Computer Makers: Not Yet Fat and Happy


By Megan Graham-Hackett It's that time of year when computer hardware companies start announcing September-quarter earnings. The season wraps up in mid-November with reports from Hewlett-Packard (HPQ

; Oct. 15 stock price: $21.86) and Dell (DELL

; $36.24) describing their October-quarter results.

IBM (IBM

, $93.10) kicked off the group's season on Oct. 15. Big Blue said earnings per share were $1.02, meeting the consensus forecast, but revenues of $21.52 billion came up short due to pricing pressures, among other factors. We at Standard & Poor's believe the hardware market remains competitive, and we believe IBM's competitors will echo its sentiments: that pricing is tough, that the focus is on gaining market share, and that IT (information technology) demand has stabilized. IBM also stopped short of calling a recovery in the IT market.

We kept our buy recommendation on IBM (IBM

, $93.10), based more upon the earnings and revenue opportunities we envision for its software and services assets, rather than on its hardware division. (However, we do note that IBM's market share in servers increased in the second quarter of 2003, compared with 2002, according to market research provider International Data Corp.)

UP FROM PRETTY LOW. We also reiterated our hold recommendation on shares of Apple Computer (AAPL

, $24.87) after it reported quarterly earnings on Oct. 15. Apple's EPS came in at 8 cents, 2 cents above our estimate, while revenues of $1.7 billion exceeded our forecast. Apple saw strong growth in its laptops and iPods. It forecasts December-quarter revenues of $1.9 billion, about $100 million above our estimate, and it sees EPS rising slightly from the September quarter, in line with our model.

For the computer hardware segment as a whole, we see quarterly earnings rising 35% on average. However, this average isn't meaningful, in our opinion, since for many hardware companies, earnings are rebounding from depressed levels a year ago, and outfits that report losses in both quarters aren't included in the average.

We think our revenue estimate of 2.4% growth (on a year-over-year basis) is more meaningful in judging the stage of recovery in the computer hardware group. Indeed, anecdotal evidence from many technology companies has been more positive than in the past year. The exception was Sun Microsystems (SUNW

; $3.79), which warned that its loss for the quarter would be larger than expected. We believe this preannouncement (the only one in the computer hardware group) was company-specific, due to Sun's concentration of sales in Unix, typically a more costly server than Linux- or Windows-based servers. However, we also note that positive earnings preannouncements have been slim as well.

CASH-FLOW MANAGEMENT. The task of many computer hardware companies this quarter was to improve profitability in their server and PC divisions, in our opinion. Revenue growth was likely modest in these categories in the quarter, based on our estimates. One reason, we believe, is that gross margins may not improve given that higher unit volumes may be offset by firmer component prices during the quarter.

Another key area of focus in analyzing the quarterly results, in our opinion, will be how well cash flows were managed. Many companies made significant progress in this regard in the past four quarters, and it will be challenging, in our view, to achieve further improvements this quarter.

Finally, as is true with each quarter, investors will focus on the outlook for the next quarter. We now project EPS growth to rise 2.7% for 2003 from 2002. Our focus for the quarter will be how much this forecast rises and how much we increase our 2004 EPS expectations.

Among other companies in the group, we at S&P have an accumulate recommendation on Lexmark Computer (LXK

, $69.83), based on our forecast for its strong free-cash-flow generation. We're neutral, or have hold recommendations, on the rest of the group: HP, Sun, Dell, and Gateway (GTW

, $6.69). Analyst Graham-Hackett follows computer hardware stocks for Standard & Poor's


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