IBM Pre-Announces a Strong Q3, But Don't Expect a Tech Sector Trend

It appears that there is a little life in Technology and Services, as IBM (IBM) pre-announced 3rd quarter results above estimates Wednesday evening. Obviously management wants to stem the tide of losses hitting the stock in the past two weeks; shares are down nearly 23% in the month of October alone. In this market, the mantra rings true - if you’ve got it, flaunt it.

IBM earned $2.05 per share for the quarter, about 4 cents above estimates. Those estimates were in the middle of being slashed, so if IBM had waited until its original release date the beat would been more pronounced. Revenue for the quarter came in at $25.3 billion, $1 billion below estimates and up about 5% YoY. The rising dollar is beginning to hurt currency conversions rather than help (as has been the case of late), as most of IBM’s business is now done overseas.

Investors by now should be expecting the worst for both results and guidance, so any company delivering 15% plus earnings growth and modest top-line growth ought to be applauded by the market. IBM is rather unique in the tech space, a global IT services & outsourcing goliath that happens to sell servers as part of their long term Razor & Blade Strategy.

Mild Support Case for Global Growth

News this morning of rate cuts in South Korea, Taiwan, and Hong Kong should help to spur growth (read: stop bleeding) in the Asian markets, although these cuts along with yesterday’s integrated global cut will take a while to pull at anything besides slack in the monetary string. But it does represent a concerted recognition of growth as the key concern over inflation, and this can only help a company with a global footprint as wide as IBM going forward.

Management yesterday also confirmed its full year forecast of $8.75 EPS or better, which would represent a 20% increase over 2007 levels. In order to hit that target, IBM will have to earn over $3.05 per share in the fourth quarter. Seasonal trends in the past indicate that IBM gets some extra deals done at the end of the year, but investors should remain wary of their ability to follow that pattern in 2008. Even if the company misses by a few dimes on the 4th quarter results, investors should be happy with results in comparison with the company’s peers.

IBM’s global position, high percentage of recurring revenue, and strong balance sheet should keep this a stock to own at current levels. Year-to-date free cash flow is already north of $6 billion, Cash & Equivalents are $9.8 billion, and gross margins actually improved a full 200 basis points in the last quarter. Operationally this company is extremely balanced, so even if the financial sector clamps down on spending, international growth plus long-term contracts should be enough to drive 12-15% earnings growth.

A Little (Gulp!) Fundamental Analysis

That’s all I need to feel warm and fuzzy about this stock, which trades at just over 10 times 2008 estimates, 1.2x sales, and a 6.7 Enterprise Value/EBITDA. I’d like to see management pare down debt over the next few quarters rather than repurchase shares, at least enough to get the 1.2 Debt/Equity ratio down below 1. This is the time for companies with strong cash flows to show off their feathers to investors.

Tech stocks may get a bump today on the news, but don’t expect many more positive pre-announcements. Actual earnings for the third quarter may end up solid (in the mid-teens), but outlooks for the 4th quarter and into 2009 will be dark and gray. Look for companies to ride the wave of negative sentiment and set the bar low - if they choose to set the bar at all. For their part, IBM shares may have found a bottom in the $90 range, and represents one of the few tech stocks that has an existing dividend with room to grow.

Disclosure: Author does not hold shares of companies mentioned; IBM is held in the Epiphany Investing Secular Trends Model Portfolio.