International Business Machines’ (IBM) CEO Ginni Rometty on Q3 2014 Results – Earnings Call Transcript

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 – SVP and CFO

Thanks Patricia. We’ve a lot to cover today, our third performance, actions that accelerate the transformation of our business, including important announcements that impact our results and the basis of our reporting, our 2014 guidance and what it means as we move into 2015. Let me start with the top level results.

We reported revenue of $22.4 billion, which is down 4% or 2% at constant currency, excluding our customer care divestiture. We delivered operating net income of $3.7 billion and earnings per share of $3.68, all excluding the discontinued semiconductor manufacturing business. These results fell short of our expectations and I would attribute the shortfall to three primary drivers.

First, our software revenue was weaker than expected. We had some sales execution issues and in addition we’ve made it easier for our clients to manage their IBM software capacity across new and more traditional workloads as they invest in our platform for the longer term. I’ll expand on this later.

Second, we didn’t get the productivity required in our services business, impacting both our profit and margin and third, the environment including currency isn’t helping.

With a sharp movement in currency rates in September, there was some effect in the quarter and we expect it to have a larger impact going forward and for the business overall, we did see a slowdown in September, which had a particular impact on us given the skew of our transactional business.

I’ll get into the details of the quarter shortly, but let me first describe the actions we are taking and put them into context. For some time now, we’ve been clear about our strategic direction and how we address the market shifts around data, cloud and engagement. All of this year, we’ve been launching initiatives and making significant investments to drive this shift.

We’ve been very successful, with strong revenue growth in our strategic imperatives and you’ll see in our third quarter results that the strategic imperatives again delivered double-digit revenue growth, but some of these fundamental shifts in the industry are happening faster than we planned.

So we’re putting in place a series of actions to accelerate our transformation. I want to address these right up front. First, we’re continuing to remix to higher value. We just took a bold step in our transformation going fabless with the divestiture of our semiconductor manufacturing business.

We have world-class technologist and intellectual property, but this is a capital intensive business, which has been challenging for us without scale. With future node progression and the potential transition to larger wafer sizes, the capital requirements will substantially increase.

Global foundries will acquire our Microelectronics business and will become the semiconductor technology provider for our future systems. This agreement leverages the strength of each company.

IBM semiconductor and material science research, development capabilities and leadership in high end systems and global foundries leadership in advanced technology manufacturing at scale and commitment to delivering future semiconductor technologies enabling them to address new business opportunities.

With global foundries operating at scale, we’ll get supply at market based pricing for the long term and we’ll exit a business that was not only capital intensive, but also a drag on our profit. Clearly, this is the right move for our business for the long term.

Also in January, we announced the sale of our x86 business to Lenovo and earlier this month, we completed the initial closing. This was a $4 billion business for us in 2013 with effectively no annual profit.

With the transaction, IBM and Lenovo have formed a strategic alliance, which includes an agreement for Lenovo to resell selected IBM storage and software products and to ensure a smooth transition for our clients, IBM will provide x86 related maintenance on Lenovo’s behalf.

We’ll continue to remix our portfolio by investing in higher value areas and making decisions on businesses that no longer support our high value strategy. Second, we’re implementing changes that make it easier to consume our capabilities and innovations and increase our agility.

We’re creating vertically integrated units to address key growth areas. As we did with Watson earlier this year, we’re creating a dedicated business unit for cloud and other integrated units to address growth areas like security and smarter commerce.

This enables more focused investment and improves our integration and speed in bringing solutions to the market and with our clients.

We’re also providing more flexibility to clients in the way they buy our software. Specifically, we’re accelerating investments to make our software more directly consumable through digital channels, but we’ll have an end-to-end digital sales and marketing channel, which will improve our reach.

Third, we’re taking additional actions to simplify our structure and accelerate productivity. For example to improve productivity and services, which at the same time providing greater value and innovation to our clients, we’re implementing a number of actions.

These include accelerating the use of automation in our data centers and being more aggressive in our use of global delivery skills and intellectual property across our service lines. Let me tell you what these actions do for our financial model.

In the near term, our revenue will be down, not surprising since the three divestitures this year represent about $7 billion of revenue with pretax losses of about $500 million. So clearly we’ll have improved margin profile.

These actions also free up our spend and capital to be reinvested to areas that will accelerate our transformation and these allow us to continue to provide very strong returns to our shareholders through dividends and share repurchases.

All of this is consistent with our strategic directions and while there are impacts in the short term, we’ve improved our position for the longer term.

I want to spend a minute on the high level financial implications of the two most recent transactions. We’ve posted additional information in two articles on our Investor portal.

For the System x business, as I mentioned, this was over a $4 billion business for us last year. Though the business is breakeven on an annual basis, the transactional skew would have driven profit in the fourth quarter.

Starting in the fourth quarter this year, we’ll no longer have the System x hardware revenue and profit and the related maintenance will be at a lower revenue and profit level, reflecting the new relationship. At an IBM level, this will result in about a four point impact of revenue growth over the next four quarters, but an improved margin profile.

Our fourth quarter results will include the gain on sale associated with the countries closed net of related transaction and performance based cost. This net gain, as well as the operational profit we lose in the fourth quarter will be included in our view of the full year, which I’ll talk about later in the call.

Free cash flow will be impacted by two items, accounts payable for the balances at closing as well as the future procurement IBM will perform on Lenovo’s behalf and for cash tax payments made in 2015.

We estimate this will be a use of cash of approximately $0.5 billion in the fourth quarter and another $0.5 billion in 2015.

Turning to the Microelectronics business, the 2013 OEM revenue associated with the divested business was $1.4 billion and our STG segment included pretax losses for this business of over $700 million.

This is being reported as a discontinued operation. In the third quarter disc-ops will include both losses from the ongoing operations of about $90 billion after tax and a one-time after tax charge of $3.3 billion, associated with the transaction.

The transaction had no impact to free cash flow in the third quarter. Now let me spend a minute on the reporting structure.

All of our results obviously start with GAAP, which is in the middle of the chart. To the left is a reference to our prior definition of operating results, which we introduced a few years ago to provide a better perspective on the operational performance of our business. This presentation excluded non-operating retirement related and acquisition related items.

Operating results is the basis of our 2015 roadmap objective and we’ve provided a view of our results on this basis since 2011. This definition of operating results no longer exists.

Now moving to the right side of the chart, with the reporting of our Microelectronics business as a discontinued operation, all of the financial impacts of that business are lifted out of each line of our P&L and reported in one line, loss on discontinued operations net of tax.

Starting in the third quarter, our GAAP P&L will be on a continuing operations basis. We’ll make the same non-operating adjustments to determine our operating results. Then are operating results definition will now be continuing operations basis. This is the basis for our third quarter and year-to-date results, all historical periods presented and our guidance for the fourth quarter and full year.

So now let me get into the third quarter results and again, these are all operating results, which exclude the discontinued operations. We delivered $3.7 billion of operating net income on revenue of $22.4 billion. Revenue was down 4% or 2% at constant currency, excluding the divested customer care business.

On that constant currency basis services was flat, our software segment declined 2% and systems and technology revenue was down double-digit. 90 days ago, we expected that currency would be a modest help to our revenue growth, but in September we saw a sharp move in the currency markets. I’ll talk more about currencies later.

Our margins were down with weak hardware performance and insufficient productivity and services. We had a tax headwind of three points year-to-year and we generated $3.7 billion of net income in the quarter. On the bottom line, we reported operating EPS of $3.68, which is down 10%.

Looking at our free cash flow, we generated $2.2 billion, which was relatively flat year-to-year.

Turning to revenue by geography, when you look at the year-to-year performance at constant currency, major markets decelerated two points from last quarter and growth markets one point. These results aren’t normalized for the customer care divestiture. Both major and growth markets are impacted by a point of growth, consistent with last quarter.

As I mentioned earlier, we saw a deceleration in September. This is true in nearly all regions and was most pronounced in our growth markets that have a higher transactional content. Within the growth markets, we again had double-digit growth in Latin America, led by Brazil and good growth in the Middle East and Africa region.

I think it’s important to understand the impact of the System x divestiture on the geographic results going forward. Given the geography mix of that business, major markets growth will be impacted by about three points and growth markets by about nine points.

Reporting our divested semiconductor business as a discontinued operation will adjust the OEM revenue, but not impact the geographic results.

Turning to the segment perspective, I’ll cover the revenue drivers when we get into the segment discussions. Looking at the gross profit in total, our operating gross margin was down 90 basis points driven by margin declines and systems and technology and in both of our services segments.

The six point decline in systems and technology was due to a combination of lower margin across the brands and a mix away from higher margin z due to the product cycle.

In global technology services, we did get the savings from the workforce rebalancing actions we took earlier in the year and we continue to make investments in capacity and skills, but we didn’t get the base productivity we had planned through automation and the transition on some new contracts took longer than expected.

In global business services, we had strong growth with good margin performance in the strategic imperatives, but in the more traditional back office implementations, we continue to see price pressure.

Our total operating expense and other income was up 2% year-to-year. Acquisitions over the 12 months drove two points of expense growth and currency drove one point. The base expense, which is total expense less the impact of acquisitions and currency was essentially flat.

Within our base expense, we’ve been shifting our spending to drive our strategic imperatives and differentiated offerings and with the actions we’re taking, we’ll accelerate that shift. There are few items that are impacting the year-to-year expense dynamics.

First, we increased our accounts receivable reserves, which impacted expense by over $70 million year-to-year. This coverage is now at 2.2%, which is up from a year ago, but not as high as 2009 levels.

Second, as you would expect; our accrual for 2014 variable compensation is down relative to where we were at the end of the first half. However the reduction in the quarter was not as substantial as last year and so across cost and expense, this element was up $230 million year-to-year.

Finally I want to spend a minute on the impact of currency. The dollar appreciated dramatically in the last several weeks of the quarter and as you know when the dollar appreciates broadly against other currency, it impacts our revenue and earnings.

What is unusual about this is not just the sharp move, but the movements were nearly all in an unfavorable direction for our business profile. We hedge a portion of our cross border cash flows, which as you know differs the impact of the currency movement, but doesn’t eliminate it.

While our hedges are designed to provide stability around the receipt of cash, there no year-to-year benefit in the income statement when a currency’s direction is sustained over a longer period.

Looking at the third quarter, we had a modest impact of profit from currency. However at current spot rates, we would expect a significant impact of fourth quarter and into 2015. Now let’s turn to the segments and we’ll start with services.

This quarter, combined services generated $13.7 billion in revenue, which was flat year-to-year at constant currency adjusted for the customer care divestiture.

Services pretax profit was down 13% year-to-year. Total backlog was $128 million. Adjusting for the divested business and currency, total backlog was down 2% year-to-year.

Global Technology Services revenue was $9.2 billion, down 3% as reported, but up 1% at constant currency, adjusted for the divestiture. In the third quarter we ramped on the SoftLayer acquisition and it continues to attract new workloads to the platform.

We’re expanding our footprint, and in the third quarter we opened cloud data centers in London and Toronto as well as two federal data centers outside of Dallas and Washington DC. We also added cloud capacity in Singapore.

GTS outsourcing grew 2% at constant currency, adjusted for the divestiture. That growth was driven by IT outsourcing performance from the substantial new contracts we brought on in 2013. GTS pretax profit declined 11% in the quarter.

While we continue to benefit from the rebalancing action earlier this year, this was more than offset by the investments across our portfolio in areas like new resiliency centers, additional security skills and the SoftLayer cloud hub expansion.

The loss profit associated with the divested customer care business and we didn’t get sufficient productivity in the base. Part of this is due to the large deals we signed last year, which have lower margins in the early stages and we didn’t execute those transitions as rapidly as expected.

Global Business services revenue was $4.5 billion down 1% at constant currency. Consulting and Systems Integration declined 1% year-to-year and was flat at constant currency.

We had strong double-digit growth in our practices that are highly differentiated in the marketplace, which address cloud, analytics, mobile and social, offset by declines in the areas that are becoming less differentiated such as the more traditional back office implementations.

During our last call, we discussed our strategic partnership with Apple to deliver a new class of enterprise ready MobileFirst business applications for iOS, combining mobility and analytics. This quarter, we will launch the first dozen applications.

Application outsourcing was down 6% at constant currency, reflecting modest sequential improvement. Our performance continues to be impacted by pricing pressure and client renegotiations as well as a reduction in elective projects.

GBS pre-tax profit was down year-to-year. Hereto we got the benefit from the previous workforce rebalancing actions, but it was more than offset by couple of factors. Lower revenue on a relatively fixed cost base and where we have strong differentiation such as our solutions that address the strategic comparatives we get good growth and margin performance.

But in parts of our portfolio that aren’t as well differentiated, we’re continuing to see price and profit pressure. These are the areas where we’ll be more aggressive on the use of global delivery centers and applying intellectual property for faster time to value for our clients and improved business results for us.

Software revenue of $5.7 billion was down 2% and middleware was flat. We had solid growth in many of our solution areas like security and mobile and cloud. Across our software brands, Software-as-a-Service offerings were up nearly 50%. But overall software results didn’t meet our expectations.

First, we clearly had some sales execution issues and second given our client’s substantial investment in the IBM Software platform we’ve been providing more flexibility on how they deploy our software with economics that enable their mobile and social work loads on our platforms.

This enables them to better manage their capacity and commit to our platforms for the long term. This will drive higher utilization of our middleware as these mobile and social platforms drive additional on-premise work load.

Looking at our results by brand, WebSphere had another good quarter, up 7%, but by commerce, mobile solutions and business integration offerings. Both on-premise and SaaS offerings contributed to WebSphere growth, with the majority of growth continuing to come from on-premise solutions.

In commerce we saw broad-based growth with strong momentum in commerce as a service, which includes our recent acquisitions such as Silverpop and Aspera.

Across offer and services, IBM’s mobile business more than doubled from the prior year. Information management software was down 5% where we were impacted by our sales execution challenges and some product transitions.

Tivoli revenue was up 3% at constant currency, driven by security and storage software. Security once again grew at a double digit rate. Workflow solutions grew 1% with growth in our social and collaboration solutions mitigated by decline in notes. Rational software was down 12% facing a tough compare.

Across software, we are transitioning our portfolio to capture growth areas. We continue to drive innovation in our core franchises and we will be accelerating investments to make our software more consumable through digital channels.

Systems and Technology revenue of $2.4 billion was down 15%. This reflects the product cycle of System z, and declines in Power, Storage and System x where both power and storage improved sequentially.

We got a lot done recently, including the initial closing on the sale of our industry standard server business to Lenovo, an agreement to divest our semiconductor manufacturing business to Global Foundries and the introduction of our first OpenPOWER based scale out system.

Looking in our results by brand System z revenue was down 35% now in the ninth quarter of the current product cycle. We continue to innovate on this platform and as an example we have recently made available new analytics offerings for the mainframe to provide real time customer insights. With this, IBM adds new analytic capabilities to the mainframe platform, providing clients with the ability to integrate Hadoop big data.

Power revenue declined 12%, which is a significant sequential improvement in year-to-year performance. We have repositioned power. We introduced scale-out systems based on POWER8 in June, and earlier this month we announced high end POWER8 based enterprise systems. These systems are highly scalable and can handle the most data-intensive mission-critical applications in the industry.

In addition, we saw continued expansion of the OpenPOWER consortium now with over 60 members. Through the efforts of consortium members, we have for the first time introduced a system built on IBM’s POWER8 processor that tightly integrates IBM and other OpenPOWER member technologies including end videos, GPU accelerator technology.

Our System x revenue was down 10% and this of course was last quarter before the divestiture. Storage hardware revenue was down 6%, sequential improvement from the rate in the prior quarter.

We again saw strong contribution from our FLASH systems and our store wise portfolio. This was more than offset by weakness in high-end disk and the continued wind down of our legacy OEM business. We see value in the storage business shifting to software and this quarter, our storage software grew.

We will continue to expand our software defined storage portfolio. So across our systems and technology business, we’ve taken significant actions to reposition our portfolio and maintain our commitment to driving innovation in our high-end systems and storage.

We committed $3 billion of investment in the next era of chip technology as we strengthen our semiconductor research and development and systems innovation with future chip supply coming from an at scale provider.

We repositioned power through creation of our POWER8 systems, which are built for cloud and big data and also made available the POWER8 architecture through the OpenPOWER consortium to build an open ECO system and an IP Play. We are repositioning storage to capture values through software defined environments and we divested our low end System x business

Moving on to cash flow in the quarter, we generated $3.2 billion of cash from operations, excluding our global financial receivables. We invested a $1 billion in Cap-EX and we generated $2.2 billion of free cash flow, which was down 60 million year-to-year. This includes a $300 million year-to-year increase in cash tax payments.

Through the first three quarter of the year, our net cash from operations excluding financing receivables of $8.6 billion was down $700 million year-to-year. Within that, our cash tax payments were up $1.5 billion year-to-year.

We invested $2.8 billion in capital expenditures, which was up about $100 million from last year. This includes about $350 million investment in software. So this was a good example of where we are shifting spending in the base to new areas. The free cash flow was $5.8 billion down $800 million or up $700 million excluding the impact from cash tax.

Turning to the balance sheet, we ended the quarter with a cash balance of $9.6 billion. Our total assets reflect a reduction of more than $1.5 billion associated with the semiconductor transaction. This concludes a non-cash charge for fixed assets and an increase in deferred tax assets.

Total debt was $45.7 billion, which includes just over $28.5 billion in support of our financing business. We target global financing leverage to be in the range of 7.0 to 7.2 to 1 and we do not have plans to change this model. However, the late quarter impact of foreign exchange on equity was the main driver of the leverage being slightly elevated 7.4 versus our model.

Our non-financing debt was $17.1 billion and our non-financing debt to cap was 62%. While the semiconductor manufacturing divestitures does not affect that levels it does impact equity by approximately $3.3 billion resulting in a seven point impact of the debt to cap ratio. At these levels we continue to have the financial flexibility to support our business over the long term.

Before we ramp up, I want to spend a minute on the performance of our strategic imperatives that address the areas of data, cloud and the way our clients are engaging.

We have a broad analytics portfolio that helps our clients to extract value from their data. This is a large business for us with revenues last year of $16 billion.

Through September our business analytics revenue was up 8% this year with the strongest growth coming from GBS. Our cloud portfolio support the full scope of enterprise client cloud requirement including solution for private clouds, hybrid clouds and public clouds. Our revenue was up over 50% year to date.

Our as-a-service component was up over 80% and we existed the third quarter with an annual run rate of $3.1 billion. Addressing engagement on year-to-date basis, our mobile revenue more than doubled, our social offerings returned to growth with double-digit growth in the third quarter and our security revenue was up over 20%, marking the eighth consecutive quarter of double-digit growth and security. Together the revenue in our strategy imperatives was up double-digits and about half of the content was in software.

Now let me bring all of this back together. As I mentioned earlier in the call, we’re driving the shift toward our strategic imperatives. Earlier this year, we created a Watson Unit and committed a $1 billion to bring Watson cognitive capabilities to the enterprise.

We launched the BlueMix. We’re globally expanding our SoftLayer cloud data centers and we formed a partnership with Apple for enterprise mobility. Now as we exit the third quarter, we’re making it easier to do business with us, including creating vertically integrated units to address key growth areas and making our software more consumable through digital channel.

We’re taking additional actions to drive more productivity and increase the agility of our company and while we invest the drive for the growth areas, we’re also aggressively moving away from the businesses that don’t fit our strategic profile.

The sale of our x86 business and the divestiture of our Microelectronic business are the two most recent examples. Earlier this year, we divested our Customer Care BPO business and as I mentioned, the revenue from these three businesses were $7 million in 2013 and in aggregate, they incurred of pretax loss of more than $500 million, all supporting the shift to higher value.

So let me spend a minute on our view of the full-year. As I said earlier, our operating results are moving to a continuing operations basis. So they exclude the financials associated with the semiconductor business in the current and prior periods.

So when we reflect the discontinued operations in the base, our full-year 2013 operating EPS was $16.64 versus $16.28 based on the prior definition. Within this new operating definition, we’ve considered a number of items in our guidance for 2014.

First we have completed the initial closing of the sale of our System-X business and as we said, we will no longer have the revenue and profit associated with that business. But in the fourth quarter we will report a gain on the sale, net of related deal and performance based cost.

That net gain will contribute about $0.75 of earnings per share, but that does not reflect a loss profit in the fourth quarter. Additionally, as we execute some of our plans to drive simplification and accelerate productivity in our business, we expect to take a workforce rebalance charge in the fourth quarter.

We are striating to work through our plans, but at this point, we would expect to take a charge of up to $600 million. We’ve also had a dramatic move in currencies. We’ve taken into account an impact based on current spot rates. We will see how that plays out.

And of course we’ve considered the rate and pace of business coming out of the third quarter including the environment. As I noted, we saw slowdown in September in the fourth quarter as our largest transaction quarter.

Put all of this together and we expect full year 2014 operating EPS to be down between 2% and 4% and that’s off of last year’s computable base of $16.64.

Given that reduced outlook for earnings, we see a comparable impact of free cash flow for the year. As I mentioned, we can estimate the x86 divestiture impact at about $0.5 billion in the quarter and so with that included, we see free cash flow for the year between $12 and $13 billion at this level of income. Of course this doesn’t include the gain from the divestiture.

Looking forward to 2015, we’ve always considered a few factors as we look at the progress toward our 2015 objective. The trajectory of the business including the macro environment, the investments we need to be successful over the longer term in enterprise IT and our return of capital to shareholders. Two of these have now changed. The trajectory of the business and the timing of investments we need to make.

Of course it remains a priority to return significant value to our shareholders through dividends and share repurchases. Given our third quarter performance, the actions we’re taking and with only 15 months till the end of 2015, we longer expect to deliver $20 operating earnings per share in 2015. As is our practice, we will provide our view of 2015 in January.

In the mean time, we have a clear and compelling strategy and we’re accelerating our implementation. We will continue to manage our business for the long term and we will absolutely continue to return significant value to our shareholders.

Ginni I look forward to your questions.

Patricia Murphy – VP, IR

Thank you, Martin. Before we begin the Q&A, I would like to mention a few items. First we have supplemental chart at the end of the slide deck that provide additional information.

As Martin mentioned earlier, we’ve also posted articles to our Investor website that contain additional information on the two transactions discussed today. Second I would ask you to refrain from multipart questions. And finally I want to remind you that Ginni Rometty has joining today’s Q&A.

Operator, please open it up for questions.

Question-and-Answer Session

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