New Financials At IBM Can’t Mask Growth Issues

April 25, 2016 Timothy Prickett Morgan

It is easy to say that the IBM we know today, or more precisely are trying to get to know as it undergoes its changes, is far different from the one that we were trying to understand two decades ago as it was going through another tumultuous transformation. The Big Blue from the middle 1990s was a systems company before and after that change, but it is harder to see the International Business Machines skeleton inside the new Big Blue.

But if you dig around, that core systems business is still there, even after IBM has completely reclassified its financials in an effort to try to gussy up its image with Wall Street and to reflect its focus on cloud, social, mobile, security, and analytics–the drumbeat of the modern data processing age.

As we pointed out earlier this year, with Steve Mills, the executive who has run the combined Software Group and Systems Group for many years, retired and gone from the company, the way IBM presented itself to the outside world was largely an artificial construct. IBM has always been a systems company, selling hardware, operating systems, middleware, and services to customers who often bought their whole stack from Big Blue. This is certainly even more true now that IBM has jettisoned its X86 server business. Each quarter, we tried to peel apart the numbers and put the systems business back together, and after IBM’s reclassification of its financials, which it unveiled last week, we have done the same thing again. What it shows is that IBM’s systems business continues to shrink, in this case along predictable product lifecycle curves, but when looked at as a whole, beyond the core systems and operating systems, is still a good and profitable business for the company.

In the first quarter of 2016, IBM’s revenues declined by 4.6 percent to $18.7 billion, and its gross profits fell by 8.1 percent to $8.7 billion. After paying taxes and other expenses, IBM’s net income came in at just a hair over $2 billion, down 13.5 percent. This is exactly the opposite direction that Big Blue masterfully pulled off with its financial engineering in the wake of the “near death” experience it had in the early 1990s, when it missed the Unix wave and thought mainframes were going to take over the world. After reorganizing and focusing on services as its salvation, IBM was able to get low single digit revenue growth and double digit net income growth for many, many years, giving it lots of cash to make acquisitions and to buy back an astounding amount of its own stock to boost earnings per share even more. Since Wall Street rewarded EPS growth, IBM’s executives rewarded themselves on the same metric, and it was tough but happy days for IBM. In the wake of the dot-com bust and the rise of the hyperscalers and the cloud builders, IBM lost its way just like other IT suppliers did. The efforts to modernize the mainframe with Linux, OpenStack, Hadoop, and Spark and to broaden the appeal of the Power architecture through the OpenPower collective and the rise of Linux in the distributed datacenter are helping shore up the IBM systems business, to be sure, but growth is not easy and has not been sustainable.

In the quarter ended in March, IBM’s Systems group posted revenues of $1.68 billion, down 21.8 percent as both the System z13 and Power8 launches from the prior two years have wound down. Under the new classification, IBM has provided some sense of systems hardware sales–including servers and storage–separate from operating systems that run on them. The company provided detail for the 2014 and 2015 calendar year, while we compiled, and enough percent change data that we can figure it out for the first quarter of 2016, and what that shows is that IBM’s systems hardware business declined by 25 percent to $1.24 billion, and if you drill down into the IBM presentation, within that you will see System z iron fell 43 percent, against a very tough compare last year when sales for Q1 2015 rose by 130 percent. IBM’s chief financial officer, Martin Schroeter, said on a conference call with Wall Street analysts that mainframe margins actually rose, which usually happens in this part of the cycle as companies activate cores (which costs IBM nothing to do) on existing systems.

While IBM showed four quarters of consecutive growth for Power Systems in 2015, it is off to a poor start in 2016. IBM is largely to blame for that. With a lot of people thinking that there was a Power8+ upgrade cycle coming–something that IBM’s own roadmaps suggested last year was the case–we are not surprised if there was a lull in Power Systems sales. Now that everyone knows there will be no new iron for Power Systems until the Power9 comes out next year, we think those companies that need new machines to expand their capacity will buy now if they can’t wait. IBM had better start cutting some deals to move IBM i and AIX customers ahead and stop focusing almost exclusively on its Linux on Power business.

Power Systems sales were off 14 percent, and storage was down 7 percent. IBM is still not providing individual revenue levels for System z, Power Systems, and storage, by the way, and we wish that it would do so, but the company did say that Linux on Power is now driving 10 percent of Power Systems revenues. We think it was only a few percent only a year ago. Operating systems comprised another $432 million of IBM’s systems sales, down 10.7 percent. A large portion of IBM’s operating system revenues come under monthly fees for mainframes, which tends to level it out, but on the Power platform, operating systems are sold when machines are upgraded, so revenues tend to rise at the beginning of a new cycle and fall at the end of that cycle.

IBM also added that of the $1.68 billion of iron it sold in the first quarter, around $500 million of that was dedicated to a cloud in some fashion–be it private or public.

The four other IBM business groups after the reorganization following the departure of Mills include Cognitive Solutions, Global Business Services, Technology Services and Cloud Platforms, and Global Financing. The latter is the same as it ever was, providing financing for IBM’s own wares as well as those of other IT vendors when it can.

We found it particularly amusing to see the stack of mainframe transaction processing systems and related database software tucked up under Cognitive Solutions, where IBM is also putting its Watson QA systems and other data analytics wares. This is a big chunk of the former Software Group and certainly its most profitable pieces. Almost none of the $4.65 billion in revenues and $1 billion in pre-tax income that Cognitive Solutions generated had much to do with the IBM i platform. A year ago in Q1 2015, Cognitive Solutions had a little more than $4 billion in sales and had pre-tax income of $1.53 billion. Revenue has stalled and profit dropped like a stone.

The Technology Services and Cloud Platforms group, which posted $8.42 billion in sales and pre-tax income of only $258 million, has various infrastructure services (hardware outsourcing) and technical support services for IBM’s wares as well as integration software (which means WebSphere for the most part) tossed in. It is amazing that this, the largest of IBM’s groups now, is not more profitable. It certainly was this time last year, when it had pre-tax income of $1.13 billion against $8.55 billion in revenues.

Global Business Services, which is largely unchanged, includes consulting, application hosting, and global process management services and brought in $4.13 billion in revenues but only $190 million in pre-tax income. The revenue is down slightly and the income has been cut by a third.

IBM likes to direct everyone to the progress it is making in its strategic imperatives–cloud, social, mobile, security, and analytics–and Schroeter pointed out that in the last 12 months these areas drove $30 billion in revenues and comprised 37 percent of revenues in 2015. In the first quarter of 2016, he said, the strategic initiatives accounted for $7 billion in revenues and rose 17 percent year-on-year. Analytics was up 9 percent to $4.2 billion. Cloud was up 36 percent to $2.6 billion and the annualized run rate for the “as a service” portion of the cloud business (where IBM itself sells capacity for others to use) is now at $5.4 billion, up 46 percent. Mobile products generated $800 million, up 93 percent, security software pushed $400 million, up 20 percent, and social generated $200 million, down 1 percent. (These growth rates are at constant currency and are somewhat lower in U.S. dollars.)

We gathered up all the data IBM has presented to try to get a view of the “real” IBM systems business based on this new classification, and here is what it looks like:

In our model based on the latest classifications, we are allocating 90 percent of the integration software business, 75 percent of the technical support business, and 75 percent of the financing business to IBM’s own systems. When you do that, the combined bits added up to $5.89 billion in the first quarter of 2016, accounted for about 31.6 percent of total revenues. We think you could add in a chunk of hosted systems and cloud to this, too, but those are not IBM’s own systems in the SoftLayer cloud, they are Supermicro Xeon machines, and even when IBM does do Power-based machines, it looks like it will be using Power9 iron made by Supermicro and perhaps others. The chart makes all too obvious how much of an impact that the sale of the System X business has had on its hardware revenues, but the other parts of the business have declined a lot less. There is a chance that IBM can build a business on Power and maybe even System z that grows.

We shall see. This is the IBM plan, but it may be others that benefit from OpenPower more than IBM itself does.

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