Can IBM Shake Its Big Blues?


By Amy Tsao Cautious investors have long looked to tech giant IBM (IBM) as a safe harbor during times of trouble. That held true during the technology swoon of 2000-01. But at the beginning of 2002, IBM stock began to falter amid allegations that aggressive accounting methods were helping to offset weakness in its businesses (see BW, 4/15/02, "Can IBM Keep Earnings Hot?"). Then, on Apr. 8, the company issued its first earnings warning since the early '90s -- and the stock tumbled 10% in one day.

Time to panic? In the short term, smart investors might want to steer clear. IBM said it expects first-quarter revenues to be about $1 billion less than analysts had forecast, due to weakness across the board and particularly in the division that makes microchips and hard drives for other companies. The period's earnings will be around $1.65 billion to $1.75 billion, or $0.66 to $0.70 per share, down at least 32% from $0.98 a year ago.

Such a miss, even for a company expecting $18.4 billion to $18.6 billion in quarterly revenues, has many investors running scared. But anyone with a longer-time horizon still may want to keep an eye on Big Blue, especially if short-term woes continue to pummel its shares.

PEELING THE ONION. The belief that IBM stock is a bulwark in a difficult economy is certainly taking a pounding. Its shares hit a 52-week high of $126 in early January. But now they're near a 52-week low, closing at $86.20 on Apr. 16. Analysts are starting to worry that IBM's strategy of providing a broad range of products and services, while probably wise in the long term, may be magnifying its woes in the near future. IBM declined to comment before the release of its earnings report.

Its business segments now include global services, three hardware-product segments, software, global financing, and enterprise investments. "The reason for weakness doesn't all add up," says Barry Miller, a tech analyst at Dreyfus Corp. (which owned 4.9 million shares of IBM as of the end of February). "We have to peel back the onion and see what beyond the [microchips and hard-drives segment] is weak."

Analysts will be scouring the details of first-quarter results, to be announced on Apr. 17. They expect the numbers will show that IBM's big push to diversify into goods and services, beyond the manufacture of computer servers and mainframes, isn't generating enough revenue, with no pickup in tech spending in sight.

STEEP RATIO? "We look at changes in inventories, receivables, and payables and aggregate them to see how a company is making current earnings," says quantitative analyst Mike Farrell at Boston-based investment advising firm David L. Babson. "Where IBM is falling apart is in the quality of its earnings." Based on his analysis -- which involves looking at price-to-book ratio, the rate at which analysts change their earnings estimates, IBM's cash-flow statement, and its required quarterly filing to the Securities & Exchange Commission -- the stock currently ranks in the bottom 10% of those he tracks.

IBM's price-earnings ratio of 20 times consensus 2002 earnings per share (EPS) of $4.16 is high, considering its lack of growth, says David Robertson, an analyst with Baltimore-based Allied Investment Advisors. "Before this preannouncement," he says, "I was recommending buying IBM stock anywhere below $100." Now he admits he's not so sure.

Robertson remains convinced that IBM is strategically on the right path over the long haul, and he believes that its stock deserves to trade at a premium relative to its growth rate. Trouble is, not much growth is on the horizon. He thinks investors would be better served by buying IBM at a multiple in the mid-teens. At 16 times his 2002 EPS estimate of $4.23, that would mean a price of about $68 per share. Basu Mullick, portfolio manager of Neuberger Bergman Partners Fund, says IBM shares would be compelling anywhere under $80 -- assuming he had evidence that 2003 EPS would come in around $4.80 to $4.90 per share.

OTHER WORRIES. Any additional sales weakness in microelectronics would give still more cause for concern since it would indicate that market demand hasn't yet picked up in that area, says Toni Sacconaghi, an analyst with investment-research group Sanford C. Bernstein. Of IBM's other units, Sacconaghi sees significant problems in high-end servers and particularly in services.

Wall Street's bigger worry is IBM's global-services business, which accounted for some 40% of revenues in 2001. This fastest growing piece of the company may have seen a decline rather than the forecasted rise in the first quarter. "I expect services to have missed fairly substantially on the revenue line," says Daniel Kuntsler, analyst with JP Morgan Chase.

From systems integration to consulting and outsourcing, IBM has likely had a hard time converting a strong backlog of service contracts at the end of 2001 into real deals, as corporations continue to postpone IT spending. Says Kuntsler: "I expect a repeat of last quarter, where you can't really harvest on new contracts."

SAM'S CHANCE. If the recent disappointments from software companies are any indication, IBM's software segment may have been hit in the first quarter, too. The business contributed 15% of $85.9 billion in total 2001 revenues. Companies such as Oracle (ORCL), PeopleSoft (PSFT), and Siebel Systems (SEBL) have fallen short of expectations, and their CEOs continue to warn of weakness in the software market. IBM's software division isn't likely to plummet, but flat to lower revenues aren't out of the question.

In the near term, the earnings warning serves as a way for new IBM CEO Sam Palmisano to lower expectations. It also gives him an opportunity to prove he can show growth with less help from financial engineering. Indeed, many of the accounting steps the company has used -- such as booking gains from pension income, one-time asset sales, and share repurchases -- aren't expected to produce the desired results in the current environment. IBM says it expects return on 2002 pension income to come down significantly from $904 million in 2001, and it plans to spend less on stock buybacks over the year.

Over the long term, IBM's role as the one-stop shop for IT products and services will likely prove the distinction that sets it apart. "It's putting together a service package that competitors can't offer because they don't have all the pieces," Robertson notes. But for now, as its businesses suffer, investors might do well to wait for its stock price to fall more in line with lower expectations before jumping in.

Editor's Note: Since this story was originally published, IBM's Palmisano has recently unveiled plans to slash costs yet further amid tepid info-tech spending. On June 4, IBM said it'll take charges of up to $2.5 billion to pay for thousands of layoffs and the sale of its disk-drive business. Analysts say the plans will have a positive effect later in 2002, but second-quarter earnings could still look weak. For now, analysts on average expect earnings of $0.86 per share for the quarter. Meantime, as market sentiment on tech stocks - even marquee names like IBM -- continues to sour, the stock has fallen to $74 as of June 12. Tsao covers financial markets for BusinessWeek Online in New York


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