International Business Machines Corporation
Q4 2006 Earnings Call Transcript

Published: 19 Jan 2007

[Patricia Murphy:]

Thank you. This is Patricia Murphy, Vice President of Investor Relations for IBM. I’m here with Mark Loughridge, IBM’s Senior Vice President and Chief Financial Officer. Thank you for joining our fourth 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 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. We had a very strong finish to the year. We delivered $26.3 billion in revenue, which was up 7% as reported and 4% at constant currency. Our pre-tax income was up 5% to $4.8 billion and we delivered $2.26 of earnings per share, including a $0.06 benefit from a lower tax rate. Our EPS was up 12% year-to-year. Excluding the one-time pension curtailment charge from the 2005 results, EPS was up 7%. This quarter, we had the best software revenue growth in over five years, with continued momentum in our strategic middleware, and additional benefit from our recent acquisitions. Our focus on building up our software capabilities is clearly paying off. The profile of our services business continued to improve. Revenue growth accelerated in the quarter, and we had exceptional signings performance, closing almost $18 billion of new business. From a geographic perspective, the Americas and Asia Pacific posted the strongest growth, with a solid recovery in Japan and good contribution from emerging countries. We are driving productivity initiatives across the business. At the same time, we’re ramping investments to drive future growth. And once again we had strong cash performance, with an increase in net cash from operations for the year of $2.2 billion, excluding Global Financing Receivables. Let’s move on to our full year performance with Chart 4. Our full year performance was the result of a series of actions we’ve taken over the last several years to improve our mix of businesses and globally integrate the company. We delivered $91.4 billion of revenue, pretax earnings of $13.3 billion, and earnings per share of $6.06. We expanded margins, had record cash performance, and provided record return to shareholders. In summary, we had a strong fourth quarter and 2006, and we feel good about the momentum of our business as we enter 2007. But before moving on, I’d like to add some perspective to our profit performance on the next chart. There are a few items in our operating results that many other companies, especially in the tech sector, exclude from the discussion of their earnings. For example

[Patricia Murphy:]

Thanks, Mark. Before we begin the Q&A let me comment on two items. First, we have supplemental charts at the end of the deck that complement Mark’s prepared remarks. We have a few new charts this quarter, including a chart that bridges the software and services segment revenue to the income statement, and an estimate of retirement-related expenses based on year end 2006 assumptions. Also, as always, I’d ask you to refrain from multi-part questions to allow us to take questions from more callers. Operator, please open it up for questions.

[Operator:]

(Operator Instructions) Your first question comes from Toni Sacconaghi - Sanford Bernstein.

[Toni Sacconaghi:]

Thank you. Profitability in your Global Technology Services group was lower than expected, and typically services profitability spikes up in the fourth quarter due to volume. Certainly it doesn’t appear on that side of the business that that happened this quarter. Can you go into a little more detail? You talked about increased infrastructure in sales as the reason behind it. You also talked about optimizing resources in the first half of ‘07. Is that a code word for saying that you will be taking out people and expense in the first half of '07 in your Global Technology Services business and we should see the benefits of that in the second half?

[Mark Loughridge:]

Thanks, Toni. Let me take that question and first, look at it from an overall total services prospective. The issue that I would like to highlight first of all, that total services margin improved sequentially and year-to-year in the fourth quarter and also improved on a full-year basis. So it was really the combined fourth quarter margins as you look at it, were the highest in the past three years but were down against a very difficult compare in fourth quarter 2005. If you look under total services, that difficult compare was predominantly in Global Technology Services. If you look at GBS, as you can see in the results, we had very strong margin performance in GBS again this quarter with most of improvement coming from improved utilization, improved contract management and delivery discipline. I expect that momentum in our margins to continue as we go into 2007. For GTS this quarter, as I had said, we had a very difficult compare from the fourth quarter of 2005. The fourth quarter margins would have been flat sequentially really, adjusted for the impact of acquisitions, and we do continue to make investments in sales resource in the ITS transition area, as well as in the infrastructure supporting our SO and BTO accounts. So we believe these investments are paying off. I think you can best see them in the performance that we had in ITS. It did show improving revenue performance. We certainly saw improved signings performance not only here but across our services organization, and I think as you look at the profitability in our Global Technology Services it is predominantly an issue of the earlier year compare. I think if you put that margin in context for the general quarterly improvement across the year, it is not out of line. In all, an element of our overall IBM margin that was, in fact for the full year, up a point.

[Patricia Murphy:]

Thanks, Toni. Let's take the next question, please.

[Operator:]

Your next question comes from Richard Gardner - Citigroup.

[Richard Gardner:]

Thank you very much. Hello, Mark. I was hoping that you could talk a little bit about the microelectronics business. Obviously it was down year-over-year, but based on my math, it looks like it might have been down sequentially as well, which is a bit of a surprising outcome given that you are finally shipping chips to all three major game consoles. They are all shipping at volume this quarter, and we had actually picked up some strength in the networking portion of that business. Can you give us a sense of, in addition to a tough year-over-year compare, what happened to that business sequentially and what caused what looks to be a sequential decline?

[Mark Loughridge:]

Well you know, Richard, if you look the microelectronics business, it really experienced very strong growth through the first three quarters in advance of the fourth quarter launch of new game consoles from Nintendo and Sony as well as supplying Microsoft for the holiday season. So given the seasonality of the consumer segment, we anticipated demand will continue to moderate through the first half of '07 but should improve later in the year. In the fourth quarter, we did experience strong growth in our communications and electronics segments, contributing to an improved margin mix as game processors growth slowed. But if you look at it over the years, despite the revenue decline of 6% in the fourth, microelectronics did grow 22% for the full year. So, as I look at that performance, we had very strong micro performance in the game chip platform for the year. We supplied all three game platforms. This is, in many respects, a function of the holiday season on our shipments into that. We had very strong micro performance in other elements of our technology base, and I think the strongest element of our micro platform is supplying our base server business.

[Patricia Murphy:]

Thanks, Richard. Let me just correct Richard that, in fact, the revenue was up sequentially in microelectronics from third quarter to fourth quarter.

[Mark Loughridge:]

Right, good point, Patricia.

[Patricia Murphy:]

Let's go to the next question, please.

[Mark Loughridge:]

Your next question comes from Bill Shope – JP Morgan.

[Bill Shope:]

Great, thanks. Obviously very impressive signings numbers, so congratulations on that. My question is

[Mark Loughridge:]

Very good question. We did have, as you all know, a very good quarter in signings, which enabled us to grow both short term 16% and long-term signings a pretty stellar 88% in the quarter, for a 55% signing growth for the quarter. In fact, if you look at it now for the full year, we have grown overall signings 4%, and we enter the year 2007 with a pretty strong backlog at $116 billion. So we have clearly made progress in our shorter-term business in the second half of the year, and looking at the opportunities out there in our pipeline, I expect the progress to continue into the first quarter. If you look at longer-term signings, they can be very inconsistent from quarter to quarter, and we certainly saw that in the third quarter of this year. So, as I look at it first from a long-term perspective, we're not going to replicate the fourth quarter performance, but we do see substantial opportunity there. If you take both the short-term trends and long-term together and look at our first quarter opportunity, we still see opportunity for growth in the first quarter.

[Operator:]

Your next question comes from Laura Conigliaro - Goldman Sachs.

[Laura Conigliaro:]

Thank you. For much of the year, you have actually struggled with your hardware growth, other than a quarter or two here or there in individual categories, as well as profitability here and there. Why should we think that this is going to change on a sustainable basis? Why, in fact, were blades flat? Then a clarification. Could you please just tell us what your software growth would have been excluding acquisitions?

[Mark Loughridge:]

Sure. Let me take those in sequence. So, first of all, if you look at overall S&TG and you look back at 2006, two really different stories from the first half to the second. In the first half, our 3% growth was on the strength of microelectronics, while servers declined 3% and storage grew 1%. During this time, we saw areas to improve our execution and facilitate in our client's progression into the mainframe z9 technology. Now if you look at the second half, it is a different perspective. In the second half, our actions in working with our clients on the z platform have continued to show strong results through the fourth quarter, providing 12% growth for the half and a substantial share gain for System z. In fact, System z in the quarter was the strongest mix growth on record. So, as I look at S&TG going into next year, I think we've done a lot to refine our System z sales cadence and our customer strategy with our clients. Storage had a lot of momentum as we went through the fourth quarter that I expect to extend in the first. As you know, we are the leader in server share. Secondly, if you look at overall organic growth for software, I would like to again take you back to the fourth quarter 2006. From an external basis, software revenue grew 14% as reported and 10.6 at constant currency. Underneath that, branded middleware grew 25% as reported and 21% at constant currency. Organically, at constant currency, branded middleware grew 10% for the quarter. So you can see about half of that was organic, and I think if you look at this performance that we had in software in the fourth quarter, it was really, really very powerful on the organic side, very powerful on the acquired side as we quickly integrated those businesses into our global reach.

[Operator:]

Your next question comes from Richard Farmer - Merrill Lynch.

[Richard Farmer:]

Mark, you mentioned the pension retirement assumptions, the actuarial assumptions might be changing. Would you mind just clarifying what are the changes in the return and the rate assumptions or other assumptions? What would be the going forward view of pension and retirement expense without those changes and assumptions?

[Mark Loughridge:]

Now I didn’t say that we are changing assumptions. Assumptions in our base return objectives have been 8% for quite awhile now; we are maintaining that at 8%. What has changed has been the interest rate environment. So all we are referencing is the change in the interest rate environment, especially at the long end of the curve and how that affects your long-term liability. So if you look at pension expense year-to-year, this year we expended about $2.4 billion, and we expect that to increase year-to-year by a little less than $100 million. So it will be in the range of 2.5 or a little less than that. But if you look at the supplemental, if you take those same end of year assumptions in the industry -- these are not our assumptions; they are, in fact, the interest rate that we use to calculate that long-term liability -- you can see how based on that interest rate environment, it will continue to improve, frankly, as we go into 2008 and 2009. I think the graphic that we provided is pretty clear there.

[Operator:]

Your next question comes from Harry Blount - Lehman Brothers.

[Harry Blount:]

Hi, Mark. A similar question on the retirement and a broad question on expenses in general. You do lay out fairly clearly on the supplemental side what your expectations are around that, and some of the earlier slides -- 5 and 8 I believe -- you laid out some of the individual expense items. But, as I look through your 10% to 12% earnings growth target, I'm trying to get a sense of why the earnings growth couldn’t actually be better in '08 and '09 given the significant ratchet down you guys might be looking for on the pension side of the equation?

[Mark Loughridge:]

Well, first of all, if you go back to my comments, pension expense is actually going to increase as we go into 2007. So again, pension expense for 2006 was $2.4 billion, and as we take the end of year interest rates and environment and we calculate that future liability, pension expense in 2007 should be slightly below $2.5 billion. So it is an increase year-to-year in pension expense of a little less than $100 million. So much less of an increase in 2007 than we have seen in the past. Nevertheless, still more expense in 2007. It does not really at current interest rates begin to ratchet down until we go into 2008 and 2009, and that is the point of the graphic at the end of the chart. So I think that as we go into next year, we certainly have the momentum and the structure to continue to meet our model expectations, even if you roll through the fourth quarter overachievement.

[Operator:]

Your next question comes from Ben Reitzes - UBS.

[Ben Reitzes:]

Good afternoon, thanks. I guess a little more clarification on the guidance, Mark. Obviously you said The Street estimates look reasonable. That is 9% growth from your current 2006 of 606. So your IBM business model of 10% to 12%, the midpoint of that puts you at 673. So I was hoping you could clarify that and also talk about what kind of tax rate was implied in your guidance. Given that you had the R&D tax credit this quarter, do we go back to 30%? If you do think it is 9%, if you could please tell us why it would be a little below your model, that would be great.

[Mark Loughridge:]

I think my point was the growth rate in analyst estimates was reasonable and the original growth rate was about 10%. So even if you rolled through the overachievements that we saw in the fourth quarter and still maintained your 10% growth, that is a reasonable expectation. So it is above the 9% that you referenced, Ben. Is that clear?

[Patricia Murphy:]

And let me just add clarification on the tax rate for next year. As we said in the prepared remarks, Ben, that we expect the tax rate for next year to be in the range of about 28.5%. Let's go to the next question, please.

[Operator:]

Thank you. Your next question comes from Rebecca Runkle - Morgan Stanley.

[Rebecca Runkle:]

Good evening, thanks Mark. Just looking at cash flow from ops, you spent about 25% of that on acquisitions in '06, which is a pretty big step up from what you have been running the last couple of years. I was just curious how you're thinking about acquisition rate in '07? Does that level of investment continue, or would you characterize '07 as more of an integration year, and you might see some moderation in the rate of acquisition activity?

[Mark Loughridge:]

Well, a very good question. I think what I would like to do as you look at acquisitions if you don't mind, is go back to the presentation that we made in India, and the presentation we showed in India is, we think there's a strong category of acquisition content out there that if we pick them correctly and they are highly scalable and have not yet globalized, basically IT-related, that we can rapidly scale those investments. If you remember, the IRR for those was in excess of 20%. So my view of that is

[Operator:]

Your next question comes from David Grossman - Thomas Weisel Partners.

[David Grossman:]

Thanks. Mark, could you go back to the expenses? I know you made some comments in your prepared remarks on slide 8. But if I understood you correctly, you said that the higher expense levels would continue in the first half of '07. So if you could maybe just help us better understand what you mean by that and the underlying drivers? Secondly, when we apply that 10% year-over-year growth in '07 to the base EPS, are we using the $6.11 number including the $0.06 benefit from the lower tax rate in the fourth quarter?

[Mark Loughridge:]

First of all, let's start with expense. As we laid it out in the presentation, we tried to be very clear. If you look at that, the 16% expense growth adjusted for currency in last year's real estate gain, which we clearly laid out, is actually 9%. Underneath that 9%, about half of that was driven by our acquisitions, which are primarily in our software group and our GTS business. The remaining 4.5 points of growth is largely driven by investments we're making in our software and our services business in emerging markets. Against that organic investment, I point to the positive returns on these investments that are very encouraging. E-branded middleware is up 21%. We had 47% signings growth in our GTS business alone and our 14 emerging countries together grew 18%. So I think that is a substantial achievement given that 4.5% growth in our organic expense equation. I also want to step back a little bit as you look at that expense performance. I want to give you a feeling for the process that we are using here. We are being very surgical and very deliberate in our investment for 2007. First, our organic growth, we will continue to invest to drive our momentum in the software business, which has roughly 85% gross profit margin and performed well in the fourth quarter and throughout 2006. So we see a real increase in our momentum in that software business from our organic investments. Emerging countries at 21% for the year 16% constant currency, also very attractive margins as they continue to build their infrastructure. We invested to drive signings. I think the results speak for themselves, and we're investing in our channel growth like IBM.com. Now I will also tell you on the other side, we are working pretty hard to mitigate the impact of these investments with a tough-minded focus on spending on areas that are not clearly revenue generating, including reductions in support functions as we continue to globalize IBM in diverse centers of excellence and will continue our efforts to derive greater productivity in our operations through balancing and prioritizing resources in support of higher-yielding opportunities. In fact, if you just look of a microcosm of the finance organization, we have about 11,000 people currently in finance. If you look at our trajectory in globalization, by the end of 2008 we will have almost 40% of that resource in global centers of excellence. So that covers the organic investment. On the acquisition investment, as I said earlier, we are focused on strategic acquisitions that complement our product offerings that we can quickly integrate and accelerate through the IBM global structure. They are generally highly scalable, generally intellectual property-based and aligned with our growth opportunities. If you go back to the data that we reviewed in our analyst conference in India, you can see that of the 24 acquisitions in this strategic profile, the population almost doubled that revenue in two years, was accretive in year 2, and accretive without intangibles in year 1. So against this investment, again very tough-minded and a very disciplined approach.

[Patricia Murphy:]

Thanks. Let me just clarify that the earnings per share for 2006 for continuing operations is $6.06, and that would be the base that you would apply your growth assumptions to.

[Mark Loughridge:]

Right. So to be very specific, against that $6.06, we see 2007 and the opportunity to support both our model and your estimates at 10% growth.

[Operator:]

The last question will come from Keith Bachman - Banc of America Securities.

[Keith Bachman:]

Hi guys, thanks for taking my questions, sneaking under the wire. I had a question going back to margins for a second. The Systems and Technology group margins were lower on a year-over-year basis and certainly a bit lower than we were anticipating. I was just hoping you could add a little color on that group. I wouldn’t think it would be implicated at all by any of the acquisitions you have done, so I'm not sure what is happening there.

[Mark Loughridge:]

Well, overall when you look at margins, I would look at margins in their broader scope for IBM. So first of all, if you look at IBM, the margin for '06 was up a point, and I thought that the fourth quarter, though down year-to-year, was in line with the other quarterly performance; it was predominantly down based on last year's real estate investment and the acquisitions that we have made. The difficult compare we saw was predominantly in GTS. GBS had spectacular margin performance as they continued to improve our utilization, contract management discipline driving 37% growth in their profitability for the year. Software, the software acquisitions were a real addition here to the overall performance of that unit. But if you look at the margin decline, more than two-thirds of that was driven by the acquisitions we made. S&TG margins did decline, driven largely by that same real estate deal and currency items that impacted our overall IBM margins. So actually, if you airlift those out, they did well operationally.

[Patricia Murphy:]

Thanks, Keith, and I want to thank you all for joining us today. Have a good evening.