International Business Machines Corp (IBM) — Q3 2018 Earnings Call Transcript

Thank you. This is Patricia Murphy, Vice President of Investor Relations for IBM, and I’d like to welcome you to our third quarter earnings presentation. I’m here today with Jim Kavanaugh, IBM’s Senior Vice President and Chief Financial Officer. Our 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 also 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 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. So, with that, I’ll turn the call over to Jim.

Thanks, Patricia, and thanks to all of you for joining us. In the third quarter, we delivered $18.8 billion of revenue, $3.6 billion of operating pretax income and $3.42 of operating earnings per share. And over the last 12 months, we generated $12.2 billion of free cash flow with realization over 100%. As compared to last year, our revenue was flat at constant currency though down 2% with the impact of the stronger dollar. Gross profit margin was flat, which is the best year-to-year performance in years. The improvement was led by services margin expansion. We expanded our overall operating pretax margin and we grew operating profit and earnings per share. We continue to see strong client demand in the emerging high-value segments of the IT industry. And our performance this quarter was driven by the offerings in hybrid cloud, security, digital, and analytics and AI, a testament to our ability to deliver differentiated value to our clients through innovative technologies with the skills and expertise to implement these technologies. We see the results in our strategic imperatives revenue growth of 13% over the last 12 months. We also see this playing out in higher operating margin over the last few quarters, which supports both our long-term investment and return to shareholders. With our success in these higher value areas and our focus on delivering consistent operational performance, we remain on track to our full-year expectations of earnings per share and free cash flow. Coming into the second half, we said we expected to improve our services revenue trajectory and to expand total services margins for the half. We also said we faced some headwinds as we wrap on the new mainframe launch and our strongest software performance in the third quarter of last year. And so now this quarter, we delivered revenue growth and gross margin expansion in both services segments. In global business services, our revenue growth accelerated, driven by consulting as we help clients with their digital transformations. And we grew revenue again in Technology Services and Cloud Platforms, driven by hybrid cloud implementations. In systems, our IBM Z revenue grew, despite a wrap on new mainframe launch, resulting in what is now the most successful Z program in our history. In software revenue, we had growth in integration software, driven by offerings that help clients modernize applications and enable hybrid cloud adoption. In solution software, we had good performance in several areas including security, key offerings and analytics like data science, and our Watson health verticals, as we embed AI into more of our offerings. We continue to deal with challenges in a few horizontal solution areas and a tougher compare in transaction processing software, both of which impacted overall software revenue growth. Across our segments, our strategic imperatives revenue has grown to $39.5 billion over the last 12 months. Within that, our cloud revenue is $19 billion, and we exited the third quarter within an as-a-service annual run rate of $11.4 billion, which again was up 24%. While that’s already a significant revenue base in the emerging high-value segments of the IT industry such as cloud and AI, it’s still early in the adoption of these technologies.

Thank you. Jim, I guess, when I think about this quarter, there were multiple cross currents that IBM dealt with across the portfolio. So, I guess, it would be helpful just to hear how you would characterize IBM’s performance in the September quarter versus what you guys were expecting 90 days ago, and importantly the sustainability of some of the trends that you’re seeing, especially on gross margins, which were flat on a very difficult compare I think versus last year. And then, on the other hand, you had Cognitive was down somewhat more than I thought. So, if you could maybe just characterize the performance and sustainability of some of these trends versus what you thought 90 days ago, that would be really helpful for us.

Okay. Thanks, Amit. And it’s a good place to start here talking about the characterization of our quarter, now that we’re through three quarters of 2018. But, I guess from my perspective, I would say, first, we had a solid quarter. We delivered $18.8 billion of revenue, which was consistent with our guidance of a typical quarter-to-quarter seasonality, even in light of a strengthening U.S. dollar, which continues to go against us. But, the headline overall would be, we fundamentally have taken the actions to reposition our business entering 2018. You see that playing out as we enter the second half where we grew operating profit, we expanded operating pretax margins by 50 basis points, we grew EPS 5% consistent with the first half, and we continue to drive strong free cash flow realization to deliver value back to our shareholders. Now, some of the underpinnings behind that. One, we still see strong demand in key high-value segments, and you see that play out in our third quarter performance, and we think that will continue moving forward. Areas like hybrid cloud where we’re winning with our hybrid cloud value proposition to the marketplace, data and AI, security, digital, all of these are instantiated in our strategic imperatives, which now from a trailing 12-month perspective were at $39.5 billion, pretty close to that $40 billion target that we put in place well over three years ago. Today, we’re roughly at 50%. That’s a massive transformation over a period of time. And that’s led to significant improvement in trajectory of our revenue growth overall, whereas year-to-date we’re up 2%. But underneath that you see some of the areas of growth around cloud, $19 billion, growing 20%. And within that, it’s being driven by our high-value as-a-service content, driving our cloud component. That’s up now to $11.4 billion on an annualized exit run rate, growing consistently at 24%. But, if you put all that together, yes, we’re seeing the underlying fundamental shifts of our top line. We’ve done the tough work to transform our portfolio. But really, what I would call as an inflection point as we enter the second half of the year is what’s happening with our operating leverage. And you see that play out in our gross margin performance, which is the best we’ve had year-to-year in over three years. Now, let’s talk a little bit about that, because each of you is analyst; and more importantly, as I go out and meet with many of our investors, it is a very critical signpost in a high-value-based business model. And they’ve been talking about our gross margin performance and when are we going to stabilize and how are we going to get back to expansion towards our model. We knew we had headwinds coming into the second half, predominantly around mix, mix around our successful mainframe launch but also mix is starting to hurt us from a currency perspective as we talked at length 90 days ago on how currency and the strengthening of dollars is actually hurting our product-based businesses in hardware and software. We delivered both units back to growth, we actually delivered 160 basis points of margin improvement year-over-year. That’s the best year-over-year in our services business in over five years. And we see that continuing and we expect that to continue to accelerate as we move into the fourth quarter. So, you combine that margin with our continued enterprise productivity, and you see that we’re able to deliver strong operating pretax margins, and you couple that with our strong free cash flow which on a trailing 12 months is still in excess of $12 billion and free cash flow realization over 100%. And that gives us confidence to reaffirm our expectation of at least $13.80.

Good afternoon. Jim, I want to get your early thoughts as you think about planning for next year, in particular because you face a number of headwinds, services backlog is down, the mainframe comps get more difficult, the dollar is strong, and there are questions about what tariffs do to demand. So, in the context of all those headwinds, can you talk about what some of the offsets are as you start to plan for 2019? Whether there is a potential to continue to grow PTI as you go into next year, even as some of these headwinds don’t?

Thank you for the question. We still have a lot of work ahead. We are currently 16 days into a crucial fourth quarter and are committed to achieving consistent operational performance to provide value for our clients and shareholders. We will provide guidance updates in January. Let me outline what we perceive as the trajectory of our business considering the potential challenges and opportunities as we move forward. To begin with, concerning services, as we entered 2018, we noted an improved position on our backlog for the near term, and that trend has continued throughout the year. This is a result of taking decisive actions to reposition our services business and leverage a unique services model to tap into growth opportunities in digital, cognitive, and cloud sectors. In our GBS business, we've seen continued progress with revenue acceleration through the third quarter, benefiting from our hybrid cloud value proposition and the value clients see in our established presence. Looking at our outsourcing backlog, it was around 25% of a $90 billion backlog previously. Now, exiting the third quarter, that backlog has increased to approximately 32% to 35% cloud content. We are seeing positive developments in both of our services businesses. However, we do have a significant fourth quarter for signings, and we fell short in the third quarter. While signings can fluctuate, we are optimistic about the fourth quarter with a robust lineup of deals over $100 million that puts us in a strong position in our services business as we approach year-end.

Yes. Thank you. I was wondering if you could talk, Jim, a little bit about free cash flow for this year. You mentioned that it will be greater than 100% of GAAP net income this year, despite the fact that you have some headwinds in cash taxes and higher CapEx, and that number is higher than your longer-term guidance of 90% to 100% realization. So, I’m wondering if you can help us understand what are the positive tailwinds that you’re seeing that are enabling free cash flow to be higher than 100% of GAAP net income?

Okay. Toni, thank you very much. Free cash flow, as we entered 2018, we entered 2018 coming off of a very strong fourth quarter in 2017 where we drew significant working capital efficiency through the launch of our mainframe product cycle. We said in our January call that we expected about $12 billion of free cash flow in 2018 and the drivers of that from 2017 were going to be centered around, one, incremental cash taxes that would be a headwind to us in '18; number two, that we work on a plan on driving that strong working capital efficiency with the introduction of our mainframe as we exit the fourth quarter of 2018. Now, let’s get to free cash flow realization. First of all, we see positive impact to our stated goal of at least 90% free cash flow realization, driven by working capital efficiency, which is driving that free cash flow above 100%. We feel comfortable and expect about $12 billion for the full-year based on any metric I look at in payment wise and our trailing 12 months is at $12.2 billion.

Thank you. Jim, I was wondering if you can talk a little bit about the strategic imperative performance within Cognitive including the cloud revenues and as-a-service, both of which declined versus overall strategic imperative growth. Can you maybe talk about some of the puts and takes there and some color on what do you think drove that client buying seasonality that you mentioned to a prior question?

Okay, Wamsi. Thank you very much for your questions. There is a lot there. But, let me talk about strategic imperatives first. So, as I stated on the call, trailing 12 months, $39.5 billion. We talked about three years ago, we put the signpost out there. At that point, we had $40 billion, but now we’re approaching 50%. We’re growing in mid-teens, 13% over the trailing 12 months. But within that strategic imperatives, our cloud business is at $19 billion right now, up 20%. And the high-value as-a-service component underneath that is up 24%, consistent with where we’ve been in the first half of the year. Now, getting to Cognitive, our horizontal apps are still depressing our revenue. But those three areas are still a function of a secular shift in client value and consumption models to as-a-service. And we’ll see that play out as we get into '19 and throughout '19. So, we see that part of the portfolio continue to improve and we expect with a strong pipeline that we would return IBM software back to an expectation of modest growth in the fourth quarter. And we’ll see as we get through fourth quarter, how that momentum will continue in '19.

Hi. Thank you so much for taking my question. I wanted to ask about Technology Services and Cloud Platforms. A little less focused on Q4 but more focused on the outlook say for CY '19. The simple question is, can it grow? The backdrop to the question is, your backlog is down a little bit, but I think your duration is also down. But against that context, can Technology Services support decline meaningfully this quarter down 3%? With presumably being a harder mainframe cycle next year, can that grow and enable the whole business unit to grow? So, if you could just talk more broadly about the outlook for Technology Services and Cloud Platforms.

Sure. Thank you very much for the question. Remember, within this segment, we’ve got multiple components. You want to get to the services aspect of Technology Services and Cloud Platform. But let me start first with the integration software, which is an essential part of our integrated value proposition around our hybrid cloud strategy, which differentiates us. That integration software is going to be critical moving forward. Now, let’s go to our GTS business. That’s made up of two primary offering segments, one TSS, which has been a drag on us throughout 2018. That is entirely aligned to what our expectations would have been with a mainframe product launch cycle. But as we start accelerating growth, we’ll see better operating leverage in that segment as we go forward. And we’ll also see our core infrastructure service offering tied back to our overall outsourcing backlog.

Hi. I think you’ve given a mid-single-digit long-term growth target in Cognitive Solutions. Is that still a target and can you hit it in '19? How do you feel about the portfolio at this point? Could you be divesting other pieces?

Yes. Thanks, Joe. I appreciate the question overall. Our model is mid-single-digit growth. We believe we’ve got the right portfolio for that. But as always, portfolio optimization has been a critical strategy to our overall business model. We’ll continue to evaluate that, and we’ll update you in 2019 on where we’re at.