In the Pink at Big Blue?


By Megan Graham-Hackett IBM (IBM

; ranked hold; recent price: $85) helped lead the second-quarter earnings season for computer hardware stocks. The outfit posted earnings of $1.12 per share (EPS), excluding one-time items -- well above our estimate of $1.02.Still, we believe expectations were set low following disappointing first-quarter EPS results. We think it could be argued that some of the strength in services and hardware was a result of sales slippage from the first quarter to the second quarter.

IBM's second-quarter EPS beat our estimate by 10 cents, led by a recovery in its Global Services business. The story was gross margin -- up 300 basis points year over year and 300 basis points above our estimate. The quality of EPS was OK, in our opinion, but lower shares outstanding (below our forecast) contributed about 2 cents to the upside.

MAINFRAME DROP. Overall second-quarter revenues of $22.3 billion were down 4% year over year, but up 6% excluding PCs (IBM's PC unit was sold to Lenovo during the quarter). This mostly stayed in line with our expectations.

Hardware sales rose 4% -- excluding PCs and in constant currency (cc) terms -- but were slightly below our forecast. Mainframe sales fell 25%, but high-end Unix sales increased 34%, and storage jumped 17% (with both disk and tape advancing in the double digits). The performance in storage strengthened from a disappointing first quarter.

Services revenue was up 4%, and signings increased to more than $14 billion, led by strength in longer-term contract signings. Still, the focus for the quarter was on this segment. In our opinion, IBM knew it had to deliver.

DURABLE MARGINS? Coupled with the first-quarter miss, we believe Global Services appears on track, but the sustainability of this recovery is still in question, in our view. For instance, longer-term contract signings, which recovered to $9.2 billion, had been at a run rate of about $5 billion to $5.4 billion in four of the past five quarters. Before that, those contracts were running at a rate of $10 billion to $11 billion per quarter.

We'll also monitor the company's gross margin performance -- volumes helped this quarter, and IBM said gross margin was aided by better utilization rates. Big Blue also noted that pricing trends were stable-to-improving, but we believe some of the factors contributing to pricing pressure remain in the business. And as volumes potentially drop in a seasonally tougher third quarter, gross margin could narrow again.

Software sales advanced 7% led by strength in middleware. Sales of middleware were up 11% overall, and the company believed it gained market share. Websphere sales increased 14%, Lotus rose 14%, and DB2 sales were up 14%.

ASIAN DEMAND. We note that IBM has made a number of software acquisitions over the past year, but it stated that determining its organic growth for the segment was difficult due to quick integration of these acquisitions. We think it's fair to say that acquisitions contributed more than 3 percentage points of revenue growth on a year-over-year basis.

As far as the performance in specific geographies, overall Europe (specifically Western Europe) and Japan appeared to continue to be a drag on results, reflecting relatively weak economies. Meanwhile, demand from the Americas and Association of South East Asian Nations (ASEAN) region was relatively healthy.

All told, IBM's second quarter was solid, in our opinion. While it confirmed (again) that second-half consensus EPS estimates by the Street were "reasonable," it did state the year would be back-end loaded. That means while we look to EPS of $1.18 in the third quarter, we project fourth-quarter EPS of $1.65 -- up 40% sequentially.

"FAIRLY VALUED." Finally, currency could be a headwind as we continue through the second half of the year. If current spot rates hold, IBM estimates that its fourth-quarter revenue could be hurt by currency translations to the tune of 3%.

In our view, IBM has to show better consistency in its Global Services results in the future -- and that will likely be tough in a seasonally weak third quarter -- and turn its operations around in Europe. Given these challenges and the valuation of the shares, we kept our hold opinion on the shares, following the company's second-quarter earnings report. At 1.5 on a price-to-sales basis, IBM trades in line with the peer average, and we view the shares as fairly valued.

Required Disclosures

In the U.S.

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services U.S. have recommended 30.2% of issuers with buy recommendations, 57.5% with hold recommendations and 12.3% with sell recommendations.

In Europe

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services Europe have recommended 34.4% of issuers with buy recommendations, 46.8% with hold recommendations and 18.8% with sell recommendations.

In Asia

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services Asia have recommended 33.3% of issuers with buy recommendations, 47.2% with hold recommendations and 19.5% with sell recommendations.

Globally

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services globally have recommended 31.0% of issuers with buy recommendations, 55.4% with hold recommendations and 13.6% with sell recommendations.

5-STARS (Strong Buy): Total return is expected to outperform the total return of a relevant benchmark, by a wide margin over the coming 12 months, with shares rising in price on an absolute basis.

4-STARS (Buy): Total return is expected to outperform the total return of a relevant benchmark over the coming 12 months, with shares rising in price on an absolute basis.

3-STARS (Hold): Total return is expected to closely approximate the total return of a relevant benchmark over the coming 12 months, with shares generally rising in price on an absolute basis.

2-STARS (Sell): Total return is expected to underperform the total return of a relevant benchmark over the coming 12 months, and the share price is not anticipated to show a gain.

1-STARS (Strong Sell): Total return is expected to underperform the total return of a relevant benchmark by a wide margin over the coming 12 months, with shares falling in price on an absolute basis.

Relevant benchmarks: in the U.S. the relevant benchmark is the S&P 500 Index, in Europe the S&P Europe 350 Index, in Asia the S&P Asia 50 Index, and in Malaysia the KLCI or KL Emas Index.

For All Regions:

All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report.

Additional information is available upon request.

Other Disclosures

This report has been prepared and issued by Standard & Poor's and/or one of its affiliates. In the United States, research reports are prepared by Standard & Poor's Investment Advisory Services LLC ("SPIAS"). In the United States, research reports are issued by Standard & Poor's ("S&P"), in the United Kingdom by Standard & Poor's LLC ("S&P LLC"), which is authorized and regulated by the Financial Services Authority; in Hong Kong by Standard & Poor's LLC, which is regulated by the Hong Kong Securities Futures Commission, in Singapore by Standard & Poor's LLC, which is regulated by the Monetary Authority of Singapore; in Japan by Standard & Poor's LLC, which is regulated by the Kanto Financial Bureau; in Sweden by Standard & Poor's AB ("S&P AB"), in Malaysia by Standard & Poor's Malaysia Sdn Bhd ("S&PM"), which is regulated by the Securities Commission and in Australia by Standard & Poor's Information Services (Australia) Pty Ltd ("SPIS"), which is regulated by the Australian Securities & Investments Commission.

The research and analytical services performed by SPIAS, S&P LLC, S&P AB, S&PM and SPIS are each conducted separately from any other analytical activity of Standard & Poor's.

S&P and/or one of its affiliates has performed services for and received compensation from this company during the past 12 months.

Disclaimers

This material is based upon information that we consider to be reliable, but neither S&P nor its affiliates warrant its completeness, accuracy or adequacy and it should not be relied upon as such. With respect to reports issued by S&P LLC-Japan and in the case of inconsistencies between the English and Japanese version of a report, the English version prevails. Neither S&P LLC nor S&P guarantees the accuracy of the translation. Assumptions, opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Neither S&P nor its affiliates are responsible for any errors or omissions or for results obtained from the use of this information. Past performance is not necessarily indicative of future results. Graham-Hackett follows computer hardware stocks for Standard & Poor's Equity Research


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