Jittery Investors Punish IBM

Its earnings rose 10% year over year, but the company gives no evidence of a robust IT-spending recovery.
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Updated from 11:01 a.m. EDT

It's what


(IBM) - Get Report

didn't say that apparently disappointed investors in the wake of its June quarter conference call. The massive tech company offered precious little solace for those seeking evidence of a second-half rebound.

Meanwhile, IBM managed to bring in sales slightly above consensus estimates. But while the company firmly maintained that it also met Wall Street's earnings expectations for the quarter, some analysts said it appeared to come in a penny light.

The shares were down $3.91, or 4.5%, to $82.83 in Thursday morning trading.

On an unusually lengthy conference call, Big Blue said it remains on track to meet analysts' full-year average estimates on revenue and profit -- though Goldman Sachs analyst Laura Conigliaro noted that it seems likely to meet those numbers partly through currency gains.

Chief Financial Officer John Joyce said that the second quarter, like the first, was "a good quarter in a tough environment." He talked up the company's annuity-like core business and the breadth of its customer base. While no doubt reassuring to current investors, that's hardly the commentary that would hint at expectations of a significant recovery.

Even IBM's supporters sounded lukewarm. "IBM reported a decent quarter that should have been an excellent one," says Steven Milunovich of Merrill Lynch, pointing to a steep loss in microelectronics and light services bookings. His firm has done banking for IBM.

"With first half services signings at only $23 billion versus $26 billion last year and semis getting worse, we continue to believe the stock is stuck in an $80 to $90 trading range in the near term," says Lehman's Dan Niles in a morning note. His firm has done banking for IBM.

Niles cut his EPS estimate for calendar year 2003 by a dime to $4.25. Niles says Street EPS numbers for the third quarter are likely to be cut by 6 cents to 8 cents in light of losses in IBM's semiconductor arm, which saw red ink grow from $11 million to $110 million sequentially and whose losses are expected to get worse in the third quarter.

Net income totaled $1.7 billion, up dramatically from last year's $56 million profit (though the latter number reflected a raft of charges). Excluding last year's after-tax charge of $1.1 billion, IBM said EPS was up 10% year over year.

Earnings per share of 97 cents reflected a one-penny loss for discontinued operations. On a pro forma basis, analysts were expecting 98 cents per share of earnings.

"What stands out for us most blatantly is that IBM missed by a penny before foreign exchange gains," notes Richard Williams of Summit Analytic Partners. "While we are big fans of IBM's on-demand strategy and believe that the company will be one of the leading web channel vendors in time, there is a troubling scenario that we feel is important to consider, that of earnings quality erosion."

"Without non-recurring items, IBM missed by as much as 7% to 12% and in our opinion should be valued as such," Williams writes. "It posted sales of $19 billion and EPS of 85 cents of operating results ex foreign exchange." Williams, who has a small short position in IBM, says his firm remains "sellers of IBM" at yesterday's closing levels.

But another analyst, John Jones of SoundView Technology, said that in his view IBM met expectations, explaining that it's standard practice for analysts to exclude discontinued operations in their estimates.

"IBM beat revenue numbers with a very strong performances in the services sector, though their microelectronics business was weaker than we expected it to be," he said. Jones had an outperform rating on IBM leading up to the call; his firm has no banking with IBM.

Michael Mahoney, a managing director at hedge fund EGM Capital, says the EPS number appeared to be a "near-miss. It's not a disastrous miss, but they sure didn't beat the number." Adds Mahoney, "Their earnings quality has left a lot to be desired for a couple of years now. I don't give them a lot of leeway in terms of how much I trust the quality of their earnings."

On top of that, he says, "If you 'x' out the gains on currency, their revenues are up 3% instead of 10%. That's not a disaster, but it's pretty anemic growth. It's probably not something that would send IBM dramatically in either direction in terms of the stock."

IBM's results "kind of support the argument that tech is stabilizing and in a few areas spending is picking up, but we're not at the point of a generalized pickup that can extend to most parts of tech," says Mahoney.

Sales notched $21.63 billion, reflecting a rise of 10% from last year's levels. Revenue was a notch above the analyst consensus estimate of $21.38 billion.

Stripping out the currency benefits of a weak dollar, however, sales in continuing operations grew a much more humble 3%.

That suggests organic growth was minimal, since at least some of the added revenue was due to the purchase of PricewaterhouseCoopers and Rational Software over the past year.

Gross profit margins from continuing operations totaled 37%, unchanged from the second quarter of 2002.

By business division, sales in IBM's global services unit, including maintenance, were up 14% when adjusted for the weaker dollar (23% when not adjusted), helped along by the acquisition of PricewaterhouseCoopers.

But as expected, IBM's service signing declined from the prior quarter, falling to $10.7 billion from $12 billion.

Hardware sales from continuing operations dropped 6% when currency is adjusted (down 1% including currency gains).

IBM said its microelectronics line suffered from disappointing yields at its new 300 millimeter fab. "The foundry business is not seeing the ramp as fast as we would like," added Joyce on the conference call. "We have design-ins with major customers; they're just not ordering at a rate and pace we had assumed. We think that will push out of the third into the fourth quarter."

But on the hardware side, strength in the e-server business helped offset weakness in IBM's chip line, Joyce added.

Meanwhile, software sales declined 2% when adjusted for currency fluctuations currency (but rose 6% including currency gains).