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THE DAY AHEAD: Big Blue&#039s Y2K bummer; Gateway&#039s smooth move

Microsoft Corp. (Nasdaq: MSFT) rallied the market Wednesday and now IBM Corp. (NYSE: IBM) will bum it out on Thursday. What was supposed to be a snoozer quarter for IBM went awry. There might be something to this Year 2000 effect.

Going into IBM's third quarter earnings report, ZDII took an informal poll of three analysts. The consensus outlook for the quarter went something like this: Services and software will look good, the hardware business will stink, but the company will beat estimates by a penny. IBM was also expected to be bullish on a seasonally strong fourth quarter and reiterate that there were no dreaded Year 2000 effects.

Kaboom.



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Very little of that outlook happened after market close Thursday.

The company met estimates with operating earnings of 90 cents a share, but sales were a bit light at $21.1 billion. As for the outlook, IBM has a bumpy ride ahead.

"We saw a Y2K slowdown toward the end of the quarter, particularly in our large servers, and to a lesser extent in services and operating systems software," said IBM chief Louis Gerstner in a statement. "We were hurt by shortages of flat-panel displays, margin pressure in our hard disk drive business, and sales disruptions related to our sale of certain networking hardware assets."

But Gerstner's prognosis was just the tip of the bad news. CFO Douglas Maine said fourth quarter earnings will be 15 cents a share to 20 cents a share lower than the year ago period. Analysts were expecting fourth quarter earnings to be about 9 cents higher compared to a year ago. In the 1998 fourth quarter, IBM had earnings of $1.24 a share (see financials).

The fourth quarter also faces Y2K hurdles. Why is IBM getting the Y2K crunch when it didn't see any impact in prior quarters? And why is IBM seeing Y2K problems when EMC Corp. (NYSE: EMC) and Microsoft see no potholes ahead?

IBM hardware holds about a fifth of all business data. IBM's customers, which worked their Y2K fixes earlier in the year, can't afford to mess with crucial data and upgrades in the fourth quarter. In addition to the well-documented PC woes, IBM saw a dip in mainframe sales courtesy of Y2K. That's life when you're in an old-world mainframe business.

The good news? Services and international sales were strong and once this "sales respite" is over, Big Blue will be reporting big and boring quarters again.

Gateway finds a Net strategy

If IBM represents old techs, Gateway Inc. (NYSE: GTW) is looking downright trendy. Gateway found its Net access strategy and it sure beats buying an Internet service provider. Gateway inked a distribution pact with America Online (NYSE: AOL) that benefits both parties.

Gateway, which topped estimates with the third quarter earnings of 35 cents a share on revenue of $2.18 billion, has been trying to diversify with its Gateway.net service and has been moderately successful with non-PC revenue equaling 15 percent of revenue in its latest quarter. Gateway.net has 600,000 subscribers, but it's clear that the computer maker had to do something to get bigger.

Rumors that Gateway was looking to buy MindSpring (Nasdaq: MSPG) and/or EarthLink (Nasdaq: ELNK) died when the two latter parties merged.

Enter AOL. The two companies announced a distribution pact where AOL will run Gateway.net under the Gateway brand and invest $800 million in cash and stock in the PC vendor. AOL gets "aggressive marketing" for its service on Gateway PCs and the pair will share revenue. Gateway will be able to get much more revenue out of AOL bounties and can offload its infrastructure costs.

AOL, which also topped estimates Wednesday, grows it's AOL everywhere strategy. The two companies will also work on home networking devices.

The deal is that latest dose of creativity from Gateway and investors will probably cheer judging from the aftermarket stock movement. As for AOL, look for weakness. AOL's quarter was typically strong, but investors get a bit picky when the laws of large numbers and whisper estimates come into play.

SGI's collapse

And just to ensure that this column is hardware heavy and another 85 words too long, here's something to ponder: Silicon Graphics (NYSE: SGI) looks hopeless.

SGI lost five times more than Wall Street expected with a third quarter loss of 37 cents a share. To make matters worse, current management doesn't look so hot.

After the surprise defection of ex-CEO Richard Belluzzo to Microsoft, new CEO Richard Bishop said the company was on track to profitability.

Now Bishop admits SGI lost a few steps in the management transition and is losing some credibility points for not issuing a profit warning.

Looks like Belluzzo bailed just in time.