Download Abstract:

Abstract:
International Business Machines Corp. (IBM) has produced an almost unbroken
string of quarterly earnings improvements in 1995, 1996 and 1997. Analysts'
consensus is for a record $6.18 a share in 1997, with another nice gain
in 1998. Though the $80 billion (revenues) company reported a 27% increase
in per-share earnings for the first 9 months of 1997, it lost some ground
in 4 of its main business lines. Overall gross margins at the company
have fallen from 42.2% in 1995 to 38.5% in 1997.
Copyright Forbes Dec 29, 1997
Full Text:
IBM's shares are up 50% this year to an alltime high. Its fundamentals
haven't nearly kept pace.
ARE CORPORATE EARNINGS as good these days as they seem to be? In their
lust to produce upbeat news analysts have become lamentably uncritical
(FORBEs, Dec. IS). Take no less a case than mighty International Business
Machines Corp. IBM has been delivering nicely on the numbers it has promised
investors. With the big writeoffs of the early 1990s behind it, IBM has
produced an almost unbroken string of quarterly earnings improve- ments
in 1995, 1996 and 1997. Analysts' consensus is for a record $6.18 a share
in 1997, with another nice gain next year.
Accordingly the stock has more than trebled in price over the past three
years, easily outpacing the market. This year alone it is up 50%.
But has the quality of the earnings matched the reported numbers? No. You
can make an excellent case that the fundamentals have, in fact, been
deteriorating.
Though the $80 billion (revenues) company reported a 27% increase in per-share
earnings for the first nine months of 1997, it lost some ground in four
of its main business lines.
In the third quarter computer hardware, 45% of IBM'S total revenues, inched
downward from the same period in 1996. Also showing declines in the quarter
were software and maintenance sales; rentals and financing revenues were
flat. Gross profit margins fell from the year-earlier quarter in all businesses
except software and services. Overall gross margins at the company have
fallen from 42.2% in 1995 to 38.5% today(see charts). By its own admission
IBM continued to lag in booming pcs and server products.
The slack in profitability and sales was taken up by services, which grew
at a fast 20% in revenues from the third quarter of 1996. This handsome
gain enabled the company to show a 4% overall rise in revenues.
How was IBM able to convert a 4% revenues rise into a 27% gain in share
earnings? Stock buybacks and a lower tax rate. In the preceding 12 months
IBM had retired 7% of its outstanding
common shares. Its tax rate meanwhile fell from 40.3% in 1996's third quarter
to 33.5% this year.
[IMAGE GRAPH] Captioned as: A very rosy stock price...
Captioned as: ..but how blue the outlook!
Back out these factors, and IBM would have earned $3.35 per share in the
period, only 5.3% more than it made in the first three quarters of 1996.
This is not to take anything away from the impressive turnaround engineered
by Chairman Louis Gerstner and his aides. When Gerstner took over in the
early 1990s, IBM was spurting red ink and foundering. Today it is solidly
profitable again. The question, however, remains: Is IBM as good as the
market seems to say it is?
IBM's lone major growth area is services, which account for roughly one-quarter
of the company's revenues. Some $9 billion in new services contracts were
signed in the quarter. Accounting for profits on service contracts is tricky
and subject to considerable leeway. IBM won't say, for example, what percent
of total contract earnings it books on its contracts each year. But this
much is known: Overly optimistic contract earnings assumptions have caused
headaches recently for competitor Electronic Data Services (see box).
Take a five-year contract. Easy enough to know how much it will cost to
carry out the contract for the current year-but how about the fourth and
fifth years? There's a lot of assuming in this kind of bookkeeping.
Elsewhere IBM doesn't have a great deal to cheer about. In mainframes the
company is losing market share to Hitachi, which has more than 20% of the
market, up from under 5% several years ago. Because a lot of the software
IBM sells is tailored to its mainframes, weakness there is hurting software
sales. IBM'S minicomputers and workstations are losing share to servers
built by Compaq. A bright spot for IBM is the disk drive business, but
this accounts for only a small part of overall revenues.
>From 1995 through this year, IBM will have bought in 181 million common
shares, reducing its common capitalization by about 15%. Some of the $16
billion for repurchases came from earnings, but some of it was, in effect,
financed with borrowings. IBM's debt to total capitalization stood at 49.1%
in 1995. It is now 57%.
The real bottom line for IBM, then, isn't as rosy as the reported bottom
line. Not only is the computer colossus lagging its industry in growth,
but much of the growth it has shown comes from financial shuffling rather
than fundamental improvement.
"Long tails"
TECHNOLOGY services have been the sunny spot at IBM. But IBM will not reveal
the assumptions it uses when it books profits from these long-running
contracts.
Electronic Data Services earlier this year found that the costs of servicing
many of its contracts were ending up much higher than the company had
anticipated.
In the first six
months of 1997 EDS had to write off earnings they'd already booked on
contracts,
causing its stock to plunge from around $43 to $32.50. Going forward, the
company said it would not record any profits from contracts recently won
until after their startup phases had been completedan admirably conservative
approach to contract accounting.
This is a highly competitive business; if IBM
is underbidding established competitors like EDS, Keane Inc. and Andersen
Consulting, it may have trouble maintaining its present 20% margins on
the business.
Fred Hickey, a New Hampshire-based technology analyst who pens the High
Tech Strategist, says of these contracts: "You don't know the outcome in
year one, two or three. They have very long tails."
Reproduced with permission of the copyright owner.
Further reproduction or distribution is prohibited without permission.