Let’s Take a Deep Dive Into IBM’s System Sales in Q3

November 8, 2010 Timothy Prickett Morgan

Well, I took a little time last week and I found the bug in my Excel spreadsheet model of IBM‘s quarterly revenues for its systems, and that means this week I can tell you what I think happened in the server racket for Big Blue in the third quarter. You will recall that back in August I admitted that something was wacky in my model where it broke server sales down by platform type, and it turns out I had three cells in the chart that were making absolute references instead of variable ones as I cascaded the equations. Anyway, it is all fixed, and I am happy to share the updated Q2 and now Q3 figures with you.

As I have cautioned you in the past, I am not an insider at IBM and I am also not at one of the big IT consultancies that get help from Big Blue as they build their economic models of the server business each quarter. Since 2006, I have had to build a model of IBM’s sales of mainframe, Power, and X64 server sales because no one else is doing it any more on Wall Street (I was perfectly content to use Salomon Smith Barney or Merrill Lynch numbers in the past), and in August I made a typo in three cells that screwed the model up. I was tired and didn’t see it, but I caught the error and fixed it. And not only that, but when I plugged in the publicly available information from IBM about its System and Technology Group sales in Q2 and Q3, the numbers matched about as perfectly as you could expect. (Within a few tenths of a percent, which isn’t bad considering that IBM is clearly rounding its own percents in its presentations.) The table I normally put into this story’s column going back to Q1 2008 no longer fits in the column, so you will have to click this much larger and easier to read version.

It is hard to take data in quickly with a table, so here is the normal pretty picture showing the quarterly sales of IBM’s System z, Power Systems, and System x rack and tower/BladeCenter X64 blade machines:

What is immediately obvious from this chart–and what you cannot know from the presentation that IBM puts together–is that the X64 portion of Big Blue’s server business is recovering better than the transition-weary mainframe and Power iron, but even with that, these machines have posted the best third quarter that IBM has had since 2006. In fact, last quarter was one of the best quarters that IBM has had in the past four years. The Power Systems business had a sequential decline as well as a quarterly decline and is trending about $300 million a quarter on average lower in 2010 than it was in 2006 and 2007 before the Great Recession kicked in.

To get anywhere near 2008’s sales levels for System z and Power Systems, IBM would have to have the best Q4 in its history, with double the normal sales level. That ain’t gonna happen, no matter how well received the entry and high-end Power7 boxes and System zEnterprise 196 mainframes are at IBM shops. To match 2009’s annual sales levels, IBM has to push $966 million in System z boxes and $1.7 billion in Power Systems servers. The former is not only possible but probable (if there is as much pent up demand for faster mainframes as there should be), while the latter is possible but not probable. It really depends on demand for Power 720 machines at IBM i shops and Power 795 machines at AIX shops. IBM’s X64 server biz is already ahead of plan, and that is no surprise. Look at how sales just tanked as the recession was building steam. IBM’s X64 server business was a leading indicator in part, I think, as well as suffering from internal issues relating to product positioning, direct sales efforts, channel sales that slammed Big Blue in the middle quarters of 2008.

Despite that, the uptick in System z sales, what I presume is juicy revenue from fat eX5-based Xeon 7500 servers and fatter Xeon 5600 and Opteron 6100 configurations due to server virtualization, and a rebound in midrange Power Systems revenues have helped the profitability of the Systems and Technology Group. IBM had $4.325 billion in sales in Q3, with another $196 million of machines and chips peddled to other IBM groups and divisions. That gave Big Blue $327 million in pretax income for all of STG. That’s 45.3 percent better pretax income than a year ago and the best margins STG has had in a third quarter in three years. IBM is going to need a killer Q4 to match past history, though, when it come to PTI.

You’ll notice one change, and something I should have been doing all along but it hadn’t occurred to me. In addition to fixing the bug in the Q2 data, I also added operating systems from Software Group to the mix. Just like IBM carves up the Systems and Technology Group pie into servers, storage, chips, and retail systems each quarter, IBM carves up the Software Group pie into operating systems, key branded middleware, other middleware, and other. So you can figure out to several significant digits how much money IBM raked in for operating systems. IBM never talks about what is in this number, but it no doubt includes new sales of AIX or IBM i as well as monthly license fees for z/OS, z/VM, z/TPF, and z/VSE and probably any clustering tools and System Director. It also has to include any resales of Windows or Linux that IBM does for its X64, System z, or Power Systems.

Take a look at this chart to see why IBM loves its software business:

The System and Technology Group’s overall sales are there in red, and you can see how choppy it is and also how the trendline has been down over those four years. By the way, this model removes the effect of the sale of the high-end printer business (somewhere between $346 million and $250 million per quarter in my model) from the IBM data, so don’t think the trendline slightly down and to the right is caused by that. As you can see, the shrinking of sales in retail systems and chips is pulling the line down, but so is the overall sales of IBM’s servers, which are trending toward $2.5 billion quarterly from somewhere closer to $3.5 billion quarterly four years ago. This trend can reverse as we pull more solidly out of the recession, but my gut says that this is the new normal. That is how the past five recessions I have seen in this IT racket have affected server sales. I don’t see why this one should be any different.

But look at that operating system number. Now, provided that most of that is not Windows and Linux distribution, look at how beautiful and flat that line is. And the profit margins are probably on the order of 85 percent to 90 percent for this software–and maybe even higher.

And that reminds me: I need to add maintenance from Global Services to this data next quarter. Then we will have a better picture of IBM’s “real” systems business.

Until then.

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