IBM's Q3
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IBM's Q3
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(FOOL CONFERENCE CALL SYNOPSIS)* By Debora Tidwell (MF Debit)
International Business Machines Corporation <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: IBM)") else Response.Write("(NYSE: IBM)") end if %> UNION CITY, Ca., October 21, 1996/FOOLWIRE/ --- IBM released third quarter 1996 results this morning. They reported net earnings of $1.3 billion or $2.45 per share compared to $2.30 per share a year ago, up 6.5% and two pennies above analyst consensus estimates of $2.43 per share. Revenues grew 7.8% year-over-year to almost $18.1 billion.
The company is very comfortable with their prospects for 1996 and for how they are positioned for growth going forward. They remain very pleased with their momentum. They have introduced new products and services behind network computing solutions. From a financial perspective, their revenue growth continued to strengthen. They stepped up their investments to sustain that growth, particularly in the fast-growing small and medium size company markets. And they continued their very healthy share repurchase activity in the quarter.
KEY POINTS FOR THE QUARTER: STRONG REVENUE GROWTH. Revenue grew at 8% this quarter or 11% in constant currency, a sustained improvement in their growth rate. The $18.1 billion in revenue was a record 3rd quarter for them. In fact, going back they only find one quarter in the 1990s that has constant currency growth rate that is higher, and that was the first quarter of 1995 when they grew at 12%. They talk about constant currency because they believe that for a global company, constant currency is the best measurement of their business momentum.
Hardware revenue grew a strong 8%, 11% at constant currency. Services revenue grew 26%, 28% at constant currency, and the $3.9 billion in services revenues generated this quarter alone reflect a full $800 million of additional business over the same 3-month period last year. Software was flat in the third quarter due to the reflection of Lotus now being in the comparison, but the basic dynamics of host-based and distributed remain unchanged. Maintenance revenue declined slightly. The Rental/Financial revenues are starting to grow, up 4% on a reported basis and 7% in constant currency.
REVENUE GROWTH BY BUSINESS: SERVICES: The Services business continues to be a very strong one for IBM. In addition to the Services growth of 28% at constant currency, their backlog continues to grow. They think there were approximately $10 billion worth of large contracts valued at over $300 million that they are aware of having closed during the quarter worldwide. They won 2/3 of that $10 billion, including 3 of the largest 4 contracts. And, on the 4th, they decided not to compete because they didn't like the terms and conditions. So, competitively they are doing extremely well. Their total Services signing, which include outsourcing, systems integration, IBM Global Network was up $11 billion in the quarter. They are delighted with this success although they aren't sure how much importance to attach to it. The love the business, but they are also sure that there are going to be quarters where you can sign $11 billion and other quarters where there is just not that much out there. So, they encourage analysts not to look at $11 billion a quarter and extrapolate a lot of trends, because that is obviously a very powerful quarter.
Five major wins in the quarter were Lucent, Bell Canada, and Advo which were all managed operations outsourcing; and Prudential Insurance which was systems integration and outsourcing; and Integrion Financial Services was an IBM Global Network contract signed with a series of major banks.
In the quarter they hired about 5,000 new people into the services business and integrated about 2000 others who were employees of other companies that came onto IBM's payroll. So, in this quarter, they had a huge integration issue partly to reflect the success of the signings they had taken on, but partly because with this kind of backlog they knew they had to hire aggressively to do the work they are committed to do within the next few quarters. That kind of number compares to 1,500 in the third quarter last year. The reason that is important is that it is a good news/bad news kind of story. The good news is that they are happy they can attract the talent to do the work, the bad news is that when you bring on people initially it has an impact on your utilization rate. When you hire a lot of new people you have to train them and it hurts your utilization rate. Looking at software and services gross margins for the quarter which are down a couple of points, that is basically because of the new people they had to bring on in order to deal with the demand. Another minor factor is that in Europe everyone goes on vacation in August so utilization goes to hell in August in Europe anyway. So they had to hire people, that had an impact on gross margins, but they understand and think that is positive based on the longer term nature of the business.
So, overall Services continues to be a very powerful growth business for IBM.
SERVER BUSINESSES. They promised that their new System 390 G3 product with a 45 MIP uni-processor would ship in early Fall and they did it in mid-September. They had continuing acceptance of the 23 MIP machine, so they had a very strong growth in MIPs of 77% in the quarter including the shipments associated with their services business.
There are two ongoing phenomena they are seeing. First, they are continuing to see their bi-polar machines decline as a proportion of total, but the pricing of bi-polar is declining much faster than CMOS, so that is a negative revenue drag. But there is another factor recurring also which is that they are seeing a growing proportion of the MIPs shipped under services contracts, and particularly under ICC operating leases. So, in contrast to sales revenue, services and operating leases spread the realization of revenue out over several years. So, if you normalize for that, the revenue for the quarter would have been sort of flat. This is an important fact because they are seeing quite a jump in the amount of leasing, particularly in the US. Services, to a lesser degree, but particularly leasing and that does change the direct link between MIPs shipped and sales revenue simply because you don't get the full sales from the machine in the month you ship it, you spread it out over a period of time on the lease.
There is a hardware transition which is the one from bi-polar to CMOS and then CMOS gets improved and improved and improved. Then there also is a software transition from standalone systems to parallel sysplex. The huge advantage in parallel sysplex is that it always runs, if machines go down backup machines automatically come online, etc. The acceptance of the new CMOS processor has been exceptional and it is driven by two factors -- new applications and very attractive estimates of the total cost of computing.
Of the new shipments this year, they estimate that over half of them have been generated by new applications or the growth of existing applications. For example, they have over 900 ISVs, including 150 UNIX IS vendors who are actively developing new applications for the S/390. These ISV numbers have doubled over the past year and some of them are very important ISVs. Only about 1/3 of the MIPS growth reflects the replacement of older technology. As a consequence, the size of IBM's installed base, which is the total number of S/390s or their predecessors measured in MIPS is now about 25% higher than a year ago. The rate of growth in this installed base of 25% has been steadily picking up since 1993 when it was in the low double-digits. In fact, they have not seen this kind of growth rate since the 1990-91 period. So they are back to almost 1980s mainframe installed base growth rate.
This reflects their 3-part strategy to make the S/390 price competitive with alternative platforms, to expand the basis of applications and independent vendor support, and greatly augment the scalability and usability of the S/390.
They also think the parallel sysplex transition is also going well. IBM is heavily focused on the large corporate market. So, when you talk about the PC market and numbers like 80 million units, it is important to understand that 1,000 customers for IBM, for example in S/390s, probably represents over half the revenue. So, when they talk about 1,000 customers, these are great big customers that can afford to spend huge amounts of money on massive amounts of computing. IBM thinks that 40-45% of these huge customers are now ready for parallel sysplex. They have the requisite systems and hardware ready and installed. And that is roughly triple what it was at the beginning of the year, so they have made a lot of progress on getting their customers ready to move into this parallel sysplex environment. So, in general they thought it was a very good quarter for S/390 and they are pleased with their progress in all these dimensions.
They mentioned that AS/400 revenues declined in the third and fourth quarter last year, a little less in the first. IBM said that these revenues would hopefully continue to rise as they did in the second quarter in single digits. AS/400 revenue grew in solid double-digits in the third quarter, so their product transitions are working in the marketplace and they are doing extremely well. AS/400 continues to do well in its competitive battles in the marketplace. They think as they track their engagements, they are winning about half of the engagements against the likes of H-P, DEC, Fujitsu, and Microsoft NT. Their problem is that they are probably not actively raising the number of engagements enough. They fight the ones they win, they win those, they now need to raise the number of engagements.
In July AS/400 announced the first of a series of network computers. They think there are 30 million dumb terminals out there for which this is a logical replacement and they are going to go after this market actively.
RS/6000 had a weaker quarter this quarter. Revenues were roughly flat. They have introduced a new family of products two weeks ago, early in the fourth quarter, ranging from notebooks to SPs. This was the largest announcement they have made since RS/6000 was announced. These announcements were widely anticipated by the market in the third quarter. In general, this quarter their workstations continued to decline, the servers had modest growth, and the high end SP continued to show very strong growth.
The PC Server continued double-digit growth, however they know they need some improvements in that market particularly in the ease-of-use, channel readiness, and the channel mindshare kinds of activities. So, they had a decent quarter in PC Servers, but they have more to do.
On the whole, they think this was pretty good performance for the server group with strengths in enough areas to overcome a couple of soft spots.
SOFTWARE. This is the first quarter that software revenue has Lotus reflected in both the current period and the base period. The slowing rate of growth reported does not reflect the change in the basic dynamics of the software business and it is pretty much on course as they laid it out in June in their overview of the software strategy. The key points of that strategy were to aggressively grow their distributed base software by offering it on all leading platforms and by leading in the commercialization of the Internet, and they are doing that. At the same time, they are repositioning their host-based software to make it attractive in a parallel sysplex environment. Last quarter they broke out their software revenue into two segments, host and distributed, in line with that overview. About 75-80% of their software revenue was host based, generated by the monthly license changes from the entire installed base of their S/390 family. This segment of their revenue declined about 6% in the third quarter, an amount comparable generally with the first half.
But they think they might be at about the low point of the host-based revenue decline and here's why. There are basically two opposing trends going on. On the downside, customers are in the middle of this shifting over to the new licensing arrangements that better suits the parallel environment. During this transition, customers will benefit from the incentive of lower prices and, once shifted, their prices will rise again as usage rises. That's the negative. On the upside, the installed base of S/390 has been accelerating its growth (25%) and IBM is seeing an acceleration of the number of DB2, CICS, and other licenses drawn on the S/390 platform. And they think they could be at the point where the growth in capacity is really starting to offset the decline relative to pricing. So they may be very close to that changeover at this point. Now, obviously if 80% of your business is growing at a -6%, and that -6% becomes less than that, that changes your dynamic.
The other major segment, the IBM software that runs on both IBM and competitive distributed platforms, grew at about 24% in the quarter. And these growth figures have been normalized for both Lotus and Tivoli as though they had been in the base period. This growth is very comparable. 19%, 32%, and 24% were the kind of growth rates they have had all year long. Behind this there are some very pleasing results. They had a very good double-digit growth in Lotus Notes seats and revenue in conjuntion with 1.2 million seats that they shipped in the quarter, a lot of expansion in major corporate accounts which they are delighted to see. Their Tivoli systems had very strong performance. And, in particular, the new effect in the quarter was a very strong surge in database sales, particularly DB2 on NT. So the issue for overall software growth is that this fast growing distributed software is only 20-25% of the total. As it becomes proportionately larger, it will help their total software revenue grow.
THE PC COMPANY. Once again, the PC Company enjoyed the best quarter it has seen in many years. The growth rates for both the volumes and revenue continued to be very strong. They continued to gain share in all geographies, which is a very strong statement because they are not aiming at all the markets. So, when you're aiming at 70% of the market and gaining share, then you're doing pretty well in the segment you're aiming at.
This sales gain was driven entirely by end-user sales. If anything they had less channel inventory than before. And, they expect that they are going to see share gains when all the industry data is in.
Their gross profit margin improved sequentially from both the second quarter and year-over-year by good amounts. Last quarter they gave some comparisons on five financial performance measures between their PC business and Compaq. Compaq had a terrific quarter. In the second quarter IBM did better than Compaq on 4 out of 5 measures but missed on the most important one which was gross profit margin. They did better on volume growth, revenue growth, expense to revenue relationship, and inventory turns. This quarter, the contest is much closer. IBM did much better in volume growth. On revenue growth it was virtually a tie because of Compaq's server position. On gross profit margin, Compaq still did better than IBM but IBM materially closed the gap. On expense to revenue IBM is lower for the fourth quarter in a row. And, on inventory turns Compaq regained the lead. So, this quarter on these 5 measures, IBM was better on 2, Compaq was better on 2 and they were roughly tied on 1. But, in total IBM feels better about the PC Company and its competitive situation than they did last quarter because of the most important of these measures, gross profit margin, where they made a lot of progress. And, they retained their strong momentum in unit growth and in revenue growth.
The PC Company has brought some terrific new products to market including the thin 560 ThinkPad and the new Stealth Aptiva which has gotten rave reviews and has been redesigned so that it is much easier to use in the home.
GEOGRAPHIC REVENUE. Their growth pattern in the major geographies was very much what they saw in the second quarter. Their reported revenue growth was 8% in the third quarter, at a constant currency they had 11% growth. Asia/Pacific continued to generate extremely high constant currency growth of 19%. That region is roughly 1/5 of IBM's revenue, growing at 19% at constant currency and 8% at reported. North America accelerated its growth to 14% growth in the quarter, an improvement over last quarter's 11%. It is the principal geographic driver of their improved growth given the size of growth and the size of IBM's business there. They also saw some accelerating growth in Latin America. It is only 5% of their revenue, but its growth rate increased to 12% this quarter, up from 6% last quarter. Europe, at about 1/3 of IBM's revenue, was essentially flat again this quarter.
CURRENCIES. The year-to-year impact of currency in the third quarter was roughly half of what it was in the second quarter. If current spot rates held for the remainder of the year, the yen would impact their results in the fourth quarter, but not quite as much in the third and a lot less in the second quarter. On the other hand, the European currencies are starting to impact more in the fourth than in the third quarter.
IMPROVEMENT IN HARDWARE GROSS MARGINS. Their gross margin at over 40% was up a point from last quarter driven principally by improving hardware gross margins across a number of their business units. Their hardware gross profit margins improved 3.5% in the second quarter and about 1% last year. This is an area they have been working very hard on.
The improvement is driven by almost all of their product units, about 75% of their product units improved their gross profits in the quarter. So this is not a S/390 phenomenon. It takes place across all the businesses. If you look at the comparisons from a year ago, the S/390s are not even a factor, it's PCs, storage/hard disks, consumers, and a few other things. The S/390 was a factor in the improvement from Q2 to Q3, but again The PC Company, consumer, storage, hard drives, etc. drove a big part of the change. What they think they are seeing is what fast time to market and simplified process can do when it gets to the higher volume products such as the storage, hard drives, and the PC Company. As they get more competitive, they are delighted to see that it is showing up not only in their revenue line, but in their profit numbers as well.
DRAM PRICING. They are continuing to feel the impact of lower prices even through the fourth quarter. They are both a DRAM producer and a DRAM buyer, so they get both a negative and positive impact. What they are finding out is that even more of those costs are having to pass through to the market than they thought last quarter, so they are not seeing the net benefit to the company in the fourth quarter that they indicated they would see. It's not a big move, but a small one that looks like it will continue.
HOW THEY ARE FOCUSED ON EXPENSE MANAGEMENT. Total expense to revenue, as in the first half, was about the same as last year, just over 29%. They had some increased investments including some substantial expenses for the Olympics. The tax rate was 35% and improved their year-to-date tax rate to 37%. Their net income from margin remained at just over 7% as it has in the previous two quarters.
Their growth in expense this quarter was 9%, so their expense/revenue ratio was roughly the same as last year. They had a restructuring expense again this quarter of a little over $200 million. But, they ended up bringing back a building in San Jose California off their balance sheet that they expected not to bring back (they put a valuation reserve on it), because of the growth in their storage business. So the net of that San Jose building was $152 million. That was roughly 3 points of the year-to-year expense growth. They put a lot into the Olympic program in the third quarter. That is probably 2-3% of expense growth. After some other miscellaneous things, what's left is an increase of 5-6% year to year.
The 5-6% goes back to the discussion on their ongoing efforts to focus on infrastructure on one hand and expenses that lead to revenue generation on the other. The infrastructure and base expense reduction they are continuing to push on and they are seeing that reduced by about 2% in the quarter. But, they saw the opportunities to grow their business, particularly in their small to medium size enterprise. They have seen that opportunity develop over the last 18 months and made some decisions in Q2 to put some money behind it, and that money showed up this quarter.
They are putting some new marketing programs, industrial solution programs, telemarketing, agencies, etc. all of which drives this. But the bulk of the money is going into the small to medium enterprise area. This is a step up of their investments and it is discussed in more detail in the section further down that deals with longer term dynamics.
The most important message is that they plan to manage their expense base to produce profits for their shareholders. Shareholders should not view this expense growth as something that is out of control in any way, shape, or form. They will cut expenses that aren't profitable for the company. They have the management will and discipline to do that. They had some one-time issues that were mentioned before. They are cutting back on their infrastructure in their low-yield investments. But they do think there are investments in some pretty good programs that are going to fuel revenue growth. They are making judicious investments to grow the company and they think a lot of these investments minimize infrastructure and are highly variable with revenue.
SHARE REPURCHASE PROGRAM. They continued the same pace at investing cash in common share repurchases, spending nearly $1.3 billion for nearly 12 million shares. Thus, their average shares outstanding for the quarter were 522 million, down 8% from last year and they entered the quarter at 518 million shares. Earnings per share was $2.45, up $0.15 from last year. Currency negatively reduced revenue growth by about 3% and earnings per share was negatively impacted by about $0.08 per share this quarter.
Over the past 7 quarters IBM has invested $8.7 billion in repurchasing 87 million shares on a very steady basis quarter by quarter. They are out in the market regularly, they like their stock, they buy it back. They think this is an important part of their activities looking forward. They have $1.3 billion left under the current authorization from the board and their average purchase price is well below current market. The EPS has benefitted from the number of shares being down a net of 12% since the beginning of 1995.
LONGER TERM DYNAMICS OF THEIR BUSINESS. In July they talked about the fact that their portfolio of products was strong and that 90% of sales were #1 or #2 and that the portfolio continues to improve. They talked about that their net income margins had remained relatively stable and that they think a disciplined use of their cash both to fund future investments and fund their share repurchase can add to EPS growth.
PRODUCT PORTFOLIO MIX SHIFT TOWARD HIGHER GROWTH PRODUCT SEGMENTS. They segmented their product portfolio into two groups, those that were growing faster than the industry average (high growth) and those that by industry view would be low growth. And, in 1993 only 46% of revenues were in the higher growth segments. This made it mathematically difficult to grow with the industry as a whole unless they gain share in one of the two segments or in a mix of the two. Year to date in 1996, 63% of their product revenues are in the higher growth segment. So, their portfolio is moving the direction they want it to.
Now, while 63% of IBM's business revenue comes from the higher growth segment, they estimate that the industry has moved up to where 84% of the whole industry is now in this higher growth segment. So IBM is still mixed negatively compared to the industry. But, since the beginning of the year, IBM's growth has improved 6% and the industry has only improved about 2%. So, they are continuing to get a lot of traction on this mix issue moving forward because their mix is improving a lot faster than the industry's mix. So they are closing the gap and it will be easier to drive their revenue in the future.
What is driving this improvement is their strong Services business, the improved performance of the PC Company, the consumer units, and a bunch of other units. On their base business they are doing well on their high-end servers and other areas.
INVESTMENT IN SMALL TO MEDIUM ENTERPRISE (SME) MARKET. IBM has traditionally had a very strong role in the large corporate market. This, in fact, accounts for almost 75% of their revenue. Their successful and traditional focus on this market is strengthened by some key IBM attributes -- an enormous set of technical alliances and skills, a very high level of senior level contacts that extend throughout all levels of the enterprises, and a very active client team organized by and deeply trained in each industry. They lost a lot of position in the early 1990s. But they focused initially on rebuilding their strength in this segment and rapidly did that. They think their position now is very strong and they fully intend to strengthen these relationships further.
As they look ahead, it is possible that the large corporate segment might only grow 8%, the SME segment at 11%, and the consumer segment at 16%. They take these growth rates as a little less than literal because as you talk about something like the network computing opportunity, it is not exactly clear how that is going to play out by customer segment at this point. But, looking at the traditional IT industry, those are the kind of growth rates they could see.
About two years ago they realized that they had some very successful local businesses that they had established outside the US to deal heavily in the SME segment -- in Italy where much of the economy is based on the SME companies and in Canada. In 1995 they broadened their efforts, did a lot of research and discovered that the SME segment is growing faster than the industry as a whole. The market is very fragmented with no dominant player. The top ten players have less than 30% of the market, so it is much more fragmented than the large corporate market. And, they found 18 months ago that IBM is #1 in this market, partly by intention where they focused on it, but also because they had a lot of smart people doing local things that they never really focused on. They are, in fact, #1 in all major geographies -- North America, Europe, Asia, and Latin America. In fact, only in Japan are they not #1, they share that spot with Fujitsu. Finally, their experience to-date has shown that this market has above-average margins. So, they focused on 1994, improved their focus in 1995, and have decided to step up their investment levels in 1996.
This Summer they established a worldwide organization with a key focus to further increase market value, to help SME customers exploit the benefits of network computing that they see their large corporate customers exploit, to grow the services business through dedicated services personnel and packaging, to deliver more packaged solutions and channel-ready products, and have more capability of working through the channels. They also worked with each of their product divisions to create packaged solutions for this market much more aggressively. This market is one in which companies do not have the resources to put together their own solutions, so IBM has to create more off-the-shelf solutions for this market. They are going to expand their telemarketing efforts and support their channel partners better. They are implementing brand management approach to insure that each of their product divisions use this as a priority market and develop the appropriate products for it.
They are not going to let the expenses get too far ahead of revenue, but where they see the momentum in the market occuring they will be willing to put some expense behind it. A lot of this will be variable in nature. * A Fool conference call synopsis represents an effort to highlight the salient points of a conference call and should not be taken as an authoritative accounting or transcription of the entire event. |
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Copyright 1996, The Motley Fool |