IBM poised to steal market spotlight

By Robert Walberg

It has been a long time since IBM (IBM, news, msgs) has been the star of the show, but like William Shatner in "Boston Legal," the company is now poised to steal the spotlight.

Big Blue flexed its muscles with surprisingly solid quarterly results, helping the Dow Jones Industrial Average to a record high Wednesday.

As I noted in earlier Street Patrol columns, the company’s decision to bet big on software over hardware would eventually pay considerable dividends by stabilizing sales and improving margins. We’re starting to see those benefits. Software was the strongest contributor to profits, with a 9% jump in sales from a year ago. Gains were bolstered by the performances of Tivoli and Websphere, which increased sales by 44% and 30%, respectively.

IBM’s scaled down hardware group also delivered solid results, with a 9% jump in revenue. Chip sales were driven by increased demand from gaming companies such as Sony (SNE, news, msgs), Nintendo and Microsoft (MSFT, news, msgs) -- all of which are gearing up for the holiday season. (Microsoft is the publisher of MSN Money.)

Finally hitting its stride

Interestingly, IBM’s biggest business -- services -- grew most slowly. Though the company reported signed contracts worth about $500 million less than the $11 billion analysts expected, it was the first time in 15 quarters that Big Blue's order backlog didn’t decline. Several deals expected to close in the quarter were simply pushed back, suggesting that the miss isn't a sign of serious trouble.

To the contrary, after years of repositioning the company to the realities of a changing IT environment, IBM is finally hitting its stride. Hardware has been streamlined into higher margin, higher profit segments, and the company continues to gobble up software companies to bolster its long-term growth. Margins jumped to 42% in the quarter from 40.6% a year ago.

True, some analysts questioned the quality of earnings growth, noting that IBM again relied heavily on share buybacks (it cut the number of outstanding shares by 5%, adding 6 cents to the bottom line). But this is nitpicking. IBM is sitting on nearly $11 billion in cash, so buying back shares with some of that money is prudent. Investors should expect more of the same, though the pace of repurchasing should slow now that the stock is at a 52-week high.

With interest rates stabilizing and oil prices declining, spending on IT should rise. As long as that story holds true, there’s no reason to think that IBM’s stock, which catapulted nearly 6% today, will lose momentum.

Much more upside ahead

Buoyed by the fact that IBM is enjoying sales growth across product lines and geographical regions for the first time in many quarters, Wall Street is tripping over itself to raise price targets and upgrade ratings. Goldman Sachs, UBS, Bank of America and Credit Suisse are among today’s converts. Nothing gooses a stock more than better-than-expected results and a wave of analysts upgrades.

Based on an industry PEG (the ratio of P/E to long-term growth rate) of 1.7-times, IBM has upside over the next 6 to 12 months in the $108 area. That’s still well below its all-time high of $139.18 set in July 1999, but 18% above current levels.

Considering IBM’s strong balance sheet, proven management team and industry leadership position, that’s the kind of star performance that wins applause from investors. I’ll add the stock to my Street Patrol portfolio as of Wednesday’s close.

Robert Walberg is a financial writer based in Chicago and a regular guest on CNN's "Moneyline." He was formerly chief equity analyst at Briefing.com and ran for Congress in Illinois in 1994.

At the time of publication, Robert Walberg did not own or control shares of any companies mentioned in this article.