International Business Machines Corporation (IBM) Q2 2012 Earnings Report, Transcript and Summary

Welcome, and thank you for standing by. (Operator Instructions) 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. Ma’am, you may begin.

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 CFO, Finance and Enterprise Transformation. 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 the related GAAP measures in accordance with SEC rules. You’ll 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 website, or from us in Investor Relations. Now, I’ll turn the call over to Mark Loughridge.

Thank you for joining us today. In the second quarter we reported $25.8 billion in revenue, expanded gross, pre-tax, and net operating margins, and delivered operating earnings per share of $3.51, up 14% year to year, and generated free cash flow of $3.7 billion, up 9%. So when you look at it, our results demonstrate the strength of IBM’s business model, which is designed to deliver profiting cash on a sustainable basis. Consistent with this performance, we're increasing our full-year 2012 expectation for operating EPS to at least $15.10. This is up $0.10 from our previous view of at least $15. I will comment on a couple of the second quarter highlights by segment. In software, we had mid-single digits constant currency growth in Europe and Japan, double-digit growth in the growth markets, while the U.S. growth was lower due to very stronger performance a year ago. Services growth of constant currency was consistent with last quarter, with our annuity content providing a solid base of revenue on profit. Our backlog was flat year to year at constant currency, and we again expanded margins and grew our combined services segment profit by 18%. Our hardware business declined as you would expect at this point in our product cycles though we continue to extend our share leadership in our two high-end server brands. In total IBM’s revenue growth at constant currency was fairly consistent with the first quarter. We ended the quarter with a currency headwind, but it got even tougher over the last 90 days, when you look at the reported revenue, currency impacted our revenue growth by almost 4 points or a $1 billion of revenue. But despite of this headwind we generated strong operating profit performance, with pretax and net income each of 8%. Now an important element…

Thank you, Mark. Before we begin the Q&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. And 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, please open it up for questions.

Thank you. At this time we would like to begin the question-and-answer session of the conference. (Operator Instructions) The first question comes from Toni Sacconaghi with Sanford Bernstein. You may ask your question. Toni Sacconaghi – Sanford C. Bernstein & Co., LLC.: Yes, thank you. Mark, you commented on a couple of headwinds namely the top comparison in currency dynamics. Absent from that was any commentary on the macroeconomic environment. And I’m wondering if you can comment on that, particularly in light of services performance because I think when we entered 2012 you said, 70% of services revenue in 2012 will come from backlog and that 70% will be up 3%, with your total services business in the first half is tracking well below that. So perhaps you can address the macroeconomic question in the context to the fact that the services revenue that you are generating this year appears to be very weak?

Okay, Toni very good question. Let me start from a macro perspective for the second quarter. First of all, if you look at the kind of geographic breakdown going first quarter to second quarter, Americas was up 2% in the first one to 1% of the second quarter, really that differential was due to the software compare that we had in the second quarter of last year. And if you look at the third quarter just based on a compare basis, we’ll pick up another 2.5 points, so I feel pretty confident about that content, as it going to the third. Europe was up 1% in the first quarter, relatively flat in the second quarter; we will talk about that a little more. In Asia, it went from plus 1% in the first quarter to up 4%, so real strength in Asia. If you look at the distribution of that performance across the month, that was relatively linear; in other words, it didn’t have big fluctuations across the month, but if anything, it relatively strengthened as we went through the quarter, so June was little stronger than the rest of the quarter. In some of our transactional businesses like our hardware base of business, in fact, we noticed that against typical ways of performance had a pretty [down good] last week of the quarter, indicating momentum as we are going at the third. So that’s why I’d give kind of an overview. Now from a markets perspective, let’s talk about the growth markets. They continue to perform well across the board; BRIC countries were up 12%, they represent about a third of our overall growth market business; within that China was up the very impressive 24%, and I’d remind you, we now have opened our 68th face-to-face branch in China,…

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

The next question comes from Bill Shope with Goldman Sachs. You may ask your question. Bill C. Shope – Goldman Sachs Group Inc.: Okay, thank you. Looking at the guidance, can you help us understand your thoughts on both the earnings and revenue trajectory to the third and the fourth quarter? And regarding the sale of the point-of-sale business that you talked about last quarter, how should we think about the timing of that gain now and the timing of the work force for balancing charges that will periodically counter that gain?

Sure. Great question, Bill. So if you look at the full year we’ve taken our guidance up to at least $15.10 and that would imply for the second half about 10% EPS growth. Now within that EPS growth, it’s reasonably distributed across both the third and the fourth quarter if anything a little skewed to the fourth quarter of the new product announcements. Currency in the second half is going to be a headwind, about four to five points in the third quarter, two to three points in the fourth and that spot rates that would be a headwind for us, about $2 billion in the second half compared to the $1 billion that we just had in the second quarter. On a third quarter basis, I would say that our constant currency revenue growth should be approximately equal to what we saw in the dynamics in the first half of the year with the fourth quarter really presenting opportunity with our new announcements for additional growth. So back to your second half of your question, we regard this really as an all in forecast. We realized that we do have some tax headwind as we entered the third and the fourth quarter. The divestiture of our retail store systems business should generate a gain of about $450 million to $550 million in the second half. We do expect to close that shortly with the major countries really closing first. So the gain will be recognized as we close those counties and get the cash. And I would expect that both of that to happen in third quarter, but based on country closing some may extend in to the fourth. Now, as we’ve discussed a number of times in the past, when we get that cash inflow from a divestiture, we put that to good work to improve the productivity of our business and that’s why these divestitures are accretive to IBM. So constantly, we will also have workforce rebalancing in the second half, I expect slightly greater than the first half of 2012. Now that workforce rebalancing will be focused on our non-U.S. operations, very little, but really in the U.S. So all in all, we feel optimistic about our hand for the second half in spite of the headwinds that we see.

Thank you, Bill. Can we go to the next question, please?

The next question comes from Ben Reitzes with Barclays. You may ask your question. Ben Reitzes – Barclays Capital, Inc.: Hi, thank a lot. Mark, when I look at your earnings year-over-year, you improved about $0.42 and I can get about $0.17 from share repo, but I get like $0.23 from GTS margin expansion considering revenue was down a little. That was a really good margin performance in GTS. I guess the question is how sustainable is this 3.6 percentage point improvement year-over-year, can you just – you went over it already in the call little bit, can you reiterate what you’re doing to make that sustainable in GTS and maybe how those rebalancings are working into the equation as well? Thanks.

Sure, sure, absolutely, Ben. So first of all in the context, as we go into the second half of the year for our services business, we see strong profit growth across services from both the GTS and GBS organizations. So I think we have a very good hand as we go into. Now you know we run this business for profit and cash contribution, a couple of key dynamics within that, within GMU, we had very good margin performance in our business there, our revenue in GMU, our growth markets unit is up 10%, that’s 10 points faster than we see in the major markets. In fact, over time that’s driven our backlog to also be up 10% in our growth markets unit. Our transactional business, if you look at the growth initiatives, cloud is more than double, so consequently we see our backlog up to 6%. We have growth in really 14 straight quarters in our transactional business. And I want to return again to the work that we’re doing on ongoing basis in productivity because I think a lot of this is really leadership work on the part of our services organization, especially the GTS content that we saw this quarter driving that 24% increase year-to-year. A lot of that is driven by automation and the partnering that they’ve done with research that gives us unique capability that I don’t think you’d see in our competitors. As well as utilizing the global scale, but once again I want to turn to the work that we’ve done on the distribution of profitability in our contract. So once again, if you imagine this as a normal curve distribution of the profitability within the services contracts, they did a very discrete piece of work on how to improve the value contribution in the context of those – contracts in that weaker end of the distribution. And that contributed about a third of that 24%, we should see that ongoing to some degree as we go through the year, and I think as we continue to work on that weaker side of the distribution and move actually the average to the right, we continue to contribute. Again, if you wanted to put in a context of backlog, to generate that same level of profitability in our outsourcing business, our opening backlog this year would have needed to have been richer by about $5 billion to $10 billion. So once again you can see how the impact of that work, how it is relative to the backlog and I think it’s very consistent with our overall objective to manage these business for profit and cash generation.

Thank you, Ben. Operator, can we take the next question please.

Next question comes from Scott Craig with Merrill Lynch. You may ask your question. Scott D. Craig – Bank of America/Merrill Lynch: Hey thanks. Good afternoon. Hi Mark can you go through a little bit with regards to the systematic disciplined approach being taken with some of the lower margin businesses in the services side. So where are we in that process and how much of that been helping the margins and should we expect that to continue here for six months or 12 months, how do you think about that whole dynamic? Thank you.

Well, first of all I want to point out that that work really driving that impact really is something that the GTS organization has been implementing relatively over the past six to nine months starting out. So, and the objective was, we do so much work in driving our competitive position on the engagement, what can we do to really help drive our level of productivity in a ongoing basis as well. And so to start that, it seemed very logical, let’s pick the contracts that really in that left tail of the distribution of contracts. So that was the first starting point that they took. And then they applied kind of leadership delivery content, real value ad content and these are elements that when you apply them to the left hand tail of the distribution, if you can move that average it has tremendous impacts. So I think that that approach, that approach of really on an ongoing basis working hard to apply better value contribution to drive that margin is something that we can continue to apply both in our GTS and GBS businesses and they really had substantial impact that contribute to that operational performance that we saw in GTS.

Thanks, Scott. Can we go to the next question, please?

The next question comes from Rob Cihra with Evercore Partners. You may ask your question. Robert Cihra – Evercore Partners Inc.:

Sure. Well, if you look at the high-end performance, I quite agree with your observation. For this position in the product cycle we do really have stronger z performance than you would have statistically kind of expected to have. A lot of that, in my opening remarks, we saw downward growth in our z content in the growth markets. And so, the growth market z content was up 11%. Well, you can drive 11% growth in the substantial part of your business in those growth markets that have new opportunities for us that obviously has substantial leverage in our business. So the z performance did improve. Some of that was backend loaded in the quarter and we did see, as I pointed out earlier, that last week of the quarter we saw an uptick in our SCV business as we left the second entry and the third. On an x basis, they really did face a very tough competitor last year. If you remember they were up 15% in 2011. So that really did contribute to a lot of it. The high-end, we did have a double-digit growth and we’ve had double-digit growth on the high-end for eight of the last nine quarters including the second quarter. So as we go into the second half, we do have some very good content the x series business will take advantage of their content within peer systems. And they will be part of the move as we go into our second half announcements of volume roll out.

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

The next question comes from Brian Marshall with ISI Group. You may ask your question.

Hi, thanks. This is Stephen calling for Brian. We’ve been hearing a lot lately about the new public cloud offerings, and I was wondering if you could talk a bit more...

Brian, it’s kind of hard to hear you. Can you start again?

Can you hear me better now?

Much better. Thank you.

We’ve been hearing a lot lately about new public cloud offerings and I was wondering if you could talk a bit more about your progress with smart cloud, what kind of adoption are you seeing and are there any particular services that are driving your growth in public cloud?

Well, if you look at our cloud offerings and we’ve been pretty pleased with the overall growth rates. So if you look at that first half, we had very strong performance with our roll out doubling, as we went through the first half. And that’s been a big part of the overall momentum we see across our growth initiatives business analytics, Smarter Planet or growth markets and our cloud performance. Now, within cloud, we do drive public cloud, but we also drive the enterprise attention for cloud and the mechanisms for our customers to set up their cloud operations within their business, and in sometimes are more responsive to their requirements for real security and which we can provide as well, but overall we think that the cloud business both in 2011 and first half of 2012 has been spot on for us.

Thanks Brian. Let’s go to the next question please.

The next question comes from Steve Milunovich with UBS. You may ask your question. Steven Milunovich – UBS: Thank you. I was going to say that things actually have held up surprisingly well, you mentioned the constant currency growth by geography, Mark. In the back, you gave your industry numbers and constant currency I think finance is up 1, public is up 4, they are actually among your better performing sectors. So perhaps you can explain that and is there a risk that you have to see the cliff in a sense?

Well, that’s a great – that’s really a great point, Steve. I think as you look across the sectors, it really gives an interesting perspective on our business. So if you look at general business GB, I mean that was up 5%. Frankly, within GB we have really 60% of our Smarter Planet references, so it’s a pretty strong sector in its own right, but it’s also a good vehicle for many of our growth initiatives. And that plus 5% is – representative of 10 consecutive quarters of growth. Secondly in public, public was up 4%. And if you look underneath public sector government was up 4%, education was up 16% and our health and life sciences business was up 3% for the 21st quarter of growth in that area. Within our public sector and education, we installed the fastest computer in the world in the Lawrence Livermore Laboratory. So very good performance in public and an indication of the kind of roll out our initiatives have had. In industrial, we were up 3% that was highly driven by automotive that was up 11%. And as you said, when you open financial services was inline with IBM; interestingly, within financial services, our growth markets unit was up 12%. So really, really strong performance in the financial service in our growth markets business.

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

Your next question comes from Mark Moskowitz with JPMorgan. You may ask your question. Mark Moskowitz – JPMorgan: Yeah, thank you. Good afternoon, Mark. I had a question regarding the software business, I think you said earlier that IBM expects to hire 200 to 300 new sales reps each month for the rest of the year, and you also talked about middleware – key brand of middleware growing inline with the market, what should we take from that, does that mean the run rate of above market growth is starting to peter out here, is there anything competitively speaking here going on, can you just kind of give us a little more color that is really appreciative.

Yeah. No, I think, I think that’s a very important question. So if you look at the software business, let’s first look at the performance we had in the non-U.S. business, so for software outside of U.S., we had 4% growth in Europe, now that’s a very, very good performance in my book in Europe in the current conditions; in Japan, we had 6% growth in software; in growth markets, we had 10% growth in software. So all of those constant currency references all strong performance from my perspective all were meeting the objectives that we had set. The U.S. organization really faced just the difficult compare in last year, I mean that’s kind of function of their achievement in the prior year, they’re up 17%. So that 17% historical achievement drove the performance last year for the total software business is 10.5% growth. So as we look at the compare for the third quarter that’s about 8% growth. So we’re going to pick up about 2.5 points just on a compare, as the software business moves into the third quarter. Now the other point I wanted to make is, we are continuing to invest in the software business in a very big way, acquisitions to drive and integrate with those solutions, continuing the higher 1 to 200 software reps every month, so we think of anything we have a very strong hand as we go into the second half. I think the first half performance was very, very good; and in the third quarter, we should see growth rates so we are consistent with the first quarter performance.

Thanks Mark. Let’s go to the next question please?

The next question comes from Chris Whitmore with Deutsche Bank. You may ask your question. Christopher Whitmore – Deutsche Bank Securities, Inc.: Thanks very much. I wanted to ask about the competitive environment in services and maybe ask the margin question in a different way. We heard from some of your competitors their pricing for new deals has gotten more aggressive and you are not growing your bookings and your backlog much on an organic basis. Is IBM making the decision to you to be less aggressive on competing for new deals in order to reap the gains from your productivity initiatives or is something else going on?

Well, first of all, when you look at the overall performance in the business, our transactional backlog is up 6%, and we had growth in our transactional backlog now for 14 straight quarters. So I think that’s pretty good performance on that transactional side of the house. And if you look at the operating base for the – outsource inside of the house, we do have very strong growth, in our overall services business, in our growth markets. So I think we are driving aggressively around the world. I think we are driving leadership costs, I will say that consistent with the IBM business point of equation we are driving for real profit and cash generation and return on our investments, but I think we’ve got a good play with some areas of very strong performance.

Thanks, Chris. Can we take one last question, please, operator?

Thank you. The last question comes from David Grossman from Stifel Nicolas. You may ask your question. Sir, your line is open. Please check your mute button. David Grossman – Stifel, Nicolaus & Co., Inc. : Sure, thank you. So Mark the emerging markets have been very resilient. Can you help us better understand the composition of the mix in that geographic segment, and the visibility over the next several months relative to the other geographies that you serve?

Yeah, one way to look at that relative mix is to look at it both from kind of a sector stand – let’s look it from a sector standpoint, then let’s look it from a brand standpoint and then we’ll look at the distributed across the growth within country. So, first of all, if you look at the performance in the growth markets, I mean, I think for them they’re once again be stronger than we had seen in the major markets by nine points and that’s a trend line that we’ve seen in 2008, 2009, 2010. We’ve seen that for a long time, 2011, first half of this year that has been a very, very consistent phenomena for us. And if you look at the individual quarter it’s been pretty strong by individual quarters. Now if you look at the BRICS, the BRICS were up 12%. Within that, as I have said, China was up a very strong 24%. Russia was up very, very strong. Within that mix of business we had real power within the z side of the house in China, but if you look at across the sector dimension, and the brand dimension, I mean we had really strong growth in our sectors, every single sectors had growth, strong growth in the growth markets. We had very strong growth across every single brand, our software business grew double-digit, our services businesses grew double-digit within our STG content, with z growing a 11%. And I’d remind you that it’s not just constructed within the BRICs, that’s about a third of our business. So two thirds of our business was also going very, very well and we had this double-digit growth phenomena across 32 countries. So I think the composition of their growth this quarter was balanced across…

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