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Big Blue's Breakout Quarter

By Megan Graham-Hackett IBM surprised the Street on Jan. 15 by reporting fourth-quarter results before the market opened, rather than releasing the news on Tuesday, Jan. 20. The surprise wound up being positive: Big Blue's results were ahead of Standard & Poor's estimates. Revenues rose 9% (up 1% on a constant-currency basis) to $25.9 billion, compared with our $23.7 billion estimate. Earnings per share were $1.56, ahead of our $1.51 estimate and the Street's forecast of $1.50.

IBM (IBM) also issued an upbeat outlook, indicating that corporate spending on technology is picking up. Investors applauded the news and propelled the stock to new 52-week high of $97.10 on Jan. 21.

Most of IBM's upside in revenues, vs. our estimates, came from a 12% rise in hardware. At $9 billion, revenues for the segment were some $2 billion higher than our model. High-end servers did well, with the zSeries posting 33% revenue growth, as did low-end systems (the xSeries servers rose 20%).

WIDER MARGINS. Another positive surprise came from global services. Revenues rose 8%, but the real surprise was in signings for the quarter. IBM posted $17.3 billion worth of new business, despite many reports in the market that IBM would come in short of expectations at about $11 billion in fourth-quarter signings.

And software revenues rose nearly 12%, led by 14% growth in "middleware." While currency exchange helped all segments, we believe IBM clearly gained market share as well.

Despite the higher mix of hardware sales in IBM's fourth quarter vs. our expectations, gross margin widened to 38.4% from 36.3% in the third quarter, in line with our model. We note that hardware gross margin was 31%, well ahead of our model of 27.5%. This partly reflects the higher sales volume, but also the loss in the technology group narrowed sharply from the third quarter, and the personal systems unit turned profitable vs. a loss in the third quarter. Importantly, IBM expects the technology group to be profitable in 2004 and noted stronger demand from original equipment manufacturers (OEM) and better production yields.

STRONG PIPELINE. Although IBM's fourth-quarter report was stronger than we expected, we didn't increase our 2004 EPS estimate of $4.86. However, we believe this forecast could prove conservative. In fact, on the earnings conference call with analysts, IBM stated that its 2004 revenues could be higher than current Street expectations of $93.6 billion. Our 2004 revenue estimate is for $99 billion.

In what we view as an important signal, IBM finally commented on its long-term business model -- something it didn't feel comfortable doing during the turmoil of tech's downturn. With early signs of an overall improvement in spending by its corporate customers, IBM believes it can produce revenue growth in the high single digits and EPS growth in the mid-double digits. We think this suggests that IBM has a strong pipeline of business.

Given the increased momentum IBM is witnessing, plus the market-share gains we foresee in services, software, and hardware -- as well as an improved operating performance in microelectronics -- we believe our estimate might prove too low. Our S&P Core EPS forecast for 2004 is $2.57, reflecting our estimate of the impact of stock option expenses and pension costs.

ANNUITY-LIKE REVENUES. We believe the shares are currently undervalued, based on our discounted cash flow (DCF) and price-to-sales analyses. On Jan. 22, we raised our 12-month target price for IBM shares to $121 from $113, based on our revised DCF analysis. Given the increasing signs of a moderate improvement in the info-tech spending environment, as IBM noted in last week's conference call, we now project a 15-year free cash-flow growth rate of 7.8% vs. our prior estimate of 7.4% (on a compound annual growth rate basis). Our DCF model also includes a weighted average cost of capital (WACC) of 10.4%.

IBM has consistently shown that it has been able to gain market share throughout the technology spending downturn. It still has a leadership position in services, and we think the annuity-like revenue stream provided by this business yields a stable earnings base in the current uncertain macroeconomic environment. We continue to recommend that investors buy the shares, and believe the stock will outpace the S&P 500-stock index as IBM leverages its competitive strengths.

Note: Megan Graham-Hackett has no stock ownership or financial interest in any of the companies in her coverage area. She's a registered representative of Standard & Poor's Securities, Inc. Other S&P affiliates may provide services to the companies under discussion. Analyst Graham-Hackett follows computer hardware stocks for Standard & Poor's Equity Research

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