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12/10/2004
01:40 PM
William Schaff
William Schaff
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Taking Stock: IBM PC-Unit Deal: It's All In The Numbers

Deal emphasizes IBM's growing services and software orientation.

When I left engineering grad school in 1980, one of the jobs I looked at was with IBM, but its conservative style didn't fit in with my West Coast ways. But one aspect of the company that I did appreciate was its commitment to innovation. IBM launched its PC business in 1981, and I never dreamed that I'd one day see it leave the market. Though tech innovation continues, global competition is even more pervasive. Pressure to increase profits remains intense for all publicly traded tech companies. So it should be no surprise that IBM has decided to shed its PC business.

The story of the divestiture has been examined extensively, but I'd like to take a different perspective. Much of the motivation for the deal is in the numbers. For example, the pretax operating margins of the PC business in the third quarter and year to date were only 1.6% and 0.7%, respectively. Overall, the company generated pretax margins of 10.8% and 11.1% for the same periods. Through nine months of 2004, the personal-systems group's revenue was 13.6% of total revenue, or almost $9.4 billion. Assuming all expenses were variable, the sale would boost pretax operating margins for the overall business in that nine-month period to 12.7%. Unfortunately, there are fixed costs, and the overall benefit is likely to be closer to only a 1% improvement in overall pretax margin. For a company the size of IBM, however, this is a significant increase in profitability.

I believe the sale will have very little impact on the balance sheet. $650 million in cash represents about 0.6% of total assets ($100.7 billion as of Sept. 30). The transfer of net liabilities of $500 million also represents only 0.7% of $71.0 billion in total liabilities at the end of the third quarter. Getting 18.9% of the outstanding equity of the PC unit's buyer, Lenovo Group (estimated value of $600 million), is nice, but it does little to increase the overall book value of IBM today. However, if Lenovo is able to increase market share and profitability versus Dell and Hewlett-Packard, it might be a nice upside surprise for investors down the road.

Most important, this sale re-emphasizes the fact that IBM is becoming more of a services and software business than a hardware business. The systems and technology business segment, its remaining hardware business, would represent slightly more than 20% of the overall revenue of the new company. This means that almost 80% of IBM's revenue would be generated by services (about 60% of the new company) and software (about 20%).

This makes the overall business a lot less cyclical than the past, in my view. Business IT spending usually has been tied to the overall economy. However, services and maintenance revenue typically is more stable, so IBM's earnings could become less cyclical. In my opinion, this might warrant, both going forward and after the sale, a premium earnings multiple to the broader U.S. market, given IBM's financial stability, size, and potentially more stable earnings growth.

William Schaff is chief investment officer at Bay Isle Financial LLC, which manages the InformationWeek 100 Stock Index. Reach him at william.schaff@bayislefinancial.com. This article is provided for information purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security. Bay Isle has no affiliation with, nor does it receive compensation from, any of the companies mentioned above. Bay Isle's current client portfolios may own publicly traded securities in one or more of these companies at any given time.


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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