IBM Corp. has announced better than expected results for 2Q08. While Business and Technology Services continue to dominate IBM’s revenue streams, Software revenue has also shown impressive growth. Exhibit I shows IBM’s software revenue growing better than overall revenue consistently over the last eight quarters. As a result, software business now contributes 21% of total revenue against 17% in Mar05.

Exhibit I: Software Revenue Vs Total Revenue

Source: Gridstone Research

We decided to compare IBM’s software business with Microsoft Corp.(MSFT) and Oracle Corp.(ORCL) to see how IBM compares against the software majors. Since IBM & MSFT have other revenue streams, we used the reported segmental information available on the Gridstone Platform and derived software revenues. Therefore for MSFT we have taken only the Client, Server & Tools and Business division’s revenue and reported metrics and for IBM we have considered data on the software business.

Revenue Growth

IBM has been able to match MSFT’s growth rate in the recent quarter. MSFT has uneven growth rates in the software business (Server, Client and Business divisions put together) due to revenue deferrals related to the Technology guarantee program for Office and Windows Vista. MSFT’s growth in QEJun07/08 (~16%) is closer to its typical growth rate and IBM has been clocking growth rates in the mid-teens recently. ORCL has been a notch above both IBM and MSFT in revenue growth but ORCL’s revenue growth has largely been acquisition-led. In size, IBM with 2Q08 revenues from software at ~$5.6 Bn is in striking distance of ORCL($7.2 Bn).

Exhibit II: Software Revenue Growth - Last 8 Quarters

Source: Gridstone Research

IBM has narrowed the gap with ORCL in top line growth thanks to its own acquisitions in the software business. A quick search on IBM’s acquisitions in the Gridstone  platform reveals that most of IBM’s acquisitions have been in the software business (Cognos,  FileNet, ISS etc). Based on the Goodwill allocated across segments, we could calculate that nearly 80% of the acquisition spends has been for the software business.

To put IBM’s and ORCL’s top line growth in perspective, we compared the cash spent on acquisitions in the last eight quarters (Exhibit III). (IBM’s acquisition spends for software business (80% of total acquisition spends) only has been considered.)

Exhibit III: Acquisition Of Businesses – IBM & ORCL

Source: Gridstone Research

ORCL has been more aggressive in acquisitions and this resulted in better top line growth.

Operating Margins

Exhibit IV: Operating Margins – MSFT, ORCL & IBM

<Source: Gridstone Research

While MSFT’s operating margins hover in the ~60% range, despite a marginal decline (100-200 bps) in the last three quarters, IBM and ORCL have had comparable margins in the mid to high thirties. For both IBM and ORCL, in quarters with acquisition related charges, the margins have dipped only to bounce back to mid-high thirties range in the ensuing quarters. Exhibit IV, when seen in conjunction with Exhibit III, clearly signifies this trend. With the COGN acquisition having a significant impact in 2Q08 (See Exhibit III), IBM’s margins are expected to be back on track in the next few quarters.

Conclusion

IBM has been able to put up a comparable performance  in software viz. ORCL and MSFT though software is not its largest revenue stream. In all aspects, IBM is a major software vendor to contend with and looks set to garner an even larger pie of the software market.

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