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

International Business Machines Corporation (NYSE:IBM)

Q3 2014 Results Earnings Conference Call

October 20, 2014, 08:00 AM ET

Executives

Patricia Murphy – VP, IR

Martin Schroeter – SVP and CFO

Ginni Rometty – Chairman, President and CEO

Analysts

Bill Shope – Goldman Sachs

Katy Huberty – Morgan Stanley

Toni Sacconaghi – Sanford Bernstein

Ben Reitzes – Barclays

David Grossman – Stifel Nicolaus

Steve Milunovich – UBS

Jim Suva – Citi

Keith Bachman – Bank of Montreal

Sherri Scribner – Deutsche Bank

Amit Daryanani – RBC Capital Markets

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 – VP, IR

Thank you. This is Patricia Murphy, Vice President of Investor Relations for IBM. I want to welcome you to our third quarter earnings presentation.

I’m here with Martin Schroeter, IBM’s Senior Vice President and CFO, Finance and Enterprise Transformation. Today we’re also joined by Ginni Rometty. As you know, Ginni is IBM’s Chairman, President and Chief Executive Officer.

First, Martin will go through our prepared remarks and then Ginni and Martin will take your questions. The prepared remarks will be available in roughly an hour, and a replay of the 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 website, 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 – 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.