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IBM Profit Speaks Softly

The company's 13-cents-a-share beat on earnings can't offset a shortfall in the top line.

Updated from 4:43 p.m. EDT


(IBM) - Get Free Report

on Monday posted third-quarter earnings that handily beat analysts' estimates, but the company failed to match sales expectations.

Although the results were mixed, investors bid shares up by $1.65, or 2%, to $84.24 in recent after-hours trading. The stock closed the regular session up 24 cents to $82.59.

IBM posted third-quarter earnings of $1.52 billion, or 94 cents a share, on sales of $21.53 billion. During the same quarter last year, the company earned $1.55 billion, or 92 cents a share, on sales of $23.35 billion.

The company's results for the quarter included a one-time charge this year of 32 cents a share for a "homeland" repatriation tax as well as a litigation charge last year of 11 cents a share last year. Excluding those one-time items, IBM earned $1.26 a share in the third quarter, compared with $1.03 a share in the same period a year ago.

IBM's bottom line easily beat analyst estimates of $1.13 a share excluding items, as gathered by Thomson First Call. But sales fell short of the $21.71 billion that Wall Street targeted, by more than $100 million.

Excluding 2004 revenue from IBM's PC business, which the company sold May 1, third-quarter revenue increased a modest 4% from the same period a year ago.

"The top line was disappointing, especially on the services side," said Dan Niles, CEO of Neuberger Berman Technology Management, an investment management firm that doesn't hold shares of IBM. But "the margins are definitely encouraging," he added.

Overall gross margin was 40.6% in the third quarter, up from 36.5% in the third quarter last year and 39.4% in the previous quarter. Excluding the PC unit, gross margin was 40.0% in the third quarter last year.

Big Blue's services unit, which made up 54% of total sales, posted a 3.3% increase in revenue from a year ago to $11.69 billion. The unit, which suffered a major slowdown in the first quarter and then rebounded in the second quarter, marked its second consecutive quarter of increasing contract bookings, to $11 billion from $9.8 billion last year.

That's a sequential decline, however, from $14.6 billion in signings in the second quarter. Niles noted that shorter-term contract signings -- which he calls a good near-term indicator of the services unit's health -- dropped to $4.7 billion from $5.4 billion in the previous quarter.

Services backlog remained flat sequentially at $113 billion, which represents an increase of $3 billion from a year ago. The services unit's pretax operating margin improved by 1.1 points from a year ago to 9.7%.

On a postclose conference call, CFO Mark Loughridge did not provide explicit fourth-quarter guidance but offered some cryptic clues to help analysts adjust their estimates.

He told investors to "roll through" the company's third-quarter earnings upside to full-year results and to expect double-digit earnings growth for the fourth quarter and full year.

The CFO reiterated that the second half of the year would be characterized more by cost and expense management than by revenue growth with the fourth quarter "similar in texture" to the third quarter, even as the hardware unit benefits from a new mainframe cycle and video-game chip sales.

Earlier in the year, IBM announced

plans to lay off thousands of workers after its services division surprised Wall Street with weak first-quarter results. Loughridge indicated on Monday that IBM's services pipeline is continuing to grow from the just-reported third quarter.

On the basis of Loughridge's comments, Niles said he expects analysts to maintain earnings targets but lower revenue estimates for the fourth quarter. Analysts are projecting earnings of $1.87 a share on $25.65 billion in sales in the fourth quarter.

Outside of the services unit, IBM's hardware sales (excluding the PC business) rose 7% to $5.1 million, software sales increased 5.5% to $3.82 billion, and global financing sales dropped 5.8% to $600 million in the third quarter.

IBM's hardware unit suffered from a 4% decline in mainframe sales compared with a year ago. The company began shipping its new z9 mainframe line in the last two weeks of the quarter; this is expected to result in rising mainframe sales starting in the fourth quarter.