IBM's Second Chance

Investors have returned to this stock on faith that April's weak earnings report won't be repeated Monday.
Publish date:

Leading into a crucial second-quarter earnings report after the bell Monday, shares of


(IBM) - Get Report

have broken out of their depressed state in the past couple of weeks, as once again investors raise their hopes for better things to come.

The company isn't expected to repeat the dour performance of the prior quarter, when it

soundly missed its financial targets, plunging its shares to a two-year low, but IBM's overall progress in strengthening its services operations and in cutting costs will be keys to extending the stock's current momentum.

Shares are up 10% in July to $81.77, after bouncing between a range of $73 to $77 from mid-May through June. For the year, however, shares remain sacked -- off 17% from its starting level just under $100. The prospect of a rebound above triple digits is enticing, though, considering that an extended stay above the century mark hasn't happened since early 2002.

But for that to happen, investors will need signs of a sustained turnaround at the Armonk, N.Y.-based company, which has increasingly positioned its services division as the company's new hub. Consistent execution during the second half of the year, when business is traditionally strongest, will go a long way toward erasing the memory of the first-quarter stumble.

That misstep showed that IBM's transition from a hardware specialist to services company has been

long in coming and not without difficulties. IBM blamed service contract deferrals, poor execution and a delayed product transition as reasons for its difficulties.

Mark Morris, head technology analyst at Nuveen Investment's NWQ Investment Management unit, which runs $34 billion in assets, says the transition is the right thing to do but that the services side of technology is an extremely competitive landscape.

"It makes sense that companies want to leverage their strengths, and clearly what IBM provides beyond hardware and software is the ability to put it all together," Morris says. "Customers are moving toward simplifying their lives."

He expects IBM's services operations to show improved performance and good bookings for the just-completed second quarter. And overall, he doesn't forecast the company to miss its targets. "I would expect a reasonable rebound vs. the disappointment they had in the last quarter," Morris says.

On average, analysts forecast earnings of $1.03 a share on sales of $21.9 billion, according to Thomson First Call. These estimates exclude an expected charge of $1.3 billion to $1.7 billion for

job cuts announced in May and a $1.2 billion gain from the sale of its PC unit. However, they include the 10 cent-a-share impact from employee stock options.

IBM is struggling to prove it can grow as it sticks with its services-centric strategy. Its long-term targets call for double-digit earnings growth and mid- to high-single-digit sales growth.

So far, Wall Street hasn't totally bought into the growth story. Consensus estimates project a 4% decline in earnings and a 5% drop in sales this year. For 2006, early targets project an 11% increase in earnings, and sales growth of 2%.

Investors also will be keying in on the direction of margins in each business unit. Services account for half of IBM's revenue, but carry the lowest margins, at 24.3% in the first quarter. Hardware is the next-largest group, but revenue will take a hit as the sale of the PC division officially closed during the second quarter. Software accounted for 15% of IBM's first-quarter sales, but carried the company's highest margins at 86.7%.

Another factor for this international provider is the dollar's strengthening against both the euro and the yen. What had been a boost in prior quarters' results is now a drag.

As always with IBM, there are myriad moving parts to consider, but services clearly has become the pivot around which the stock is trading. The job-cut announcements weren't enough to lift shares back in May and the recent rally only started once indications started trickling out that IBM didn't flub another quarter. Another leg higher in the stock will only come once services appear to be fully righted.