International Business Machine’s
(IBM) third-quarter 2009 earnings exceeded the Zacks Consensus Estimate by one cent. As a result of expense management, net profit improved by 14% to $3.2 billion, while earnings per share rose 18% to $2.40 per share. This compares to a profit of $2.8 billion or $2.04 per share in the year-ago period. Net margins increased 250 basis points to 13.6%.

Profitability in the quarter was fueled by higher gross profit margin, which improved to 45.1% from 43.3% in the year-ago quarter led by improved margin in the Services and Software segments. IBM has benefited from the growing focus on these high margin businesses. This has allowed the company to expand its gross margins for 20 of the past 21 quarters. Moreover, the company benefited from lower interest expense, which fell 46.9% from the year-ago period.

IBM remained focused on its cost-cutting initiatives, as a result of which third quarter operating expenses fell 11% year-over-year. SG&A expense decreased 11.2% to $5.0 billion and RD&E expense decreased 8.4% to $1.4 billion from the year-ago period.

Total revenue was in line with the Zacks Consensus Estimate, although it declined 6.9% (down 5.0% when adjusted for currency) to $23.6 billion from the year-ago quarter. We remain cautious about currency fluctuation, which is taking a toll on revenue and may be critical to earnings growth over the next two years.

Overall, sales were down across all segments. However, IBM benefited from market share gains in its Hardware and Software segments in the quarter. The company reported improved revenue from its branded middleware products that include WebSphere, Information Management, Tivoli and Lotus products, which increased 2% year over year. As a result, the decline in the company’s Software segment was the lowest of all segments and fell just 3% year over year in the quarter.

From a geographic perspective, revenue was down 5% in the North American region and 6% in growth markets, but dropped 12% in the EMEA (Europe, Middle East and Africa).

Weak IT spending pulled down revenue, and we do not expect a recovery this year. IBM did not provide any comment on the IT spending environment, but said that the economy is improving. Moreover, IBM’s rival Accenture (ACN) has refrained from predicting a full recovery in business spending. Intel Corp. (INTC) also expects corporate spending to remain weak until 2010.

Weak recovery in technology spending has made it hard to win new business. As a result, IBM reported a drop in signed services contracts, which fell to $11.8 billion, a decrease of 7% from the year-ago period. Thus we remain concerned on the company’s long-term customer wins. Signings in Consulting and Systems Integration and in Integrated Technology Services decreased 16%. The estimated services backlog on Sept. 30 was $134 billion.

The balance sheet continues to be strong as IBM delivered $11.5 billion in total cash and marketable securities, compared to $12.5 billion in the previous quarter. The company reported cash flow from operations (excluding Global Financing receivables) of $4.4 billion, with free cash flow of $3.4 billion. Debt was reduced by $4 billion in the quarter.

2009 EPS Outlook Raised

The company raised its earnings outlook for fiscal 2009, the second time this year, and now expects full-year earnings of at least $9.85, up from the previous forecast of $9.70. This is above the Zacks Consensus Estimate of $9.77 per share.

IBM expects to return to revenue growth in the fourth quarter. Management stated that IBM is well on course to deliver an EPS of $10 to $11 in 2010. The company also expects 2009 pre-tax income for its software and services businesses to grow at double-digit rates and reach around $8 billion.

IBM has been growing its profits and stands to benefit from cost-cutting measures, strong liquidity position, operational efficiency, substantial free cash flow and earnings momentum. We believe that IBM is fundamentally a sound company with a strong market position. Thus we remain optimistic on the company’s long-term growth and expect it to post stronger results in 2010.

We expect further upside on IBM’s share price and advise stockholders to wait for a favorable exit point. Until then we remain Neutral on IBM.
Earlier this week, IT giants, Google Inc. (GOOG), Advanced Micro Devices (AMD) and Intel Corp. all reported better than expected results due to the improving economy. We expect the year 2010 to be a good year for the IT sector as a whole, due to improving demand and better tech spending.
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