IBM Is Facing Steep Growth Targets

Software sales are the metric to gauge whether Big Blue is overreaching.
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Investors will be watching

IBM's

(IBM) - Get Report

second-quarter earnings report Wednesday for signs that the company can hit its ambitious targets for earnings growth.

This week's financial report will be the first since Big Blue's CFO Mark Loughridge outlined plans to double earnings per share by 2010. For the current fiscal year, the company is expecting EPS growth of 13% to 14%.

Loughridge's plans rely heavily on software-fueled revenue growth and potent doses of stock buybacks. He is hoping to increase the proportion of revenue coming from software, which has broader profit margins than hardware and information technology services.

In the last quarter, software sales accounted for approximately 20% of total revenue. The cornerstone of IBM's software business is its middleware products, which manage the exchange of data between computer systems from different software makers.

IBM holds roughly 53% of the market for that type of software, according to Goldman Sachs' Laura Conigliaro, who doesn't own shares but whose firm provides investment banking services for IBM.

This market is expected to grow at an annual compounded rate of 44% to $75 billion by 2010.

The bullish case for IBM is based on software generating about 50% of revenue, says Igor Golalic, manager of Federated Investors' American Leaders Fund. IBM is one of the fund's top holdings.

To watch Brittany Umar's video take of this column, click here

.

Because the second quarter is seasonally weak and likely to bring only single-digit software sales growth, Golalic expects the stock to be volatile as traders take profits. But he believes that strong orders in the third and fourth quarters could lift IBM's stock price to $118 or $120 by the end of the year.

IBM also has rolled out so-called virtualization software, which helps hardware such as servers and data-storage equipment tap unused capacity. This helps companies cut IT operating costs and pare hardware purchases.

The growing popularity of virtualization also could lift IBM's hardware sales by creating demand for its high-end, high-margin servers. Market analysts say companies are more inclined to pay for top-of-the-line tech gear if virtualization helps them get more out of their purchases.

"The virtualization trend will be like having the wind at their backs," said Golalic.

Hardware sales may have suffered a bit in the second quarter because IBM was late in launching new servers with faster processors. But sales should get a lift in the second half of the year when tech spending generally picks up.

IBM's servers are generally considered premier products alongside of those from

Sun Microsystems

(SUNW) - Get Report

, and above

Dell's

(DELL) - Get Report

and

Hewlett-Packard's

(HPQ) - Get Report

.

Analysts are expecting second-quarter earnings to jump 13% to $1.47 a share, including options expenses, on a 5.3% rise in revenue to $23 billion.

Another important question on investors' minds is how much revenue growth stems from acquisitions vs. IBM's core businesses. The company has said acquisitions will play a key role in expanding its software business.

On Monday, IBM announced plans to acquire software-maker

DataMirror

for $162 million. DataMirror's software spots changes and deletions to information stored in databases and business applications.

IBM's technology services business looms large over the company's empire. In the last quarter, business and technology services, which include consulting and outsourcing, generated 57% of revenue. Perhaps most importantly, IBM's services business helps spur demand for its higher-margin software and hardware products.

Federated's Golalic is looking for $11 billion in second-quarter service bookings, which would represent a third consecutive quarter of double-digit growth. On Monday, IBM announced a $1.4 billion outsourcing deal with drug maker AstraZeneca.

But projects of this size are increasingly rare, putting the burden on IBM to increase the volume of new outsourcing and consulting deals.

In the short term, Loughridge is relying on financial engineering to help meet his earnings growth target. In April, he secured board approval for an additional $15 billion in stock buybacks, financed by $11.5 billion in bank loans.

By the end of May, IBM had already spent $12.5 billion buying back 118.8 million shares at $105.18 a share.

IBM also has announced plans to cut certain pension benefits. This will help earnings, but ultimately, the bull case for IBM rests on increasing software sales. This could help IBM's share price eventually reach $150 if its forward price to earnings ratio begins to reflect greater software sales, says Golalic.

IBM's focus on software may also help stabilize its revenue if tech spending becomes volatile, says Ken Kuhrt of Ariel Capital Management, which holds IBM shares in its Focus fund.

"With shift away from hardware, IBM's sales rely less on capital expenditures and more on reoccurring revenue from software licensing," says Kuhrt. "Tech spending is still a factor for IBM -- but less so than it historically was."

Want more? Check out TheStreet.com TV video.Brittany Umar takes a look at the IBM CFO's lofty goals.