Should IBM's Software Business be Considered a Freestanding Entity?

As I’ve written here, and in many other places over the last four years, it takes a little work to research the investment and market potential of the IBM (IBM) software business’s role in the overall IBM lineup. It’s easy to lose sight of the fact that the IBM software business has been basically flat the last few years. IBM’s numerous software acquisitions this decade, various reporting detail changes, and financial-statement reclassifications mask apples to apples results. Because IBM defines technical terms differently than other suppliers and brands its middleware software differently than IDC’s or Gartner’s taxonomies, investment and market analysis is a challenge. In a perfect world, like in the 1950s and 1960s, it wouldn’t matter. IBM software (and systems) should simply be the technology engines under the covers that IBM leverages to make its IT [GTS] and business [GBS] services businesses run smoothly and highly profitably.

But it is not a perfect world. The software group, with all the money spent acquiring companies (and representing over 20% of the total IBM revenue), is the IBM strategic fall-back if the services division strategy (e.g., acquiring PriceWaterhouseCooper) does not play out. IBM software revenue grew 8% in 2006 over 2005, from $16 billion to $17.3 billion (taking into account adjustments I make for such things as the Dassault passback). How could that be when quarter after quarter IBM reports double-digit growth rates for WebSphere, Tivoli, and so forth? Well it’s just math; IBM started with a low number back in 2001 or 2002 when it first started talking about brands and less about host vs. distributed software. At the same time, revenue for IBM’s old-architecture products is deflating almost as fast as revenue for the new services oriented architecture [SOA] stuff is rising.

• In 2006, a little more than half of IBM’s software revenue was for so-called branded products such as WebSphere, Tivoli, Lotus, etc. This category grew 17% by IBM’s calculations but I think as much as half of the 2006 “branded” growth came from the Filenet, Micromuse, MRO, and other software acquisitions.
• The same phenomenon held through quarter 1 of 2007 according to remarks made by CFO Mark Loughbridge on April 17, 2007 (see transcript on SeekingAlpha when available); just 51% was for branded middleware and apparently most of the growth was acquisition-related rather than organic.
• At the same time, “unbranded” products (e.g., IBM operating systems; CICS) deflated 3% in 2006, partially cancelling out the organic revenue growth for branded software
• A billion dollars worth of product lifecycle management [PLM] applications from Dassault flow through IBM, about half of which goes back to Dassault.
• Finally when last reported separately, most of this software was designed for the IBM “proprietary” platforms, the “z” and “i” series. As much as 60% to 70% of the IBM software business is “captive.” No one else can compete for it on a level playing field (although BEA can and does try to convince 30-year CICS mainframe users to switch to Tuxedo on UNIX, and Microsoft gets longtime AS/400 users to move to Windows).

In its quarterly revenue reports, we also see that another $2.2 billion in IBM software revenue (2006 total) passed through other IBM divisions, primarily IBM Global Services. That flow is not as good a test of market acceptance as software that flows through outside third-party channels or direct to enterprises. But like the “z” series and “i” series businesses, it’s real money. Yesterday’s first quarter 2007 earnings release shows the same trend: the “internal” software revenue grew almost 14% quarter over quarter while the external revenue—even before being adjusted downward for the 2006 acquisitions—grew 9%

So should the IBM software business be analyzed as a freestanding entity? Software is too important to unload as IBM has done with its printer, PC, EDI services, and other technology-based businesses. If it were, you would buy a piece of the action only if your investment play was to look for steady heritage-product annuities. Software Group dependence on IBM legacy hardware is not all bad. On the systems side, IBM reported growth in mainframes and IBM in Quarter 1 said that that growth tied to Linux open source operating software and virtualization trends. That means IBM could sell Linux-based Tivoli, Lotus and information management products to those tried and true “captive” users.

Also IBM reported growth in the services businesses. The growth in the services businesses might mean that the need to watch the software business carefully may be moot. So far, the services business strategy is working.

As a sidelight, the overall IBM revenue slowdown in the U.S. reported by IBM has to raise flags for those IT Top 12 suppliers (Microsoft (MSFT), Oracle (ORCL) and a few others) that depend on the U.S. for much more of their business than overall economic statistics would indicate to be balanced. Multiple financial analysts tried to dig into that statistic at the quarterly conference call but IBM would not comment on whether this was an IBM issue or a U.S. economy issue. (IBM did say it was an “enterprise” issue.) I think the geographic slowdown may have all been in IBM’s services businesses, which makes it less a concern for others in the IT Top 12 (and more of a concern for Bearing Point, Accenture, etc.).