Big Blue Cranks Up The Profit Engine In Q2

July 23, 2012 Timothy Prickett Morgan

You have to hand it to IBM. The major economies that used to lead the global economic engine are having a bit of trouble with the growth markets coming on, and being that International is in fact the company’s first name and Business is its middle name, you would expect for Big Blue to not worry about where it makes its sales or even if sales grow so long as profits do. And that is exactly what the company has focused on and accomplished in the second quarter.

In the quarter ended in June, IBM’s revenues took a $1 billion beating as they are reported in U.S. dollars because of currency fluctuations that are seeing the value of foreign currencies increase against the greenback. In the second quarter, this “currency headwind” shaved 4 percent of IBM’s top line revenue growth, according to Mark Loughridge, IBM’s chief financial officer, who spoke to analysts after the market closed to go over the numbers. Sales came in at $25.78 billion in the quarter, down 3.3 percent, but through cost cutting measures, IBM was able to boost net income to $3.88 billion, up 5.9 percent.

Revenues in the Systems and Technology Group, which lost money in the first quarter of the year, were off 9 percent to $4.26 billion. But system sales across all product lines were only off 7 percent, to $2.81 billion, with Power Systems propped up by some very large supercomputer sales (which get their revenue booked upon acceptance, not when IBM takes the order or builds the machines) and System z mainframe sales doing a little better than expected. That said, pre-tax income for all of Systems and Technology Group was still down by 40.4 percent to $234 million in the quarter, but that is a whole lot better than going into the red ink as it did in Q1. The hope and expectation, no doubt, is that new Power7+ and System zNext processors will be ready for market toward the end of the year and will help bring a revenue and profit bump.

In the quarter, Power Systems sales were down 4 percent at constant currency and off 7 percent as reported because of the dollar dive. IBM said that high-end Power Systems machines continue to sell well, with double-digit revenue growth. While no one wants to say this, it is fair to say that IBM competes very well with bigger midrange and high-end servers using Power7 chips against other RISC rivals and X86 alternatives, but it is probably getting its clock cleaned by Xeon and Opteron boxes with virtualization in the two-socket space that used to represent a lot of revenue and volumes for Big Blue’s AS/400 and RS/6000 businesses in days gone by. (If this wasn’t true, those aggressively priced PowerLinux machines, which have much less expensive hardware and software than plain vanilla Power Systems machines, would not exist.)

Another factor is that the big competitive replacement deals seem to be getting harder to find for IBM. The company did 320 competitive replacement deals in the second quarter, but collectively these deals only drove $265 million in revenues for the company. If this were a year and a half ago, the number of deals would be smaller and the revenue per deal would be larger–somewhere on the order of $1 million a pop on average.

System x revenues were off 8 percent in the quarter (down 5 percent at constant currency), but the high-end of the line had double-digit growth as well. What IBM does not talk about is how many RISC/Unix deals (including those of customers moving off Power Systems iron as well as mainframes) are going to System x and soon PureSystem machines. It would be interesting to see those stats, but don’t expect IBM to reveal that data unless it shows the company gaining against its rivals.

IBM’s storage hardware has been largely divorced from storage software, which now sits over in Software Group under the Tivoli division, so it is no surprise that storage hardware was off 4 percent in Q2 while storage software was up 13 percent. In aggregate, it seems likely that IBM’s storage business grew or at least came to breakeven. (Loughridge didn’t say.)

On the mainframe front, System z sales were down 11 percent as reported, with an 8 percent decline in the aggregate amount of MIPS activated in the mainframe base during the quarter. As always happens toward the tail end of a mainframe product cycle, sales shift from shiny new boxes with big sticker prices to core activations with modest prices. The good news for IBM is that a mainframe core is very pricey indeed, and costs next to nothing to deliver, and hence even with mainframe revenues on the wane, mainframe profits are waxing like a Brazilian supermodel. Mainframe sales in the growth markets were up 11 percent, by the way, so don’t think the System zEnterprise 196 and 114 mainframe cycle is all done yet.

Companies and governments in the BRIC countries and the 36 other growth markets IBM plays in have money to spend. We don’t. They are getting jobs and we are not. It is really that simple. Speaking of which, IBM’s sales in the Americas region was down 1 point to $11.1 billion in the quarter and sales in Europe, the Middle East and Africa were down 9 percent to $7.9 billion. All of that decline was due to currency effects. Sales in Asia/Pacific were $6.3 billion, up 2 percent as reported but up 4 percent in local money. IBM sold $512 million in OEM parts, mostly chips to electronics and game console makers, off 24 percent and not tied to any particular geography. Germany was more or less flat for the third quarter in a row, while Spain and the United Kingdom grew yet again with France and Italy falling. Japan was off 5 points and the United States was flat while Canada continued to grow. (Guess who has an oil boom and didn’t have a housing crisis?)

Sales at Software Group, which peddles all of IBM’s bits, were flat at $6.17 billion, and this unit had $2.49 billion in pre-tax income, up 7.9 percent. The secret, of course, is that a lot of the profits in the software biz come from systems software like operating systems and middleware that is tied to IBM’s own systems, so this explains why IBM doesn’t ditch hardware entirely. (It may someday. Don’t be surprised.) Operating systems accounted for around $620 million in sales, and middleware software–outside of the five key brands, WebSphere, Information Management, Tivoli, Lotus, and Rational–accounted for around $1.1 billion. WebSphere was up 3 percent in the quarter, database and related products fell 1 percent, Tivoli was up 2 percent (thanks to storage software), Lotus was off 8 percent (no explanation but I blame Google Apps and Microsoft Office 365 and SharePoint), and Rational fell 7 percent.

The beast that is Global Services had a 2.9 percent revenue drop to $14.66 billion, but raked in $2.56 billion in pre-tax income, an increase of 18 percent. So now you know why IBM is in a constant state to offshore jobs overseas in its services unit. It has to do that to throw off profits in a Global Services unit where revenues have stalled and the backlog is down 6 percent to $136 billion. Again, a lot of this is currency effect. Global Services was up a point or so and the backlog was flat in constant currency.

What IBM is focused on is two things: Operating earnings per share between now and 2015 and free cash flow. After posting its Q2 results, IBM raised its EPS guidance for 2012 by a dime to $15.10, up a quarter since the beginning of the year and probably up another quarter before the year ends–if not more. IBM wants to get to $20 per share EPS on an operating basis (meaning, not counting the effects of acquisitions or divestitures) by the end of 2015.

The other thing is that it needs cash to do this because it requires buying back shares and doing acquisitions that add to profits, so generating free cash each quarter is key. Loughridge said on the call that in the tailing four quarters, IBM has generated $18 billion in free cash, which is more three times the level of cash it threw off when it was an $82 billion company back in 2002. That is a 200 percent increase in cash against a 24 percent increase in revenues if IBM hits $102 billion in sales in 2012.

“I think that is a real achievement,” said Loughridge, “because that free cash flow is what we use to power this engine.”

Think about that cash pile the next time you are doing your deal with IBM. You paid for that. IBM should send you a thank you note.

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