IBM Bull's Pen
by Louis Corrigan ([email protected])

As the saying goes, you don't get fired for buying IBM. That's a little less true today than it was in Big Blue's heyday, yet it still applies -- particularly to its stock. In an otherwise gloomy market, old dependable is still up about 21% for the year. Moreover, the stock price has tripled over the last 22 months as CEO Louis Gerstner, Jr., has convinced Wall Street that IBM's turnaround has worked and that better times lie ahead.

Frankly, IBM is so huge and diversified that I find it overwhelmingly dull. More important, its overall results of late haven't been all that impressive considering the opportunities at hand. Strange as it may seem, these are both great reasons why IBM may be the perfect defensive investment for these troubled times. IBM is so huge, and it's still got plenty of room for improvement.

David will no doubt mention the lame revenue growth. Yes, revenue rose just 3.4% in FY97 and is up just 0.7% for the first half of FY98. But let's think about what's happened during this period. About 55% of IBM's revenues come from international markets, and world currencies have been going nuts. In constant currency, revenues actually increased 8.3% last year and 5% in the first half of FY98. Not great, but not bad either.

Consider as well that hardware still accounts for the bulk of IBM's sales (46% for FY97, 40% so far this year). And hardware has had an incredibly rough time. Weakness in Asia and inventory issues here in the states pressured selling prices in PCs, hard disk drives, and memory chips while depressing demand across the board. A product transition to the G5 model of its System/390 processor family also impacted 2Q '98 sales. As a result, gross margins in this important segment plunged from 34% to 29.4% in the first half of this year.

But earnings have been nearly flat in 1998, and they even managed to outpace revenues last year, vaulting 11.1% to $6.01 per share. Cost-cutting has been partly responsible. Selling, general, and administrative expenses as a percent of revenues have been declining steadily from 23.3% in FY95 to 22.2% in FY96, to 21.2% in FY97, to 21.1% in 1Q98, to 20.3% in 2Q98. Managing costs at a huge multinational is quite a feat, so the trend here is remarkably promising. IBM has also bought back 4.6% of its shares in the last year in what's proved a smart investment.

Zacks lists the current Wall Street consensus estimates at $6.49 per share for FY98 and $7.46 for FY99. That means the Street is looking for 16% growth over the next six quarters. Yet this technology giant trades at just 19.5 times this year's estimates and 17 times next year's numbers. In a market where technology stocks remain priced at several times earnings growth, IBM looks like a good deal.

Where are the rising profits going to come from?

The non-maintenance services business has been booming. Accounting for just 17.7% of sales in FY95, services made up 24.6% of revenues last year and 29.1% so far this year. Corporate computing has become a nightmare that's left companies happy to outsource the headache to IBM. Big Blue added 15,000 services employees last year alone to keep up with demand for professional services (systems management; integration, design and development) and network services (such as product support and network management). What's more, gross profit margins in this unit increased to 21.5% from 20% for the first half of '98 due to better utilization of employees and improved contract management.

Sure, non-maintenance services are IBM's lowest margin business. But with revenues in this segment soaring 27% this year on a constant currency basis and the growth expected to remain robust for a while, it's crucial that IBM has found a way to make this segment not just profitable but increasingly so. Moreover, this business is expected to boost sales of the very high margin Tivoli systems management software.

IBM's own savvy e-commerce ads are driving the services biz as well as related software and hardware operations. A recent report from International Data Corp. indicated that IBM's mindshare has tripled in the last year among information technology executives interested in beefing up their companies' Web presence. IBM now scores well ahead of Sun Microsystems and Netscape. And while everyone's still talking about Microsoft NT, market leader Wal-Mart recently scrapped its Microsoft products for IBM's more robust mainframes. Meanwhile, the e-business ads are supporting UNIX server sales, too.

A recent commentary in Business Week listed five businesses worth $8 billion that IBM could jettison. (It's already asking $3 to $4 billion for its Global Network, which provides consumer connections to the Internet.) Without debating the particulars, I think it's a positive that some observers still find so much more room for restructuring.

What's even more compelling, though, is that IBM remains a research powerhouse. It spent $4.9 billion last year on R&D and was awarded 1,724 patents, making it America's top research outfit for the fifth consecutive year. Recent major advances include giant magnetoresistive heads, which are already helping increase disk drive storage capacity, and the use of copper instead of aluminum in the manufacture of semiconductors. A new copper PowerPC chip launched this month used the microprocessor design for a 300 MHz aluminum chip to create a 400 MHz microprocessor. So the use of copper alone boosted performance by 33%.

Such developments will continue to make IBM a technology leader capable of rejuvenating its currently weak hardware revenues. Add in more restructuring, continued fast growth in services, and accelerating software sales, and it's easy to see how IBM can reach Gerstner's goal of double-digit revenue gains with slightly better earnings growth.

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