Big Blue Is in the Pink

Thanks to its consulting business and strong chip sales, IBM beats expectations to end a sometimes rocky fiscal year on a high note

A fiscal year that included a major black eye for IBM (IBM) ended on a more upbeat note, as the company reported better-than-expected fourth-quarter earnings on Jan. 17. Profit from continuing operations was $3.2 billion, or $2.01 a share, 7 cents per share higher than analysts were expecting. Excluding a one-time charge for pension changes, income for the quarter increased 19%.

The best news, however, was evidence that IBM's efforts to rely more on higher-margin and faster-growing businesses are paying off. These are IBM's Business Process Transformation Services, which include strategic consulting, business-process outsourcing, and related software sales -- keys to its strategy of helping clients transform the way they do business. Annual sales there rose 28% to $4 billion.

Contract signings in the fourth quarter were up 23%, overall, for the Business Consulting Services segment and 144% for business-process outsourcing -- indicating positive momentum for the future.

The combination of strong profit and bright prospects for strategic services had some analysts bubbling. "I'm sure they're popping Champagne in [IBM's headquarters in] Armonk," says analyst Frank Gens of tech market researcher IDC. "It suggests there's a lot of upside if they continue to execute."


  Not all of IBM's numbers were cause for celebration, though. Quarterly revenue was a bit disappointing, coming in at $24.4 billion, down 1% from a year earlier, and $1.1 billion less than analysts expected. IBM Chief Financial Officer Mark Loughridge said currency fluctuations had hurt the company's sales performance, and he expects that to be a drag for several quarters. After that, he said, investors can expect the business to tick up. "We expect mid-single-digit services growth in the second half, with better margins," he said.

Loughridge told analysts to raise 2006 earnings estimates by 12 cents per share. Before the conference call, the consensus forecast was $5.66 a share.

IBM's 2005 got off to a lousy start in April, when it announced a significant first-quarter earnings shortfall. Ultimately, it took a $1.7 billion write-off for restructuring costs -- mostly in its services businesses. Aftershocks followed. The way IBM communicated with analysts and investors in the aftermath of the first quarter has resulted in an investigation by the U.S. Securities & Exchange Commission (see BW Online, 1/13/06, "The Heat Rises Under IBM").


  The services outfit isn't totally out of the woods yet. While there were positive signs in key segments, services overall were a mixed bag last quarter. Global services revenue declined 5%, to $12 billion, for the period. Contract signings also declined, to $11.5 billion from $12.7 billion.

IBM is being pressured by chief rival Accenture (ACN) on the high end of its service business and a gang of Indian upstarts on the low end. Accenture on Jan. 5 reported strong quarterly revenue growth of 12%, to $4.17 billion. Meanwhile, Infosys Technologies (INFY), the best performer among the larger Indian outfits, posted fourth-quarter revenue growth of 32%, to $559 million.

IBM is scrambling to adapt. Last year, it cut more than 13,000 jobs worldwide -- mostly in Europe -- to lower costs and become more competitive. The company also hired an additional 15,000 people in low-cost countries, Loughridge said.

As if to show the once-booming strategic-outsourcing business still has some vitality, IBM early on Jan. 17 announced a 10-year, $1.1 billion contract to provide Gap (GPS) with mainframe, server, network, and help-desk support for the retailer's North American stores and corporate offices. And those are not just routine services, either: IBM is creating a new system of virtualized servers and storage devices, so it can take full advantage of the gear it has on hand.


  Hardware was one of IBM's strong points in the earnings call. Revenue came in at $6.9 billion for the quarter -- up 6% -- driven by strong sales of a mainframe computer and continued healthy sales of its powerful Unix servers. Sales of servers based on Intel (INTC) processors were flat, due to severe pricing pressures, though unit sales increased 13%.

Sales of compact blade servers, which slip into cabinets in corporate data centers, were the highlight, with a 41% jump in the fourth quarter. A strategy of prepackaging hardware and software for particular industries has helped IBM gain and hold the lead in this fastest-growing server category. According to market researcher IDC, IBM maintained the No. 1 spot in blade-server revenues in the third quarter, with a 42% market share.

The company's profits were greatly enhanced by the sale last year of its $10 billion -- but barely profitable -- PC business to China's Lenovo. The hardware division's gross profit margin improved, quarter over quarter, by 9.2 points to 42.1%. "They got rid of a dud, so the profitability of the rest of IBM hardware can now shine," said analyst Bob Djurdjevic of Annex Research.


  Another boost came from chips. Sales for the microelectronics division were up 48%, due to strong demand for chips in video-game consoles. IBM makes the main processors for Microsoft's (MSFT) Xbox 360, Sony's (SNE) PlayStation, and Nintendo's GameCube. Software sales were flat, but that masked a solid performance once again in the company's WebSphere middleware products, whose sales rose 4%.

Analysts made light of IBM's inability to grow overall revenues. "It's an ocean liner," says IDC's Gens. "You can't turn it rapidly." Progress may be sluggish, but positive signs in the fourth quarter show that this ship is certainly no Titanic.

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