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IBM: Revenues down, profits up in Q2

Raises earnings guidance for 2009

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IBM's top brass must surely be glad that the acquisition of Sun Microsystems that was in the works since last November fell apart in the spring. Because the current configuration of Big Blue, with its emphasis on services and software and decreasing dependence on hardware, means it can continue to generate profit growth, even when hardware sales are slammed and software and services sales take some hits, too.

In the second quarter ended on June 30, IBM reported total sales of $23.25bn, down 13.3 per cent, more or less in line with other big players in the IT sector. And its gross profits were down 8.8 per cent to $10.6bn. But through the magic of cost cutting (including surgical layoffs), of integration of its global businesses (meaning consolidating and offshoring major operations such as managing its customer support centers or supply chain, but IBM never admits that), of acquiring small, profitable software and services companies, and of exiting unprofitable commodity businesses, IBM was still able to boost net earnings by 12.2 per cent to $3.1bn.

If the economy moves from a recession to a full-blown depression, presumably IBM's profits, thanks to its oft-professed "business model", would shoot right through the roof.

Anyway, whatever IBM is doing to cut costs and boost margins - and chief financial officer Mark Loughridge has been understandably vague over the past several quarters about "workload rebalancing" and other initiatives that are driving margins - it is working out better than expected, because IBM is now saying that it can hit $9.70 per share earnings in 2009, up from its previous guidance of at least $9.20 from earlier this year, and putting it well on track to its goal of delivering $10 to $11 EPS in 2010. (As if anyone except Wall Street cared about EPS, which IBM largely makes happen through the billions and billions of dollars it expends buying up mountains of its own shares.)

While the company may still be called International Business Machines, the machinery was certainly nothing to brag about in the second quarter. Revenues for its Systems and Technology Group, which designs, manufacturers, and sells chips, servers, and storage, fell by 26 per cent to $3.85bn. This drop was more or less in line with the overall server market, which cratered in the first quarter (see here and here) and which are expected to do a little worse in the second quarter just ended.

Revenues for IBM's System z mainframes were down 39 per cent, and the aggregate amount of mainframe processing capacity (as measured in MIPS) fell by 20 per cent. Loughridge said that in growth markets (meaning not North America, Western Europe, or Japan), mainframe sales were actually up by 17 per cent when measured in local currencies. To help boost mainframe sales, IBM is going to put out special "solution edition" bundles of mainframes, complete with enterprise software stacks and security software.

Power Systems servers, which run AIX, OS/400, and Linux, had a 13 per cent decline in the quarter, but IBM believes that it gained yet more market in the second quarter (the fifth quarter in a row that IBM has done this, apparently). Loughridge said IBM has done over 100 competitive replacements of Unix iron in the quarter, and that in the first six months of the year, the value of Unix competitive replacements accounted for nearly $250m in revenues.

IBM believes that even though its System x server business, which includes blade, rack, and tower machines using x64 processors, declined by 22 per cent in the quarter, it nonetheless gained some market share, just like it did in the first quarter. IBM lost quite a bit of market share in the third and fourth quarters of 2008 and it is not clear when the company will get back to where it once was.

IBM was pretty vague about its storage business, except to say that it had double-digit declines in disk and tape storage and an overall 20 per cent decline for all types of storage when all sales worldwide are reckoned in U.S. dollars. Loughridge did say that the mix of software sales was shifting from hardware to software (including features for deduping, replicating, and otherwise fussing with data), and that Big Blue had added over 100 customers for its XIV clustered storage arrays in the quarter.

OEM chip sales fell by 23 per cent.

The margin expansion story - and the reason why IBM is throwing off cash and is able to buy back so much of its shares - is happening in its two services groups. Global Technology Services, the part of IBM that does outsourcing and technical support, reported sales of $9.1bn, down 9.8 per cent, but gross margins were 34.8 per cent (up 3.2 points), getting close to the margins that IBM has on hardware. Global Business Services, which does business process engineering, application outsourcing, and systems integration, reported sales were off an eye-opening 15 per cent, but gross margins here were also up, to 27.2 per cent (an increase of 1.4 points). Loughridge said that while outsourcing revenues were down in the quarter because existing customers were tightening their belts, other customers were looking for ways to cut costs and IBM's signings for new strategic outsourcing and business transformation and optimization contracts rose by 13 per cent to $6.7bn. IBM's total signings across the two services groups came to $14bn in the quarter, and the company had a $132bn service backlog as it exited the quarter, about the same as it had last year.

The real profit engine - and one that is less and less dependent on IBM's mainframes and proprietary midrange servers - is IBM's Software Group, which booked $5.17bn in sales in the quarter, down 7.3 per cent, but still manage to boost gross margins to 85.9 per cent (up 1.3 points). IBM said that its WebSphere middleware family actually had real sales growth of 8 per cent in Q2 (up 17 per cent in constant currency), while sales of its Information Management line (DB2 databases, Cognos business intelligence tools, and such) fell by 4 per cent. (Cognos product sales rose by 20 per cent in the quarter, so don't blame them for the decline.) Tivoli systems management and security products saw a 2 percent decline in the quarter, and so did Rational development tools. IBM's Lotus family of groupware and messaging servers and related client software had a 14 per cent decline in the quarter, which Loughridge attributed to a "softening in demand driven by customer consolidations and downsizing."

During the quarter, IBM generated more than $4bn in cash from operations and spent $700m on dividends and $1.7bn on share buybacks. In the first half of 2009, IBM has shelled out $4.8bn in cash to buy shares and pay dividends, and exited the quarter with $12.5bn in cash and actually paid down some of its long-term debts not relating to the financing of equipment to resellers and end users, which amounted to $22.8bn in Q2 compared to other long-term debts of $6.6bn. Ignoring that Global Financing debt, IBM has a net cash position of only $5.9bn, and now you can see another reason why IBM didn't really want to buy Sun. It would have to blow all of its cash, issue stock or debt, or stop its share buybacks to do the deal. And for IBM, for some reason that must only make sense on Wall Street, is focused mostly on that earning per share growth that is enabled through cost-cutting and share repurchases.

Beyond the upwardly revised EPS guidance for 2009, Loughridge did not provide any other guidance for 2009, except that IBM did not believe that the effects of the stimulus spending by the governments of the world had kicked in yet and that its current models for profitability did not have stimulus effects built in, but rather assumed that things stayed more or less as they are now. But, Loughridge said, when the economy does improve and becomes a tailwind instead of a headwind, IBM was positioned to "come out even stronger." ®

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