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Is it Time to Buy IBM?

Sunday - 4/21/2013, 2:51pm  ET

Shares of International Business Machines recently took a tumble, after the New York-based company reported earnings that missed analyst expectations on both its top and bottom lines. IBM, which has evolved from the personal computing giant that it was several decades ago into a streamlined software and services company, is widely considered a bellwether of the tech industry. Should investors fret over the company’s first quarter fumble, or is the stock’s post-earnings dip a good buying opportunity for value investors?

A first quarter fumble

For its first quarter, IBM earned $2.70 per share, or $3.07 billion, slightly up from the $2.61 per share, or $3.03 billion, it reported in the prior year quarter. Analysts polled by Thomson Reuters had expected the company to earn $3.05 per share.

Meanwhile, revenue fell 5% from $24.67 billion to $23.41 billion, barely topping the consensus estimate of $24.62 billion. This marks the company’s fourth consecutive quarter of declining revenue.

IBM attributed its disappointing decline in top and bottom line growth to fewer software and mainframe transactions, as well as a weaker Japanese yen. IBM generates approximately 10% of its revenue from Japan, where the yen has declined 18% during the quarter, due to the country’s aggressive monetary easing measures.

Macro problems in the United States, caused by spending cuts caused by the sequester, have forced government agencies to delay their investments in IT software, hardware, and services, which has also notably impacted earnings from Oracle, F5 Networks, Red Hat, Compuware and Infosys during the first quarter.

Shifts in technology, especially the growing popularity of IT as a service (ITaaS), have changed the way IBM must approach its core business. ITaaS treats IT services as a commodity, and provides companies with a fixed amount of software, hardware and support services catered to a business’ individual needs, for a set monthly fee. This shift has decreased IT expenses for many companies, which now opt to hire ITaaS companies such as EMC to oversee their IT needs.

Sales growth

IBM generates its revenue from six main segments - technology services, business services, middleware software, operating systems, servers & storage and financing.

IBM’s largest business segment comes from its software services. Revenue at its services declined rose 4.0% year-over-year to $14.08 billion. Global technology services revenues declined 4.3% to $9.61 billion. Global business services revenues also slid 3.3% to $4.48 billion.

Meanwhile, sales of IBM’s middleware software products, which are used to connect two unrelated applications (such as database systems to web servers), grew 1.0% year-over-year to $3.5 billion. These applications include products such as WebSphere, Tivoli, social workforce solutions and Rational products. However, operating system sales slid 2.0% to $578.0 million.

IBM attributed these declines and anemic gains to economic uncertainties that kept certain software deals, worth roughly $400 million, from closing during the first quarter. However, its order backlog rose 1.0% year-over-year to $141.0 billion, which included 22 new service agreements worth $100.0 million. Therefore, although IBM’s first quarter numbers weren't too strong, its order backlog suggests that the rest of the year will be more favorable.

Hardware revenues, which include its servers and storage business, plunged 17.2% to $3.11 billion. IBM attributed the slide to product transitions and execution problems. Financing revenue, which comes from interest earned off financing plans for its IT services and products, rose 1.8% to $499.0 million.

Selling its server business

Although IBM’s physical x86 servers account for a relatively small part of its business (16.7% of 2012 revenue), the company still surprised Wall Street when it announced that it was in discussions to sell the struggling business to Chinese tech giant Lenovo (NASDAQOTH: LNVGY), the second largest personal computer company in the world after Hewlett-Packard . According to unnamed sources close to the deal, IBM wants $5 billion to $6 billion for the server business unit.

Most of Lenovo’s current success can be attributed to IBM, which sold its personal computer business to the Beijing, China-based company for $1.25 billion back in 2005. Adding physical servers to its product line would make it a serious threat in the enterprise world to Hewlett-Packard. Lenovo has increasingly gained ground against HP in the personal computers business over the past few years with its ThinkPad products.

Shedding its server business would make sense for IBM, since the division has posted annual declines in revenue ever since 2008, which offset gains from its higher-margin IT software and services segments. Considering that IBM’s sale of its personal computer segment to Lenovo came right before the PC industry crashed, I think investors should trust IBM’s decision.

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