International Business Machines Corp. (IBM) reported first-quarter 2010 earnings after the bell that surpassed the Zacks Consensus Estimates. The company also lifted its earnings forecast for fiscal 2010, the third time in a row.

The market seemed quite positive ahead of IBM earnings as shares rose 1.22% and closed at $132.23 yesterday. Despite upbeat results, IBM shares fell 2.31% to $129.17 after hours. Investors hoped for much better results and a stronger recovery. Thus IBM’s earnings beat wasn’t enough to impress Wall Street after hours.

IBM’s results signify that corporate IT spending is picking up and the company is a major beneficiary of the improving economy. Moreover, Gartner Inc. (IT) has indicated IT spending increase of more than 5% in 2010, after falling 1% in 2009. The better-than-expected results from Intel Corp. (INTC), Advance Micro Devices Inc. (AMD) and Oracle Corp. (ORCL) is further proof of the rebound in IT spending.

Further, IBM stands to benefit from its increased focus on software and services. We believe IBM’s high-margin recurring revenue business and its increase in profitability will be the main drivers of growth in 2010.

The company provides a broad array of services and software, which has helped it expand its global footprint. IBM has also benefited from new initiatives such as Smarter Planet, Business Analytics and Optimization and Cloud Computing.

The current quarter profitability was fueled by a 5% sequential revenue improvement. 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.

Operating Performance

IBM’s quarterly earnings exceeded the Zacks Consensus Estimate 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 to 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%.

Gross profit margin improved to 43.6% from 43.4% in the year-ago quarter, led by improved margins in all but the Services, Software and Financing segment. This was partially offset by lower gross margin in the Systems and Technology group. IBM has benefited from the growing focus on high-margin segments, such as Services and Software.

The company benefited from lower interest expenses, which fell 39.6% from the year-ago period and higher Other income, which rose 79.6% year over year. IBM also benefited from a lower effective tax rate of 26% in the quarter.

Operating expenses increased 6.6% year over year in the first quarter due to higher SG&A expense (24.8% of total 1Q revenue), which increased 7.8%  to $5.68 billion and RD&E expense (6.6% of total 1Q revenue) increased 2.0% to $1.51 billion  from the year-ago period.

As a result, the operating margin fell slightly to 12.2% in the quarter from 12.4% in the year-ago period.


Total revenue for 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 – $23 billion. Revenue of $22.9 billion was up by 5.3% (flat when adjusted for currency) to compared to the year-ago quarter. Overall, sales were down in one of its five segments. Services, Software and Systems and Technology revenues were higher, while Financing fell from the year-ago period.

Total Global Services revenue increased 4.3% (down 2%, adjusting for currency) year over year, driven by an increase of 6.3% in Global Technology Services revenue and a 0.3% increase in Global Business Services revenue.

However, IBM reported a decrease in signed services contracts, which declined to $12.3 billion, down 2% (down 7%, adjusting for currency) from the year-ago period, primarily due to a decrease of 23%, or approximately $700 million in Application Management signings.

The company signed 13 contracts, which were greater than $100 million. Signings in Transactional services (Consulting, Integrated Technology Services and Application Management Systems Integration) decreased 1% (6%, adjusting for currency), however Consulting services signings increased 18% in the quarter with 25% of signings related to Smarter Planet and Business Analytics.

The company’s total outsourcing signings (Strategic Outsourcing and Application Management Outsourcing) decreased 3% (8%, adjusting for currency) to $6.8 billion. The estimated services backlog on March 31 was $134 billion, an increase of $8 billion year over year.

IBM reported improved revenue from its branded key middleware products that include WebSphere, Information Management, Tivoli, Rational products and Lotus products, which increased 13% (8%, adjusting for currency) year over year to $2.8 billion. As a result, the company’s Software segment increased 10.6% (up 5%, adjusting for currency) from the comparable quarter a year ago.

Systems and Technology revenue increased 4.9% (2%, adjusting for currency) year over year to $3.4 billion. Systems revenue increased 4% due to an increase in System x revenue, which increased 36%. This was offset by a decrease of 17% in revenue from POWER Systems. Revenues from System z mainframe server products decreased 17%. The hardware revenues that include servers and high-end mainframe computers grew 5% in the quarter.

From a geographic perspective, revenue was up 2% (flat, adjusting for currency) in the Americas and grew 10% (up 1%, adjusting for currency) in the Asia-Pacific region. EMEA grew 5% (down 2%, adjusting for currency) in the quarter. Revenue from OEM customers increased 18% and revenues from the growth markets increased 20% and represented 19% of total geographic revenues.

Balance Sheet

IBM ended with $14.0 billion in total cash and marketable securities, flat compared to the previous quarter. The company reported cash flow from operations (excluding Global Financing receivables) of $2.3 billion. For the quarter, IBM generated free cash flow of $1.4 billion, up approximately $400 million from the year-ago period. The company returned $4.7 billion to shareholders through $0.7 billion in dividends and $4.0 billion in share repurchases.

Guidance Raised

Historically, IBM’s earnings have consistently surpassed the Zacks Consensus, and IBM has raised its guidance for almost every quarter over the last two years. For fiscal year 2010, the company raised its earnings forecast to at least $11.20 per share from the previously expected $11 per share.

The company also said it expects constant-currency revenue growth for its total services, software and hardware businesses in the second quarter.

We remain positive on IBM’s long-term growth and therefore reiterate our Neutral rating on the stock.
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