IBM's mainframe upgrade cycle weakens

With IBM missing Wall Street's expectations for revenue growth in its third quarter by $103m, a sell-off in after-hours trading was already underway and will no doubt be in full swing when the market opens up tomorrow.

Wall Street just doesn't get Big Blue.

What the Street's moneymen don't realize is that IBM doesn't care about revenue growth. What IBM does care about is making profits and boosting earnings per share because that is how it measures its own performance and how its top brass is compensated.

Revenue is not irrelevant, but it is not the point.

In the quarter ended in September, IBM's revenues were up 7.8 per cent, to $26.2bn, but thanks to sales, marketing, interest, and income tax expenses that grew faster than revenues, net income only grew by 7 per cent to $3.84bn. But thanks to share buybacks, earnings per share rose by 13.1 per cent to $3.19.

Most of the questions posed by Wall Street analysts on the call with IBM after the market closed were in one way or another related to macroeconomic issues, with the tech analysts trying to recon the state of the global economy from the books of International Business Machines.

Judging by this, you would reckon that the economies in North America, Canada, and the United Kingdom were doing alright, and some 40 other growth countries that had double-digit revenue growth around the globe were doing fabulously.

That said, in some places the growth is decelerating and IBM has some pretty tough compares – particularly for its mainframe and Power Systems lines – coming up in the fourth quarter.

Hardware humming along

In the quarter, IBM's Systems and Technology Group, which was merged with its Software Group back in July 2010 but which it still reported as a separate group, had $4.48bn in revenues in Q3, up 3.6 per cent despite flagging System z mainframe sales.

IBM CFO Mark Loughridge said that the mainframe slowdown was no better or worse than the last three mainframe cycles, and that this one fell "right in the middle" of the past slowdowns in the year following a major update to the zSeries and System z machines.

System z sales in Q3 were down 5 per cent, and that was despite the launching of the midrange zEnterprise 114 midrange machines in July, which should have helped sales. But mainframes saw a 5 per cent decline in revenue and an 11 per cent decline in aggregate-capacity computing shipped (as measured in MIPS), and that was after IBM added 80 new mainframe customers in the past year.

IBM's mainframe revenues were up 15 per cent in Q3 2010, and MIPS shipments were up a grunting 54 per cent – the best capacity growth IBM has seen in the past seven years – and maybe for a long time, depending on how the next mainframe cycle goes a few years from now.

The high-end and entry Power Systems lines were updated at more or less the same time last year, and overall Power Systems revenues rose by 15 per cent in the quarter, with high-end, mainframe-class boxes up 50 per cent compared to the year-ago period. Moreover, in the year-ago period, as IBM was ramping up its new Power7 machinery, Power Systems sales were off 13 per cent, so this was an easy compare.

No one asked any questions about the System x and BladeCenter x86-based server business, which was up only 1 per cent overall even after posting a 15 per cent revenue bump in the growth markets as measured in constant currencies in those 40 markets. But IBM's x86 server business was up a staggering 30 per cent in the year-ago period, so that was a very tough compare indeed.

Storage revenues within the Systems and Technology Group were up 8 per cent, and if you add storage software to storage hardware and count it as one line, then sales rose by 12 per cent this quarter.

The main thing that IBM was excited about is that pre-tax income for Systems and Technology Group rose by 7.8 per cent to $318m. And that hardware drives a lot of software and services revenues for Big Blue – particularly those big mainframe and Power boxes.

Software Group posted sales of $5.82bn in the third quarter, up 12.9 per cent, and posted a pretax income of $2.21bn. This is half of the printing press that IBM uses to do acquisitions and buyback shares. (STG prints $5 bills by comparison to the $50 bills that Software Group prints.)

Revenues at IBM's software business were helped by a slew of acquisitions, including Sterling Commerce, Unica, Coremetrics, and Netezza – the latter being a hardware platform doesn't matter, it is part of IBM's Information Management database division.

Netezza had 36 per cent growth in the quarter and has an 80 per cent win rate since 2009, according to IBM. That database appliance business helped the Information Management division to post 12 per cent revenue growth in Q3, but that paled compared to the 52 per cent revenue growth showed by the very wide WebSphere brand of products.

Tivoli system management and security products showed an 8 per cent bump up in the quarter, thanks to strong performance in storage management software, while Lotus groupware had 6 per cent growth. Rational Development tools saw a 7 per cent increase in sales.

The human-powered Global Services behemoth

Global Services has the most people working for it at Big Blue, and generates more than half the revenues and a big chunk of the company's profits. This part of IBM had $15.2bn in sales during the quarter, up 7.7 per cent, and generated $2.47bn in pre-tax income. That's 58 per cent of IBM's reportable revenues before cross-divisional eliminations and 45 per cent of its pre-tax income.

IBM's system-outsourcing business grew by 9 per cent in the quarter, maintenance revenues on hardware and software rose by 5 per cent, and application outsourcing grew 11 per cent. IBM ended the quarter with a services backlog of $137bn, up $2bn from a year ago.

Looking ahead, Loughridge said that IBM was adding a dime to its EPS estimates for 2011, raising it to $13.35 per share. As for the macroeconomic climate and IBM's prospects for the fourth quarter, Loughridge did not provide any specific revenue or profit guidance.

"I think we have a pretty good hand, outside of STG, which has a pretty tough compare," he said – though he was quick to add that STG would "book a lot of business" and "book a lot of profit." ®