Blue Skies for Big Blue - TheStreet

Blue Skies for Big Blue

IBM shares rise more than 4%; some analysts call growth expectations 'conservative.'
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Investors could not have asked for more from

IBM

(IBM) - Get Report

.

Judging by its quarterly earnings and bullish guidance, the world's largest information technology company has exceeded expectations and is taking tangible steps toward reaching its long-term profit target.

Indeed, everything seemed to go according to plan in the second quarter. Strong sales of high-margin software helped the company ratchet up its gross profit margin. A hefty round of stock buybacks added extra juice to the profit to help Big Blue beat analysts' earnings forecast.

The news lifted IBM's stock after the markets closed Wednesday. This momentum carried over into trading Thursday, boosting shares by $4.83, or 4.4%, to $115.92.

The strong results and bullish comments during the postrelease conference call suggest that IBM's ambitious earnings growth plan may have been conservative. Since laying out plans to double earnings per share by 2010, Chief Financial Officer Mark Loughridge has twice raised the company's annual earnings growth target.

Loughridge now expects to grow EPS in the range of 14% to 15% for 2007, up from an original level of 12% to 14%.

In the second quarter, net income rose 12% to $2.26 billion. Adjusting for the falling value of the U.S. dollar, net income rose 9%. During the quarter, IBM repurchased $12.5 billion in stock, helping to lift earnings per share more than 15% to $1.50, excluding proceeds from the sale of its printing business. That beat Thomson First Call analysts' average forecast of $1.47 a share.

Revenue rose 9% to $23.8 billion, also topping forecasts. When adjusting for currency changes, revenue grew 6%, the best in six years.

Software sales posted the greatest gain among IBM's core businesses, followed by technology services, IBM's largest business. Investors and analysts had been keeping a close eye on IBM's services business, which has been a laggard in recent years, but is strategically important for its role in helping to sell hardware and software.

"Revenue clearly accelerated with strength in software and services, emerging countries and SOA," said Loughridge during the conference call.

SOA refers to service-oriented architecture, a type of software that lets companies automate processes such as billing and accounting, and exchange data between different software applications. IBM holds roughly 53% of the market for SOA, according to Forrester Research. Forrester expects this market to grow by 44% a year, on average, to more than $70 billion by 2010.

Typically the second quarter is seasonally weak for IBM and tech companies in general. If purchases of tech gear pick up as expected, the second half of the year may be even better for IBM's hardware and software businesses.

The company is rolling out its new line of computer servers that include faster processing chips. Also, the trend toward virtualization can boost demand for IBM's servers, which reside on the high-end of the market alongside

Sun Microsystems'

(SUNW) - Get Report

.

Virtualization helps companies make better use of servers, and thus increases their willingness to buy one or a few expensive models rather than tying together a string of midrange models.

IBM has also beefed up its software business through acquisitions. On Monday, the company announced plans to acquire

DataMirror

for $162 million, a software company whose products help companies monitor updates and changes to information stored in different computer systems.

CEO Sam Palmisano has focused the company's resources on these two businesses, rather than on weaker units such as its hard drive business, which posted flat revenue growth compared with the second quarter last year.

The shift toward a greater role for software can add stability to IBM's revenue growth, says Ken Kuhrt of Ariel Capital Management, which holds IBM shares in its Focus Fund.

Software generates recurring revenue from licensing fees, whereas sales of hardware such as servers require large, one-time capital outlays that companies don't make on a regular basis.

This should boost IBM's stock prices as investors treat the company more like a software vendor. Stocks of software companies generally trade at a premium to those of hardware vendors.

Based on expectations for the current fiscal year, IBM trades at a price-to-earnings multiple of 17 vs. 18 for

Oracle

(ORCL) - Get Report

and 21 for

Microsoft

(MSFT) - Get Report

.

"A lot of people have misconception that IBM is primarily a hardware manufacturer," said Kuhrt. "That's really not the case in terms of where the value and where growth has been. We really see software and services as undervalued parts of the story."