Annex Bulletin 2007-15                              April 17, 2007

Excerpts from CONFIDENTIAL edition (Annex clients click here for FULL version)

Recent...

IBM Stock Still Grossly Undervalued (A preview of IBM first quarter business results]

Accenture Beats Forecasts, Again (Analysis of Accenture's 2QFY07 results)

IBM FINANCIAL

Updated 4/24/07, 11:00AM PDT, adds IBM ratchets up stock buybacks...

Analysis of IBM First Quarter Business Results

No Big Surprises in Good Opening Quarter

Mainframe, Unix Servers Lift Hardware Profitability; Services Sales Stumble Again; Software Shines

The Economist: IBM Up for Sale?

SCOTTSDALE, Apr 17 - "What do you think will be the market reaction? (to IBM's first quarter results)," a reporter asked this writer just before the company's teleconference with analysts this afternoon.  "A shrug," was the reply.  "Big Blue hit both the earnings and revenue targets but did not exceed either.  There were no major disappointments.   But there were no spectacular upside surprises, either.  So it was a good quarter overall."

[chart]

IBM CFO's subsequent comments, and the initial market reaction to the release, were pretty much along the same lines.  Mark Loughridge (CFO) called it "a solid quarter" during the post-earnings teleconference  The IBM stock first moved up by about a point in after-hours trading, before sliding down by about the same amount, and then settling to about a half a point loss ($96.50 as of 5:40PM EDT).

[snip]

Strong Demand in Asia, Europe, Emerging Markets

The demand in Asia/Pacific and Europe outpaced that in the U.S. by a wide margin.  Last year, it was the other way around.  Yet this is consistent with impressions we have gleaned from customers and independent IT vendors during a recent trip to Asia and Europe. 

[charts]

These results represent a complete reversal of geographic performances a year ago.  The segments that were up last year are down in this quarter and vice versa (click on the thumbnail image for last year's first quarter results).  Except for the emerging markets... they stayed strong all around.

[snip]

Mainframe, Unix Servers Boost Hardware Performance

HARDWARE. The mainframe revival (System z, up 12%), now in its second year (seventh successive quarter of growth), continues to lift IBM hardware revenues, as do the Unix servers (System p, up 14%).  Both product lines are gaining market share around the world.  We can attest as to the strength of demand for these servers based on this writer's recent 'round the world trip that included many customer meetings in China and Russia.

[charts]

System i's "Marketing Weakness."  The System i decline was all the more disappointing as the first period of last year was also a down quarter.  So it should have been an easy comparison.  IBM said the latest drop was due to an "upgrade weakness."  But we think the System i suffers from a chronic "marketing weakness."

[snip]

Distribution, Financial, SMB - Best Sectors

Among the vertical IBM segments, the old stalwart performers - financial and SMB sectors, also two biggest industry units - again did very well for IBM, rising 9% each.  But this time, they were outdone by the distribution sector, the only IBM industry to achieve double digit growth in the quarter (up 10%).  Indeed, we have seen many examples of rapid growth in distribution sector, especially in food or appliance retailing (see the chart).

[snip]

IBM Should Create Market Buzz by Building Up Its SMB

Yet the "real SMB" (or "midmarket" as some call it) is by far the best IT market opportunity, growing at rates of 30%+ in many countries (vs. 9% in IBM's case).  And is very profitable for a lot of SMB companies in this business.  This is also a potential gold mine of acquisition opportunities for IBM, so "Baby Blue" could grow even faster than the market.  

"Baby Blue?"  Perhaps you recall our Annex Bulletin from last fall in which we suggested IBM ought to consolidate and break off its SMB operations into a "Baby Blue," and brand it as a separate entity? (but keep 100% ownership).  That's because SMB companies prefer to buy from other SMB companies (see "From Little Acorns Might Oaks Grow?", Nov 2006). 

[snip]

So let's just wait and see... maybe that $125-stock price isn't as daunting as it seems.

Services Sales Performance Disappoints Again

SERVICES. Meanwhile, back to the first quarter results, the biggest part of IBM - Global Services - is again suffering from an old malaise - slow or no growth.  New signings are down 3% to $11.1 billion, while backlog is down $1 billion since the end of the fourth quarter (see the chart).

[snip]

Software Continues to Rake It In, But STG Most Improved

SOFTWARE. Perhaps the best part of IBM's first quarter was its software performance, especially that of its branded middleware.  Websphere, Tivoli, Information Management and Rational all grew at more than double the overall corporate growth rate (between 14% and 20% vs. 7%).  These products are becoming defacto standards in customers future IT plans.  Everywhere we have been overseas lately, CIOs and independent software developers are installing or considering these IBM application enablers.

[snip]

PROFITABILITY. Another reason software was the best part of IBM was its enviable profitability (84% gross margin, 21% pretax margin).  In fact, at $1.04 billion pretax profit, IBM software towers over the other lines of business (see the thumbnail chart).

But the most improved IBM unit in that sense is actually IBM hardware (STG) whose gross margin surged by nearly three points (to 35%).  That's because the highly profitable mainframe (System z) and Unix servers (System p) are doing so well that their growth is helping offset the weaknesses elsewhere in the IBM product line.

[snip]

Outlook

Looking ahead, the IBM CFO acknowledged the need for his company to take some corrective actions to improve the profitability of the GTS business, and that of the sales effectiveness in the U.S.  

[snip]

"Bottom line, we believe earnings per share growth in 2007 will be in line with our long term objective" (of delivering double digit earnings growth), the IBM CFO summed it up.

And what did Wall Street think of that?

It shrugged.  By the end of the evening, the IBM stock was down 0.8% to $96.33.  So it goes...

Happy bargain hunting!

Bob Djurdjevic

The Economist: IBM Up for Sale?

SCOTTSDALE, Apr 18 -  Forget the talk about the acquisitions IBM should make with all its surplus billions.  What if the hunter became the hunted?  What if IBM itself were up for grabs?

We know.  It sounds far fetched.  And it wouldn't worth repeating if the rumor did not come from one of the world's most respected media organizations - the London-based Economist.  In its comprehensive report on IBM globalization, "Hungry Tiger, Dancing Elephant," Apr 4, 2007, the Economist alluded to just such a possibility:

IBM's share price rose from $11 in March 1993 to $125 in December 2001—a price it has never since matched. Last July it fell below $74, although it rallied after that—perhaps as the message that the firm is taking India seriously started to get through. Having briefly touched $100, it slipped back to $93 during the recent market wobbles. That is not the sort of performance to make a boss feel secure in his job, especially in this era of trigger-happy boards. (Though, if rumours are to be believed, a record-breaking bid from private equity may yet rescue Mr Palmisano's reputation.) 

(bold italics added by Annex Research)

If such a thing were even remotely possible, it would have to be indeed a whopper of a takeover bid.  So far, the biggest private equity deal ever done was Blackstone Group's buyout of Equity Office Properties, the largest  U.S. real estate holder after the federal government.  The deal was worth $38.9 billion.  It closed on February 7 of this year.  

The price comprised of $23 billion in cash and $15.9 billion of debt.  It eclipsed the previous record buyouts, including a $33 billion takeover of HCA health care provider last November by a consortium including Bain and Kohlberg Kravis Roberts.  Blackstone Group is a private investment fund co-founded by Peter Peterson and Stephen Schwarzman.

Now, keeping the above in mind, consider what it would take to buy an IBM.  Even at its current (we think undervalued) price of $94.70 (yes, the stock is down another 2.5% this morning), IBM is worth $143 billion.  We think a fair market price for it is $125 per share, a 32% premium.  That would put Big Blue's price tag at $187.5 billion - five times bigger than the biggest private equity deal ever done!

Who's got that kind of money lying around?  Even the treasuries of developed countries would find it hard to scrape that much spare cash together, let alone private equity funds.  So sorry, Economist editors.  Even with your stellar reputation, one cannot help but wonder what you had inhaled the day this story came out.  Or was it just an April Fool's Day joke?  After all, the publication date was only three days later...  :-)

But we did like your story's art... and that's no "elephant in a china shop"-joke.

IBM Ratchets Up Stock Buybacks, Dividends

SCOTTSDALE, Apr 24 -  The IBM Board ratcheted up its stock buybacks today by15_IBM14.jpg (45132 bytes) earmarking another $15 billion for it.  Including the remaining balance at the end of March from prior authorizations, IBM has now about $16.4 billion available for share repurchases.  Big Blue said in a release that it "may complete a substantial portion of the repurchases over the next several months."  Since 1995, IBM has spent more than $79 billion on stock buybacks (see the chart).

But what really boggles one's mind, however, is that IBM plans to borrow a large portion of the15_IBM2.gif (12629 bytes) funds for this repurchase.  Borrow the money to pay the shareholders?  O tempora o mores... The only winners we can see in this type of a deal are the bankers.  Some of them may be also IBM shareholders (see the chart).  So it's a win-win deal for them.

Jesse Greene, IBM treasurer, defended the idea of borrowing the money to buy back shares.  Speaking in an interview today, he said IBM is doing it because "the interest rates are still relatively low," and because "IBM has lots of unused borrowing power."

But credit agency Fitch Ratings said today that it may downgrade its rating on IBM because of this move.  What worries Fitch is not only that the new stock buybacks are more than double the IBM historical levels, but the very issue that also stymied us - that a substantial portion will be funded with debt.

But any downgrade is likely to be limited to one notch in the near term, Fitch said. It currently rates IBM at "AA-minus," the fourth-highest investment grade.

Asked about why everybody is so infatuated with stock buybacks in the first place, the IBM treasurer Greene said that it was because they provide a company more flexibility than the dividends.  

"Dividends are a one-way trip," he said.  "With stock buybacks, we can decide when and how much money we want to return to shareholders."

Speaking of which, the company also boosted its dividend by 33% to $0.40 per share.  This was the 12th consecutive year that IBM has increased its quarterly cash dividend.  And that's a good thing.  For, it rewards all shareholders, not just those willing the sell their shares to the company (such as with stock buybacks).

Obviously, both moves are intended to bolster the IBM stock, which is still grossly undervalued, in our opinion (see "No Big Surprises in Good Opening Quarter," Apr 17, and "IBM Stock Still Grossly Undervalued", Apr 16).  Wall Street reacted favorably, pushing the IBM stock up by over four points to just under $100.

For additional Annex Research reports, check out... Annex Bulletin Index 2007 (including all prior years' indexes)

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Volume XXIII, Annex Bulletin 2007-15
April 17, 2007

Bob Djurdjevic, Editor
(c) Copyright 2007 by Annex Research, Inc. All rights reserved.
e-mail: annex@djurdjevic.com

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