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What to Look for When IBM Reports Earnings Tomorrow

Source: Patrick H on Flickr

As International Business Machines (NYSE: IBM  ) prepares to report its first-quarter earnings on Wednesday after the market closes, investors should be focused on the long-term story playing out at the venerable company. Hardware sales have been weak, falling 26% last quarter, but IBM is becoming less of a hardware company every year.

In January, IBM sold its x86 server operations to Lenovo, a move that gets IBM out of a market that is becoming increasingly commoditized. This comes about 10 years after IBM offloaded its PC operations, also to Lenovo, and it continues the trend of dumping low-margin businesses in favor of high-margin businesses where IBM can clearly differentiate itself from the competition.

This leaves IBM with servers built around its Power architecture, something that no other company can offer. Recent moves like integrating graphics processors from NVIDIA into its servers and using the hardware to accelerate its enterprise applications give IBM's customers a good reason to stick with Big Blue. These Power-based systems have also been in decline, but IBM has a much better chance of turning sales around compared to its x86-based systems.

IBM is also looking to unload its chip foundry operations as its market share declines. Intense competition from market leader TSMC (NYSE: TSM  ) , along with an increasing willingness on the part of Intel (NASDAQ: INTC  ) to manufacture chips for its competitors, leads me to believe that this is a good move for IBM.

TSMC currently holds a 50% share of the market, and the explosion of mobile devices has led to increasing revenue and profit over the past few years. With Intel getting serious about contract manufacturing as a way to grow revenue -- even resorting to manufacturing chips based on the ARM architecture -- a battle between the two companies will likely lead to lower margins for any company unable to maintain a manufacturing edge.

Both companies are aggressively pushing to smaller transistor sizes, with Intel already using a 22nm process and planning to be at 14nm sometime in 2015. TSMC is currently behind Intel, with chips based on its 20nm process expected in 2015. By then, Intel will have already moved on, and it's clear that competing in this market will be both difficult and capital-intensive, given Intel's manufacturing advantage. IBM's exit from the industry looks to be the right move, as there's no way for the foundry business to produce the kinds of margins that IBM enjoys from its other businesses.

These divestitures allow IBM to shed its low-margin revenue and instead focus on growing its software and services businesses, particularly its cloud-based offerings. In 2013, revenue from the cloud grew by 69% to $4.4 billion, and investors should look for continued strong growth in the first quarter.

IBM made a $1 billion investment in Watson, the "Jeopardy"-winning computer system, during the first quarter, and the plan is to deliver the Watson service over the cloud. Watson offers a way to interpret unstructured information and generate hypotheses, improving over time. Potential applications are nearly endless. Watson certainly isn't a plug-and-play solution, but if IBM can prove to enterprise customers that Watson adds real value to their operation, the company believes that Watson could someday become a $10 billion business.

This shift from low-margin hardware to high-margin enterprise software and services has been under way for many years, and the sale of the x86 server operation, along with the potential sale of the foundry operation, are both steps in the right direction. Software and services grew last quarter, adjusting for currency, and the services backlog grew to $143 billion. In contrast, the hardware business recorded an operating loss of more than $500 million in 2013; shedding the worst parts should give IBM an earnings boost going forward.

Analysts expect earnings and revenue to decline during the first quarter, but IBM is still on pace to reach its goal of $20 of adjusted EPS by 2015. Earnings may decline, given that the deal for IBM's x86 server operation hasn't closed yet, but growth in software and services, as well as the cloud, are the most important things to look for. As time goes on and software and services make up a larger slice of IBM's total revenue, earnings should start to look a lot better.

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