No Bounce for Big Blue

Despite posting a higher profit, IBM shares slid Friday amid disappointment over hardware sales. But analysts see momentum in its services biz

IBM's (IBM) investments in software have been helping the whole company profit in recent months. While the Armonk (N.Y.) technology giant's fourth quarter results disappointed investors, who sold the stock on Jan. 19, analysts remain hopeful that the company will keep ahead over the long haul.

IBM said its net income during the three month period ended Dec. 31 rose 11.1% from to the prior year's quarter to $3.5 billion, including one-time items. "We are well-positioned in the growth areas of a changing IT industry, focused on our evolving business model, and poised for long-term success," IBM's CEO Samuel J. Palmisano said in a press release late Jan. 18.

It's easier to make a profit on software these days than services -- and IBM can also sell its software products bundled together with other parts of its business. When companies buy new software, they typically spend up to five times as much on services to install and maintain it. Palmisano has been trying to turn around his business by spending billions in recent years to buy up dozens of software companies that specialize in various areas, ranging from document management at FileNet to the complex computing systems manager MRO Software (see, 8/15/06, "IBM's Revved-up Software Engine").

Wall Street players had already been buzzing hopefully about IBM's plan for months. The mean analyst forecast for IBM's earnings per share during the fourth quarter had amounted to $2.19 per share, according to the San Francisco research firm StarMine, which aggregates data from Thomson Financial. IBM's earnings ended up at $2.26 per share, but that includes an extra 6 cents that resulted from a lower tax rate.

Investors sold IBM's stock by 3.7% to $95.74 per share in early trading on the New York Stock Exchange Jan. 19.

Why? Standard & Poor's Corp. analyst Richard Stice said some people saw problems with the company's hardware sales results. (IBM's hardware-focused Systems and Technology group's revenue only gained 3% year over year to $7.1 billion.) “There's also some general profit-taking or negative sentiment associated with the technology sector at the moment,” Stice says. Noting things like IBM's leading share position in a number of key sectors, Stice kept a strong buy opinion on the shares anyway. (S&P, like, is owned by The McGraw-Hill Companies.)

Stice wasn't the only one to see more positives than negatives for Big Blue.

"While we acknowledge that there is no near-term catalyst for IBM shares, we are encouraged by multiple signs in the 4Q06 financial results of improvement in the struggling services business and strong momentum in software," Citigroup analyst Richard Gardner said in a research note Jan. 19. (Citigroup has done business in IBM within the past five years, but Gardner certifies that the views in the report are not affected by compensation.)

IBM sold more programming that joins together separate computer programs, which is known as "middleware." Revenues from IBM's middleware brands, which include WebSphere, Information Management, Tivoli, Lotus, and Rational, were $4.4 billion, up 18% compared to the fourth quarter of 2005. Gardner called IBM's middleware software growth "impressive" and thinks it suggests that the company is gaining market share.

IBM ended up profiting more on sales, too. The company's total gross profit margin was 44.6% in the 2006 fourth quarter compared with 44.1% in the 2005 period.

Strong services signings pulled what would have been a year of contraction into one of modest growth, which management suggested should persist in the first quarter of 2007, Merrill Lynch analyst Richard Farmer said in a research note. (Merrill does business with IBM but Farmer certifies that his compensation is not related to his view.)

The company signed services contracts totaling $17.8 billion, up 55% year over year. It ended up with unfulfilled orders of $116 billion for services ranging from business transformation outsourcing to technology maintenance; that's $5 billion more than IBM had during the same period a year ago.

Citigroup pointed out that IBM's services backlog grew for the first time since the second quarter of 2005 and says this shows that the company's existing contracts are being expanded. IBM hasn't signed so many new short and long-term services contracts since the fourth quarter of 2002.

IBM "has been successful in acquiring its way to revenue growth and successfully implementing changes to position better for revenue and profit expansion," Technology Business Research senior analyst Eugene Zakharov said in a research note.

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