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Are IBM's Big Blues Lifting?

By Spencer E. Ante In a speech at IBM's annual meeting on Apr. 29, CEO Samuel Palmisano seemed to underplay the company's lackluster financial performance. In 2002, IBM's stock fell 36%, from $121 to $77.50 a share. Said Palmisano: "While our stock was down year-over-year -- no one is happy about that -- it held up better than all of our major competitors."

On closer inspection of its rivals' stock prices, though, Palmisano's assertion may not be completely justified. Compared to IBM's swoon, Cisco (CSCO) dropped 28%, Microsoft (MSFT) and Oracle (ORCL) plopped 22%, and Hewlett-Packard (HPQ) slid 15%. And not all big tech players suffered stock-market declines: Dell (DELL) gained 2%, and Intel (INTC) rose 9%. Sun Microsystems (SUNW), whose stock plummeted 75%, and EMC Corp. (EMC), whose shares plunged 54%, were the only major rivals that IBM (IBM) bested on Wall Street.

IBM's restructuring efforts may be starting to gain momentum, however. In the midst of a dreary environment for tech companies, Big Blue reported relatively strong results in the first quarter of 2003. Driven by strength in its services and software businesses, sales increased 11%, to $20.1 billion, while net income jumped 16%, to $1.4 billion, helped by the weak U.S. dollar. Of course, excluding gains from currency translations, IBM's sales would have risen just 4%.

SOUND STRATEGY. Still, analysts praised the results, saying IBM improved the quality of its earnings and continued to gain share in key markets. Investors cheered too. This year, IBM stock has risen $9, or 12%, to around $87, as of May 5. "We believe we stand our best chance in decades of returning IBM to a position of leadership -- leadership in our industry and leadership in the broader world of business," Palmisano said at the annual meeting.

The recent run-up in IBM stock, however, may leave it with little room to grow much in the short term, say analysts and investors. At around $87, IBM's price-earnings ratio for this year is 20. Based on 2004 earnings estimates, its p-e is 18, which is closer to its historical mid-teens p-e. "It's about fully valued," says Jimmy Chang, senior analyst with U.S. Trust Corp., which owns 5.5 million IBM shares. "At this very point, we think at the current price it's likely to be a market performer."

The stock may not be ready to rocket, but IBM does seem to be making all the right moves on the strategic side. Palmisano wisely cleaned house while simultaneously investing in profitable software and services businesses. According to IBM's internal research, by 2005 68% of the tech industry's profits will come from software and services, up from 45% in 2002.

COMPUTING ON TAP. IBM last year laid off 15,000 people, sold its money-losing disk-drive business, and wrote down the value of some unproductive chip technology. At the same time, it spent more than $6 billion on acquisitions, including the purchase of PricewaterhouseCoopers Consulting and Rational Software, opened a $3 billion state-of-the-art chip plant, and launched a new bet-the-company initiative called e-business on demand.

This new e-biz effort aims to provide a business model for computing power in which customers pay only for what they use, like a utility. But a few years from now, the idea is to deliver technology that helps solve thorny technical problems, such as those that arise in the development of drugs or the simulation of car crashes for safety research. Says Sanford C. Bernstein & Co. analyst Toni Sacconaghi: "The table has been set for a much stronger year operationally."

A few factors could help fuel faster growth. In January, Chief Financial Officer John Joyce soothed investors when he said, "IBM can grow revenue without growth in [tech] spending." That's partly because IBM has half of its earnings for 2003 under contract. What's more, throughout the downturn, IBM has been gaining share in its key services, software, and server markets. So a stronger-than-expected recovery in tech spending could produce an upside surprise.

LOU'S LEVERS. The other key element to watch is IBM's microelectronics group. This $2.9 billion business designs and makes computer chips for IBM and other companies, such as Cisco. Analysts expect the group to rebound to a profit of around $200 million after losing $1.1 billion in 2002, including $803 million in one-time charges. IBM has been signing new customers for its foundry, but it must ramp up the plant to full capacity by yearend as planned to realize its potential. "The facility could be nicely profitable," says Sacconaghi.

Many investors and analysts, however, continue to question whether IBM can generate consistent financial returns without the aid of financial engineering. Critics say retired IBM Chairman Louis Gerstner Jr. pushed and pulled on a variety of levers -- including gains from an overfunded pension plan, income from one-time asset sales, and $44 billion in share repurchases -- to squeeze double-digit growth in earnings per share while eking out an annual average of 5% sales growth. For this year, Merrill Lynch analyst Steven Milunovich expects IBM to increase net income 10%, to $7.5 billion, and to achieve a 9% rise in sales, to $88.3 billion.

The good news is that Palmisano has taken steps to increase the quality of IBM's earnings, such as lowering the expected rate of return on its pension and significantly slashing stock buybacks. In the most recent quarter, IBM only spent $65 million on stock repurchases, down from $1.8 billion in the year-ago period.

Still, without creative financial steps, analysts such as Milunovich say "IBM's earnings-growth rate will be very difficult to achieve." Satisfying the Wall Street earnings machine without crutches is IBM's key financial challenge going forward. Analysts and investors so far seem to have faith in the plan. If Palmisano can pull it off, he and his believers will have something to crow about. Ante is Computers Editor for BusinessWeek in New York

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