IBM’s Q1 Driven by Mainframes, Unix, Services, and the Weak Dollar

April 21, 2008 Timothy Prickett Morgan

That good ole annuity-style revenue stream, which accounts for a little more than half of IBM‘s sales in any given quarter, was gurgling and burbling along in the first quarter of 2008, helping to float the company’s product sales and delivering pretty hefty overall revenue and profit increases considering the shaky nature of the economy in the United States. And lucky for Big Blue, three-quarters of its revenues come from outside the United States, which means the weak dollar amplifies overseas sales when they are brought back to IBM HQ.

Look at how much the weak dollar helps. Sales across all product and services lines for IBM rose by 11 percent to $24.5 billion in the first quarter of 2008, but if measured in their local currencies where the deals actually got done and booked in IBM’s various units, sales would have only been up 4 percent compared to sales in the first quarter of 2007. Gross profits for the quarter rose by 14.7 percent to $10.2 billion, and net income rose by 25.7 percent to $2.3 billion. That works out to $1.65 per share, up 36.4 percent compared to net earnings per share in the first quarter of 2007, which was bolstered by IBM’s ongoing and aggressive share buybacks. The $4.9 billion acquisition of business intelligence software maker Cognos and those share buybacks emptied IBM’s cash coffers a bit, with cash down to $12 billion from the $16.1 billion the company had in the bank at the end of 2007. IBM expects to spend $12 billion this year on stocks, and cash flow from operations was sufficient to handle most of the stock buybacks in the first quarter.

IBM’s president, chief executive officer, and chairman, Sam Palmisano, made his customary appearance in the press release announcing the financial results but was, as usual, nowhere near the conference call that Mark Loughridge, the company’s chief financial officer, held with Wall Street analysts after the market closed last Wednesday.

“IBM had a very good quarter and a good start to 2008,” Palmisano explained in the release. “These results reinforce our confidence in IBM’s ability to perform well in a dynamic global economy. Our performance is a tribute to the way we have repositioned our company over the past several years, as well as the hard work of IBMers across the globe. IBM is a different company today, with a number of unique advantages: our global reach and scale, our strength in profitable growth segments, strong recurring revenue and profit streams, products and services that create real value for clients, and the discipline and financial strength and flexibility that enables us to adjust our business model as conditions require. We feel good about the rest of the year.”

It remains to be seen if the rest of us out there in the world do, but apparently there are enough good vibes among the 6,000 top global companies that drive IBM’s businesses and the several hundred thousand smaller companies that make up the foundation of IBM’s reseller channel sales for Palmisano and his peers at those companies to be optimistic. Here’s to hoping that the optimism spreads . . . .

While IBM positions itself as a services and software company, the reality is and will continue to be that its mainframe, Unix, i5/OS, Linux, and Windows systems drive a substantial portion of its business, including hardware, software, and services components. If you wanted to be fair, IBM should include operating system and middleware sales relating to its own platforms with those platforms, but because IBM wants to be thought of as a software player like Microsoft and Oracle (which it most certainly is), the company breaks the software that only runs on its own hardware to make Software Group look good. Ditto for services. A lot of what Global Services does today for a fee is the kind of things IBM used to provide for free when machinery was orders of magnitude more expensive per unit of performance than it is today. And that is why a discussion of IBM’s systems business is always an important starting point for any discussion of any quarter of sales at Big Blue.

Loughridge said in the call that the Systems and Technology Group, which makes servers and storage as well as PowerPC and Power chips and other stuff sold on an OEM basis to other suppliers, saw sales fall by 6.7 percent in the quarter, to $4.2 billion, but added that excluding IBM’s divested Printing Systems Division, which it sold to Ricoh last year, sales were only off 2 percent. Of course, that decrease was despite a rather large amplifier effect from exchange rates to U.S. dollars as IBM brought the money home to Armonk, New York. Even though the new System z10 machines, announced on January 29, were only available for 34 days in the first quarter, System z mainframe sales managed a 10 percent revenue growth (2 percent at constant currency), which suggests these boxes sold well outside of the United States and that IBM will probably have a pretty good upgrade cycle this year for mainframes. MIPS shipments were up 14 percent in the quarter.

IBM has not yet copped to its own Power Systems rebranding in its financial reporting, and seems to be stuck in between categorizations in its financial reporting. Loughridge made some silly statement about how the convergence of the System p and System i lines into Power Systems would now give customers all this new hardware, as if they had never been in synch with IBM’s Power processors in the past. The reality is that a converged product line should mean lower prices for i5/OS workloads, and while this will hamper sales, it should allow more revenue opportunities. Loughridge could have explained that, but didn’t. In fact, when questioned later in the call to give a little more detail on the various server products, Loughridge forgot to mention the System i at all.

The so-called Legacy System i business, by which IBM means non-Power6 machines sold before the lines were converged formally, took a big hit, with sales down 21 percent (down 27 percent at constant currency). This revenue decline is probably due in large measure to the substantial price cuts that the user-priced System i 515 and 525 servers had compared to earlier machines and to the expectation that IBM would deliver entry Power6-based servers running i5/OS V6R1 (now called i 6.1) early in 2008. The so-called Converged System p business, which means all of System p products as well as the Power6-based System i 570 that sold pretty well in the quarter. Even with the addition of the high-end of the System i business, this Converged System p category only had 2 percent revenue growth as reported, and declined 3 percent in constant currency. The high-end of the Power Systems lineup was soft, since everyone was expecting the Power 595 refresh with the Power6 processors, but sales of 570-class machines rose by 59 percent in the quarter, including the i5/OS contribution to the cause.

System x sales (weren’t these rebranded as Modular Systems?) disappointed IBM in one way, with sales flat (down 6 percent in constant currency), but Loughridge said that given the commodity nature of these products, the decline had no material effect on IBM’s profits. Storage System sales rose by 10 percent, with high-end DS8000 array sales up 17 percent and tape up 18 percent. Overall disk sales were up by a muted 6 percent. OEM technology sales fell by 16 percent, to $696 million. (This is one of the few areas where IBM gives a precise number for an element of STG sales.)

Global Services, as usual, made up the majority of IBM’s sales, and Loughridge said that like in past quarters, IBM was seeing a shift to short-term engagements where the payoff was quick in services engagements. Global Services accounted for $14.6 billion in sales, up 17.3 percent. IBM breaks Global Services into two pieces these days to make the numbers look smaller. Global Technology Services accounted for $9.7 billion in sales (which means outsourcing, systems integration, and maintenance services), which Global Business Services (which means business process reengineering and other witchcraft services that are much harder to describe but which companies love to buy) accounted to $4.9 billion in sales. Both elements of services grew at the same rate, more or less. IBM had $12.6 billion in new services contract signings in the first quarter, up 6 percent, and the services backlog stands at around $118 billion.

On the software front, IBM’s Software Group kept plugging along, showing real growth as it has done quarter after quarter for a long time. Software Group posted sales of $4.8 billion, up 14 percent as reported (but only 6 percent at constant currency). The key branded middleware–DB2, Lotus, Rational, Tivoli, and WebSphere–accounted for 53 percent of sales in the quarter, or $2.54 billion. WebSphere middleware and tool sales rose by 20 percent, while database and related information management sales were up 27 percent (boosted by Cognos) and Lotus/Domino groupware and middleware rose by 17 percent. Tivoli systems management and security sales were up by 9 percent, and Rational development tools rose by a mere 3 percent. Other middleware–meaning things like CICS, VSAM and stuff that runs on IBM’s System i gear, accounted for $1.15 billion in sales in the quarter. Operating systems brought in $528 million in sales, and other software accounted for $576 million.

Loughridge said that sales in the United States was stronger than expected, but added that IBM was not expecting to do any more than pursue opportunities to help customers improve their IT infrastructure or cut costs. He said that the emerging markets, such as China and India, were like a “gold rush” and that IBM was deploying resources to chase opportunities there and catch as much of the growth as it could. IBM had $9.9 billion in sales in the Americas region during the first quarter, up 8 percent as reported (6 percent when adjusting for currencies), while sales in Europe, the Middle East, and Africa rose by 16 percent (only 4 percent at constant currency) to $8.8 billion. The Asia/Pacific region grew by 14 percent to $5.1 billion, but was only up 3 percent in local currencies. This suggests that the gold rush is as much the result of a crashing dollar and a strong rupee and yuan as anything else. But just don’t tell Wall Street. They want to drink the blue Kool-aid.

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