Earnings Preview: IBM

Tech bellwether International Business Machines Corp. (IBM) is scheduled to report its second quarter 2010 results after market closes on July 19. Historically, the company’s earnings have consistently surpassed the Zacks Consensus, and IBM has been raising its guidance for almost every quarter over the last two years.

We expect the company to post another good quarter with year-over-year growth in revenue, margins and profitability. The Zacks Consensus Estimate for the quarter is pegged at $2.57 per share, which represents growth of 10.8% from $2.32 reported in the year-ago quarter.

Analysts expect IBM to report in line; however, the company could post a surprise of 0.8% according to the Zacks Consensus. Hence, we do not expect any significant stock price movement in the near term.

Agreement of Analysts

In the run-up to the earnings release, only 1 of the 21 analysts covering the stock has raised the estimates for the second quarter 2010 in the last week, and just 1 has raised estimates in the last 30 days. No downward revisions were witnessed in the same period. Pick up in IT spending, improvement in demand, operating leverage, growth in the Hardware segment and shift to a more profitable services/software business has led to the revision.

However, the single upward revision proves that the majority of the analysts are in agreement with the company’s in-line earnings expectations.

During the first quarter earnings call, IBM lifted its earnings forecast for fiscal 2010 to $11.20 per share from the previous expectation of $11.00, the third time in a row since the third quarter of 2009. Despite the raise, analysts remain cautious for the overall macro environment, lack of constant currency growth, weakness in most of its segments, late cyclical recovery and weak revenues.

For fiscal 2010, 1 analyst has lowered the estimates and 1 has moved in the opposite direction in the last 30 days. Also, 1 analyst has made a downward revision to estimates for fiscal 2011 due to the lack of catalysts for multiple expansions.

Magnitude of Estimate Revisions

For the second quarter, analysts’ estimates remained unchanged in the last 30 days. However, estimates for fiscal 2010 were lowered by a penny from earnings of $11.26 per share to $11.25 over the last 30 days. Also, estimates for fiscal 2011 moved down from earnings of $12.34 per share to $12.32. Thus the revision trends and the magnitude of such revisions indicate some weakness in the stock.

Although estimates have been reduced, it is still above the company’s revised guidance of $11.20 for 2010. We do believe that IBM is fundamentally a sound company and has a strong market position, but the estimates reflect lower visibility in results.

Last Quarter Highlights

IBM reported first-quarter 2010 earnings that surpassed the Zacks Consensus Estimates of $1.94 per share by 3 cents. Net profit improved 13.3% year over year to $2.60 billion, while earnings per share rose 15.9% to $1.97. This compares with a profit of $2.30 billion or $1.70 per share in the year-ago period. Net margin increased 80 basis points year over year to 11.4%.

The first quarter profitability was fueled by a 5% sequential revenue improvement. Total revenue in the quarter was in line with the Zacks Consensus Estimate of $22.8 billion. Revenue came in at the low end of management’s guidance range of $22.8 to $23 billion. Revenue of $22.9 billion was up 5.3% (flat when adjusted for currency) compared with the year-ago quarter.

Although costs increased in the quarter and margins were slightly below expectations, we remain positive on the company’s increased signings in software and consulting. However, first-quarter new service-contract signings were below expectations.

Long-Term Positives

We remain optimistic on the company’s long-term growth and expect it to post stronger results, helped by its growing initiatives in smarter planet, business analytics and optimization, and cloud computing.

Management expects to achieve earnings of more than $20 per share by the end of 2015 with strong revenue growth, operating leverage and geographical expansion. IBM plans to spend approximately $20.0 billion in acquisitions over the next 5 years, which is expected to contribute 90 cents in earnings per share each year.

With $14.0 billion in cash and marketable securities, impressive free cash flow, aggressive share repurchase and increase in quarterly cash dividend, IBM is a long-term value stock for investors.

Maintain Neutral

Although we believe that IBM is well positioned among its peer group, we would advise investors to wait for a more attractive entry point. The limited number of changes to estimates also point to the fact that there are no major catalysts that could drive results. Given the lack of near-term drivers of growth, we maintain a Zacks #3 Rank, which translates into a short-term ‘Hold’ recommendation.

We believe IBM is currently undervalued and stands to benefit from a strong liquidity position, operational efficiency, substantial free cash flow and earnings momentum. However, we are compelled to maintain our long-term Neutral rating on the stock as these positives are already priced into its shares.

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