IBM’s mantra – Margins, Margins, Margins!

(By Anthony Miller and Philip Carnelley – Friday 17th July 2009 9:00am). IBM may not be immune from the current ‘more for less’ (or more precisely, ‘less for even less’) spending crunch, but boy does it know how to manage the margins! Last night’s bumper Q209 earnings – with EPS the highest ever for a non-Q4 quarter – was all about margin expansion. Pre-tax margins grew in every one of IBM’s business segments – yes, even hardware (though only just – despite a gross margins decline). IBM CFO Mark Loughbridge was inspired to raise FY09 EPS guidance from $9.20 to $9.70 saying that they are “well ahead of pace” to hit $10-11 a share in 2010. This is all joyful news for investors.

But let’s look under the covers, starting with services. Both of IBM’s service segments suffered revenue decline (all % year-on-year at constant currency): Global Technology Services down 2% to $9.1b and Global Business Services down 9% to $4.3b. Gross margins rose in both segments: GTS +3.2 pts to 34.8% and GBS +1.3 pts to 27.2%. Pre-tax margins did even better: GTS +5.4 pts to 14.9% and GBS +1.5% to 13.3%. By the way, this gives IBM a total services pre-tax margin of 14.4%, which beats HP/EDS’ 13.8% services operating (note) margin for its Q2 (to 30th April). HP/EDS services revenues were some $8.5b in the quarter. Titters all round at Armonk, no doubt.

But it’s when you look into the order book that you really see the effect of the still continuing shift in IT spending to cost-cutting programmes. ‘Strategic Outsourcing’ bookings (i.e. ‘bog standard’ infrastructure outsourcing) rose 38% whereas ‘Business Transformation Outsourcing’ bookings (i.e. off into the wild blue yonder, so to speak) plunged 32%. Having said that, there was one anomaly I haven’t yet figured out: ‘Application Outsourcing’ bookings also plummeted 27%, which seems contra to the theme. There was no comment or even a question on this on the concall, but there again the numbers were hidden away in the ‘supplemental information’ slides, for which you do need an exceptionally strong will to live to get through.

On to software. Revenues were essentially flat (all % at ccy) adjusted at $5.1b. for currency. However within that there are notable trends: The Cognos BI suite was the shining star with 30% growth. Websphere middleware did well too, up 8%, helped by a 50% growth of the ILOG rules management software. Tivoli (infrastructure management) and Rational (software development tools) also rose. Most notable was a poor performance from the Lotus suite of office and collaboration tools which suffered a 14% decline – IBM simply cited "weakening of demand". We know of no-one who has ditched another ‘collaboration’ product to move to Lotus in years; growth here relies on upselling to existing customers. Furthermore, with the move to netbooks, waiting for Windows 7, the rise of cloud applications like Google Docs -- all the stars are aligned against Lotus. Nonetheless, profit from the IBM's software segment is soaring – up 24%, to $1.8bn – and expected to grow at double digit rates for the rest of the year.

Finally a word on hardware, which as you know is not usually what we talk about for IBM. Sure, sales were down heavily, -22% to $3.9b, and are now just 17% of IBM’s total business (gee, how the world has changed!). But we got an interesting ‘data point’ on ‘mainframe’ price/performance, when Loughbridge reported that Z-series revenues fell 39% whereas MIPS delivery (millions of instructions per second) ‘only’ fell 20%. So, demand for large-scale computing power is in decline, but suprise, surprise, prices are falling faster! Even so, as we said before, pre-tax margins rose, albeit just by 80bps, to 8.1%.

Anyway, this really was a cracking set of results for IBM where it really matters – on earnings. Let’s hope they can keep it up.