of that, and maybe a lot of that, on the slowdown in the financial services sector in the wake of the credit crunch caused by the sub-prime mortgage mess. But some of that is undoubtedly due to the fact that mainframe customers are expecting new iron soon from Big Blue. The same holds for System i and System p shops, who know a fully fleshed Power6 server line will ship sooner or later.

Sometimes, what IBM doesn’t say is as important as what it does say. “When you look at gross profit margins in Systems and Technology, it was up three-tenths of a point, with the largest contribution coming from System p,” said Loughridge in his call last week with Wall Street. “We also had margin expansion in Systems z and x.” What he didn’t say is that margins were holding or expanding in System i, which almost certainly means that margins are under pressure. Some of that is because of the user-based System i 515 and 525 servers, which have lower prices and inherently lower margins than their 520 Express predecessors. Bu the thing to remember is that the gross profits on i5/OS and DB2/400 are a lot higher than on AIX or Linux, so the combined System i platform has much better gross margins than a hardware-only analysis would reveal.

The trick that IBM needs to pull off is getting a revamped and repriced Power6 line out the door for both System i and System p customers. These machines need dense, small disk drives, energy-efficient main memory, user-based software prices across the board, very aggressive hardware and software prices, as well as blade, tower, and rack configurations. And they need one more thing. They need to ship yesterday.

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