Transitions Push Systems and Technology Group into the Red

May 24, 2010 Timothy Prickett Morgan

As previously reported a month ago in The Four Hundred, IBM had a pretty good first quarter to start out 2010. Big Blue’s overall sales rose by 5 percent to $22.9 billion, and net income increased by 13 percent to $2.6 billion. The Systems and Technology Group, which makes and sells IBM’s chips, servers, and storage arrays, managed 4.9 percent growth, to $3.38 billion. But if you drill down into the numbers, as I did, you’ll see that the Power7 transition and the wait for the System z11 mainframes have pushed STG into the red.

As I do each quarter when I get a moment, I take out the bottle of ibuprofen and try to turn IBM’s statements about how products are doing inside STG in terms of percents into actual revenue figures so we get a better sense of what is actually going on within the group.

As best I can figure, IBM’s overall server business was dead flat in the first quarter, coming in at $2.15 billion in revenues. In my model of IBM’s revenues and profits for STG (which admittedly do not perfectly match IBM’s own figures because of rounding issues and the imperfectness of my initial assumptions in 2006 when I last put down a new foundation for the model), I figure that IBM’s System x and BladeCenter sales rose by 36 percent to $986 million in the first quarter, almost perfectly offsetting the 17 percent decline in System z mainframe sales in the first quarter, to a tiny $383 million, and an 18 percent decline in Power Systems sales, to $780 million. If you are like me, sometimes data doesn’t make sense until you visualize it. So take a look at the last couple years of sales of Power Systems, System x/BladeCenter, and System z server sales:

What becomes immediately obvious to me in looking at this chart above, and which I cannot see as clearly in a table of numbers, is that System z and Power Systems sales in the first quarter of 2010 were the lowest for these product lines in a long time. Not just seasonally down, as you can see, but also dampening down as the quarters go by. The lows are getting lower and the highs are getting lower for both product lines. That could be the worst quarter for revenues in the recent history of the mainframe–since the mid-1990s for sure–and certainly the lowest numbers for the combined AS/400 and RS/6000 businesses since I have been tracking these systems. Even in the first quarter of 1993, when the mainframe business was utterly collapsing thanks to a recession and a shift to open systems, IBM’s mainframe line was down 49 percent, but to $1.15 billion in hardware; and in that same awful quarter, AS/400 sales were off 13 percent to around $700 million, and the relatively small RS/6000 workstation and server business rose by 3 percent to around $400 million. Adding up to a combined $2.25 billion for IBM’s own homegrown server platforms. Flash forward to the first quarter of 2010, and these combined products raked in only $1.16 billion–about half of that low point in early 1993.

Some of that change is Moore’s Law improvements in price/performance, some of that is due to a much more jarring recession, but some is also apparently due to the increasing pressure that X64-based servers are putting on all manner of non-X64 iron.

As best as I can figure, IBM’s storage business accounted for about $660 million in revenues across tape and disk products, (up 9.5 percent in my model but 11 percent in IBM’s reported results), with chip and chip technology sales coming in at $420 million (up 15.1 percent in my model and by 16 percent in IBM’s figures).

Here’s the table of numbers from my model since the first quarter of 2006:

	1Q 2008	2Q 2008	3Q 2008	4Q 2008	1Q 2009	2Q 2009	3Q 2009	4Q 2009	1Q 2010
System z	$569 M	$1,176 M	$775 M	$1,087 M	$464 M	$713 M	$574 M	$799 M	$383 M
Power Systems	$975 M	$1,338 M	$1,166 M	$1,598 M	$955 M	$1,247 M	$987 M	$1,305 M	$780 M
System x	$997 M	$724 M	$939 M	$950 M	$728 M	$562 M	$948 M	$1,298 M	$986 M
Total	$2,541 M	$3,238 M	$2,880 M	$3,635 M	$2,147 M	$2,521 M	$2,509 M	$3,402 M	$2,149 M

Storage	$738 M	$949 M	$833 M	$1,085 M	$604 M	$771 M	$725 M	$1,095 M	$660 M
Micro OEM	$536 M	$594 M	$532 M	$488 M	$365 M	$439 M	$525 M	$498 M	$420 M
RSS	$184 M	$193 M	$186 M	$205 M	$113 M	$123 M	$159 M	$195 M	$156 M
STG Total	$3,999 M	$4,974 M	$4,431 M	$5,413 M	$3,228 M	$3,855 M	$3,917 M	$5,190 M	$3,385 M

Now, here’s the puzzle. According to IBM’s financial statements, gross margins across STG were only down four-tenths of a percent in the first quarter of 2010, to 33.6 percent against external revenues of $3.38 billion. IBM also had $173 million in internal sales to other IBM divisions, which peddle appliances and other hardware based on STG products. That brought total revenues for STG to $3.56 billion, up 4.5 percent compared to the combined external and internal sales in the first quarter of 2009. So the cost of putting technology in the field rose a little faster than revenues, which is what you would expect during product transitions. But pre-tax income for STG, which was awful a year ago at only $28 million, meaning STG was losing money after IBM paid its taxes, was even worse this year, with a pre-tax loss of $170 million.

Whoops.

That would seem to imply that sales, research, and development costs hit STG hard in the first quarter, which is what you would expect given the Power7 and System z11 transitions. And that, perhaps more than anything else, explains why IBM has moved up Power7 announcements as much as possible and will no doubt try to get the System z11 mainframes out the door as quickly as it possibly can. I don’t happen to think IBM can afford to wait until September to announce the z11 mainframes, just like it could not wait until May, as it had planned all along, to launch the Power7 machines.

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