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How Delicious is EMC’s VMWare off of IBM’s Quarter?

Wow, was that IBM quarter a thing of beauty…I don’t think it gets better than that. Double digit revenue increases across the GLOBE except for the U.S., which still increased up to 6%. For me, Mark Loughridge, SVP & CFO, seemed to hammer home the point that while the U.S. business is picking up, this quarter’s success was due to 3 things:

  1. IBM’s unique portfolio of products, a lot of which have been in R&D for a long long time.
  2. IBM’s execution.
  3. Virtualization is in demand, and is also the factor helping convert sales by making products worthwhile for customers.

While I believe like many people that the 2nd half of the year is the time to own tech, I’m not sure every company fired on all cylinders like IBM did. We’ll see how earnings play out, but I wouldn’t be surprised to see earnings come in as hit and miss depending on each company’s execution. “First of all, this was really a great quarter. I think every CFO waits for a quarter like this one, but those was a great quarter.” ~Mark Loughridge

If you had reserves about how valuable EMC‘s VMWare will be, the IBM call should erase any doubts you may have had (from IBM’s conference call transcript from SeekingAlpha):

“Ben Reitzes – UBS Securities

Could you talk a little bit more about hardware. In particular, you are going to a product transition. So, what is your confidence in potential revenue acceleration as you move throughout the year, given hardware is really the least recurring of all your businesses? And what’s your confidence in the new product cycle there, not only in the servers, in the pSeries, but also in storage, it looks like disk was obviously pretty weak in the quarter, if you can comment on servers and storage with regard to the new products in the year end, that would be helpful? Thanks.

Mark Loughridge

Sure, I will be glad to. Thanks Ben. As I look at the hardware performance in the second quarter; if you go down to that line that I withdraw at systems, systems did grow 4% at constant currency. So, at 4% at constant currency, systems on the model that we reviewed with you at Analyst Day, remember the revenue growth we are looking for over the longer term from our systems business, system technology was 4% to 5%. So they did lineup with the model.

With that systems growth and the attention that they paid both in margin expansion and expense management, they did grow profitability by a pretty impressive 77% now top a low base last year, but a pretty strong profitability growth. A lot of that margin improvement I think is also a reflection of the same attributes we discussed at the Analyst Meeting, virtualization and mixing the higher-end servers, because virtualization gives our customer a very strong economic reason to buy into the high end. So, I think we are seeing that.

So, as I look at the systems business, I would check-off as a make, the systems performance to the model on both margin expansion, exploiting the advantage of virtualization to a higher-end products and meeting the revenue objective of 4%. And we would have the same expectation for that business as we go into the second half. As far as storage is concerned, we had tremendous performance that of our tape business was up 19%. As you point out, this was relatively flat. We were not satisfied with that. So, we are looking for improvement in the overall disk performance as we go into the second half.

The other question you asked is what impact did we have from new technology, a POWER6 and the implementation of product line, I think it did have some impact in our pSeries product line, remember that we implemented that in June in the second quarter to the midrange. But I don’t think it was a lot of impact. We’ll see that begin to normalize as we go into the third quarter.”

“David Grossman – Thomas Weisel

Thank you. Mark, you are making a lot of very good progress in the initiative to expand margins and accelerate growth this year. So, as we move into 2008, excluding mix in the pension, what should we look to be the primary margin drivers next year, particularly in the second half of the year?

Mark Loughridge

Sure. Now, it’s a little early I think to be talking about 2008 specifically, but I think it’s very appropriate to talk about 2008 to the length of our longer term model. So, what are we looking for on margin expansion on that longer term base, looking at about four-tenth of a point, where do we expect to get that? First of all, we are investing heavily to drive our software business, heavily to drive that software, but you can see exactly the results of those investments. Look at the composition of our overall software content, it’s now 53% driven by key branded middleware and that mix percentage is up 10 points since 2004. As we continue to grow though that software business at these very high margin that software generates, just on a mix basis that’s going to drive the improvement.

Secondly, we’re going to continue to drive in each of our business units for better margin improvement and better margin mix within their businesses. We saw some of that this quarter in our services. There is still opportunity for improvement. I am pleased with the improvement. I am not pleased with the end state right now. There is a lot more opportunity. And if you look at our hardware business, I think Bill Zeitler has set up the STG, a value proposition very effectively at the analyst meeting. We are looking to now exploit virtualization as an economic proposition to our customers, and with that, move our mix to higher end servers to help them solve their own costs and energy problems, and their business. So, I think all of those are going to contribute to margin expansion as we march to our model objectives.”

If you’re still unsure about what makes virtualization so exciting and ultimately, a profitable investment, here’s a basic rundown. It’s not about virtual environments such as chat rooms that appear and disappear. Well, sort of. The virtualization that IBM and EMC’s VMWare does is it creates virtual computers on a computer (also virtual servers on a server, but it’s the same concept). So, instead of starting up a new computer for 2 of your workers, for instance, you just start up a virtual copy of Windows Vista. Now you have two workers working on their own projects, with their own settings and installations, but you only had to buy 1 computer. Most of the time not all of the computer’s resources, such as computational power or memory, is being used. So, if all your workers do is something simple like write email, you might be able to have 100 workers using 1 computer just by virtualization and creating 100 virtual Windows Vista for each person. As you can see, virtualization maximizes the productivity of the hardware of your company by using the hardware to its full capacity. Thus, you save money by buying less hardware and saving energy because you have less hardware to power. The energy efficiency story might actually be the stronger driver here as gigantic data centers such as those that power Google are becoming one of the largest consumption of our country’s electricity.

Software, such as virtualization, is also much better for IBM and EMC’s business than hardware. With hardware, you have to deal with headaches of component prices and inventory control on top of development costs. With software, you just have to hope your software developers come up with the right code. And, even if the code has flaws, you can always release patches or upgrades easily. However, for hardware sales, if there’s a significant problem with your hardware product you might have to revamp a whole production line with products getting wasted and delay times and lost of customers. The right software, if its in high demand, is almost always a better product and thus contributes to the awesome margins IBM had.

IBM’s quarter highlights this sea change as IBM’s now more of a software company, providing services such as virtualization, and distancing themselves from being a hardware company which, as you see, gets hurt by virtualization as people need less hardware. I think both IBM and EMC are great buys. Can’t wait for EMC’s spinoff of VMWare. Then again, maybe you don’t speculate on VMWare’s success and just buy IBM, the ‘ ole Big Blue…the original Blue Chip. IBM just reported, it’s firing on all cylinders, it’s been around forever, and has the brand name. Check out VMWare’s website for more on virtualization.

** Disclosure: I own shares of EMC as of this post ** 

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