IBM's Strategic Focus Beats the Tech Slump

Don't get the wrong impression from IBM's stronger-than-expected performance in the second quarter. Coming two days after surprisingly strong results by fellow tech titan Intel (INTC), Big Blue's numbers might be seen as further evidence that a recovery looms. But IBM (IBM) said revenue declined 13%, to $23.3 billion, slightly more than analysts expected, so there's no sign here of an overall uptick in demand from corporate technology purchasers.

At the same time, IBM's net income rose 12%, to $3.1 billion, and it beat the earnings-per-share estimates of analysts by 30¢, or nearly 10%. The company also issued a more bullish profit forecast for 2009. Bottom line: Under CEO Sam Palmisano, IBM is operating very well under miserable business conditions, and his decision to jettison less-profitable divisions in the past half-decade at a time when rivals were adding heft in several areas is paying off.

Buoyed by the results, IBM Chief Financial Officer Mark Loughridge increased his forecast for earnings per share this year by 50¢, to $9.70 per share. He said the company's divestiture of low-profit disk drives, printers, and PCs since 2002—even while it built up software and services—is to be credited for the company's performance. "IBM is fundamentally a different company," Loughridge told analysts on a conference call. "We're able to improve margins and profits even with declining sales." Still, he warned, "It's a tough economic environment."

IBM Proves "Bigger Isn't Better"

In after-hours trading, IBM's stock immediately rose 2, to 112 per share.

Analysts had been waiting for IBM's earnings announcement to see whether the company could outperform rivals Dell (DELL), Hewlett-Packard (HPQ), and Accenture (ACN)—all of which disappointed investors with their most recent earnings reports. For instance, in spite of reporting higher revenue than IBM, HP's net income of $1.7 billion in the most recent quarter was down 17% from the previous quarter. While IBM slimmed down, HP made several major acquisitions in recent years, bulking up in such areas as hardware, software, and services. Bob Djurdjevic, president of market researcher Annex Research, says IBM's performance shows that its strategy is superior to HP's. "[HP Chief Executive] Mark Hurd is infatuated by size," Djurdjevic says. "His aim was to make HP the biggest computer company. He made it. But IBM's performance shows that bigger isn't better."

Dell, too, is poised to embark on an acquisition spree, yet has suffered in recent quarters amid lackluster demand from corporations, which make up about half of its sales. The Round Rock (Tex.) company on July 13 said companies are putting off computer purchases and that margins remain under pressure.

Automation, Offshoring Boost Profits

By contrast, IBM's strength is showing up in software and services. Software revenue fell a modest 7%, to $5.2 billion, but the pretax profit margin grew by a whopping 8.3%, to 32%. In an interview before the results were released, Steve Mills, head of IBM's software group, said there's strong demand for software that helps corporations reduce the complexity and costs of their computing operations. There's also demand for so-called business intelligence software that helps executives to make better sense of the data they amass, and to predict the future. "They know they need to collect more data and they know information technology will help them do a better job of predicting," Mills says. "That creates opportunities for us."

The company's global services revenue declined 12%, to $13.4 billion, but pretax profits increased 23%. Profit margins in the technology services piece of the business increased by 5.4 percentage points, to 14.9%.

Loughridge said IBM was able to increase its profit margins in software and services thanks in part to increased automation of services and a continued shift of work to lower-cost offshore locations.

There was a dose of bad news tucked into IBM's report. Computer hardware revenue continued its multiquarter decline, dropping 26%, to $3.9 billion. Especially hard-hit was IBM's mainframe business, which declined 39%. Loughridge said he expects the hardware business to stabilize in the current quarter and return to profitability in the fourth quarter. The company had little to say about the prospects for an industrywide recovery but—based on its results amid the downturn—IBM appears well-positioned, even if the slump persists.

Before it's here, it's on the Bloomberg Terminal.