International Business Machines Earnings Call Nuggets: Second-Quarter EPS Growth and Workforce Outlook

International Business Machines Corporation (NYSE:IBM) recently reported its first quarter earnings and discussed the following topics in its earnings conference call.

Second-Quarter EPS Growth

Toni Sacconaghi, Jr. – Sanford Bernstein: Mark, I just wanted to make sure I understood what you’re commenting for Q2 and how that relates to the rollover impact that you also mentioned. So I think you said that operating EPS growth would be similar in Q2 to Q1, which I think was about 3.5%. I’m surprised that that’s not dramatically higher than it was in Q1 because you have a much easier comparison and also because you’re suggesting that you had several hundred million dollars in pushed out revenues at high margin. In fact, I think if you work backwards from consensus, you missed revenues by $1.04 billion. If you take out currency, you missed by almost $1 billion. If you really were on plan other than slip deals, that would suggest that you should have $1 billion of high-margin incremental deals next quarter, and I’m not sure why your pre-tax, why your EPS growth wouldn’t be a lot higher. And related to that, are you expecting any EPS growth after your restructuring charges in fiscal Q2?

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Mark Loughridge – SVP and CFO, Finance and Enterprise Transformation: Let me talk through that. First of all, when you look at the second quarter, in your comments on the second quarter, we have a very good set of rollover transactions going into second as you correctly pointed out. And if you look at that composite that rolled over the dateline for us, we’re talking about more than $400 million of mainframe software and intellectual property. So that does give us confidence in the second quarter. But Toni, I did not mean to indicate that all else would also be on the original performance track. So, in fact, I still believe there are parts of our business that are in transition or have been underperforming that also were disappointing that are going to take some time to recover. So let me do a couple of things to help clarify that. If we look at the first quarter, I think our total Services business did perform as expected on an I&E basis. Revenue was about what we saw in the fourth quarter. Pre-tax profit was up 10%. The real positive news out of the Services business in the – first, was in fact backlog performance. So, backlog was up 5% at constant currency, and I’m sure you’ve looked at all the supplementals. We really had a great quarter for bookings up almost 50%. So, that drove a lot of new business in the quarter. That backlog performance is well distributed. Major markets backlog is up 3%. Growth markets backlog is up 10%. If you look at the other elements through the different axis; outsourcing backlog, up 4%; transactional, up 9%. So I think the teams in Services delivered on their objectives on profit and they did sign a lot of new business. And I would tell you, when you look at the content and the deals, they too have rolling into the second quarter, they’ve got a very strong lineup. So, with that, I think that for both of the Services businesses, by the time we get into the second half, they should be growing at a low-single-digit and I’d peg that at about 2% constant currency for both of them. We’ll start to see this backlog really improve their performance. Second, as you did point out and I quite agree your comments, we had a shortfall in the sales execution of our software mainframe businesses. Those should roll over and they should present us with very good performance in the second quarter. Now by that, I mean, in that over 400 million of mainframe software and intellectual property that rolled over, we should see our strategic middleware, I think, kind of the double-digit framework which would give us total Software in mid-single-digits. We should see our mainframe business at double-digit as well. So with that performance, really our STG business should return to profit in the second quarter. Third, when you look at our growth (of the) initiatives, I think that to be quite clear about it, was mix; Smarter Planet I think did well, up 25%, our cloud business up 70%. I though they did well and it came across content that we sell to our customers so they can set up the private cloud. That was up more than 75%. Managing that content for our customers in private cloud doubled. Our Software and Service business was up 65%. So, all those elements we thought performed well. But on the other side, our growth markets revenues was up only 1%. So, they need to get that back to that mid-single-digit characteristic that we’re looking for in the second quarter. If you looked at their metrics today and put them on the table, they’d be pointing at mid-single-digit performance. But I think to your – to the point I was earlier, there certainly are parts of business that I put in the category of underperforming and they did disappoint us in the quarter. Power storage products within that. I do think in Power if you look at their performance in that opportunity of UNIX space. Once again they picked up share but it doesn’t mean much if you’re declining at double-digits now. Part of that was compare based on high performance computing, but even if you subtract that they are double-digit declines. So, new products are going to take some time to improve their performance by say six to nine months, but they also need to move into new opportunity spaces like Linux in a better way. We do have some real success there and the Linux market right now is as big really the UNIX market growing more rapidly. And then in the storage products, we need to take advantage of the flash memory content that we’ve built up and that we reviewed in Almaden. If you look at the second quarter, flash memory could improve that storage growth rate by about a point-and-a-half and by the time we get to the fourth quarter by 3 to 4 points, but those elements are going to take more time than I think we would originally have thought. The other point that I’d tell you about the second quarter; I want to be clear about, is the yen. So the yen had an impact – total currency had an impact about 1.5 points in the first quarter, then we’d see about 2 points in the second quarter, and at the current spot rates it will lead to a year of about 2 points impact. A lot of that impact is frankly the yen, and you’ve seen how much the yen has moved in a short period of time. Now, when we hedge free cash flow, we hedge the underlying cross-border cash flow. So, you tend to have royalties for Software, you have costs for our hardware content, really related to the big export business that we do. But on Services, you don’t have that underlying cross-border cash flow to hedge and most of that is done on a local basis with local resources, local competition; not many cross-border cash flows in a lot of that content, especially in Japan. In Japan, the lion’s share of the business – and I mean, we’re talking 75%, 80% is Services content. So when we get hit by the yen in our largest country without the ability to hedge that free cash flow on a cross-border basis that does fall to the bottom line and we’d look at the impact in the second quarter at about $0.10.

Workforce Outlook

Steven Milunovich – UBS Securities: Mark, first I wanted to clarify the employee workforce charges in the second quarter. Are you excluding that from your operating earnings guidance or is that somehow in there? In the past, you’ve often been able to find gains to offset that, but it sounds like you’re kind of excluding that. And then I just wondered if you could comment on the environment. You had some execution problems in the third quarter last year. You’ve currently got some in the first quarter. It sounds like either you need to maybe swap out some managers, or more likely, everybody is missing enterprise numbers this quarter. What do you think is going on? Is it macro, is it people looking at their cloud architectures and just delaying things, and why particularly at the end of the quarter?

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Mark Loughridge – SVP and CFO, Finance and Enterprise Transformation: Okay, let me take both of those questions. I’m going to start with your first. First, let me put this in context. So, when we gave our original guidance in January this year, we said that this year would be like other years and that we’re going to buy and sell businesses, we’re going to record gains and charges, we’re going to invest in innovation, and continue to rebalance our workforce to future opportunities. And we said that in an all-in basis, we feel confident with an at least $16.70 of operating EPS for the full year and that is still the case. Now, in the first quarter, we recorded 8% EPS growth and as we look at our book of business, especially the strength of the rollover deals for software mainframe, we should see similar year-to-year EPS growth in the second quarter, just as we had the conversation around Tony’s question. However, this will be further impacted by workforce rebalancing charges, which I will come back to. So, in the second half of the year, we would expect our EPS growth to improve in the third quarter and further improve in the fourth quarter to double-digits. So even excluding the second quarter workforce rebalancing charge and second-half gains, we feel that – very confident that we can achieve the 9.5% EPS growth for the year to drive at least $16.70 of EPS. Now, remember, last year we had about $800 million in workforce rebalancing charges spread across the year. This year we expect the workforce rebalancing charges to be closer to $1 billion and concentrated in the second quarter, though we really haven’t finished the work for a specific action yet. But like last year, we expect the bulk of that charge to be outside the U.S. And with that, on an all-in basis, including all gains and charges we are confident we can achieve at least $16.70 of operating EPS for the year just as we said in January. Now, on your second question regarding the first quarter, let me give you a view on a kind of our side of the table, the IBM Corporation and then I’ll give you a feeling for some of the macro issues that we also faced. So, I think as we explained in the prepared remarks that by and large this is an execution problem. I mean, we should have closed on those rollover deals and we thought we had them right up to the end. We put a lot of work into how to build that pipeline and our execution against it to compensate in a way for Easter at the end of the quarter. And the last time we had an Easter in March was 1Q ’05 and that was also very disappointing quarter for us. But were those deals affected by Easter? Well, the bulk of that 400 and plus deals that crossed the dateline, the bulk of them, I mean, really by far the majority were in Europe and there were in the U.S. So it’s hard to imagine that we weren’t affected by Easter. Secondly, if you look at the U.S., was there effect of the – some effect of the sequester? Well, it’s hard to measure. I can’t tell you that our U.S. federal business was down 13%, which was certainly a drag on the U.S. performance. But I think the other element that in a way we kind of misjudged, the change in the Chinese government really ripples down all the way to the provinces and state-owned businesses. And as we went through that – I mean we’re talking, well, once every 10-year event – as we went through that with the team, I don’t think we fully accounted for the impact that would have. Then the last point I would make is the yen. But once again I want to return to the point that had we simply closed on those deals at the end of the quarter, we would’ve certainly had sufficient business to close the first and to enter the second with strength.

A Closer Look: International Business Machines Earnings Cheat Sheet>>

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