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NEW YORK (CNN/Money) -
At first blush, it may seem that IBM's prospects are in quick decline.
The technology titan will release first quarter results on Monday and is expected to post a profit of 90 cents a share. But only a week ago, analysts were expecting $1.04.
What explains this sudden drop?
Take a deep, Big Blue breath. Business didn't just fall off a cliff. The reason that analysts now expect profits to be lower is because IBM announced on April 5 that, starting in the first quarter, it would include the cost of stock options it grants to employees in its earnings reports.
Investors should get used to seeing lower reported profits in general. Thanks to an accounting rule change, all companies will need to start expensing options.
The rule was supposed to take effect in mid-June, meaning that companies would have to report options expenses for quarters that began after June 15. In most cases, that's the third quarter. But the Securities and Exchange Commission announced on Thursday that it would delay the change until the next fiscal year beginning after June 15. So most companies now won't need to begin expensing options until the first quarter of 2006.
Still, IBM should be applauded for jumping the gun and showing investors just how much options eat into earnings. But has the company paid a price for its candor? Shares of IBM have fallen more than 6 percent since last week's announcement.
No fundamental problem
The negative reaction seems overdone. Steve Weber, an analyst with SG Cowen, said in a recent report that the accounting change "does not affect in any way the underlying business fundamentals and superior [return on invested capital]; nor, does it undercut IBM's terrific cash flow dynamics."
Thomson/First Call has already adjusted last year's results to reflect the effect of options expenses. Based on these numbers, IBM is expected to report earnings growth of 14 percent from a year ago.
What's more, Weber wrote that investors should take advantage of some "valuation confusion" that's taking place. IBM now trades at 17 times 2005 earnings estimates, a slightly higher P/E than where it was before the company announced it would begin expensing options.
But Weber said that earnings estimates for the S&P 500 will need to eventually come down as well once options expensing kicks in for all companies. He thinks that the S&P 500, currently trading at about 17 times earnings, would have a P/E closer to 18 if options expenses were included. And since IBM often trades at a 10 to 20 percent premium to the S&P 500, he thinks IBM is a relative bargain.
Keep an eye on sales
Still, investors will need to focus mainly on whether the company is able to report a decent increase in revenues. That will ultimately determine the stock's next move.
Analysts are forecasting a 6 percent increase in total sales from a year ago, to $23.7 billion. That's respectable given the company's size. But how much of this growth will come from true demand?
The weaker dollar has helped to boost sales for IBM, which generates nearly 60 percent of its revenue from outside the Americas. In the fourth quarter, IBM reported a year-over-year sales increase of 7 percent but said that sales only increased 3 percent after excluding the effect of currency. So stronger organic sales growth would be a plus.
And for the stock to truly become a Big Blue Heaven as opposed to a Big Blue Bore, IBM will need to show strong growth in its global services business, which includes outsourcing, consulting and maintenance. Global services accounted for nearly half of its sales and a third of its pre-tax profits in the fourth quarter.
Eric Pelander, the leader of strategy and change services for IBM's business consulting services group, said that IBM's future success will depend less on products. As such, IBM is in the process of selling its low-margin PC business to China's Lenovo Group.
"We are interested in teaming with business partners for ways to go beyond traditional IT spending," Pelander said. "It's not just about how much hardware and software is being sold."
Some investors were concerned about slowing momentum in the services business when IBM reported its fourth quarter results. And since then, Accenture (Research), a top IBM rival in services, reported a mixed quarter, with profit margins coming in a bit lower than some analysts expected.
Richard Petersen, an analyst with Pacific Crest Securities, said IBM could reassure investors by reporting stronger-than-anticipated new contract signings for the quarter. He estimates that IBM booked a little more than $11 billion in contracts.
But because the stock is relatively cheap, IBM probably doesn't need to blow away the numbers. Unlike Apple (Research), which saw its stock get cored Thursday even though the company crushed earnings estimates, IBM won't be a victim of high expectations. A modest surprise would likely be greeted warmly.
For a look at IBM and other blue chip tech stocks, click here.
For more news about Fortune 500 companies, click here.
SG Cowen's Weber owns shares of IBM and his company has an investment banking relationship with the firm. Pacific Crest's Petersen does not own IBM and his firm does not do banking for IBM.
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