Asia hits IBM 4Q but next quarter could be worse

Electronic News, Jan 26, 1998 by Carol Haber

An "unusual confluence" of events is expected to barrage IBM's first quarter of 1998, producing a significant negative impact. Those events are: a worse than expected impact from currency translation, weakness in Asia, and pricing pressures. This, in addition to investments, and IBM's seasonally softest quarter, could signficantly impact earnings per share (EPS) bringing it in as much as 10-15 cents per share below last year's first quarter.

The company made this gloomy prediction during a phone conference with finan- cial analysts as it released its fourth quarter and 1997 results, characteriz- ing them as "a good close" for the year.

Slim gains in the fourth quarter and the bleak scenario for the first quarter unnerved investors. But the company is doing better operationally than the figures show, say analysts, with non-operational, non-fundamental items hit- ting earnings disguising a better performance.

Distortion of Performance

IBM's very recent practice of including acquisitions as operational expenses is "distorting" performance, noted Gary Helmig of Soundview Corp. Also, while revenues were slower than expected, gross margins were better, he said. Weak- ness showed up in lower-margin products, like PCs.

Laura Conigliaro of Goldman Sachs noted: "I feel that a number of the expenses really are less fundamental, more unusual, with the obvious exceptions of Asia and currency."

IBM reported 4Q97 revenue rose 3 percent to $23.72 billion from $23.14 bil- lion, with a strong North America countering a flat Asia-Pacific. Net income rose 3 percent to $2.09 billion, or $2.11 per diluted share, from $2.02 bil- lion, or $1.93 per fully diluted share, in the year-ago quarter, adjusted for a two-for-one stock split. The results were 4 cents short of consensus estimates, as determined by First Call Corp.

The effect of currency translation was about five points of impact on revenue growth and 18 cents on EPS.

"Last quarter I cited currency, continuous resource rebalancing, economic con- ditions in Europe and Asia, demand shifts in HDDs and consumer PCs and the never-ending price pressures everywhere in the technology sector," said CFO Larry Ricciardi to analysts at the phone session. "Many of these issues were more intense in the fourth quarter than the third. And they are all still with us today."

'Worse Than You Think'

If exchange rates stay where they are, the impact on the first quarter "may be larger than most of you think," he told analysts. Asian markets? "The key to this region is Japan. How much more will it slow down or when it will begin to turn around we don't know. All we really know is that coming into the quarter, the core business is slower and the PC business is very tough."

At the same time, Mr. Ricciardi warned analysts not to base their expectations of 1998 on the "bunching" of negative events in the first quarter. Look instead at the "strong turnaround" in IBM's struggling PC business, and the still-sizzling services growth and backlog, which could actually benefit from pressures on local businesses in Asian markets, he urged.

Other unusual items to impact the first quarter include expenses linked to the $200 million acquisition of Software Artistry, Inc. and IBM's marketing of the Olympics. "...Let me stress that this is an unusual bunching of events into our seasonally smallest quarter. It doesn't signal any change in our longer term business or financial model." The rest of 1998 should improve, he sug- gested, with much riding on the likely resolution of the Asian crisis. He admitted that his was an optimistic view of a timely solution to the Asia crisis.

Said Mr. Helmig of Soundview: "I was disappointed with the revenues. I was looking for them to be able to get better constant currency growth than they got. But then that was almost totally offset by significantly better gross margins than what I was expecting. Part of that is that they have not been taking down prices as much as they have in the past. That's true in main- frames, AS400s, RS/6000s. Some of their revenue softness was in product areas where they have low gross margins, such as PCs."

Meanwhile, Mr. Helmig pointed to IBM's recent move to report acquisitions as operational expenses, "distorting" actual performance. IBM actually had a very good quarter, he said. But figures don't show it.

"We ended up with a company being able to report $2.31 from operations and analysts would have knocked it back to $2.26 because they had a lower tax rate than they were guiding to," he explained. "IBM reported $2.16, just a penny above consensus. What they did is take a couple of one-time events and buried them in SG&A and R&D. One was a writedown of what was deemed to be bad debt and receivables in Asia. The more significant is a writedown for in-process R&D for Unison, which they put in R&D. It was about $100 million, I think, but they didn't say. But this is not tax deductible, so it goes right through to the bottom line, to the operational earnings performance. None of the models would have had the writedown in it."