International Business Machines (IBM) Q2 2014 Results – Earnings Call Transcript

July 21, 2014 1:55 am | By More

Source: Seeking Alpha

 

International Business Machines Corporation (NYSE:IBM)

Q2 2014 Earnings Conference Call

July 17, 2014, 04:30 PM ET

Executives

Patricia Murphy – Vice President, Investor Relations

Martin Schroeter – Senior Vice President and Chief Financial Officer, Finance and Enterprise Transformation

Analysts

Bill Shope – Goldman Sachs

Toni Sacconaghi – Sanford Bernstein

Katy Huberty – Morgan Stanley

David Grossman – Stifel Nicolaus

Ben Reitzes – Barclays

Lou Miscioscia – CLSA

Steve Milunovich – UBS

Tien-Tsin Huang – JPMorgan

Sherri Scribner – Deutsche Bank

Brian White – Cantor Fitzgerald

Operator

Welcome and thank you for standing by. At this time, all participants are in a listen-only mode. 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.

Patricia Murphy – Vice President, Investor Relations

Thank you. This is Patricia Murphy, Vice President of Investor Relations for IBM. I’m here with Martin Schroeter, IBM’s Senior Vice President and CFO, Finance and Enterprise Transformation. I want to welcome you to our second quarter earnings presentation.

The prepared remarks will be available in roughly an hour, and replay of this webcast will be posted by this time tomorrow.

I’ll remind you that certain comments made in this presentation may be characterized as forward looking under the Private Securities Litigation Reform Act of 1995. Those statements involve a number of factors that could cause actual results to differ materially. Additional information concerning these factors is contained in the company’s filings with the SEC. Copies are available from the SEC, from the IBM web site, or from us in Investor Relations.

Our presentation also 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 of the presentation, and in the Form 8-K submitted to the SEC.

Now, I’ll turn the call over to Martin Schroeter.

Martin Schroeter – Senior Vice President and Chief Financial Officer, Finance and Enterprise Transformation

Thank you for joining us today. Our second quarter and first half results reflect the stability of our overall business model, as we transform the company.

Looking at the dynamics of our portfolio, we’re continuing to drive double-digit growth in the parts of our business that address the emerging trends in enterprise IT. We had stability in our core franchises, where we continue to drive innovation. We’re dealing with secular shifts in parts of our hardware business and as we shift to higher value, we have the impact of a divested business.

Overall, our year-to-year revenue performance improved from last quarter at actual rates and was fairly consistent at constant currency. We expanded margins and we grew earnings per share. The profit dynamics also reflect the actions we’ve taken to transform our business. I’ll get into that shortly.

In the first quarter, you’ll remember that we announced a number of initiatives that support the shift to our strategic areas of data, cloud and systems of engagement. These included the launch of Bluemix, which is our cloud platform-as-a service for the enterprise. It included a $1.2 billion investment to globally expand SoftLayer cloud hubs, and it included a $1 billion investment to bring Watson’s cognitive capabilities to the enterprise.

In the second quarter, we made progress to implement these initiatives, including in June, Bluemix became generally available. We opened new SoftLayer data centers. We started to ship POWER8, and expanded the OpenPOWER consortium. And we completed substantially all of the divestiture of our customer care business.

More recently, we announced additional actions to continue our shift to higher value. You saw last week that we’re investing $3 billion over the next five years in research and in early-stage development to create the next generation of chip technologies. Those will fuel the systems required for cloud, big data and cognitive systems. And just a couple of days ago, IBM and Apple announced a strategic global partnership to provide a new level of business value from mobility for enterprise clients.

The underlying theme of all of this, from the expansion of our cloud platforms and capacity to the OpenPOWER consortium, to the partnership with Apple for enterprise mobility to next generation chip technologies, is that we’re leveraging our unique strengths and innovation, and enterprise capabilities to maintain our differentiation in the emerging areas of enterprise IT. While some of these actions impact our results in the short-term, they better position our business for the long-term.

For the quarter, we delivered revenue of $24.4 billion and operating earnings per share of $4.32. Our revenue was down 2% or down 1% at constant currency, adjusting for the customer care divestiture. We improved gross margin by 10 basis points, the 22nd consecutive quarter of operating gross margin expansion.

Our pre-tax and net margins are up significantly. Last year’s profit base was lower, due to a workforce rebalancing charge of about $1 billion. We took a charge of a similar size in the first quarter of 2014, and so on a six-month basis the charges are fairly neutral to profit growth.

On the bottomline, we reported operating earnings per share of $4.32 in the second quarter, which is up 34% and we generated $3 billion of free cash flow, which is up $300 million over last year.

Let me spend a minute on the first half performance. The revenue performance for the half is very similar to the second quarter. Through six months, we had double-digit revenue growth in strategic initiatives, stable performance in our core franchises and the impact of some secular trends in parts of hardware and from the divested business.

Looking at profit. We expanded gross margin 50 basis points, pre-tax margin by 70 basis points and net margin by 50 basis points. All while shifting investment to key areas. Operating earnings per share for the first half were up 9.5%. We generated free cash flow of $3.6 billion, which is down $800 million, though up $400 million without the higher level of cash taxes we paid in the first half.

So now I’ll get into the details of the quarter, starting with revenue by geography on a constant currency basis. Americas’ revenue was up 1% year-to-year, a 3 point sequential improvement from the first quarter rate. From a regional perspective, the U.S. rate also improved 3 points, and we had another great quarter in our Latin America region. The improvement in the Americas was driven by the strong System z mainframe performance.

EMEA declined this quarter. Within Western Europe, we had continued growth in Germany and Italy, though the U.K. and France were down. Eastern Europe also declined. Our performance in Asia-Pacific was pretty consistent with last quarter. We had another good quarter in Japan, our seventh consecutive quarter of revenue growth in the country. Asia-Pacific, outside of Japan, declined at a double-digit rate.

In total, major markets were down 1%, while growth markets were down 4%. Within the growth markets, the BRICs were up 1%, which is a 7 point sequential improvement from the first quarter rate. The improvement was driven by Brazil, India and China, each up between 9 points and 10 points sequentially.

Brazil grew over 20% year-to-year, driven by large deals in the financial sector and India returned to growth. Our revenue in China was down 11%, effectively halving the rate of decline from the last couple of quarters. So this is a change in trajectory in China, but we haven’t yet seen improvement in the other Asia-Pacific countries. Put it all together, and we had modest sequential improvement in our growth markets performance.

Turning to the segment perspective. Our Services revenue was up 1%, adjusting for the sale of the customer care business. Global Technology Services performance at constant currency was similar to last quarter, with growth in cloud and a ramp in the large outsourcing contracts we signed last year. Global Business Services once again had very strong growth in the practices that address the digital front office, however performance in the globally integrated enterprise offerings lagged.

In Software, middleware is up 3%, while operating systems were down, resulting in modest reported growth for total software. We’re continuing to drive strong results in strategic areas like mobile and security, as well as in some of our core franchises like our app servers and distributed databases. While still down, our hardware year-to-year revenue performance improved significantly from the first quarter rate, driven by our System z mainframe, System x and Storage.

Looking at the gross profit, in total, our operating gross margin improved modestly. The increase was driven by margin improvement in Global Technology Services and an improving mix. This was mitigated by margin declines in Global Business Services and in Systems and Technology.

When you look at gross profit dollars, the year-to-year decline was driven entirely by our Systems and Technology business. Aside from STG, our gross profit is flat, even after a $70 million impact from the divested customer care business, and while we transition to some of the emerging areas, where the profit and margins will benefit from scale.

Our total operating expense and other income was better by 14% year-to-year. Acquisitions over the last 12 months drove 2 points of expense growth. For the last three years, acquisitions have contributed between 1 point and 3 points of expense growth each quarter. Currency drove 1 point of expense growth; so base expense, which is total expense less the impact of acquisitions and currency, was down 17 points.

There is one large item that is impacting the year-to-year expense dynamics. As I mentioned earlier in the call, we had $1 billion workforce rebalancing charge in the second quarter of last year. This impacted the base performance by 12 points. So without the impact of that item, our base expense would have been better 5 points year-to-year. This is a better indication of the productivity in the base.

The other item I’ll mention is the gain of over $100 million from the sale of our customer care business, associated with the country closings we completed in the second quarter. This is in other income and expense. Keep in mind, the divested business removed about $70 million of gross profit.

Within our base expense, we’re also continuing to shift our spending to drive our strategic imperatives and differentiated offerings. The substantial investments we’re making in cloud, which includes Bluemix, in Watson and in chip innovation are examples of this.

Now let’s turn to the segments, and we’ll start with Services. This quarter, the Services businesses generated $14 billion in revenue, which was down 1% at constant currency. This is where we see the impact of the customer care divestiture in the year-to-year results. So adjusting for that divestiture, total services revenue was up 1% year-to-year.

Services pre-tax profit was up 26% and margin improved over 4 points. I’ll discuss the profit drivers within the brand details. Total backlog was $136 billion. We reduced backlog by nearly $4 billion, when we divested the customer care business in January. Adjusted for the divested business, total backlog was down 1% at spot rates.

Global Technology Services revenue was $9.4 billion, down 1% as reported, but up 2% at constant currency, adjusted for the divestiture. SoftLayer contributed about 1 point to GTS revenue growth in the quarter. We’re expanding our footprint, and in the second quarter, we opened a cloud data center in Hong Kong, and followed that with London, earlier this week. We’ll continue to roll out additional capacity in the third and fourth quarters.

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