International Business Machines Corporation (IBM) Q2 2011 Earnings Report, Transcript and Summary

Welcome, and thank you for standing by. [Operator Instructions] Today's conference is being recorded. [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 Chief Financial Officer, 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 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.

Thanks for joining us today. In the second quarter, we delivered revenue growth of 12%, and operating earnings per share of $3.09, up 18% year-to-year. With this performance, we're increasing our full year 2011 expectation for operating earnings per share to at least $13.25, which is up $0.10 from our previous view of at least $13.15, and up $0.25 from the beginning of the year. The 12% revenue growth was driven by our transactional businesses in hardware and software. Software growth was driven by key branded middleware, which was up 21%. Our systems revenue was up 20%, with strong performance in System z, POWER and System x servers. In services, our total backlog increased to $144 billion. That's up almost $15 billion from last year with $13 billion from currency and $2 billion of constant currency performance. Services revenue was up 10%. Within this, growth markets were up 22% or 10% at constant currency. Overall, growth markets performance was strong, and revenue from these countries was up 13% at constant currency, our fourth consecutive quarter of double-digit constant currency performance. In fact, we had continued momentum in all of our growth initiatives, growth markets, business analytics, cloud and Smarter Planet. Turning to profit. We increased operating pretax income by 10%, and operating net income 11%. Bottom line, we delivered operating EPS of $3.09, which was up 18% year-to-year. Our strong earnings performance resulted in $3.4 billion of free cash flow in the quarter, and in the last 12 months we've generated $16 billion of free cash flow. With this strong cash performance, we've delivered significant returns to shareholders, with almost $5 billion in share repurchase and dividends this quarter and almost $19 billion over the last year. Now I'll get into the second quarter details, starting with revenue by geography.…

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.

[Operator Instructions] The first question comes from Bill Shope with Goldman Sachs.

Mark, can you walk us through the current competitive landscape in services and outsourcing in particular? You mentioned that you're gaining share here. Where, specifically, do you think you're seeing the most market share momentum, and are you seeing any signs your competitors are responding to that now?

Well, let's look at some of the dynamics that we have in our services business. First of all, when you look at it from a backlog perspective, a really strong backlog quarter for us. Now at a $144 billion, up $15 billion year-to-year, and if you look at that balance on backlog growth, it was pretty strong on both sides, so 11% backlog growth. Within that, though, I'd like to point out that we really had strong performance in GMU. So if you break down that backlog growth in total, up $15 billion, about $7 billion was in major markets, but $8 billion of that $15 billion was in the growth markets. So growth market backlog is now about 20% of the total and over the last 2 years, it's doubled -- it's up 50%, excuse me. So within that 50%, then you look at the margin content, the margin content for Total Services in GMU was 2 points richer than we see in the major markets. So frankly, underneath those dynamics we're seeing real strength as we move into growth markets with a lot of opportunity that comes at good margins given the capability that we bring to the table. If you look overall in the services business, now looking towards the second half of the year, we expect to see yield off of that workforce rebalancing that we did have in the second quarter. And with the yield off that plus the ongoing momentum, because frankly, without that restructuring, workforce rebalancing charge, we had 10% profit growth in services in the second, balance of the 10% revenue. Now getting the yield off that momentum in the second half, we should see margin expansion and double-digit profit growth from our services business. So I think we've got a pretty strong hand, and I would like to reemphasize how encouraging we've seen the performance in GMU.

The next question comes from Toni Sacconaghi with Sanford Bernstein. Toni Sacconaghi - Sanford C. Bernstein & Co., Inc.: Mark, I was wondering if you could comment on pretax margins. I think this was the first time in 15 quarters that they declined year-over-year. I know that currency and acquisitions were a factor, but you have those benefits on the cost side and on the revenue side. You've also mentioned workforce rebalancing several times. Is that really the driver? And if so, can you dimension the size of the workforce rebalancing this quarter relative to other quarters, and where that impact was felt most in the P&L?

Sure. So if you look at it, as you know, as we detailed the business model going through to 2015, within that roadmap, we're looking for a margin expansion on a net income basis, and we're looking for a kind of magnitude of say, 0.3, 0.4 point. In the second quarter, in fact, if you exclude the workforce rebalancing, and within the quarter it was about $175 million, that's up about 160 year-to-year with the bulk of that in the services part of the business, without that effect in the second quarter, we were, in fact, 0.3 point margin expansion on net income. If you take it to the first half, then the first half was expansion of 0.2 point, and without the second quarter restructuring, alone, we would have been up by 0.5 point. Now, again, going into the back half of the year, we'll see some yield against that restructuring. But I feel pretty confident that the margin performance we're seeing in the business is going to be improved as we go into the second half of the year. And frankly, the run rate underneath our performance, I think, is right on the model. So I think it's simply a matter of the workforce rebalancing charges, Toni.

The next question comes from Benjamin Reitzes with Barclays Capital.

Mark, could you talk a little bit about the financial services vertical? It's 29% of sales the last 2 quarters, still grew 8% at constant currency in the quarter. Obviously, we're all feeling the stock prices and the pressures that are out there in the financial services segment. So could you talk about how IBM is going to continue to grow in that sector maybe throughout the year, what your initiatives are to grow in the financial services and whether you can, and any other detail around that?

Yes. Well, we had really positive performance, as you pointed out, Ben. Financial services, up 17% at actuals. That's the fifth consecutive quarter of positive growth for the financial services sector. And I'd add, when you look at that performance, big placements around the world. The financial services sector is certainly not just deploying by major market participation, some of our biggest banking customers now are, frankly, in the growth markets. Some indicators of that, let's look at the 68 new customers that we brought to the zSeries platform since we introduced zEnterprise, 1/3 of those 68 are in the growth markets. So I think we've got real momentum in the financial services sector. It's a strong play for us. But I would expand that a little bit. We didn't just have strong performance in the financial services sector, up 17%. GB, General Business, was up 16%. Our overall communication sector was up 16%. Those 3 alone account for almost 2/3 of IBM's business. So if you look at the volume of business that we have, exiting the second quarter, we've got real momentum across those largest sectors.

The next question comes from Katy Huberty with Morgan Stanley.

Mark, given the strong growth in IBM transaction businesses, generally, and strong consulting results at your peers, are you surprised by the downtick in constant currency growth within transactional services? I know you mentioned the impacts from government spending, but can you talk about the other factors that drove that deceleration?

Well, let's -- when you look at it on a Total Services basis, we were about 3% constant currency in the first quarter, 2% constant currency in the second quarter. I don't know if I'd call 1% change in the trajectory a deceleration. But if you look forward, really, I would now go back to where we see our sales competitively in our backlog performance. And the backlog performance, once again, we had strong backlog in total, up $15 billion, that's 11% growth, but the transactional backlog was up 16% and the outsourcing backlog was up 9%. Now all of those have different contract lengths and extend over a multiple time periods, but I think it puts us in a pretty good position as we go forward. Now within that, I want to remind ourselves as we look at that performance, the business model is to drive profitability growth, and the GBS business did a great job on profit growth in the quarter. In fact, if you look at Total Services again, adjusting for workforce rebalancing is up 10%, we see that services engine going forward generating double-digit profit growth in the second half. I would also point out that the real mission that we're looking for from our GBS organization, our consulting organization, is to lead our key growth plays. We've already talked about the growth that we've seen in GMU. But I want to reiterate, a big part of their job is to drive that ongoing momentum in Smarter Planet. Smarter Planet was up 50% in the first half. If you look at business analytics, we're up more than 20% in the first half. Cloud computing, we've done as much work in cloud in the first half of this year as we did all of last year. So they are driving that momentum, that's a big play for the IBM Corporation. GBS is on their model on a profitability basis, and we see that yield from the second quarter restructuring moving into margin expansion in the second half.

The next question comes from Chris Whitmore with Deutsche Bank.

Mark, the weaker dollar contributed to 7 points of revenue growth in the quarter. You gave us some details around hedging losses, but can you take or quantify the weak dollar impact on earnings? And in addition, can you comment on how IBM would be impacted if the dollar were to materially strengthen from here?

Yes. Well, Chris, that's a really, really good question. Let me give you an answer on it, but I want to start with kind of the operational aspects of movements in currency. So when you see movements in currency, especially when you see sustained movements over longer periods of time, the competition adjusts, the marketplace adjusts. We use some of that advantage, especially in consecutive quarters of a weakening dollar, to improve our position competitively at the table and, essentially, pass some of that currency advantage to our customers. And I want to keep that operational aspect of competing in a global business in mind as we go through this explanation. When we do the calculation of currency, that's a straight mathematical analysis, translational impact netted for the hedge. When we do that analysis, that really kind of defines the theoretical maximum that currency would be. I don't think it's that much. I know in my business work, when I was pricing PCs, we were adjusting special bids for changes in currency every single day. And we're doing that because competition was doing the same at the table and rolling some of that advantage into their price point to win the business. So if you take that simple mathematical calculation and remember that, that's a theoretical maximum netted for the hedge, that's about $300 million. Now within the quarter, we also had a unique event with the amount of restructuring that we had. Again, $175 million. If you net those 2, the difference of that theoretical maximum on currency netted for restructuring, that's about $125 million. So now with that $125 million in mind, let's return to the operational example I gave of how much is really a pass-through to your customer set to win the deal at the competitive table. Is it 20%? How much benefit did we get on the revenue line? It was about $1.7 billion. Did we pass 20% of that through? Did we pass 30%? Would you pass 1/2 through? I mean, we see it not only in transactional businesses, but we see it in annuity business over sustained periods of time as well. Well, frankly, just to kind of bookend the argument, all you'd need is about 5% to 10% at that $1.7 billion theoretical maximum to be pass-through to your customer set, and that adjustment, alone, would mitigate all of that net benefit of currency relative to a restructuring. If it was more than that 5% to 10%, in fact, the net effect would have been a hurt to the P&L within the period. So I think it's -- Chris, a long answer, but it really is the way currency rolls out, and there are real operational aspects of that, that we need to consider as we analyze the effect.

The next question comes from Scott Craig from Bank of America Merrill Lynch.

Mark, I was just wondering if you could go into the software margins and sort of expectations there as you go forward. They were, roughly, flat to slightly down year-over-year, so just curious, you talked about the services margins and the impact from some of the items, what was their impact in there, and sort of your outlook going forward for margin expansion?

Sure. Well, if you look at the software businesses, as you know, as we ran through that business in 2010, we had a lot of acquisition content. In fact, we did 17 deals for well over $6 billion. It was really one of our largest years ever on a dollar amount and on a number of deals. So -- and the bulk of those, the majority of those deals, all flowed into software. So software had a lot of work to integrate these businesses into those key plays that we're running. When we do that integration, we're adding resource, we're adding expense for the integration. We're building those teams to grow those deals. So actually, that acquisition integration process was the biggest element in analyzing the margins for the software business. Now I'd reiterate -- I mean, software grew their profitability at 12%, so that was a very strong case to begin with. But as we look at -- going into the second half and we start to yield the growth rates against the software acquisitions, we expect to see margin expansion in the software business on top of the revenue performance. And one point I would also add is the software acquisition based in the second quarter, they did a great job, a great job.

The next question comes from Richard Gardner with Citigroup.

Mark, I was hoping that you could provide a little bit more detail on competitive placements in UNIX, and just talk about whether you're actually seeing that rate of competitive placements pick up based on some of the actions of Oracle in the market, or has it been pretty steady here of late?

Well, when you look at it overall, I mean as we've pointed out in the script, it's just quite remarkable, I think, that since beginning of 2009, we're talking about 2,300 customers, $2.3 billion of business that we pulled away from our competition, with 60% of that Oracle and 30% Hewlett-Packard. We've had growth in the UNIX business now for 2 quarters in a row, 8% in the first quarter, 5% in the second quarter, all of that growth was driven by IBM. And if you look underneath it, not only are we gaining very good key pSeries performance, from strong deals with the major markets, but boy, we're getting really strong performance in growth markets. So within the growth markets, we're expanding that platform into new customer sets. So I think the pSeries is going to be an ongoing source of strength. And when you kind of divide it down by the elements, we had more than 20% growth in the high end of pSeries, the entry model pSeries, I mean that more than doubled year-to-year. So it's a pretty strong play. It's going very well in the marketplace. And I think we've done a good job versus competition, but we've also done a good job as we expand that marketplace, especially in growth markets.

The next question comes from Robert Cihra with Caris & Company. Robert Cihra - Caris & Company: Kind of similar, I guess, to the last question but on mainframe, just obviously, you're having a great up cycle here, but the comps get a lot tougher in the second half. I guess, I'm just curious if your thoughts, if you feel this is simply product cycle, how long the product cycle will go for, or do you think there really is kind of structural mainframe strength that maybe there is some growth to this market beyond cycling, any sort of sense you have on that?

Well, we, as you pointed out, I mean, we had a really powerful quarter in our mainframe. I mean, goodness gracious, when you're up 61%, I mean that's a pretty powerful quarter in the mainframe business. And as you look at those mainframe new customers that we've brought to the platform was zEnterprise, I mean 68 new customers. That's 68 new flags we planted that are going to be a source of business on financing and software, services, all down the road, so it is a very good indication. Now it's not that different from a typical mainframe cycle, the front end of the mainframe cycle defined by new placements and new placement growth as we go into the back half of the cycle. It's more defined by microcode upgrades, less revenue, but more profit margin performance. As we go into the second half of the year, we do start to wrap on that substantial performance that we saw out of the mainframe last year. But for the overall momentum that we see in the STG business across pSeries, which grew 12%; xSeries up 15%; Storage up 10%; Total Services up 20%, we see, again, double-digit profitability from our hardware business in the third quarter. And a difficult comparison going on to fourth quarter, albeit, but a very, very strong year from the unit.

The next question comes from Mark Moskowitz with JPMC. Mark Moskowitz - JP Morgan Chase & Co: Mark, I want to come back to the software business. I wonder if you can give us a little more color about what's driving this impressive growth. Clearly, IBM is tracking at or above market now for consecutive quarters with respect to software, which is a good thing. So just trying to get a sense, how much of that could be driven by maybe some transitory benefits, either from competitor displacement or as you talked about earlier, the Oracle-Sun displacement versus just a broader trend where you're just winning new customers in general?

As I look at the momentum that we're seeing across the software business, we do have advantages in the marketplace that I believe are playing out. First of all, we don't go to the marketplace with just the software business. It's a very strong, robust software business, but it has this terrific linkage into our GBS consulting business and terrific linkages into the hardware business. So we now can advance those key strategic themes. And those strategic themes are really important to our ongoing business equation. So what we're really focused on is how we're driving software through those key plays of Smarter Planet, business analytics, cloud computing, acceleration in these new opportunity spaces. Underneath the software, again, the way I would look at this, software now has the opportunity to continue to expand of the new placements, the new flags that we have planted on a global basis in our hardware base of business. So it's not as if the minute you close that hardware deal, all your software rolls into the account. That software rolls in over time, and it has opportunity from those new placements. Our real focus is on driving those key strategic plays consistent with our 2015 roadmap.

The last question comes from David Grossman with Stifel, Nicolaus. David Grossman - Stifel, Nicolaus & Co., Inc.: Mark, you seem more optimistic about Europe, and if, in fact, that's an accurate read, can you help us better understand the need to take another rebalancing action in Europe after a similar action taken in the first quarter?

Well, let's -- I do feel that we're in a more stable position in Europe. The growth rate in Europe went from 2% to 3%. Within that, we returned to growth in Germany. We returned to growth in Italy. We've got some very strong plays in Europe. Our business, though, is a business of resources and capability, and we're constantly refining that mix of capability through workforce rebalancing. That's simply a part of our business model and the ongoing equation, and that will continue through all businesses and all years, I think. So let me take this opportunity now to just make a few comments as we wrap up the call. So this quarter, we continued our strong performance. Revenue growth at 12% was driven by our transaction businesses, with hardware and software, both up 17%. We had fantastic performance across our growth initiatives, Smarter Planet, business analytics and cloud, and, of course, our growth market countries, which were up 13% and grew 10 points faster than the major markets. We delivered 18% growth in operating EPS this quarter and 19% for the first half. We're exiting the second quarter with a lot going for us, a strong systems portfolio, continued momentum in software, growth in services backlog with a lot of opportunity in growth markets, momentum in all of our key growth plays and a very strong balance sheet. We've taken our expectations for operating EPS up to at least $13.25. That's up $0.25 since January. So as IBM enters its second century, we have our eye on delivering performance over the long term. And the first half of 2011 is a good start towards at least $20 of EPS in 2015. So thanks for joining us, and now, as always, it's back to work.

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