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International Business Machines Corp. (IBM) Earnings: Taxes, Easter and Lenovo

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International Business Machines Corp. (NYSE:IBM) posted top-line revenue of $23.4 billion, which was down 5% year over year, but it did post increased bottom-line earnings of 8% year over year. IBM’s big initiatives of a smarter planet and cloud computing were up over 25% and 70%, respectively. As these items continue to grow, they will contribute to greater portions of IBM’s earnings.

IBM has stated that it will shift to higher value services, even if that gives up some revenue. This is exactly what we saw, with revenue declining 3% to $23.4 billion for the quarter, while earnings increased to $3.00 per share for the quarter. International Business Machines Corp. (NYSE:IBM) expects to earn $16.70 per share for 2013, as sales were pushed from the first quarter into the second quarter.

Quarter anomalies

On the earnings call, CFO Mark Loughridge cited the renewed R&D tax credit as savings to the company. This means we should see the tax credit as a tailwind to other companies’ earnings that have large R&D divisions, like Oracle Corporation (NASDAQ:ORCL) and Western Digital Corp. (NASDAQ:WDC). Loughridge also pointed out that Easter weekend landed in the last week of the first quarter, which is typically the week where most deals are closed, delaying deliveries until the second quarter. IBM cited software contracts and System Z sales that were rolled over into second quarter, noting that these will bolster sales next quarter, and this is consistent with IBM’s backlog of business, which increased 1% year over year.

Dump the low margin business

An analyst asked Loughridge if IBM was looking to sell its low end server business to China’s Lenovo Group. Simply put, Loughridge didn’t want to speculate on what International Business Machines Corp. (NYSE:IBM) was planning on doing, but it does seem to go with IBM’s road map of exiting more commoditized businesses.

International Business Machines Corp. (NYSE:IBM)IBM did sell its PC business to Lenovo, but IBM is targeting software as its main driver of earnings growth. If IBM sells the server business to Lenovo, what’s to stop Lenovo from switching the software it offers to Oracle’s suite of products? Lenovo has turned around the ThinkPad brand, why wouldn’t it follow IBM’s lead into server software and middleware and sell its systems to clients with its own proprietary software?

US PC companies like Dell Inc. (NASDAQ:DELL) have seen this happen in the past. Dell and Hewlett-Packard Company (NYSE:HPQ) would outsource the low margin parts of their businesses, like components, to companies in Asia, only to have those competitors make their own competing systems. Acer started as a parts supplier, grew to a PC maker, and in a twist of fate purchased US rival Gateway and now rivals Dell in size.  Dell believes its saving grace will be to go private, reduce headcount, and shape itself more like IBM. Dell has seen these overseas competitors beat their operating margins down to a fraction of what they once were — the same could happen to IBM’s server and software business if it jettisons its low end server division.

Financial power

This past year, International Business Machines Corp. (NYSE:IBM) repurchased 4% of shares outstanding, and maintained non-financing debt to capital at a 30% ratio, down 3% from last quarter or $600 million. IBM has maintained discipline and kept its balance sheet strong during the good times and the bad. IBM’s revenue decline was offset by share repurchases. The big improvement in earnings ($0.23 per share) shown below came from expanding margins on the products that IBM sells, as well as favorable tax renewals.

Source: IBM’s 1Q’13 Earnings Charts

Storage

Cloud computing and storage solutions were two of IBM’s largest-growing initiatives this quarter. IBM is pushing to incorporate highly efficient flash memory into its storage solutions. This is good news for Western Digital, which releases its earnings on April 22. As a top supplier for IBM, Western Digital should see robustness in its sales for its fiscal third quarter earnings.

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