Neutral On IBM Ahead Of Earnings

International Business Machines Corp. (IBM) will report third-quarter earnings after market close today. We have a Neutral rating on the stock.

Positives:

• 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.

• The company relies heavily on its technology services and software as a result of which it has recently signed various large IT contracts.

• IBM has been executing a strategy to accelerate initiatives such as Smarter Planet, Business Analytics and Optimization, and Cloud computing and is expanding into ‘smart’ power grid projects, thereby driving higher profit margins.

Negatives:

• IBM’s long-term revenue growth potential is very limited and we remain cautious about currency fluctuation, which is taking a toll on its revenue.

• We believe that the scope for further cost cutting is limited. Consequently, if costs are further reduced, there could be a negative impact on product quality. It could also delay the launch of new innovative products, causing it to fall behind peers.

• Weakening demand, continued decline in hardware sales and rising pressure in its Services business are impacting IBM’s business. The drag in the company’s Services business may further lower sales volume which may become a problem if demand remains under pressure.

Results Overview:

IBM’s second quarter results were above the Zacks Consensus estimates, driven by higher gross margins and operating cost controls. Earnings rose to a record $2.32 per share, up 17.8% from the prior-year quarter, while total revenue declined 13.3% to $23.3 billion year-over-year.

Looking ahead, Zacks consensus estimates are for earnings of $3.39 per share in the third quarter. In the July quarter, IBM raised its earnings for fiscal 2009 to $9.70 per share, up from $9.20 per share, but did not give specific revenue guidance.

We do believe that IBM is fundamentally a sound company and has a strong mark et position but our caution is related to our expectations of near-term bumps. As IT spending is rebounding, we expect IBM to post stronger results from the fourth quarter onwards.

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