International Business Machines Corp. Q2 2010 Earnings Call Transcript

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International Business Machines Corp (NYSE:IBM) Q2 2010 Earnings Call July 19, 2010 4:30 PM ET


Patricia Murphy – Vice President of Investor Relations

Mark Loughridge – Chief Financial Officer, Senior Vice President


Toni Sacconaghi – Sanford C. Bernstein

Ben Reitzes – Barclays Capital

Robert Cihra – Caris & Company

Katie Huberty – Morgan Stanley

David Grossman – Thomas Weisel Partners

Richard Gardner – Citigroup

Mark Moskowitz – JP Morgan

Keith Bachman – BMO Capital Markets

Chris Whitmore – Deutsche Bank

Maynard Um – UBS


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 Second-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 Relation’s 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 the related GAAP measures in accordance with SEC rules. You will find reconciliation charts at the end and in the Form 8K submitted to the SEC.

Let me remind you that certain comments made in this presentation may be characterized as forward looking under the Private Securities Litigation Reform Act of 1995. Those statements involve a number of factors that could cause actual results to differ materially. Additional information concerning these factors is contained in the company’s filings with the SEC. Copies are available from the SEC, from the IBM website, or from us in Investor Relations.

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

Mark Loughridge

Thank you for joining us today. This quarter we continued the trend of improving business performance; increasing constant currency revenue growth, expanding margin, and once again, delivering double-digit earnings per share growth.

We’ve now grown EPS in each of the last 30 quarters. And since the beginning of our 2010 roadmap, we’ve grown EPS at a double-digit rate in 12 of the last 14 quarters.

Our revenue growth of 2% was two points better than our constant currency performance in the first quarter, and seven points better than our fourth quarter growth rate.

Our revenue growth would have been about a point higher, adjusting for the divested PLM business. So on this basis, the improvement was broad based across all segments and all geographies, including Europe.

Our performance is driven by the investments we’ve been making to capture growth opportunities and to deliver value to our clients. We’ve been investing heavily to build out the infrastructures in the emerging countries.

This quarter, our growth markets were up 14%, or 9% of constant currency; led by the BRIC countries which were up 16% of constant currency. Our performance in the growth markets has consistently outpaced the major markets.

And as a result, for the first half of this year, our business in the growth markets is now as large as our Euro-Zone business for the first time.

We’ve been investing to extend our technology leadership. Earlier this year we introduced Power7 technology to our Midrange unit servers. And this quarter, the Midrange grew 11%, which resulted in four-points-a-share gain in Power Systems.

In the third quarter, we’ll have Power7 across our entire UNIX product line. And we’ll introduce and ship our next generation mainframe solution. We have been investing in key growth areas such as Business Analytics. Our Business Analytics revenue was up 14%, which contributed to the strong performance of both Software and Global Business services.

Global Business Services revenue growth improved to 3%, and Software Key-Branded Middleware was up 10% at constant currency. And we took share again, this quarter in Software.

We’ve been investing in acquisitions to build our skills and technology in support of our growth initiatives. In the first half, we have closed six acquisitions and announced another three, for a total of about $3 billion.

These acquisitions add to our capabilities in areas such as Industry Solutions for Smarter Planet Initiatives, and Business Analytics and Cloud Computing.

In this quarter, we also continued to improve our profit profile, expanding pre-tax margin by a point, and growing earnings per share by 13% to $2.61.

And remember, we’ve delivered this profit performance compared to a strong second quarter of 2009, where we expanded pre-tax margin by over four points, and grew EPS by 18 percent.

So now based on our first-half performance and our view of the second half, we’re increasing our expectations for the full year of 2010 to at least $11.25 of earnings per share. That’s up from our view in April, and up $0.25 from January.

Now, let’s turn to the financial results for the quarter with a quick walk down the P&L.

We delivered $23.7 billion of revenue. That’s up 2% as reported in a constant currency. We completed the sale of the Software PLM operations at the end of the first quarter. This divestiture impacted IBM’s revenue growth by about a point, and our Software growth by about four points.

This quarter we dealt with a sharp strengthening of the Dollar versus the Euro. Currency provided 40 basis points of revenue growth as compared to the 200-to-300 basis points projected based on mid-April spot rates. So that’s a two-to-three point impact to our revenue growth.

So the currency movement since April impacted second-quarter revenue by about $500 million. And if you consider the currency movements since mid-January, second-quarter revenue was impacted by $1 billion.

We expanded gross margin, driven by better margins in Global Business Services and Software. Our expense was down 1% year to year. Our Operational Expense Performance was five points better, mitigated by impacts from currency and acquisitions.

We increased pre-tax income by 7%, and pre-tax margin was up a point, to 19.3%. Our tax rate was down just over a point, year to year, to 26%; in line with first quarter and our expected range for the full year. Net income improved 9% and margin expanded nearly a point to 20.3% [ph]. And finally, our ongoing Share repurchase Activity drove a 3% reduction in our share count.

So bottom line, we delivered $2.61 of earnings per share, up 13% from a year ago.

And while it’s certainly more difficult to measure the currency contribution to the bottom line due to the impact of pricing and sourcing actions, we estimate that currency, including hedging activity, impacted earnings growth by $0.10 or $0.11 per share.

So it’s important to note that we’re achieving this 13% growth off of strong profit performance in second quarter 2009, and in the face of a significant currency headwind. I’ll address that in more detail in a few minutes.

Now, I’ll turn to the revenue details, starting with the geographic view.

In discussing the geo results, as always, I’ll focus my comments on constant currency. After substantial improvement in the year-to-year growth rates from fourth quarter to first, we again had an improving trend in year-to-year revenue growth from the first to the second quarter across our geographies; with the Americas and Asia Pacific, each better by two points, and Europe better by a point.

The major markets also improved a point, with the best growth, again, coming from the UK, which was up a very strong 11%. And the US returned to growth for the first time in seven quarters.

Our growth markets grew 9%, outpacing the majors by nine points. In the BRIC countries, which represent over 1/3 of the growth markets, revenue grew 16% with double-digit growth in each of the four countries.

Our strong performance extended beyond the BRICs. In fact, we had double-digit growth in over 35 countries this quarter, up from 30 in the first quarter. Our ongoing investments have positioned us to capture the fast-growing opportunity in these markets. And we’ve been rapidly expanding our base of business.

As I mentioned earlier, our Growth Markets Business is now as large as our Euro-Zone Business. And at this pace, we expect our growth markets to be larger by the end of the year.

Turning to Revenue by Segment, our Services Business returned to revenue growth at constant currency, led by an eight-point improvement in Global Business Services growth rate compared to the first quarter.

Our Software performance was excellent, with Key-Branded Middleware up 10% at constant currency, and total Software up 6%, excluding the divested PLM Business.

We’re capturing growth in key areas like business analytics, storage management, and business integration.

This quarter our Systems and Technology Business delivered mid-single-digit growth, as expected. And we gained or held share in every brand. So on this basis, similar to the Geo performance; we had improvement versus the first-quarter growth rate in all segments at constant currency.

Turning to expense, our total expense and other income was down 1%. With a 2% increase in revenue, our expense-to-revenue ratio improved 9/10 of a point year to year. The expense decline was driven by operational expense improvements of five points year to-year. But this improvement was mitigated by currency, which impacted expense growth by two points, and acquisitions for another two points.

We’ve had an ongoing focus on increasing efficiency and driving productivity across enterprise. This is our eighth consecutive quarter of operational expense improvement.

Some of the savings from our productivity initiative goes to the bottom line, and some is reinvested back into the business.

As an example this quarter, while overall SG&A was down 4%, excluding currency and acquisitions, SG&A in the growth markets was up 10%. This is consistent with our investment profile over the last two years, where our operational SG&A spend for the growth markets was ten-or-more points higher than the majors.

I want to mentioned just a couple of items that had significant year-to-year impact to our profit this quarter. This quarter, our workforce for balancing charges were less than $20 million, down about $50 million for the second quarter of last year.

When you look at the year-to-year benefit in Other Income and Expense, remember that last year we had a charge of almost $120 million related to investment in a joint venture. Other Income contains a significant portion of the impact from our Hedge of Cash Flow Programs.

As you now, we hedge our major cross-border cash flows to mitigate the currency volatility in global-cash planning.

While our hedging programs generated a gain this quarter, it wasn’t as large as the gain last year. The result is a year-to-year impact of profit of over $130 million, which is roughly 70% in Expense and 30% in Cost of Good Sold.

This $130 million hedging impact is about $0.07 per share year to year. We also estimate that we had a translation impact to our earnings growth of about $0.03. So the total impact of the bottom line from currency is estimated at $0.10 or $0.11 overall.

So now let’s turn to our Segment Pre-Tax Margins.

Our improving-business mix and productivity initiatives have yielded consistent improvement in our margin overtime.

This quarter, Software and Global Business Services had great margin performance; each up over a point. Our Systems and Technology Margins declined due to mix of business and a higher level of investment to support our new product introductions this year.

Now, let’s turn to the segments, starting with Services.

The two services segments return to growth at constant currency this quarter, delivering 13.7 billion in revenue, up 2% year-to-year as reported, and up 1% at constant currency.

This revenue performance was largely driven by Global Business Services, which improved its year-to-year growth rate by eight points sequentially. Total signings were flat sequentially at 12.3 billion, down 12% year-to-year, with Global Business Services signings up 2% at constant currency. Backlog remains steady at 129 billion, up $1 billion adjusted for currency.

The biggest drive of the signing’s decline was outsourcing; down 19%. Based on an assessment of our large outsourcing contracts, we had a significant decline in contract extensions as a number of large deals rolled out of the quarter.

Contract extensions have little-to-no benefit to near-term revenue. In contrast, we had good growth in new business signings, which have a more immediate contribution to revenue. When you look at the revenue that will be generated from these outsourcing signings, we will actually get more revenue over the next 12 months from this quarter’s outsourcing signings of $6.5 billion then we did from last year’s second quarter signings of $8 billion.

So the strength of new business signings and outsourcing contributes to an improving revenue trend for the rest of the year, and shows why it’s important not to put too much emphasis on just the absolute signings number.

Moving to Transactional Signings, which include Integrated Technology Services, Consulting, and AMS Systems Integration, signings were down 3%. Again, an improvement from first quarter at constant currency.

You can see improving performance in transactional signings over the past several quarters in our supplemental charts. It shows a positive trend and good momentum as we move into the third quarter.

This quarter, ITS growth improved from first-quarter rates to constant currency, and AMS grew. In Consulting, signings were up 17% in North America and up in total for the first half, although total Consulting was down in the quarter as a number of deals rolled out of the quarter.

Overall, we signed 15 deals greater than $100 million. And as I said, total services backlog at the end of the quarter was $129 billion, up $1 billion adjusting for currency, though down $2 billion at actual rates. And we had another quarter with very low backlog erosion.

Now, I’ll go to the Key Drivers of Performance in the two services segments.

In Global Technology Services, revenue was $9.2 billion, up 1% year to year as reported, and flat at constant currency. GTS Outsourcing revenue was up 2% in the quarter and Integrated Technology Services revenue was down 2%.

We had good performance in the growth markets with revenue up over 8% at constant currency in each of these businesses.

Global Technology Services pre-tax income was up slightly in the quarter with margin at 14.9%.

With the benefit of the first quarter rebalancing activity coming in the second half of the year, and an improved revenue growth trend, we expect to expand margin in the second half.

Turning to Global Business Services, revenue was up 3% both as reported and at constant currency. We saw an improved performance in many areas of the business as we grew revenue in both the major markets and the growth markets in all sectors with the exception of Communications sector. And in both consulting and AMS, where we had particular strength in North America with combined revenue up 8% at constant currency.

From an offering perspective, we had double-digit growth in both Business Analytics and Smarter Planet.

Global Business Services pre-tax profit was up 12% year to year with margin expanding 1.3 points to 14.6%. This expansion was driven by higher utilization and benefits from the continued implementation of our globally integrated capabilities. At the same time, we were continuing to add to our skill base and invest for further growth.

To wrap up services, we saw a number of positive signs in improving trends in the quarter. We had improvement in the revenue growth rate sequentially, with a return to growth at constant currency for Total Services. GBS revenue was up 3% with eight points of improvement in the growth rate. We had good recovery in AMS. We had very good new-customer signings in Outsourcing. Backlog was up $1 billion year-to-year with a low level of erosion. And we have a good pipeline of deals going into third quarter.

With this level of performance, the Total Services Revenue Growth Rate should improve in the second half. This improvement will be led by GBS with its higher transactional content. And with the benefits of the first quarter resource for balancing, we expect to see margin expansion in the second half as well.

Software had another strong quarter of revenue performance with revenue of $5.3 billion. That’s up 2% year to year, or 6% adjusting for the divestiture of PLM, which is a more appropriate view of our ongoing business.

Key Branded Middleware grew 9% at actual rates and 10% at constant currency, and gained share for the 11th-straight quarter as we continued to solidify our lead in the Middleware Market. The Share Gain was broad based across WebSphere, Information Management, Tivoli and Rational. Key Branded Middleware accounted for 62% of our total software revenue, up four points from this time last year. Both the WebSphere and Tivoli brands grew at double digits year to year, and we had strong performance in the Business Analytics product set.

Segment pre-tax income was $2 billion, up 7% year to year, and pre-tax margin improved 1.3 points to 33%.

This is the 11th consecutive quarter of margin expansion in the Software Segment.

Now, let me take you through the brands. WebSphere had another excellent quarter, growing 17%, and gained share in all segments with strong performance across the portfolio. Application Servers, which provide customers with secure and resilient infrastructure for mission-critical business applications grew 32%.

Business Integrations Software, which includes our ILOG and Lombardi acquisitions, grew 12%. Information Management also had a strong quarter, growing 7%. Information Management Software offerings provide the foundation for IBM’s business analytics and optimization offerings.

Tivoli had another terrific quarter in all three market segments, and grew 18% in total. Enterprise Asset Management, within the Systems Management portfolio grew double-digits. This continues to be a critical component of IBMs Smarter Planet Solutions.

In Security Software we had strength across the portfolio and in all geographies. Our Tivoli Storage products also continued to perform very well, growing double digits and gaining share.

As an example, XIV Software, which provides ease of use and lower total cost of ownership, more than doubled. And Tivoli Storage Manager grew 10% this quarter, driven by its market-leading data reduction capabilities and related cost benefits.

The breadth and diversity of our Software portfolio combined with strategic investments in high-growth areas have enabled us to achieve consistently strong results in the software segment. We expect to deliver similar levels of revenue performance in the third quarter.

Systems and Technology revenue was $4 billion, up 3% year to year or 4% at constant currency. Revenue was driven by continued growth in System x, storage, retail stores and microelectronics.

We had strong performance in the growth markets. BRIC countries grew 20% year to year with growth in all brands, and we expect the strength in growth markets to continue in the second half. Gross profit margin was down one point driven by mix.

In the third quarter, we will announce new high-end servers. Both the System z and high-end power servers will be refreshed with availability in the middle of September.

Now, let me take you through more detail on the brands. Power Systems Revenue declined 10% year to year. Our new Power7 products drove mid-range growth of 11% and Power Blades growth up over 65%. This performance drives our ninth consecutive quarter of share gains.

In the second quarter, we had 225 competitive units displacements, of which almost 2/3s were from Sun. This resulted in $225 million of business and nearly four points of share gain. This is a sequential increase of over $75 million from the first quarter where we gained over seven points of share. We have now won 620 deals from Sun, totaling nearly $650 million over the last six quarters.

The win rate has been increasing and we expect these takeouts to continue throughout the second half. This quarter we will announce our Power7 entry in high-end systems with availability in September.

Our high-end systems will scale up to 256 cores, and are capable of running 1,000 virtual images, which is four times more than our current high-end Power6 processors.

Additionally, the energy efficiency of these new high-end systems will be five-to-seven times more efficient than the latest Unix Systems from both Sun and Hewlett Packard.

Storage revenue grew 5% year to year. Disk revenue grew 12% or 14% of constant currency driven by continued strength and high-end offerings; XIV and DS8000.

XIV added more than 130 new customers to the platform in the second quarter, and revenue more than doubled year to year.

System x revenue grew 30% year to year, led by our high-volume offerings in our System x Blades. X Blades grew 16% year to year. The high-end of System x was up 17% and gained share. This high-end performance combined with the growth in blades and improvements in end-to-end operational efficiencies contributed to improve gross profit margin performance in System x.

System z revenue declined 24% year to year. This week IBM will announce the next generation of System z; the fastest and most-scalable enterprise server in the industry. This server provides 40% more performance on a mix of workloads than the equivalent Z10. Some workloads can achieve greater performance improvements, such as Linux, which has 60% better performance and 35% lower costs.

This announcement is the foundation for IBM’s first system of systems, which provides the capability to manage ten times the virtual machines of the M-ware by extending mainframe governance to our other industry-leading technologies.

Microelectronics OEM revenue is up 23% year to year. Both our 300 millimeter and 200 millimeter fabs are fully utilized.

Systems and Technology continued its revenue growth this quarter with strong performance in Disk Storage, System x, Microelectronics, and Retail Store Solutions. And with the introduction of new high-end systems in third quarter, I expect this growth rate to improve in the third and fourth quarters and to deliver double-digit PTI growth for the second half of the year.

Turning to Cash Flow, we generated $3 billion of free cash flow in the quarter, which was down $400 million year to year, driven by higher-capital investments of $100 million in support of hardware product announcements as well as a prior year foreign-tax refund of $360 million.

In the first half, our pre-cash flow of $4.4 billion was flat year to year. We had strong operating performance driven by higher net income of $600 million and sales-cycle working capital improvements of $350 million year to year.

This was offset by higher-capital investments for new hardware products and semiconductor technology. And a year-to-year impact of over $700 million for unique one-time tax refunds as previously disclosed. Excluding these unique tax refunds, free cash flow would have been up $700 million.

Looking at the uses of cash in the first half, we spent $1 billion for six acquisitions in support of our growth strategy. The largest of these were National Interest Security, Initiate Systems, Lombardi, and Cast Iron Systems.

In addition, we’ve returned almost $10 billion to the shareholders in the first half; $8.1 billion dollars was in the form of Share Repurchases, and we have about $6 billion remaining from our last board authorization.

We took our dividend up 18% in April and paid out $1.6 billion in dividends. This is the 15th consecutive year that we raised our dividend and we’ve more than tripled our dividend over the last five years.

Now, let’s turn to the Balance Sheet where we see the impact of our cash performance.

We ended the quarter with a cash balance of $12.2 billion. More than 2/3 of which was in the US. Our collections remain strong.

Total debt was $26.7 billion dollars. $21 billion of debt was in support of our financing business, which has leveraged at 7.1-to-1. $5.5 billion dollars was non-financing debt that was down from $6.6 billion a year ago.

Non-financing debt-to-cap was 23%, up from 16% in December and down from 35% a year ago. With this level of leverage, we continue to have a high degree of financial flexibility. The balance sheet remains strong and positioned to support the business over the long term.

I’ll start to wrap up with a brief discussion of the drivers of our Earnings-Per-Share Performance.

This quarter, all categories positively contributed to our earnings growth. Our Revenue Growth at constant mix and margin contributed a nickel. The largest contributor was Operating Leverage, driven by gross-margin expansion, improving expense productivity, and a year-to-year improvement in the tax rate. And a 3% reduction in share count contributed $0.08.

So once again, our growth was delivered through a combination of revenue growth, margin expansion, and an effective use of cash. And lastly, uniquely identified in the Bridge, we overcame a currency headwind of $0.10 to $0.11 on our way to 13% earnings-per-share growth.

Now, for the last several years, we have consistently delivered strong earnings growth. Since early 2007, when we first introduced our 2010 roadmap we’ve delivered double-digit EPS growth each year, and in 12 of the last 14 quarters. Compared to the DOW, IBM is the only company to have positive year-to-year growth in each of the last 14 quarters.

In each of these periods, which span a variety of economic environments, we faced unique opportunities and challenges. There are many dimensions of IBMs business model, from business mix to global scale and structure, to financial strength and flexibility that have allows us to overcome challenges and capitalize in opportunities while we consistently deliver.

This quarter we dealt with a significant currency headwind caused by the sharp strengthening of the dollar and still delivered 13% earnings-per-share growth against a very strong second quarter of last year, which had 18% EPS growth.

So while some companies will show growth this quarter as they recover from losses in the recession, IBM is building on our strong performance over the last eight years. We continued our steady improvement in the business in both revenue growth and margin expansion. And we used our strong profit and cash position to invest and expand our base of opportunity while returning capital to our shareholders through dividends and share buy-back.

Looking forward to the second half, we’ll have exciting new product introductions with our new mainframe system of systems, and Power7 technology across our Power Systems product line. We’ll continue to leverage investments in our growth initiatives; Smarter Plant, Business Analytics, and Growth Markets. We’ll integrate the acquisition announced with quarter. We’ll yield the benefit from our first-quarter workforce rebalancing actions. And we’ll continue to drive efficiencies and increase productivity, all while continuing to invest in innovation throughout the business.

All of this supports our expectation of at least $11.25 of earnings per share of the year.

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 compliment our prepared remarks. And 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 final comments. Operator, please open it up for questions.

Question-and-Answer Session


Thank you. At this time, we’d like to being the Question-and-Answer Session of today’s conference. (Operator instructions).

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

Toni Sacconaghi – Sanford C. Bernstein

Yes, thank you. Mark, you went through each of the businesses in terms of your outlook for the remainder of the year. On Software you said to expect a similar kind of growth rate to continue. For hardware you stated that it should improve. And for services you stated it should improve as well. Can you clarify that those are constant currency statements? And given the currency outlook, at current spot rates, is it realistic to believe that either Q3 or Q4, IBM could grow its revenues above the 2% rate year over year that it did this quarter?

Mark Loughridge

The statements that I made, Toni, where in fact constant currency statements. I mean, we look at the impact of currency and gives some analysis on that in the supporting charts, but it’s very difficult to look at how that’s going to effect it given the volatility in current periods.

I mean, as an example, just look at how much currency moved in the last week and a half. I mean, frankly, we were revising this supplemental chart on a daily basis because the change was so significant. So at least from my perspective, Toni, the important part from the IBM Team as the – in an operational mode, is to be able to build a fundamental business model and capability to deal with that fluctuation in currency.

And so if you look at it, at today’s spot rates, we would look forward on an EPS basis and project about the same level of currency impact in the second half that we had in the first half. And we were certainly able to deal with that in the first have and I would expect we would be able to do deal with that in the second half. And I think you can kind of make that same statement if you look over longer periods of time. We’ve certainly been in periods where currency has gone against us, and with us, and in those – each of those quarters in the last four or five years, we have grown EPS.

So from my perspective, the statements we made looking at individual businesses on a constant currency basis, I look at our capability to deal with fluctuation currencies in the first half, and we should be able to do the same in the second half. And on an earnings-per-share basis at current spot rates, we would look at that earnings-per-share impact in the second half being about the same magnitude as the first half.

Toni Sacconaghi – Sanford C. Bernstein

Mark, just to clarify, so you’ve done the exercise for what you think earnings impact – earnings will look like given a prevailing spot rate. My question is, have you done the exercise for what revenue looks like in trying to balance your commentary about improving fundamentals in two of your three businesses. Do you think the reported revenue growth rate at the spot rates can actually improve in the second half, or is that unrealistic?

Mark Loughridge

Well, let’s look at the third quarter. I mean, in the third quarter, on current basis, we look at revenue going against us by about a point. And if we get the acceleration of revenue that we’re looking for from Services Business now with better momentum and on better trajectory, Software repeating the kind of quarter that they had, and now the new-announcement content, I mean, I will look at that third quarter and I would say, yes, we should be generating positive revenue growth even in the face of that currency fluctuation.

Patricia Murphy

Okay, thanks, Toni. Let’s go to the next question please.


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

Keith Bachman – BMO Capital Markets

Hi, Mark. I wanted to ask you about services if I could. You indicated that the backlog, or signings, excuse me, was down because of extensions didn’t come in, renewals. Is that an anomaly, or a trend? And how should investors be thinking about signings as we look out, certainly, this quarter, but indeed for the second half of the year?

Mark Loughridge

Yeah, let’s step back. On the signings basis as we analyzed it, you know, we had – on the – in the GBS Business we had good revenue growth, we had positive signings performance. So then when you look at Global Technology Services, the issue that we wrestled with was really in our outsourcing business.

Keith Bachman – BMO Capital Markets


Mark Loughridge

And the point I was making on the outsourcing business is that if you look at kind of the completion of those signings, by analyzing the larger deals, we actually did very well on a year-to-year basis on the new-business signing. And it was not only a year-to-year basis, but it was also quarter-to-quarter. So if you look at deals greater than $50 million in outsourcing, that new-business content was up 33% year to year, it was up 36% on a quarter-to-quarter basis. That frankly, generates better near-term characteristics than we see in extensions, obviously. And it gives us confidence as you look at the second-half billions in outsourcing this quarter, we’ll frankly get much better characteristics on a revenue side from those signings than we did last year at $8 billion.

Now, two your point about the trend laying on this and the characteristics, as we looked at the analysis, frankly, we believe that last year we had a high level of extensions because our customer base was wrestling with the economic difficulty of the recession and there were a lot of contract renegotiations. And in part of those contract renegotiations we saw a number of extensions. But I think, frankly, as we’ve worked with the operational team, we believe the bulk of that trend is in the rearview mirror. And I do think it’s quite reasonable to be encouraged by the strong growth rate that we did have in a new-business content. And that’s what really led us to project on a forward-looking basis that we ought to have improving revenue characteristics even as we move into the third quarter in GTS as well as GBS.

Patricia Murphy

Thank you, Keith. Could we go to the next question, please?


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

Ben Reitzes – Barclays Capital

Yeah, thanks a lot. Mark, can you comment on how trends are going in the public sector vertical for you? There’s obviously concerns out there on the State, and Local level, on the Federal level, and then on the European-public level. And then comment on Europe as well. So what you saw there, and if any of those verticals impacted the signings as well. So revenues, and signings, and those in the European market as well as the public vertical; if you have any comments on how things are going in those. Thanks.

Mark Loughridge

Sure, let me start with public sector. I mean in public-sector basis, if you look at the US Federal performance, we did pretty well. You know, revenue was up about 5%. So if you look as you kind of mentioned in your remarks, Ben, it was really – State and Local was more challenging. And as you look at it, I think it’s more indicative of the State and Local Governments wrestling with tough local budgets.

When you then say, well, how did we perform on a growth market basis? Like the US, state, and local, I mean Australia was down, but we had a number of very strong performances in public sector in our growth market. So as an example, ASEAN was up 11%, India was up 14%. China was up 16%. Korea was up 10%. Latin America was up a whopping 77%.

So I did see public-sector challenges in state and local in North America. I think US Federal did pretty well, up 5%. And we had a number of very strong performances in public sector in our growth-markets unit.

Now, turning to your second question, on Europe in general, really Europe had pretty good performance if you look at that growth rate compared to first quarter. That was in fact an acceleration. And they were more affected than North America by the PLM divestiture to Dassault. So frankly were it not for that, they would have been flat.

I do think however, it’s interesting when you look at the characteristics and the overview of our business, that this is the first quarter where our growth-markets unit has equaled in size the content that we have in the Euro-Zone. So that will obviously be an ongoing trend. We’ve had our growth-markets growth rate exceeding that in major markets now for, I think it’s ten quarters in a row. And generally, it’s in that magnitude of about eight points. Interesting, this quarter, it’s in fact ten points.

But we saw improvement in year-to-year growth rate across the board even in Europe. We did well. Some counties in Europe, you look at the UK, we’re up 11%. Last quarter, UK was up 8%, and the fourth they were up 4%. So it does vary quite a bit by individual country.

Patricia Murphy

Thanks, Ben. Can we go to the next question, please?


The next question comes from Rob Cihra with Caris & Company. You may ask your question.

Robert Cihra – Caris & Company

Hi. Thank you very much. Can you give us any idea you think with the Power7 and the – I’m sorry, the Power Series I guess, and the mainframe declines in the quarter. I mean, do you think that’s all hesitation ahead of the new Q3 products. And maybe if you even try to attempt to get an idea what those markets look like had you not had a big refresh come in? How do those markets feel relative to what obvious strength we’re seeing in X86? Thanks.

Mark Loughridge

Yeah. I mean, I think what you saw in the quarter is a function of the anticipation of the new announcement content we have coming out in the third quarter. And by the way, these are very strong announcement. I mean, the Z series, this is a major new announcement. It’s not just a new Z, it’s now Z and a system of systems implementation. And we’ll be able to tell you much more about that during the announcement later this week.

On the power side, we’re now announcing the high-end of power as well as the entry-power content.

If you want to look at how power is performing, let’s look at the content in the mid-range where did have the power announcement. The new Power7 technology and that mid-range system grew 11%. And if you look at the Blades content that Power7 technology was on, it was up 67%. So you snap out those elements with the new announcement, we did very well.

We’re still taking strong market share in this platform. You saw – I would imagine, the first quarter took seven and a half points this year, and the second quarter, four points this year. Now moving into a third quarter, where by the end of the quarter, we’re going to have Power7 technology across the board, coupled with the fact that we’ll have the new Z Series announcement. I think we should have a very strong quarter as we move into the third.

Patricia Murphy

Thank you, Rob. Let’s go to the next question, please.


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

Richard Gardner - Citigroup

Okay, thank you. Mark, I just wanted to clarify your comments around the mix of outsourcing renewals versus new business. Is the takeaway there that some renewal business was actually pulled into 2009 as customers sought to renegotiate contracts and get better pricing? And therefore the renewal business is a little weaker than most investors and industry sources thought for this year? And then if you could also perhaps give us your view of the pipeline for the rest of the year and maybe some sense of what you think the growth rate will be for signings this year. And how that’s different from the revenue growth rate you expect given this mix of renewals versus new business.

Mark Loughridge

Sure. Let’s look at outsourcing specifically where I made those comments. First of all, if you look at the progression through the quarter, Richard, we had double-digit signage growth for our services right through week ten of the quarter. And what we saw is we had a number of contracts roll into the third quarter. So as I look at the outsourcing business on forward-looking basis on the third quarter, we should have pretty strong double-digit growth in our outsourcing business going into the third.

Again, I think the impressive part on the new business was the growth rate, not just year-to-year, but also quarter-to-quarter where it was up 36% now generating more impressive revenue implications as we go into the third quarter.

But overall, on a forward-looking basis, we did have a number of contracts roll from second quarter into third quarter. We’re generally on a trend line for double-digit signage growth through week ten. And now given that, as we look forward to the third quarter, that outsourcing business should have a good double-digit growth rate in signings for the third.

Patricia Murphy

Thank you, Richard. Can we take the next question, please?


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

Katie Huberty – Morgan Stanley

Thanks. Good afternoon. Mark, I just want to go back to Europe. Clearly, the year-on-year revenue-growth trend improved. But if you look at linearity through the quarter and the pipeline going into the back half, is this fair to expect that the growth rate in Europe continues to improve in the next couple of quarters, or should we expect that to flatten out conservatively?

Mark Loughridge

Well, again, you know, I’m looking at the implications of what I see in the business as we’ve gone through the first half of the year. And in the first half of the year, certainly Europe was wrestling with those individual economic challenges. It’s not like they just occurred at the end of the quarter. And we had overall kind of steadily-improving performance in our European business. And as I said, we had some very strong performances, like the UK. I mean, Katie, you know, you look at a country like the UK growing 11% a quarter, that’s pretty powerful.

And you could pick even Greece and Spain, they were relatively flat, even amongst the turmoil that they had. So from my perspective, as I look at the data, I do think we should expect that Europe should have an improving trend as we go into the third quarter.

And overall for the IBM Corporation, it should see the same.

Patricia Murphy

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


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

Chris Whitmore – Deutsche Bank

Thanks very much. Good afternoon. I wanted to follow up on those last two questions around linearity in the quarter, particularly as it relates to bookings trend. It sounds like outsourcing bookings slowed. And I believe previously you said you saw some deal slippage in the consulting business outside of the US. So maybe hoping to get some more color on kind of the global-IT demand as you see it, and whether or not customers are delaying or deferring signing large contracts to wait to see how this European situation shakes out. Thanks.

Mark Loughridge

I would not jump to that conclusion off my comments. And the reason I say that, remember we’re talking about contract extensions. Those could be driven by a number of different things.

First of all, I’ve already said that we think it was a high-level extension of last year due to the economic environment.

Secondly, they can be influenced just by contract dates and windows-contract dates. So we had a number of those extensions roll to the third quarter. But as I said, as you look at that outsourcing performance, moving into the third quarter, we expect that to have double-digit growth rate. And that’s pretty strong.

Additionally, I would say within the quarter, we saw that new business content with very strong growth on a year-to-year basis and a quarter-to-quarter basis.

Additionally, we had a very strong close with our software business. The software had a very, very powerful third month of the quarter. So overall, revenue trends in the quarter were very measured and steady throughout the quarter. So I do not think I would take this and interpret a reflection that there is a pull back in spending.

I think my remarks are, in a way, indicating the reverse in that we think that rollover deals should accelerate performance in the outsource and signings content in the third quarter. And we should see measured improvement once again in revenue performance for services and the IBM Corporation as we go from second to third.

Patricia Murphy

Thank you, Chris. Can we go to the next question, please?


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

Mark Moskowitz – JP Morgan

Thank you. Good afternoon. Mark, can we shift gears to growth margins? How should we think about some of these puts and takes here in terms of some of these services extensions maybe not being renewed. I know they can be higher value. And also we have the refreshers here with the power in the mainframe. Will there be any sort of margin impact, either good or maybe some head winds temporary on the hardware perspective in 3Q versus 4Q?

Mark Loughridge

Sure. Well, let’s take those in separate parts. First of all let’s look at margin. For the IBM Corporation as a whole, when we have taken you through our business model and the – either the roadmap to 2010, or to 2015, we’re looking for productivity on PTI margin and the model is about 4/10s to 5/10s of a point. As we look at that PTI margin improvement, it was a point. So I would look at it and say, pretty good performance.

If you look at the gross margin, it was up 1/10th of a point. And remember, within that 1/10th of a point, it was absorbing some of the impact of currency in the hedge that is within the cost element.

So I think margin did a pretty good job. I think our productivity actions did a good job. And frankly, if you just took a real steely-eyed view of that, you’re improvement in our productivity versus the model. You’d have to say that it was about two times the model.

Now, the other point that you had asked about is on a service base. So if you look at services, again, at the PTI margin base, overall services had an improvement of about 4/10ths of a point. Again, I would say that’s very close to model. I mean, 4/10ths of a point within a quarter in the services business, that in and of itself is absorbing some of the impact of currency in a hedge. Outside of currency in the hedge, that margin would have been up about 8/10ths of a point.

So once again, I look at that content, I think the performance was pretty positive. And then your last question, as we go into the third quarter, the product announcements that we have in high-end P and our Z-series content are high-margin end of the product line. So they are absolutely going to drive stronger hardware margins in the third quarter. And frankly, you’re going to see that on a forward-looking basis because we should have very strong double-digit PTI growth rates in our hardware business in the third quarter as we announce these newer, high-margin platforms in both the Power Series as well as our Z-Series mainframe.

Patricia Murphy

Thank you, Mark. Can we go to the next question, please?


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

Maynard Um – UBS

Hi. Thanks. I just want to dive a little deeper into the public business. The weakness in the State and Local, I think makes sense. But from a Federal level, I think that was more backward looking. If you look at the US Government and the OMB recently put a halt on government contracts that are kind of behind the US, it doesn’t sound like you’re expecting any impact in your outlook from that. But I’m just curious how we should look at that, and whether that’s embedded into your outlook.

Mark Loughridge

Well, I think – I think on that public sector statement, on the US Government statements that you’re referencing, we’ve got to see how this plays out. Let me tell you what I have heard. I think what they have said is that they’re reassessing kind of the mix of their spend, not necessarily a reduction of the spend, but a mix of their spend towards projects that are yielding the best productivity and yield against their business cases in their platform. And I think that sounds like a very logical thing for them to do. As we look at it, and we look at our contracts, we think we have very strong contracts. We think they’re performing well. So on that kind of a base, I would not project a big impact, but I’ve got to wait and we’ve got to see how this rolls out. But that’s how I have heard it described.

Maynard Um – UBS

Okay. And that cautiousness is embedded into your outlook for the growth into the back half?

Mark Loughridge


Maynard Um – UBS

Okay, great. Thank you.

Patricia Murphy

Thank you, Maynard. Operator, let’s take one last question, please.


Thank you. The last question comes from David Grossman with Thomas Weisel Partners. You may ask your question.

David Grossman – Thomas Weisel Partners

Thanks very much. You know, Mark, I know there’s been a lot of questions on the bookings, and I think I understand the outsourcing phenomenon, but on the transactional side of the business, you know, bookings have remained negative, I think which were negative last year on a constant currency basis, although they’re improving. Yet the GBS revenue growth has turned positive. So again, it seems there’s a little bit of disconnect between what’s happening in the bookings and what’s happening in terms of revenue growth. Can you, you know, help us understand and reconcile, you know, what’s going on now in the short-term side of the business that may be leading to that?

Mark Loughridge

Well, you know, first of all we had shorter durations on some of the contracts. Second of all, we had a very positive consulting performance in the first quarter. Third, you know, you look at this quarter, our North America Consulting Business did a very good job, signings were up 17%. And I think lastly on that point, that’s why we included that supplemental chart. You could see, you know, just draw that trend line yourself into the third quarter, measured performance increasing every quarter as we go into the second half, and now against an easier set to compare. So I feel quite confident that we’re going to have good transactional performance on that base as we move into the third quarter and the back half of the year.

So with that, let me take a minute and let’s wrap up.

Now, for revenue, let’s look back at our April Earnings Call. Now, we said we’d have modest revenue growth in services, and we did that. We said we’d have mid-single digit growth in systems and technology, and we did that. We said software performance would be consistent with first quarter, and we did that. In fact, we grew a point faster. And overall, we said we’d return revenue growth at constant currency for the corporation, and we did that.

So for revenue, we did exactly what we said we were going to do. If you really look at the difference to analyst’s expectations, the difference is all currency. Due to the strengthening of the Dollar since our first-quarter earnings announce, that impact as we included in the supplementals, about $500 million. So our operations performance is really right on target.

Now, we delivered 13% earnings per share growth despite a $0.10 to $0.11 currency headwind, and that’s compared to a very strong second quarter 2009 base. And we have a strong hand going into the second half, an improving profile in services, ongoing momentum in software and great high-end hardware product announcements.

So with all that, and with at least $11.25 of earnings per share for the year, we’re now well above our 2010 roadmap projective building on 30 straight quarters of EPS growth.

So again, thanks for joining us, and now, as always back to work.


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

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