Wall Street Braces for a Big Blue Shoe to Drop

Now to see about that big, blue shoe.

Computing-systems giant IBM (IBM Quote) is scheduled to report second-quarter earnings after the close of trading Wednesday. While most observers expect a solid quarter, Wall Street has been tied in knots for weeks over the notion that IBM finally will give in to the widespread technology slowdown and slash earnings guidance for the second half of 2001.

"They're definitely susceptible to weakness," says A.G. Edwards analyst Shebly Seyrafi. "I think they'll lower the bar." (A.G. Edwards hasn't done recent underwriting for IBM.)

Holding Up

A warning from IBM would be hugely upsetting to Wall Street, which has come to see the company as one of the few dependable producers in the now-abysmal tech sector. Sick of an investing landscape littered with the remains of former hypergrowth names, investors have embraced IBM for its diversity. Accordingly, its stock has risen a massive 27% in 2001 -- leaving plenty of room for a major selloff should things turn out badly on the conference call following IBM's earnings release.

Where Are They Now?

Of course, IBM has been here before. When it last reported earnings, back in April, the wheels were already coming off at pretty much every other tech company. IBM nailed its estimate and maintained its guidance, and the stock sailed toward $120. IBM was sheltered by its vast exposure to the mainframe business, an industry on which IBM holds a virtual death grip, and which produces a stable stream of recurring maintenance and service revenue.

IBM still has that on its side. Its Global Services division has signed deals worth nearly $20 billion this quarter, and the company now has a backlog of services contracts approaching $90 billion. That could provide IBM with some much-needed cushion.

"The services business remains quite strong," said Wit SoundView analyst Gary Helmig. "Outsourcing thrives in a weak economy. The open question is whether that backlog turns into revenue quickly enough to offset some of the weakness that we know about." (Wit SoundView hasn't done recent underwriting for IBM.)

Analysts expect IBM to earn $1.15 a share in the second quarter, 9% higher than the $1.06 it made in the year-ago period. Sales are expected to total $22.6 billion, up just 4.3% from last year's $21.7 billion.

The Coming Weak

All that good cheer aside, the rest of the year is already looking to be on the disappointing side. For the year ending in December, analysts polled by Thomson Financial/First Call expect earnings per share to grow 8.6% on a minuscule 2.1% sales gain. At IBM's analyst meeting back in May, CEO Lou Gerstner reiterated the company's existing long-term target of high single-digit annual percentage sales growth, paired with double-digit earnings growth. If Sweet Lou is forced to cut guidance much more below those goals, IBM could have a good deal of difficulty sustaining its current valuation. (IBM was lately carrying a forward price-earnings ratio above 20.)

There are plenty of reasons IBM could warn. There's the company's significant exposure in Europe, where a strong dollar is making tech gear more expensive for corporations, and where business in general continues to slacken, if one believes anecdotal evidence gathered by U.S. firms. There's the protracted weakness in demand in core markets like personal computers, servers and storage. One need only look at IBM's competitors to get the point. EMC (EMC Quote), Sun Microsystems (SUNW Quote), Hewlett-Packard (HWP Quote) -- they've all been hammered by the slowdown. And with annual sales of more than $90 billion, IBM may have nowhere to hide.

"If you look at EMC, if you look at Sun, customers are really buckling down, especially on high-priced items," Seyrafi says. "IBM sells a lot of high-priced mainframes and Unix servers."

Double-edged sword or not, IBM investors have no choice but to hope the company keeps selling a lot of those for the foreseeable future.