InformationWeek

November 15, 1999

IBM's Mixed Third Quarter Reflects Market Changes
Hardware profits suffer due to Y2K slowdown; PC line continues to cut expenses

By Paul Korzenowski with additional reporting by Martin J. Garvey and Paul McDougall

BM's mixed third quarter showcased some of the troubles that beset its hardware business. Although revenue from IBM Global Services and software was up, hardware revenue decreased 2% compared with the same quarter last year--though it had been expected to be up slightly. IBM blamed a Y2K slowdown at the end of the quarter for much of the fallout, which hit its mainframe and AS/400 business particularly hard. Revenue for its RS/6000 Unix line also declined slightly.

Things aren't expected to get much better in the near future. "We believe we will continue to feel the effects of the Y2K slowdown in the fourth quarter and into early next year," said chairman and CEO Lou Gerstner in the company's earnings release. The company cautioned that it could show a profit 15 to 20 cents below the consensus estimate of $1.34 per share.

Ravi Marwaha, VP of IBM server market planning and strategy, explains the numbers this way: "Our surveys indicate that by virtue of large customers using IBM servers [particularly the S/390 and AS/400] for mission-critical apps, we are more affected by a freeze. Mission-critical apps are more exposed to the Y2K freeze than new apps and departmental apps." Marwaha also points out that IBM's new 24-CPU S80 RS/6000 had a successful launch at the end of the quarter.

Overall, IBM's quarterly revenue increased 5% year over year, to $21.1 billion, with net income at $1.8 billion. But this counted as a disappointment following a first quarter that analysts called spectacular, with the company posting net income of $1.5 billion, up 42% compared with its year-ago quarter, while revenue rose 15% to $20.3 billion. The company's second quarter had continued the trend.

Revenue from the server group dropped from $2.9 billion in the third quarter of 1998 to $2 billion this year. Analysts say one problem is internal competition among IBM's multiple server lines. In September, IBM put senior VP Sam Palmisano in charge of its server group, following his two-year stint as head of IBM's successful Global Services Group. He's got his work cut out for him, observers say. "He needs to eliminate redundancies between the AS/400 line and the Unix products," says James Poyner, an analyst with CIBC World Markets. AS/400 revenue has declined in each of the last three quarters; RS/6000 systems picked up, albeit briefly, in the second quarter.

Palmisano wasted little time getting down to business. Earlier this month, he said the server group needs to reduce costs and get more competitive. Part of the plan involves laying off 3% to 6% of server group employees. Chuck Jones, an analyst with Solomon Smith Barney, says it's hard to know whether Palmisano will be able to turn the server group around. "It's a lot easier to grow revenue in a robust market like services than it is to increase market share in a price-conscious space like servers," he says.

But not everyone is worried. Ed Delano, systems manager for Mazda's North American operations, runs an IBM mainframe and several AS/400 systems. "Every platform IBM has will be enabled for the Internet, and you're going to use that technology," he says. "Once customers get past Y2K, the future looks good for IBM servers."

Meanwhile, IBM has mapped out plans to incorporate CC-NUMA (Non-Uniform Memory Access) technology into its RS/6000 and AS/400 lines. The company completed its $810 million acquisition of Sequent Computer Systems Inc., whose NUMA memory-management technology enables highly scalable symmetric multiprocessing systems, last quarter. "To remain competitive, IBM needed to add CC-NUMA capabilities to its servers--and the fastest way to get it was through an acquisition," says Jones.

IBM also points out that its Netfinity Windows NT servers showed strong growth in the third quarter, with revenue rising to $610 million from $420 million in the year-ago quarter. James Gargen, Netfinity director of product marketing, says sales are being boosted by the trend to consolidate servers. For example, he says, "companies are consolidating single- and dual-CPU servers on four-way servers to lower costs and ease maintenance."

As a whole, IBM's Personal Systems Group made progress last quarter, increasing revenue from $3.3 billion to $3.7 billion and reducing losses from $122 million to $69 million compared with the third quarter of 1998. But it still faces many challenges--some of which the company itself created. IBM Global Services' deal with Dell to supply the direct vendor with services for its systems was good for IBM Global Services, but "it was not so welcome in IBM's Personal Systems Group," says Rob Enderle, a VP at Giga Information Group. "Service had been a key product differentiator. Now Dell can offer not only low prices but also high-quality service."

Photo by Marc Escher Tom Conway, IBM's director of global personal computer services, says there's no grounds for concern about IBM's PC business. "IBM has learned over the years that the customer wants solutions that are not 'blue' only," he says. "But IBM's PC company is doing extremely well, and our position in that market drags along a tremendous amount of other revenue, so we'll continue to vigorously compete in that market space. There's no de-emphasis on any of the product line." IBM Global Services' revenue increased 13.7% in the last quarter.

IBM has continued to cut expenses in its PC business. It folded its Aptiva consumer PC line's marketing group in with the rest of its PC offerings, a change that will result in the elimination of between 500 and 1,000 jobs, and said it primarily will sell Aptivas online. Indeed, the vendor is more aggressively embracing direct sales. "We expect our direct contacts with customers will increase in the future," says Richard Cheston, director of management and total cost of ownership at IBM's Personal Systems Group, which now has 300 direct sales corporate accounts, up from 150 in 1998.

Yet speculation remains that the company may get out of the PC hardware business and hand the task over to Dell, a persistent rumor that IBM denies. "The company is making significant investments in its PC business, which is not a sign of an organization getting ready to exit a market," says Cheston. Analysts agree that such a move wouldn't be smart. "IBM's Personal Systems Group may not turn a profit by itself, but it generates a lot of business for other areas, such as software and services," says Enderle. "Large companies often feel comfortable buying everything from one vendor and the company would lose that if it stopped manufacturing PCs."

But IBM is pursuing component outsourcing opportunities, exemplified by its deal with Dell, which will buy components worth $16 billion over seven years. IBM's original equipment manufacturing business has grown by 24% to $2 billion.

As IBM moves forward, many customers are sitting tight. "I look at the long term," says Mazda's Delano. "There are too many nervous Nellies focused only on the short term. I'll stick with companies like IBM and Cisco. I think they know what they're doing."

Photo by Marc Escher

Go on to the next story, "Intel Aims High In Server And Services Markets ."

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