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Will IBM ride out computing turbulence?

Big Blue is one of the few major high-tech companies to pass through the fourth quarter without delivering bad news--so far.

    Like a bowling ball busting down pins, slow sales are toppling fourth-quarter earnings. Will IBM remain standing?

    The Armonk, N.Y.-based computer maker is one of the few major high-tech companies to pass through the fourth quarter without issuing a profit warning.

    The sagging economy and slow sales have battered rivals, with Compaq Computer and Hewlett-Packard lowering forecasts and Gateway, Motorola and other high-tech companies set to announce extensive layoffs. But IBM has pushed through the quarter without delivering bad news.

    So far, that is.

    Analysts expect mixed results from the computing giant, with acceptable but not great performance from servers, lingering difficulties in software, continued sales declines in microelectronics, and potentially the second straight quarter of PC profitability. Analysts polled by First Call expect earnings of $1.46 per share for the fourth quarter and $4.43 for the year when the company announces results after markets close Wednesday.

    "Because of the softness industry-wide, there's going to be some softness that comes out in the revenues for IBM," said Technology Business Research analyst Bob Sutherland. "However, to some degree they are the last one standing because they are so diversified."

    That diversification may cushion the sales blow IBM is expected to take along with other high-tech companies, but Wall Street analysts have remained unusually cautious about Big Blue. One reason is the credibility gap, as IBM used one excuse after another to explain weaker-than-expected revenue for the first three quarters of 2000.

    "The past quarters there were little surprises that cropped up, whether it's ceramic packaging or using currency conversion as excuses for revenue shortfalls," Sutherland said.

    Overall outlook
    On Thursday, Banc of America Securities analyst Kurt King cut his 12-month target for IBM shares to $110 from $125. He maintained his "buy" rating.

    In December, IBM joined other high-tech companies slammed by downgrades or revised fourth-quarter estimates. Among them: Merrill Lynch analyst Thomas Kraemer cut his near-term rating to "neutral" from "accumulate" but kept his long-term rating at "buy." A.G. Edwards & Sons analyst Shelby Seyrafi downgraded IBM to "maintain position" from "accumulate" and cut his target price to $110 from $140.

    Prudential Securities analyst Kimberly Alexy cut her IBM fourth-quarter revenue estimate to $24.5 billion from $25.3 billion.

    Sutherland predicted that revenue growth would not break 5 percent year over year. For comparison, IBM shocked Wall Street during the third quarter with sales growth of about 3 percent, off more than half from the most conservative estimates.

    But Alexy did not share Sutherland's optimism. In a research note on Tuesday, the Prudential Securities analyst predicted year-over-year growth of just 1.2 percent and earnings per share of $1.39.

    Servers and services
    IBM's biggest problem could be a slowdown in technology spending that cuts across some of its most profitable business segments, particularly servers and services. On Tuesday, Kraemer issued a report on server buying trends.

    "Spending intent on nearly every class of server...decelerates for the next two years--a bearish sign for all server-centric companies," he wrote. "So Unix growth drops from 28 percent to 14 percent and legacy servers--S/390, AS/400, Vax--drop from 28 percent to 5 percent from 2000 to 2001." Of the Unix server manufacturers, IBM and Sun Microsystems are likely to see the largest declines, he warned.

    In some ways, analysts are more closely watching server sales from the third to the fourth quarter than they are year-over-year changes. Sales sluggishness resulting from the Year 2000 technology glitch hit IBM hard in the fourth quarter of 1999, making year-ago comparisons a relatively unreliable measure.

    Merrill Lynch's Kraemer predicted quarterly declines for mainframes, AS/400 and low-end servers, as well as PCs. But he anticipated increases in RS/6000 servers and workstations.

    IBM spent much of the quarter trying to recover from two problems hurting sales. A shortage of ceramic material used in chips prevented Big Blue from meeting demand for high-end severs during the third quarter. Just as troubling, S/390 mainframe sales declined 24 percent in anticipation of the G7 mainframe.

    Sutherland praised IBM's innovation grappling with the ceramic problem. "They signed up a spark-plug company to help them with that," he said. "But how fast they were able to ramp that up, I don't know."

    Big Blue released its new mainframe late in the quarter, delaying the full revenue benefit until the first quarter.

    Still, Alexy remained optimistic that IBM would see 30 percent growth in servers based on MIPS processors. But Merrill Lynch analyst Peter Goldmacher did not share Alexy's optimism.

    Goldmacher warned that there is "decelerating demand for mainframes, and correspondingly MIPS. Our data suggests that 30 percent year-over-year growth will be difficult." The Merrill Lynch analyst also cautioned that slow technology spending could curb the usual sales growth cycle associated with the release of a new IBM mainframe.

    Software and services, both tightly but not exclusively tied to IBM mainframe and server sales, are expected to again disappoint. Many analysts predict flat software revenue or a slight decline. Services revenue could grow 6 percent or more compared with fourth-quarter 1999 but be down for the year.

    "This would equate to 3 percent (growth) for the year vs. 12 percent for 1999," Alexy wrote in Tuesday's research note.

    PCs and components
    IBM's microelectronics business is expected to be stung by a number of factors, including ongoing ceramic supply problems. The company also faces pressures from falling component prices.

    IBM's larger challenge will be continued profitability in its PC group, which makes desktops, portables and PC servers. After about two years of losing money, the PC division made $65 million in the third quarter.

    But IBM faces problems from slowing PC sales that blindsided many computer companies during the fourth quarter. Retail PC revenue sales, for example, plummeted 30 percent in December year over year, according to PC Data. This led to a glut of inventory going into the holidays.

    "IBM definitely saw the slowdown coming, and by the beginning of (the fourth quarter) they already had the signs," said IDC analyst Roger Kay. "They did make some internal decisions to throttle back so they wouldn't get caught with too much inventory."

    Given IBM's holiday position, $1 billion in cost-cutting and improved manufacturing, Sutherland predicted that the PC division will "break even for the year, which means pretax income over $182 million."

    By contrast, Alexy predicted the PC group's revenue will decline 1 percent for the fourth quarter.