Last Tuesday (April 18, 2006), IBM announced first-quarter profits that were 22% higher than at the same time last year, beating Wall Street estimates. But how it achieved these results reveals the shift in the corporation's overall strategies and reflects its continuing transformation from a nuts-and-bolts computer hardware manufacturer to a purveyor of software and services. There are winners and losers in this strategy, and some analysts say the System i is dragging down IBM's server growth rate. Is this true? Is the System i actually the canary in the mine shaft? Should we be worried?

First of all, let's look at what the execs say and how the numbers play out.

IBM: "We're Doing Great!"

Sam Palmisano, IBM Chairman and CEO, said "IBM had a good quarter with excellent earnings-per-share results. We continued to improve our profit performance with our strategic focus on higher-value segments of the marketplace, as well as with our emphasis on productivity and global integration. Our performance underscores the strength of our business model across a balanced portfolio of software, services and hardware, and demonstrates the benefits of the strategic actions we've taken in recent years to reposition the company.

"We had very strong results in middleware and continued revenue growth in microelectronics for our 300-millimeter wafer products that serve the major gaming platforms. Services signings increased, services margins rose for the seventh straight quarter year to year, and IBM again grew in emerging markets. Our cash position remains strong. After investing in our business and returning nearly $3 billion to investors, we ended the quarter with a cash balance of more than $12 billion, significantly above a year ago. Our clients continued to demonstrate that they value IBM's ability to help them innovate."

The Numbers

Now the numbers:

In the first quarter of 2006, the company's gross margin rose to 39.1%, compared with 36% in the year-ago period including the now-divested PC business.

Revenue from software was $3.9 billion, an increase of 2% compared with the first quarter of 2005.

However, this is not the full picture: Revenue from IBM's Global Services business fell 1% to $11.6 billion in the first quarter. Moreover, hardware sales fell 32% percent to $4.6 billion in the first quarter compared to $6.8 billion a year ago, due in large part to the sale of IBM's PC business to Lenovo last year. And revenue from IBM's Global Services business fell 1% to $11.6 billion in the first quarter.

So, on the surface, the message from IBM looks like this:

• "Software is good!"
• "Hardware is bad!"
• "Services need work!"

Digging Deeper

But as we dig deeper into the "Hardware is bad!" message, we see some interesting numbers: Though hardware revenues decreased by 32% (31% adjusting for currency), if you take out the impact of IBM's divestiture of its PC business to Lenova, its revenues in this sector actually increased by 3% (6% if you adjust for currency.)

Furthermore, look at what IBM servers (now called "Systems") are doing compared with the year-ago period:

• Revenues from the System x server products increased 10%.
• Revenues from the System p UNIX servers decreased 9%.
• Revenues from the System z server products decreased 6%.
• Revenues from the System i server products decreased a whopping 22% .

In other words, if hardware is bad, server hardware is really bad, right? Or is it?

Servers and the Soft Sell

First, let's note that these server hardware offerings are delivered through the IBM Systems and Technology Group (STG). On the surface of things, the only bright note for STG—as far as revenue growth is concerned—was the phenomenal increase in the microelectronics sector (game and micro-processor chips), which had a revenue growth of 37%, and the storage division, which grew its revenues by 6%. These two units brought the overall revenues of the STG to $4.4 billion for the quarter, up 3% (6%, adjusting for currency.)

So what does this mean? Does it mean that IBM servers (systems) are losing ground?

You're the Tops!

Not at all! IBM is still the world's top server vendor, according to IDC's and Gartner's server market share reports. But the server market is cyclical, and it's soft right now: 2005 was a big year during which IBM provided a lot of nifty pricing incentives and succeeded in capturing yet a larger share on the server market.

In other words, IBM's server game in 2005 (and previously, during the recession years coming out of 2000) was to capture market share. It added significant horsepower with its Power5 processors and decreased prices. That's a hard act to follow in the first quarter of 2006. IBM beat the commodity server game against HP and Dell by capturing the largest market share.

So, right now, IBM's STG is trying to redefine that server market—away from commodity "servers" and toward integrated "systems." And this market re-definition is just getting underway with the re-branding of all its "series" servers as "Systems."

In light of this marketing dynamic, it's clear why revenues from IBM operating systems were also down 12% to $520 million: Fewer sales of servers mean fewer sales of operating system licenses. It also explains why IBM middleware tools—which include WebSphere, DB2, Tivoli, Lotus, and Rational products—were $3.0 billion, up 6% over the first quarter of 2005: Companies are buying more tools to take advantage of the increased power of the server technology that is available.

The Server Business Strategy

So why does IBM stay in the server market? Will it ever sell its server divisions, as it did its PC division? Is the System i in trouble because it made less in the first quarter of 2006 than it did in the previous year?

Hardly!

IBM's server position—coming out of the STG division—drives nearly every other aspect of IBM's business model. Unlike the PC market, IBM's position in servers is dominant and growing. Its hardware technology is still leading the industry, and this is bolstered by both storage and microelectronics, which supply critical parts to the product line.

Furthermore, IBM has positioned the rest of its products and services to leverage the cyclical purchasing nature of the server industry customers: When customers are not buying servers, they're purchasing software and services to make the systems they have more productive.

Commitment to System i

In this light, IBM's System i product is the epitome of the marketing challenge facing STG. System i is the most integrated of all IBM's server products, bundling nearly all of IBM's software and services into a neat package that touches every other product sector of IBM's business model. The goal, from IBM's perspective, is dual: Dominate the other sectors of the SMB computing sector to win converts to IBM's middleware strategies; then, transform these SMB customers into System i customers by offering a completely integrated package.

When you look at the overall IBM server strategy in this manner, the importance of the System i customer is clear: System i customers represent IBM's best clients, with the highest satisfaction rating and the greatest potential for new server revenue. Even though percentage of growth in revenues between fiscal quarters may falter—as it has during this critical market transition—IBM will not abandon System i as long as revenues continue to grow.

Thomas M. Stockwell is Editor in Chief of MC Press Online, LP.