Power Systems Show Sequential Revenue Gains

October 27, 2014 Timothy Prickett Morgan

There was not a lot of good news with IBM‘s third quarter financial results when they came out early next week, but one of the few bright spots was that the Power Systems business was at the least showing some sequential growth as the Power8 systems ramp begins in earnest. But the Power Systems division is still down year-on-year, and it is very likely that the declines will continue at least into early 2015.

IBM does not provide revenue figures for its various server lines, and never has included such information in its financial reports. It would be a lot easier on those of us outside of IBM if it was compelled to report such information, but that is not the way financial reporting works, and to be fair, IBM provides a lot more clarity about its various lines of business than many of its peers in the IT sector.

For the quarter, IBM’s revenues continued to decline for the ninth straight quarter, with sales down 4 percent to $22.4 billion and income from continuing operations–meaning not including the IBM Microelectronics division that was just sold to GlobalFoundries falling 12.3 percent to $4.36 billion. IBM posted loss from continued operations of $3.44 billion, mostly related to that sale, and net income was only $18 million, a very sharp decline compared to the $4.14 billion in posted in the year-ago period.

Aside from the chip business, which hurt IBM’s bottom line even when it wasn’t being written off, one of the things that is hurting IBM is the U.S. dollar. The company’s CFO, Martin Schroeter, said on a conference call with Wall Street analysts that Big Blue’s business in its growth markets in Asia, Eastern Europe, and South America has tended to be dominated by transactional business, rather than engagements with steady revenue streams. That refers to organizations building out new systems of engagement, record, and analysis, in the IBM lingo, and that also means buying servers, operating systems, middleware, and databases. These growth markets have slowed down their buying in recent quarters, and to make matters worse, the U.S. dollar is strengthening against foreign currencies. And together, therefore, that means that the revenue that IBM does make overseas in these growth markets translates into fewer revenue and profit dollars when it is brought home to Armonk, New York. IBM hedges against such currency swings, but you cannot hedge everything.

In the Systems and Technology Group in particular, the slowdown in the System x business due to the sale of that division to Lenovo Group took its toll, with revenues off 10 percent. IBM said that it sold around $1 billion in machinery in the year-ago period in a separate document relating to the sale to Lenovo, so that puts revenues at around $900 million. IBM also said in that document that IBM made around $4.2 billion in System x hardware sales in 2013, with another $400 million in support for that hardware, and that the business was essentially breakeven for the year and only profitable in the fourth quarter.

The shrinking IBM Microelectronics chip business and declines in sales of System z mainframes and Power Systems during the transition from Power7 and Power7+ to Power8 machinery also hurt Systems and Technology Group. While Power Systems and storage array revenues were up sequentially from the second quarter, Power Systems sales dropped 12 percent year-to-year and overall storage hardware sales fell by 6 percent. FlashSystem and Storwize storage arrays did comparatively well, but high-end DS series arrays and tape fell by more than enough to offset those gains, and IBM’s revenues were also adversely impacted by the winding down of a reseller agreement with NetApp. System z mainframe sales were down 35 percent, and for the first time in a long time, IBM did not provide a figure that showed the change in aggregate MIPS shipped across the base.

IBM has booked the Microelectronics division as a discontinued business effective September 30 of this year, so it did not have the revenue or the losses from this division on its books in the third quarter. IBM says that 72 percent of the $2.43 billion in sales for Systems and Technology Group were for server sales, which works out to $1.75 billion. That includes System x division revenues, but we did the math above and we know that these X86 products accounted for about $900 million. So that leaves around $850 million in sales for System z mainframes and Power Systems machinery together. Another 25 percent of revenues were for flash, disk, and tape storage, which works out to $609 million. Gross margins for all of Systems and technology Group were 33.9 percent, and this is down 5.9 points. Remember this is after taking Microelectronics out of the year-on-year comparisons. Even with that, pre-tax losses for STG widened to $99 million. Schroeter did not say in the call where the margin pressure came from and it is too hard to guess. What is obvious is that IBM wants to have hardware profit on its own, but IBM, Wall Street, and customers all need to remember that companies buy systems and the profitability of the system has to include systems software, middleware, and support for both that are not going to be sold without the underlying hardware. Perhaps a future IBM financial presentation will show the revenue and profits of IBM’s Power Systems, System z mainframes, and storage systems with all of these elements.

Speaking of which, if you extract operating systems from Software Group, that added another $514 million to system-level revenue, and so did maintenance for hardware and software, which added another $1.78 billion. We can’t know what the margins were for these elements, but clearly, IBM’s revenue stream for the operating systems and support alone is on par with the hardware itself. If you added storage software, middleware, and databases tied specifically to IBM’s systems, it would be even larger.

IBM’s Software Group brought in $5.71 billion in revenues across middleware, databases, operating systems, and application software, down 1.6 percent, and pretax income fell by 3.2 percent to $2.33 billion. The Global Services unit, which comprises the bulk of IBM’s sales and a fair chunk of its profits, had $13.68 billion in sales and $2.49 billion in pretax income. Outsourcing, which includes either systems or applications or both, accounted for 44 percent of revenues and consulting and systems integration accounted for 26 percent. I still have no idea what Integrated Technology Services is (and it is kinda fun not knowing in a way) made up 17 percent. IBM existed the quarter with $128 billion in its services backlog, which is for a mix of long-term and short-term contracts.

For the past five years, IBM has been on a tear to engineer its financials in any way that allows it to get $7 billion in cloud revenues and to have at least $20 per share in earnings for 2015, based on continuing operations not actual operations. (As if you could pretend to not take hits selling off a chip business. The hits are real.) Along with announcing the financial results last week, IBM chairman and CEO, Ginni Rometty, put the kibosh on that plan, which was formulated by the predecessors of both Rometty and Schroeter. That would be former CEO Sam Palmisano and former CFO Mark Loughridge, who both have retired. IBM does not know what its profit outlook will be for 2015, but says it will enlighten Wall Street in January at its analyst meeting.

What we do know for sure is that there are another $600 million in charges for layoffs coming in the fourth quarter and we also suspect that many of the more senior executives at IBM, whose compensation was tied to the so-called 2015 Roadmap, will decide it is a good time to exit Big Blue. If the numbers get bad enough, I would not be at all surprised to see Tom Rosamilia, who is the architect of the System x and IBM Microelectronics spinoffs among other reorganizations at IBM, who used to run the Power Systems division, and who now runs System and Technology Group, tapped to be president and therefore heir apparent to Rometty. But Rometty will want to architect a turnaround before stepping down, and will therefore probably stay until at least age 60, three years from now, unless the numbers don’t improve.