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October 31, 1999

IBM’s Q4 Looks to Be Even Worse Than Q3

By CBR Staff Writer

By Timothy Prickett Morgan

It is ironic that just as IBM seems to be getting its server hardware act together, Y2K lockdowns and the related slowdown in enterprise resource planning software purchases among medium and large enterprises has put IBM’s executives in a tizzy and its stock price in the tank. The latter has the added benefit of making it cheaper for IBM to boost net earnings by buying back its stock, a favorite past time of IBM’s chairman Louis Gerstner and his board of directors, who last week authorized the purchase of another $3.5bn in stock and who have thus far spent close to $30bn on stock buybacks since 1995.

IBM is facing some pretty tough problems in the fourth quarter of this year and the first quarter of next year. While the situation is not dire – IBM’s services and software businesses are still growing despite the utter collapse of S/390 and AS/400 server sales, and its Technology Group is busy rifling around IBM’s labs and factories for intellectual property and raw computer components to peddle to its competitors for a short-term benefit – it does make people who watch the server markets some measure of concern.

So just how bad was the third quarter just ended, and what does the fourth quarter hold? We ran some preliminary estimates on the breakdown in IBM’s various businesses last week, and have since then obtained updated figures from analysts at brokerage house Salomon Smith Barney. SSB tears apart IBM’s numbers each quarter and tried to rearrange them so they fit the way people talk and think about IBM, not the way IBM tries to disguise problem areas within its balance sheet. John Jones, the head IBM analyst at SSB, believes that the fourth quarter will not be a particularly good one for AS/400s and S/390s, but he expects the RS/6000 to maintain momentum and the Netfinity PC server line to continue to bring in big bucks even as year-on-year growth by quarter is slowing in that line.

Here’s how the third quarter looked according to SSB. RS/6000 workstation sales held steady at $100m, much better than our guess. Jones reckons RS/6000 server sales were actually up 6% to $540m, which differs from IBM’s official proclamation that overall RS/6000 sales were off slightly in the quarter because Jones allocates hardware revenues slightly differently from the way IBM does today to match the way SSB has broken down IBM’s hardware revenues in the past. SSB figures that the X86-based PC server business, which is dominated by the Netfinity line but also includes other PC servers, grew by 39% to $585m in the third quarter. High-end mainframe disks fell 60 percent as expected to $90m, while open systems disk sales rose 15% to $190m. Jones says S/390 mainframe revenues were $805m, down 38% from $1.3bn in the quarter last year and down $75m from where he expected S/390 sales to be. AS/400 sales were off 28% to $550m compared to $760m in 1998’s third quarter; SSB had expected AS/400 sales to be off a modest 5% as it fixed sales execution and channel problems in Europe. Northstar and Pulsar 64-bit PowerPC SMP server sales from the AS/400 and RS/6000 lines appear to have represented about $1bn in business during the quarter, making it IBM’s highest revenue generating hardware platform.

The Northstar and Apache lines have been generating between $1.2bn and $1.4bn in recent quarters, and had the AS/400 business not stepped in a hole, this line of PowerPC machines would continue to be bigger than Sun Microsystems’ entire enterprise server line. People forget this sometimes. In the past seven quarters plus the one we have yet to finish, the PowerPC SMP server lines at IBM have, according to my estimates, brought in more money than IBM’s S/390 lines in every quarter except in the third quarter of 1998, when IBM had a stellar quarter selling G5 series mainframes against Hitachi Data System’s Skylines. And in the fourth quarter of 1998, when G5 sales were still rolling along, Northstar sales, pushed up by the popularity of low-end 170 Invader AS/400 servers and high-end S7A RS/6000 servers, nearly matched the $1.4bn in sales of the S/390 line. The point is that IBM is not an al so ran in the midrange, and the PowerPC server lines have accounted for between 39% and 47% of IBM’s total server sales (including Netfinities) in past quarters. Nonetheless, the Northstar and Pulsar lines appear to be in decline at least for the next few quarters, thanks to IBM’s difficulties in selling AS/400s in a slow ERP market, unless the S80s take off like a rocket to balance against this decline, which will be substantial.

Going forward into the fourth quarter, SSB’s Jones is willing to venture some guesses about how IBM’s four server lines will perform. Jones figures that the RS/6000 server line will bring in about $650m, up 7% from the fourth quarter 98 and up 20% from this year’s fourth quarter. My guess is that Northstar and Pulsar SMP sales will dominate those numbers, accounting for $585m or about 90% of RS/6000 server sales in the quarter. While IBM will sell lots of B50 Pizzazz ISP servers, they are so inexpensive that until the company closes some truly huge ISP deals and gets customers to buy racks of them to support e-business applications, they won’t show up much on the radar. Neither will SP sales, which will decline as customers can add Northstar and Pulsar nodes into their SP racks. Netfinity server sales will, if SSB is right, be up 48% to $800m in the fourth quarter since the action in the Netfinity line is not entirely propelled by what is going on with Y2K and ERP. Just like over at Sun. The stunner here is that Netfinity sales, for the first time in IBM’s history, will be bigger than RS/6000, S/390, AS/400 server sales in a quarter if Jones is a good prognosticator. SSB reckons that AS/400 sales will be off a whopping 47% to about $500m in the fourth quarter and that S/390 sales will be off an even more staggering 54% to $655m. Even the good growth in the RS/6000 line and the very good growth in the Netfinity line will not be enough to come close to making up the difference.

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When you add up all the numbers SSB has estimated for IBM for the four quarters for 1999, the RS/6000 server business will be up 4% to $2.57bn. The AS/400 server business will be off 25% to $2.45bn, down from the usual $3.3bn. The 64-bit PowerPC SMP server portion of these two lines, if my estimates are accurate, should be about $4.7bn, down about 3% from 1998’s $4.85bn thanks to difficulties in the AS/400 line. The PowerPC SMP server line utterly dwarfs the Netfinity line for the year, despite 100% growth in the first two quarters of 1999 in Netfinities. Still, at $2.2bn in revenue, the IBM PC server business is certainly holding its own and is almost as big as the RS/6000 server biz. Jones expects that S/390 sales for all of 1999 will be down 24% to $3.25bn. Total server sales (which remember is distinct from the numbers reported by IBM’s Server Group) will be about $10.6bn for 1999, down 8% from $11.5bn in 1998.

Analysts over at Merrill Lynch were equally disappointed in IBM’s results for the third quarter, and are a bit confused about what the Y2K downdraft is all about. Steve Milunovich has lowered his rating on IBM stock from buy to neutral, but said he expected earnings to get back on track and double-digit revenue growth possibly in the second half of 2000. Milunovich was expecting a 20% decline in S/390 sales, not the 40% IBM reported, and says that IBM knew it was having problems in the AS/400 channel and just didn’t react fast enough to it. Merrill Lynch believes that IBM’s overall revenue will be down 1% to $24.98bn with hardware sales declining by 10% to $10.32bn. Merrill Lynch also expects services revenue taper off to single-digit growth to $9.32bn, and expects server sales to be off as much as 30% (not counting Netfinities). All that said, both Salomon Smith Barney and Merrill Lynch believe that IBM will be able to capitalize handsomely on e-business projects next year when customers start spending money again.

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