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4/12/2002
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Taking Stock: Despite An Earnings Dip, IBM Remains A Good Bet For The Long Term

Software is one of IBM's fastest-growing segments.

Well, the first big warning of an earnings shortfall in the upcoming quarterly season was a doozy. IBM said revenue would be lower than projected, and first-quarter earnings would come in lower than analysts' consensus. This isn't what Wall Street likes to hear from one of the most predictable technology companies in the past 10 years.

The last time IBM said it would have lower-than-expected earnings was the first quarter of 1991. This time, just like the last, the company's share price declined 10% on the day after the announcement. The stock went from $97.25 to close the following day at $87.41. At this price, IBM is about 30.8% below its 52-week high of $126.39 a share, which it hit on Jan. 9. For the comparable time period, the Nasdaq 100 Index was down 18.6% from its Jan. 9 peak.

Let's take a longer-term perspective of IBM as an investment within a diversified portfolio and compare it with the perspective of the IT professional deciding what company to work with.

IT and IBM are almost synonymous for most large and midsize businesses. IBM is a steady, if unspectacular, business partner. It may not be the best-looking or the hippest at the party, but, somehow, it always steals the spotlight. I've heard many complaints about IBM over the years, but few IT personnel have ever gotten fired for hiring the company or using its services. Frustrated, maybe, but not fired.

Why is this perspective important? Because, like many short-term investors, we forget that investing is similar to making a partnership decision in business. We may look for a short-term return on investment, but the real consequence of a business partnership is the year-in, year-out benefit of the ongoing, long-term relationship. Sometimes, it's more important not to quibble about a few dollars at the front end if you think the cost difference will easily be made up over the lifetime of the relationship.

Many investors have lost this perspective. But then, investors can just sell the stock if they're wrong. For the IT manager who chooses poorly, the negative consequences will be much more severe, with substantial bottom-line impact.

Why do I think that the probability of making money on IBM over the next decade is quite high? History is on my side and the business model reduces (notice I didn't say eliminates) the business risk of technology.

Let's look at history. IBM's gross sales have grown about 3% annually for the last 10 years, but gross operating income has expanded 28% per year for the same time period. In the meantime, the number of publicly traded shares have shrunk about 3% per year. The result has been a compounded annual return to shareholders of 15% per year since the beginning of 1991. If you bought IBM shares after the first-quarter miss in 1991 and held them through the first-quarter 2002 price adjustment, the share price appreciated more than 13% per year--not bad for a business that's gotten more profitable and more stable because of its diversified business mix away from pure hardware.

This brings me to the business model. IBM Global Services represented 41% ($34.96 billion) of last year's $85.87 billion in revenue. I'm aware of the problems in professional services, such as extended sales cycles and slow corporate demand, but outsourcing will continue to grow. More important, the stability of the recurring revenue that comes from services is appreciated in volatile markets. Software, representing 15%, or $12.94 billion of total revenue, is one of IBM's fastest-growing segments. Non-hardware revenue now represents more than 55% of IBM's income.

Will IBM produce 13% to 15% compounded growth for the next 10 years? Maybe not. But I expect the share-price return will be very competitive with the broader Standard & Poor's 500, with potentially better underlying growth prospects than the average S&P 500 company. Though I'd rather buy it below my valuation of $82, most investors who buy the shares today at $87 won't notice the difference 10 years from now.

William Schaff is chief investment officer at Bay Isle Financial LLC, which manages the InformationWeek 100 Stock Index. Reach him at bschaff@bayisle.com.


To discuss this column with other readers, please visit William Schaff's forum on the Listening Post.

To find out more about William Schaff, please visit his page on the Listening Post.

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