International Business Machines' Management Discusses Q4 2012 Results - Earnings Call Transcript

| About: International Business (IBM)

International Business Machines Corporation (NYSE:IBM)

Q4 2012 Earnings Call

January 22, 2013 4:30 p.m. ET


Patricia Murphy - VP, IR

Mark Loughridge - SVP and CFO


Bill Shope – Goldman Sachs

Toni Sacconaghi - Sanford Bernstein

Ben Reitzes – Barclays

Steven Milunovich – UBS Securities

David Grossman - Stifel Nicolaus

Rob Cihra - Evercore Partners

Shaw Wu – Sterne, Agee & Leach

Mark Moskowitz – JPMorgan

Keith Bachman – BMO Capital Markets

Chris Whitmore - Deutsche Bank


Welcome and thank you for standing by. (Operator Instructions). Now, I will turn the meeting over to Ms. Patricia Murphy, Vice President of Investor Relations. Ma'am, you may begin.

Patricia Murphy

Thank you. This is Patricia Murphy, Vice President of Investor Relations for IBM. I'm here with Mark Loughridge, IBM's Senior Vice President and CFO, Finance and Enterprise Transformation. Thank you for joining our fourth quarter earnings presentation. The prepared remarks will be available in roughly an hour and a replay of this webcast will be posted to our Investor Relations website by this time tomorrow.

Our presentation 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, and in the Form 8-K submitted to the SEC.

Let me 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.

Now, I'll turn the call over to Mark Loughridge.

Mark Loughridge

Thank you for joining us today. In the fourth quarter, we improved our year-to-year revenue growth rate, primarily in higher margin areas, driving significant margin expansion and profit growth. We delivered operating earnings per share of $5.39, which is up 14% year-to-year and generated $9.5 billion of free cash flow.

For the full year, we delivered revenue of $104.5 billion and expanded gross pre-tax and net margins.
Our operating EPS for the year was up 13% to $15.25 and we generated $18.2 billion of free cash flow. That’s up over $1.5 billion year-to-year.

Now let me put this full year EPS and cash flow performance in perspective. This is the tenth consecutive year of double-digit EPS growth. So a decade at a double-digit pace. And $18.2 billion of free cash flow is $12 billion higher than a decade ago. That’s an increase in the cash flow we generate in a year, not accumulative increase.

Looking at our fourth quarter by segment, our performance was led by continued momentum in our growth initiatives and successful product launches in our high end systems. Both of which drive a more profitable mix. We had another good quarter in software. The performance was broad-based driven by business analytics, smarter commerce and cloud, with strength in several of the emerging areas where we have been targeting our investments like social business, mobile and security. Our new hardware product introductions really performed in the quarter.

We had excellent acceptance of our new mainframe and our System Z revenue was up 56% year-to-year. So it has been a very successful launch. Not only in major markets but in growth markets where we were up 65%. And we had significant growth in our mainframe specialty engines, led by Linux. This is a good indicator not only of new workloads moving on to the platform but also the value of a vertically integrated system.

The year to year revenue performance on our total services business was fairly consistent with last quarter. Once again we had strength in all of our growth initiatives which are becoming a larger part of the business. While IBM’s revenue was down 1% at actual rates, it was up 1% at constant currency adjusting for the divestiture of our retail store solutions business. That’s a 2 point improvement from last quarter’s constant currency growth rate. Consistent with our business model to move to higher value areas, we had revenue growth in our higher margin businesses.

The improving business mix and our productivity initiatives drove 10% growth in operating pre-tax and net income. Now looking at the margin dynamics, we expanded operating gross margins by over two points with improvement across our major segments in a continued mix to software. With our ongoing focus on expense productivity, we improved operating PTI margin by 2.6 points. This quarter our operating tax rate was flat year to year and we continue to expect an operating effective tax rate in the range of 25% for 2013.

Our net income margin was up almost two points and with 12 billion in gross share repurchase over the last 12 months, we reduced our share count by 4%. When you pull this all together, we delivered operating EPS of $5.39 which is up 14%. For the year, operating EPS was up 13% to $15.25. Our strong earnings performance drove $9.5 billion of free cash flow. Terrific performance for the quarter and for the year over $18 billion of free cash flow, a record for IBM.

Looking forward, we are confident in our ability to continue to leverage our business model to expand our margins, grow profit, generate cash, and deliver shareholder value. And in 2013, we expect to deliver at least $16.70 operating earnings per share for the year, keeping us on track to our objective of at least $20 in 2015. Looking at the geographies on a constant currency basis, Americas revenue was up 1% led by terrific growth in Latin America. The U.S. revenue was down 1%, a 3 point improvement in the year-to-year growth rate compared to third quarter. Canada was down 9% off of last year’s very strong growth of 13%.

EMEA’s revenue decline of 3% reflects the macroeconomic climate in the region. It was challenging this quarter in the UK and Germany though we did see an improvement in Italy. Asia Pacific growth improved to 5% led by Japan. Early in 2012, we said that we expected our performance in Japan to stabilize in the second half of the year. And in fact, we returned to growth this quarter. So we had great performance from the team in Japan. Across all of the geographies our growth markets delivered 7 points of outpacing major market by 9 points. The BRIC countries delivered 14% growth, the strongest quarter of the year. Brazil contributed to almost 20% growth in Latin America.

We also had good performance in Africa, led by South Africa and the Middle East. In fact across all of our growth markets, we had double-digit growth in over 30 growth market countries reflecting ongoing broad-based strength.

Turning to revenue and gross margin by segment, year-to-year revenue performance in our combined services businesses was fairly consistent with the third quarter. At constant currency, Global Business Services year-to-year performance improved modestly while Global Technology Services revenue growth slowed a bit. We had good results across our software business with growth in all of the key brands and particular strength and share gains in WebSphere, Lotus and Rational.

In System Technology, we returned to growth adjusting for the divested RSS business. This was driven by powerful performance in System Z.

Turning to gross profit, our operating gross margin improved 2.1 points to 52.3%, driven by a combination of the strong mainframe growth, good margin expansion in both services segments and improving segment mix due to the relative strength of software. Finally, our Global Financing Business delivered over 40% return on equity.

So now let’s take a look at our expense profile. Our total operating expense and other income was down 2%. Acquisitions over the last 12 months drove 2 points of expense growth. Year-to-year benefit from currency translation and hedging moderated this quarter, contributing about a point of expense decline. Consequently, our base expense excluding currency and acquisitions was better by 3 points.

Turning to the expense items that have more significant year-to-year profit impact, I’ll comment on just one item. Our accounts receivable provision was about $20 million in the quarter, an improvement of almost $70 million from last year when we increased the provisions to reflect the European credit environment. Typically, we talk about the impact of our hedging programs as a driver of expense. However, this quarter, there was effectively no period or year-to-year impact on expense due to our hedging programs.

So now let me get into the segments. In the quarter, the two services segments delivered $15 billion in revenue, grew pre-tax profit 4% and expanded pre-tax margin by 1 point. Total backlog was $140 billion, up $1 billion year-to-year of constant currency, driven by growth in the transactional businesses.
From a geographic perspective, the growth markets backlog was up 15% at constant currency. For the year, the combined services business grew profit 10% and expanded margin by nearly 2 points, excluding workforce rebalancing charges in the third quarter.

Turning to the two segments. In Global Technology Services, revenue was $10.3 billion, down 2% as reported and flat at constant currency. There were two major categories within the major markets that affected revenue growth. First, we did a tremendous amount of work to address a number of low margin contracts to improve the profitability of the outsourcing portfolio. We see the benefits of that work in our profit and our margin performance, though it does have some impact on revenue. This quarter, the impact was 1 point of revenue growth to GTS and to services in total.

Second, we saw a decline in revenue from sales and volumes into existing base accounts. This activity tends to be more transactional in nature and economically sensitive. You can see the impact of these in our GTS outsourcing revenue which was down 2% at constant currency.

In outsourcing, we continued to have strong performance in growth markets with revenue up 8% and backlog up 9%, both at constant currency. This backlog growth reflects an ongoing trend as our clients are building out their infrastructures and scaling to meet the growth objectives of their businesses.

In Integrated Technology Services, revenue was up 3% at constant currency with the growth markets up double digits at constant currency. Global Technology Services delivered 5% pre-tax profit growth in the quarter and expanded pre-tax margin by over 1 point. This quarter, margin expansion resulted from increased efficiency and productivity from our focus on automation and processes, primarily through our enterprise productivity initiatives.

Turning to Global Business Services, revenue was $4.7 billion, which is down 3% as reported and down 2% at constant currency. From a geographic perspective, the growth markets turned in solid performance and the recovery in Japan continued as they grew for the second consecutive quarter.
Looking at the GBS businesses by offering, the growth initiatives continue to drive strong performance. We had solid double digit growth in Business Analytics, Smarter Planet and Cloud and for the year, these initiatives now represent over a third of our total GBS revenue. So as we retool the GBS business and mix to higher value work, these larger, more complex engagements are having a positive effect on GBS backlog. In fact GBS backlog has now grown for the fourth consecutive year at constant currency though mixing to longer duration engagements. And as I stated last quarter, we have been taking actions to address the more traditional package application work.

We have added partners to this base and have increased sales capability. We have targeted and closed large transformation opportunities in the growth markets and we have already seen some success in building the backlog in those areas this quarter.

Turning to profit, GBS pretax income was flat year-to-year and pretax margin expanded 0.5 point. Improved utilization and service delivery helped to overcome the impact from revenue. For total services, we are providing you with additional detail around the projected total services revenue run out from backlog in 2013. This includes the impact to revenue from the work we have done to restructure a number of lower margin contracts in our outsourcing business primarily in the U.S.

Now keep in mind that revenue generated from backlog is approximately 70% of total revenue in any year, with the remainder coming from transactional signings in the year and sales and volumes in our existing client base. In 2013, the projected revenue generated from backlog is up 1%. This includes 2% growth from the backlog and 1% [hurt] from those restructured contracts. But despite the impact to revenue growth, these restructured contracts have lifted the profitability of the portfolio. They provide substantial year-to-year growth profit improvement in 2012 which carries through to 2013 and will contribute modest profit growth in 2013 off this higher profit base.

So for total services, as we enter 2013, we will continue to drive our key plays and shift towards higher value content. We will continue to invest in the growth markets, which now represents over 20% of total services revenue and is where we see the most opportunity for growth. We will continue to be aggressive in transforming our portfolio to higher value content and away from the more commoditizing labor based content. Our profit and margin performance will continue to benefit from the work we are doing with research and software to infuse more and more IP into our offerings.

In addition, Services is the primary beneficiary of our focus on enterprise productivity. Overall, we think we have a good set of opportunities to continue to drive profit growth and margin expansion in 2013. Software revenue of $7.9 billion was up 3% of 4% at constant currency. Key branded [middleware] grew 6% at constant currency and gained share as we continue to be the clear leader in the middleware market. We had continued momentum in our growth initiatives with strong performance in business analytics, smarter commerce and cloud. These initiatives cross all of our software brands.

Our results reflect the sustained investments in our strategic branded software. In addition to our organic investments, acquisitions provide additional capabilities while leveraging the existing portfolio of offerings. For example, in the first quarter of 2012 we acquired Worklight, a provider of mobile software which enables enterprises to manage and secure mobile applications. Worklight is now an important addition to our mobile strategy and has accelerated from $1 million a year business when it was acquired, to generating tens of millions for the year. Worklight is just one example of our ability to leverage and grow acquired businesses.

Looking across our software portfolio, we grew the pre-IBM transactional revenue of our 2012 acquisitions by nearly five times. Now let me take you through the revenue drivers from a brand perspective. WebSphere grew 11% and continued gain share. We continue to expand our portfolio to capture the emerging opportunity around mobile computing and saw significant uplift in some of our core WebSphere offerings, such as application servers and commerce. As a result, we are well positioned to continue to help enterprises build, connect, run and manage their mobile applications.

Information management was up 3% at constant currency and held share. We had strong performance in information integration and predictive analytics, both driven by big data. Tivoli software was up 5% at constant currency and held share. Performance was led by our storage and our security offerings. Revenue from our storage portfolio was up 13% at constant currency reflecting the value of storage software. Tivoli Security was up 16% at constant currency, driven by Q1 Labs which provides next generation security intelligence.

We continued to transform the Lotus portfolio to the faster growing social business offerings and consequently, we had 9% growth in Lotus revenue, gained share and had a great quarter. This was driven by strong performance from our existing social business offerings and the recent acquisition of Kenexa, which we closed in December. Kenexa, a leading provider of recruiting and talent management solutions, helps clients create a more efficient and effective workforce and brings a unique combination of Cloud based technology and consulting services to an already extensive portfolio of social business solutions.

Rational posted double digit growth of 12% and gained share. Software had a solid quarter, with revenue up 4% at constant currency, pre-tax income up 8% and pre-tax margins up 2.4 points. The fourth quarter rounds out another good year for our software business.

Systems and technology delivered revenue of $5.8 billion, up 4% adjusting for the divestiture of retail store solutions. This performance was driven by our new mainframe and momentum in PureSystems, our expert integrated system. In fact, in its introductory year, we have already sold more than 2300 PureSystems in more than 70 countries.

System Z revenue grew 56%, driven by our first full quarter of our new mainframe. MIPS grew 66% year-to-year. This is the largest quarter of MIPS shipments in history. About half of these MIPS were specialty engines, which were up 80% year-to-year, driven by Linux workloads, a good indicator or new workloads moving to the platform. Growth in Z was up 50% in the major markets and up over 65% in the growth markets. In the growth markets, we had strong sales to our established as well as new mainframe customers. This performance reflects a technology leadership and value of our vertically integrated stack that IBM’s new flagship server is delivering to our customers. It is simply the fastest and most capable enterprise system to date.

Turning to Power where revenue was down 19%, our new P7 Plus midrange and high end Power servers performed well. We will continue the refresh of the Power portfolio in the first half of 2013.
Our success in competitive take outs continued in the fourth quarter. We had over 350 competitive displacements, resulting in over $335 million of business, about half of which came from Oracle Sun and half from HP. For the year, we had nearly 1,200 competitive displacements resulting in over $1 billion of business.

Our storage hardware revenue was down 5% driven by tape. Disc was flat. Within Disc, we announced the new high end DS8870 in October and it was sold out in the quarter. This will continue to ramp in the first quarter.

Our systems and technology pretax income was up 23% year-to-year, driven by new product introductions in mainframe, power, storage and of course PureSystems.

Across all of our segments, we’re continuing the strong performance in our key growth initiatives. These are not standalone offerings but integrated into our client offerings and included within our segment results.

In the growth markets, our revenue was up 7% at constant currency and these countries now represent 24% of IBM’s geographic revenue. That’s up 8 points since 2006 when we introduced our 2010 roadmap. So we’ve been very successful in capturing the opportunity in these faster growing markets. We’re doing this by continuing to expand into new countries and territories to build out IT infrastructures in support of economic growth and to take a leadership position in key industries. To drive market expansion in 2012, we accelerated our opening of new branch offices. This year we doubled the number of face to face branches, bringing the total number of face to face and virtual branches in the growth markets to almost 450. So this is tremendous growth.

Our business analytics initiative continues to expand, allowing clients to make informed decisions everywhere in their organization to improve outcomes and to manage risk. We made significant strides and expanded our leadership position in a number of strategic areas, including risk management, price and promotion optimization and sales performance management, just to name a few. Our value proposition and business analytics uniquely leverages the integration between our software portfolio and GBS consulting expertise. This year business analytics grew 13% led by our GBS consulting practice.

Our SmartCloud portfolio addresses the full scope of enterprise client requirements. We have seen continued strong demand for our foundational offerings in hardware and software that help companies build and run their private clouds, as well as for cloud-based solutions like our SaaS offerings. With strong global growth, our cloud revenue for the year was up 80%. In 2012, we launched our family of PureSystems expert integrated systems as well as our SmartCloud Enterprise Plus public and managed private cloud offerings for large enterprises. These offerings further extend our cloud capabilities.

We saw tremendous expansion of our Smarter Planet growth initiative over the last 12 months measured in terms of offerings, markets, customers, and revenue. Our clients are leveraging our growing capabilities in areas like smarter commerce or acquisitions such as Emptoris, DemandTec and Tealeaf helped fuel growth in new market segments. Social business for our industry leading social platform and Kenexa, come together in a powerful combination to allow our clients to engage a smarter, more effective workforce.

Smarter cities which includes a portfolio of solutions ranging from public safety to social services to intelligent water systems. And finally, our next generation analytics systems like Watson which are helping tackle some of the most complex challenges facing our customers. For the year, our Smarter Planet solutions generated more than 25% revenue growth. When you look at our offerings in business analytics, cloud and Smarter Planet, about half of our revenue is software. So as these offerings become larger parts of the IBM business, they are driving a higher quality revenue stream, improving our mix and our margin.

Turning to cash flow, we generated $9.5 billion of free cash flow in the quarter. That’s up almost $600 million year-to-year. In line with past year, is about half of our annual cash flow was generated in the fourth quarter. And on a full year basis, we generated $18.2 billion of free cash flow which is up $1.6 billion over last year. Within our strong free cash flow performance, our capital investments are up by almost $250 million. The year-to-year improvement in free cash flow reflects our growth in net income and as you will recall the fact that our 2011 cash flow was impacted by income tax payments for audit settlement activity in the first quarter of last year.

When I look at the uses of cash for the year, we continue to return significant value to shareholders including $3.8 billion in dividends and we bought back $61 million for $12 billion. Net of the cash we received from options and employee stock related transactions, our cash outflow for share repurchases was $10.5 billion. At the end of the year, we had $8.7 billion remaining in our buyback authorization. In addition, we spent $3.7 billion to acquire 11 companies. In the fourth quarter we acquired Kenexa. Over the course we acquired DemandTec, Emptoris, Platform Computing, Tealeaf and Texas Memory Systems, to name a few to add to our capabilities in analytics, cloud and Smarter Planet.

We also acquired Vivisimo, which expands the breadth of IBM’s big data capabilities and creates the most complete end to end big data solution for our clients. Over the last three years we have spent $11.5 billion for acquisitions. To wrap up the cash dynamics for the year, we generated $18.2 billion of free cash flow and spent $18 billion on acquisitions, net share repurchase and dividends.

Looking at the balance sheet, we ended the quarter with a cash balance of $11.1 billion. Total debt was $33.3 billion of which $24.5 billion was in support of our financing business which is leveraged at 7:1. Our non-financing debt was $8.8 billion down $1.6 billion for the third quarter and up $800 million from a year ago. Now let me spend a minute on our retirement related plans and the impact to the balance sheet.

Despite volatile market conditions in 2012, we had good returns on global assets exceeding our expected return on assets in the U.S. and on a global basis. But the discount rate environment remained challenging, resulting in $5 billion impact to equity at the end of the year due to the pension liability re-measurement. As a result, our debt to cap ended the year at 36%, up 4 points year-to-year, including a 6 point impact from the pension re-measurement.

At the end of 2012, our defined benefit qualified plans continued to be well funded and our cash requirements remain stable. We have included supplemental charge to cover ongoing dynamics in our pension plans. Our balance sheet remains strong and we continue to have a high degree of financial flexibility.

So now let me wrap up with the drivers of our operating earnings per share performance. Our total revenue performance had little impact on our profit growth, but we did have good revenue growth in our higher margin areas which significantly contributed to margin expansion and profit growth. You see this in our margin expansion which was the largest contributor, driving $0.47 of EPS growth through a combination of gross margin improvements and expense productivity and a lower share count resulting from our ongoing share repurchase program contributed $0.24. Bottom line, we delivered 14% EPS growth in the quarter and 13% for the year. As you can see, the profile for the full year is very similar to the fourth quarter.

Our results demonstrate the strength and flexibility of IBM’s business model, which is designed to deliver profit in cash on a sustained basis. In 2012, we continued to deliver value to our clients and capitalize on key trends. We had strong performance in Analytics and Cloud and Smarter Planet, key initiatives that leverage our software portfolio and contribute to our margin expansion. We continue to expand our capabilities and build out infrastructures in emerging markets. This year, our growth markets revenue outpaced major markets by 8 points.

We continue to invest for innovation. Our investments supported the introduction of our new System Z mainframe, our PureSystems offerings and our new storage and Power7 Plus products and we just were named number one in U.S patents for the 20th consecutive year, with many of the patents issued this year in key areas like analytics and big data, cyber security, Cloud, mobile, social networking and software environments.

We invested almost $4 billion in 2012 to acquire 11 companies, adding significant capabilities to support our growth initiatives. At the same time, we divested our retail store solutions business as we focused our smarter commerce portfolio on the higher value IP based opportunities. So as you can see, in 2012 we continued the transformation of the business, shifting to higher value areas and improving our structure. This results in a higher quality revenue stream.

So while our overall revenue performance was modest, we had 8% growth in our operating net income and expanded net income margin by 1.6 points, well above our model level and we delivered operating EPS growth of 13% for a decade of double digit EPS growth and over $18 billion of free cash flow, a record for IBM. This demonstrates a flexibly of the IBM business model.

In 2013 we’ll continue this transformation. We’ll acquire key capabilities, divest the businesses, rebalance our workforce and invest in innovation. Bottom line, we’re continuing to retool our skills and our offerings to shift to higher value and meet our clients’ needs. We’ve taken all of this account in our view of 2013. We expect to deliver operating EPS of at least $16.70 for the year, with the first half growth rates slightly higher than the second. And now, two years into our 2015 roadmap, we are well on track to our objective of at least $20 of operating earnings per share.

Now Patricia and I will take your questions.

Patricia Murphy

Thank you, Mark. Before we begin the Q&A, I'd like to remind you of a couple of items. First, we have supplemental charts at the end of the deck that complement our prepared remarks. And second, I’d ask you to refrain from multipart questions. When we conclude the Q&A, I'll turn the call back to Mark for final comments. Operator, please open it up for questions.

Question-and-Answer Session


(Operator instructions). The first question comes from Bill Shope with Goldman Sachs. You may ask your question.

Bill Shope – Goldman Sachs

Thank you. On your prior earnings call, you had mentioned that the month of September was more challenging than the first two months of the third quarter. Can you talk about how the broader demand environment and your execution evolved into the December quarter? And was there anything unusual this time around that you would call out in terms of linearity?

Mark Loughridge

Good question, Bill. Really if you look at the monthly performance across the quarter, it was really pretty constant. We saw a good performance through the quarter. Obviously, within that we feel very, very good about the performance we saw in our software business with key branded middleware up 6%, a breakout performance from our Z Series content, revenue up 56%. Within that the growth markets up a, I think, spectacular 65%. MIPS up 66%, the biggest MIPS performance in the history of the IBM Corporation.

And so ongoing contribution from our base businesses. And with all that, to generate half of our free cash flow in the quarter and a total of $18.2 billion, the largest ever, up $1.6 year-to-year. I think that was just a very, very strong quarter. But if you look across the months, it was fairly constant month-to-month.


The next question comes from Toni Sacconaghi with Sanford Bernstein. You may ask your question.

Toni Sacconaghi - Sanford Bernstein

I was wondering if you could comment on your expectation for services revenue growth in 2013. The reason that I ask is, I think on the fourth quarter call last year you talked about getting about 3 points of revenue growth from your backlog driven businesses. And you ended up with services at constant currency about flat this year, suggesting that non-backlog revenue growth was down about 6% in the year. So if you are looking at backlog revenue growth or revenue from backlog only growing about 1% this year, and again you struggled and had weak current period revenue growth this year. Why shouldn’t we be thinking about revenue growth being down in 2013 in the services business overall?

Mark Loughridge

So very good question. Let's start by looking at our GBS business. So the GBS business, if you look at the backlog over the last four years, they have actually been growing that backlog each year as they move into 2013. Now within that, as we explained in our third quarter call dynamics, you see a retooling if you will, or a mix shift, into these higher value initiatives that are so important to the IBM Corporation because those growth initiatives drive about 50% software in their mix and so they have a very high profit for the corporation. But if you look at that retooling from the GBS perspective, they tend to be longer duration.

And so as we look at that duration and four years of backlog growth, both transactional and in total for GBS, we feel that as we enter 2013 GBS should once again return to revenue growth. If you look at the point that you had made on backlog run out, we included that very discrete chart for the following reason. If you look at the backlog content moving into the year, we were impacted to some degree by the contracts that we restructured as we went through the end of 2011 to 2012. And that magnitude was about a point.

Now that’s the point on revenue. How did that perform on a gross profit basis? The fact is, it was a substantial improvement in our growth profit dollars. In 2012 we had a lot of growth in our GTS business driven by that. But that improvement in gross profit dollars in the sense, Toni, it raises the waterline and continues into 2013. And that’s a very big point. That improvement that we saw across those contracts because we maintained about 80% of the revenue within those contracts generally drove a much higher level of gross profit dollars in the ongoing base that we will enjoy this year. And in fact we will see some modest improvement in the year-to-year gross profit from those contracts moving into next year.

So net-net, the gross profit dollars coming out of the backlog are much stronger because of that. So we expect the overall performance of the gross profit dollars coming out of the backlog to be more typical of say a 2% backlog growth and necessarily 1%. At 2%, very close to the dynamic we saw last year. And with that dynamic, the services businesses did a good job of driving to the model.

And I think the last point that I would make in this roll-out, we had about $3 billion worth of very strong contracts roll-out off the fourth quarter into the first quarter. We have already closed $1 billion of this. And if you look at the complexion of those contracts, they come in the -- many of them in the growth markets where we’re having real success on that operations – and the value-adds that we’re showing our customer base. You see it reflected really in the backlog in our growth markets which for total services base, that backlog is up 15%. So, really strong performance on that basis. You put all that together, we feel very confident as we go into 2013 that the profit generation from our service business in total should meet our model expectations and frankly, if you look at the first quarter of 2013, we think that the services business to generate double digit profit growth.


The next question comes from Ben Reitzes with Barclays. You may ask your question.

Ben Reitzes – Barclays

Hi. Mark, wanted to talk a little bit more about your roadmap. Your tone sounds a lot better than three months ago. You've grown EPS over the last three years in the mid-teens, maybe 14% average or so and 13.5% this year. And in order to make the roadmap, all you have to do is grow 9.5% the next three years to get there. So that would be slower than you've been doing. Can you talk about your confidence and overachievement and maybe preview some of the tone in what you may say at your Analyst Day coming up soon?

Mark Loughridge

Sure. Well, I think when you look at it, that at least number for 2013 at $16.70; I would have said that, Ben that rounds to $10, but at any rate. At $16.70, that's the at least number for the beginning of year and I think if you look at that relative position, that’s pretty consistent with what we've said the last couple of years. Additionally I’d point out, when you look at the generation of value from the Corporation, I think it's worth stepping back and just recognizing that the performance that we saw in 2012 was in fact the 10th year of double-digit EPS growth out of this place. That is a pretty big number. So underneath it, to drive that, we've driven this business to big growth opportunities in the higher value, higher margin spaces.

Stepping back again, you think about since 2010 alone, we've invested $19 billion in R&D, $12 billion in 34 acquisitions. If you look at the enterprise productivity initiatives that we're driving for $8 billion over the roadmap, fully about 60% of that is driven to reinvest in growth initiatives like GMU, Smarter Planet, cloud and Business Analytics. So from my perspective, to drive that level of performance we're plowing investments hand over fist, back into the business. Now what are the results? Are we seeing this? Well, let's look at Software. Since 2000, Software has gone from $2.4 billion annually. 2012 we did $4 billion in the fourth quarter alone and $11 billion for the year.

Free cash flow, that $18.2 billion that we talked about, 2000 was $6.7 million and in fourth quarter of '12 we had the largest MIPS shipment in the history of the Corporation, with our GMU content going from 16% of our business mix to 24% since the 2006 initiation of the business model. So I think as we look forward those growth initiatives, the effect that they're having, their ability to continue to move that higher value content and continue that growth gives us a lot of confidence, not only in what we'd see in 2013, but our remaining roadmaps to 2015.

Ben Reitzes – Barclays

Okay. Thanks a lot.


The next question comes from Steven Milunovich with UBS. You may ask your question.

Steven Milunovich – UBS Securities

A question on the Power side. I guess the 90% decline, I was a little surprised there, particularly since you had indicated you had a new high-end product. Is this the UNIX business finally kind of turning over like everybody else's? And I was also curious, how much of your PureSystems, what's the hardware breakout there S86 versus Power?

Mark Loughridge

Well, if you look at – for your first question, Steve, one thing that we've recognized in the rollout of the cycle of the product introduction, when we introduced new Z cycle product, it hits right with the announcement and you've seen that in the performance that we've generated in this fourth quarter. Frankly, in a Power systems announcement, many of those volumes go to our customers and product test evaluations before that customer goes to volume shipment.

And so generally in a Power announcement, volume shipment, especially for mid-range and high-end which we had in our announcement, that will lag by a couple of quarters. So I wouldn’t really expect to see the volume shipment again, those announcements, till we get into the second quarter of 2013. Now with that, Power once again had a very strong competitive replacement. You know 330 customers, over 300 million. And if you look at that mix, about half from HP and half from Oracle, Sun. But the effect of that overall volume shipment really we will see in about the second quarter of 2013.


The next question comes from David Grossman with Stifel Nicolaus. You may ask your question.

David Grossman - Stifel Nicolaus

Mark, can we just follow-up a question I was asked earlier. Obviously the focus on margin impacts revenue growth, so how should we really think about this trade-off as we go forward through the road-map. As revenue growth accelerates, we prepared for margin expansion to moderate even though we are getting some benefits from mix.

Mark Loughridge

Well, I guess I would look at it this way. First of all, let's look at the operational, model driven plays to drive margin. And if you looked at our -- maybe one way to look at it -- let's look at the fourth quarter. So fourth quarter PTI margin expanded by 2.1 points. That’s about $2 billion. And I would attribute about half of that to the ongoing effect of the model driven initiatives from margin. And those two model driven initiatives are continuing to mix to higher margin categories like the software business. And then the second category would be all of this spend takeout that we see in kind of the support structures around the business that we call the globally integrated enterprise.

Well, I don’t think either of those impact your go-to-market pricing content that you see in your business. That go-to-market pricing content, it’s really going to be dependent on the competitiveness of your offerings at the client, not the spend structure in your back office enterprise. Nor will that margin improvement impact revenue growth simply by mixing into those higher margin spaces like software. And I think if you looked at that 2.1 points of margin growth in the fourth quarter, I would attribute about half of that to those ongoing initiatives we have to drive performance in margin for the business units.

The other half were unique items that we drove during the year. So a good example of unique item that did drive real profitability was the work we did on those contracts that we did in services. To restructure them with our customers we maintained about 80% of the revenue but the profit generation out of it was quite significant. And that play alone produced about a third of that balance of a point of margin growth in the billion dollars. That generation is going to continue into 2013 because once again I would describe that as if we raised the water level on the ongoing contract performance.


The next question comes from Rob Cihra with Evercore Partners. You may ask your question.

Rob Cihra - Evercore Partners

I was wondering with the software shortfall you had in Q3, a meaningful part of that at the time you had attributed to growth markets and it looks like obviously you closed that in Q4. I am just wondering if that’s, you feel a function of growth markets environment getting better or were you simply able to close those and yet you are still looking at growth markets that maybe the environment is still weak. So I am just wondering how much of that is sort of improvement in the environment or simply you are booking those and the environment is still soft?

Mark Loughridge

No, I think we had performance in the fourth quarter from our software business. It was more consistent with the ongoing performance we are looking for in their business model. So I think they did a pretty strong job here as they went through the quarter. Let's just go through some of the elements. IDC now ranks them number one in bringing social software to the business environment. Tivoli grew 5% against strength in the overall storage offerings. Rational, 12%, gained share. WebSphere, 11%, gained share. Information Management, up 3%. So if you look across that base of business, we had very strong performance across the board. I thought they did a very nice job in transitioning from the third quarter and as we looked at 2013, we think we ought to be looking at revenue growth in the mid-single-digits and very strong profit performance once again.


The next question comes from Shaw Wu with Sterne, Agee. You may ask your question.

Shaw Wu – Sterne, Agee & Leach

Hi. When you look at the previous product cycle with Power7, you had approximately – basically lasted about 18 months. What do you see with Power7 Plus? Thanks.

Mark Loughridge

Well, I think we'll get a pretty strong product cycle out of it. As I had said earlier, the characteristic that I would focus on here is the couple of quarters it takes to get the volumes shipped, but we think we should have a very strong set of offerings with strength building as we go through the year. As I said, in the marketplace, it's performing quite well on a competitive basis.


The next question comes from Mark Moskowitz with JPMorgan. You may ask your question.

Mark Moskowitz – JPMorgan

Good afternoon. Mark, I had a question. As we think about 2013, you've done a great job in terms of optimizing the operating margin profile. How should we think about the various rates contribution for 2013 in terms of incremental contribution to margin in terms of A, is it going to really from a mix driven up to Software? Or B, is it going to be an increasing level of optimization of Software and less labor in Services? Or C, will it be more about just OpEx reductions in general?

Mark Loughridge

If you look at the overall performance basis, it's really those two very strong plays that we’re driving through the model, both with good results in 2012 and we think we'll present good results in 2013 as well. First of all being the ongoing mix in the higher value, higher margin spaces. Again, the best example of that would be the tremendous progress I think we've made on our Software business. Again, I gave earlier the statistic, but I think it's kind of remarkable that in 2000 we were doing $2.4 billion. Last year we did $11 billion. So that ongoing mix to Software we think should continue. And then supplementing that will be all the work that we have ongoing in that $8 billion of focus spend that we talked about in our globally integrated enterprise initiative.

Now, one point I want to make clear in that $8 billion, we do work to drive about 40% of that to the bottom line, but the other 60% is firmly dedicated to remixing our spend profile and our resources. So there is higher growth, higher margin initiatives like Business Analytics, Smarter Planet, Cloud computing and if you look at the business mix within those, about 50% of the revenue mix within those initiatives is Software. So, much higher Software mix that we see in the base business. That too should help propel our mix into higher margin content.


The next question comes from Keith Bachman with Bank of Montreal. You may ask your question.

Keith Bachman – BMO Capital Markets

Thank you. Mark, you previously spoke to you thought Software would have mid-single digits as you look at calendar year '13. I want to see if you could specifically address then the services and the systems part of the business. I think to Tony's question you said you thought GBS would have positive revenue growth, but I didn't hear a GTS number. So if you could speak to both the services element if you think in constant currency dollars whether that will have positive revenue growth in any metrics and then the same question for the hardware system side please.

Mark Loughridge

Okay. Let's – I think the best framework I can give you on the services side – and I’m not going to walk through each of these elements, but on the services side, we built that view of backlog run-out in the presentation and that covers about 70% of the revenue that we realize in a year. So another way to look at it, we already have 70% of revenue as we enter the year. But in that, the math would say, it's up 1%, but the point I was making, as we are more explicit about the dynamics, is really from a profit standpoint it should perform more like a business that has a backlog run out of closer to 2%. Now, the dynamics underneath that, just given the backlog growth that we have had in our GBS business should move GBS into positive revenue performance as we go through the year.

But I think the more important aspect of that is that revenue performance, that better mix of contract profile within the business, closing out on those $3 billion of deals that were rolled across the dateline, that should generate model level profit performance at our services business and as I said earlier, we would think it would drive kind of double-digit profit as going to the first quarter.

From a hardware standpoint as we go into 2013, that first half is really going to be defined by the Z Series momentum that we have going and we would expect that that would help us drive double-digit profit in the first half as well. And on the software base of business, with key branded middleware at 6% in the fourth quarter we'd expect, as we had said earlier, mid-single digit revenue performance and a very strong profit contribution as well. So, all those things put together give us confidence in the at least $16.70 of earnings per share that we pointed out for the year.


The last question comes from Chris Whitmore with Deutsche Bank. You may ask your question.

Chris Whitmore - Deutsche Bank

Just to follow up on Keith's question. I believe in earlier comments you've indicated earnings will be a little bit more front half loaded than second half loaded. Can you talk through the dynamics that would drive that type of unusual seasonality in 2013?

Mark Loughridge

Yeah, absolutely. So when you look at the seasonality -- and here I'd make a couple of comments. First of all, the year-to-year performance across the quarters is relatively similar but will be more pronounced in the first half of the year. And that's really driven by kind of Z Series content and the Z Series dynamic. Remember, by the time we get to fourth quarter of next year we'll be facing the big announcement in the rearview mirror. So, I do expect that the first half of the year should be better growth than we see in the second half but we still expect to have a good second half.

Now, within the first quarter the additional comment I would make, is really we'd kind of expect to see a little better performance in the second quarter compared to the first quarter, and that comes down to Easter. This year, Easter falls in that last week of March and we've seen that in, especially in countries where Easter is a major holiday, that tends to move that business because you just have more difficulty getting hold of your clients and your customer base at the end of the quarter, and those contracts will generally roll to April. So, once again, a little stronger performance in the first half than the second half but a good second half at that. And within the first half, a little more strength in the second quarter than we would see in the first quarter based on the calendar date for Easter.

So with that, let me take the opportunity to wrap up the call. Our 2012 results demonstrate the flexibility of IBM's business model. We had strong performance in our growth initiatives, especially in our higher value areas. We expanded our margins and had excellent profit growth which drove our 10th consecutive year of double-digit EPS growth. And we generated over $18 billion of free cash flow which is up $1.6 billion year-to-year and a record for IBM.

So in 2013 we will continue to move our business forward, shifting to higher value and improving efficiency. We're going to buy businesses, we're going to sell business, we're going to rebalance our resources, align those to opportunities and continue to invest in innovation. Now, all of this is captured in our view of 2013. We are confident in our ability to deliver at least $16.70 for the year on our way to our objective of at least $20 in 2015. So, thank you again for joining us today and now as always it's back to work.


This concludes today's conference. Thank you for your participation. You may disconnect at this time.

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