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International Business Machines (IBM) Earnings Report: Q1 2016 Conference Call Transcript

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The following International Business Machines (IBM - Get Report) conference call took place on April 18, 2016, 05:00 PM ET. This is a transcript of that earnings call:

Company Participants

  • Patricia Murphy; IBM; VP of IR
  • Martin Schroeter; IBM; SVP & CFO

Other Participants

  • Tien-tsin Huang; JPMorgan (NYSE:JPM); Analyst
  • Toni Sacconaghi; Bernstein; Analyst
  • Katy Huberty; Morgan Stanley (NYSE:MS); Analyst
  • David Grossman; Stifel Nicolaus; Analyst
  • Lou Miscioscia; CLSA Limited; Analyst
  • Steve Milunovich; UBS; Analyst
  • James Schneider; Goldman Sachs (NYSE:GS); Analyst
  • Amit Daryanani; RBC; Analyst
  • Jim Suva; Citigroup (NYSE:C); Analyst
  • Wamsi Mohan; BoA Merrill Lynch; Analyst

MANAGEMENT DISCUSSION SECTION Operator: (Operator Instructions)

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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. Ma'am, you may begin. Patricia Murphy (VP of IR): Thank you. This is Patricia Murphy Vice President of Investor Relations for IBM. I'm here today with Martin Schroeter, IBM's Senior Vice President and Chief Financial Officer. I'd like to welcome you to our first-quarter earnings presentation. The prepared remarks will be available within a couple of hours, 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 and 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 of the presentation and in the Form 8-K submitted to the SEC. Before turning the call over to Martin, I want to remind you that at our investor briefing in late February, we discussed a number of changes to our management system and our organizational structure. As a result, our segment reporting structure has been updated to reflect our business structure. We provided two years of historical financial information by quarter on these segments a few weeks ago. This can be found on our investor website. Today, we'll be discussing our first-quarter results in this new segment structure. In addition, you'll see that we've updated our earnings presentation slides not only to address the new segment structure but also to provide additional disclosure on our strategic imperatives and to provide more commentary on the business drivers. So with that, I'll turn the call over to Martin Schroeter. Martin Schroeter (SVP & CFO): Thanks, Patricia. Again this quarter, we made a lot of progress in transforming our business and we got done what we set out to do to start the year. We delivered $18.7 billion in revenue, $2.3 billion in net income, and operating earnings per share of $2.35. Importantly, we also made significant investments and took significant actions to accelerate our transformation and move our business into new areas. Our enterprise clients are looking to get greater value from their data and their IT environments. They're not just focused on reducing costs and driving efficiency but using data to improve decision making and outcomes. They are looking to become digital enterprises that are differentiated by cognitive. Our strategy is based on the point of view that this requires a solutions focused, industry expertise, and innovative technology, all supported by leading edge skills. And so to move our clients to the future, we've been making significant changes to our business. We're not only transforming our existing businesses, but building new markets and addressing new opportunity areas. We're creating cognitive solutions that marry digital business with digital intelligence. We're bringing our industry expertise together with these cognitive solutions, and we're building it all on cloud platforms. And because we're running our clients' most critical business processes today, we're in a unique position to move them to the future. We've been shifting investments and resources and as we move our business forward, we've also changed the way we run the business to be more aligned with these opportunity areas. We have proof points that we're making progress. This quarter, we continued our pattern of strong double-digit growth in our strategic imperatives. This revenue was up 17% at constant currency, which is consistent with our performance in the fourth quarter and continues to be substantially faster than the market's growth. I'll talk about our revenue results on a constant currency basis throughout the presentation.


So now over the last 12 months, strategic imperatives delivered $30 billion in revenue, which represents 37% of our total revenue; that's two points ahead of where we were 90 days ago. In the quarter, our total cloud revenue grew 36% to $2.6 billion with the as-a-service components growing 46%. Our annual run rate for the as-a-service revenue is now $5.4 billion. Our analytics revenue grew 9% on a large base. You'll recall it was an $18 billion business for us last year. And mobile and security each posted strong double-digit growth.

As we transform our business and move into new areas, we need to transform our workforce, not only the types of skills but how we operate. This quarter, we took significant actions to transform our workforce and shift our skills base to new areas and to improve our structure primarily outside the US. This resulted in a pre-tax charge of just under $1.5 billion. As we discussed in late February, we also had a tax refund in the quarter of $1 billion plus interest. And so the amount of the tax benefit was essentially equivalent to the charges on an after-tax basis. It's important to recognize that these actions are impacting our profit and margins this quarter while improving our position for the future. We're continuing to invest and to add capabilities to build out our cognitive and cloud platforms. I'll comment in a few items from just the first quarter alone. We completed the acquisition of The Weather Company's digital assets. This is not only a source of valuable weather data but a high-volume, cloud-based, inside-driven platform. We're bringing this together with our organic launching capabilities to form the basis of our Watson IoT platform. This quarter, we announced a number of partnerships with companies including VMware to accelerate the adoption of enterprise hybrid clouds and GitHub to advance the development of next-gen cloud applications for enterprises. And we've brought Swift to the cloud, enabling mobile developers to build end-to-end mobile hybrid apps. We've integrated a portion of our software business into our cloud business, and all of IBM's relevant software is now on the IBM cloud. We acquired UStream and will bring it together with SoftLayer and our object storage capabilities to extend our leadership in cloud video services. At the end of the quarter, we announced the acquisition of Bluewolf, a top salesforce partner and leader in cloud consulting and implementation services. GBS was already the largest digital design agency, and this quarter we extended our capabilities with the announcement of three acquisitions that will be integrated into IBM Interactive Experience. We're continuing to expand our Watson ecosystem and reach. Over the last 12 months, the number of developers using Watson APIs is up over 300%, and the number of enterprises we've engaged with has doubled. Watson solutions are being built, used, and deployed in more than 45 countries and across 20 different industries. And this quarter, we significantly added to our Watson Health platform with the acquisition of Truven, a leading provider of cloud-based healthcare data, analytics, and insights. This was announced in February and closed just over a week ago. I'll expand on these solutions and go into more detail on our strategic imperatives performance in the segment discussions, but first I'll turn to our financial metrics for the quarter. Our revenue for the quarter was $18.7 billion. Currency continues to be a headwind to our reported revenue performance, over 2.5 points this quarter. This is 0.5 point better than the low end of the range we provided in mid-January, or about $90 million translation benefit. On a constant currency basis, our decline of 2% is consistent with last quarter. Now within that 2% decline when you consider the impact of the mainframe cycle and the additional content from acquisitions this quarter, our underlying revenue growth rate improved by 2 points versus the prior quarter. From a geography perspective, our performance in the Americas was consistent with last quarter, with improvement in the US and decline in Latin America driven by Brazil. We've built a strong business in Brazil over the years, though the last few quarters have been more volatile. This quarter, Brazil was down in part due to a tough compare but also an economic environment that looks uncertain. We've taken some action to refocus our business, which impacts our growth in the short term. EMEA posted a modest decline while Asia Pacific grew for the first time in quite awhile. Our gross margin performance reflects higher levels of investment and a mix impact within our segments. Our systems margin was up consistent with the product cycle dynamics in our zSystems as well as improvements in power and storage. You can see our expense was up significantly driven by charges for the actions to accelerate the transformation of our business. These charges impacted pre-tax income by a $1.5 billion and pre-tax margin by 8 points in the quarter. I'll talk more about the charges and implications to the future later.


Our tax rate for the quarter reflects an underlying rate of 19% as well as the benefit from the resolution of a tax case outside the US. This was a discrete item and drove our tax rate negative. From a cash perspective, we generated over $2 billion of free cash flow in the quarter, about half of that coming from the tax benefit.

Over the last 12 months, we've generated over $14 billion of free cash flow and this is 110% of GAAP net income. Given the seasonality of our cash flow, it's best to look at realization on that trailing 12-month basis, and in the last year, we returned about two-thirds of our free cash flow to shareholders through dividends and gross share repurchases. With the changes we've made to our management system and organizational structure, we've implemented a new segment structure. As Patricia mentioned, we provided historical information on this segment structure a few weeks ago. Before getting into results for this quarter, I want to spend a minute on the structure. Our segment discussions will also be a little longer than as typical to address the drivers of performance on this basis and the progress we're making in moving our business to the future. So looking at the segments, Cognitive Solutions includes the solutions software addressing many of our strategic areas including analytics, security, and social, as well as the transaction processing software. Many of these are new opportunity areas like Watson Health and Watson IoT opening up revenue and profit pools beyond traditional IT. Because we're building new businesses in new markets, they will ramp over time. The scope of our Global Business Services segment overall is unchanged, though we are now providing our revenue results for consulting, global process services, and application management which is aligned with the way we're now organizing and going to market. GBS has been shifting its business toward the solution areas including creation of a cognitive consulting practice, and earlier this year, GBS strengthened its industry capabilities. As we bring the industry expertise together with cognitive solutions offerings, we'll put more focus on the combination of these two businesses, which we refer to as cognitive solutions and industry services. Technology Services & Cloud Platforms includes our global technology services business and IBM's cloud infrastructure and platform capabilities. This business now includes WebSphere and related software products reflecting the importance of integration software to the enterprise grade hybrid clouds. Systems includes our hardware offerings of zSystems, power, and storage, and now also the related operating system software. Global Financing is unchanged consisting of client and commercial financing and used equipment sales. Now as we've said, the primary driver of the changes to our operating structure and subsequently our segments is the realignment of our software portfolio as software value shifts to new areas. Software is made up of our Cognitive Solutions segment, integration software, and operating system software. We've broken out the revenue and gross profit results within the segments but as we transition to the new structure, we'll also provide a perspective on total software. I'll talk about it after going through the four segment discussions and we've also provided information in our supplemental charts.

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Given the solutions nature of our offerings, our strategic imperatives are included in each of our segments and so going forward, we are providing additional information on the strategic imperatives revenue within each segment. So now let's turn to the segment performance and I'll start with Cognitive. I mentioned that solutions software includes analytics, security, and social. To give you some context, analytics is the largest part of our solutions portfolio and includes our traditional analytics platform, industry solutions, commerce, and the Watson related businesses. Transaction processing software, on the other hand, primarily runs mission-critical systems in industries like banking, airlines, and retail. This includes our offerings such as CICS, TPF, and IMS running on zSystems which were primarily reflected in other middleware in our previously reported software segment. Most of it is on-premise and annuity in nature and not a growing opportunity in the software market. In the first quarter, Cognitive Solutions generated revenue of $4 billion, which was up modestly year to year. Solutions software grew mitigated by a decline in transaction processing software. Our solutions software growth of 3% was a significant sequential improvement from the fourth quarter of last year. Contributing to this growth was strong double-digit performance in our Watson cloud-based offerings and acquisitive content. From an offering perspective, the growth was led by analytics and security. In both of these areas, we have highly differentiated strategies and capabilities.


Security isn't just about trying to keep things out. We approach security as a big data problem. On average today, organizations use 80 security products from 40 different vendors, and they're looking for us to bring all this together. We're in a unique position as we not only provide our own leading capabilities but bring it all together for them in an integrated solution. Security solutions are a mix of on-premise software and software-as-a-service, and we believe we have the largest enterprise security software-as-a-service...


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