FOOL CONFERENCE CALL SYNOPSIS*
By Debora Tidwell (TMF Debit)

International Business Machines
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One Old Orchard Road
Armonk, NY 10504
(914) 765-1900
http://www.ibm.com

ALEXANDRIA, VA (July 22, 1997)/FOOLWIRE/ --- IBM Corporation released their results for Q2 1997 after the market close on Monday, July 22nd. IBM's portfolio of businesses and their breadth of geographic presence have produced overall results that are on target. Because of their diversified portfolio and its continued balanced performance this quarter, they believe they are on track for full year 1997. Their ability to produce such results for the year will depend on execution in a tough external environment. But, they are very well positioned for industry trends, they have tremendous resources, leadership technology, and excellent relationships with their clients, customers, and business partners worldwide. They are working hard to improve cycle time, speed to market, and just getting things done.

RESULTS IN THE CONTEXT OF LONGER-TERM MODEL. They shared financial priorities in the context of the longer-term financial model for the company. First, they are driving towards high single digit revenue growth. Their focus is on ensuring they get returns on the investments they are making for growth, both capital and expense investments, capacity, alternate channels, emerging markets, new technology, and acquisitions.

ACQUISITIONS. In mentioning acquisitions, they looked at some 15 acquisitions they have made over the past two years and ranked them on a post-acquisition review basis as those that have far outstripped their criteria through those that have not. Out of the 15 companies they acquired, 6 were services companies, 5 were software companies, and 4 were hybrids. Six or seven were non-US companies. Their ranking is that one of them has knocked the cover off the ball, 13 are well within their acquisition criteria and expectations, and 1 small foreign software company has not done well. They feel that's a pretty good return and they will continue to closely monitor the acquisitions they do.

WORKING ON STABLE MARGINS. Secondly, they are focusing on achieving stable after-tax margins, with the focus particularly on costs and expense. Their top managers still feel that they have too much infrastructure in the company and they can still get more for what they spend. Taxes are also a key part of the cost/expense equation.

EPS GROWTH. Third, they must continue to improve growth in earnings per share by appropriate use of their cash. They are a strong proponent of share buybacks to increase shareholder value.

RESULTS FOR THE QUARTER. As for the quarter, revenues at $18.9 billion grew 4% as reported or 8% at constant currency (which they use because they believe for a global company it is the most accurate measure of business momentum). Net income margin was 7.7%, up a bit from last year. Both gross profit margin at 39.2% and expense-to-revenue at 27.7% were about the same as last year. Therefore, pre-tax income was up just slightly. The tax rate of 33.7% improved over 4% from last year. As a consequence of their share repurchase program, average shares outstanding for the quarter were 987 million, down 8%. At the bottom line, earnings per share were up $0.20 or 16% to $1.46 per share.

REVENUE BREAKDOWN BY LINE ITEM. For hardware, revenue was flat at $8.6 billion. At constant currency this would have been a 4% growth rate, about what they did in the last two quarters. Services continued its very strong growth. They grew 24% to $4.6 billion. At constant currency the growth rate was 28%. Software revenue declined 3% to $3.1 billion. At constant currency this would have been growth of 1%. Maintenance revenue at $1.6 billion declined 7% or 2% at constant currency. Rental and finance revenue was flat at $900 million. In constant currency this would have been a 3% growth.

SYSTEM 390. They had a very good quarter in view of the fact that shipments of their newly announced parallel enterprise servers started at the end of June. With these shipments, the 390 hardware transition from bipolar to CMOS is virtually complete. MIPs grew nearly 60%, although revenue was flat due to the continuing improvement in their price/performance. They continue to do very well against competition.

Implementation of Parallel Sysplex by their customers continued at a steady pace. The number of customers that are system enabled grew to over 900. Putting this in terms of MIPs, between 35-40% of the entire worldwide IBM installed base is now Parallel Sysplex enabled. So they are probably about halfway through this software transition since not all of their current MIPs will or should move. Of these customers, 500 are now running applications using Parallel Sysplex and of those 500, over 25% are employing application data sharing.

Information Week cited four reasons for the return of the mainframe, although IBM contends that the mainframe never went away. First, mainframe security is at least two years ahead of UNIX or Windows NT. OS 390 can run UNIX, NT, and enterprise applications such as SAP r.3. Three, mainframes have the capacity to store a database of 500 gigabytes or more without dividing it up. Four, Parallel Sysplex configurations have no single point of failure and are easy to update and maintain while the system is running. Information Week did not talk to IBM about the article, just IBM customers and competitors. So, the System 390 was a positive.

RS6000. This was a repeat of the first quarter in terms of revenue growth. Entry systems continue to decline in a tough market sector. Enterprise systems had unit growth but revenue declined due to a shift to the low-end systems. The new SMP servers announced in April and shipped in June have a good backlog, but they also need the new 64-bit SMPs coming out later this year to complete the line. Large-scale systems had their tenth quarter in a row of growth rates over 30%. While the RS6000 had to deal with product transitions and the consolidation of North American manufacturing with the AS/400 in Rochester, MN, they are not pleased with overall execution in this division.

AS/400. While revenue was down in the quarter, it was an improvement over the first quarter. They saw significant improvement in Europe where, last quarter, they fumbled the ball in a hand-off to alternate channels. But, in North America they started to feel a slowdown due to anticipation of their new models scheduled for later this quarter. They want and expect to see excellent execution in the coming product transition.

PC BUSINESS. When industry analysts publish their results later this week, they will probably show that IBM held or gained a little share during the quarter, but did not do as well as some of their large competitors. Against a strong 1996 second quarter, unit growth was solid double digits in this quarter, but revenue growth was modest. Underneath these totals is a mixed set of results. First, from a geographic perspective, they did well in North America and Asia/Pacific, but again had weak performance in Europe. Their PC server business turned in very strong growth for the third consecutive quarter. However, their consumer brand declined this quarter, in part because the high-end segment did not grow as fast as the lower-priced sectors. IBM has begun a move into the midrange segment, recognizing its potential and using a new business model. They have announced products in Europe and Canada and are just now launching in the US. Their mobile brand had strong growth, but supply is catching up with demand in that sector. Their commercial desktop brand showed continued solid volumes growth. They have been comparing themselves with Compaq on 5 business metrics recently. As opposed to last quarter, Compaq grew faster than IBM in both units and revenue. In gross profit margin, Compaq maintained their lead. In expense to revenue IBM maintained the lead. Inventory turnover was a toss-up. IBM is working very hard in the consumer area and is looking at a new way to manufacture computers as they move down into the mid-price segment (the $1000-1500 segment). They are working very hard on manufacturing costs and efficiencies and dealer efficiencies and are bringing some very unique services to bear. They matched some recent price moves by competitors recently.

PROFIT MARGIN AND INVENTORY TURNOVER. They made a few points related to gross profit margin and inventory turnover. First, with the exception of servers, their analysis indicates that their unit costs are the same as Compaq's and they monitor their competitors very closely. Second, it is also relevant to cost that their inventory turnovers are comparable. Third, back in the first quarter of 1996, IBM initiated their "authorized assembler" program aimed at enabling their dealers and IBM to deliver customized PC configurations quickly and efficiently. Today, over 20% of their commercial desktops are delivered through this program in North America. But, they have also been working with their dealers to develop efficient delivery mechanisms when even less customizing is required. This is not new. One sales side report recently noted that these changes in channel delivery programs represented more of an evolutionary industry shift , than a battle of direct versus indirect models. They are inclined to agree in that the entire PC sector is increasing its focus on asset efficiency and optimizing its relationship with business partners -- both suppliers and channels. But, IBM also brings additional assets to bear on customer needs. They are using their services and financing strengths to provide system care and solution pricing -- offerings that manage the administrative and financing burdens as well as the risk of technology transitions. Their competitors do not have that breadth. So, overall they rate the PC company a neutral this quarter. But they put the PC servers in the "positive column" and the consumer PCs in the "negative column."

SERVICES. Services remains in the positive column. They again had strong revenue growth of 24%. While this rate of growth cannot continue, they do expect to grow significantly faster than the industry as a whole. They are first and foremost focused on profitable growth. They will not chase unprofitable bids for the sake of high growth every quarter. Their backlog stands at $36 billion and they had new contract signings of over $3 billion including the Prudential Health Group and Ryder, which they won with a partner. There were leaks in the press about a transaction in Australia with Telstra. Telstra plans to sign agreements on Tuesday or Wednesday with IBM Australia Limited and a partner lend/lease corporation. This is a large outsourcing contract for the IT operation of Australia's major telecommunications operator. It will help IBM with their third quarter compares against last year with Lucent and Veritech. But, this backlog principally represents managed operations, outsourcing. Outsourcing is only one-third of their services business. IBM's real strength lies in their ability to provide a complete range of services to help customers improve their business. This includes systems integration, availability services, consulting, education, and network outsourcing. In this last area, network outsourcing, they acquired Sears' 30% equity interest in Advantis, bringing their networking technology talent home. In addition, they hired over 4000 people during the quarter in the services business.

SOFTWARE. Results here were also much like the first quarter. Host software, which is over 2/3 of their software revenue and realized mainly through monthly license charges, declined slightly, as it has the past few quarters. Distributed software grew modestly. There were a range of results. Tivoli's distributed revenue again more than doubled. Lotus shipped 1.8 million Notes seats in the second quarter -- more than any previous quarter and there are now twice the number of Notes seats than there were a year ago. But, OS/2 and OS/2-based middleware declined, negatively impacting the distributed software performance. So, they put software in both the positive and negative columns.

HARD DISK DRIVES. Hard disk drives again had a very strong quarter with results that nearly doubled. In June, their board approved another $1 billion in capital commitments to further increase HDD and MR head manufacturing capacity. They have a competitive technology, and a competitive manufacturing cost advantage that will benefit both their customers and shareholders. Their OEM hard disk drive business is now over half of their storage division's hardware revenues. They had a better quarter in their high-end storage systems, DASD, but revenues still declined as the competitive pricing environment remained very tough. So, hard disk drives will stay in the positive column.

MICROELECTRONICS. With falling DRAM prices, this business was in the negative column all last year. While DRAM prices are still down significantly year to year, the bulk of the financial impact is now behind them. In the meantime, SRAM and their custom logic business showed very strong growth. So, overall this business is growing well with good profitability. They moved microelectronics into the "positive" column this quarter.

MIX CHANGE TO HIGHER-GROWTH SEGMENTS. They have shown periodically the changing mix of their overall revenue from lower to higher growth segments. This improvement continued through the first half of 1997 with higher growth segments now representing 66% of their revenue. While this is still less than the industry's mix, they are continuing to make progress.

GROWTH BY GEOGRAPHY. Geographically, North America revenue grew 10% to $8.6 billion. Europe's revenue was $5.7 billion, a 5% decline as reported but a 3% growth in constant currency, so the impact from currency was about the same as in the first quarter. Asia/Pacific's revenue was $3.8 billion, a 4% growth as reported and a 10% growth in constant currency. In the Asia/Pacific region the negative impact of currency was still substantial but down from the first quarter. They continue to have strong growth outside of Japan, notably in China, Singapore, Hong Kong, and India. Finally, Latin America grew 8% to $800 million.

CURRENCY IMPACT. Looking at year-over-year comparisons for currency and recent spot rates, if spot rates hold for the rest of the year, currency's negative impact on IBM's reported results would increase in the second half of the year for Europe and decrease in the second half for Japan. As in the first quarter, North America and Asia/Pacific remain as positive contributors, Europe stays in the negative column, and currency is the same negative factor (about 4% of impact on growth and about $0.10 on earnings per share).

PROFIT MARGINS BY SEGMENT. Total gross profit margin was 39.2%, down 0.3% from last year and up 1% from Q1. Over the longer run, the changing mix of businesses in the industry should tend to drive gross profit margin down about 1% per year. In IBM's results, there are two mix changes to focus on -- the mix of their five revenue segments to more services and less hardware, and the mix of businesses within hardware to more PCs and less System 390. In the second quarter, the negative impact from the changing mix of their revenue segments was offset by year-to-year improvement in hardware and software margins. Hardware gross profit margin improved 2% to 35.5%. The changing mix of hardware businesses would have driven this gross margin down by a point, but year-to-year improvements in storage, System 390, and PCs more than offset this trend. Underneath this was some good progress made in reducing costs including lower inventory writeoffs and lower warranty costs. Services gross margins was stable at 20.6% despite the strong growth in revenue. Software gross margins improved 2% to 70.6% -- the consequence of lower capitalization rates and the associated reduction in amortization. Maintenance gross profit margin declined a point to 46.5% as it did in the first quarter. Rental and financing declined 8 points to 49.6% principally due to a trend towards financing a greater amount of low-end products and faster growth in the more competitive US market. In summary for the quarter, the secular trend towards a lower gross margin was offset by operational improvements, holding it steady year-to-year.

EXPENSES. Total expense grew in line with revenue in the second quarter so that expense-to-revenue was virtually the same at 27.7%. SG&A and other charges grew only 2% so its expense-to-revenue improved by 0.4%. R&D grew 9%. About 4% of this growth was due to the acquisition of a majority position they took in Net Objects. Their flagship product, Net Objects Fusion, is used by tens of thousands of Web designers, developers, and professional site builders within both small and large businesses. In the longer term, they know that expense-to-revenue must continue to improve. They continue to cut infrastructure and invest in areas that will grow the business -- product areas (e.g., those relating to network computing like Domino or acquisitions like Net Objects or DBMX), marketing areas such as alternate channels like telemarketing, and emerging markets, and solutions such as those developed with customers in their industry solutions business units like Integrion where they have worked with a number of banks to help them extend their reach to customers.

CASH FLOW. Net cash from operations and net cash flow for the first half of 1997 is very much the same as in 1996. But, Tivoli and other investments in 1996 have been replaced by increased capital expenditures in 1997. These are principally in outsourcing, hard disk drive capacity, and microelectronics. Cash flow for restructuring is down in 1997. Finally, they have increased share repurchase activity over last year.

BALANCE SHEET. Cash on the balance sheet stands at $6.9 billion. Core debt-to-total-cap is 15%, well below their general comfort zone of 20%. Customer financing leverages at 6.6-to-1, also well below their general target of 7-to-1. The balance sheet remains very healthy.

SHARE REPURCHASE ACTIVITY. In the second quarter they spent $1.6 billion to repurchase some 20 million shares. Their remaining authorization from the board is $2.7 billion. Their average shares outstanding was 987 million, down 8% from a year ago, and they ended the quarter at 982 million shares.

LONG-TERM ACCOMPLISHMENTS. Since 1993 they have accomplished progress in the following long-term focus areas. For constant currency revenue growth, from no growth in 1993, they improved to 9% growth in 1996. The 8% in the first half of 1997 matched the 8% in the first half of 1996. Second, from zero net income margin in 1993 to 7% in the first half of 1996, they again show 7% net income margin in the first half of 1997. Third, from growth in outstanding shares in 1994 to 7% reduction in 1996, they show 8% reduction in the first half of 1997. They are performing in line with their longer term objectives.

NEW CFO. They are looking both in-house and outside for the next CFO. They have strong in-house talent but also recognize that the opening represents an opportunity to bring new talent in.

* 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. Note: Statements made by a company other than historical information may constitute forward-looking statements for which the company can claim protection under the Safe Harbor Act. Please consult the company's filings with the SEC for information on risk factors which might cause actual results to differ materially from the information contained in these forward-looking statements.