International Business Machines Corporation (IBM) Q1 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 first 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 first quarter, we have reported $24.7 billion in revenue, expanded gross pretax and net operating margins and delivered operating earnings per share of $2.78, which is up 15% year-to-year. And now, 90 days into the year, we're increasing our full year 2012 expectation for operating EPS to at least $15. This is up $0.15 from our previous view of at least $14.85. Looking at the results by segment. We continued our strong performance in software as we aggressively address opportunities in analytics, cloud and Smarter Planet. Our software profit was up 12%. In services, we expanded margins and increased Total Services profit by 11% as we leverage our productivity initiatives and mix to higher margin offerings in markets. Services revenue growth was again led by growth markets, which were up 10% at constant currency. And our backlog in growth markets was up 14% at constant currency. As expected, our hardware business declined as compared to a very strong growth of 19% in the first quarter of last year. This quarter, we extended our leadership in the UNIX market as we continued our competitive displacements in POWER. And just last week, we announced PureSystems, the first new class of computing in over 20 years. This solution leverages IBM's decades-long investment in innovation and radically simplifies enterprise computing. This should start to contribute to the systems performance in the second half of the year. Turning to profit. Our ongoing focus on productivity, together with the relative strength of our software business, drove strong margin performance. We expanded operating gross margin by over a point, led by services. And our operating net margin was up a similar amount, 1.1 points. Within net income, this quarter, we had a couple of unique items that impacted the…

Thank you, Mark. Before we begin the Q&A, I'd like to remind you of a couple 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 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 Sacconaghi with Sanford Bernstein. A.M. Sacconaghi - Sanford C. Bernstein & Co., LLC., Research Division: I was wondering if you could comment on the services business. I look at GBS and on a reported basis, it was down 2%, and I realize its public and Japan contributing very negative growth overall. But do you actually see that getting any better going forward? And in fact, it seems like it's getting marginally worse. And when I look at the outsourcing side, your backlog is now down 5% relative to a year ago. And backlog is a good leading indicator, especially in the outsourcing business. So perhaps you can help us understand how things get better from here. And on an as-reported basis, can GBS grow this year? And with a minus 5% backlog in outsourcing, how does that grow from here for the remainder of the year?

Okay, Toni, a very good question. Let's start from first principles. First of all, when we started the quarter, we told you that the backlog run out we expected would be up 3% year-to-year. So in other words, we're looking at one, at the backlog for total services that it should influence revenue this year. And that backlog should affect about 70% of the revenue, so 70% of that 3% will drive about 2% revenue. And we had indicated that we felt confident that at that level of revenue, we could drive double-digit profit growth for the year. So let's look at it now by the individual units. If you look at GTS, I would argue they're right on track. This is the fourth consecutive quarter of 2.6% performance from our GTS team, and I think it's an indication that we do have that model specified correctly. And with that 2.6%, what did they do? They drove 20% profit growth and 2 points of margin improvement. So again, very consistent with our indication. When you look at GBS, actually the mechanics underneath that more on track, but we did get clipped by a couple of contracts that were more challenging for us. I gave you an example of a couple in Japan that impacted our profit by $60 million. Now outside of those 2 contracts, frankly, GBS would have grown their profit on a year-to-year basis. So if you consider those 2 contracts, I would tell you, number one, I think from a financial standpoint, we had the bulk of that behind us. And I don't expect and I don't see contracts in the distribution that will have that kind of impact going forward. Now I can't predict the future, but I do have a pretty good purview to the contracts that we're working on. Secondly, I'll tell you that GBS has, generally, over a longer period of time, been pretty good at managing these challenging contract elements. So I think from my perspective, this is a bit of an anomaly, and GBS should get these 2 contracts behind them in the first and improve their performance to more typical levels as we go into the second quarter. By the way, just as an aside I'd add, that if you look at IBM's revenue growth for services, up 1%, we were shy of 2% by $7 million. That's $7 million on a $15 billion base, so obviously, very close to the 2% level to begin with. I would also reiterate that even in the face of that, we had double-digit profit growth in services for the quarter, and we feel quite confident, given all of the elements that we see in the business equation for Services, we should be driving double-digit profit growth for the year.

The next question comes from Bill Shope with Goldman Sachs.

I have a question off of the profit comment you just made on services. How should we think about the drivers of pretax margin this year and frankly, beyond this year? You've had some pretty substantial improvements here. So how do we think about how much room you have left, a steady state on pretax services margins, which are certainly approaching record levels on an annualized basis? And frankly, where do you have room left to enact further savings?

Sure. If you look at -- let's look of the drivers underneath the performance in our GTS business, again, profit up 20%, 2 points of margin. How did we achieve that and what do they have as far as sustainability going into the future? So number one, they -- GTS business, and frankly GBS as well, but GTS on a large part is a beneficiary of all the work that we're doing on productivity. Now you remember, at the Investor Day, Linda Sanford defined that and how we were managing that across those elements. The objective is about $8 billion over the roadmap period. We felt that we did quite well on that base last year. And I'll tell you that our view is that we're right on track in the first quarter. GTS once again benefits from that work. And they are really part and parcel of all the elements that we drive for productivity and spend management. Number 2, with those advanced tools and intellectual property, we're also working on not only the margins in the overall distribution but also the margins in the products that I would call the tail of the distribution, so more challenging contracts. And this year, the GTS team did a great piece of work on those contracts in the low-margin tail in the distribution of thousands of contracts and generated a very meaningful improvement in profitability that we know analytically extends throughout the year. And then lastly, I'll tell you, as we look at the dynamics in that business, our backlog growth for Total Services was up 14% in the growth markets. And in the growth markets, what we're seeing is we have 2 points better margin actually in those deals as well. So those 3 are ongoing dynamics, in my mind, and give us confidence that we have a strong play going forward.

The next question comes from Ben Reitzes with Barclays.

Mark, by guiding to $15-plus from $14.85-plus in effect with the $0.13 of upside versus the street, it would seem like you're backing where the street is for the rest of the year in EPS perhaps by quarter, at least for the 3 quarters of the year. And I was wondering if you agree with that comment. And then otherwise, what would be the upside drivers to those? Would there be cost-cutting? And/or is there any potential for revenues to start beating expectations as you go throughout the year with this IT environment?

Sure, Ben. Very good point. If you look at the performance in the quarter, EPS up 15%, a very strong performance in our overall net income. Our cash flow -- free cash flow in the business, up $1.1 billion year-to-year. Even if you take into consideration last year's tax payment, that was up $300 million or 16%. So to me, the characteristics of this first quarter are quite strong. And really, it was based on our confidence in characteristics of the quarter and the going-forward equation that encouraged us to take our view of the business up $0.15. Now remember, taking your view of the business, up $0.15 only 90 days into the quarter, I think is a real show of confidence. If you look at the next 3 quarters, we see them up about 10%. And that 10% is the underpinnings to what we view is an at least $15 for the year. Now that 10% across those quarters is reasonably uniform. I do think the third quarter is probably a little tighter for us, but reasonably uniform. And at 10%, given a $15 base of performance on -- at the least basis for 2012, that's all the trajectory we need to get to $20 by 2015. So to me, I would say that to build base of the business looks like it's in pretty darn good shape and on track to achieve our longer-term objective in 2015. Now to your point, what do we see going forward? There's a couple of dynamics that I would remind you of. Number one -- and maybe a way to look at this is kind of headwinds, tailwinds. So as we look at it going forward for the second quarter or third quarter, we still will see the headwind from currency at about 3 points. We will still, as we go through the second quarter, have the compares challenged for us in the hardware base of business. As well, we will still be wrestling with the issues that we see in Japan in the second quarter. But I think, when we go to the second half, first of all, we have very strong software momentum. Second of all, we have a stable base of profitability and margin performance in our services business. But when you get to the hardware base of business, we have new announcement content that should drive that performance. We should regain revenue growth in the second half based on those new announcement, PureSystems being the first installment. And with that, we should see double-digit profitability in the second half from our hardware base as well. Rolling through all of that is the strength of our operating model and the strength of our growth initiatives. But I think stabilizing Japan in the second half and seeing the new announcement contribution from our hardware base of business, that's going to be a significant dynamic.

The next question comes from Keith Bachman with Bank of Montréal.

Mark, on the PureSystems, could you give us a little better sense about where you think the opportunities set is? And I'll rephrase the question a different way. IT departments have fixed budgets a year, so if they use or buy PureSystems, what are they not going to buy either of your portfolio and or competitor's portfolios?

Yes, I think that's a very good question. When you look at -- let's look at our IT budget within IBM. If we were sitting here in the meeting with the RCIO and Linda Sanford working on it, what do we work on? We work on the percentage of our IT budget that we're able to move into new content and new opportunity, as opposed to just maintaining our existing base of business. That's how we run it, and we've been doing this year after year after year. Why is that relevant in PureSystems? Well, if you look at it, in a typical IT department, you could be spending about 70% of that budget on these kinds of simple operations and maintenance. We think with the PureSystems content, you'll have the opportunity to reduce that over a 3-year period by over 50%. That's an enormous contribution to your productivity. And as we would interpret that, if we were having that meeting today in my conference room, we would drive even more of our spend into new announcement content and new categories of IT spend. So I think it's a very powerful opportunity for us on a financial base. That doesn't even get to the unique capabilities and patterns of expertise that it has, built-in expertise, then the complex of business, integration by design. I mean, this can be up and running in as little as 4 hours. So to us, PureSystems is a first new system in 2 decades to hit this kind of an industry rollout, and we're very confident that it would go into the second half and as a big element of our game plan going into 2015.

The next question comes from Joe Foresi with Janney Montgomery Scott.

I know you talked about Japan. I wonder if we could get the same type of color on what your expectations are for the public sector and Europe in the second half of 2012.

Yes, sure. Let's talk about public sector first. As you could see, within public sector, we had 3% growth. In the quarter, if you break that down, the real strength in public sector was driven by 1, education. And frankly, within education, we have research laboratories as an example. We have a lot of very strong performance on our high-performance computing in our research centers. And secondly, we had real strength in health care and life sciences. They've had their 20th consecutive quarter of growth. So those 2 elements of overall public sector carried the business. On the government base of business, it's still pretty flat. And we see government spending, really globally, more challenged within that base of business. Your second question, really on Europe. Again, I would point out, as I think we've discussed before, Europe is not just a homogenous breakdown of countries. In the U.K., we had 10% growth, U.K. That's the 10th consecutive quarter of growth in the U.K. So it's not as if that's 10% on an easy compare. That's 10% on 2 years of real performance out of the U.K. business. So I think they've done a great job. Spain, we had growth for the sixth consecutive quarter. In Germany, we had growth for the second consecutive quarter. On the flip side, we're still down in France and down in Italy, but I think on balance, Europe to me, looks pretty stable. So if I would characterize it on a global basis going forward, I look at the major markets, we think they're relatively stable on a forward-looking basis. And the growth markets, I think, are showing some real strength.

The next question comes from Katy Huberty with Morgan Stanley.

Mark, you mentioned gain on sale from the point-of-sale business. Can you just give a little more clarity on the potential size and timing of that gain flowing through the P&L? And more importantly since the sale of POS gives you more confidence and flexibility to step up acquisitions and prepare for better top line growth and more mix benefits going into 2013?

Yes. So if you look at the point-of-sale transaction, first of all, let me describe that as really a partnership between IBM and Toshiba TEC. So our objective with this is on a combined basis, to have the best commerce offering on the planet, so this is a real partnership for us. The gain associated with this is in the range of $450 million to $550 million. And we would expect to complete the transaction either late in the second quarter or early in the third quarter. Within that, we're going to maintain, for a 3-year period, a 19.9% equity again as a partner, and we're very confident about this combined offering going forward. Now with that gain, Katy, it gives us the opportunity, 1, to continue the workforce transformation and productivity initiatives we have going. And to your questions on acquisitions, I mean, look at the base free cash flow performance in this business. I mean, $1.9 billion in a first quarter, up $1.1 billion year-to-year. Admittedly, even if you took the tax payment of $300 million, believe me, we have sufficient free cash flow in the evidence of the base business we have today to continue to drive our priorities in our own internal capital, our acquisitions, share repurchase and dividends.

The next question comes from David Grossman with Stifel, Nicolaus. David Grossman - Stifel, Nicolaus & Co., Inc., Research Division: Mark, I'm just going to back to the GBS gross margins. If we add back the $225 million of rebalancing back to the GBS number, and I don't know if that's right but just assume you do, and take the $60 million, I guess my math is coming out that the margins in GBS would be up modestly year-over-year. And I guess, number one, is that math right? And if so, what really drives the GBS numbers up beyond that in the second half of the year?

Well, first of all, all of that does not apply just within GBS, when you look at the workforce rebalancing number, so that's implied across IBM. And so you can't really look at it that way. You can however -- if you look at those 2 contracts that I described that were more challenging in Japan, that $60 million, if you strip that out, it would have grown on a year-to-year basis and obviously, given the revenue characteristics, that would have been expanding margin. Now on a go-forward basis, we expect them in the second quarter to get a lot of those large challenging contracts, that we had in Japan behind us from a financial perspective, get back to more normal operating conditions. But to your question on the robustness of our margin performance, I would look at the total services base of business. I mean, this was a very powerful aggregate margin performance from services. And again, as I went through those characteristics that were driving the workforce productivity initiatives with Linda Sanford, the systematic approach to deal with low margin content, the higher margins that we're seeing in Total Services, not just GTS but Total Services and our growth markets unit put all those together, we feel quite confident that we will see margin expansion for the year and generate double-digit profit growth for services.

The next question comes from Ed Maguire with CLSA. Edward Maguire - Credit Agricole Securities (USA) Inc., Research Division: You've referenced an 80% win rate on Netezza proof of concepts. Could you provide a bit more color on what you're seeing competitively elsewhere in the software division, as well as some of the dynamics around your contract renegotiations on the GTS side?

Yes, well, software -- first of all, Netezza, since the acquisition, if you look at that combined effect over a longer period of time, what a success that's been, and that offering provides a more integrated approach to deal with our customer buying patterns. It's been a real win for us. In a way, I kind of look at it and say, what a good proof of concept that is not only its application in current deal pools, but as an indicator of the kind of opportunity we have with PureSystems going forward. So I think that's been very, very successful. On the software base of business, they had a great quarter. I mean, if you look at that performance, the profitability in the first quarter, $1.9 billion profit, up 12%; the base software content, up 7%; real double-digit strength in that WebSphere platform. I think we have a very, very competitive offering. So the software base of business is doing very, very well competitively. I think Netezza on that kind of integrated offering, really good proof point for us since the acquisition and again, gives us a lot of confidence on this integrated offering of PureSystems, which is not just hardware but hardware, software and services going forward into the second half.

The next question comes from Rob Cihra with Evercore Partners.

I was actually hoping if we could go back just to the acquisitions discussion. And just the -- you spent sort of, whatever, $1.3 billion year-to-date, but you only spent $1.8 billion, I believe, last year. So as part of your 2015 roadmap, you had, I believe, earmarked, call it, around $20 billion for acquisitions. But you're sort of 25% of your way time-wise there and you only spent about 15% on acquisitions. Does that signal any change in your view? Or is it simply that the reality of the math is never that linear and we should be still thinking about similar acquisitions strategy in something around $20 billion?

Well, my advice to you is that the best indicator to use now is $20 billion for acquisitions through 2015. Now let's just go back to the math and the way we've describe this in the investment meetings that we've had in the last couple of years. As you look at it, if you look at that kind of $4 billion a year run rate -- and by the way, this is not going to be linear because it's dependent on how frothy the market or attractive the market is and how it integrates with our initiatives. But if you look at that, we frankly exited 2010 in a very strong position. Remember, we did well over $6 billion in 2010. So when we went through the model at that time, we said, we frankly have a pretty substantial head start. And if you have considered that we don't expect this to be linear. If you look at those -- that 2-year period of 2010 and 2011, $6 billion and $2 billion . On average, we did about $4 billion. So I think that run rate, on average, is a good indicator. I don't think it's going to be $4 billion every year. This year, $1.3 billion just for the first quarter, I would say we're kind of a hit pace [ph] on a run-rate basis. The second point I would make is given that we did get ahead of the profile in 2010 with a very successful set of acquisitions, 17 in total, that, frankly, put us ahead of the game as we looked at our EPS objective for acquisitions as part of the 2015 roadmap. Remember, we're looking for about $0.90. And given that the head start that we had coming out of 2010, we had to be able to hit that $0.90 at a spend rate of between $10 billion and $15 billion as opposed to $20 billion. So that provides, I think, opportunity for us. But from my perspective, I'd tell you from what I'm doing, I am viewing this as an opportunity for $20 billion in our treasury and our capital planning processes, believe me, we're reserving about $20 billion over the roadmap.

The last question comes from Chris Whitmore with Deutsche Bank.

Mark, you alluded to applying the funds from the point-of-sale to your workforce rebalancing. So that, combined with the $225 million you took this quarter implies $700 million, $750 million of workforce rebalancing charges. Can you talk about the payback on those efforts, the timing on the execution and when we should start to expect that to flow through?

Yes, sure. If you look at the overall view, I would use the 2010 as kind of a guide here. Now this year, it could be a little richer than that, as you correctly pointed out. On a full year basis, the vast majority is going to be spent outside the U.S. So we'll have slightly longer payback periods. But in the dollars that we spent on workforce rebalancing at the first quarter, we expect that to payback in the year. So I think we have a good plan. We still have a lot of work to do. We just signed a deal. We've got a lot of work to do if you get to closing that deal. But I think I would use that as kind of a guide on the workforce rebalancing charges. So let me now just take a few moments to wrap up the call. From my perspective, the first quarter had a similar characteristic to the fourth and was a strong start to the year. We had great margin and profit and cash performance and continued the momentum in all of our growth initiatives. Remember, last quarter, I said that in 2012, we'll take a number of actions that position us to achieve our 2015 roadmap objective, including acquisitions and divestitures, investing in key growth initiatives and rebalancing our workforce to where we see the best opportunities. In the last 90 days, we've made great progress. We have a couple of strategic announcements that demonstrate our focus on higher value and ongoing transformation of our business. Our PureSystems announcement is a result of $2 billion of R&D and leverages decades of technology innovation and know-how. It's a new platform, and we believe it's a game-changing event for our clients. And we announced today a strategic partnership with Toshiba TEC that better positions us to address the important Smarter Commerce opportunity. So all of this gives us confidence to take up our expectation for the full year to at least $15 of operating EPS for the year. That's up almost 12% from last year and puts us on a good track to deliver at least $20 in 2015. So thanks for joining us. And now, as always, back to work.