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Earnings Preview: IBM Unlikely To Report Big Gains For 2006

The bright spot for IBM could be the company's enterprise software business with offerings like Websphere and Tivoli, along with security and SOA products.
Was 2006 the year in which tech heavyweight IBM finally saw some big growth? Probably not, according to analysts surveyed by Thomson Financial Network.

The computing giant, which reports fourth quarter and year-end financial results after the close of Wall Street trading on Thursday, will actually post a marginal decline in year-over-year sales, according a survey of 22 analysts by Thomson Financial Network.

The analysts, on average, expect IBM to report full year revenue for 2006 of $90.82 billion, which would represent a small decline of .05% compared to 2005, with the low-end estimate at $90 billion and the high end at $91.67.

The outlook is somewhat rosier for earnings growth, according to the survey. The analysts are, on average, expecting IBM to post per-share earnings of $6.00 for 2006, a 12% improvement over actual 2005 EPS of $5.32.

Predictions for IBM's fourth quarter performance are modest. The analysts surveyed, on average, expect IBM's quarterly revenue to increase 6% to $25.66 billion and EPS to increase 3.7% year-over-year to $2.19.

So why is IBM growth challenged? Like most U.S.-based tech companies that rely heavily on outsourcing sales for revenue, IBM is facing increased price competition from low cost Indian service providers that are growing at between 40% and 50% annually. Services sales account for about half of IBM's total revenue.

To level the playing field, IBM is investing heavily to build out its own operations in India, pledging to spend up to $6 billion in the country over the next three years. It's also hiring low-cost Indian IT pros by the tens of thousands. Still, it's going to take some time for those efforts to show up on the company's bottom line.

And despite its divestiture of its PC business in May of 2005 to China's Lenovo Group, IBM is still a major hardware player, particularly in the market for servers and mainframes. But most classes of servers increasingly are a commodity product, and the market for mainframes is generally limited to large financial institutions and scientific research centers. Hardware accounts for about 30% of IBM's total sales.

The bright spot for IBM, and its investors, could be the company's enterprise software business. Middleware offerings like Websphere and Tivoli, along with security and SOA products, have shown relatively strong growth in recent quarters and their development takes too much R&D to fall into commodity status. It's also a market that the Indians have for the most part left alone, at least for now.

Software sales only account for about 17% of IBM's total sales but are by far the company's most profitable product, with gross margins running in excess of 80%. In other words, it's the part of the business that IBM would like to see growing the most quickly -- and it is.

In a research note, Goldman Sachs analyst Laura Conigliaro said she expects IBM to at least meet the Street's fourth quarter expectations, "led by strength in software and short term services and helped by an incremental currency tailwind." Sanford Bernstein's Tony Sacconaghi is also optimistic, as he said in a report that he expects IBM "to beat consensus throughout 2007."