Technology titan International Business Machines (NYSE:IBM) has chosen to pursue a strategy that emphasizes profitability over size. Many industry rivals place too high a priority on market share and top-line growth. Not IBM; service revenue is helping this company through the current economic downturn, although it may not be the best play in this segment of the market.
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Quarterly Review
Total reported revenues fell 13% to $23.3 billion but only fell 7% when removing the effects of currency fluctuations. Reported results fell in all five primary business segments, with the least severe drop in software sales, which declined 7% to $5.2 billion. "Key middleware products", or software that links multiple applications, grew 5% on an organic basis. Organic sales of operating system applications fell in the low single digits. This segment posted the highest pretax margin of 32% and grew pretax income 24.1%. (See Understanding The Income Statement to learn about how to find these numbers.)
The largest segment, global technology services, posted the next highest margin of 14.9% and pretax income improved an impressive 41.3%, although reported revenue fell 9.8%% to $9.1 billion. The other segments all reported double-digit revenue declines and more mixed profit growth trends. Yet despite IBM's overall double-digit top-line decline, it was able to boost operating income 11.8% and earnings 18% to $2.32 per diluted share.
IBM Choosing Cash Above Flash
IBM is pursuing a strategy of right-sizing its business mix and has prudently chosen profitability and cash flow generation over meaningless market share statistics and flashy sales growth. It could still announce a large acquisition but for now, it's content with continuing its "strategic transformation … that is, delivering superior earnings, cash and client value." The proof this strategy is working is coming through in the bottom line as IBM raised its full-year earnings outlook 50 cents to "at least $9.70 per share" and stated it is "well ahead of pace for our 2010 road map of $10 to $11 per share."
Its strategy to deemphasize hardware is also paying dividends. Arch rival Hewlett-Packard (NYSE:HPQ) posted a 19% fall in combined computer desktop and laptop sales, although it benefited in services from the acquisition of EDS. IBM is also focused on services, with current initiatives referred to as "smarter planet" solutions. This also involves the development of a new generations of data centers, which rival EMC (NYSE:EMC) specializes in and in which Sun Microsystems (Nasdaq:JAVA) lost its edge long ago.
Bottom Line
With the benefit of perfect hindsight, investors should have loaded up on IBM stock when it dipped below $70 per share last November. But what matters now is how the business will perform going forward and how this growth is reflected in the current share price. At a current share price of around $115, the P/E multiple isn't at all unreasonable, particularly if IBM reaches close to $11 in earnings next year. However, peer Accenture (NYSE:ACN) may be even more compelling at a lower forward P/E multiple off this year's projected earnings (fiscal year end August). As one of the largest consultants in the industry, it is also a pure play in technology services. (Also read Technology Sector Funds if you plan on investing in this segment)
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