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IBM juices profits in Q2 despite sales drop

Servers stall, currency flux erases $1bn

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Big Blue has once again demonstrated that it knows how to wring profits out of itself even as revenues across its many product lines have stalled in the wake, of or in anticipation of, product transitions.

In the second quarter, which ended in June, IBM's sales were down 3.3 per cent, to $25.78bn, but intellectual property sales and tight expense controls helped to boost the company's net income in the period by 5.9 per cent, to $3.88bn.

Earnings per share (EPS), bolstered by $3bn in share buybacks, rose by 11.3 per cent to $3.34. This is how IBM grades itself. Specifically, the profit roadmap established by former IBM CEO Sam Palmisano and carried forward by current CEO Ginni Rometty calls for IBM to hit at least $20 in operating EPS by 2015.

This, apparently, is what some IBMers are calling the "profit roadkill" – because they are not getting raises this year, or worse, are being laid off.

In any event, this roadmap is what IBM's top brass are focused on, and in a conference call with Wall Street analysts after the market closed, Mark Loughridge, Big Blue's CFO, said that the company was raising its projections for operating EPS this year by a dime, to $15.10.

When measured in local currencies, the quarter "was fairly consistent with the first quarter," said Loughridge on the call, but the currency headwind, which was bad in April and got worse as the quarter progressed, impacted reported revenues by 4 per cent, wiping out $1bn in overseas sales that were converted to US dollars to be put on the books.

What Loughridge and his peers up in Armonk, New York are focused on is not just earnings per share but free cash flow, and as he ended the call with analysts, Loughridge tossed out an interesting statistic. Last year, IBM generated $16.7bn in cash, and in the trailing four quarters, free cash flow was $18bn.

Ten years ago, when IBM was not much smaller because it was in a lot more unprofitable businesses, the company only generated $6bn in cash. That's a whopping factor of three expansion in free cash flow against a 25 per cent expansion in revenues.

"I think that's a real achievement because that free cash flow is what we use to power this engine," Loughridge bragged. That money is used for acquisitions, share buybacks, and dividends.

Walking through the groups

The Global Services behemoth that dominates IBM had $14.66bn in sales in the second quarter, down 2.9 per cent from the year-ago period.

Global Technology Services – that part of the Global Services beast that does outsourcing, maintenance, and technology services related to systems – had just under $10bn in revenues as reported, down 2.4 per cent but up 2 per cent at constant currency. Gross profit margins were actually up 2.3 points to 36.3 per cent on an as-reported basis.

Global Business Services, which does various consulting and systems integration services, business process re-engineering, and application outsourcing, had $4.67bn in sales, off 4.1 per cent as reported. Gross profits also rose here by 1.8 points to 30.7 per cent.

Across both units of Global Services, pre-tax income came to $2.56bn.

IBM exited the quarter with a $136bn services backlog, which is flat at constant currency but down 6 per cent when reckoned in US dollars at current exchange rates. Loughridge said that within the major markets, North America was stable, Japan was down but improving, and Europe decelerated compared to the first quarter of the year.

IBM wants everyone to know that the GBS segment drives Smarter Planet engagements, and therefore a lot of hardware and software sales, so we shouldn't get too focused on the way the revenue gets allocated.

IBM's Software Group had $6.18bn in sales, dead flat against a very tough compare with the year-ago period and gross profits stayed the same at 88.4 per cent. The group delivered $2.49bn in pre-tax income, up 7.9 per cent from Q2 2011, and that is what, again, IBM is focused on.

The Websphere family of middleware products saw a 3 per cent sales jump, and Tivoli systems management tools (driven by storage management) posted a 2 per cent bump, but database and other information management products took a 1 point hit, Lotus groupware took an 8 point hit, and Rational development tools took a 7 point hit. Add those five branded software lines up, and revenues were up a smidgen.

Other software, mostly running on System z mainframes and Power System-IBM i platforms but also including AIX licenses, declined by a smidgen.

The Systems and Technology Group is at the tail end of the System zEnterprise 196 and Power7 system cycles and at the beginning of the x86-based System x ramp. IBM was expecting to see declines until it launches new products in the second half based on Power7+ and zNext processors and ramped up Xeon E5 system sales.

Loughridge said on the call that the high-end Power and System x lines had double-digit revenue growth despite these issues, and said that thanks to mainframe sales in the growth markets, which rose by 11 per cent, System z sales were not as bad as expected.

Still, System z sales were off 11 per cent in the quarter and the aggregate amount of computing capacity shipped or activated during the quarter on existing machines fell by 8 per cent. Because IBM is doing a lot of capacity-on-demand processor upgrades on existing mainframes these days, profit margins for System z are on the rise.

IBM's Power Systems biz was certainly helped by the deployment of a bunch of BlueGene/Q machines during the quarter, including the 16.32 petaflops "Sequoia" beast at Lawrence Livermore National Laboratory.

But the many BlueGene/Q machines sold were not enough to counter the fact that Power7+ chips are coming later this year for general-purpose machines, and everyone knows it. So Power Systems revenues were down 7 per cent in the quarter, and that is after doing 320 competitive Unix replacements against HP and Oracle, which generated $265m in new business.

By the way, the contract size on these competitive deals has been shrinking in the past several quarters. They had been averaging about $1m a deal, and now it is more like $830,000.

System x rack and tower and BladeCenter blade server sales were down 8 per cent, and no one knows where IBM is putting PureSystems sales, but it seems likely that these will be counted as System x boxes, except for those shops that use Power-based compute nodes.

IBM's storage sales were down 4 per cent, and part of that is because IBM has shifted storage software out to the Tivoli brand in Software Group instead of keeping it inside Systems and Technology Group.

By geography, sales in the Americas were down 1 per cent to $11.1bn and EMEA took a 9 per cent hit to $7.9bn as reported, and the Asia/Pacific region was up 2 per cent to $6.3bn. IBM's OEM sales, which come mostly from processors for game consoles, were down 24 per cent to $512m.

Loughridge said that on a constant currency basis, revenues in the United States were flat, but Canada was up and that means Central and South America must be losing steam somewhere. The United Kingdom showed growth for the eleventh straight quarter, and Spain was up for the seventh. But Germany was essentially flat for the third quarter in a row, and Italy and France were down. Europe is a mix bag – of angry cats, apparently.

The major markets – meaning North America, Western Europe, Japan, and Australia/New Zealand – were down 1 per cent in constant currency. That's compared to an increase of 8 per cent for the 40 growth markets IBM is shifting its attention (and jobs) to, and a 12 per cent increase for Brazil, Russia, India, and China collectively. Big Blue's sales in China were up 24 per cent, and you can bet that Ginni Rometty is going to be spending a lot of time in Hong Kong, Shanghai, and Beijing.

IBM finished the quarter with $11.2bn in cash and non-financing debt of $9.8bn. The company has another $22.6bn in debt related to its financing activities for downstream channel partners.

IBM is realistic about the macroeconomic issues it faces, but has plans to cut costs to make up for lost revenues and to expand in the growth markets where easier money lies.

"Overall, we feel optimistic about the second half despite the headwinds that we face," said Loughridge. ®

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