Blue Skies for IBM?

The IT titan is in the right place -- and way ahead of its peers -- as profits shift from hardware to services and software

By Megan Graham-Hackett

It's pretty rare to hear upbeat comments from computer hardware makers these days. But IBM (IBM ) had some positive things to say at its Spring Security Analyst Meeting, held May 15 in New York. IBM's recently anointed CEO, Sam Palmisano, said the company still expects to meet the consensus earnings-per-share forecast of $4.16 for this year.

Overall, Palmisano was much more bullish on the long-term outlook for information technology than we at Standard & Poor's would have expected. IBM expects IT investment to grow 2.5 times faster than gross domestic product starting in 2003. Palmisano described IT as a growth industry, despite the current weakness in tech spending.


  IBM noted that the profits in the IT industry, however, are shifting away from hardware and toward business insight (applications used to enhance business productivity and efficiency), services, and software infrastructure. According to company estimates, business insight garnered an estimated 10% of the industry's profits in 1995, 13% in 2000. Business insight is expected to grab 17% of industry profits in 2005. Services and software infrastructure accounted for 30% of industry profits in 1995, and 29% in 2000. IBM's analysis calls for service and software infrastructure to represent 41% of industry profits in 2005.

Meanwhile, the server and storage market, which garnered 20% of industry profits in 2000, is expected to account for only 12% in 2005. And PCs are expected to trend down from 9% of industry profits in 2000 to 6% in 2005.

IBM figures it should be able to capitalize on this business shift since it garners roughly 70% of its profits from its global services and software operations. The company has a unique portfolio of well-developed businesses. Indeed, many of IBM's peers have stated that they need to devote more resources to software and services to be competitive.


  Areas that have become top priorities for IT departments include collaborative CRM (customer relationship management), application integration, and supply-chain management. These areas all require advanced software such as middleware and EAI (enterprise application integration), along with hardware and software integration services, and IT outsourcing services.

With characteristic candor, IBM discussed its business model, classifying its businesses into three categories. The first is its profitable annuity base businesses, including host software, maintenance, and financing. The second group includes those facing operational challenges, such as PCs and hard-disk drives. The last represents those areas in which IBM is the market leader and which will help fuel growth. These are consulting/systems integration, outsourcing, Web-transaction software, database software, servers, and storage.

The profitable annuity base is used to fund research and development in growth markets. The company said that businesses with operational challenges will eventually help to drive profit growth after the challenges are overcome.


  IBM also admitted it needs to fix its cost structure, vowing to eliminate $1 billion to $2 billion every year. Layoff plans were not discussed (it has been rumored that as much as 2.5% of its workforce will be cut).

Based on the meeting, S&P didn't change its EPS forecast. However, we believe there is significant leverage in IBM's model, and if the company were to cut operating expenses significantly and improve profitability in such areas as microelectronics, our 2003 estimate could prove conservative.

We continue to view the shares as attractive, selling at just 17 times our 2003 EPS estimate of $4.83, and at a 13% discount to our $95 price target, based on our discounted cash flow analysis.

Analyst Hackett follows computer hardware stocks for Standard & Poor's

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