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

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.

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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.

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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.

GTS outsourcing, one of our core franchises, continue to improve, with revenue growth of 2% at constant currency, adjusted for the divestiture. Revenue growth was driven by the substantial new contracts we brought on in 2013 and we expanded gross margin.

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