Palmisano Needs Acquisitions to Sustain IBM Growth (Update2)

April 5 (Bloomberg) -- International Business Machines Corp.’s Sam Palmisano, who increased net income almost fourfold in eight years at the helm, may need a multibillion-dollar acquisition soon to keep up the pace, some investors say.

“It’s time for a bold stroke, or a series of bold strokes,” said Peter Sorrentino, senior portfolio manager at Huntington Asset Advisors in Cincinnati, who helps handle $12.8 billion, including 390,000 IBM shares as of Dec. 31. “It really takes a major acquisition or a series of midsize acquisitions.”

While IBM has boosted earnings per share through buybacks, expense controls and other measures, rivals Oracle Corp. and Hewlett-Packard Co. have eclipsed its stock-price performance, lifted by big acquisitions that helped revenue soar.

Under Palmisano, IBM has spent $25 billion buying companies. Compare that with at least $42 billion for Oracle and Hewlett-Packard’s $45 billion. IBM’s share price has risen 32 percent in the Palmisano era, versus 54 percent for Oracle and 168 percent for Hewlett-Packard.

Revenue will rise 3.8 percent this calendar year at IBM as Hewlett-Packard’s sales increase by 6.9 percent and Oracle’s by 24 percent in the same period, according to a Bloomberg survey of analysts.

The conclusion, some investors say: Palmisano’s current strategy may have its limits. During the past eight years, he has worked to shift IBM’s focus from hardware to services and software, which are more profitable. He’s also cut operating expenses and headcount, sent work overseas and sold off low-margin businesses. All this may not be enough to maintain IBM’s earnings growth.

‘Maximized the Model’

“They’ve maximized the model to the full extent they can,” said Ben Rogoff, a manager at Polar Capital Partners in London who helps oversee $2.5 billion, including more than 127,000 IBM shares, as of Dec. 31. “It takes a fair amount of M&A to move the needle on a $100 billion revenue company.”

After outperforming the Dow Jones Industrial Average and the Standard & Poor’s 500 Index for four straight years, IBM has trailed the market for the past 52 weeks. The shares missed the stock market’s best first-quarter gain since 1998, falling 2 percent as the S&P 500 Index rose 4.9 percent and the Dow Jones Industrial Average gained 4.1 percent. IBM rose $1.10 to $129.35 at 4:10 p.m. in New York Stock Exchange composite trading.

Through internal growth and deals, revenue has more than doubled at Oracle and Hewlett-Packard since their 2002 fiscal years. Hewlett-Packard, led by Mark Hurd, increased sales to more than $114 billion last year, passing IBM’s $96 billion. At Oracle, CEO Larry Ellison has snapped up more than 60 companies since 2005 to fuel revenue. Sales have grown 18 percent at IBM under Palmisano.

‘Elephant in the Room’

“Revenues are the elephant in the room,” said Brian Marshall, an analyst at Broadpoint AmTech Inc. in San Francisco. “They have to boost revenues materially.”

While IBM will continue to focus on smaller deals, its unsuccessful $7 billion bid for Sun Microsystems Inc. shows it is open to acquiring larger companies, a person familiar with the company’s acquisition strategy said. The person said IBM isn’t likely to spend more than $10 billion on a single deal.

IBM spokesman Michael Fay said the company has undergone a “profound transformation” since 2002. It has added $12 billion in pretax profit, created $80 billion in free cash flow and met or beat earnings forecasts for the past 19 quarters.

The company’s shift to high-margin software and service businesses and its expansion into cloud computing, analytics and new geographic markets provide significant opportunity for revenue and profit growth, he said.

Financial Wherewithal

IBM’s biggest purchases under Palmisano were $5 billion for Cognos Inc. in 2008 and $3.5 billion for PricewaterhouseCoopers LLP’s consulting business in 2002.

Palmisano declined requests for an interview. The company’s best year under his leadership was 2009, when IBM shares rose 56 percent. That compared with 23 percent for the S&P 500, 38 percent for Oracle and 42 percent for Hewlett-Packard.

“We have the financial strength to invest for growth and to deliver on our objectives as we have done over the decade,” Fay said. “None of this is to say IBM will or won’t do large acquisitions as it did with PWCC and Cognos.”

IBM began an initiative March 31 to help some startup software companies develop their technology as a way for IBM to identify partners and acquisition targets. IBM has bought about 75 of the 1,500 partners it has worked with, the company said.

Some investors are especially critical of IBM’s devotion to stock buybacks, a practice that dates back to the tenure of former CEO Louis Gerstner and has continued under Palmisano.

‘Sucking in the Stock’

“It means you don’t have any prospects out there,” Sorrentino said. “You buy back stock because it’s the only way to add to your bottom line. You’re sucking in the stock to shrink the company down.”

Palmisano has spent almost three times as much on stock buybacks as on acquiring new companies. Since 2002, the company has spent $68.5 billion on buybacks, equal to 41 percent of its current market value. That has increased IBM’s earnings per share almost fivefold as net income rose less than fourfold. Sanford C. Bernstein & Co. estimates that 22 cents, or 17 percent of IBM’s earnings-per-share growth, will come from buybacks this year.

Investors will penalize IBM if it spends too much on buybacks, said Bill Gorman, an analyst at PNC Capital Advisors, a unit of PNC Financial Services.

“Wall Street won’t put a multiple on a company that speeds up buybacks to hit a certain growth target,” Gorman said.

Profit Slowdown

Pressure will mount on IBM to do acquisitions as its earnings growth slows, some investors say. Since 2002, IBM’s net income has risen at an average 21 percent compound growth rate, almost nine times the pace of revenue, which climbed 2.4 percent annually.

Sustaining that pace of profit growth isn’t realistic, given IBM’s sluggish revenue, said Kevin Landis, chief investment officer at Firsthand Capital Management in Santa Clara, California, which manages $300 million. His firm sold all its IBM shares last year.

“The simple math is the bottom line usually doesn’t grow that much faster than the top line at most companies,” Landis said.

IBM’s net income growth will slow over the next two years, falling from 10 percent in 2010 to 9 percent next year and to 7 percent in 2012, according to estimates by Richard Nguyen, an analyst at Societe Generale in Paris. A Bloomberg survey of analysts shows a similar slowdown in earnings per share and net income.

Of 27 analysts tracked by Bloomberg, 17 recommend buying the shares and 10 advise holding them.

Acceleration Needed

IBM’s revenue will rise an average of 3.9 percent compounded annually through 2012, according to Bloomberg consensus estimates. That growth must accelerate to 12 percent to 13 percent yearly to achieve the same rate of earnings growth, said Sorrentino at Huntington Asset Advisors.

Investment bankers who have pitched deals to IBM say the company may look at larger companies than in previous years, such as storage makers EMC Corp. and NetApp Inc. Other targets could include networking firm Juniper Networks Inc. and Research In Motion Ltd., maker of the BlackBerry.

Although IBM has said it’s not interested in the mobile-handset market, the company will have to expand into wireless software and services to stay competitive in the corporate-technology field, some investors say.

Midsize Possibilities

“IBM will continue to buy companies of all sizes to complement its internal growth,” said Alec Ellison, global head of technology investment banking at Jefferies Group Inc. Ellison has sold small companies to IBM.

Rogoff at Polar Capital says it’s more likely IBM will examine small and midsize targets such as BMC Software Inc., Brocade Communications Systems Inc., NetApp and Juniper. A single deal could add $2 billion to $3 billion in annual sales and plug holes in IBM’s product line.

“There are a lot of assets available out there,” Rogoff said. “IBM and others are feeling the pressure of a new cycle and need to find the right pieces to the puzzle.”

Brocade doesn’t comment on rumor or speculation, John Noh, a spokesman for the San Jose, California-based company, said in an e-mail. Hopkinton, Massachusetts-based EMC also doesn’t speculate on rumors, said spokeswoman Lesley Ogrodnick.

Juniper Deal?

Juniper declined to comment, said Melanie Branon, a spokeswoman for the Sunnyvale, California, company. Waterloo, Ontario-based RIM doesn’t comment on rumors or speculation, spokeswoman Marisa Conway said. At BMC, Mark Stouse declined to comment on IBM’s potential interest in the Houston-based company. Jodi Baumann, a spokeswoman for Sunnyvale-based NetApp, didn’t respond to messages seeking comment.

Juniper, which makes networking equipment, would accelerate IBM’s expansion into cloud computing, which is central to Palmisano’s strategy. “Juniper would be a strategic deal for them,” Societe Generale’s Nguyen said.

Some investors say IBM doesn’t need big acquisitions to increase earnings per share. After reducing expenses by $3.7 billion last year, “we assume the company can reduce their cost structure through restructuring by $1.5 billion this year,” said Dick Glasebrook, a managing director at Straus Group, a unit of Neuberger Berman, which owned 13 million shares of IBM as of Dec. 31. “Throw in the buybacks, you can get in double-digit earnings growth.” He expects $1 billion a year in reduced costs after this year.

Liquid Investment

IBM will remain attractive to some investors as a reliable, liquid investment even if earnings growth slows, said Gorman at PNC Financial Services, which owned 4.5 million IBM shares on Dec. 31. Gorman estimates IBM’s net income growth will slow to 7 percent to 8 percent this year and the following two years, while earnings per share growth runs between 8 percent and 9 percent annually.

Some investors aren’t waiting. “The stock will get dragged down because of slow earnings,” said Paul Meeks, a principal at Winsor Asset Management in Charleston, South Carolina, which invests $300 million and sold its IBM shares last year. “That’s why I’m no longer in it. I don’t see the price appreciation.”

To contact the reporter on this story: Greg Miles in New York at gmiles1@bloomberg.net; Serena Saitto in New York at ssaitto@bloomberg.net; Katie Hoffmann in New York at khoffmann4@bloomberg.net

To contact the editor responsible for this story: Jeffrey Taylor jtaylor48@bloomberg.net