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Shares of International Business Machines (IBM) fell more than 3% in after hours trading on Tuesday. 'Big Blue', the global information technology company reported its third quarter results after the close.

Third Quarter Results

IBM reported third quarter revenues of $24.7 billion, down 5.4% on the year. Revenues took a $1 billion hit as a result of a strong dollar. Revenues fell short of analysts expectations of $25.4 billion.

The company managed to boosts its gross profit margins by 90 basis points to 47.4%. Operating earnings per share came in at $3.62 per share, beating analysts consensus by a penny.

Net income fell 0.4% to $3.82 billion. Sizable share buyback programs boosted diluted earnings per share by 4.4% to $3.33. Net income was hurt by a $160 million payment in retirement-related expenses in the UK unit.

An economic slowdown, especially in North America pushed back software deals and business technology service packages. Investors were cautious after CFO Mark Loughridge said that especially the final month of the quarter in the US was weak.

CEO and Chairman Ginni Rometty commented on the results, "In the third quarter, we continued to drive margin, profit and earnings growth through our focus on higher-value business, strategic growth initiatives and productivity. Looking ahead, we see good opportunity with a strong product lineup heading into this quarter and annuity businesses that provide a solid base of revenue, profit and cash. We are reiterating our full-year 2012 operating earnings per share expectation of at least $15.10."

Segmental Information

All major divisions from IBM reported a decline in revenues.

Global technology services reported a 3.9% decline in revenue to $9.92 billion. Tight cost control boosted gross profit margins by 160 basis point to 37.3%. The division boosted its order backlog by an estimated one percent to $138 billion.

Global business service revenues fell 6.0% to $4.54 billion, yet gross margins rose 180 basis points to 31.2%.

Software revenues fell a mere 0.9% to $5.76 billion, with gross margins remaining as high as 88.0%.

Systems & Technology revenues were hit hard, falling 13.1% to $3.90 billion. Gross profit margins fell by 2.5 percent point to 37.3%.

Outlook

For the full year of 2012, IBM expects to report GAAP diluted earnings per share of at least $14.29. Operating non-GAAP diluted earnings per share are expected to come in at least $15.10.

Valuation

IBM ended its third quarter with $12.2 billion in cash, equivalents and marketable securities. The company operates with $33.7 billion in short and long term debt, for a sizable net debt position of $21.5 billion.

For the first nine months of 2012, IBM generated revenues of $75.2 billion. Net income came in at $10.8 billion, or $9.27 per diluted share. Full year revenues are expected to reach $104 billion. Full year earnings could reach $16.5 billion, or $14.29 per diluted share.

Factoring in a three percent fall in after hours trading, the market values IBM at roughly $233 billion. This values the firm at 2.2 times annual revenues and 14 times annual earnings.

Currently, IBM pays a quarterly dividend of $0.85 per share, for an annual dividend yield of 1.6%.

Investment Thesis

Year to date, shares of IBM have risen some 15%. Shares started the year around $185 per share and quickly advanced to $210 per share by April. Shares fell back to $180 during the summer months, as investors were worried about global economic growth. Shares hit a new high at $210 during Tuesday's regular trading session, but fell back to $204 in after hours trading.

Over the past five years, shares of IBM have risen some 80%. Shares traded as low as $85 in 2008, but steadily rose up to all time highs of $200-$210 at the moment. Shares of IBM have shown impressive performance despite the fact that annual revenues fell from $103.6 billion in 2008, to an expected $104 billion in 2012. Net income rose from $12.3 billion to an estimated $16.5 billion this year. IBM repurchased roughly 17% of its own shares during the same time period. Consequently, earnings per share rose from $8.89 to at least $14.29 in 2012.

IBM is still targeting four growth areas to add some $20 billion in incremental revenues over the next three years. The company is transforming itself from a low-margin hardware business into the areas of lucrative cloud computing, analytics software, data analysis and emerging markets.

I think shares are valued a bit rich. Shares have almost doubled over the past five years, while revenues have been stagnant. Shareholder returns have been driven by improved earnings, share buybacks, and an increased valuation. Shares are valued at a fairly rich 14 times annual earnings and pay a mere 1.4% dividend yield at the moment. IBM has sufficient financial flexibility, but still drags along a net debt position of roughly $22 billion.

I am fearful that stagnating operating performance might impact next year's earnings, given the weakness in the economy.

Source: IBM - Investors Should Be Cautious On Weakening Operational Performance