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IBM reports marginal Q4: Pensions remain a drag, but software, services are strong

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Armonk (NY) - It was not the record fourth quarter that some analysts had predicted for IBM - in fact, it wasn’t even close. Looking at the numbers leading up to Q4 2005, one wonders how record profits could have been expected. Instead, IBM did indeed post higher profit percentages...on lower revenues.

The sale of the company’s personal computer unit to Chinese manufacturer Lenovo, said IBM’s chief financial officer, Mark Loughridge, this afternoon, may have saved the quarter from looking completely bleak. 2005 was not a particularly good year for IBM, although the company tried to avoid characterizing it that way in any respect other than mathematical. Revenue was down 12% for the quarter year-over-year, to $24.4 billion, capping off a year where revenue overall dropped 5% over 2004, to $91.1 billion.

Fourth quarth 2005 results from IBM Corp.

So where did the company take the hit ? If you adopt Loughridge’s frame of mind, a lot of it was due to circumstances beyond IBM’s control. Dividing the company into its constituent components, it’s hard to find the problem. Revenue from the Services division dropped 5% year-over-year for the quarter, to $12 billion, while the Software division’s revenues remained flat last quarter, year-over-year, at $4.6 billion. One might like to focus on what appears, on the surface, to be a 27% drop in revenues in the hardware division last quarter, year-over-year. But that particular pair of parentheses is due to IBM’s sale of its PC division to Lenovo, the revenues from which still have to be reported for 2005 in some cases, though apparently not for 2006 - to the company’s very apparent relief. Omitting the PC division from the figures, revenues for the hardware division actually gained 6% in the quarter, year-over-year, to $6.9 billion ; while for 2005, the division brought in $21.4 billion in revenue, up 5% over 2004.

The cost of pensions is weighing down not only on IBM this year as a company, but on the mind of its financial chief. "Retirement related plans - both pension and health - were a year-to-year hurt of $522 million," Loughridge reported this afternoon. "For the full-year...retirement related costs were up approximately $1 billion, in line with our estimates at the beginning of 2005. In spite of the fact that our pension plan changes will save us between $450 - 500 million in 2006, retirement related expense will still increase another $400 - 500 million year-to-year," he warned.

Full year 2005 results from IBM Corp.

The accounting changes that all large companies are undertaking, to account for the way they report the value of options contributions, has resulted in IBM coming under the microscope this month. Last Thursday, the US Securities and Exchange Commission announced it has launched a formal investigation into how it reports the value of options it grants its employees. Options are among the perks that companies such as IBM have granted to employees as part of - or in some cases, in place of - their pensions. Under the new SEC rules which took effect last year, companies must deduct the cost of option dispensations from their own income. With the price of IBM shares rising, the SEC is wondering whether the company is undervaluing this expense. But critics charge that the SEC has put forth no set formulas for companies to use to evaluate options values on a particular timeline, and contend that companies like IBM can’t exactly break a law that hasn’t really gelled. The SEC matter did not come up in this afternoon’s conference, nor was it even alluded to by analysts.

Mark Loughridge also noted that IBM’s profit growth was negatively impacted by a decline in IP income, down $70 million year-to-year. So count IBM as not among the companies making up for lost revenue by cashing in on investments in other people’s patents.

If you consider IBM as a mainframe and processors company, in terms of hardware, it’s actually doing moderately well. But the balance of the company is shifting, said Loughridge. Looking at profit margins, you begin to understand quite well : IBM’s hardware division reported a gross profit margin of 42.1% for the fourth quarter. Compare that to a 27.4% gross profit margin for the services division, whose growth momentum is fueled entirely by humanpower - the costliest of all businesses. On the other side of the spectrum, though, is the software division, with an astounding gross profit margin of 89% for the quarter.

Building on that theme, Loughridge used a pie chart to demonstrate what he explained to be the company’s current business model. When you break down the company in terms of profit, he said, the Hardware division only accounts for 28% of what the company earns. By contrast, the Services division - the one that requires the most staffing to maintain - pays off by contributing 35% of the company’s profits. It’s the Software division, if you can believe it, that’s responsible for the remaining 37% of profits. Given the fact that Software reaps only about 38% the revenue of the Services division, that profit number is electrifying - enough to make one say that IBM is practically a software company.

Which brings us to the stars of the day : Middleware, of all segments, was the stellar performer for IBM. Revenues from the company’s WebSphere product line increased 4% for the quarter, year-over-year, with Tivoli’s revenues up 3% and Lotus (can you believe we’re talking about Lotus ?) perking up by 2%. "Lotus continues to enjoy strong customer response to the Domino Version 7 product line, as well as very high interest in Workplace software," Loughridge said, referring to his company’s collaboration software platform. "Workplace more than doubled both year-over-year and sequentially," he added. But Rational software declined 2%, as its development tools continue to fall out of practice among software artisans moving to XML-based platforms.

One of the most interesting stories told by the Hardware division this quarter comes from its eServers, which are clearly divided into distinct categories. Its zSeries is comprised of its top-of-the-line mainframes, many of which are now based on Linux. In a throwback to the old days of performance measurement, zSeries deliveries are still measured in MIPS (millions of instructions per second, for those of you too young to remember the ’80s). In that category, MIPS shipments increased 28% for the fourth quarter, year-over-year, with revenues increasing 5% in that time period. The company’s pSeries of Unix-based midrange servers also fared well, with revenues increasing 4%. But IBM’s line of iSeries - based mainly around its proprietary i5/OS, but with options to run AIX, Linux, or Windows - suffered an 18% decrease in revenues, while its Intel-based xSeries, which primarily runs Windows on Xeon processors, garnered flat revenues for the quarter.

You’d think xSeries would be underperforming, or that demand for Xeon processors wasn’t rising at the rate of demand for, of all things, big iron. But that’s not the problem here, reported IBM’s Loughridge : "We posted our highest volumes in xSeries history," he told a Prudential Securities analyst, "and are growing double-digit at 13%, so we gained volume share for the third consecutive quarter. However, our revenue per unit has declined year-to-year, resulting in 4% growth at constant currency." Loughridge blamed three factors : While shipment volumes in the high end actually grew 31%, he stated, revenue per unit has eroded, largely due to what he called "competitive price pressures." From the content of the analyst’s question, you can take that to mean, "HP." Secondly, pressures in the Asia Pacific and European market have triggered even more price drops (read : "HP"). Third, Loughridge admitted honestly but quickly, "we under-called demand on some products in the fourth quarter, and were not able to secure supply to satisfy demand."

A surge in demand for IBM’s new storage appliances led to a surprising 24% increase in revenues in Q4 2005, year-over-year. And for those of you who think IBM was serious about exiting the microprocessor business, demand for its Power5 processors - in high demand for high-capacity computing clusters - pushed revenues for IBM’s Microprocessors division up a phenomenal 48% over Q4 2004.

"The strength of the IBM business model," the company’s CFO said this afternoon, "is not in any single component. It is in our ability to generate consistently strong cash and earnings, with balanced contributions across our broad portfolio of industry-leading business segments." Though 2005 was by no means a stellar year for IBM, nor particularly a growth year, it was a period of time when the company gained ground in finding its own way again. It may have had to cut tens of thousands of employees in so doing, but at the end, it is something of an achievement for the company to say it can regain some sense of its own balance.

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