Merrill Lynch sees good times ahead for IBM

In a research note today, Merrill Lynch analyst Steven Milunovich said the answer is an unequivocal "yes."

The financial analyst predicted a strong rebound in the second half as Armonk, N.Y.-based IBM recovers from slow server sales related to the Year 2000 glitch, a marketing misstep in disk drives and ongoing losses selling PCs.

"We are becoming more optimistic on second-half results," Milunovich wrote. "We expect a confluence of events may allow IBM to show not only better profits but double-digit revenue growth."

Milunovich also said he anticipated IBM's stock moving up 20 percent in the second half.

But the hard times are not over, as IBM must still struggle through a lackluster second quarter. Analysts also warn that Big Blue has taken risks with its PC business that, if successful, will pay off big but could also prove disastrous.

Speaking to financial analysts last month, IBM chief executive Lou Gerstner admitted mistakes had been made but insisted a turnaround was inevitable.

Milunovich faulted management's response to recent troubles. "The quality of earnings hasn't been good," he said. "IBM has benefited from big-bath write-offs, pension plan boosts to profits and other earnings management moves that bolster the bottom line."

Other analysts agree good times could be returning at Big Blue, but said execution is the key. "If all things go well, they may have a decent second half of the year," said Technology Business Research analyst Bob Sutherland.

Merrill Lynch expects continued problems with hard-drive sales to original equipment manufacturers (OEMs) will hurt any gains that could have boosted second-quarter results. In the first quarter, IBM was missing a crucial technology switch to 10,000-rpm drives that shaved $350 million off hard-drive revenue.

Overall, second-quarter revenue is expected to rise a modest 3 percent to $22.5 billion. But beyond that, things look quite rosy, particularly as IBM fixes a multitude of problems with its hardware business. Merrill Lynch predicts at least 9 percent growth in the third quarter, reaching 14 percent the next quarter.

Some of the best improvements in the second half will be in technology sales, particularly in OEM hardware. But the turnaround has been a long time coming. Technology profit for the first quarter was $20 million, down from less than $600 million last year and $2 billion the previous year.

Besides problems with hard-drive sales, IBM's DRAM business has been another troubled area. But losses on the memory chips are lessening. While DRAM revenue declined 22 percent the first quarter, IBM halved its losses.

Technology revenue is expected to climb 15 percent in the second half, as hard-drive sales rebound, and IBM further cuts DRAM losses, Milunovich said. He anticipated the technology division to shave 3 to 5 cents per share off the year's operating profit growth versus 38 cent hit last year.

The rebound in high-end server sales also could contribute significantly to second-half revenue. Milunovich forecasted 12 percent server growth in the third quarter and 21 percent for the fourth quarter. Mainframe sales could top 30 percent growth as early as the second quarter.

The biggest turnaround could be IBM's PC group, which fell on hard times two years ago. The unit has struggled through a difficult transition and will need the whole year for recovery. In the first quarter, for example, Aptiva consumer PC sales plummeted 45 percent, and commercial PC sales dropped 30 percent. Overall, PC system sales declined $550 million for the quarter.

"IBM really got tanked last year when they got the Aptiva out of retail in the U.S. and Western Europe," said International Data Corp. (IDC) analyst Roger Kay. "What that did to them was reduce their unit shipments a lot. It's true all of those shipments were money-losers--kind of the gangrenous arm you lop off--but having done that, they have a lot of room for upside at this point."

During the first quarter, PC system losses reached $180 million compared with a $571 million loss for all of 1999. Merrill Lynch forecasts a turnaround could reduce losses to as little as $50 million by year's end.

Unfortunately for IBM, gains are not being made so much in sales but in cutting costs. Aptiva sales, for example, which accounted for less than 10 percent of PC revenues, accounted for nearly 30 percent of losses. IBM has cut out much of the fat by streamlining manufacturing and distribution and taking its consumer PC business direct. The company hopes to reach 35 percent direct sales this year, up from 14 percent in the fourth quarter.

But the problems are far from over. "I understand IBM has quite a backlog of Apitvas and PC 300s right now, and something they're trying to do is cut costs and get those out the door," said Technology Business Research's Sutherland.

Big Blue in many ways is betting the success of its PC business on the new NetVista brand, which the company began selling last month. The main NetVista is built around an LCD display, which is a risky undertaking, said IDC's Kay.

"Even though they get the best price for a flat-panel based unit around, there's still an issue of who's going to pay 1,800 bucks vs. a thousand bucks with a monitor," he said. "One of things that is killing flat-panel adoption rates is the price of CRTs."

"Even if IBM is successful restructuring its PC model, it will not be able to match the efficiency of Dell and Gateway in the long run," Milunovich said. "Selling small devices is not in IBM's DNA."