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International Business Machines Corporation (NYSE:IBM)

Q4 2008 Earnings Call Transcript

January 20, 2009 4:30 pm ET

Executives

Patricia Murphy – VP, IR

Mark Loughridge – SVP & CFO

Analysts

David Bailey – Goldman Sachs

Toni Sacconaghi – Sanford Bernstein

Mark Moskowitz – JPMorgan

Bill Shope – Credit Suisse

Richard Gardner – Citigroup

Scott Craig – Banc of America/Merrill Lynch

Keith Bachman – Bank of Montreal

Ben Reitzes – Barclays Capital

Katie Huberty – Morgan Stanley

Maynard Um – UBS

David Grossman – Thomas Weisel Partners

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

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 Chief Financial Officer. 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 web site, or from us in Investor Relations.

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

Mark Loughridge

Thank you for joining us today. This was a very strong quarter. At the bottom line, we delivered $3.28 of earnings per share, up over 17% year to year. This was driven by terrific margin performance, with pre-tax margin up 2.5 points year to year. By business, Global Technology Services was up over four points; Global Business Services was up 3.6 points to a record level; and Software was up over four points. And this was on software revenue growth of 9% at constant currency, driven by sales execution, and growth in mission critical production software. And services signed $17.2 billion at actual rates. Within that, Strategic Outsourcing signings were up 20%, with North America up 44%. And we had solid short-term signings in Global Business Services, up 4% at constant currency.

We had good cash performance, and ended the year in a very strong financial position. The fourth quarter wrapped up an exceptional year in which we delivered record revenue of over $103 billion, record profit of $16.7 billion, record earnings per share of $8.93, and a record free cash flow of $14 billion, up almost $2 billion year to year. That’s a lot of records. And our software profit grew 18% year to year, while we successfully integrated Cognos and Telelogic.

In services, we generated 30% profit growth, and signed over $57 billion of new business. I’ll say that again, $57 billion. And in hardware we had a successful roll-out of our z10 mainframe, which was up 12% for the year. So overall, no two ways about it, this was a very strong year for us. And building off of this base, we expect to deliver at least $9.20 of earnings per share in 2009.

Now, before moving on to the details of the quarter, I want to take a step back and talk about what’s driving our performance over the last several years. As you know, since the last time we entered a recession, we have been executing a strategy that is transforming our business. With innovation and global integration at the core of this change, we are driving a shift to higher value businesses; investing for growth in emerging markets; integrating solutions that address clients’ needs in any environment; and improving efficiency which drives higher profit margins. The results over the past several years are clear and compelling. Since 2002, we have added over $10 billion to our pre-tax profit base; our pre-tax margin more than doubled; earnings per share more than tripled; and cumulatively, we’ve generated about $65 billion of free cash flow. Now that’s a lot of cash.

Now let’s look at how those results were generated over time. Looking at IBM’s performance over the last several years, you see that we have consistently generated strong profit and cash growth since 2002. Now that was a low point where you can clearly see the impact of the last recession and the resulting actions we took that year. So what’s different now? In the IT space, that recession was more about overcapacity, which is not the case today, and the IT industry in general is much different now. But more importantly, IBM is a fundamentally different company. Today, we have much less dependence on the cyclical and commoditizing products that are most affected in the downturn. In services, we have a much more flexible labor model that can adapt to changing market environments, and much of our software is embedded in the fabric of our clients’ IT infrastructures.

A combination of the mix of our overall business, and the mix of the products and services within those businesses puts us in a much stronger position than we had going into 2002. We have implemented a tremendous amount of change this decade. We are globally integrating the company. We are investing to capture the opportunity in growth markets. We exited commoditizing businesses, including HDDs in 2002, PCs in 2005, and printers in 2007, which represents nearly $15 billion of annual revenue. In that same time, we acquired over a 100 companies for a total of about $20 billion. Now this includes the acquisition of PwC Consulting in 2002, which gave us best-of-breed process and industry skills that are critical to delivering high value services to clients, and set the stage for the performance you saw this year in GBS.

Software acquisitions such as Cognos, Telelogic, and Ascential have extended our end-to-end middleware capabilities and solidified our position as the leading middleware provider. We also invested over $50 billion in research and development, to strengthen our technology leadership. As one measure of this leadership, last week we announced that for the 16th consecutive year, we were number one in U.S. patents, with over 4,000 in 2008. That’s more than the total of Microsoft, HP, and Cisco combined.

Consistent with the direction of our business, over 70% of our patents were for software and services. And we also announced a new initiative designed to further leverage our technology leadership by significantly increasing the number of technical inventions we publish, making those inventions freely available to others, and spurring follow-on innovation, especially in support of the build-out of newer, smarter infrastructures. You can see this transformation reflected in the profit mix of our business over time.

In 2008, our pre-tax profit was $16.7 billion, and over 90% of our segment profit came from software, services, and financing. You can also see that 40% of our profit came from our software business, and 42% from services, while hardware contributed just 9%. And if you exclude the amortization of intangibles, and the year-to-year benefit from our pension in 2008, software increases to 43%. This really illustrates how our business has changed over time as a result of our significant portfolio actions and targeted investment strategies, as we shift to where we see the best long term opportunity.

Now I’ll turn to the detailed financial results for the fourth quarter. Looking at our income statement for the quarter, our revenue was $27 billion, down 6% as reported, and 1% at constant currency. We had outstanding margin performance. Gross margin expanded three points, led by services and software. Together with focused expense management, we grew pre-tax income 6% over last year, and PTI margin expanded 2.5 points. With a lower tax rate year to year, primarily driven by utilization of tax credits, net income grew 12% and margin expanded to 16.4%. So bottom line, we delivered $3.28 of earnings per share, up 17% year to year. Our balance sheet and capital structure are also on very solid ground. We finished the quarter with almost $13 billion of cash on hand, and we had continued good performance in the capital markets in the fourth quarter. Our liquidity position remains strong.

For 2008, we delivered $103.6 billion of revenue, pre-tax earnings of $16.7 billion, and earnings per share of $8.93, all record levels. We expanded margins, with gross, pre-tax, and net margin all up over a point. We generated over $14 billion of free cash flow, and returned over $13 billion to shareholders through share repurchases and dividends. Let me tell you how we’ve been able to achieve these results in a tough environment. We had relatively stable revenue performance, by delivering what customers need in this environment. So for the customers that are trying to save cost and conserve capital, we can adapt our offerings to help them do that. As a proof point, of our $4.5 billion of short-term signings in GBS, about three-fourths of the signings delivered cost reduction to our clients. For our growth markets unit, where growth is driven by infrastructure build-out, we aggressively invested to capture that opportunity.

For the year, our constant currency revenue growth in these markets was eight points higher than in the major markets. And by building on our long term relationships with clients, we generate about half of our revenue in annuity businesses, which provides a solid base of revenue and cash. Our gross margin expansion was driven by a combination of three elements; mixing to higher value businesses, pricing for value, and our focus on cost management. And in expense, we’re focused on driving productivity, in sales, development, and our global support functions.

So let me get into the fourth quarter details, starting with revenue by geography. Our total geographic revenue was down 6% as reported and flat at constant currency, with mixed performance by geography. As always, I’ll focus my comments on the constant currency growth. Americas had the strongest performance, up 2%, while Europe and Asia Pacific were down 1%. Globally, the major markets declined 1%, though we had some countries that performed very well. Germany had the fastest growth of the G7 countries with 7% growth. Canada grew 6%, while the UK grew 4% and France grew 2%. The U.S. was flat, and Japan and Italy declined.

Now, in the emerging markets, our growth markets organization grew 6%. Revenue from these markets represented 18% of IBM’s geographic revenue in the quarter, and the year. We’ve been investing to capture opportunities to build out public and private infrastructures. This quarter, we also saw customers in these markets focus on cost savings, a reflection of the global economic environment. We’re obviously very well positioned to address these needs.

The BRIC countries, a subset of our growth markets, grew 13%, with strong double-digit growth in Brazil and India. China was up 9%, an improvement from the third quarter. However Russia declined as it was significantly impacted by credit limitations. But while Russia was weak, other countries, like Chile and Egypt had very strong performance. We’ll continue to shift resources to where we see the best opportunities to ensure we’re positioned to capture the growth.

Turning to our industry view, revenue was down 6%, or flat at constant currency. I’ll comment on a few of the sectors. Public sector was the fastest growing sector again this quarter with strength in government and with education returning to growth at constant currency. In the growth markets specifically, our clients are investing in education as a way to develop national skill sets. In addition to solid revenue growth, we also had good signings in the public sector, up 50% worldwide and over 100% in the U.S. Lagging overall performance was the Industrial sector, as concerns with the credit markets and margin pressures continued. Worldwide Financial Services declined 1% at constant currency, in line with IBM’s overall performance for the fifth consecutive quarter. These clients remain focused on cost reduction, risk management, and integration services. Revenue from our small and medium business clients declined 3% at constant currency; however services signings were up 10% globally, with U.S. signings up almost 90%.

So now let’s look at our revenue by segment. Our revenue performance was impacted by currency and the economic environment, but also reflects our broad business capabilities, and the contribution of our annuity content. Software was the fastest growing segment, as our customers continue to utilize IBM’s infrastructure software in their production environment to optimize their data centers. Services revenue was driven by a strong annuity base and full year growth in short term signings. Systems and Technology declined this quarter reflecting growth in high end servers offset by a decline in our x86 and storage products. In Global Financing, financing revenue was up 3%, though this was more than offset by a decline in the sales of used equipment.

But the really impressive story within our segments is margin. So let’s take a look at our progress in driving productivity. This quarter, our total expense and other income was down 5%. Eight points of the decline was due to currency, both translation of non-dollar based expenses, and the impact of the hedging programs that flow to expense. We estimate that acquisitions contributed about six points of growth. So operational expense actually improved by two points year to year. Now underneath this, we’re executing our investment strategy and allocating our spending to areas where we see the best opportunity. In our growth markets, where we’re investing to capture this rapidly growing opportunity, SG&A excluding currency and acquisitions was up 9%, while in the rest of the world it was down 5%, reflecting our focus to drive productivity in our major markets organization. However, our emphasis is not just on expense, but on our entire spending base of almost $90 billion, and you see the benefit of these operational actions in our margins. We will continue our focus on structural changes that reduce our spending levels and improve productivity in 2009.

Let me give you an example of the types of things that will contribute to ongoing margin performance. First, we’re tackling our globally integrated processes, applying the same capabilities we sell to our customers to improve efficiency and drive cost savings. As an example, we’ve announced the outsourcing of our internal logistics process to Geodis. This enables us to take advantage of industry-leading skill and scale, and ultimately improve our productivity in the supply chain. In addition to the ongoing savings, we’ll have an up-front gain when we close the transaction in the first quarter. Second, we’ll continue to drive cost out of services delivery through implementation of lean processes, tools automation and standardization and growth in our global delivery centers. And finally, we’ll continue to redeploy skills to areas of growth, moving more and more skills out of support and headquarters’ functions out to the field.

Before I show our margins by segment, I want to comment on the items that significantly impacted our profit growth this quarter. Retirement-related plans generated about $200 million of cost and expense in the quarter. This is a decrease of about $475 million year to year. About $140 million of the year-to-year improvement was a one-time gain resulting from changes to the Japan plan described last quarter. As we indicated in October, this was largely offset by fourth quarter workforce actions in Japan. For the full year 2008, retirement-related plans cost about $1.4 billion. This is better by about $1.2 billion year to year, or $1.0 billion excluding the Japan gain. As a reference point, at the beginning of the year we expected year- to-year improvement of $950 million to $1 billion.

Let me comment on the performance of our pension plans. In the U.S. plan, return on assets was down 15% for the year. While this is below our expected return, it is considerably better than the S&P performance, which was down 38%. Our non-U.S. plans which comprise about 40% of our assets, in aggregate were down 21%. So globally, our pension plans were down 17% for the year. Looking forward, we will hold our expected U.S. long-term return assumption at 8%, and we will take our discount rate down to 5.75%, reflecting the current interest rate environment. In 2009, with these assumptions, together with other factors such as changes in actuarial assumptions, we expect retirement-related cost and expense of about $1.5 billion, consistent with our 2008 cost and expense levels excluding the Japan gain. From a funding perspective, we ended the year with total assets in our defined benefit plans of about $75 billion. Our U.S. plan is 97% funded, and globally, our qualified plans are about 93% funded.

Turning to workforce rebalancing, in the fourth quarter, our workforce reduction charges were up about $380 million year to year, an impact of $0.20 per share. This includes about $120 million for the activity in Japan. The remainder of the expenses reflects the ongoing skills rebalancing that is a regular element of our business model. A couple of other items that I’ll mention, within other income and expense, interest income was down $120 million, reflecting the current interest rate environment. Currency negatively impacted our results, partially offset by our hedging programs. We hedge the major cash flows to mitigate the effect of currency volatility as we manage our cash globally. The impact of these hedging programs is reflected principally in other income and expense, and cost of goods sold. This quarter, our hedging instruments flipped from a loss to a gain, resulting in a year-to-year benefit of about $190 million in other income and expense.

Our tax rate was 23.8% in the quarter, down from the previous ongoing rate of 27.5%, which contributed $0.16 of earnings per share in the quarter. For the full year 2008, our tax rate was 26.2 %. This lower rate reflects improved foreign tax credit utilization, and the retroactive reinstatement of the U.S. research tax credit. Most of these benefits will be sustained, and we expect a rate of about 26.5% in 2009, so fairly consistent on a year-to-year basis.

Now, before getting into the segments, I’ll quickly show you our margin performance by segment. Our margins reflect the shift of our business to higher value areas, and our constant focus on improving productivity. Our fourth quarter margin improvement also reflects lower total managed labor costs year to year across all elements. However on a full year basis, total managed labor costs were up 5% year to year across all elements, excluding retirement related. This all contributed to great margin performance in our services segments, software and financing, while hardware declined.

So now I’ll turn to our segment performance, starting with Services. Our two Global Services segments delivered very strong margin and profit performance this quarter. On combined revenue, that was down 4% as reported and up 2% at constant currency, our services business delivered a record level of pre-tax profit, and margin of 14.5%, which was up four points year to year. We performed exceptionally well in the current economic climate, through disciplined execution on resource optimization and improved operating efficiencies, while at the same time delivering services with a very high level of quality and customer satisfaction. Signings were $17.2 billion at actual rates, down 5% and up 2% at constant currency. We signed $7.3 billion in short-term deals this quarter. Coming off a very strong fourth quarter last year, overall short term signings were down 7% at actual rates and down 1% at constant currency, while long term signings were down 3% at actual rates, and up 3% at constant currency. We signed 24 deals larger than $100 million, and that’s the highest number we’ve seen in quite some time. Backlog at the end of the year was an estimated $117 billion, up $2 billion quarter to quarter.

Now with that overview of total services business, I’ll highlight the key drivers of performance in the two services segments. Global Technology Services revenue was down 4% as reported and up 3% at constant currency. Strategic Outsourcing, our largest services business and the industry leader, was down 3% as reported and up 3% at constant currency. We really had a very strong quarter in SO signings, up 23% at constant currency. North America was up 45%, with the U.S. up 34%, and Europe was up 66%. This was really terrific performance across these units. Our Strategic Outsourcing offerings provide a compelling value proposition in this environment. In particular, our clients in the major markets are turning to outsourcing as an effective way to quickly meet their financial objectives. We’re seeing some very impressive performance in this business. Our initiatives around standardization, global integration, and improved efficiency are not just driving margin improvement, they’re also resulting in improved quality and customer sat. Our metrics in both of these areas are at some of the highest levels we’ve ever seen. Being able to drive continuous efficiency and productivity improvements while satisfying our clients is the cornerstone of this business, and is ultimately reflected in our ability to attract new business. You saw the results this quarter in our signings performance.

Integrated Technology Services revenue was flat as reported and up 6% at constant currency. Although signings were down this quarter, we continue to see good results in our key infrastructure plays. Global Technology Services pre-tax profit was up 35%, and margin was 14.4%, up four points year to year. This was the sixth consecutive quarter of double-digit pre tax profit growth, and we had gross margin expansion in all lines of business. GTS continues to execute on the bottom line, driven by a delivery structure that maximizes utilization and flexibility, a mix to higher value offerings, lower total managed labor costs; and a global skills mix that enables us to rapidly put our people where the work is. A great example of this was announced just last week. We’re opening a new Technology Services Delivery Center in Dubuque, Iowa. This center will primarily support IBM’s U.S. strategic outsourcing clients, where we will manage IBM’s world-class servers and storage systems, which are critical for assuring optimal IT infrastructure performance. This center meets our clients need for data center services, and gives IBM access to key skills.

Turning to Global Business Services, revenue was down 5% as reported and flat at constant currency. Cost savings offerings continue to drive the majority of business, although we’re seeing some increased demand for transformational offerings and compliance offerings. So, although market conditions remain tough and clients remain cautious, cost savings offerings continue to sell. Short term signings were $4.5 billion, down 1% at actual rates and up 4% at constant currency. As I mentioned earlier, cost savings accounted for about three-fourths of the new deals signed. By sector, Financial Services posted the strongest growth, up 27%, with Banking up 55%. Public Sector, Communications, and General Business all grew signings double digits, while Industrial and Distribution logically showed steep declines. Long term signings are down 25% at actual rates and 16% at constant currency. Public sector was a bright spot, with U.S. public sector signings up over 90%.

We recently announced the creation of a Delivery Center for Application Services located at Michigan State University. This is a first of a kind center that will provide innovative application development and support services to modernize older and less efficient IT systems for state and local government agencies and universities, certainly a timely investment. Global Business Services delivered a record level of profit again this quarter. Pre-tax profit was up 26% and margin expanded 3.6 points to 14.9%, the best ever. GBS has consistently executed with strong profit growth. 2008 represents the third straight year of profit growth greater than 20%. This demonstrates strong operating discipline, the benefits of a globally integrated operating model, stable pricing, and lower managed labor costs. So despite slower revenue growth, utilization actually improved year to year, which is a function of resource optimization, and the balancing of our domestic, global, and subcontracted resources. And we continue to be very selective and structured in our deals. We’re not just driving signings, anyone can do that. We’re driving for a long term, profitable relationship for both IBM and our clients.

Software Segment Software revenue of $6.4 billion was up 3% year to year, or 9% at constant currency. Branded middleware was 61% of our total software portfolio, and grew 6% year to year, or 13% at constant currency. We had a very strong pipeline going into the fourth quarter and our sales team showed solid execution in a difficult environment. In the quarter, WebSphere, Information Management, Lotus, and Tivoli software sold well. Many of our largest customers signed multi-year deals with us, demonstrating continued commitment to IBM technology. These customers value the depth and breadth of our product portfolio, and world-class support capabilities. The Americas had a particularly strong quarter, up 10%, or 13% at constant currency, with good growth in both large and small deals, up 11% and 5% respectively.

Let me give you some insight into our branded middleware performance. Information Management software grew 18%, or 25% at constant currency. Information Management grew organically and Cognos also had a terrific fourth quarter. Since the launch of our Information on Demand initiative in early 2006, Information Management software has grown at a compounded rate of 18% over the last 12 quarters. Distributed Relational Database has grown at 14% over the same period, and in the fourth quarter alone, our Distributed Relational Database grew over 30% at constant currency. WebSphere software was down 1%, and up 5% at constant currency. In December, we completed the acquisition of iLog, which helps customers improve business decisions with optimization, visualization, and business rules software. Lotus was flat at actual rates, and up 6% at constant currency, capitalizing on the strong performance of our collaboration software. Tivoli software was down 4%, but was up 4% at constant currency. Tivoli’s software provides the advanced capabilities required to run large mission critical environments. This includes systems management; security and storage software which helps customers improve utilization and reduce costs. Rational was down 1% at actual rates but grew 5% at constant currency versus a difficult compare. The constant currency growth was fueled by the Telelogic acquisition. The Software segment pre-tax income grew 15% year to year to $2.8 billion. The large annuity base in our software business continues to provide a predictable and growing stream of profit and cash for IBM. We’ve been investing heavily in our software business for some time, with good results. Our revenue in 2008 was over $22 billion, and in the last five years pre-tax profits have more than doubled to $7 billion.

Systems & Technology revenue of $5.4 billion was down 20% year to year, or 16% at constant currency. Our system z and converged system p servers did well, but our x86 platform declined. In this tough macro-environment, customers are focused on reducing the cost of running their IT infrastructure. Virtualization, which provides the ability to run multiple workloads on a server, is a key enabler of efficiency. System z is the ultimate platform for virtualization, able to support thousands of images and run fully utilized. Our POWER architecture supports hundreds of partitions, often driving utilization rates of over 60%. Both of these platforms leverage the entire system, from their custom semiconductors right through the software stack, to achieve these high levels of efficiencies, and lower cost of ownership. By contrast, the distributed computing model, with many small servers and typical utilization rates of less than 20%, simply cannot offer the same level of efficiency and value.

Now let’s turn our focus to the brands. System z revenue declined 6% year to year, but was up 1% at constant currency. MIPS grew 12%. This is the fourth consecutive quarter of double-digit MIPS growth. MIPS from specialty engines were up 43%, driven by new workloads on the mainframe. We had very strong growth in the Americas, revenue was up double-digits. By sector, Financial Services and Industrial sectors were particularly strong. Converged System p delivered 8% revenue growth, or 14% at constant currency. This is the tenth consecutive quarter of year to year revenue growth. The energy efficiency and multi-operating system capabilities of POWER6 technology continues to resonate with customers. Coupled with exceptional performance, POWER6 is the right solution for a multitude of workloads. The result is strong performance in both high-end and mid-range servers, both growing 16% at constant currency. Storage revenue declined 20% year to year. Disk was down 16%, and tape declined 31%. System x server revenue declined 32% year to year, with blades down 27%. This reflects a significant slowdown in the x86 market, as customers are virtualizing and consolidating workloads into more efficient platforms such as POWER and mainframe. So as you look at these results, you can see that the industry standard hardware is clearly more susceptible to an economic downturn.

Turning to IBM’s cash performance, we generated $7.9 billion of free cash flow in the quarter, up $600 million year to year. For the year, our free cash flow was up $1.9 billion to $14.3 billion. The year-to-year improvement was driven by growth in net income and tight controls on capital spending. Our collection performance for the quarter and the year was very strong. Our ability to consistently generate a high level of free cash flow positions us well for 2009. When I look at the uses of cash for the year, we have funded net capital investment of about $4.5 billion, and invested $6.3 billion in acquisitions. This is the highest level of acquisition spending in IBM’s history. We also returned $13.2 billion to shareholders. $2.6 billion of this was through dividends. And we bought back 90 million shares for $10.6 billion, including $700 million this quarter. To put our 2008 spend in perspective, on a net share repurchase basis, which includes the impact of employee stock purchases, we returned $6.8 billion to shareholders, which is consistent with our 2005 and 2006 spend rate. And at the end of the year, we had $5.6 billion remaining from our last Board authorization.

Turning to the balance sheet, we finished 2008 with a strong cash balance of nearly $13 billion, up $3 billion from September. Our experience in the capital markets in the fourth quarter was very positive. We raised $5 billion of term financing. And while our experience in the Commercial Paper market remains unchanged, we reduced our CP balance by paying off $4 billion of the $4.5 billion that was outstanding at the end of September. So we finished with less than $500 million of outstanding CP at the end of the year. In addition, we retired $1 billion of debt from our 2009 maturities. We are well-positioned for 2009 with our strong cash balance, CP flexibility, $10 billion global credit facility and our positive experience in the capital markets. Turning to debt, our total debt of almost $34 billion is down $1.3 billion year to year and down $500 million in the quarter. Of the $34 billion, $24 billion supports our Global Financing segment, leveraged at 7 to 1.

Regarding our Global Financing business, almost 60% of this portfolio is investment grade, as you can see in the supplemental charts. 97% of this portfolio is in our core competency of technology equipment and solution financing. There are no exotic assets, and as you would expect, no consumer or mortgage exposures. And finally, while our reserves have increased, consistent with the economic environment, this business still provides a very strong 29% return on equity. Our remaining debt, the non-financing debt was $9.6 billion, down $1.2 billion year to year. This debt is supported by our cash balances of $12.9 billion and our annual free cash flows, which were over $14 billion in 2008. I am very comfortable with this level of debt relative to those repayment sources. Non-financing debt-to-cap increased to 49% reflecting an equity reduction of over $15 billion due to lower returns on our pension funds. This in turn reduced total stockholders equity to $13.5 billion by year end. But this impact on book equity is non-cash, and does not affect our borrowing capacity or our liquidity.

Now let me start to wrap up with a discussion of the drivers of our 17% earnings per share growth. Our revenue declined 6%, including five points of year-to-year currency impact. At constant mix and margin, this 6% decline reduced EPS growth by $0.18. Now once again, by far, the biggest driver of our earnings growth was gross margin expansion, led by higher margins in services and software, and a mix to higher margin businesses. Gross margin improvement contributed $0.41 of EPS growth in the quarter. Expense productivity impacted EPS growth by $0.07, driven by acquisitions. Within that, we absorbed a $0.20 year-to-year impact from restructuring. A lower tax rate contributed $0.17 to EPS growth, and we had $0.15 from share buyback. When you look at this chart, it’s clear that the growth came from margin expansion, the result of an improved business mix and an ongoing focus on increasing operational efficiencies. You’ll see the same holds for the full year. Looking at the 2008 bridge, we had contribution from several items. But similar to the fourth quarter performance, you can see the largest contribution came from margin expansion, driven by improved mix, a shift to higher value businesses, and a focus on cost management and improved productivity.

Now, let me wrap up. To maintain leadership in the IT industry, you need to continue to innovate, integrate, and reinvent yourself. For the last several years, we have been executing a strategy to transform our business. Shifting to higher value services and software, with less dependence on commoditizing and cyclical business. In hardware, the value has shifted to the high end to address clients’ needs to consolidate and virtualize their environments. Our services business now contributes 42% of IBM’s segment profit, and over 60% of IBM resources. It’s also a fundamentally different business, more flexible, and more focused on higher value areas. Our software capabilities have grown through internal investment and acquisition, and in the last five years our software profit has more than doubled to over $7 billion. In 2008, over 80% of our segment profit came from services and software, and over 90% was from services, software and financing.

So we have changed the profile of the business to make it more adaptable, with offerings that allow us to succeed in a variety of different environments. We are entering the current market from a position of strength. We will take advantage of the environment to continue to execute our strategies and make ourselves even stronger. And as I mentioned earlier, we continue to invest to capture new infrastructure spending in emerging markets. Although some of these economies have slowed, they still offer good growth opportunity relative to the rest of the world. We moved very quickly to develop strong value propositions for our established markets, based on cost reduction, capital conservation and risk management. Our high value, integrated offerings, like green data centers, and outsourcing and virtualization on high end systems, have performed well in this environment. You can see that even in tough sectors like financial services.

And finally, we see a real opportunity in smart infrastructure as governments around the world launch massive stimulus programs focused on things like next generation smart grids, healthcare IT and broadband. These projects require both technology integration as well as deep industry insight, so IBM is uniquely positioned to help advance these efforts around the world. The key here is to move quickly to ensure our skills are appropriately balanced with these high value opportunities. We’ll also continue to focus on cost reduction and improved efficiency. But as you know, the true measure of success of cost and expense reduction is how this translates to profit and margin growth. In 2008, we had terrific margin expansion, and we’ll continue this into 2009. So as we enter 2009, we expect EPS of at least $9.20 per share for the year. Given what we are seeing in the economy, we’re not counting on constant currency revenue growth to achieve this, it’ll come more from margin improvement, just as it did in 2008. And with this strong 2008 performance, we are clearly ahead of pace on our roadmap to $10 to $11 of 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 Mark’s prepared remarks. Second, I’d ask you to refrain from multi-part questions. When we conclude the Q&A, I’ll turn the call back to Mark for some final remarks.

Question-and-Answer Session

Operator

Thank you. At this time, we would like to begin the question and answer session of the conference. (Operator instructions). The first question comes from David Bailey with Goldman Sachs. You may ask your question.

David Bailey – Goldman Sachs

Great. Thank you very much. Could you comment on the duration of the services contracts that you have signed in 2008 compared to 2007 and have you seen rescoping of existing contracts or cancellations pickup as of late?

Mark Loughridge

Yes. If you look at the duration, David, the duration in 2008 was about a half year longer than we saw in 2007 and it was about the average what we saw for the prior two years. So I don’t take a big message from that. As far as the repricing, rescoping, I think it was fairly typical. I mean obviously we always go through those kind of discussions with our clients, but in this kind of environment, we also are very focused on delivering additional value to our clients. And additional value to help them in this environment save costs, conserve capital, and deal with the risk and compliance.

Patricia Murphy

Thanks David. Let’s go to the next question please.

Operator

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

Toni Sacconaghi – Sanford Bernstein

Yes, thank you. It looks like you will have a significant year over year contribution again in 2009, from a lower share count, and from a modestly more favorable tax rate. I think if you back those out, your guidance appears to imply relatively flat or slightly down operating profit dollars in 2009. Can you comment on, given the fact that you appear to be forecasting improving margins through productivity initiatives and potentially gross margin, can you comment on what that replies about your expectations for revenue growth that would suggest that it would be materially negative?

Mark Loughridge

Well, first of all, let me just go back on your initial statement about tax. I mean the tax rate for quarter as we go in from 2008 to 2009 is actually, given that the actuals of fourth quarter, Tony, is modestly up, right, from 26.2 to 26.5. But nevertheless, I still think it’s a very good question. I mean as we looked at it, I said in the tax, that we have built a plan to deliver on $9.20 as an at least statement. And within that constant currency, we didn’t anticipate we are not building that assuming we are going to grow that constant currency revenue growth. And with currency clearly working against us, that implied that revenue will be down especially through the first three quarters of 2009 at today’s spot rate. So I think we have already built in a significant impact to revenue. We do think that we can manage through that however quite successfully. I think you saw that in the fourth quarter by continuing to drive real margin performance and productivity at the expense lines. So we’re pretty confident that even in the face of a difficult environment with the actions that we are taking an the ability to move to higher value content, mix improvement through the year, ongoing cost initiatives to consistently drive better cost base, that we can maintain our commitment to an least $9.20 for 2009.

Patricia Murphy

Thanks Tony. Let’s go to the next question.

Operator

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

Mark Moskowitz – JPMorgan

Thank you. Good afternoon. Quick question here on the BRIC growth. Mark, could you give us sort of a qualitative context around how much of the growth is driven by US or European companies setting up shop in the BRIC regions versus actual domestic companies in those regions?

Mark Loughridge

Well, let me – first of all, from the date I haven’t seen data that says that this is substantively driven by nine US companies in those growth market locations. But I think one way to look at the growth performance in the quarter, we had very, very good growth in Brazil, at growth of 17%. If you looked at India, we’re up 30%, another very, very powerful quarter. China came back from the impact that we saw from the Olympics with growth of 9%. We did have the impact from Russia, that was down. And I think given all of the analysis and news that I’m sure you have done as well as us, I think that is quite logical. But still, if you look at the BRIC countries, they came in at 13% growth which at 13% is very consistent with what we saw for the year. So we still see very good ongoing opportunities.

And one thing that I would comment on that I think is also an important analysis when you look at these growth markets, look at the growth rate, albeit there has been some reduction in that growth rate in the second half. But look at that growth rate relative to major market growth, and that differential has been in this kind of 8% range for some time. So, even as we have seen some slowing which when I analyze that slowing, it is not – I wouldn’t paint all of the countries with the same brush. Many countries continued to have this very vital, vibrant growth were impacted by some countries that saw some deceleration due to economic conditions, but that relative differential of growth market, the major markets at constant currency maintained at about the 8% differential. So, it still has a very, very strong investment characteristics that we are interested in.

But as we look at the investment and growth markets, we’re looking at the long-term. I mean believe me, as we roll out our offerings and our investments, we’re looking at what we think growth markets are going to be in a decade, not just a year. And so in good times, and bad times, we’re going to continue to exploit those opportunities. We think it presents very good investment opportunities for us, that margin and differential to major markets is ongoing, and we think they are going to be big contributors to the world economy over the next decade.

Patricia Murphy

Thank you, Mark. Operator, let’s take the next question please.

Operator

The next question comes from Bill Shope with Credit Suisse. You may ask your question.

Bill Shope – Credit Suisse

Okay, thank you. Mark, last quarter you noted that you expected to see improvements in x86 segment by the first quarter of 2009? Is that still the plan or has market conditions just fundamentally changed since then? And within that context, can you give us your view or some clarity on strategic importance of this business to the overall hardware portfolio and the overall IBM portfolio?

Mark Loughridge

Yes, sure. I’d be happy to do that. Let’s start with kind of a discussion of the strategic importance. The x System is an important element of our portfolio, so that when we put our broad based solutions together, we can use those to deliver value to our customer set. And to the extent that the customer is looking for that x86, that blade content, we want to make sure we have real capability that we can use to solve their problems. But if you look at the fourth quarter, let’s think about what the environment looks like from a customer standpoint. What is the customer looking to do? Number one, that customer is looking to improve their cost base, are looking to save on capital expenditures. They are looking for improvement in their cash base, and you just cannot beat the mainframe system and the p series systems to provide that kind of capability. I mean you can utilize a mainframe system up to the 100% of its capacity, or a p series up to 60% of its capacity. An x86 system, generally even in precision operations, less than 20%, so it just doesn’t have that capability to solve that particular customer problem, which I think is at the forefront of – their concern is they put together their budgets going forward. So I think naturally you’d see better performance from the high end of our product line with mainframe and p series, both showing strong growth characteristics as opposed to what we saw in the x86 platform.

Now in addition, you just can’t separate from the fact that even in kind of market intelligence analysis, even in this kind of an economy, the market view of the UNIX platform has stayed down 2%, 3%, but x86 is down 14%, 15%. So it is kind of four times more negative view of the opportunity set. So I think it’s a combination of those factors that accounts for the difference. But I think our Harbour platform gives us real opportunity to virtualization and cost savings, to deliver real value to our customer set in this kind of an environment.

Patricia Murphy

Thank you, Bill. Let’s take the next question please.

Operator

The next question comes from Richard Gardner with Citigroup. You may ask your question.

Richard Gardner – Citigroup

Okay, thank you. Mark, I think a lot of folks expected strength to continue to the end of calendar 2008, but a lot of investors are concerned that there might be a sharp fall off in 2009 as the budgets get reset and as your customers become concerned about economic conditions this year. Your guidance implies that you think things continue to be strong but can you give us any sort of sense as to how things are shaking out so far, whether you have seen a sharp off in the business? And as a corollary, whether there is any reason to expect the contribution of earnings throughout the year per quarter to be any different this year than it has been in the past?

Mark Loughridge

Okay. There’s a couple of points to deal with there. Let’s start with kind of the distribution across the year, and then we will come back and talk about what we're seeing in the demented environment. So if you look at the quarterly skew that we're anticipating in 2009, we think that the first-half, first quarter, first half of next year, from an economic standpoint is going to be more difficult than the second half. We believe that with the stimulus packages being rolled out globally that the economy starts to improve as we go into the back half of the year. And like that assumption, we think that in the first quarter, our performance will be relatively flat on a year to year basis with an expanding role in our EPS as we go into the second quarter, and certainly the second half of the year.

Now within that, there is a lot of moving parts in that first quarter. First of all though we expect the workforce rebalancing to be in kind of the normal range that we run every year, say $300 million to $400 million, I do think that it's going to be more front end skewed, and that front end skewing will impact the first quarter to some degree. On the other hand, as we have outsourced the logistics process for our business to Geodis, again that will occur in the first quarter, we expect will offset that. So I think there is a lot of moving parts, but if I put it all together, I think the first quarter is going to be relatively flat, and growth prospects in the second and the fourth quarter.

Now as far as the demand profile, as we go into the first quarter, let's go down – some of the brands on the software base of business, and we gave you the distribution of our profitability, so let's start from the fact that 90% of our profit now comes from software services and financing. But as we start with software, again we think we have a pretty good pipeline going into the first quarter. And not only do we see a pretty good pipeline going into the first quarter, versus typical first quarter pipelines, it's relatively more mature. So I think we have a good operating position going into the first quarter. And as we go through 2009, I would think we will see again a combination of both opportunities and our work on productivity and efficiency, we ought to be able to generate double-digit profit growth over the year from software.

Now let's go to services. On a services basis, as we go through – look at the opportunity, you saw the growth that we had in our SO signings from the fourth quarter. I mean we are the largest SO provider on the globe and it grow 23% at constant currency signings in the fourth quarter, and North America was up 45%. So that gives you a lot of business as you move into the next quarter, the reason that our backlog is up from $114 billion to $117 billion as we enter the year. Our short-term signings have been three years of growth. We think we have a very good handle on that. As we go into the first quarter, you saw real strength in our GBS short term signings, was sort of at the highest level we have ever achieved. So I put all that together and I say although we will still be focused on margins as the key contributor to our profit growth, we are looking to do double-digit profit growth over the year from both of those segments as well. So all of that together with the work that we are doing to drive more efficient, streamlined and productive structure in the back half of our business as well, leads me to believe that we can accomplish our view of at least $9.20 for 2009.

Patricia Murphy

Thank you, Richard. Let's go to the next question please.

Operator

The next question comes from Scott Craig with Banc of America/Merrill Lynch. You may ask your question.

Scott Craig – Banc of America/Merrill Lynch

Thanks, good afternoon. Mark, one thing on the restructuring opportunities here, it sounds like you are just pulling forward a little bit of what would be some normal workforce reductions. But in an environment like this that seems tougher than we have seen over the past couple of years, and even you're pointing to some revenue challenges, is there an opportunity to do some larger restructuring outside of the realm of what you would consider normal?

Mark Loughridge

Well, let's look at the restructuring in the quarter to begin with. I mean if you just look at the yield off that fourth quarter restructuring, that alone would improve our spend base by about $1 billion in 2009 which we expect to drop to the bottom line. So I think it already has a fair amount of yield in it. And if you look at the restructuring that we have done, in most years, and you can go back some time, we do about $300 million to $400 million of restructuring that consistently drives improvement in our cost base. We did more of this year. In 2008, it was a little north of 700, but if you take out the Japan action, we are back down about $580 million. So I think we have got a good plan there. There will be, as I said, some acceleration in 2009, but the total 2009 workforce rebalancing number will be in kind of normal range. And as a look across all of the actions that we are taking on cost and expense and spending, I think we have a very good plan and a very good hand to play as we go into 2009. You’ve certainly started to play out in 2008.

Patricia Murphy

Thank you, Scott. Operator, let’s take the next question, please.

Operator

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

Keith Bachman – Bank of Montreal

Hi, thank you. I wanted to ask about the revenue growth and more specifically, Mark, how much either of software of IBM total did software acquisitions add in Q4 with Cognos? And as we look over at 2009, given your characterization, what's presenting challenges to systems and technology, wouldn't that suggest that the revenue growth of that entity will continue to be significantly negative, large double-digit negative type of growth, and therefore would expect to see more margin pressure there throughout the balance of 2009? Thanks.

Mark Loughridge

Okay. If you look at our branded middleware, I think they did quite well in the quarter. We did have a very good quarter with our acquisitions. Cognos did do a great job. But we have pretty good organic performance in the quarter from our branded middleware content at constant currency, and I think we can carry that on. I’d also remind you that as we grew this business, albeit good contribution from our acquisitions, we really grow that profitability at the bottom line. And the profitability on a GAAP basis also had overcome the amortization of intangibles as well as the additional developments that we acquired in those businesses. So remember that profit performance had to overcome those elements of the accounting structures since we report on a full GAAP basis, and it still generated really strong profit contribution from our software business. So as I look forward, I think we ought to be able to maintain that ramp up profitability in the software business.

Patricia Murphy

Thank you, Keith. Let's go to the next question please.

Operator

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

Ben Reitzes – Barclays Capital

Good afternoon. I wanted to ask about margins a little bit more. It sounds like you definitely are expecting revenue decline in your guidance, but of the 300 basis point margin benefit in gross margin year over year, it seems like maybe you lose a third to pension, but you could still carry through significant benefit unless there is either pressure from the lower revenue that maybe hit some fixed cost or pricing, and I was just wondering what the puts and takes are and what you are expecting for gross margin line in particular for 2009, Mark?

Mark Loughridge

Sure. Well, let me first of all go back to you statement. I mean as we pointed out, when you look at pension, pension expense is going to be relatively flat on a year to year basis. So I would count it, excluding the Japan pension gain, if you exclude that, it’s pretty flat on a year over year basis, I would count it as neither a head wind nor a tailwind. And if you look at the revenue decline based on the fact that we are kind of structuring this assuming no constant currency revenue growth, the real negative comes from the currency impact in the first three quarters of the year. So we take very specific actions to counter that. You know that we hedge cash flows and that the hedged cash flows helps us to substantially offset a lot of that currency impact. We have natural hedges because we source different products from different geographies, so the natural hedges help. We price to offset currency movements across our business lines as well as specify terms and conditions on the contract structure to help mitigate the effect. And that's the biggest element of this negative revenue growth performance.

So then you look at it on top of that, you say, well, okay, I understand that it mitigates the negative impact of currency, how about your base level performance? We continue to move to higher value offerings, benefits from mix benefits. We will continue to display that. I think has been very successful for us and the major markets have constantly driving productivity to yield profit growth in the growth markets to satisfy those customer requirements of infrastructure, cost and capital conservation, which are not peripheral commodity like product installations. In many of those, we have had some of our biggest back office installations of that from the growth markets. So I put all of that together, and I look at it, and I think we certainly have enough capability to deal with the challenges that we are facing on both a tough economy and the headwind of currency and still achieve our objective of at least $9.20.

Patricia Murphy

Thanks, Ben. Let’s go to the next question please.

Operator

The next question comes from Katie Huberty with Morgan Stanley. You may ask your question.

Katie Huberty – Morgan Stanley

Thanks, good evening. Mark, how would you characterize your appetite for acquisitions in light of current market conditions, your cash levels, valuations, et cetera?

Mark Loughridge

Well, that is a very good question, because as we close out the year, I mean we have $12 billion in cash. We just looked at our free cash flow generation, that was very, very powerful. So we have good cash flow generation capability of the business with free cash flow. We have got a lot of cash on hand as we close off the year, and there are a lot of alternatives that we will look at as we utilize that cash most effectively. We have got good investments to make in our base level of business, to exploit what we see as being opportunities in cloud computing and a smarter planet. We see opportunities in our own stock price because we would get a much bigger yield of that dollar spent on a share now because one, it is obviously at a lower price, but there won't be any dilution against this. But third, you know valuations in the marketplace are very attractive. And our operating capability to acquire, integrate and exploit those values I think has been very, very credible and very reliable for us and did a pretty darn good job in 2008. So I think they all have very attractive elements and I think we are in good shape to exploit them given our cash balance and our free cash flow generation.

Patricia Murphy

Thanks Katie. Let's go to the next question please.

Operator

The next question comes from Maynard Um with UBS. You may ask your question.

Maynard Um – UBS

Hi, thanks. If I could just ask the margin question another way, in some of the segments you’re already achieving margins at levels that you haven't seen or haven't seen in a while or ever, and reaching levels closer to the those of your respective segment peers. I'm just curious, do you think you can close the gap across the different segments in reaching those levels of margin expansion because IMO I think you have done a great job on the margins, just a little bit surprising that further margin improvement is really what's going to drive the EPS upside going into 2009? Can you just let us extrapolate a little bit here and let us know if you think you can close that gap with your peers? Thanks.

Mark Loughridge

Sure, absolutely. That's – bottom line, that obviously our plan, is we are only climbing on building this at kind of flat revenue on a constant currency basis. So when I look at it, we did have really good margin performance at our services business. But you know that margin wasn't the all time high for services either, and I look at the capability that we're driving in our services business, then I think there is more to be had. When I look at our software business, I don't expect to see substantial improvement in our margin software, but I do expect that we will mix more into our software business, and that mix is going to fall to the bottom line. And then lastly, I know what our plans are for cost takeout against the $90 billion spend base and we have been very effective here. And you have seen that in our current level of performance. So when I put all of that together, against that headwind that we earlier discussed of a difficult economy and currency against this, I think we have sufficient alternatives and levers, capabilities, good plans in place to achieve the margin performance required to deliver that $9.20.

Patricia Murphy

Thank you, Maynard. Let's go to the next question please.

Operator

We have one question left and that question comes from David Grossman with Thomas Weisel. You may ask your question.

David Grossman – Thomas Weisel Partners

Sure. My question is actually on the mainframe, it looks like growth obviously continued to slow in the fourth quarter. First, is there anything that you can share with us that would provide better insight into how to think about performance in 2009? And second, is there any guide for us that you can give us to think of how a slowing mainframe cycle in 2009 will affect the other two segments in software and services?

Mark Loughridge

Sure. Well, if you look at the mainframe, I mean we had I think pretty good performance. I mean we shipped the z10 and grew revenue 12% year to year for the year. In the quarter, we had MIPS up 12%. So as I look forward, and the ability for the mainframe to solve customers requirements, to substantially improve their cost structure, to me it would still look like very good opportunity ahead of us. So I kind of look at it and compare it to the z9. I mean the z9 product cycle was ten quarters long. It had MIPS growth for eight of those ten, and it had revenue growth for six of the ten. And I think that the rollout of the z10 and that life cycle will be reasonably similar to that z9 profile. Now the mainframe does face a tough compare in the first half of 2009, so I don't think that’s going to roll out exactly every quarter. But over the course of the year and certainly going into the second half, I think the mainframe will continue to have a longer life cycle than the earlier models, much like the z9 cycle, and be more extended and predictable as we go through the year.

So let me take this opportunity to wrap up. While I completely understand that 2009 will no doubt be a challenging economic environment, we are ending the year I think in a very strong position. We have financial flexibility across our free cash flow, our cash balance, our position at the end of the year, and we're very well positioned to deliver the results, even in an environment where revenue growth is difficult. We have transformed this business to be more adaptable and to drive margin growth. I think you can really see that in those additional charts that we have provided, showing our performance over a longer period of time, not just in growth of profit, cash and earnings per share, but also the change of that mix of our business, we performed the elements of our offerings. And in the process, a greater mix towards software and services has also made IBM more competitive in these high value opportunities.

So we are encouraged by the performance of our offerings and solutions portfolio as clients prioritize for cost reduction and capital conservation and risk management. As we look forward, we think there is a lot of opportunity in next edition infrastructure projects that stimulate economic activity and global competitiveness. Now you have seen what we’ve thought on some of these products and projects like small utility systems and healthcare IT and broadband networks. They are very complex IT systems, demanding complex solutions, but we believe the investment we have made over the past decade in deep process insight and the integration of our software, hardware and services business positions IBM very well to make important contributions to these efforts. So admittedly, there is a lot of uncertainty in the current business environment, but with the strategy we have in place, and the transformation we continue to drive, I really like our hand. And I believe we are well positioned to come out even stronger as things improve, but as always, it is back to work.

Thank you very much.

Operator

Thank you for participating on today's call. The conference has now ended. You may disconnect at this time.

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Source: International Business Machines Corporation Q4 2008 Earnings Call Transcript
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