Tough Slogging In Q3 For IBM, Like Everyone Else

October 22, 2012 Timothy Prickett Morgan

IBM is always bragging about how good it is to have annuity-like businesses that pay out, month after month, and in discussing the company’s results for the third quarter last week, the company’s chief financial officer, Mark Loughridge, reminded everyone that more than half of IBM’s sales and about 60 percent of its profits come from these areas, which include mainframe software licenses and services contracts. That other half of the revenue stream can be tough, and that other 40 percent of the profits is not a given, as the financial results for the quarter in September showed.

As happened at Intel and Advanced Micro Devices, IBM has seen business get tougher as September started. Some big software deals in the emerging markets that Big Blue is so enamored of are slipping into later this year, and the launch of new System z mainframes and the impending launch of Power7+ systems (and the confusion around where and when they would come out) didn’t help IBM’s hardware sales do as well as they might have had the timing been different. But the timing wasn’t different, and in the quarter the company’s revenues were off 5.4 percent to $24.75 billion and net income actually fell by four-tenths of a percent to $3.82 billion.

Both numbers were lower than what Wall Street had been expecting, which is why IBM’s shares are off 5.6 percent and down below $200 a pop as we go to press. Wall Street doesn’t like surprises, but in a jittery global economy with an election in the United States causing a certain amount of deer-in-the-headlights, plus a new CEO at the helm at Big Blue, there was bound to be some trouble.

IBM’s Systems and Technology Group was hit particularly hard on the revenue front because of server transitions and because it had divested its Retail Store Systems division, which peddles cash registers and related software and equipment, to Toshiba. IBM sold it off for $600 million and booked a gain of $420 million on the sale, which helped prop up profits quite a bit, but now it doesn’t have the RSS revenue in the STG numbers. Declines across the board in systems and storage were a bigger problem, however. STG revenues were down 13.1 percent to just a hair under $3.9 billion. The good news was that despite that decline, STG had pre-tax income of $124 million, but the bad news is that it was down 61.1 percent from a year ago.

In a conference call with Wall Street analysts, Loughridge said that aggregate MIPS shipping in the System z line were only off 2 percent, but that revenues were off 20 percent, indicating that IBM was doing a lot of processor upgrades on existing systems and perhaps cutting prices a bit deep to move new iron ahead of and after the launch of the System zEnterprise EC12 in late August. He said that IBM was only able to ship the mainframes for 11 days in the quarter, which is more than it would have otherwise done had the boxes been announced in September or October as the original plan was.

On the Power Systems front, revenues were down 2 percent, and 1 percent of that decline was due to currency effects of bringing overseas sales back to the U.S. and converting them into dollars. Loughridge didn’t provide any guidance on how the Power Systems machines were doing at the low, midrange, or high-end, as he often does, but did say that the company did over 260 competitive replacements of Hewlett-Packard and Oracle Unix systems and that these deals generated over $200 million in revenues during the quarter. The just-announced Power 770+ and Power 780+ servers that came out on October 3 and that are getting ready to ship had no direct bearing on the quarter, and it is debatable if they had an indirect one. Customers had been expecting Power7+ machines, especially once IBM started talking up the Power7+ processors in August, but no one knew for sure where they would come out.

Now that everyone knows there will be no entry or midrange Power7+ machines coming out in the rest of 2012, and that the Power 795 will not be refreshed until the Power8 chips come out, the market has some certainty and the fourth quarter could be a bit easier for Big Blue in terms of Power Systems sales. Intel hasn’t put out its “Poulson” Itanium 9500s for HP Integrity and Superdome 2 machines and Oracle just pushed out its Sparc T5 launch to early 2012 (it looks like maybe March or April), so the level of uncertainty will go way down once the Itanium 9500s are out the door.

Somewhat disconcerting is the fact that System x server sales were off 5 percent in the quarter, but even Intel said in its call going over its third quarter that enterprise server buyers got edgy in September, with sales of four-socket machines not doing as well as might have been expected. Sales of processors to hyperscale data center operators were up by 50 percent in Intel’s third quarter, and you have to ask yourself why IBM has not been more aggressive here with dense-packed X86 and Power iron. IBM’s storage sales were off 10 percent, in part due to the reaction to the announcement of the high end DS8870 disk arrays.

Given the new mainframes, new Power7+ boxes, and new DS8870 storage, Loughridge said that IBM was pretty confident that it could boost mainframe sales by 20 to 30 percent (against an easy compare, mind you) and that with a bump in Power Systems and storage sales, STG could show growth in the middle single digits and pretax income up in the double digits in the fourth quarter.

At this point, Global Services and Software Group each contribute about the same in pre-tax income, although it takes three times the revenue to get a dollar of profit from services as it does from software. Global Services exited the quarter with a staggering $138 billion backlog, up 1 percent from a year ago, and booked $14.46 billion in sales in the September quarter, down 4.6 percent, with pre-tax income of $2.43 billion, off 1.4 percent. I am getting bored with the pretense that Global Technology Services and Global Business Services are separate entities, since this was an artificial construct to give new CEO Ginni Rometty her own domain to prove herself a few years back–which she did.

Here’s what matters. If you do the math from IBM’s statements and pie charts, then system outsourcing sales were off 5 percent to $5.79 billion and application outsourcing was down 7 percent to just a hair above $1 billion. IBM keeps saying that it is taking revenue hits as it extracts itself from low-profit services gigs. Smarter Planet, SmartCloud, and business analytics, which eats up a lot of oxygen at Big Blue these days, all fall under consulting engagements and represented something on the order of $1.5 billion in revenues. Integrated technology services (and I still don’t understand what that means, but it is not systems integration) accounted for $2.31 billion in sales in Q3 2012, down 1 percent, and consulting and systems integration together brought in $3.47 billion in revenues, but fell 6 percent.

That leaves Software Group, which had a nine-tenths of a point decrease in the quarter, to $5.76 billion, but still has 88 percent gross profit margins and still increased its pre-tax margins by 6.3 percent to $2.35 billion. Clearly, IBM hoped to grow Software Group more and profit more, balancing out a tough quarter for hardware and services. Operating systems accounted for $576 million in revenues in the quarter, and the five key middleware brands together accounted for $3.63 billion in revenues, leaving other products, mostly mainframe systems software, bringing in another $1.09 billion. IBM said that Rational development tool sales took a 16 percent hit–something bad happened there–and Lotus groupware took a 10 percent hit–something bad happened there, too. WebSphere middleware and ecommerce software sales were actually up 2 percent, and the Tivoli systems management, security, and storage software rose by 5 percent. Information Management products, dominated by DB2 databases and tools, fell by 1 percent in the quarter.