IBM reported an increase in earnings per share of 15% relative to the third quarter of 2003. (This and other numbers below exclude an extraordinary payment of $320 million for a partial settlement of some of IBM's pension obligations.) Revenue climbed 8.9% (5% excluding the impact of currency) during the quarter to $23.4 billion. IBM also managed to wring out more cost savings, leading to an increase in gross margin from 36.3% a year ago to 36.9% this quarter. Operating margins also increased slightly from 11.8% a year ago to 12.2% in the third quarter of '04.
Notice how deftly IBM is pulling all the financial levers to produce 15% earnings-per-share growth. IBM sees IT spending growing at 4% to 5%, and with the impact of currency this results in 9% revenue growth. The modest increase in both gross and operating margins adds a little more to the bottom line. Finally, IBM spent $4.4 billion on share repurchases this year, which elevates the EPS growth rate from 12% to 15%.
Intel last week noted reasonable strength across the globe except for U.S. retail sales. IBM's revenue numbers reflected much the same view, with one exception. Several European countries such as the United Kingdom, France, Germany, and Italy during the quarter showed weakness, which was offset by growth in the rest of Europe. IBM reported that the United States experienced the strongest growth rate in three years. Whether this will be a good indicator for smaller tech companies remains to be seen.
There has been a trend, in my view, for companies to select larger IT companies that offer more broad-based solutions and have greater financial wherewithal. IBM claims customers are more interested in platform solutions than multiple point solutions. IBM posted solid growth across its business segments except for software. Global Services, now 50% of total revenue, saw revenue expand by 10% from a year ago, and hardware experienced a 12% revenue increase, also relative to the third quarter of '03.
While IBM remains on track to meet previously set expectations, several analysts questioned the strength of the Global Services backlog. CFO Mark Loughridge explained that the contracts were getting shorter in duration, which would explain the lower backlog. Nonetheless, a falling backlog is always a concern.
The current valuation of IBM is roughly on par with the overall market at 18.4 times trailing earnings and about 16 times next year's forecast EPS. In my opinion, the stock will probably provide relatively good shelter if tech stocks were to falter, but it's unlikely to move as much as smaller tech stocks if the pace in IT spending truly picks up.
William Schaff is chief investment officer at Bay Isle Financial LLC, which manages the InformationWeek 100 Stock Index. Reach him at [email protected]. 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.