Updated from 7:31 a.m. EDT
stock regains some momentum, it's the momentum of the company's global services unit that's on investors' minds heading into Monday's third-quarter earnings report.
On the heels of a
second-quarter rebound from a major first-quarter blow-up, IBM needs to show traders that the turnaround was not an isolated one-quarter event.
"We want to make sure it's not a flash in the pan," says Sushil Wagle, an analyst at J&W Seligman. "The Street will look to see relatively clean execution.
We don't want to see any big mess-ups,
and we don't want to see any large segments come in with big misses," he says.
IBM added 35 cents to $82.70 Monday.
"That would be not just bad for IBM -- it would indicate the enterprise area is not faring well," adds Wagle, whose firm holds IBM shares.
Reporting a year-over-year increase in global-services bookings is one way Armonk, N.Y.-based IBM could assure investors that the turnaround is sustainable. Analysts are expecting anywhere from $10 billion to $12 billion in global services bookings in the quarter.
"If they do anything more than $10.5
billion, I'll be very happy," Wagle says.
That would be down from $14.6 billion in second-quarter bookings. But second-quarter results were unusually high, in part because deals slipped out from the first quarter, when IBM badly missed its targets and ended up slashing 14,500 jobs in Europe.
"What happened in the second quarter was partially a correction of what happened in the first quarter," says Bill Gorman, vice president in equity research at PNC Advisors who covers technology.
"They're making a lot of progress,
but that doesn't mean everything was fixed as of Sept. 30." PNC holds IBM shares.
Analysts on average are expecting IBM to register total third-quarter sales of $21.71 billion and earnings of $1.13 a share, according to Thomson First Call.
Wagle believes that the company is more likely to surpass sales estimates than earnings, but some buy-side analysts suggest that earnings are more likely to surprise. Investors may be anticipating the same thing: after a two-month backslide, IBM shares have run up about 8% over the past three weeks.
The layoffs also should help improve margins for global services. Gorman says he will look for some margin improvement in the third quarter. But the cuts should allow IBM to show even more margin improvement in the fourth quarter and 2006, other analysts say.
Growth in global services has become crucial to IBM's story because the unit now generates more than half of the company's total sales.
However, despite IBM's evolution into a services company, investors still will be watching two pieces of the company's hardware business -- mainframes and microelectronics -- because they're both on the cusp of new product cycles.
IBM began shipping its
new z9 mainframe line in the last two weeks of the quarter, which Gorman believes is not enough time to materially boost IBM's third-quarter results.
But mainframe sales should really kick in during the fourth quarter and result in higher growth in MIPs -- million instructions per second. The amount that IBM charges for mainframe software is determined in part by MIPs (higher MIPs equal higher software charges). Moreover, mainframe computer sales often lead to additional sales in software and services.
"We look for a decent
mainframe cycle here," Gorman says.
Meanwhile, IBM's microelectronics business should start benefiting from sales of video-game microprocessors for
upcoming Xbox 360 release after Thanksgiving,
PlayStation 3 expected next spring and
Revolution launching by the end of 2006.
Bernstein analyst Toni Sacconaghi, who rates IBM an outperform, estimates that the company could ship 2 million to 3.5 million game processors in 2005, which translates into revenue of $240 million to $400 million at $120 per processor.
Overall, that's a small portion of the $91.4 billion in total sales he's projecting for IBM in 2005. But the microelectonics division can have a larger effect on operating income because it's so capital-intensive.
Software, on the other hand, involves very little capital and is a higher-margin business. The third quarter, however, is typically soft for this unit, prompting Wagle to project flat software sales.
The fourth quarter, on the other hand, is typically strong in software and should be even stronger this year because of the mainframe cycle, he adds.
And because the fourth quarter is IBM's biggest quarter of the year overall, investors will be keenly interested in the company's outlook for the period. Analysts are expecting IBM to earn $1.87 a share on $25.65 billion in sales, representing robust sequential sales of growth of 18% and even larger earnings growth of 65%.
If IBM can deliver such strong results in the fourth quarter, investors should finally be satisfied that a sustainable recovery is under way.