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IBM: Don't Big Blow it!
After a stunning first-quarter earnings miss, investors are slowly regaining trust in IBM.
July 14, 2005: 3:31 PM EDT
By Paul R. La Monica, CNN/Money senior writer

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Black and Blue: Shares of IBM took a big fall after its first-quarter miss but the stock is making a comeback lately.
Black and Blue: Shares of IBM took a big fall after its first-quarter miss but the stock is making a comeback lately.
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NEW YORK (CNN/Money) - IBM reports second-quarter results Monday and investors have a message for the tech titan: Don't Big Blow it!

IBM is finally starting to recover from a stunning first-quarter earnings miss in April. The company blamed soft economic conditions in the U.S. and Europe in late March for its disappointing results.

There was also confusion about how much options expenses actually hurt profits in the quarter.

Big Blue voluntarily agreed to start expensing them during the first quarter but didn't announce this until after the quarter ended, causing analysts to scramble to readjust estimates. And when the company reported, it appeared that the impact of options expenses was less than what it told analysts it would be just a few days earlier.

It didn't help that IBM (Research) surprised the market by reporting results four days earlier than scheduled. The stock plunged more than 8 percent the day after the announcement and some law firms have filed class-action complaints on behalf of shareholders as a result.

But investors seem to be warming up to IBM again. The stock has shot up more than 11 percent this month due largely to expectations for strong second-quarter earnings across the tech sector. The stock's now just 1 percent below where it was before announcing results in April.

Analysts currently are predicting that IBM will report sales of $21.9 billion and earnings, including the cost of stock options, of $1.03 a share.

Blue's clues

Can IBM hit these targets? It will be important for the company to do so. Tech earnings are off to a good start thank to strong results from chip company AMD (Research) and iPod and Mac maker Apple (Research) on Wednesday.

But IBM, more than AMD or Apple, is a true barometer for the sector due to its sizable presence in hardware, software and services. Fortunately, it does appear there's good reason to expect a strong quarter for IBM.

For one, there is hope that IBM will be see some benefits from layoffs that it announced during the quarter. Several analysts said these job cuts, mainly in Europe, were long overdue.

What's more, the fears of an economic slowdown that appeared to make IBM customers hesitant to spend on software and services at the end of March have largely dissipated.

"IBM's weakness was more of an aberration than a growing trend," said Michael Cohen, director of research with Pacific American Securities. "It's more likely we'll see IBM get back on track this quarter."

Ted Parrish, co-manager of the Henssler Equity fund, also thinks IBM is smart enough to have learned its lesson after the first-quarter fiasco. So he believes that since IBM has not given any warning about the second-quarter, that's probably a good sign.

"I think they will make their numbers. I can't see them missing and not pre-announcing this time," said Parrish, who owns IBM in his fund.

It's hard to ignore good news coming from IBM competitors as well. Dell (Research) and Hewlett-Packard (Research), which both compete with Big Blue in the server market and have quarters that end a month after IBM, reported strong server sales in May.

Rebound in services expected

Then there are the two most critical areas for IBM -- software and services, which accounted for two-thirds of sales and nearly 80 percent of pretax profits in the first quarter.

Oracle (Research), which competes with IBM in the database software market, reported solid sales last month. And last week, tech consulting and services firm Accenture (Research) posted much stronger-than-expected results for the latest quarter.

To that end, one analyst said that a key number to watch in IBM's upcoming report will be the dollar amount of signed services contracts. IBM said in April that it had $10 billion in contracts and many were expecting at least $11 billion.

But this time around, the services business should rebound. The analyst, who asked not to be named, said that based on Wall Street chatter, bookings should come in above $12 billion and could be as high as $14 billion as deals that fell apart late in the first quarter were probably signed during the second.

"IBM had a great March quarter until the last two weeks. But the company relaxed and was overconfident that people would sign at the last minute. There was a lot of business that had been left hanging at the end of March," the analyst said.

Another miss would leave investors feeling blue

Of course, IBM is not out of the woods yet.

The second-quarter numbers will be a bit murky since they will probably include only one month's results from IBM's personal computer business, which IBM sold to China's Lenovo Group in May. For this reason, analysts are predicting a sales decline of 5 percent from the $23.2 billion in sales IBM generated a year ago. Last year's figure includes $3.2 billion in PC sales.

IBM will also be reporting a pretax charge of $1.3 billion to $1.7 billion to account for the job cuts.

And analysts will be paying close attention to the effect of options. In the first quarter, Wall Street expected options costs would reduce earnings by 14 cents a share but they wound up having only a 10-cent impact. That annoyed analysts because it made earnings per share appear to be four cents better than they otherwise would have been.

As a result, analysts adjusted their second-quarter numbers from a consensus in April of $1.13 to the current $1.03. In other words, Wall Street expects options to reduce earnings by 10 cents a share as they did in the first quarter. So if IBM reports a stock option expense number that isn't 10 cents a share, that probably won't go over well with analysts.

Finally, that leads to whether IBM can fully regain Wall Street's trust. Another earnings miss would be disastrous.

"The company has lost credibility and if they were to disappoint this quarter, it would be a serious blow to the stock and I would have to question owning it going forward," Henssler's Parrish said.

For more about IBM's first-quarter miss, click here.

For a look at more tech blue chip stocks, click here.

Analysts quoted in this story do not own shares of IBM and their firms have no investment banking relationships with the company.


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