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Also, check out: "Lou's Lair vs. Bill's Loft", "IBM's Best Years Are 3-4 Decades Behind," ICC: More Armonk "Fudge," Armonk's "Fudge Factory," "Now IBM Is Even 'Officially' Spineless", "Where Armonk Meets Wall Street, Greed Breeds Incest", "Some Insiders Cashed in on IBM Stock Buybacks", "Louis XIX of Armonk", "Wag the Big Blue Dog", "the new blue"

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Analysis of IBM's Third Quarter Results

Big Blue Sings Y2K Blues

IBM Stock Drops Like a Stone, Sheds $37 Billion of Market Cap

WESTERN AUSTRALIA, Oct. 21 - We've been telling you for years that it was just a matter of time before some of the hot air gets released from of the overpriced Big Blue stock (see, for example, "Stock Buybacks - A New Wall Street Fad: Corporate 'Cabbage Patch' Dolls of the 1990s," Annex Bulletin 98-39, Oct. 31, 1998).

"Overhyped and overpriced stocks, like the Big Blue's, tend to trade UP on rumors, and trade DOWN on facts," we said in a January report which few seem to have heeded (see Annex Bulletin 99-02, Jan. 22, 1999). Because IBM stock AGAIN traded up in advance of the third quarter announcement. Only to drop like a stone following it despite IBM's higher earnings and revenues.

Only this time, a lot more hot air was taken out of IBM shares than was the case last January. The Big Blue stock shed a cool $37 billion of its market capitalization in a single trading day.

Ostensible reason? The Y2K impact on IBM's S/390 and AS/400 server hardware businesses, whose revenues plummeted by 40% and 30% respectively in the latest period.

louis-99.jpg (51086 bytes)Well, the Y2K issue is an excuse, not the reason. And a lame excuse at that. The Y2K issue has been well known and researched for years. So for IBM executives suddenly to wake up after one down quarter and then realize what had hit them is almost comical. Especially after IBM's chairman and other insiders have been selling stock (see "Gerstner: Best Years Are Behind; Dumps 328,000 Shares Worth $40.9M" - Annex Bulletin 99-28, Aug. 10, 1999).

But when it comes to a stockmarket as perverse today's Wall Street, distinctions between an excuse and a reason are blurred. As are those between a comedy and a tragedy. Which is why the market interpreted the Armonk clowns' pontification as a tragedy, rather than a farce laced with greed that it was.

For, a swan song-type writing was on the wall for the IBM S/390 and AS/400 servers for years. We said back in January 1994, for example, that the best the Big Blue can do is play tough defense so as to prolong the life of its hardware businesses:

"IBM must play tough defense - cut costs, fight as heck for every percent of market share so as to minimize the inevitable erosion."

(Annex Bulletin 94-06, Jan. 25, 1994)

And we repeated such a warning in the summer of 1996, pointing out that IBM was still way too dependent on its 4,000 large customers, from whom it was getting about 70% of revenues, yet whom we called were corporate dinosaurs in the longer scheme of things (see "Louis XIX of Armonk," Annex Bulletin 96-42, Aug. 24, 1996).

Of course, all this fell on deaf ears in Armonk and on Wall Street, both of which preferred fairy tales to reality. As a result, IBM stock soared, mostly thanks to its "financial engineering" line of business, such as the $30 billion of stock buybacks, for which Armonk bought an illusion of prosperity on Wall Street (see Annex Bulletin 97-17, Apr. 29, 1997).

As a result, on the eve of the greatest single-day market value loss in IBM's history, 19 of the 25 analysts surveyed by Zacks had the Big Blue stock listed as a "strong buy" or "moderate buy" (two top ratings), and zero (none, nil) had it rated as a "strong sell." With "research" like that, investors might be have better luck picking stocks by throwing darts at the board.

Meanwhile, even after having lost 28% of its value since the end of July, when it reached a record share price of $139, IBM stock is still up 268% since July 1996, a growth rate 3.1 times higher than that of the Dow Jones Industrials Average. And IBM's current market cap of $164 billion still carries a "fluff ration" 8.2 times equity, up from 7.4 times in October 1998, when we first wrote about the "Fluff Championship of the IT World" (see Annex Bulletin 98-39, Oct. 31, 1998).

Which means that there is still plenty of hot air left in the IBM stock. And that only fools will be buying the Big Blue "fools gold" at such inflated prices. The latter includes Armonk, by the way, which continued to waste its shareholders' assets by spending $1.5 billion in the latest quarter on stock buybacks. Since the start of its stock repurchases in 1995, the company has now squandered nearly $30 billion lining Wall Street's pockets without creating a single job or a product!

Business Segment Analysis

It is ironic that Wall Street chose to dump the IBM stock at a time when the company actually reported very good results in four of its seven major business segments - services, software, technology and rentals. And when the two of the remaining three - PCs and Enterprise Investments - while still losing money, nevertheless cut their losses considerably since a year ago (see the tables).

Which leaves only the IBM servers (S/390, AS/400 and RS/6000) as a factual disappointment. The server revenues declined by 30%, from $2.8 billion to $2 billion., while its pretax profit plunged by 60%, from $731 million in 3Q98, to $295 in the latest quarter.

Services. Meanwhile, some IBM units' third quarter results were downright stellar, such as that of its Global Services unit (IGS). It closed $9.2 billion in new contract signings during the last three months, the fifth consecutive quarter in which IGS had rung up more than $9 billion in new sales. As a result, its backlog now stands at over $57 billion, an impressive achievement even for the world's No. 1 IT services provider.

IGS' revenues were up 16% to $6.5 billion, excluding maintenance and without normalizing for the sale of the IBM Global Network (IGN) to AT&T. Adjusted for the IGN sale, however, they were up 19%. Including maintenance, which declined by 2%, IGS revenues were up 12% over the third quarter of 1998.

But even more important to IBM shareholders has been a growing contribution to the bottom line which the IGS unit has been making. Including the declining, but highly profitable maintenance business, this IBM segment now accounts for 45% of the total corporate pretax profit (over $1.1 billion). And its gross margin has improved by 1.7 points since a year ago.

As for the non-maintenance portion of IGS, which offers closer to an apple-to-apple comparison with other IT services vendors, its $6.5 billion third quarter revenues were up 16% over the same period last year (without normalizing for the IGN sale to AT&T). And its gross margin improved by more than two points - from 20.5% to 22.7%.

Finally, its estimated pretax profit margin of 8.4%, still puts it ahead of the IT services leaders' average of 6.5% (see the "Annex IT Services Hexathlon," Annex Bulletin 99-16, May 25, 1999).

Software. IBM software segment also experienced good growth in the third quarter, particularly in the so-called "middleware" products. Overall, IBM software revenues increased by 7% to $3.0 billion, while the gross margins improved from 80.6% to 81.2%. But software pretax margins were basically flat - 18.8% in 3Q99 vs. 18.4% in the same period last year.

IBM PC and Rentals and Financing units both experienced double digit growth (11%) in the latest quarter. But while the PCs lost $69 at the pretax level, the latter financing operation raked in $322 million, for the highest pretax margin by far of any IBM business unit (32.9%).

Happy bargain hunting!

Bob Djurdjevic

NOTE: The print edition contains additional charts and tables not included here.


Volume XV, No. 99-32
Oct. 21, 1999

Editor: Bob Djurdjevic
Published by Annex Research

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