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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.