IBM had a strong quarter with revenue up 5.1% at $22.62 billion compared to last year’s 3rd quarter and earnings up 46% with a net income of $2.22 billion or $1.45 per share. BUT, as with many large corporations, there is an asterisk to earnings. First, the tax rate comparison (30% this year’s quarter versus 48% last year due to a $525 million tax charge for the repatriation of overseas earning) significantly improved the earnings percentage. Second, IBM has aggressively repurchased stock reducing shares outstanding by 5% thus boasting earnings per share by 6 cents. Earnings increased 15%, excluding the favorable tax rates, which is still strong, especially with IBM’s size.

The revenue and earnings results illustrate the strategic shift underway at IBM. Prior to the 1990s IBM was a hardware company. Lou Gerstner transformed IBM in the 1990s into a services juggernaut culminating with its purchase of PwC’s Consulting Unit. IBM rode the IT spending boom of the 90s that extended though the Internet boom and the NASDAQ 5000. Y2K, the transition first to client/server and then to the web, and an industry-wide shift from custom-built applications to ERP (enterprise resource planning) packages were some of the major categories of IT expenditures for that period.

IBM is in another major transformation shifting to software as its growth engine. IBM announced four major acquisitions of software companies last quarter totaling $3.6 billion. Since the start of 2003, IBM has acquired approximately fifty companies at the cost of $11.4 billion, of which 31 have been software companies. IBM’s services unit still accounts for over half, $12.02 billion, of its overall revenue with an excellent profit margin. Services are and will continue to be a major component of IBM’s portfolio. However, software revenue of “only” $4.41 billion for the quarter topped services in total earnings. Chief Financial Officer Mark Loughridge stated that software “was our largest profit contributor… We’ve been investing heavily in our software business for some time. Our performance in 2006 underscores that this strategy is working.”

Overall software grew 9% for the quarter versus 3% for services. IBM’s middleware brands, including WebSphere, Information Management, Tivoli, Lotus and Rational products, accounted for $3.4 billion revenue, up 12 percent. WebSphere sales, driven by data integration and service oriented architecture (SOA) implementations, increased 30%. Software sales were weighed down by operating systems revenues that decreased 6% and Rational product sales that increased 2%.

Although the Wall Street Journal (WSJ) titled their article “IBM Net Climbs Amid Rebound in Services Unit” it was clear when you read the article that software and hardware revenue gains of 9% each along with software’s profit margins were the stars of the quarterly results. The article stated IBM “showed sales growth and profit-margin improvement in its huge services business, which had been weak in recent quarters…” It was really the fact that services performance stabilized and improved, rather than dragging down overall results as it had in the past, that the rebound that WSJ referred to.  Services sales did increase 3% and profit margins increased to 27.8% from 26.1%.

Is there aything wrong with consulting? Why the strategic shift to software?

I’ll discuss both of these questions later.