Analyzing IBM

By Yaser Anwar, CSC of Equity Investment Advisors

• IBM posted revenues of $26.3 billion beating The Street’s $25.7 billion. IBM’s results benefited from an improvement in margins, enabled by cost cutting and the better margin profile of its portfolio lines, following the company’s exit from the PC business.
• The reaction in the after hours can be credited to unexpected investments in sales and incremental acquisition expense, yielding gross margins that were lower vs last year’s Q4.
• Also, one time benefits of a real estate transaction negatively impacted software margins by 270 bps. Furthermore, systems and technology group was negatively impacted by, give or take, 100 bps by currency and the allocation of real estate. If these events had been foreseen, EPS would have been another $0.10 or so higher.
• Top-line growth of 7% was ahead of the 5% expected by The Street, thanks to strength in software and services which was offset by weakness in hardware. EPS of $2.26 beat expectations by $0.06.
• The Services division posted strong 4Q bookings of $17.8 billion which helped push TTM bookings growth to 5% (a 55% YoY increase). Services revenue growth of 3% thanks to the recent ISS acquisition.
• IBM storage had a solid quarter with revenue growth of 9% YoY. Disk systems grew 12%, with double-digit growth in both midrange disk and SAN. IBM’s high end storage, DS8000, saw shipments grow 15%+ YoY.
• Out of all the divisions, Hardware was by far the worst. Gross margins fell 100 bps, mainframes fell and the Microelectronics division dropped sharply to -6%. Moving on, Global Technology Services margins fell 370 bps YoY to 9.3%, while Global Business Services margins continued to exceed expectations, increasing 230 bps YoY to 11.8%.
• Global Services has been growing at an average double digit rate over the past several years. It is evident by IBM’s strong bookings that revenue growth is progressing, and expect to see more consistency from IBM’s Global Services unit over the next 12 months. Also, investors should keep in mind the acquisition of Internet Security Systems appeared to negatively impact margin on the quarter.
• Furthermore, IBM indicated that it is continuing to make investments in sales, and investing in skills building across the company services portfolio. To accomplish this, management has indicated that it plans to continue improving its processes, increase productivity and improve flexibility and scalability.
• IBM’s results have benefited from an improvement in margins, enabled by cost cutting and the better margin profile of its portfolio lines, following the company ‘s exit from the PC business. IBM indicated steady demand and a healthy services deal pipeline going into 07.
• Management also kept their long term target of mid single digit revenue growth and 10-12% EPS growth, which I believe will be achievable given its on-going investments, through acquisitions and productivity initiatives.
• If the economy slows, investors should expect slower than expected IT demand environment making it difficult for IBM to meet its double digit EPS growth long term guidance targets. Also, thanks to a very competitive environment there could be greater than expected hardware pricing pressures.

According to Goldman– Operating leverage was disappointing, with margin improvements not likely until the second half of 2007. IBM’s more typical earnings performance has been to combine lower-than-expected revenue with higher-than-expected earnings.

In the December quarter, the reverse was the case with IBM indicating that recent investments in sales for services, software, and emerging countries will continue at least through the first quarter and probably into the second as well. As a result, we have lowered our March and June quarter estimates slightly even including IBM’s lower tax rate for 2007.

According to BAC– IBM pension expense will increase by~$100 million in 07, vs. a ~$400 million increase in 06. IBM’s pension expense will decline by $500 million to $1 billion in 08 compared to 07, and decline further in 09.

We have assumed a margin benefit of approximately $0.25/share in 08E from pension. Depending on interest rate and return assumptions, IBM could have another $0.25 benefit in 08E. We believe that our CY08 estimates will be above Street expectations ($7.28), helped by a lower pension expense.

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