Power Systems Bucks The IBM Trend And Grows

April 24, 2019 Timothy Prickett Morgan

The Power Systems business continues to grow, and that is good news for all IBM i shops, particularly for those of us who actively want for there to be boisterous competition in server processors and systems architecture. It comes as no surprise that we think Big Blue still has much to offer when it comes to engineering systems that provide real differentiation in the market. The ongoing growth of Power Systems – maintaining the happiness of the substantial IBM i and AIX customer bases and expanding the Linux base – is what is required for IBM to continue to make the heavy investments in processor and system design that it has done since launching the Power architecture back in February 1990.

IBM has done a bit of rejiggering in its financial reporting segments as it prepares to absorb open source software giant Red Hat, which it offered to acquire for $34 billion last fall, into its organization sometime in the second half of this year. This rejiggering was also done as IBM is preparing to sell the Domino collaboration software and various on premises marketing applications to HCL, sells off its remaining marketing applications to Centerbridge, and has just completed selling off its Seterus mortgage servicing business to Cooper Group. In the first quarter, these businesses represented around $417 million in revenues, so this time next year, when those businesses are gone, the Q1 2019 numbers will be that much lower when looked at from a continuing operations perspective.

The good news is that Red Hat is a $3 billion (annual) software company growing at 25 percent or so, and its numbers will snap in and more than make up the difference. As part of the reporting segment rejiggering, IBM merged its cloud software and so-called cognitive software into one group – cognitive means database, analytics, and transaction processing platforms – and also merged its security services with its security software. The latter makes good sense. I think it is a stretch to call databases, transaction monitors, various middleware, and such “cognitive” but IBM has to try to shape some sort of rejuvenation story that Wall Street will buy – as do all IT vendors that have been around for as long as Big Blue has been.

In the first quarter ended in March, IBM’s total revenues were $18.18 billion, down 4.7 percent, and the company posted net income of $1.59 billion, down 5.2 percent. IBM is generating plenty of cash, although nothing like a hyperscaler does, and finished the quarter with $18.14 billion in cash and securities, roughly equivalent to that first quarter of revenue. IBM is building up its war chest to pay for that Red Hat deal, and is selling those software units above to raise money to pay off Red Hat shareholders, who have given the acquisition the green light. (Regulators in the United States, Europe, and China have yet to weigh in, but they will.)

IBM’s Systems group, which peddles System z and Power Systems servers as well as storage arrays and software and operating systems for these devices, had sales of $1.33 billion to reseller partners and end users, down 11.5 percent, with another $163 million sold to other IBM groups and divisions, up 6.5 percent year on year. Total systems sales came to $1.49 billion, down 9.8 percent. We estimate that within these figures, IBM sold about $907 million in systems hardware (adding up server and storage hardware) externally, down 16 percent, and operating system revenue came in at $428 million, down 2 percent. We reckon that gross profits for all of Systems group were around $628 million, but due to ongoing investments, pricing pressure in the server market in general, higher component costs, an unfavorable mix of System z mainframe sales, and investment in future System z15 and Power10 processors, IBM booked a pretax loss of $202 million in the overall Systems business. That’s basically the same level of pre-tax loss IBM had in the year-ago period. The first quarter is always a bad one for IBM’s profitability in systems, so this is nothing new, and over the course of a full year, Big Blue makes money.

Jim Kavanaugh, IBM’s chief financial officer, said on a call with Wall Street analysts last week that the strong U.S. dollar has once again provided a headwind that diminishes the effect of overseas sales as deals in euro, ponds, yen, renminbi, and other currencies convert into fewer U.S. dollars than they would have a year ago. For IBM overall, if you measured its growth at constant currency, it is only down 0.9 percent, compared to the 4.7 percent decline as reported. For the mainframe, the as GAAP revenue as reported was down 39 percent in the quarter, and almost the same at down 38 percent at constant currency, while for Power Systems the as-reported sales were up 6 percent but were up 9 percent at constant currency. IBM’s storage sales within Systems group fell 11 percent at constant currency but 13 percent as reported. Operating systems revenues, which includes perpetual licenses for IBM i, AIX, and Linux but a much larger chunk that is for monthly licenses for the System z software stack, rose by 2 percent as reported but increased by 5 percent at constant currency.

As we remind you from time to time, the thing to consider for IBM as a whole is just how big its true systems business is, when you add in all of the software, technical support, consulting, outsourcing, and financing that the company does for its System z and Power Systems lines. We take a stab at estimating this every quarter, and this time around, in Q1 2019, we reckon that this real systems business had sales of $5.95 billion, up 4.7 percent, and that its gross profits were around $3.42 billion, up 12.6 percent. (None of this includes IBM’s public cloud revenues, which we could argue belong in here, or its database or application software, which you could add on.)

This way of looking at things makes IBM look as strong in systems as it really is, as opposed to so-1990s-meets-the-2010s way that IBM talks about itself. To be fair, IBM can only talk about itself in a way that it is measuring itself, and clarity has not usually been the precise goal of financial reporting. Just enough clarity to keep investors and regulators happy is the real goal because too much information can cause more problems for a publicly traded company than not enough. In any event, this real systems business foundation represents about a third of the company’s revenues and about 40 percent of its gross profits, depending on the quarter.

That brings us to Power Systems, the iron upon which IBM i runs. This is the sixth consecutive quarter that the Power Systems business line grew, and the push of Linux on Power is paying off, particularly in the HPC space. SAP HANA in-memory processing, and various kinds of data analytics, particularly the kind that uses machine learning with GPU acceleration to provide the training for neural networks. The Power9 upgrade cycle for customers running big workloads on Oracle 11g and 12c as well as IBM Db2 databases is also helping, particularly at the high end of the Power line. “Both the high end and entry level offerings posted strong growth this quarter as clients continue to adopt this new technology,” Kavanaugh said in reference to sales of Power-based iron.

But Power-based storage sales, like the high end DS8800 disk arrays, took it on the chin a bit in Q1 2019, and that was due to the downdraft in the mainframe market, which is due mostly to the fact that the System z14 is in the seventh quarter of its life. It would seem that IBM needs a new generation of mainframes (presumably the System z15), but that probably won’t happen until 2021 or so, when the Power10 chips are also expected to be put into at least two exascale-class supercomputers and also be spread across the more generic Power Systems line.

Based on our revenue model for Power server sales and storage sales based on Power iron (like the DS series), here is how we think the quarter mapped out compared to those since the Great Recession started in 2009:

The first quarters for 2017, 2018, and 2019 have been trending upwards, however slightly, and would have looked even stronger had storage hardware sales not taken a 13 percent dive. Just so you don’t have to squint your eyes there, we think that IBM had $302 million in Power Systems sales – again, including servers based on Power processors as well as a portion of the storage array hardware sales that come from things like the DS series – up 3.8 percent. This does not take into account sales of operating systems for Power iron or sales of Power machinery to IBM’s outsourcing customers. That could have added substantially to the revenue stream from Power, but we have no way of guessing how much that could be. We recently went out on a limb to try to reckon these numbers for all of 2018, and that is about as far as we feel comfortable doing.

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