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IBM's got the Big Blues
Shares are trading at their lowest level since October 1998. Can it get worse?
June 24, 2002: 4:57 PM EDT
By Paul R. La Monica, CNN/Money Staff Writer

NEW YORK (CNN/Money) - As the first half of 2002 draws to a close, IBM is one of the worst performing stocks in the Dow, plunging 42 percent so far this year. The stock hit a new 52-week low on Friday and is now trading at its lowest point in nearly three and a half years.

What a difference a few months make. Shares of Big Blue surged 43 percent in 2001 and IBM (IBM: Research, Estimates) was one of only a few technology stocks that traded at a higher price at the end of last year than at the Nasdaq's March 2000 peak.

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IBM's main source of strength in 2001, namely its diversity, is being blamed for its woeful showing this year. The company's three major lines of business -- hardware, software and consulting services -- are all struggling, with first quarter revenue falling 12.5 percent from a year ago.

Analysts have begun to pile on as well. Goldman Sachs lowered earnings estimates on Monday morning. Three other Wall Street firms cut 2002 estimates last week. Earnings estimates for this year have fallen from $4.82 a share at the beginning of the year to $4.05. So instead of earnings increasing 10.8 percent this year, analysts now expect an earnings drop of 7.4 percent.

And it might get worse before it gets better. John Rutledge, manager of the Evergreen Technology fund, thinks analysts' estimates are still too high. "The so-called second half recovery for IT spending isn't going to be happening," he says, adding that earnings for the year could come in as low as $3.85.

Is there more downside for IBM?

That said, Rutledge likes the long-term prospects for IBM. The stock is the ninth largest holding in his portfolio. Even though the near-term earnings picture is bleak at best, he thinks this bad news is more than priced into the stock.

Using Rutledge's worst-case earnings estimate of $3.85 for this year, IBM has a P/E of just 18, below the S&P 500's average multiple of about 21 times 2002 earnings, and well below the multiple of other tech leaders. Even with the beating large cap tech stocks have taken this year, most still trade at a premium to the overall market. Microsoft (MSFT: Research, Estimates), for example, trades at 28 times earnings estimates for its next fiscal year (which ends in June, 2003). Dell (DELL: Research, Estimates) has a P/E of 32, based on estimates for this fiscal year.

In addition, IBM is trading at just 1.5 times estimated 2002 sales. Dell trades at nearly two times estimated revenue for this fiscal year and Microsoft is valued at more than 9 times estimated sales for fiscal 2003.

Mark Schultz, a portfolio manager with M&T Asset Management, which runs the Vision family of funds, says he expects IBM to generate earnings growth in the low-double digit range for the foreseeable future, in line with the current estimate of about 12 percent earnings growth for the S&P 500. For this reason, he thinks IBM should not be punished as much as it has.

"It's become very fashionable to be skeptical of IBM's earnings potential," says Schultz. "But IBM still has the most compelling business model in the sector. There aren't too many companies in the tech sector that are consistently profitable and cash flow positive." IBM is a holding in the Vision Large Cap Core fund. Schultz says he has been buying shares of IBM on its way down this year.

Schultz adds that hardware companies Hewlett-Packard (HPQ: Research, Estimates), which recently completed its merger with Compaq, and EMC (EMC: Research, Estimates) are both trying to duplicate the success of IBM by bulking up their software and services offerings.

Rutledge also thinks that recent cost cutting decisions and asset sales by new CEO Sam Palmisano will work out well for IBM in the long term.

The company announced earlier this month that it will take up to a $2.5 billion charge to cover restructuring in its struggling semiconductor division. IBM is laying off approximately 1,500 workers in that division. Big Blue also announced that it was selling its money-losing disk drive unit to Hitachi.

Don't bet on a recovery anytime soon

Still, investors waiting for an IBM comeback will probably need to be patient.

Critics have maintained that IBM's earnings look a lot better because of the inclusion of pension fund income. IBM has come under fire for having a relatively high estimated rate of return for the assets in its pension plan. If a company estimates that the assets in the plan are earning more than the expenses needed to run the plan, then the company is said to have an "overfunded" pension plan and the surplus is required to be reported as income.

In the first quarter, pension income accounted for nearly 16 percent of pre-tax earnings. There is nothing legally wrong with this practice (i.e. this isn't the same thing as Enron keeping debt off its balance sheet) and the pension income figures are available in IBM's quarterly and annual filings -- albeit buried in footnotes. But this is a concern that has dogged the stock for the past few years and has not yet gone away.

In addition, the company has historically used share buybacks to boost earnings. Buybacks lower the amount of shares outstanding, thereby increasing earnings per share.

There's also the fact that it will be tough for IBM to move substantially higher, regardless of its valuation, until there is more clarity about when companies will begin spending on technology again.

Alex Vallecillo, a portfolio manager with National City Investment Management Co, the sub-advisor for the Armada family of funds, says he sold his stake in IBM a few months ago when the stock was trading in the mid $80s. Although he says he'd consider buying IBM again if the stock falls much further, he adds that there's no urgency since the near-term outlook for tech remains weak.

"IBM is a proxy for the whole IT environment. And at this point, we're not necessarily at the bottom. There's no reason to go rushing in," Vallecillo says.  Top of page