International Business Machines Corporation
Q2 2006 Earnings Call Transcript

Published: 18 Jul 2006

[Operator:]

Welcome and thank you for standing by. All participants are in a listen-only mode. Today’s conference is being recorded. If you have any objections, you may disconnect at this time. Now I will turn the meeting over to Ms. Patricia Murphy, Vice President of Investor Relations. Madam, you may begin.

[Patricia Murphy:]

Thank you. This is Patricia Murphy, Vice President of Investor Relations for IBM. Here with me today is Mark Loughridge, IBM’s Senior Vice President and Chief Financial Officer. Thank you for joining our second quarter earnings presentation. By now, the opening page of the presentation should have automatically loaded, and you should be on the title page. The charts will automatically advance as we move through the presentation. If you prefer to manually control the charts, at any time you can un-check the synchronize button on the left of the presentation. The prepared remarks will be available in roughly an hour, and a replay of this webcast will be posted to our Investor Relations website by this time tomorrow. Our presentation includes certain non-GAAP financial measures, in an effort to provide additional information to investors. All non-GAAP measures have been reconciled to their related GAAP measures in accordance with SEC rules. You will find reconciliation charts at the end, and in the Form 8-K to be submitted to the SEC. For those of you who are manually controlling the charts, please click on the Next button for chart 2. Certain comments made in this presentation may be characterized as forward looking under the Private Securities Litigation Reform Act of 1995. Those statements involve a number of factors that could cause actual results to differ materially. Additional information concerning these factors is contained in the company’s filings with the SEC. Copies are available from the SEC, from the IBM web site, or from us in Investor Relations. Now, I’ll turn the call over to Mark Loughridge.

[Mark Loughridge:]

Thanks, Patricia. For the second quarter, as reported, we delivered $21.9 billion in revenue, which was down 2% as reported and at constant currency. Without PC’s in 2005, IBM revenue was up 1%. Our pre-tax income was $2.9 billion, up 6% over second quarter of last year, and we delivered $1.30 of earnings per share, which was a 14% improvement over last year’s second quarter. In 2005 we had three non-recurring items in the reported results. When you exclude the non-recurring charges from last year’s results, IBM’s pre-tax income was up 11%, and earnings per share were up 16%. In addition, we concluded the sale of our PC business to Lenovo in the second quarter of 2005, and last year’s results include one month of activity. On a comparable basis, without the now-divested PC business

[Patricia Murphy:]

Thanks, Mark. Before we begin the Q&A, let me comment on two items. First, we have a few supplemental charts at the end of the deck that complement Mark’s prepared remarks. Second, I would ask you to refrain from multi-part questions. This will allow us to take questions from more callers. Okay, Operator, let’s open it up for questions.

[Operator:]

Thank you. (Operator Instructions) Our first question comes from Richard Farmer with Merrill Lynch. You may begin.

[Richard Farmer:]

Thank you. Mark, I would like to ask a question about the demand environment. You mentioned the elongated sales cycles in June. There is a lot of debate among investors as to whether demands, broadly speaking, is starting to rollover in some of the important end markets right now, particularly given some of the pre-announcements at companies like AMC and SAP. So given your very broad view of demand at IBM over many of the segments in the market, what is your feeling about the environment right now? Do you think it is essentially stable, or do you think on a margin demand is getting a little softer? Any differentiation you might be willing to provide between the end markets like servers, storage, services, etc. would be very helpful. Thank you.

[Mark Loughridge:]

Sure, Richard. Let me first give you a description as we went through the quarter. I would say, as I pointed out in the script, a number of transactions around the world, we have seen that the sales cycle for enterprise clients appears to have lengthened, as customers have increased the level of scrutiny and approvals on their transactions. So we saw that most distinctly as we closed out the quarter in the third month. I would say underneath this, however, we have seen a relative divergence in our performance in the enterprise versus SMB space. While growth in our SMB customers has remained generally solid, growth in enterprise space slowed again due to lengthening of transaction closure at the end of the quarter. As you know, we have managed through these kinds of cycles before, and we will continue to drive productivity initiatives to leverage our overall performance. At the same time, as we see strategic opportunities, we will move aggressively, consistent with the model that we discussed in India. So I guess, Richard, I would conclude by saying there is really no definitive indicator that this is a trend, but I would say the breadth of our portfolio, the strength of our financial model, and our strong market leadership positions us well as we move into the third quarter.

[Patricia Murphy:]

Thanks, Richard. Let’s go to the next question, please.

[Operator:]

Thank you. Our next question is from Laura Conigliaro with Goldman Sachs. You may begin.

[Laura Conigliaro:]

Yes, on the services side, your services signings are now down in the mid-teens for the first half of ’06 versus ’05, and your second half signings would need to be up probably in the mid- to high-teens just to actually be flat with last year. Is this even plausible and what kind of services growth can you actually drive on the revenue side in ’07 if signings do end up flat, or maybe even slightly down?

[Mark Loughridge:]

Okay, Laura, let me -- I think first of all I would like to go through the data with you, so we can lay a foundation for the answer to this question. First of all, if you look at ’05, the long-term signings were up 19% in the first quarter. Long-term was up 20%. As we entered the second quarter, as we closed it out again affected by a lengthening contract cycle, our long-term signings were down. Again, I would reemphasize that that was against a very powerful second quarter 2005 and we did greater than $9 billion of long-term signings last year. So I would put the long-term performance in the context of that longer time frame -- 2005 long-term at 19%, first quarter long-term up 20% and really, short-term contracts, if you look at the half, were down 2%, so I would say that is, on a rough comparable basis, that we go into the second half roughly even on a year-to-year basis. Now, I would also emphasize that as we have discussed before, longer term signings tend to be lumpy. They are a little more unpredictable and they do not occur smoothly quarter by quarter throughout a year. They can be uneven. Even in short-term signings, while down year to year, they were up on a sequential basis. Regardless, I certainly have to admit that signings performance did not meet our expectation and we are driving the actions required to improve our execution and our results as we enter the second half of the year. As we look at that pipeline going into the second half of the year, we do have a strong deal list. The pipeline is up year to year. The pipeline went up quarter to quarter but I think it is more the context of the individual deals that is more encouraging. A strong deal list which should enable us to grow our signings in the third quarter. Now, or course, we have to execute to do that but clearly there is enough opportunity. We just need to get it signed. But we are going to continue to be selective to drive our profitability. We are not going to sign bad deals. We do have the discipline to walk from a bad deal. As we just looked, the opportunity, the deal list and the progression of that deal list and where we stand with those individual clients, we feel relatively confident that as we go into the third quarter, we should see signage growth on a year-to-year basis.

[Patricia Murphy:]

Thanks, Laura. Let’s go to the next question.

[Operator:]

Thank you. The next question is from Bill Shope with JP Morgan. You may begin.

[Bill Shope:]

Great, thanks. Looking at your signings performance as well, given this quarter’s performance and given the decline in short-term signings, I think you had set a target several quarters ago for mid-single-digit growth in the services segment for the second half of the year. Can you still achieve that number, given the signings performance we have seen thus far?

[Mark Loughridge:]

Well, I mean, we clearly did not meet our signings expectation this quarter. As you know, revenue performance trails signings performance, so as we look at the third quarter, as I said earlier, our pipeline is up year to year and quarter to quarter. More importantly, look at the quality of that deal list and the progression of the deals, we should be able to return to signage growth in the third quarter. Of course, we need to execute on that deal list. We are all committed to growing the signings in the third quarter. If you look at the INE, obviously revenue in the INE will follow signings going forward but first job is get the signings growth back on track next quarter, and we feel confident that we will see growth in the quarter.

[Patricia Murphy:]

Thanks, Bill. Let’s go to the next question please.

[Operator:]

Thank you. The next question is from Richard Gardner with Citigroup. You may begin.

[Richard Gardner:]

Thank you very much. Mark, I was hoping that you might be able to provide some detail on the mainframe mix in the quarter. Obviously last quarter you had an unusually high mix of Java and Linux workloads and I believe it was about 35% of the MIPS shipped in the quarter. What did that do in the current quarter? Did you see a return to more traditional workload? Thank you.

[Mark Loughridge:]

Yes, if you look at our V series performance, specialty engine MIPS represented approximately 21% of total MIPS shipped in the second quarter versus 16% in the second quarter of ’05 and 38% in the first quarter of ’06, so we experienced 36% year to year growth in specialty engine MIPS in the second quarter, and as we had laid out in the first quarter call, this resulted in a much improved MIPS, especially to traditional MIPS compared to the first quarter.

[Patricia Murphy:]

Thanks, Richard. Let’s go to the next question please.

[Operator:]

Thank you. Our next question comes in from Chris Whitmore with Deutsche Bank. You may begin.

[Chris Whitmore:]

Thank you. Good afternoon. There has been some talk in the marketplace about increasing pricing pressure in the services industry in general. Can you comment on current pricing that you see out there for the deals, both on large and small deals? Thank you.

[Mark Loughridge:]

I think if you looked at services, I would break that pricing question down as follows -- I think ITS price pressure remains fairly stable. There is increased price pressure in the BTO area. Consulting prices are stable to improving. I think you saw that in our margin performance as well.

[Patricia Murphy:]

Thanks, Chris. Let’s go to the next question please.

[Operator:]

Thank you. Our next question comes is from Tony Sacconaghi with Sanford Bernstein. You may begin.

[Tony Sacconaghi:]

Yes, thank you. You alluded in your earnings release to your $10 billion cash balance creating “opportunities”. When you allude to opportunities, are you implicitly referring to acquisitions? Can you clarify your historical preference in the unwritten rules of effectively than to do smaller acquisitions, less than $5 billion in revenue I would say is a rough guidepost, and also not to do dilutive acquisitions? Can you comment on whether those are ultimately aspirations or constraints on potential acquisitions going forward?

[Mark Loughridge:]

Well, that is a very good question. I think what I do in answering that, Tony, is we would look at the data that we presented in India. We looked at a profile of acquisitions that we did from 2002 to 2004, and we looked at acquisitions that were in the $500 million to $700 million at the high end and down as well. If you looked at those 24 acquisitions, and that is all of the acquisitions 500 and below, for that period, you looked at the revenue growth that resulted from the pre-acquisition year, over the next two years that profile really almost doubled. It was generally accretive in the second year. If you took out the amortization of intangibles, you would see cash benefit very quickly. I think we would also point out that a number of these acquisitions were accretive even in the quarter that we acquired it -- the Micromuse, that was accretive in the quarter we acquired it. Candle was accretive in the quarter we acquired it. So as we concluded on that data that we presented, we drew some conclusions. One, that is we buy capability that enhances our own capability, it is really the ability to now globalize that across IBM, to scale it rapidly across the IBM business structure that pays off in that business case. Now, I do not want to say that we would never do a large acquisition. If it was appropriate for us or if it drew a strategic capability and enhanced the overall shareholder position, but what I do want to say is that for acquisitions and that kind of a category, that is now a more operational part of our performance and we include that as part of even our pipeline view of opportunities, especially in areas that scale rapidly like software, like intellectual property.

[Patricia Murphy:]

Thanks, Tony. Let’s go to the next question please.

[Operator:]

Thank you. Our next question comes is from Keith Bachman with Banc of America. You may begin.

[Keith Bachman:]

Thank you. I wanted to, Mark, see if you could talk a little bit about the hardware margins as a category. How should we be thinking about this going forward? What are the key drivers? If you could speak to that, including MIPS? Thank you.

[Mark Loughridge:]

First of all, if you look at overall margins, we improved from first quarter to second quarter at bottom-line profitability, and that provides us momentum as we go from the second to the third. Moving forward into the third, our hardware profitability should improve from the second quarter for a number of reasons, which I will list. The first, the transition to RoHS is now behind us, which reduces the complexity that impacted us in the second quarter. The server transition to Power 5+, which impacted some of our mix in the second quarter, will complete in the third quarter. We believe we can continue our strong momentum in Blades. We are the leader in this fast-growing space. We continue to see excellent adoption of storage virtualization. So if you put all of that together, along with the actions that we put in place to lower our end-to-end cost, we feel pretty confident that we should see that momentum and profitability for our hardware businesses continue as we go into the third quarter.

[Patricia Murphy:]

Thanks, Keith. Let’s go to the next question please.

[Operator:]

Thank you. Our next question comes is from Andrew Neff with Bear Stearns. You may begin.

[Andrew Neff:]

If I could, just going back to your comments about the outlook for the year and you talk about your comfort, how comfortable can you be, given the signs of slowing in the services, given the comments you made about what is going on in terms of the sales cycle? What gives you that level of comfort? We are only half-way through the year and you have seen lots of things go in the other direction. Why are you so comfortable at this level, Mark?

[Mark Loughridge:]

Well, you know, if you look at it, I would go down to the deal base. We did not see those deals leave the opportunity set. We did not see those deals -- we did not lose them to competition, but they did generally roll. As we have looked at the progression of those deals in the third quarter, they seem to be continuing on a very logical pace. So to us, as we just look at the engagement detail that we have, it looks like that lengthening contract cycle has rolled those deals into the third quarter but those deals and progression of those deals is still continuing. I would say that the backdrop I would apply to this though is relatively the SMB space seems to be performing and driving at a fairly constant rate, and we did not necessarily see this same impact of lengthening contracts that we saw in enterprise.

[Patricia Murphy:]

Thanks, Andy. Let’s go to the next question please.

[Operator:]

Thank you. Our next question comes is from Ben Reitzes with UBS. You may begin.

[Ben Reitzes:]

Thank you. With regard to services again, Mark, could you talk about how -- in the past, you talked about duration, you’ve talked about other aspects of the contracts and you have gotten pretty detailed in the past to just give us a handle on I guess your handle on how you are going to hit these estimates based on the contract profile you see. If you could you just give us a little more detail on some of the commentary you provided in the past with regard to duration and maybe the contract profile. I know you have answered it, and obviously if you could give us just a little more detail on what gives you confidence that you can keep the services margins up, given the bookings trend, and short-term in particular and what you see. Thank you.

[Mark Loughridge:]

First of all, if you are looking at services margin, number one, we have a very disciplined process. So we are not going to chase bad deals that would erode our overall position. Number two, I think we have a very strong cost base. We established that with some of the restructuring work but that better base of cost extends well into the second half of the year, as well as continuing the actions that we have to constantly drive productivity, not only in our services businesses but across the IBM platform as well. I will say that as we go into the quarter, we also have very specific action plans for both GTS and GBS. In ITS, we are developing new offerings in the higher value-add market opportunities. Examples like security and privacy services, business continuity and resiliency services, storage and data services. We are developing new offerings within these areas that is well underway, as well as training our sales reps to sell to the value in those offerings -- all of those should promote not only deal growth and volume growth but also profitability. Likewise in GBS, we are driving specific action plans to ramp up and invest on our high value of services, adding incremental industry resources, subject matter experts, and solutions specialists to drive this improved value base in our offerings. In application management services, we are adding sales in key delivery resources, expanding our geographic delivery footprint. In support of these high-growth plays, we implemented the Global Business Solution Centre in India to create and enhance our portfolio of industry solutions. So all of these actions across the ITS elements and the GTS elements, as well as GBS, are intended to drive continued -- recovering our signings base but also a very positive cost base and driving towards that value, higher-margin space.

[Patricia Murphy:]

Thanks, Ben. Let’s go to the next question please.

[Operator:]

Thank you. Our next question comes is from Rebecca Runkle with Morgan Stanley. You may begin.

[Rebecca Runkle:]

Good afternoon, Mark. Just a quick clarification on public sector, which is your second-largest vertical, I believe, and was down about 6% year on year. Take that and combine that with your comments about changing vertical dynamics related to services, and I’m just wondering -- how cautious should we be about public sectors outlook in the second half? Any commentary or meat you could put around what you are seeing there? How you are adjusting your second half expectations would be helpful.

[Mark Loughridge:]

If you look at public sector, I think within that, the point that we are making is there has been, at least for us, a shift in the spending within the government to fund certain defense efforts. BBS has elected not to participate in military department defense spend relating to mission systems and weapons systems. So given this, we have experienced a downturn in U.S. federal revenue over the past 6 quarters. Now, we continue to focus on our value propositions and the agency spend that we have targeted, and we had improved signings over the last couple of quarters. Given that our federal contracts are longer-term in nature, it takes some time for revenue ramp to occur, so I think that is the most significant aspect of the public sector that I would point out.

[Patricia Murphy:]

Thanks, Rebecca. Operator, let’s take one last question, please.

[Operator:]

Thank you. Our last question is from David Grossman with Thomas Weisel Partners. You may begin.

[David Grossman:]

Thank you. Mark, typically software in periods of slowing demand has a tendency to lead services. Based on your current results, at least, it seems that almost the reverse is happening at IBM. I am wondering if you could perhaps help us better understand why we are seeing the software continue to perform, despite what you suggest is some slowing enterprise demand that may be impacting services.

[Mark Loughridge:]

A very good point. As we look at our software performance in the second quarter, it comes off the back of a very positive performance in the first quarter as well. What I find most powerful about our software performance is that it was very consistent across all geographies, so we grew software in all geographies, and at constant currency. We gained share in Europe and held share in the Americas and Asia. This is in our base performance. We had WebSphere up 18%. Information management, our database content, up 7%. Lotus up 6%, Tivoli up 12%, our Rational up 8%. So in aggregate in the second quarter, branded middleware grew 9% as reported and at constant currency. So we believe we have gained share in branded middleware and specifically in the WebSphere, Tivoli and Rational brands. Now, behind that, we have been investing heavily in our key middleware brands, both internal development that has generated strong products which add organic growth. These products include SOA related WebSphere products, Information on Demand products, and Tivoli Storage Management. We have invested heavily in our sales and marketing investments, allowing us to capture a bigger share of the market. We have augmented our internal development with synergistic acquisitions -- for instance, Micromuse that I pointed out earlier, which adds new leading systems management capabilities. So all of this together I think highlights our capability in software but also as a function of a well-laid out set of investments that has now achieved very positive results, not only in the second quarter but in the first quarter and across each of our geographies.

[Patricia Murphy:]

Thank you, David. I want to thank you all for joining our call this evening.

[Operator:]

Thank you for participating in today’s call. The conference has now ended. You may disconnect at this time.