International Business Machines Corporation
Q2 2009 Earnings Call Transcript

Published: 17 Jul 2009

[Operator:]

Welcome and thank you for standing by. (Operator Instructions) Now I would like to 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. I’m here with Mark Loughridge, IBM’s Senior Vice President and Chief Financial Officer. Thank you for joining our second quarter earnings 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. Let me remind you that 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:]

Thank you for joining us today. This quarter we delivered $2.32 of earnings per share, up 18% year to year. This is a record level of EPS for a first, second or third quarter, adjusting for stock splits. We generated over $4 billion of cash from operations, and ended the quarter with $12.5 billion of cash on hand. And we returned another $2.4 billion to shareholders, with $700 million in dividends and $1.7 billion of share repurchases. With this powerful performance, we now expect to generate at least $9.70 of earnings per share for the year, up $0.50 from our previous view of at least $9.20. This is the result of the strategic transformation of our business. Our ongoing shift to higher value areas has positioned us to better meet clients’ needs. This quarter, our strategic outsourcing signings were up 38% at constant currency, and our key branded middleware revenue, now 58% of software, grew 5% at constant currency. Our strategic acquisitions continue to contribute to our higher value capabilities. This quarter Cognos, Telelogic, ILOG and storage solutions XIV and Diligent all showed very strong results. But as you will see, margins are fueling our profit growth. I’ll discuss how our transformation is driving this but it is the shift to higher value, globally integrating our business, and our ongoing productivity initiatives that led to significant margin improvement. We expanded our pre-tax margin by 4 points. That’s our best margin improvement in almost four years, when we divested our PC business. This quarter, our strategy and business model together delivered high levels of profit in a tough economic environment. A key point here is that our model delivers improved margins, even when revenue growth is a headwind. So when revenue growth becomes a tailwind, the operating leverage we’ve created will really come through and continue to drive our earnings. We’re using this financial strength to invest in new areas that will help drive the next growth cycle for our clients, areas like Smarter Planet, business analytics and cloud computing. I’ll come back to that later in the discussion. Looking at our income statement for the quarter, our revenue was $23.3 billion, down 13% as reported, and 7% at constant currency. Despite the revenue decline, we improved both pre-tax and net income by 12%, with outstanding margin performance. Gross margin expanded over 2 points, due to improving margin in services and software, and the mix to higher value businesses such as software. Our expense was better by 19% year to year, driven by actions we’ve taken to continue to transform and globalize the business, focused expense management, and the benefit of a stronger dollar. Pre-tax margin was up over 4 points year to year to 18.3%. This is IBM’s highest PTI margin in 10 years in a first, second or third quarter. And IBM’s total net income margin was up 3 points. With a lower share count from our ongoing share repurchase activity, bottom line we improved earnings per share by 18% year to year to $2.32. The actions to develop this margin improvement didn’t just happen. We have been working on this strategy for a decade so let me give you some background that will provide perspective on our second quarter results. Looking at IBM’s performance over the last several years, we have consistently generated strong profit and cash growth since 2002. You can see the impact of the last recession following the dot.com bubble, where a sales decline and the resulting charges impacted our margins and our earnings. Since then, we have been executing our strategy

[Patricia Murphy:]

Thank you, Mark. Before we begin the Q-and-A, I’d like to remind you of a couple of items. First, we have supplemental charts at the end of the deck that complement our prepared remarks. Second, I’d ask you to refrain from multi-part questions. When we conclude the Q&A, I’ll turn the call back to Mark for final comments.

[Operator:]

(Operator Instructions) Our first question comes from Toni Sacconaghi with Sanford Bernstein.

[Toni Sacconaghi:]

Thank you. Mark, you wrapped up by saying that you felt the company had tremendous operating leverage as the economy picked up. If I simply look at what happened between Q1 and Q2, total company revenues went up $1.5 billion, your pretax income went up $1.1 billion, so you got $0.74 in incremental profit for every dollar in revenue that you generated sequentially from Q1 to Q2. If I look back at your average over the previous six years between 02 and ’08, you got $0.34, or 34% in terms of operating leverage. So the question is how should investors think about a marginal contribution in operating leverage going forward? And if it’s not the 70% that we saw in Q1 to Q2, what happened in Q1 to Q2 that was so unique that led to that very high leverage ratio?

[Mark Loughridge:]

Well, that’s a great question, Toni. The point I was making on the operating leverage going forward, I think in this quarter it was a pretty strong statement to be able to improve our margin so substantially when currency and revenue was a headwind, and my point going forward as you look at fourth quarter, currency will now be a tailwind and I would argue that we go into the fourth quarter and 2010, we should have a better economy and a stronger revenue platform and with that, operating leverage should really show through. Now to your point on the operating leverage that we generated going first quarter to second quarter, a lot of that operating leverage was in fact structural operating leverage that should continue. On the other hand, the only point that I think deserves some caution, this is still a tough economic environment. We have not seen the stimulus packages flow through. We’re still watching our overall price points -- now price points held very, very well in the second quarter and the bulk of our initiatives all dropped to the bottom line. But outside of that, if you just look at the raw leverage, we should have a very strong position, as you point out, sustaining and going into this second half.

[Patricia Murphy:]

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

[Operator:]

Our next question comes from Richard Gardner from Citigroup.

[Richard Gardner:]

Thank you. I was just hoping, Mark, you could give us a sense of, assuming current spot rates, what’s going to happen to the $400 million benefit that you received from hedging in the current quarter as we progress throughout the rest of the year? How do we think about how that number evolves going into Q3 and Q4?

[Mark Loughridge:]

Okay. I think the way that I look at it, and there’s a lot of dynamics underneath it so I don’t think you can take my statement and extrapolate it on a uniform basis but if you look at the overall impact of currency in the quarter, it was about a net zero, so if you looked at the impact that we had on gross profit, the offsetting impact on world trade expenses and the hedge, that year to year impact from currency was about a net zero impact. Now as you go forward and currency starts to reverse itself, one would argue that it’s going to be helped in the fourth quarter of 3 to 4 points and that will generate improved operating performance in our gross margin line. Now, there will be some mitigation of that in the hedge that would offset some of that impact but right now, just look at the raw performance in the second quarter between expense and the hedge, the year to year effect of currency was just about zero on our overall performance.

[Patricia Murphy:]

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

[Operator:]

Our next question comes from Chris Whitmore from Deutsche Bank.

[Chris Whitmore:]

Thanks very much. Mark, reported revenue ex currency was down about 7% in the quarter. I think that missed most people’s expectations and last quarter you talked about accelerating growth, particularly in the services as we move through the year with potentially growing services revenue in Q4. Can you give us an update as to what you expect in terms of constant currency revenue and its progression over the next couple of quarters?

[Mark Loughridge:]

Sure. Let’s start off by recognizing that this second quarter was really the toughest compare we had for the year and we all recognize it. We had real powerful revenue performance last year across the product line. So we knew that this was going to be our toughest compares going into the second half. Let’s talk about what we see in the second half now and I’ll do this by line of business. And with that, let’s start with hardware. So hardware was down double-digits in the quarter and as we look forward, we expect that rate of decline to halve as we go into the third quarter and halve again as we go into the fourth quarter. And we have a number of offerings, and we talked about the benefit we thought we could get from these new work load offerings and v Series, ongoing share performance in t Series and x Series. So we are pretty confident that we’ve got a very good hardware play going forward and in fact, it’s that recovery in the overall rate, along with the margin improvement that we expect that should generate positive profit growth from hardware as we go into the fourth quarter. So I think that’s a pretty start. Software, I mean, we just had a terrific quarter here on a software base and we expect going forward to see about the same revenue performance in the second half from software. We had very good performance out of our acquisitions and we have really strong margin performance. So we expect to have double-digit profit growth in our software business for a year. And last, if you look at services, we had a little more difficulty in the year in the areas of the business that were more discretionary, in the GBS area. But if you look at the strength that we have had in our longer term signings, that should compel our S.O. business as we go forward. I mean, we have had three very good quarters in a row on long-term signings growth. I mean, look at S.O. this quarter, up 38%. And we expect in our outsourcing business again to have double-digit signings growth as we go into the third quarter. So you put all that together and I think we are going to see S.O. come back to growth in the fourth quarter. So I think with all of those things, that gives us a strong base to go into the second half and I think frankly all of this gives a good platform in 09 as we prepare for 2010.

[Patricia Murphy:]

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

[Operator:]

Our next question comes from Ben Reitzes from Barclays Capital.

[Ben Reitzes:]

Thanks a lot. The question is with regard to signings and leverage -- Mark, at your analyst day, I think you said you thought long-term signings would be up double-digit. I wasn’t sure whether that was constant currency or not but on an actual currency basis, they didn’t make the double-digit but I was just wondering also, when you combine that with the actual currency on the short-term signings, they were down 14. I was just wondering actually if signings were below expectations, actually as you went throughout the quarter and what that does to leverage in the back half, you know, considering that we don’t have the $400 million in hedging benefit too per quarter? I was just wondering how those dynamics play out.

[Mark Loughridge:]

Well, when we look at that, we always make those statements on a constant currency basis. We had very good signings performance this year so at a constant currency, we had growth in total signings, we had growth in long-term signings. You know, our outsourcing signings of 12% globally, S.O. up 38% -- I mean, you can’t look at that and not be impressed with that level of signings performance. And I think on your currency points, if you look at overall backlog, though backlog was flat on a quarter to quarter basis, it was in fact up $5 billion due to currency, so we are facing and moving into a period where actually currency is going to start to help that backlog performance. But our statement, my statement that I made at analyst day was based on constant currency performance and I think this has been very, very strong performance in the quarter.

[Patricia Murphy:]

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

[Operator:]

Our next question comes from David Bailey from Goldman Sachs.

[David Bailey:]

Thank you very much. I was wondering if you could give a little bit more detail on what drove six points of sequential PTI improvement in software, and how sustainable that is?

[Mark Loughridge:]

Well, the PTI improvement that we had in software, a lot of that is driven by all of the structural improvements that we’ve been driving for our business, and those structural advantages are going and improvements in productivity are going to continue as we go into the second half of the year. So as you look at these results in the second quarter, there was nothing in these results that I would call a unique one-time advantage. So as I look at it going into the second half, those structural elements coming off of all of the initiatives that we have driven to improve our processes and our management of our overhead structures and our shared staff, those will continue as we go into the back half of the year.

[Patricia Murphy:]

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

[Operator:]

Our next question comes from Keith Bachman from BMO Capital Markets.

[Keith Bachman:]

Thanks for the question. I want to ask a similar question on GTS -- you had a 10% revenue decline and yet your pretax dollars were up over 40%. What were the -- could you talk a little bit about the specific key drivers there and how you anticipate the pretax margin, which is now 15%, how should we be thinking about that moving forward? Thanks.

[Mark Loughridge:]

Well, you know, the GTS performance, I would put that in a longer term framework. I mean, they have gone, PTI, double-digits for the eight consecutive quarters and again, a very powerful performance, up 41%, in the second quarter. That is really, really driven by the margin improvements that was executed across all of the lines of business. And I think it’s appropriate to re-emphasize, when we have put margin as a key element of our 2010 roadmap, that emphasis on margin along with revenue performance, share repurchase, acquisition performance, that’s embedded in all of our segment performance metrics and strategies. And I think GTS just did a great job in the quarter capitalizing that. You know, S.O., this is really driven by delivery. They have advanced tools and automation, new process techniques that they are driving, hardware and software optimization across that -- a lot of it we regard as our intellectual property that differentiates us from the competition. ITS, they too are driving towards a more profitable labor based book of business away from OEM content. In business transformation, it’s really a function of deal selectivity and delivery performance and I think they did a great job. And you know, even in maintenance -- even in maintenance, you know, looking at adjusting for Info Print, they drove very good OEM business adoption within the maintenance business. Frankly, if you adjust for Info Print, maintenance was up 1% year to year, very strong margins. So that margin strategy is part of our ongoing work to transform the business. It’s part of each of the business units objectives and plans and I think it really showed through in the second quarter.

[Patricia Murphy:]

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

[Operator:]

Our next question comes from Mark Moskowitz from J.P. Morgan.

[Mark Moskowitz:]

Thank you. Good afternoon. Mark, you mentioned in your comments about incremental workload [inaudible] introduced here shortly. Could you maybe give us some context in terms of how the workload engines in the mainframe business the last couple of years have boosted the annuity block in your software business? Has that helped leverage and can we see it be even more leverage with these new blocks coming out?

[Mark Loughridge:]

Yeah, I mean, when you look at the z Series platform, that new workload approach is really to draw a new customer content and new customer adoption into the platform, and we’ve been quite happy with our new workload performance over time. I think what is interesting about this now is it really does expand the aperture of the workload opportunities that we apply that approach to, so that’s why we are going to implement this new data warehouse offerings that enables real-time business analytics, consistent with our emphasis on business analytics. The enterprise disaster recovery solution enabling multi-location platforms for disaster recovery. Enterprise security hubs, the WebSphere application server, the enhanced SAP solutions -- I mean, you put all five of those together, it substantially increases the aperture of opportunities that we now apply that new workload content to, and it has actually worked very, very well and we are quite optimistic about it going into the second half.

[Patricia Murphy:]

Thanks, Mark. Let’s take the next question, please.

[Operator:]

Our next question comes from Bill Shope from Credit Suisse.

[Bill Shope:]

Thanks, guys. Maybe I missed this earlier in the call but can you give us some color on the short-term signings performance, particularly on a constant currency basis? And how we should think about that going into the second half?

[Mark Loughridge:]

Well, you know, if we look at short-term signings on a constant currency basis, it was down 7% and as I said, most of that was driven by the impact as customers look at the more discretionary elements of their budget and that hit us in the more discretionary elements of our short-term offerings. So as we move forward, there’s still going to be that budget pressure on the customer side of the house but on the other hand, we also would think that as the stimulus starts to roll out through the second half, and that affects the economy, that the customer adoption of those and the discretionary should improve. Now that said, we did not [inaudible] -- as we built our view of the second half. We did not consider that. We said at best it stays about the same level moving into the second half. In fact, we kind of built this assuming that the GVS platform was about the same regular performance of second half as the first half, though it would be an improving bet going from third quarter to fourth quarter, so we did not go on the potential economic upside as the stimulus packages hit but I think that is a real opportunity for us.

[Patricia Murphy:]

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

[Operator:]

Our next question comes from Scott Craig from Merrill Lynch.

[Scott Craig:]

Good afternoon. Mark, you mentioned a $3.5 billion cost and expense savings this year, which I think is a little bit up from when you went over it on the analyst day, so first, where did that incremental $500 million come from? And then secondly, does it still -- how does it roll out over the back part of the year? How much have you already kind of put through the P&L so far? Thanks.

[Mark Loughridge:]

Okay. Very good question -- you know, when we looked at that and described the $3 billion in the analyst day, we described that in really two different categories -- you know, what was the yield off of the work force rebalancing and at that time, we said it was about $2 billion and we still look at that to be about $2 billion, so that’s quite consistent. The other element that we identified was the content from all of the work that we are doing on our integrated support functions and our integrated support processes that we manage on a global basis and at that time, we thought we’d get about $0.5 billion advantage from each of those or $1 billion in total for the year. What’s happened is we went through the second quarter, all of the work on those initiatives actually developed a much higher rate of yield than we anticipated, so now against that $1 billion, we now see closer to $1.5 billion as we go through the year. So that’s where the extra $0.5 billion kind of came on the integrated support functions and integrated support processes and all that work we are doing on process management on a global basis. Now, if you look at the way that $3.5 billion rolls out, we’ve got about $0.5 billion in the first quarter, about $1 billion in the second quarter, so that leaves another $2 billion to roll out through the second half of the year. And given that it’s kind of structural in nature, I would look at that kind of evenly distributed across that second half.

[Scott Craig:]

Okay. Thank you.

[Patricia Murphy:]

Thanks, Scott. Operator, can we take one last question, please.

[Operator:]

Our next question comes from David Grossman from Thomas Weisel.

[David Grossman:]

Thanks very much. Mark, given the upward revision to your 2009 outlook, how should we think about the 2010 range? You know, given that you reiterated again that you are well ahead of pace. And can you remind us what the key assumptions are underlying your 2010 outlook?

[Mark Loughridge:]

Sure, I’d be happy to go through that. I mean, as you’ll see, we have from our perspective, increasing the at least number from 920 to 970, we’ve got a very strong base as we look at 2009 and much of that advantage will flow in through to 2010 as well. So I think we are very well-positioned for 2010. We gave that a range of 10 to 11. I think it’s a little hard not to say we are well ahead of pace when we are now looking at least 970 per year. That was a long range forecast that we built and that forecast, if you remember the elements was built on kind of the contribution we should get from revenue, the contribution from margin, from share repurchase, our acquisitions, our big investment elements. So as I look at 2010, I look at it and say one, well ahead of pace; two, a very solid base; and structural improvements in 2009 that will roll through to 2010 and like every year, we will update our view of 2010 in January. But right now, I feel pretty well-positioned. So with that, one, I want to thank you all for joining our call today and just give me a moment to wrap up here. I would close really by saying that IBM had a very strong quarter and it really was driven by our ongoing transformation. I think you can see in the analysis that we’ve been shifting towards higher value businesses and driving productivity and efficiency across the enterprise. And it’s really a result of our business model, where we improved our margin quite significantly. We see this continuing with double-digit profit growth across both software and services for the full year. And I think if you go to that bar chart that we included in the exhibit, I personally think there’s no better indication of the transformation that we’ve been driving than the change in profit contribution from the segments from 2000 to 2009, with software going from $2.8 billion of segment profitability in 2000 to about $8 billion in 2009 -- that is real transformation progress. And services likewise, going from $4.5 billion in 2000 to almost $8 billion in 2009, the combination is about $16 billion. In addition, we see hardware stabilizing and returning to profit growth in the fourth quarter, on the back of that decline that we saw in our hardware business in the second quarter halving as we go into the third quarter and halving again as we go into the fourth quarter. This strong profit and cash flow continues to allow us to make strategic investments that will fuel new growth and margin expansion. We see this with our strong performance in XIV and Diligent key acquisitions that were part of our storage software growth, which is up 25%, as well as Cognos and ILOG, which both had very, very good quarters and are the foundation investments in business analytics where we have invested $8 billion to capture this great opportunity. I don’t think we just look at that suite of 12 acquisitions that we knitted together with our own organic investments and our research contribution -- that didn’t just happen this year. We’ve been building that since 2005. And so I think that when the economy turns, we have real operating leverage to capitalize on this growth in 2010 and that’s why we increased our guidance by $0.50 for the year to at least $9.70, which puts us well ahead of pace for our 2010 roadmap objective of $10 to $11. So once again, I want to thank you for joining the call and now, as always, it’s back to work.

[Operator:]

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