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Big Blue Not In The Clear

Posted: Oct 14, 2008 13:31 PM by Ben McClure

Tickers in this Article: IT, SAP, IBM

International Business Machines (NYSE:IBM) pre-announced third-quarter earnings that beat Wall Street’s projections, prompting some observers to call it a healthy quarter and tag Big Blue a bright spot in an otherwise gloomy tech market. But investors, please don’t get too excited. While the tech giant certainly delivered on the bottom line, its sluggish top-line numbers signal trouble ahead. (For more on the Street's projections, read Analyst Recommendations: Do Sell Ratings Exist?)

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The market wasn’t expecting much from IBM. The stock has fallen more than 23% since the end of September. The view, mine included, was that by now IBM’s earnings would have suffered the impact of slower corporate IT spending, especially in software and consulting, where IBM gets the bulk of its profits. IBM’s 20% jump in Q3 earnings eased worries.

Sales Short Of Street Projections
But all is not well. While earnings were surprisingly stronger than the $2.01 analysts had expected, quarterly sales of $25.3 billion were short of Wall Street's predicted $26.5 billion. IBM’s revenue grew only 5% in Q3 over Q3 2007.

Those sales numbers were flattered by a weak dollar, since deals done in other currencies translated into more greenbacks. IBM acknowledged that, absent currency effects, its top-line revenue would have grown by just 2%. In other words, IBM is producing low-quality revenue growth.

Dollar Rally, Global Economy A Double Whammy
If the U.S. dollar continues its recent rally, especially against the euro, the currency effect will turn sharply against IBM. Meanwhile, as the global economy slows alongside that of the U.S. dollar, IBM faces a double whammy. Much of IBM’s revenue gains came on the back of a stronger performance outside the U.S. But as the economic crisis moves to Europe, especially in banking where it has a strong presence, IBM’s strength may wither.

Indeed, just last week European corporate software giant SAP (NYSE:SAP) warned of a bleak outlook for the coming quarters. Yesterday, market researcher Gartner (NYSE:IT) slashed its forecast for global technology spending next year, seeing significant declines in spending in Western Europe and in computer hardware sales.

Cutting Costs Only A Short-Term Fix
Of course, IBM might be able to maintain profitability by cutting costs. But how long can that last? Eventually, falling revenue will be felt on the bottom line. Big corporate customers will start to insist on improved service-contract terms. What’s more, bad debt costs could rise as longterm contracts turn sour in the wake of the economic and credit crisis.

Share Buybacks An Alternative
Reducing the number of shares outstanding through share buybacks is an alternative way to prop up earnings per share. IBM management has authorized $15.4 billion for buybacks to be drawn from cash flow and its $12 billion cash pile. IBM has the balance sheet firepower to sustain bottom-line earnings growth, but that's not a sure sign that the company can keep up profitability from its operations. (Find out what these company programs achieve and what they mean for stockholders in our related article, A Breakdown Of Stock Buybacks.)

Bottom Line
IBM may be better positioned to weather a downturn than smaller and more specialized firms. But that doesn’t mean things will be rosy for the technology giant in the coming quarters. Big Blue is not in the clear yet.

By Ben McClure

Ben McClure is director of McClure & Co., an independent research consultancy. Before founding McClure & Co., Ben was a highly-rated European equities analyst at London-based Old Mutual Securities. He also spent several years as a business/technology journalist at the Economist Group. McClure graduated from the University of Alberta School of Business with an MBA.

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