IBM Discloses Details of 2009 Game Plan

SAN FRANCISCO - IBM's (IBM) steadfast loyalty to its earnings projections may look too optimistic in light of the bruising companies are expected to take over the coming year.

The company said on Oct. 16 it is confident of delivering full-year EPS of at least $8.75 a share, implying fourth-quarter earnings of $3.07, or 9.6% growth year over year, in line with analysts' estimates, according to Thomson Reuters.

IBM also held fast to its long-term earnings roadmap, which sets an end-point EPS goal of $10 to $11 in 2010. The company has not yet projected 2009 earnings. Yet Gartner has cut its 2009 worldwide IT spending growth projection by more than half, to 2.3%, with the U.S. market most affected by frozen budgets.

Analysts now expect 2009 earnings of $9.24 a share, down from $9.34 in early October and $9.59 in July. The consensus estimate predicts earnings growth of 5.6%, or 49 cents, above IBM's projection for 2008 earnings of $8.75.

IBM's 2009 sales determine the company's longer-term earnings performance, as revenue is recognized over time. CFO Mark Loughridge said on the conference call that he is confident IBM can stick to its 2010 EPS target of $10 "on operational performance and maybe even exceed that."

By cutting expenses over the past two years, particularly in developed markets, IBM has delivered margin improvements that will see it through a tough economy.

Another driver is annuity-based revenue. As IBM signs multi-year contracts that create a regular revenue stream, it is upholding pricing levels that grow margins, Loughridge said. Discounting would undercut margins.

At the close of trading Tuesday at $93.40, IBM shares are trading just below 11 times 2008 earnings -- even with the P/E ratio for competitor Hewlett-Packard ( HPQ).

In recent weeks, IBM has tried to soothe investors' worries over its guidance by releasing more detail on results and rolling out new equipment.

With the value of many contracts confidential, IBM has instead given them dimension by disclosing details on some big sales to banks and telcos signed late in the September quarter with Asian clients. One contract calls for IBM to build a cloud computing center for Vietnam Technology and Telecommunications.

And in late October, Amgen ( AMGN) signed a five-year, $500 million contract for information services.

Yet, a main driver of revenue growth across business lines over the coming year appears to be a new model of its System z10 mainframe, which just began shipping.

Aimed at mid-sized businesses, the z10 Business Class should give IBM's hardware group a needed shot in the arm.

Hurt by lower sales of x86 and storage servers, the company saw revenue in that business fall 9.5% year over year to $4.4 billion during the last quarter,

The high-end z10 was the impetus behind a just-announced contract with Finanz Informatik, which provides IT systems to German savings banks. The deal is valued at the "high-end of triple-digit millions" of euros, suggesting the contract could be worth upwards of $750 million. And it makes FI one of IBM's biggest z mainframe customers, according to Big Blue.

The System z upgrade is also helping vendors BMC Software ( BMC) and CA ( CA).

BMC also landed a contract to provide Finanz Informatik with some new mainframe software, CEO Bob Beauchamp said Thursday. And the z10 helped push CA's quarterly bookings up 44% year over year - 11% on an annualized basis - to $1.5 billion, the company said last week.

But sales of the high-end z10, which starts at $1 million, should taper off this quarter, says Josh Farina, hardware analyst at Technology Business Research.

The new, lower-cost z10 should help rescue IBM's quarter - growing total System z revenue 17.6% year over year to $1.4 billion - and the coming year, Farina adds.

At one-tenth the price, the smaller model should be an easier sell in an all-but-frozen IT spending environment. IBM is greasing the wheels by easing financing terms.

IBM financing is more relevant now due to the lack of credit available through traditional options. Deep-pocketed tech companies such as Oracle ( ORCL), Microsoft ( MSFT) and SAP ( SAP) are reportedly financing some of their customers to meet their own growth targets.

Financing is good business - generating gross margin of 49% during the last quarter, up 4.5 points year over year and far outpacing hardware systems, where gross margin was 36%.

New mainframes also drive so-called "software-attach" rates, where gross margins, of nearly 85%, are better still, Farina says. In the third quarter, software sales got an 11.8% bump to $5.3 billion, especially from the high-end z model. That compares to software growth of 7% in Q3 of 2007.

But how can companies shell out for a new mainframe in this economy? The rationale is cost-cutting and quick return on investment. The z10 BC is said to dramatically cut energy consumption, giving businesses an incentive to buy even amid an economic downturn.

IT spending surveys say corporations are still willing to approve new projects that reduce operating costs. The business class mainframe allows data centers to unplug up to 232 "underutilized" x86 servers, or about 23 virtualized servers, says Jim Porell, System z platform distinguished engineer.

While some vendors still call the mainframe yesteryear's technology, back-of-the-envelope tradeoffs don't bear that out. Farina estimates a z10 BC model - all in - will run $150,000 to $200,000 - less than half the price of a fully comparable x86 installation bought today.

Making IBM's long-term EPS projections won't mean meeting hard expectations for each specific contributor, such as revenue growth, Loughridge says. "But over the longer term, we feel pretty confident that we have a good game plan to achieve that objective."

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