IBM Earnings Call Nuggets: Services Business and Margin Drivers

On Tuesday, International Business Machines Corp (NYSE:IBM) reported its first quarter earnings and discussed the following topics in its earnings conference call. Take a look.

Services Business

Toni Sacconaghi, Jr. – Sanford Bernstein & Co., LLC: I was wondering if you could comment on the services business I look at GBS and on a reported basis it was down 2% and I realize its public in Japan contributing very negative growth overall. Do you actually see that getting any better going forward and in fact it seems like it’s getting marginally worst. When I look at the outsourcing side your backlog is now down 5% relative to a year ago and backlog is a good leading indicator, especially in the outsourcing business so perhaps you can help us understand how things get better from here and on an as reported basis can GBS grow this year and with the minus 5% backlog in outsourcing how does that grow from here for the remainder of the year?

Mark Loughridge – SVP and CFO, Finance and Enterprise Transformation: Tony, thanks very much. Very good question. Let’s start from first principle. First of all, when we started the quarter we told you that the backlog run out we expected would be up 3% year-to-year. So, in other words, we’re looking at the run out of the backlog for total services that should influence revenue this year and that backlog should affect about 70% of the revenue. So, 70% of that 3% would drive about 2% revenue and we had indicated that we felt confident that at that level of revenue we could drive double-digit profit growth for the year. So, let’s look at it now by the individual units. If you look at GTS, I would argue they are right on track. This is a fourth consecutive quarter of 2.6% performance from our GTS team. I think it’s an indication that we do have that model specified correctly and with that 2.6% what did they do? They drove 20% profit growth and 2 points of margin improvement. So, again, very consistent with our indication. When you look at GBS, actually the mechanics underneath that were on track but we did get clipped by a couple contracts that were more challenging for us. I gave you an example of a couple in Japan that impacted our profit by $60 million. Now, outside of those two contracts, frankly, GBS would have grown their profit on a year-to-year basis. So, if you consider those two contracts, I would tell you, number one, I think from a financial standpoint we had the bulk of that behind us. I don’t expect and I don’t see contracts in the distribution that will have that kind of impact going forward. Now, I can’t predict the future but I do have a pretty good purview to the contracts that we are working on. Secondly, I’ll tell you that GBS has generally over longer periods of time been pretty good at managing these challenging contract elements. So, I think from my perspective this is a bit of an anomaly and GBS should get these two contracts behind them in the first and improve their performance to more typical levels as we go into the second quarter. By the way, just as an aside I’d add, that when you look at IBM’s revenue growth for services up 1%, we were shy of 2% by $7 million, and that $7 million on a $15 billion base. So, obviously very close to the 2% level to begin with. I would also reiterate that into the face of that, we had double-digit profit growth in services for the quarter and we feel quite confident given all of the elements that we see in the business equation for services, we should be driving double-digit profit growth for the year.

Margin Drivers

Bill Shope – Goldman Sachs: I have a question off of the profit comment that you just made on services. How should we think about the drivers of pre-tax margins this year and frankly, beyond this year? You’ve had some pretty substantial improvements here. So, how do we think about how much room you have left a steady state on pre-tax services margins, which are certainly approaching record levels on an annualized basis? Frankly, where you have room left to enact further saving?

Mark Loughridge – SVP and CFO, Finance and Enterprise Transformation: Sure. Let’s look at the drivers underneath the performance in our GTS business, again profit up 20%, 2 points of margin. How did we achieve that and what do they have as far as sustainability going in the future? So, number one, the GTS business and frankly, GBS as well, but GTS in a large part is a beneficiary of all the work that we’re doing on productivity. Now, you member at the Investor Day, Linda Sanford defined that and how we were managing that across those elements. The objective is about $8 billion over the roadmap period. We felt that we did quite well on that base last year and I’ll tell you that our view is that we’re right on track in the first quarter. GTS once again benefit from that work and they are really part and parcel all the elements that we drive for productivity and spend management. Number two, with those advanced tools and intellectual property we’re also working on not only the margins in the overall distribution, but also the margins in the products that I would call the tail of the distribution, so more challenging contracts. And this year, the GTS team did a great piece of work on those contracts in the low margin tail in the distribution of thousands of contracts and generated a very meaningful improvement in profitability that we know analytically extends throughout the year. And then lastly, I’ll tell you, as we look at the dynamics in that business, our backlog growth for total services was up 14% in the growth markets and growth markets what we’re seeing is we have 2 points better margin actually in those deals as well. So, those three are ongoing dynamics in my mind and give us confidence that we have a strong play going forward.