IBM Earnings Preview: 3 Clues to Watch for in Thursday’s Report

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Against the backdrop of declining hardware sales and intense competition, Wall Street will have a watchful eye on International Business Machines (IBM) this week as the tech giant prepares to release its second quarter earnings Thursday. Expect mixed results from IBM earnings: continued (and perhaps steeper) declines in traditional hardware sales, but progress in its transition to next-generation IT capabilities like cloud computing, Big Data analytics and cognitive computing.

IBM earnings in the first quarter were $2.4 billion ($2.54 per share) on revenue of $22.5 billion — down markedly from the same quarter last year. Hardware sales dropped a whopping 23% — expected given the overall slowdown in lower-end servers used in datacenters. Emerging market sales declined significantly as well. Big Blue also took an $870 million hit on severance for workers that were laid off as part of the company's strategic realignment.

For investors, here are three clues to watch for in Thursday's second-quarter earnings release:

Hardware Sales On the Decline

Don't be surprised to see that IBM's hardware sales continued to slump in the second quarter. The hardware empire IBM built on servers is crumbling as next-generation cloud infrastructure, platforms and applications supplant Big Blue's legacy business. In a way, that's good news for IBM stock: It focuses the IT giant on high-margin software and services businesses, as well as R&D for next generation technologies and applications.

Earlier this year, IBM cut a deal to sell its low-end server business to China-based Lenovo for $2.3 billion, although the U.S. government reportedly has raised security concerns about the deal, CRN reports. China already has approved the sale, and while the U.S. security concerns may delay the deal, the sale still should close later this year.

Cloud is the Silver Lining — So Are Chips

The task of reinventing Big Blue is a tough one, but Chairman and CEO Ginni Rometty, who took the helm in January 2012, has tackled it aggressively. Rometty and her team must transform a 103-year-old tech giant into an agile innovator that can wipe out the lead that companies like Amazon (AMZN), Yahoo (YHOO), Google (GOOG) and Intel (INTC) have established in some of the highest-growth IT business lines like cloud, Big Data and business analytics. Instead of waging a price war with AMZN, GOOG and others on cheap clouds, IBM is using the cloud to distribute high-margin, enterprise-class applications.

IBM is on the right track: Advanced capabilities like cloud, Big Data analytics, mobility and security will be the growth engine for IBM stock in the foreseeable future. Last week's news that IBM will sink $3 billion into developing a new generation of computer chips demonstrates Big Blue's commitment to support increasing workloads — particularly because enterprise applications are doubling nearly every year.

And there’s another futuristic silver lining for IBM…

Elementary, My Dear Watson

Perhaps the most exciting news from IBM this year was the launch of the Watson Group, a new unit focused on developing new artificial intelligence or “cognitive” apps that are delivered via the cloud. This is where the rubber meets the road for Big Blue’s future growth: These high-end software, services and apps think, improve by learning, and deliver answers to complex questions, IBM said when it announced the plan in January. IBM will invest more than $1 billion on R&D for the Watson Group and has made $100 million available for venture investments to support its Watson Developers Cloud.

Watson, named after IBM founder Thomas Watson — not Sherlock Holmes' sidekick — is best known for beating champions of the trivia show Jeopardy in 2011. But Watson's value proposition is no game — IBM is leveraging the power of cognitive technology to bring scores of new, cloud and Big Data analytics applications to market — creating a new ecosystem that will churn out future profits as its legacy hardware business fades.

Bottom Line

I expect IBM earnings to continue to be slow for the second quarter. While earnings should remain steady, I do expect continued erosion on revenue, largely because of declining hardware sales. But if you're looking for a blue-chip tech stock to tuck away in your portfolio, IBM stock is worth your consideration. Big Blue's strategic shift away from traditional IT hardware toward high-value cloud and Big Data apps is a powerful value proposition.

IBM stock has a forward P/E of 9.6, which is comparatively cheap in the sector; the 2.4% current dividend yield further sweetens the pot. Although Big Blue has significant challenges as it reinvents itself, the company has been doing a lot of things right lately. There will be bumps in the road — and a couple of potential potholes if the Lenovo deal falls through and if emerging markets sag — but IBM stock looks attractive to buy and hold now, particularly if there is a post-earnings pull back in the stock.

As of this writing, Susan J. Aluise did not hold a position in any of the aforementioned securities.