Advance Capital (LSE:ACN)
Historical Stock Chart

From May 2019 to May 2024

International Business Machines Corp.'s (IBM) strong earnings performance validates the company's push into software and services, and offers hope in this recession to other tech companies that provide such products.

On Tuesday, IBM posted an unexpected 12% rise in fourth-quarter net profit and offered earnings guidance for 2009 that was comfortably ahead of Wall Street's forecasts. Although sales declined at its global services division, which includes outsourcing, software applications development and traditional business consultancy, higher-than-expected signings of new customers impressed analysts who say the unit is holding up well.

The results suggest some of IBM's competitors in the services-and-software sector, such as Accenture Ltd. (ACN), Microsoft Corp. (MSFT) and Oracle Corp. (ORCL), may be able to weather the recession better than some smaller companies. Like IBM, these companies have scale, products needed to run global companies, and services that corporate customers can't afford to drop. Because many of these products are sold on service contracts, the companies also have strong and predictable recurring revenue streams.

"We believe these results [from IBM] are a good indicator for trends impacting managed services providers," Srinivas Anantha, an analyst at Oppenheimer & Co., said in a note to clients. "We see overall signings trends as demonstrative of businesses looking to third-party providers to reduce costs and conserve capital."

The earnings performance lifted shares of IBM as well as some of its competitors. In early afternoon trading Wednesday, IBM shares were up 10% at $90.17, while the S&P 500 Applications Software index was up 2.9%. Microsoft, Oracle, Accenture and SAP AG (SAP) were all higher as well.

Over the past 10 years, IBM has transformed itself from a computer maker into a services-and-software giant. While it still retains a presence in hardware, it has moved to drive more revenue and profitability from its services and software businesses, which now account for 80% of the $103.6 billion in total annual sales.

In particular, the company's $58.9 billion services business has benefited by serving as an outsourcing destination for many corporate customers looking to cut costs by shifting their information-technology functions to specialists, rather than maintaining their own staffs. The business accounts for about 55% of IBM's overall sales.

Corporate cost-cutting benefited IBM in the fourth quarter as North American outsourcing signings, a closely watched measure of new business, rose 45%. Business from European customers grew even faster, at 66%.

Accenture, another large global outsourcing company, is also well positioned to benefit in the current environment.

IBM is seen as well positioned to benefit in the early and late stages of a recession. While its Global Technology Services business handles outsourcing, popular among clients in the early stages of a recession, its Global Business Services operation, which includes traditional consulting and applications development, becomes more attractive as companies begin to retool for growth.

Global Technology Services declined by 4% in the fourth quarter, up 2% adjusting for currency, and Global Business Services declined 5%, flat after adjusting for currency. While revenue for the overall services unit fell 4%, signings - a closely-watched measure of new business - were well ahead of Wall Street expectations at $17.2 billion.

IBM's outsourcing business, and those at its competitors, is expected to grow during the recession. In particular, IBM has fared well from the consolidation of the financial industry caused by the credit crisis, said Citi analyst Richard Gardner.

"IBM is clearly gaining significant market share in services, especially outsourcing," Gardner said.

Although IBM has offered outsourcing services for 15 years, it has moved to make the business more profitable in recent years by standardizing its services across different regions, said Carl Claunch, an analyst at Gartner. Claunch said IBM's services performance also shows the company has gained from global scale which has allowed it to benefit from better global sourcing, helping to keep costs down.

IBM's software unit also held up well, growing 3% on a reported basis to $6.4 billion, driven in particular by the strength of middleware, products that act like software glue to bind company-wide applications together. IBM's software strength comes from the fact that most software revenue is recurring in nature because of maintenance contracts the company signs with clients.

This makes for both more reliable revenue streams and more profitable business; gross margin for IBM's software unit is close to 90%. According to J.P. Morgan's John DiFucci, the read-across is positive particularly for companies such as Oracle, which also gets a large amount of its revenue from recurring sources.

-By Jessica Hodgson, Dow Jones Newswires; 415-439-6455; jessica.hodgson@dowjones.com

Click here to go to Dow Jones NewsPlus, a web front page of today's most important business and market news, analysis and commentary. You can use this link on the day this article is published and the following day.