International Business Machines Corp. Q4 2009 Earnings Call Transcript

| About: International Business (IBM)

International Business Machines Corp. (NYSE:IBM)

Q4 2009 Earnings Call

January 19, 2010 4:30 pm ET


Patricia Murphy - Vice President of Investor Relations

Mark Loughridge - Chief Financial Officer, Senior Vice President


Richard Gardner - Citigroup

Toni Sacconaghi - Sanford C. Bernstein

Ben Reitzes - Barclays Capital

Robert Cihra - Caris & Company

David Bailey - Goldman Sachs

Katie Huberty – Morgan Stanley

Chris Whitmore - Deutsche Bank

Lou Miscioscia – Brigantine Advisors

Scott Craig – Bank of America

David Grossman - Thomas Weisel Partners


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. Madam, you may begin.

Patricia Murphy

Thank you. This is Patricia Murphy, Vice President of Investor Relations for IBM. I am 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 will turn the call over to Mark Loughridge.

Mark Loughridge

Thank you for joining us today. The fourth quarter capped off a great year for IBM driven by continued margin expansion, profit growth, and cash generation, all in an uncertain environment.

Let me start out by sharing a few financial highlights. In systems, we had substantial share gains in POWER 4 points, System X 3 points, Blades 6 points and storage 1 point. In software, we had share gains in WebSphere, Tivoli and Key Branded Middleware and in services we booked $18.8 billion of services signings and $57 billion for the year.

In 2009, outsourcing signings were up 9% or 11% at constant currency. Once again we had great profit and margin performance. This quarter, PTI grew 10%. We expanded margin and grew pre-tax profit in every segment.

As we indicated in October, we had double-digit profit growth in Systems and Technology, up 15% for the year. PTI margin was up 2.8 points led by Services up over 2 points, Software up over 5 points and Financing up over 6 points. When you put this all together, we delivered EPS of $3.59, which is up 10% and $10.01 for the year, up 13% making this our seventh consecutive year of double-digit EPS growth.

Now let me give you another perspective on 2009 EPS. In May 2007, we established our roadmap, with an EPS objective for 2010 of $10 to $11. With EPS of $10.01 in 2009, despite a challenging economy, we got there one year early. In 2010, we expect to deliver our eighth consecutive year of double-digit EPS growth, or at least $11 of earnings per share for the year with consistent EPS growth throughout the year.

For the first quarter we expect a 4-5 point improvement in IBM’s year-to-year revenue growth rate from the fourth quarter at both actual rates and constant currency. This would result in mid single digit revenue growth at actual rates with software posting double-digit growth. We are confident in our ability to continue to leverage our business model to expand margin, grow profit, generate cash, return value to shareholders and return to revenue growth in 2010.

Now, before moving on to the details of the quarter I want to take a step back and talk about our performance over the longer term. You can see that we have consistently generated strong profit and cash growth since the last recession in 2002. So let’s look at what we have accomplished recession to recession.

Since 2002 we have added $12 billion to our pre-tax profit base. Our pre-tax margin is up 2.5 times. Our EPS is up four times and cumulatively we have generated about $80 billion of free cash flow. This is the result of a dramatic transformation we started at the beginning of this decade. It is driven by a combination of shifting our business mix, improving operating leverage through productivity and investing to capture growth opportunities.

Let’s take a look at these three initiatives. First, we have been remixing our business to move to the higher value areas. We exited commoditizing businesses while at the same time acquiring 108 companies since 2000 for a total of almost $22 billion. These portfolio actions have contributed to a significant change in our mix of business. In 2000, services segments PTI was $4.5 billion and in 2009 it is over $8 billion.

Our software profit growth is even more impressive. In 2000 software segment PTI was $2.8 billion and in 2009 it is also over $8 billion. That is almost tripled. In 2009, over 90% of our segment profit came from software, services and financing with software and services each contributing 42% of our segment PTI. The unique portfolio of businesses we have built, heavily weighted toward software and services, generates high profitability and we will continue to remix to higher value through organic investments and acquisitions.

Second, we have had an ongoing focus on driving operating leverage through productivity. We are leveraging our scale and global footprint to improve processes and productivity in a number of areas like support functions and service delivery. In 2009 we yielded $3.7 billion of cost and expense savings from the structural actions we have taken. Along with mix, this helped drive our 1.7 point improvement in gross margin and 9% reduction in operational expense for the year. These actions are reducing our fixed cost base and improving the operational balance point. This will provide a real advantage as the spending environment improves with solid operating leverage off of our now leaner cost base.

Third, our strong margins and profitability enable us to make significant investments for growth. We have been investing to capture the opportunity in the emerging markets as these countries build out their public and private infrastructures. In 2009 while the economic environment slowed globally our revenue growth in the growth markets remained 8 points faster than the majors. We have been investing in capabilities that differentiate IBM and accelerate the development of new market opportunities; areas like business analytics, cloud computing and smarter planet.

In 2009 we invested almost $6 billion in research and development to strengthen our technology leadership. Last week we announced that for the 17th consecutive year we were number one in U.S. patents with over 4,900 in 2009. That is more than the total of Microsoft, HP, Oracle, Apple, Accenture and Google combined and consistent with our shift in business mix, about 70% of our patent portfolio is for software and services. We have complemented our organic investments with acquisitions and one of our primary investment areas is business analytics which provides a solid platform for our Smarter Planet initiatives.

Since 2005 we have invested $10 billion or $8.5 billion net in 14 strategic acquisitions to build our business analytics capabilities. These acquisitions delivered strong results in 2009 generating 9% revenue growth at constant currency. So over the last decade we have driven a significant transformation of our business and we will continue to shift to higher value areas, improve efficiency of our business and invest where we see the best long term opportunities. All of this positions us for growth as we move into 2010.

Now I will turn to the detailed financial results for the fourth quarter. I will start with a quick walk down the P&L for the quarter. Our revenue was $27.2 billion, that’s up 1% year-to-year, and down 5% at constant currency. With continued strong margin performance, we increased pre-tax income by 10% and net income by 9%. Gross margin expanded 40 basis points due to better margins in services and systems.

Our expense was better by 5% year-to-year driven by actions we have taken to continue to transform and globalize the business and focused expense management. Pre-tax margin was up 1.9 points year-to-year to 23.4%. With an increase in our tax rate year-to-year, net income margin expanded 1.3 points to 17.7% and finally, our ongoing share repurchase activity drove a lower share count year-to-year, though it was up sequentially due to increased dilution because of the higher stock price.

So bottom line, we delivered $3.59 of earnings per share, up 10% from a year ago and I will remind you that we had 18% EPS growth in the fourth quarter of last year so this is double-digit growth off of a very strong base. The balance sheet is solid and capital structure is well positioned to support our strategy. Our liquidity position remains strong. We finished the year with $14 billion of cash on hand.

Now let me get into the fourth quarter details, starting with revenue by geography. In discussing the geo results, as always, I will focus my comments on constant currency.

The major market growth was consistent with the last couple of quarters. In the fourth, the UK had solid growth and sequentially we improved performance in Canada and Japan. The growth markets once again outpaced the major markets in the fourth quarter by 9 points of revenue growth. For the year, the growth markets grew 8 points faster and contributed 19% of IBM’s geographic revenue. This quarter, the BRIC countries were up 7% driven by growth in India, Brazil and China. For the full year, China grew 10%.

In China, we are leveraging our broad portfolio to provide comprehensive solutions to our clients. Recently we announced one of the largest and most comprehensive consulting engagements to date in China, where we are helping to build smart eco-cities across the country.

We see growing opportunity around the world, much of which is outside the traditional IT opportunity, to help our clients drive efficiency in their physical infrastructures.

Turning to the results by segment, I will get into the specifics within each of the segment discussions, but let me give you a snapshot of the revenue and gross profit performance.

Our total services revenue performance at constant currency was fairly consistent with third quarter and we had year-to-year growth in both signings and backlog. In Software, we gained share in key branded middleware. We had a number of transactions that didn’t close this quarter, and we are entering the first quarter with a very strong pipeline. Systems and Technology year-to-year growth improved again in the fourth quarter with share gains in most brands and particular strength in System x.

Across all of our segments we had great margin performance. Our productivity initiatives have yielded consistent improvement in our gross margin over time. This is the 21st quarter of the last 22 that we have expanded our gross margin. Now that’s quite a streak.

Now let’s take a look below the gross profit line to our expense and spending profile. Our total expense and other income was down 5% and our expense-to-revenue ratio improved 1.5 points year-to-year. The expense reduction was driven entirely by operational expense which improved 15 points year-to-year. Mitigating this improvement, currency impacted expense growth by 9 points and acquisitions by one point.

We have been executing our operational plan to increase efficiency and drive productivity, leveraging scale and our global footprint. We have focused on all areas of the business and this year we yielded $3.7 billion of cost and expense savings from a number of initiatives such as the globalization of our support functions and rebalancing our workforce. These actions reduce our cost base and make it more variable. A lower level of fixed cost improves our operational balance point, so as we return to growth we’ll get better operating leverage off of our cost base.

To close out the discussion on spending, as always I will lay out the roadmap of items that had significant year-to-year impacts to our profit. First, accounts receivable provision was better by about $70 million year-to-year, driven by a lower level of additions versus last year. Our reserve coverage is flat year-to-year at 2%.

Second, we had a year-to-year benefit of about $80 million from investment transactions driven by a charge in the fourth quarter of 2008 related to an investment in a joint venture.

Third, consistent with what we told you in October, we had workforce rebalancing charges of about $100 million in the quarter virtually all of it in Europe. These charges are down $340 million from last year’s fourth quarter. Impacting profit growth, our retirement-related plans were worse by $100 million in the fourth quarter. As we described last quarter, we had a one-time curtailment gain associated with a non-U.S. plan of about $120 million. We also had an unprecedented regulatory charge in Germany.

Let me explain. Companies with German pension plans are subject to mandatory pension insolvency insurance coverage. In the fourth quarter, we received notification of a significant premium increase due to the level of insolvencies of other companies in Germany in 2009. This does not relate to the IBM plan, it is other companies’ plans in Germany. This premium increase resulted in an annual charge of almost $140 million, a year-to-year impact of $120 million in the quarter though the cash impact will be spread over five years.

So this quarter we had a large gain and an unanticipated offsetting charge in our retirement related costs neither of which is related to our operational performance. For the full year 2009, retirement related plans, including this insolvency insurance charge, cost about $1.4 billion. This is relatively flat versus 2008.

Let me comment on the performance of our pension plans. In the U.S. plan, return on assets was up 11% for the year. Our non-U.S. plans which comprise about 40% of our assets, in aggregate were up 14%. So globally, our pension plans were up 12% 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 5.6% reflecting the current interest rate environment.

In 2010, 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, a year-to-year increase of almost $100 million. From a funding perspective, we ended the year with total assets in our defined benefit plans of $82 billion. Our U.S. plan is fully funded, and globally our qualified plans are 99% funded, so we have made great progress in a year.

I will comment on two other items. With the year-to-year change in currencies, our hedge of cash flow program generated a loss in fourth quarter 2009 as compared to a gain last year. The year-to-year impact in the fourth quarter was over $430 million which is roughly half in expense and half in cost of goods sold.

Our tax rate was 24.6% in the quarter, up 80 basis points year-to-year. For the full year 2009 our tax rate was 26% and for 2010 we expect a tax rate in the range of 26 to 26.5%, so fairly consistent on a year-to-year basis.

So now let’s turn to our segment margins. This is a snapshot of both gross and pre-tax margins by segment and as you can see, the improvement is broad based. Our PTI margin improvement of 1.9 points was led by Systems and Technology, up 2.6 points; Software, up 2.4 points and Global Financing, up 5½ points.

I will comment briefly on our Global Financing business. We are emerging from a challenging credit environment with strong financial results in Global Financing. Our financing business remained focused on core competencies, providing IT financing to our IBM customers and business partners and delivered both gross profit margin and PTI margin expansion this quarter and we ended the year with a return on equity of 34%.

Now let’s turn to the segments, starting with Services. In the fourth quarter, the two services segments delivered strong margin performance and good growth in outsourcing signings to cap off a very strong year. For the full year, the combined services businesses delivered $8.1 billion in pre-tax income, up 11% year-to-year. Pre-tax margin was up 2.3 points to 14.1%. This improved margin was a result of the structural changes we have made to services delivery over the past several years. The global delivery capabilities we have built proved to be dynamic and flexible enough to deal with very tough market conditions.

Our backlog at the end of the year was $137 billion, up $7 billion year-to-year and over $2 billion sequentially. We delivered $57 billion in new services business with outsourcing signings up 11% at constant currency for the year. Outsourcing signings growth was broad based. We grew across all major geographies; the Americas, Europe and Asia and we grew in each of our outsourcing categories; Strategic Outsourcing, Business Transformation Outsourcing and Application Outsourcing. Overall, we had very strong margin and signings performance in what was a difficult economic climate.

Now let me turn to the fourth quarter results. Our services segments delivered revenue of $14.6 billion, up 2% at actual rates, but down 5% at constant currency. Total signings were $18.8 billion, up 9% at actual rates, or 2% at constant currency. Within that, total outsourcing signings were up 15% at actual rates and 8% at constant currency and we signed 22 deals greater than $100 million.

Now I will go to the key drivers of performance in the two services segments. In Global Technology Services, total GTS signings were up 3% at actual rates but down 4% at constant currency. GTS outsourcing signings were up 5% at actual rates, down 1% at constant currency. For the year, GTS outsourcing signings at constant currency were up 8% with major markets up 7% and growth markets up 14%.

Integrated Technology Services signings continue to be impacted by client deferrals and capital constraints. However we have seen stability in the past two quarters in smaller transactions under $5 million. Global Technology Services revenue in the quarter was $10.1 billion, up 4% at actual rates or down 3% at constant currency. Revenue trends in outsourcing should improve through 2010 as we start to see the benefits of 2009 signings. In Integrated Technology Services, revenue performance largely reflects signings performance which continued to be impacted by declines in OEMs as we shift our portfolio to higher value offerings. Global Technology Services improved gross margin nearly a point and pre-tax margin 60 basis points to 15%. For the full year, Global Technology Services gross profit margins expanded in all lines of business and total pre-tax margin was up 3 points.

In Strategic Outsourcing we have improved gross margin for five consecutive years while improving overall service delivery quality. We have accomplished this through a disciplined and innovative approach to delivery focused on both labor and non-labor productivity actions. As you know, we have been executing a strategy to deliver services out of key global delivery centers using consistent global delivery methods and processes.

We are continuing to expand our capabilities with new centers in Dubuque, Iowa, Cairo, Egypt, and Wroclaw, Poland. We are also improving labor utilization with analytics and by applying supply chain tools and techniques to our labor base. In Integrated Technology Services we improved margin by mixing toward more profitable labor- based services and in Business Transformation Outsourcing through improved deal selectivity and delivery performance.

Turning to Global Business Services signings were up 20% at actual rates and 13% at constant currency. Application Outsourcing signings were up 65% at actual rates and 55% at constant currency. For the full year signings were up 25% at constant currency. This performance illustrates the strong value proposition that Application Outsourcing can provide our clients with compelling cost savings.

Consulting and Systems Integration signings were up 3% at actual rates, down 3% at constant currency, a significant improvement over third quarter. This quarter small deal performance improved as the quarter progressed. General Business and Distribution Sectors grew and the growth markets were up 34% at constant currency.

Global Business Services revenue was down 3% at actual rates, 9% at constant currency while pre-tax margin improved 1.1 points to 16%. This was a record level of pre-tax margin driven by strong utilization in our delivery centers, good subcontractor resource management and spending management. Throughout the year this dynamic delivery model has enabled us to perform well in a tough economic climate and this quarter we saw some of the leverage our delivery model can provide with profit growth on lower revenue.

Overall, we feel encouraged about the business as we saw improving trends in revenue, margin and signings. So our two services segments did a great job delivering value and managing margin in a very challenging year. We believe that our dynamic infrastructure and delivery capabilities are paying off. It is what enabled us to deliver on our profit objective of $8 billion for the year and we are well positioned heading into 2010 with double-digit outsourcing growth in 2009, backlog of $137 billion, improving trends in Global Business Services and a delivery structure that has enabled us to perform exceptionally well in a tough environment.

Turning to Software, revenue of $6.6 billion was up 2% year-to-year, down 4% at constant currency. Key Branded Middleware grew 6% and was flat at constant currency. Branded Middleware gained share for the ninth straight quarter as we continue to solidify our lead in the middleware market. In fact, it represented 63% of our software revenue in the quarter. That is up 2 points year-to-year.

Software pre-tax income was up 10% and pre-tax margin was up 2.4 points year-to-year to 41.5%. For the full year we delivered 14% profit growth in software and expanded margin by 5 points. Software delivered over $8 billion of pre-tax income; nearly triple the profit in 2000.

Now let me take you through the brands. WebSphere had another strong quarter growing 13%, or 6% at constant currency and gained share. Business Process Management, Commerce and Data Power product segments all grew double-digits. ILOG, which drives business rules management, did very well again this quarter and contributed to WebSphere growth. Information Management software was up 7% or 1% at constant currency and held share.

Business Analytics continues to be a key growth area. Cognos posted strong double-digit growth and gained share providing a proof point on analytics demand in the market. IBM’s acquisition of SPSS further strengthens our business analytics and optimization strategy by delivering predictive analytic capabilities that help customers drive better business outcomes. Info Sphere Warehouse, which helps our customers turn information into a strategic asset, also grew double-digits.

Tivoli grew 7%, or 1% at constant currency and gained share. Enterprise Asset Management, which is part of IBM’s Smarter Planet strategy, grew over 40% in emerging markets. Tivoli storage continued its robust growth as customers manage their rapidly growing storage data. Data Protection as well as Storage Management grew double-digits with broad- based geography and sector growth. Lotus software declined 5% or 11% at constant currency. Rational declined 4% or 10% at constant currency and held share.

Although Software faced a difficult compare against a very strong fourth quarter of last year we saw continued strength in the demand for software in the Growth Markets, strong growth from our recent acquisitions and an increase in the volume of small deal activity in North America. So all very encouraging signs. There were a number of large deals, however, that did not close during fourth quarter and have contributed to a very strong first quarter opening pipeline. Consequently, we expect Software to grow revenue double-digits at actual rates in the first quarter.

Systems and Technology revenue was $5.2 billion, down 4% at actual rates and 9% at constant currency. While our revenue performance bottomed in the second quarter of 2009 the rate of year-to-year decline has sequentially improved in each of the past two quarters. We had strong growth in System x and blades and improved performance in microelectronics. We gained share in System p, System x, blades and both disc and tape storage.

Gross profit margins improved year-to-year in all brands and for Systems and Technology in total. This quarter marks the highest gross profit margin for this business since fourth quarter of 2007 driven by improvements in our System x server business and converged p. Bottom line, Systems and Technology pretax profit grew 15% year-to-year in the fourth quarter.

System z revenue declined 27% year-to-year. MIPS declined 19% in the fourth quarter. Over the past two years, MIPS grew 4% compounded. This is consistent with what you would expect at this point in the product cycle. Later this year we are releasing the next generation System z. Converged System p revenue declined 14% year-to-year and gained 4 points of market share. This is the seventh consecutive quarter of market share gains.

System p has gained share in 10 of the last 12 quarters. In the fourth quarter our success with competitive UNIX displacements continued with almost 200 competitive wins totaling nearly $200 million in the quarter. For the year, we had over 500 competitive wins which generated sales of over $600 million. Later this quarter we will introduce the next generation Power systems which will deliver 2 to 3 times the performance in the same energy envelope. So quite an announcement for this product line.

System x server revenue grew 37% year-to-year taking 3 points of share. This is our fourth consecutive quarter of share gain. Our improved sales model and enhanced product offerings are the key contributors to this performance. Total System x blades grew 56% year-to-year and we expect to gain 6 points of share in blades. Storage revenue grew 1% year-to-year but was down 4% at constant currency. Disk grew 6% and gained share. Disk growth was driven by strong growth in midrange and XIV.

In fact, we added more than 130 new customers to our XIV platform in the fourth quarter and 400 since the acquisition. Tape declined 10% but gained share again in fourth quarter. Microelectronics OEM revenue was up 2% year-to-year. Our 300 mm fab is at near full utilization and our 45 nm process output was sold out again this quarter.

Systems and Technology closed out 2009 with improving year-to-year revenue dynamics, gross margin improvements in every brand, pre-tax income growth of 15% year-to-year and a margin of 15.4%, up 2.6 points year-to-year. Quite a performance for our hardware business.

Turning to our cash performance we generated $7.2 billion of free cash flow in the quarter, down $600 million year-to-year. For the year, our free cash flow was up $800 million to $15.1 billion. This is our seventh consecutive year of free cash flow growth. The year-to-year improvement was driven by growth in net income, higher cash from sales cycle working capital and lower CapEx. This was mitigated by higher retirement-related payments.

When I look at uses of cash for the year we reduced our debt by $7.5 billion and we returned $10.3 billion to shareholders. $2.9 billion of this was through dividends and we bought back almost 69 million shares for $7.4 billion including $3.1 billion this quarter. At the end of the year we had $6.1 billion remaining from our last board authorization.

Turning to the balance sheet, we finished 2009 with a substantial cash balance of $14 billion. Cash is up $2.5 billion from September and $1 billion from last December. Our strong free cash flow enabled us to add to our cash balance while reducing our debt by almost $8 billion from last year.

Our total debt balance is now $26.1 billion. Of this, $22.4 billion is in support of our Global Financing segment which is leveraged at 7.1 to 1. So, our non-financing debt was $3.7 billion, down almost $6 billion from a year ago. As a result of the debt reduction and growth in equity, our non-financing debt-to-cap is now 16%. The balance sheet remains strong and positioned to support the business over the long term.

I will start to wrap up with a brief discussion of the drivers of our earnings per share performance. This quarter, revenue growth contributed to our earnings growth. Our ongoing work to improve our operating leverage resulted in gross margin expansion and expense productivity which together contributed $0.30 of the $0.32 of EPS growth. We also had a modest benefit from share repurchases but it was offset by a higher tax rate.

For the year you can see the benefit of the shift to higher value areas and focus on driving efficiency in the spending base as margin expansion and expense productivity by far were the largest contributors to our earnings growth Our ongoing share repurchase program contributed another $0.34 and tax rate provided a very modest help of only $0.03.

All in, we delivered EPS of $10.01, our seventh consecutive year of double-digit earnings growth. This was a great year in a tough environment all a result of the strategic transformation of our business. We have been shifting to higher value businesses. This better positions us to meet client needs and drives a more profitable mix. In 2009, software and services each contributed 42% of our segment profit.

We have also been globally integrating our company to improve productivity and efficiency. Our ongoing productivity initiatives have reduced our fixed cost base and improved the operational balance point, generating more profit from each dollar of revenue. With a spend base of almost $80 billion we have got a lot of opportunity to continue to reduce structure and make our business more efficient. This operating leverage will provide a real advantage as revenue performance improves in 2010.

We are using our strong profit and cash base to drive the significant investment needed to expand our base of opportunity both organically and through acquisitions. We are positioned to capture the secular growth opportunity in the emerging markets and we are investing in areas like our Smarter Planet solutions, business analytics and new compute models such as cloud computing.

In addition to supporting investments in growth initiatives and acquisitions our great cash position and strong cash flow allow us to return capital to shareholders. This year we spent over $10 billion on share repurchases and dividends and increased our dividend for the 14th consecutive year. Bottom line, the changes to the company have allowed us to deliver strong performance since 2002 and even over the last two years in a tough environment. More importantly, the transformation has positioned us to come out even stronger in 2010 and as I said earlier, for the full year, we expect EPS of at least $11 for the year.

Now Patricia and I will take your questions.

Patricia Murphy

Thank you Mark. Before we go to the Q&A I would 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. Second, I would ask you to refrain from multi-part questions. When we conclude the Q&A I will turn the call back to Mark final comments. Operator please open it up for questions.

Question and Answer Session


(Operator Instructions) The first question comes from the line of Richard Gardner – Citigroup.

Richard Gardner - Citigroup

First of all, I was hoping you might be willing to provide either quantitatively or qualitatively some sort of waterfall to your double-digit EPS growth estimate in 2010. Then as an adjunct to that, can you tell us which segments have the most room for further structural market expansion over the next 2-3 years. Thank you.

Mark Loughridge

Let me put this in context. I think as we go into 2010 we should go back and look at the overall roadmap for 2010 because frankly the progress that we anticipate making in EPS is going to be very similar to the rollout and the balance that we had in that original roadmap. Now just to review that it had an element of our typical [weather] growth, our margin expansion actions, our share repurchase actions, our investments in growth, our acquisition focus and then lastly actively repaying the pension. But I would contrast 2010 to 2009 as 2009 working through a recession with as much pressures we had on the revenue line it really required us to over-weigh the contribution to margin.

You saw the actions we put together to do that. We put out $3.7 billion of spend. We achieved some very strong margin performance across our business lines but as you look at 2010 I would contract it. We will still have margin expansion? Absolutely. Consistent with our overall roadmap but I don’t think it is going to be over-weighted to margin like it was in 2009. In 2010 it should be a more balanced performance on revenue performance with new product and a more stable economic environment. You saw that as we described improving our growth rates from fourth quarter to first quarter between 4-5 points both in constant currency and at actual rates. You will see the ongoing focus and contribution to margins.

As we get the better revenue performance that revenue can now take advantage of the improved leverage in our business as we are able to take all this spend out as a matter of efficiencies. In addition we are always driving tools and content to drive that efficiency. Process efficiencies, standardization, tools and analytics. If you look at the first quarter we will have a gain from the sale of our PLM business offset by a charge predominately in Europe and Asia for productivity actions.

So those will continue to drive our margin performance. Then in addition we are still very focused on share repurchase and on share repurchase we had contracted a little. You will remember we closed out last year fairly high core debt to cap at 49%. So we were relatively cautious and I think conservative concerning share repurchases. Now we enter 2010 big recovering of pension funds so now our core debt to cap is in a very, very conservative 16%. So share repurchase is still [front point now]. You have to admit if the share price was higher we will still have a lot of dilution at that share price but we will still have good contributions and share repurchase.

I am most interested in the momentum that will pick up from our growth investments. Our investments in Smarter Planet, Business Analytics and Cloud Computing and the contribution we get from those as well as the ongoing performance in our acquisitions. As you saw in the fourth quarter acquisitions performed very well. Very well.

Again, the way I would look at it is in 2010 we should see a more balanced contribution to our EPS growth from all of the elements of the overall roadmap and opposed to 2009 when it was over weighted on margins and can be a recessionary end.

Now when you look at the segment that has the most room for further structural margin content they will all benefit from the structural actions that we are taking across the board as a corporation and I would say as you look at overall margins though we have had very good gross profit margin and I am very encouraged by it over the last 22 quarters I think we have expanded 21 of those 22, we are still not in that top quartile of margin performers in the S&P 500 or the Tech Universe Top 330 companies. So I think our objective should be to firmly engage in that top quartile.


The next question comes from the line of Toni Sacconaghi - Sanford C. Bernstein.

Toni Sacconaghi - Sanford C. Bernstein

This quarter IBM grew at minus 5% constant currency. Last quarter you grew at minus 5% in constant currency but the comparison was actually easier this quarter. So given what appears to be from your commentary an improving economic environment were you surprised you didn’t see better revenue growth? I know you called out some software deals not closing. Maybe you can dimension how significant that was in the quarter and whether there were other reasons why we didn’t see better revenue growth in light of a modestly easier compare year-over-year and then an improving demand environment?

Mark Loughridge

Sure. I think that is a very good question. If you look at the content businesses one of the trends that we saw in the fourth quarter that was quite encouraging is the performance of smaller deals. That is smaller deals across our hardware business, our software businesses, our services business both in major markets and [inaudible] in our growth markets.

Number one, smaller deals are a significant portion of our total revenue stream but I think what we are seeing in smaller deals have been more characteristic of a leading indicator. So as we entered the recession those smaller deals produce a little more aggressively than we see them coming back especially at the end of the quarter. But what is interesting about it, it was across our business units as well as in the major markets and growth markets. So with the stronger small deal performance entering the third quarter that gives us a level of confidence.

Secondly, we did literally have a lot of large deals that were fairly well progressed in the quarter roll over for the first quarter especially in our software business. That is why software at actual rates we see in the double-digit level performance as we go into the first quarter. Then additionally we have seen this trend through the year in our hardware base of business after we kind of bottomed out in the second quarter that the growth rates will improve every quarter as we went from third quarter to fourth quarter and with our new announcement that we see in p. series in the first quarter we think that should also help improve that level of performance.

So you put all those together and all the work that the teams and the general management have done on their pipeline and their deals and that is why we feel pretty confident we should be able to improve the relative growth rate by 4-5 points as we go from fourth quarter performance to first quarter performance over constant currency and actual rate. That would put us at actual rate kind of a mid single digit level of growth.


The next question comes from the line of Ben Reitzes - Barclays Capital.

Ben Reitzes - Barclays Capital

Over the last four years you have averaged about 18% EPS Growth and your guidance is basically 10% plus for the year as we enter an upturn in IT spending and economic activity. You said you have more leverage in your OpEx given things you have done and you have room for a buyback and your pension expense was in line with where you said it would be. My question is are you just being conservative or is there anything out there with the economy or anything else in the P&L that keeps you conservative? That hedging loss year-over-year was the big number that kind of surprised me. The $430 million. Maybe that is a hit in upcoming quarters so you are being conservative? If you could you just go through that that would great. Thanks so much.

Mark Loughridge

When you look at it from my perspective sitting here January 19th and looking out for the close of the year to be a double-digit EPS growth coming off of what really is seven consecutive years of double-digit EPS performance. I think that is a pretty strong statement. So for us to come out this early and peg that I think is pretty strong. Obviously if revenue performance turns out to be even stronger than what we are looking at now then we should have upside to that number.

Frankly as we looked at it I pegged the at least $11, and I remind everybody that is an at least number, a kind of flat constant currency performance of the year. If it is better than that then we certainly have upside. On that base we do see some encouraging signs in our business but frankly our indicators are based on that 90 day framework so I would like to get into that first quarter and get a little more validation that it is an ongoing recovery before we take this up further than we have. I think 10% growth in what would be a 8% year coming in at the very high end of the roadmap we had set for 2010, I think that is a pretty strong position.


The next question comes from the line of Robert Cihra - Caris & Company.

Robert Cihra - Caris & Company

I wonder if you can get any more in depth you went through the geos and verticals for the quarter but maybe you can give us an idea for where you see real, concrete improvement and then maybe where there are alternatively persistent weakness. Particular within verticals, for example public held in nicely for you. It looks like financials have gotten better. Can you give us any more specifics? Thanks.

Mark Loughridge

Sure. You look at the overall industry performance the financial sector was quite consistent in the quarter with the average within that they had strength in the growth markets and we saw that clients within financial services continue to focus on cost reduction, capital [inaudible] and compliant so that is actually very consistent. Distribution likewise was consistent. You have to look at it and distribution has now improved two quarters in a row. Frankly underneath that the retail industry saw growth for the first time in seven quarters.

As we said, if you look at public sector it had the strongest performance in the quarter and for the year. For the year public sector is up about 4%. If you look underneath that, in the quarter we had growth in healthcare and life sciences that marked an 11th consecutive quarter of growth there in growth markets across all industries as well as [government] where we can focus on services that will reduce costs.

So as I look at it going into 2010 that kind of maps the value propositions we are putting on the table. Within each of these sectors I can tell you that the CFO’s and the client meetings that I have, they are very interested in this transformation capability for their business and the benefits that clear business analytics can provide there and within public sector across major cities the advantages of Smart Planet. So I think we have new solutions entering in these key areas that can help these organizations transform as we go into a more stable climate.


The next question comes from the line of David Bailey - Goldman Sachs.

David Bailey - Goldman Sachs

Looking out at 2010 how should we think about additional costs and expense savings or will spending start to increase on a net basis as your revenue grows again?

Mark Loughridge

When you look at the cost and expense what they are doing that is going to be an ongoing part of our overall business model. That has been a part of the 2010 roadmap and that should continue. So we are going to see good cost and expense productivity. Now it is not going to be at that level of $3.7 billion spend takeout we saw last year. The dollars we are investing in that are more focused on Europe and Asia but we are going to have good spend takeout and it is going to be complemented this year by I believe better revenue performance that will capitalize on the improved leverage we have in the business. Those two together should I think put us in pretty good shape as we continue to drive our margin performance.


The next question comes from the line of Katie Huberty – Morgan Stanley.

Katie Huberty – Morgan Stanley

Did you see better momentum in large deals in the Systems business during the fourth quarter that would suggest that behavior may flow into software early this year? As a follow-up is there any pent up demand in the hardware business given the component constraints during the quarter?

Mark Loughridge

Well if you look at our technology business did much better in the quarter and were in fact much better loaded as we go into 2010. I think the important part of the overall hardware performance is number one the year-over-year growth rate has improved every quarter since we brought about in the second quarter. Very strong performance across some elements like x series. I think we are seeing some of the effects of the overall product cycle in our businesses as we enter 2010 where we will have new announcements in Z series and new announcements in p series. I think what we saw was an improving level of performance and within that characteristic more [series an variety] are positioned in the product cycle. As we go into the first quarter like the other elements of our business we are expecting that our STG business should improve their revenue growth rate by that same range of 4-5 points.


The next question comes from the line of Chris Whitmore - Deutsche Bank.

Chris Whitmore - Deutsche Bank

I wanted to ask about the deal pipeline we are seeing in services and if you have it can you give any color on what you expect for 2010 bookings growth?

Mark Loughridge

If you look at the progression of the pipeline in services I would reiterate the point I made earlier that in services signings like the other elements of our business we had an improving performance in the small deal content. That was characteristic for both sides of the business. I would also say if you look at major market and major markets are still very focused on cost take out, capital conservation, transformation. The GMU markets still are very focused on big infrastructure plays. We saw some really strong deals in that GMU content.

So as we go in for the first quarter, recognizing that the fourth quarter we had in our total signings 2% growth, constant currency 9% in actual rates as we look to the first quarter in total I think we could be a little stronger than that but that the trend underneath it is improving performance I think on a year-over-year basis in our short-term deals and long-term deals continue in ongoing growth.


The next question comes from the line of Lou Miscioscia – Brigantine Advisors.

Lou Miscioscia – Brigantine Advisors

Maybe you could give us a comment about Europe, obviously one of the weaker geographies and it seems like the Americas and Asia Pacific is picking up. Are you starting to see any trends here. Then can you comment on some of the other locations there?

Mark Loughridge

I think when you look at the US performance, North America performance and Europe it is kind of consistent with what we saw in major market performance. Now we do see major market performance improving as we go into the first quarter and we did have very strong performance in the U.K. and some sequential performance in other areas. I thought it was a fairly tight band around that.

The thing you clearly saw though is the difference between major market performance and growth market performance actually expanded in the quarter to about a nine point differential. When we look underneath it I thought we had pretty good performance in Brazil, India, China and all in that mid to high single digits. The element that really stabilized underneath it is Russia came in relatively flat performance. Russia has actually been declining for the first three quarters of the year given the concentration on raw materials. So Russia a bit better. Better stability process. Growth markets now growing faster than major markets by about nine points for the year. It closed at about eight points which has been very consistent for the last couple of years. I thought the performance between North America and Europe was really a fairly tight range. Though across those, we see improvements in the growth rates from fourth quarter to first quarter.


The next question comes from the line of Scott Craig – Bank of America.

Scott Craig – Bank of America

You mentioned in the first quarter you are going to still have an offset to a gain on the sale from actions you are going to be taking. Are these actions still greater than what you would consider some of the normal efficiencies you are trying to bring out in the business on an annual basis? Can you quantify perhaps the gain on sale you think you will get in the first quarter?

Mark Loughridge

I don’t think I am going to quantify the gain. We have a lot of work to do to close out that deal right now. What I will tell you is if you look at the overall actions that are driving productivity it is pretty consistent with what we have incurred on a charge basis for the last couple of years. I don’t think it is different than that. What you will see at least as we start out the year is more of that will be associated, or dominated really by Europe and Asia but that overall level of charge will be very consistent with the last couple of years.


The next question comes from the line of David Grossman - Thomas Weisel Partners.

David Grossman - Thomas Weisel Partners

You have given us several data points on the changes you have made in the business and its impact on margins. Can you share your thoughts on whether these changes impact the revenue growth of the business as the cycle kicks in? Should we think of secular revenue growth any different in a normalized economic environment? Then perhaps what you were thinking going into the downturn two years ago or 2.5 years ago?

Mark Loughridge

You know when you look at the transformation in the business that we have been working so diligently on really I would say, it is not overstating to say the last decade, our objective there was to exit businesses that were commoditizing and didn’t have strong margin potential. I think more importantly than that it was businesses that didn’t have good value proposition to our customers. That is what we are moving towards. So as you look at the money we spent buying those 108 acquisitions since the year 200 for $22 billion and go down that what you are going to see is those are big value plays for us with their growth prospects.

So we are moving out of business that we don’t think has the same growth prospect and doesn’t have the same margins and moving into businesses with better value contribution and better growth prospects that fit within the solution orientation. There is no better example of that than business analytics. When we look at business analytics we think that opportunity is going to be as big as TRM or ERP. We will see. We invested about $10 billion or about $8.5 billion net to acquire 14 companies to build that capability. They weren’t just add on, bolt on capabilities. It was really moving the corporation into this higher growth, higher margin and to our customers higher value opportunity space.

That is our objective. I think if we had the compounded opportunity of moving into better growth with better margins. You can see that underneath as well that mix of strategic Middleware within our software business is at one of our highest levels we have ever had. Those strategic Middleware products have by their nature better growth characteristics.

Let me take the opportunity now to just wrap up. We feel very good about our performance. In fact I would say it was pretty remarkable given the economic environment. We achieved 2010 EPS objectives I would say one year earlier. I don’t think I am over-stating it. If you look back at the comments that we all pulled together when we announced that in second quarter 2007 I think that is a kind of validation it was achievable to get in that $10-11 by 2010 but to hit it one year early I think is a pretty strong performance despite a two-year recession. If you look at 2010 we have guided to the high end of the range in an at least characterization.

All of this, especially the last question was a result of the transformation we began a decade ago. It is also very good execution and using the flexibility in our business model to adapt to market conditions. The structural actions of continued investments throughout the downturn have us better positioned going into 2010 than 2009. We have got improved revenue growth performance, better operating leverage, a good set of opportunities in emerging markets and in areas like business analytics and Smarter Planet.

So you put all of that together it leads to another year of double-digit earnings growth in 2010 with at least $11 of EPS for the year. Thank you very much for joining us today.


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