International Business Machines Corporation (IBM) Q3 2012 Earnings Report, Transcript and Summary

Welcome and thank you for standing by. (Operator Instructions). 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 third 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 website, or from us in Investor Relations. Now, I'll turn the call over to Mark Loughridge.

In the third quarter, we reported $24.7 billion in revenue, expanded gross pretax and net operating margins and increased operating earnings per share by 10% to $3.62. For the year, we're maintaining our full year 2012 expectation for operating EPS of at least $15.10, that's up 12% over last year. Looking at our third quarter revenue by geography, Europe was fairly consistent with last quarter, Japan's revenues stabilized, the BRIC countries in total performed well again, but North America declined. When I look at our skew of business in the quarter, through the first two months, our revenue was fairly consistent with our second quarter performance. The third month of the quarter was more challenging. This quarter we delivered double digit operating earnings per share growth driven by our strength in our solutions offerings, a solid annuity base and our ongoing work on productivity. First, we continue to drive very good results in our solutions offerings across software and services that address key demand areas like Smarter Planet, business analytics and cloud. Second, our annuity businesses which represent about half of our annual revenue and 60% of our profit provided a solid base of revenue and profit. And third, we're continuing to execute on our productivity initiatives on track to deliver $8 billion of productivity over the 2015 roadmap. The benefit from these initiatives together with our mix to more profitable businesses helped to drive our margin expansion. Now before I get into the financial metrics, I want to remind you that this quarter we closed the sale of our Retail Store Solutions point-of-sales business to Toshiba TEC in most countries. The transaction results in a loss of revenue in profit for the divested operations, a gain on the sale and an impact to our tax rate. As we go…

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 ask you to refrain from multipart 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.

(Operator Instructions). The first question comes from Toni Sacconagh with Sanford Bernstein. You may ask your question.

I was wondering, if you could provide some color, commentary around the quarter. Relative to your expectations revenues were short, your tone I think sounded a bit more cautious and you made several references to the U.S. being weaker and the third month of the quarter being more challenging. So specifically on those latter two points, can you help us understand what you think happened? Is this being driven by macroeconomic issues? Are these IBM execution issues and if we look forward, are you expecting either the execution of the macro issues to reverse or improve in the fourth quarter?

So, if you look at the third quarter performance, we did start off the first two months to the quarter on a stronger trajectory than we saw for the full quarter as we saw a fall-off in our growth rates in the third month of the quarter. Now, within that, third month phenomena, I would point to look at it from a brand perspective that was really a fall-off that we saw in our GBS business, number one, and our software business, number two, and from a geographic perspective, it was really a fall-off that we saw in North America and our growth markets unit which we refer to as GMU. Now, elementally, as you walk down those, the software content, I would attribute to a handful of deals that fell out of the quarter. Frankly, we thought we had those, right through the end of the quarter. They rolled to the fourth quarter. They would have accounted for about 2 points improved performance, which would have been more consistent with what we saw in the first two months of the quarter and those software deals were also part of the GMU performance. So, just as a software business would have performed better in the quarter, with the rollover of that handful of deals so would our GMU performance. Now, as you look at our growth market performance, in addition, they were impacted really by a couple of very large countries that had disappointing performance on a year-to-year basis. So, that would be Mexico and Australia. They are both down double digit. Our BRIC countries as a whole were up 11% and within that plus 11% positive performance very consistent what we've seen historically. Brazil was in fact down 3% but on the other countries Russia was up 11%, India…

Thanks Toni can we go to the next question please.

The next question comes from Ben Reitzes with Barclays. You may ask your question.

Mark you talked a bit about what could get better in the fourth quarter in terms of revenue. I believe you said the hardware and software revenue growth rates. Can talk about what could get better in the fourth quarter and even next year in costs? You had a very larger well put in perspective, your workforce rebalancing for us and what costs levers you have going into the fourth quarter and beyond please?

Sure. I think the overall opportunity we have in costs really goes back fundamentally to the business model and how we drive that business model over longer periods of time. The workforce rebalancing that we have done this year in total that was about $800 million predominantly outside the U.S. and should have a payback of about 15 months. Now we are constantly driving workforce rebalancing to tune our population to the best growth opportunities that we have. If you look at the overall cost and spending improvement that we saw in the third quarter, the first point I would make is that, in a period of currency headwind that impact that that has in the overall translational effect of currency that's mitigated and partially offset obviously by the hedge. You could kind of see that in the margin performance in our business. Our gross profit margins were up 1.2 points while our PTI was up 2.5 points and that differential a large part of that is the offset of the hedge helping to offset the impact that we saw on the revenue line and this flow through to gross profit margin. The 1.2 points we add in gross profit that had a very solid mix component, about 0.4 points from mix and a very solid spend component, and I think both of those are strong ongoing plays that we should leverage as we go into the fourth quarter and 2013. That mix component is predominantly the mix that we see in the software that we've been driving for a decade and the spend efficiencies are part of that overall $8 billion plan that we have for 2015 roadmap. Obviously, to break that down by year, its $1.6 billion by quarter is about $400 million if we get 30% to 40% to the bottom line, that's an advantage about $150 million. The balance, I'd remind you, that really goes to making our offerings and our products more competitive. On a price basis, it gives the ability to move spend to more aggressive growth opportunities.

Thank you Ben can we please go to the next question.

Our next question comes from Steve Milunovich with UBS. You may ask your question.

Given that the number of month weakness, could you talk a bit more about what customers are telling you in terms of the fourth quarter, I have seen some CIOs. There is some concern about not just the election, but fiscal cliff and questioning whether we're going to see the normal budget flush. Maybe you could tie into that, what you're seeing in verticals. It looks like finance in public slowed a bit, but it actually held in relatively well, so do you think there is much downside risk going forward?

I got to admit this was cutting out a little bit, but I heard the substance to your question. So, let me answer that. I think as I'm not going to kind of comment on the environment as if I were an economist but I can you tell the facts that we saw in the substance of the business will take time to describe so far. When you look at the overall issue of a fiscal cliff and a budget flush, I got to be honest, Steve, I kind of react to the position because I don't think it will be responsible kind of a performance for either public or private sector. I mean if we have spending requirements, I don't think people would rollout and maximize their spend rate this budget period to the expense of the overall spend requirements. I know if it was in my business and one of my controllers, the CFO was 'driving a budget flush' I'd be driving them out of the business. So, certainly the controllers that I have met in government, they are very responsible, they are driving to do exactly the right thing and if they see spending pressure, they are doing their work to help respond to that. To me, on a global basis, we look around the world, governments are under pressure. The spending is under pressure. I don't think this is news to anybody, but I think Steve from my perspective when you look at this proposition that there will be a budget flush to me as I had said earlier, I kind of react to that because it implies I think that they wouldn't be responding to the base economic challenges they have and I don't think that's the case.

Thanks Steve. Can we take the next question please.

The next question comes from David Grossman with Stifel Nicolaus. You may ask your question.

Mark, I'm wondering, I'm not sure if I heard you right, but I though you said that the outsourcing and the transactional backlog were up this quarter on a constant currency basis. Can you help us reconcile that with the continued loss of revenue momentum within the services unit?

Sure. If you look at the overall backlog, our total backlog for the quarter was up 1% within that our outsourcing backlog was relatively flat. Our transactional backlog if you just do the math was up 7% now. There are some dynamics that are pretty compelling within that. So, when you look at that outsourcing backlog and you break that down by unit you see much more momentum in our growth markets. So, if you take the total backlog for the business and break that down between major markets and growth markets the backlog in our growth markets is up 15% and that's kind of an ongoing momentum that we have seen in our services business in the growth markets. If you break this then down by unit, on the GTS base of business, I think they had a pretty good quarter there and actually the GTS business is up more than 1% as we enter the fourth quarter. I would also analyze the revenue performance in the quarter and remind you that we did take this very specific set of actions on the weak tail of the profitability distribution of our contracts and as we took that action on the weak tail that enhances and improves overall profitability. You saw it in the first nine months of the year of this year with the strong performance that we got out of the GTS business but it does have an impact on the other side to revenue. We knew that and we made that trade-off because our objective is to drive real gross profit and real profitability in those contracts in the backlog. It's not that hard to go through the services business and drive big signings but you have to live with that decision for a number of years in relationship with your customer. Our objective is to establish a strong relationship right up front with a profitable set of contracts that we know we can deliver over the longer term. So, I think I would caution you from looking at that GTS business, you got to recognize there was some revenue impact as we optimized to profitability.

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

Your next question comes from Bill Shope with Goldman Sachs. You may ask your question.

I have a question on the services segment as well. We're obviously seeing a pretty big dislocation in restructuring effort at one of your largest services competitors and more than we've certainly seen in a while in this sector. Is that having any noticeable impact on the competitive landscape, in outsourcing in particular, are you expecting to see any competitive tailwind as we go into 2013?

Well, I do think as we look at the capability that we're able to put on the field, we've got a pretty strong hand of very disciplined and experienced managers and executives, employees in the services business and I got to say the services business is not like the software business. It's not like the hardware business. It is a specific skillset. So, to the point that there is an impact on one of our competitor's profile that certainly should provide us opportunity, but when you look at the kind of broader trends that I think are more significant. I think you got to look at the opportunity we're seeing in the growth markets. Again, when we look at an opportunity set in growth markets, where we have about 20% of our backlog to be up 15% that's a pretty strong statement at very strong levels of profitability where we want to see where we can really put talent on the field, differentiated from our competition, there are lot of examples in the growth markets.

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

The next question comes from Mark Moskowitz with JPMorgan. You may ask your question.

When I come to Software business for a second here if we could, I know IBM has been pretty active hiring a lot more sales force individuals that capacity, does that have any impact on business in terms of visibility or some of these deal push-outs related to the piece on the sales force?

No, I mean, as we hire, we're going to continue hiring as we go through the fourth quarter. We take that resource and we train it and make it more productive and drive it into your overall sales organization, now that period of bringing that sales resource up to speed takes some time, but underneath that if you look at our Software business, the solutions contents underneath it had a very strong quarter, up double digit once again and the solutions contents is both organically generated as well as the implementation of the integration with our acquisition profile and that's been very strong across the portfolio of offerings. It was a little more challenging and new to performance on the infrastructure side, but as we look at the fourth quarter. I think we have opportunities across both and so again adjusting for that handful of deals in Software that fell out of a quarter, we were seeing performance more consistent with what we saw in the first two months of the quarter and I think we have the opportunity to close those deals and get back on a stronger trajectory as we go into the fourth quarter. So I think we have got a good software play here and I would look for them to generate mid-single-digit revenue growth in Q4.

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

The next question comes from Keith Bachman with Bank of Montreal. You may ask your question.

I wanted to ask you about GBS in particular and how you think growth can proceed as we look out and the context of the question is GBS on a constant currency basis has been down 1% each of the first two quarters, was down 3% this quarter on frankly an easier compare. You mentioned that Japan had stabilized, which is usually a positive impact on GBS. So it continues to disappoint. How does growth improve? What causes improve? Or is this the right kind of run rate for GBS as we look out over the next few quarters?

I don't disagree with your comments. I can provide more of a background. Do think we certainly do have the opportunity to improve. I think the business did what we said we're going to drive in Japan. We did stabilize our business in Japan. I think the team in Japan did a nice job. What we really wrestled with a little here was the challenge that we had in those more traditional packet solutions and they were generally kind of third-party offerings and HR supply chain or ERP. On the flipside of the coin though we did a great job in GBS on those key growth initiatives and the solutions attached to those. So on one hand I would have liked to have seen, I know the team would have liked to seen, better performance in those traditional packet areas and we're going to be rebuilding capability as we go in the fourth quarter and 2013. But I thought they did a very nice job on the solutions business, which is so important because its cuts across our business profile into hardware, software and services business. Let me remind you as you all know, those solutions drive about 50% mix in overall software business. So, we can do better as we work on that, traditional packet solutions. But I think they deserve a lot of credit for the work they have done on the solutions business.

Thanks Keith. Can we go to the next question please.

The next question comes from Katy Huberty with Morgan Stanley. You may ask your question.

Can you talk a little bit more about what you expect out of the recently announced server and storage product, specifically are you looking for growth across all the server products in the fourth quarter? Do you think growth can carry into next year and is there a structural shift towards better margins just given that your innovation seems to focus on the higher margin categories within there?

Sure. I would break the new announcements into kind of three categories, the first two we are introducing the new high end POWER7 plus and I think that has a lot of key technology offerings. It's only part of the product line, however, but it is the high-end. So, we look at that as real margin opportunity within the mix of their product line. Likewise, in the storage business, we're announcing the new high-end content introducing POWER7 to our architecture and we think that likely has real opportunity in the high-end for not just revenue, but margin contribution within their product line. But clearly the big announcement for the quarter is the new z Series and as we look at the new z Series, now we have a full quarter of opportunity. In the third quarter, we're really only shipping the new z for about 11 days in the very backend of the quarter and in front of that, ship date, we only had about three weeks of selling time, so now is the opportunity for full quarters work, and as I look at it, I think they have a very strong case on a Hardware basis for the new z platform to generate 20% to 30% growth. So, within all that, that gives us confidence within our objectives that the hardware base of business are to be generating about 5% revenue growth, our of the impact of divestiture of the Retail Store Systems content. Now that divestment has about a 4 point impact to the hardware base of business and about 1 point impact to IBM. But I think we do have good hand on that content and will see it improve the overall hardware performance not just in North America but as we go through the global rollout as well.

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

The next question comes from Jim Suva with Citigroup. You may ask your question.

The question I have is on your bookings, they were up very meaningfully here at 8% year-over-year, the constant current up 11%. As you look into that, just curious if there is anything in that number that was one-off that was something it maybe slipped in from Q2 last quarter or pulled in from Q4, any special big one-time special booking and any changes of durations, just that we should be aware of?

No I think that was capitalizing on the opportunities with the advantages that we can bring to the marketplace again. If you look at the backlog contents and I think that's the best metric to use here while backlog was up 1% overall it was up 15% in our growth markets. If you look at the components of total backlog between outsourcing and transactional, outsourcing is relatively flat while transactional is up 7%. I would not say there were some kind of very neat contracts that were inconsistent with our overall rollout contributed to that. I think one of the very powerful trends that we do see is how well our content and our capability plays in new opportunities as we look at growth markets. I think that's the more substantial trend line we see here.

Operator let’s take one more question please.

Thank you. The last question comes from Chris Whitmore with Deutsche Bank. You may ask your question.

I wanted to come back to services margins one more time if I could. What I'm really trying to understand here is the dynamic between the pruning of some unprofitable contracts, is that nearing completion? Is there more room to the deal on the pruning side? Then secondarily most of the workforce rebalancing efforts targeted at driving services margins and if so can you frame a medium-term margin target for the services business there in 2013? Do you expect margins to improve further from these levels?

Yes. So let's look at the overall margin dynamics for the Corporation. When you look at it we are driving that very focused piece of work that Linda Sanford took you through at the Analyst Meeting to generate about $8 billion of spend take-out across the business and as I'd said earlier if you just kind of mathematically break it down to about $1.6 billion a year or $400 million a quarter that content is in some respects outside of the business unit purview and it gets applied to those business units based on their kind of metrics in participation. So in other words if we take big spend rate out of the back office support organizations. The business units are the beneficiary of that spend take-out but they didn't have to drive a lot of the content since we manage on a globally integrated enterprise. That's a very structured play that we are driving not only across our back-office content but now into systematic areas that span across our processes and also spend rates within business units that collectively have more opportunities. So, we intend to continue that overall spend dynamic and as I had said earlier our services business will certainly be a beneficiary there. Now in your question about the overall workforce rebalancing that we do just given the fact that the services business have the largest share of our overall population of course they are going to be the beneficiary of that as well. But to me on the longer-term basis, I think that the model base that we provided as part of the 2015 roadmap is the best criteria, the best content that you can see as you look at that long-term run rate. So if you look at how we would attempt to implement…

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