September Sales Slowdown Hits Big Blue
IBM has made no secret that it wants to shed unprofitable hardware units, and it no doubt wishes it had been able to do some divesting ahead of its third quarter this year. IBM hit some unexpected turbulence in September and the company's business stalled, coincidentally right when the company was selling off its System x server division and, as we learned today after years of rumors, selling off its IBM Microelectronics chip manufacturing business to Globalfoundries.
We cover IBM's divesting of its chip business in a separate story, but in a conference call with Wall Street analysts this morning before Wall Street opened for business, the company did confirm that it was shedding the loss-making chip business. As has been rumored, IBM is actually paying Globalfoundries to take over the unit, and it looks the two companies are splitting the difference on how much IBM should pay at $1.5 billion. Since IBM lost the business to make game console chips for Microsoft, Sony, and Nintendo a few years back, the handwriting was on the wall for IBM Microelectronics. Each shrink in chip process manufacturing requires incrementally more money to develop, and with the industry moving to 450 millimeter wafers, too, there was no way that IBM could sustain the many billions of dollars of investment for the relatively small numbers of Power and System z mainframe chips it needs to make for its own use and the remaining merchant chip making business it had.
IBM never did break down its profits by product line, but in the presentation to Wall Street today, the company said that in 2013 the System x business had $4.2 billion in hardware sales and $400 million in support sales, for a combined $4.6 billion; it ran at breakeven with a slight profit in the fourth quarter. IBM will not get the benefit of that fourth quarter in 2014, with Lenovo taking over the bulk of that business in the major economies where the two do business. IBM sold off its customer care business process outsourcing business late last year, and when you add up the X86 server, chip manufacturing, and BPO units, they together represented $7 billion in revenue in 2013 and about $500 million in combined losses. The chip business generated $1.4 billion in 2013 and lost $700 million, and was on track to have a slightly lower loss in 2014 on slightly lower sales, according to IBM CEO and chairman Ginni Rometty, who was on the Wall Street call. That means that BPO business was making about $200 million in profits on $1 billion in revenues, but was deemed no longer strategic and was sold off to raise cash.
Over the long haul, selling off the System x and IBM Microelectronics divisions will help IBM's profits, but those divestitures could not help in the third quarter. IBM's revenues fell by 4.9 percent to $22.4 billion in the quarter ended in September, and gross profits fell by 4.9 percent as well to $10.9 billion. Income from continuing operations (meaning not including those three units that were sold off) were down 12.3 percent to $4.36 billion, and after a pre-tax charge of $4.7 billion relating to the sale of the chip business, IBM's net income was chopped all the way down to a tiny $18 million in Q3, down from a smidgen over $4 billion in the year-ago period.
Martin Shroeter, IBM's CFO, said on the call that a number of factors had adversely affected the third quarter in terms of both revenues and profits. Software sales were lower than expected in the quarter because IBM is shifting to new distribution models and also, in essence, offering customers who engage on mobile and social extensions on their software better deals to make longer term commitments to IBM's various middleware and database platforms. The job cuts that IBM did last year, mostly in its Global Services unit, did not pan out yet with the expected cost savings. And to make matters worse, the US dollar strengthened compared to other currencies, and significantly, in all of the growth markets where a weaker US dollar usually helps inflate revenues as the sales are booked back in the United States. Shroeter said to expect currency headwinds well into 2015.
The Global Services behemoth brought in $13.68 billion in revenues in the quarter, down 2.7 percent, but pretax income for the services arm of IBM fell by 12.6 percent to $2.49 billion. It is reasonable to assume that IBM will engage in more workload rebalancing here, but the fact remains that just like IBM is in the middle of transforming its systems and software business, it is also trying to move from outsourcing and systems integration services for back office systems to deals involving analytics, social, and mobile applications and cloud services. These are radically different businesses and there will be bumps in the road. IBM has a services backlog of $128 billion at the moment, down 2 percent at constant currency, and about 70 percent of this backlog in one year generates revenues in the following year, just to give you some sense of the deal flow-through.
The most interesting part of the Global Services business, as far as EnterpriseTech is concerned, is the SoftLayer public cloud. IBM spent $2.8 billion in total capital expenses in the quarter, and $350 million of that was for the build out of the SoftLayer cloud. Back in January, IBM committed to spend $1.2 billion in 2014 to essentially double the footprint of the SoftLayer cloud to around 200,000 servers and to expand it to a total of 40 datacenters around the globe. The plan was to do that expansion before the end of this year, and IBM did not suggest on the call that it was backing down on the pace. Back at the end of July, SoftLayer told EnterpriseTech that these upgrades to the datacenters and systems would be heavily back-ended to the fourth quarter. IBM does not break out SoftLayer revenues as a separate item yet, and that is because it is tiny compared to the other Global Services units.
On the systems front, IBM's Systems and Technology Group posted sales of $2.34 billion, down 15 percent year-on-year, and not including the discontinued chip business, pre-tax loss widened to $99 million from $8 million in the third quarter of 2013. Power Systems sales were down 12 percent year-on-year, but Shroeter said that both Power Systems and storage sales improved sequentially from the second quarter.
With the Power8 systems starting to ship in June and August, this stands to reason. System x revenues were off 10 percent and that means they were around $900 million because IBM said in a separate document that System x sales were $1 billion in the third quarter last year. IBM said that System z mainframe sales were down 35 percent, and this being the ninth quarter of sales for the System z12 machines, it is not at all surprising that revenues have waned. During this ending half of the System z product cycle, customers tend to activate latent cores in their systems and not buy new machines. But while the revenues are lower, the profit is much higher because there is no cost to provide that capacity; all IBM is doing is turning the golden screw driver. Servers accounted for $1.75 billion in revenues at IBM for the quarter, down 17 percent, and storage revenues came in at $609 million, down 6 percent. (These are calculated using IBM's pie charts in its presentations and are subject to rounding errors.) If you back out the System x sales of around $900 million, that means System z and Power Systems revenues came to $852 million, and fell 23 percent in aggregate from the $1.1 billion in sales in the year ago period.
Clearly, IBM needs to ramp up Power8 system sales and also to get its System z13 mainframes out the door as soon as possible to get its tidied-up technology business back on track.
IBM's Software Group posted sales of $5.71 billion, down 1.6 percent, and pretax income of $2.33 billion, down 3.2 percent. The database business, which IBM puts into its Information Management division, faced "sales execution challenges" and "some product transitions," according to Shroeter, and revenues were down 5 percent. With so much upheaval in the database market, and IBM's relational databases being a prime target like those from Oracle and Microsoft, IBM would have some issues here, no doubt. IBM's WebSphere middleware, which has been extended with mobile, commerce, and marketing acquisitions, jumped 7 percent. Tivoli system management revenues were up 3 percent, driven by security software, and Rational development tool sales were off 12 percent with "a tough compare." IBM's social and collaboration software eked out 1 percent of growth in the third quarter, despite declines in its Domino/Notes software.
With so many changes and pressures, the one last thing that IBM divested itself from today was the notion that it could deliver at least $20 in earnings per share in 2015, the so-called 2015 Roadmap that Rometty's predecessor, Sam Palmisano, laid down as the plan before he left the chairman and CEO posts five years ago. IBM did not say what its profit picture would look like in 2015 on the call today, and says it will provide a view for the year at its analysts conference in January.