IBM Hangs On to Safe-Haven Status

SAN FRANCISCO -- IBM (IBM) took the mystery out of its third-quarter earnings report by disclosing some results more than a week early.

But analysts and investors still will be listening closely to Thursday's conference call for executive comments on potential weak spots in the broad-reaching business, which has surprised investors with a solid financial performance so far this year.

IBM announced a week ago that it earned $2.05 a share in the third quarter, up 22% year over year, on revenue of $25.3 billion. Analysts had been expecting EPS of $2.01 on revenue of $26.5 billion.

The results prompted at least six analysts to lower their one-year price targets by an average of $22, although the faltering economy, rather than the results, appears to account for much of the Street's pullback. IBM's one-year price target now stands at $120, according to Thomson Reuters.

Since announcing those results, IBM shares have taken the broader market's roller coaster ride, ending Wednesday at $88.29, down 7.7% from its Oct. 7 closing price of $95.65. IBM now trades at 10 times the 2008 EPS consensus estimate of $8.72. Fellow tech giant Hewlett-Packard ( HPQ) sports a P/E ratio of 10.7.

Those early results got IBM out in front of the market to demonstrate it is "not in the same boat as Dell ( DELL) yet," says Allan Krans, software analyst for Technology Business Research. By showing the business remains stable, IBM countered the perception that shrinking IT budgets are a problem for all tech vendors, he adds.

"Although technology spending is anticipated to slow due to the current economic situation, it is better insulated from drastic cuts than other parts of the corporate budget," says Frost & Sullivan analyst James Brehm.

While IBM's third-quarter earnings were in line with the Street's expectations, its revenue came up short. That provides a clue to which business lines began to feel the pinch in the third quarter. The continuing strong margins story on lower-than-expected revenue may indicate that sales fell short on some of the thinner-margin hardware products and remained strong in high-margin software and services.

In the hardware group, sales of System x -- the company's industry-standard x86 servers, where IBM has recently lost market share to H-P and Dell -- may already have fallen some because they are sold as needed, says TBR hardware analyst Josh Farina. Even so, "that alone wouldn't have resulted in softer revenue."

Sales of mainframes should lead growth in the systems and technology group, says Farina, who doubts they've slowed yet because of the product's long sales cycles.

Mainframes pay big dividends for IBM's business across the board. "Big iron" - including mid-range mainframes - "pulls higher margins than x86s," Farina says. And it also spurs sales in software and services.

"A lot of revenue is tied to the System z platform," which came out in early 2008, says Krans. The launch of System z "is spilling over onto the software side." The software business is probably going to "come out inline or ahead of corporate growth" for the third quarter, Krans says.

IBM's software division had $4.7 billion in revenue in the same quarter of 2007, pulling off a pretax margin of 24.4%, compared with a 7% margin for the hardware group and 10.8% for technology services.

On the consulting and outsourcing side, IBM's services business and geographic diversification will be the saving grace for the company, TBR services analyst Eugene Zakharov says. "Outsourcing businesses of IBM and other vendors, like Accenture ( ACN), are likely to continue bringing solid revenue opportunities," he wrote in a Wednesday email from Shanghai, where he was meeting with IBM executives.

"IBM has its skin in the game and is able to make its story very appealing to clients ... going through tough times," Zakharov says. Yet, "IBM will have to go through some cost-cutting measures and manage its expenses very carefully over the next several quarters as the jitters in the financial markets continue." Indeed, IBM's budgets already may be frozen and internal projects delayed.

In a credit-starved business environment, Big Blue's financing unit can grease the skids for its other business lines: IBM can extend hard-to-get loans to potential equipment buyers.

The performance of the global financing unit, which has 125,000 clients, "should not negatively affect Q3 earnings for IBM," Brehm says. On the contrary, the unit's understanding of client needs puts IBM in "a unique position to be able to thrive in the midst of a recession."

Clients will turn to IBM financing "rather than through credit lines with banks, given the uncertainty with traditional financing outlets," Brehm adds. And IBM financing can provide single-source funding for IBM projects that involve services and equipment from multiple vendors.

"Where everybody else is saying IT growth is minimal, IBM and H-P are coming in at double-digit growth for first half of the year," says Farina. Despite expecting lower second-half revenue, he expects IBM to meet its margin targets. "I'd like to see continued strength for the year. It would, if nothing else, give people a safe haven" during the downturn.

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