The Arithmetic Behind IBM's 2009 EPS Guidance Revision

Includes: ACN, IBM, MSFT, ORCL
by: Naveen Selvaraj

IBM (NYSE:IBM) raised its 2009 EPS guidance to "at least $9.7" (compared to $9.2 given earlier) while announcing its Q209 results.

2009 EPS Guidance Raised Upwards

While Revenues Actually Declined Across All Segments in Q2

Source: Gridstone Research

While many would have expected IBM to stick with this guidance in its Q2 earnings call, IBM went one step-ahead and increased guidance by 50 cents to $9.7. When we look at the second graphic which shows revenue and segmental revenue growth rates on a YOY and Sequential basis, it does look surprising that IBM has raised its guidance despite all segments having YOY revenue declines. The Services business (comprising Global Business Services-GBS and Global Technology Services-GTS), the largest segment, had a 10% and 15% decline in quarterly revenues in GTS and GBS respectively. Software too has declined while the S&TG(Systems and Technology) business decline of 26% is not surprising considering that all enterprise hardware vendors have suffered.

So what helps IBM boost profitability and thereby EPS guidance while revenues continue to decline? Before we come to that, let's take a look at how IBM has performed relative to peers in the two main segments, Services and Software.

IBM has kept pace with competition in top-line growth

Technology and Business Services Revenues

Technology and Business Services - Constant Currency Growth Rates

Source: Gridstone Research

IBM reports constant currency growth rates for GTS and GBS. Due to the volatile currency environment, these numbers are a more meaningful comparison than normal growth rates. Broady GTS and GBS can be compared with Accenture's (NYSE:ACN) two segments, namely, Outsourcing (comparable to GTS) and Consulting (to GBS). In Q209, Accenture has grown at a better pace in the GTS space (Outsourcing) while IBM and ACN have had similar growth rates in the GBS space (Consulting). Since segment classifications might vary across these companies, we cannot strictly compare the numbers to each other. However, overall there is nothing much to separate IBM and Accenture in the services space in growth rates as IBM is growing on a much larger base.

Software Revenues YOY Growth - IBM, Microsoft and Oracle

Source: Gridstone Research

In the software space, we compare the revenue growth rates of IBM, Microsoft (NASDAQ:MSFT) and Oracle (NYSE:ORCL). (Microsoft is yet to report comparable quarter numbers though.) Though IBM has lagged behind the two software majors in top-line growth over the quarters, it has narrowed the gap of late (largely due to acquisitions) and in fact did better than MSFT in the Mar09 quarter. Oracle has been slightly ahead thanks to its continuing big-ticket acquisition spree.

In summary, IBM has not lagged behind competition in terms of top-line growth in the two main segments. This in itself is impressive considering IBM's size and breadth of products and services. But where IBM clearly flexes its muscle is pulling all these varied segments in a common direction and tightly controlling expenses.

Gross, Operating and Pre-Tax Margins - Last Seven Quarters

Source: Gridstone Research

Gross, Operating and Pre-Tax Margins - YOY BPS Change

Source: Gridstone Research

IBM has consistently improved GAAP margins at the gross, operating and pre-tax level quarter after quarter in the last two years. Note how the operating margin improvement outpaces the gross margin improvement in almost every quarter, another sign of how IBM has controlled expenses without lagging behind the industry in terms of top-line growth.

The Arithmetic Behind IBM's Guidance

AS the tables below show, SG&A expenses have declined by ~$1B on a YOY basis in Jun09 quarter. Core SG&A expenses (excluding amortization, bad debt, restructuring and retirement costs) has declined ~$800M in Mar09 qtr on a YOY basis. (The Jun09 numbers for different SG&A sub-heads will be available when IBM files its 10Q.)

Source: Gridstone Research

In Jun09, SG&A has declined at a greater pace than revenues ensuring better operating margins. Now taking the $1B in SG&A savings and multiplying it by IBM's tax rate of ~27% gives a near $700M boost to net profits. On a per share basis, that amounts to 52 cents per share.

Source: Gridstone Research

Therefore SG&A cost savings alone have translated to a 52 cent benefit at the EPS level in Jun09. The share count in Jun09 is ~40M lesser than in Jun08 and that again translates to a EPS benefit of ~5 cents. So effectively on a YOY basis, lower SG&A and sharecount gives a 57 cent EPS benefit while EPS has actually increased by 32 cents only - from $2.02 in Jun08 to $2.34 in Jun09. So falling revenues have been more than compensated for at the EPS level due to cost savings.

EPS and Share Repurchase Data Over the Quarters

Source: Gridstone Research

More Cost Savings and Higher 2H Revenues Can Boost 2009 EPS Significantly

Now coming back to the 2009 EPS guidance of $9.7. For 1H09, the EPS achieved is $4.05 and so the guidance implies a 2H09 EPS of $5.65 (9.70-4.05). In 2008, gross profit in 2H08 was ~$2.1B higher Vs 1H08, despite 2H08 having a very difficult macro environment. Assuming that the gross profits in 2H09 are higher than 2H08 by the same amount and operating costs, mainly SG&A and R&D, are further down as per IBM's guidance in the Q209 earnings call (Source: Q209 Transcript), that effectively translates to a pre-tax income increase of $4.1B (2.1B in higher gross profits plus $2B in savings).

Comments of IBM's CFO in Q209 call:

...Now, if you look at the way that $3.5 billion rolls out (cost savings), we’ve got about $0.5 billion in the first quarter, about $1 billion in the second quarter, so that leaves another $2 billion to roll out through the second half of the year. And given that it’s kind of structural in nature, I would look at that kind of evenly distributed across that second half...

Even if we take a conservative estimate of $3B rather than $4B in terms of increase in pre-tax income in 2H09 Vs 2H08, on a post-tax basis that would yield around $2.2B or $1.65 on a per share basis. So the incremental EPS in 2H09 would, on a conservative basis, be 4.05 (1H09 EPS)+1.65 (incremental benefit from higher gross profit and lower costs) i.e $5.7 which yields a 2009 EPS of $9.75.

Some More Aces Up IBM's Sleeve

As discussed above, this is a conservative estimate with ample upside potential based on achieving the target cost savings. Also the 2009 EPS guidance of $9.7 seems to exclude any benefit from share repurchase. This could yield another 20-30 cents EPS benefit based on how much IBM spends on share repurchase. (It spent $10.5B in 2008 and has spent only $3.4B in 2009 so far.) Further if the demand environment improves further in 2H09, which looks very likely, IBM will have some more surprises up its sleeve at the end of 3Q09 itself.

Thus the 'at least $9.7' guidance seems to suggest a further upside of 'at least' 50 cents to $1.00 per share which means that IBM could achieve its long-stated target of $10-11 EPS by 2010, a year earlier.

Disclosure: No Positions