Updated from 9:15 a.m. EDT Wall Street continued to render a mostly upbeat verdict on IBM's ( IBM) earnings Friday, recently bidding up shares $2.19, or 2.6%, to $86.21 after Big Blue delivered its second-quarter results. While a little shy on revenue, the Armonk, N.Y.-based hardware and services giant offered 4 cents upside on earnings per share. Investors were especially pleased by news of improved profit levels in IBM's flagship services division and the swing to a profit in its microelectronics arm. On a postclose conference call, Chief Financial Officer Mark Loughridge said that customer spending continues to improve, led by growth in emerging markets such as China. Management also reaffirmed annual consensus estimates on sales and earnings. IBM posted second-quarter revenue of $23.15 billion, up 7% from last year, or up 4% adjusted for currency fluctuations. The sales figure was a tad below the consensus estimate for $23.35 billion. Net income totaled $2 billion, or $1.16 per diluted share. That was up 18% from net income of $1.7 billion, or 97 cents a share, in the year-ago quarter. Analysts were expecting EPS of $1.12 in the latest quarter. Friday morning, Morgan Stanley raised its 2004 earnings estimate on IBM to $4.95 a share from $4.90, while maintaining an overweight rating. Bank of America lowered its price target on the stock to $90 from $95, voicing a concern about a quarter's end falloff in IBM's software division. First Albany's Joel Wagonfeld called the quarter a "mixed bag," but with more positives than negatives. "One key positive we came away with was increased confidence that IBM may -- finally -- be getting its arms around the yield issues that have been plaguing its microelectronics business," he wrote Friday morning. Wagonfeld said the quarter underscored the reasons behind his buy rating on the stock, writing, "IBM's ability to deliver results despite challenging circumstances in many segments highlights a key element of our investment thesis: IBM's diversified model enables the company to perform consistently in spite of various market conditions. This relative predictability makes IBM a 'safe' technology bellwether that should outperform in the long run, especially during periods of uncertainty." (First Albany has no banking relationship with IBM.)
Deutsche Bank's George Elling, who also has a buy rating on the stock, wrote: "Considering all the bad vibes that had been out there -- i.e., software misses and problems with semiconductors -- we believe IBM's broad blend of businesses, continued commitment to R&D and strong overall customer base worked well to allow for another positive quarterly result." Big Blue is "well positioned to deliver solid results in the second half of the year," Elling wrote. (Deutsche Bank has done recent investment banking for IBM.) IBM said it signed services contracts worth $10.1 billion in constant currency and $10.6 billion in spot currency, in line with Wall Street projections in the range of $10 billion to $11 billion. Marty Shagrin, an analyst at Victory Capital Management, said the biggest positive news from the report was the sequential growth in IBM's gross services margin, though he noted that a chip division profit was also clearly a big help. IBM's semiconductor arm had reported five quarters of losses leading up to today's report. "The next metric to look for will be a meaningful uptick in services signings. We would like to see that grow," said Shagrin, adding that a solid quarter at rival Accenture ( ACN) bodes well for upcoming business at IBM. At Schwab Soundview, analyst John Jones said he believes that IBM's services bookings will accelerate in the second half of the year, in line with normal seasonal patterns. In the first half of 2004, IBM reported about $21 billion in signings, and Jones expects the company to deliver a total of $55 billion to $60 billion for the year. In the just-reported quarter, Jones said IBM's top and bottom lines came in roughly where he was expecting (he'd published an above-consensus estimate of $1.14 leading up to the call). He attributed the earnings upside to a combination of higher-than-expected intellectual property revenue, improved operating margins in software and better-than-expected performance in mainframes.
Jones, who has an outperform rating on the stock, expects IBM to benefit from continuing enterprise demand and margin improvements, especially in its services business. He notes that IBM shares are trading close to their 12-month lows. His firm doesn't do investment banking business. In the second quarter, IBM reported that revenue from global services, which represents half of IBM's sales, grew to $11.3 billion, up 7%, or 2%, adjusted for currency fluctuations. Profit levels in the services division amounted to 25.2% of revenue, up 70 basis points from the prior quarter but down 70 basis points from last year's levels. IBM has lately made it a priority to hike gross margins in services, having recently assigned former CFO John Joyce to the division. Thursday, Loughridge said IBM expects services' gross margins to show year-on-year improvement in the second half of the year. Hardware sales from continuing operations were up 12% or 10% adjusted for currency to $7.4 billion. IBM said its laggard semiconductor business had showed growth in the second quarter, posting a $111 million profit, and Loughridge said it's on track to deliver a profit for the year. Undermining those claims of progress, however, prominent chip customer Apple complained just
Wednesday that lousy yields at IBM were the reason it had to delay the rollout of its new iMac computer and will miss the crucial back-to-school selling season. Asked to comment on the situation at Apple, Loughridge said, "We do hundreds of different chips, and we're meeting commitments to all our customers except for one chip." He said IBM's 300-millimeter fabrication plant had improved yields and doubled silicon output from the first to the second quarter, with the potential to double output again in the third quarter. Schwab Soundview analyst Jones said he doesn't believe the semiconductor arm poses a risk to IBM's overall business, adding that the sequential doubling of volumes in microelectronics came as a welcome surprise.
To give IBM credit, he added, the chips that it produces for Apple are on the "leading, bleeding edge." "IBM is clearly about two to three quarters behind where they thought they'd be, but they're making pretty good improvements," said Jones. "Given their visibility and the fact that they say they're doubling their capacity in the September quarter, you would expect that they're within three to four months of being able to satisfy Apple." Personal systems sales rose 16% to $3.2 billion, but the group slipped into the red with an $8 million pretax loss. Software sales were flat with last year's levels, at $4.5 billion. Loughridge said IBM's software arm had witnessed the same purchasing hesitance reported by some of its peers, including Veritas ( VRTS) and PeopleSoft ( PSFT), noting on the call that customers "deferred purchasing at the end of the quarter, and we saw fewer large transactions." On a postclose conference call, Loughridge said he believes consensus estimates for full-year revenue and EPS remain reasonable. The current consensus assumes IBM can deliver earnings of $4.95 on sales of $96.341 billion for the year ending in December.