IBM
Q2
| IBM
Q2
|
| (FOOL
CONFERENCE
CALL
SYNOPSIS)* By Debora Tidwell (MF Debit) International Business Machines <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: IBM)") else Response.Write("(NYSE: IBM)") end if %> UNION CITY, Ca., July 26, 1996/FOOLWIRE/ --- IBM announced Q2 1996 earnings and held their quarterly conference call for analysts yesterday afternoon. They reported earnings per share of $2.51, beating analyst estimates of $2.44 by $0.07 per share.
Last quarter IBM told analysts that they expected to have a very difficult Q2. They laid out some of the factors that would influence their performance for the rest of the quarter and for the rest of the year. They delivered what they said and met analysts expectations and their own expectations for the quarter. They, and many other companies, did have the kinds of problems that they mentioned last quarter.
Today they had a more optimistic tone. That is because they saw a difficult first half of the year but see a more positive second half. This is also consistent with their message from last quarter. The Q2 issues are not disappearing, but IBM expects their impact to progressively diminish in the second half of 1996.
Q2 FINANCIAL TRENDS
IBM's rate of growth picked up when viewed at constant currency. Their second currency revenue grew at 4%, but at constant currency they grew at 9%, up from the 6% they did in Q1. Though net income declined year-to-year, the net income margin at 7.4% held steady from Q1. Their tax rate declined to 38.1%, a point below both Q2 1995 and Q1 1996. At $2.51 per share, their earnings declined $0.46 per share, but the majority of that (roughly $0.33) was due to currency, reflecting the dollar's strength in this period.
Since currency grew from a 1 point revenue impact in Q1 to 5 points in Q2, they talk about the growth rate at constant currency as well as reported currency because they view constant currency as the best measure of their ongoing business momentum. Services maintained its very strong growth rate (29% at constant currency, 23% at reported), while hardware, software, and financing showed a good pickup from the Q1 growth rate.
Generally they were pleased with the performance of their services, server, and software businesses. The PC company enjoyed the most successful quarter in many years. On a geographic basis, Asia/Pacific continued its very rapid growth in constant currency, North America rebounded strongly from Q1, and Latin America improved, and Europe remained weak.
SERVICES
As mentioned, Services grew 23% on a reported basis and 29% on constant currency, so they anticipate that they maintained their position as #1 in this sector. They indicated that they see this sector of the industry growing at low double digits over the next few years. While no business can sustain their terrific growth rate this quarter forever, demand for their services business remains extremely strong, so in the short term they are very optimistic.
Outsourcing, both systems and networks, as well as systems integration, remain the primary drivers. The backlog in those two areas continued to grow in the quarter and this is before consideration of some large, well publicized contracts like Lucent Technologies (for which a letter of intent has been signed but the deal has not yet been closed).
During the quarter they signed two contracts in the over $500 million category -- AmeriTech and Washington Mutual. The total value of contracts they signed in the quarter for outsourcing, both systems and networks, was nearly $4 billion. They are delighted with this success, but frankly are not sure how much importance to attach to a quarterly figure since sometimes the quarters will be lumpy as they get into it (there will be quarters where there is a lot and quarters where there's a little). DeutscheBank was a sizable systems integration deal where they are going to help construct a new trading system. The bank will use over 3500 RS-6000s, which were chosen over UNIX servers from Sun and from Hewlett-Packard.
They are winning about 40% of their significant contracts that came up for bid in Q2. Of the seven largest contracts they think were signed over the first half of the year (over $300 million in value), they won 3 of the 7, they lost 1 of the 7, 2 they did not compete for, and 1 they were selected for but chose not to compete because they didn't see it as appropriate or profitable for them.
SERVERS
Total MIPs shipments for System 390, including those in their services contracts grew at about 50%. They think this is the right measure, to talk about MIPs growth, so in the future that is the one they are going to talk about.
Their total System 390 installed rate grew at a net annualized rate of about 22% growth. They are continuing to see good growth in their installed base and this growth rate is increasing a lot from last year and dramatically from a couple years ago. Revenue declined year-to-year at about the same pace as Q4, but the rate of decline in price per MIP between Q1 and Q2 was slower than the previous quarter. Their System 390 transition appears to be on schedule and so is their strategy to improve the overall competitiveness of the platform and to grow the installed base.
Now that the new RISC models are shipping in volume, along with the older models, the AS400 has returned to good revenue growth. They are putting the AS400 on the offensive more than they have in the past because it has a great closing percentage when it gets into the fight. They are finding that 90% of the time, when it gets into the fight, people pick AS400. Their advantage is to broaden the platform, redesign it, to make it play at a different price/performance level. Their customers like it because of the software compatibility, the availability of applications and solutions and the capacity and scalabiliity of their systems.
The RS-6000 also had a great quarter with double digit growth rate, led by a year-to-year tripling in volumes for the SP-2.
Their PC server platform also had good, high double digit growth. While they are pleased with this progress, they think there is more they can accomplish here, particularly if they work more of the channels. They think they are going to have to make their product less complex and they are going to have to improve their time to market.
SOFTWARE
Their software business is heavily weighted toward host platforms as opposed to distributed. They are focusing a great deal of development and sales effort on those distributed platforms, particularly those beyond the IBM family. Overall the software revenue grew 9% in Q2 at constant currency and 4% at reported.
Their host-based software, System 390 and AS400, is over 2/3 of the total software amount, mostly a recurring revenue stream from the monthly license charge associated with the entire 390 installed base. Host software declined 9% in the quarter or 4% in constant currency, which is about what they expected at this stage. On the upside, the capacity of the installed base of System 390 continues to grow, so they are seeing increases in the number of DB-2 and CICS licenses, among others. On the downside, their customers are in the middle of shifting over to a new licensing agreement which better suits the parallel environment. During this transition over the next year or so, their customers will benefit from the incentive of lower prices. Once shifted, the prices will once again begin to grow with volume. Over the long run industry analysts expect host software to grow slightly
Distributed software more than doubled in Q2. Much of that growth was due to Lotus, which was not in the base period, but which will be in Q3. Normalizing for Lotus and Tivoli, distributed software still grew 32% in the quarter, up 19% in the first quarter.
Lotus continued it's strong growth. They had a million Notes seats in the quarter. Since the merger, Notes seats have nearly tripled from 2.2 million prior to the merger to 6.2 million seats today. In addition, cc:Mail, which is a messaging system complementary to Notes, has had seat growth of more than 30% over last year, up to 10.3 million seats. Combined, these Lotus products are in use by about 16.5 million PC customers today. IBM is winning in Notes as well. In competitive engagements for installments over 10,000 seats, they won 9 out of 10 this quarter and in Q1 they won 4 out of 5. These multi-seat licenses are important because typically when you win a 10,000 seat order, it is the first order en route to 50K, 70K, 100K, and 120K seats. These are very important and critical orders for IBM and for their competitors and IBM is winning them pretty much across the board. In the more general market, they are winning about 70-80% of the bids.
Their systems management Tivoli licenses more than doubled over last year. Distributed databases licenses rose 30%, as results begin to register on both the AIX and, particularly, the non-IBM platforms. IBM made a very important product announcement during the quarter, particularly in the distributed software area. They announced the Lotus Notes Domino product, which establishes Notes as the leading platform for server-based Internet solutions. They announced Net Commerce, which is software that helps businesses create virtual storefronts on the Internet or Intranet. And, finally, they announced Cryptolopes which is a secure electronic envelope that can be used to distribute copyrighted information over the Internet in a secure manner. All of those are critical, ground-breaking products according to the company.
As is the case with the overall portfolio of IBM businesses, their software revenue has the opportunity to show improved growth as this higher-growth distributed segment becomes a larger percentage of the total. Q2 results showed progress.
THE PC COMPANY
The PC Company had very strong growth performance consistently across brands and geographies. They expect that when the industry analysts report on this quarter (IDC and Data Quest) that they will have gained share in every major brand group -- desktop, mobile, and server -- and in every major geography (North America, Europe, Asia/Pacific, and Latin America). That is important because their objective is not to gain share across the board. They are focusing on critical segments. So, if they gain share overall by focusing on the 70% of the market they want to serve, that's pretty good performance. IBM's chairman said that, having run the PC business for a couple of years, the performance is the best he's seen since he's been in the company and suspects that it is the best they've had going back 5-6 years. They had a very tough margin comparison against Q2 last year when they had a very good margin performance in the PC business. They had strong volumes and revenue performance in North America which traditionally has been a problem for them. Their overall revenue inventory turns improved. Their expense to ratio improved. And, they did this while continuing to tighten their inventory in the dealer channels. This revenue was true flow-through revenue to the end user.
Compaq announced their results the day before IBM. IBM compares their PC business to Compaq on 5 important dimensions and they beat Compaq in 4 out of 5 -- volume growth (a measure of pure market pull), revenue growth (a measure of brand strength and mix), inventory turns, and for the third quarter in a row their expense to revenue was below Compaq's and the gap is widening. The only category where IBM did not come out ahead of Compaq was in gross profit margins.
GEOGRAPHIC MIX OF IBM'S BUSINESSES
Without the currency effect, the improvement in the growth rate from Q1 to Q2 was due primarily to North America. With constant currency, Asia/Pacific continued its very solid growth at a 19% constant currency growth rate in Q2. North America went from a 4% growth in Q1 to 11% in Q2. Latin America improved slightly to 6% and Europe was virtually the same, about 2%, in Q2.
In Q2, it was primarily the strengthening of the dollar against the yen and, to a lesser extent against the deutschmark that led to their 5 point revenue impact and approximate $0.35 per share EPS hit. They have a very, very large Japanese business. Compared to most multi-nationals, the weight of IBM's Japanese business is probably much larger than most of the ones followed in their industry or in other industries. As such, the yen-dollar relationship is important for them.
Using the spot rates as of a few days ago, and assuming they will remain constant for the rest of the year (which won't happen, so it's just an analytical exercise), they charted what would happen to the exchange rates in the next two quarters. And, the currency diminishes its impact as they progressively move through the year.
They were generally very pleased with their units' performance this quarter. They mentioned Europe. But in addition to Europe, their Microelectronics Division suffered from the same industry DRAM pricing problems that affected its revenue and profit for the quarter. Their North American maintenance business still lags expectations. They have changed the management and are in the process of fixing it, but it may take a few quarters to play this out. Their Storage Division is doing very well on total -- doing well in open systems DASD, in high-end DASD units generally, but they are continuing to see pricing pressures in high-end DASD there as well. They signed an important arrangement with STK which they think gives them competitive leadership in the marketplace. But, on balance, the topline grew 9% in constant currency and they are pleased with that.
HARDWARE GROSS PROFIT MARGINS
In terms of hardware gross profit margins, this was an important issue for the quarter. The most important issue to understand their profit margins deals with hardware gross profits. At 33.4%, they declined from the 35% reported in Q1, but more importantly they dropped 6.7 points from the strong Q2 of last year. There are 3 primary factors in this decline. Each was roughly 1/3 of the decline.
First of all, they had a revenue mix shift occuring. The higher growth businesses have lower gross margins. And this shift was accelerated this quarter by the fine performance in the PC Company.
There are two other very important shifts that occured. The DRAM pricing is about 2/3 lower than a year ago and, since IBM is both a seller and a purchaser of DRAM, they are separate effects. The immediate effect hits IBM as a seller and this started in Q2. OEM revenues and margins were down significantly and this same impact will be felt in roughly the same way in Q3. In Q4, they will start to realize the benefit of the lower cost of DRAMs for IBM as a purchaser and, at that point, end-products whose components include these lower cost parts will be part of IBM's profit stream. And this benefit as a purchaser will roughly offset the impact as a seller in Q4. But it has very little impact in Q2 and Q3.
The third key influence is the decline of hardware gross margins from the PC Company. This quarter they are going against extremely good growth margins of a year ago and the margins of a year ago were probably the best margins in the last five years. But the compares looking ahead get easier.
EXPENSES AND INVESTMENTS
Expenses grew 4% in the quarter. Too much expense is clearly not good for them, but they do want to have enough a the right time. They have done a lot of work on their indirect expense in their infrastructure. And that reduced their total expenses by 8%. So, if the total is down 8%, the amount that you've taken out of infrastructure is a lot more than that, out of that component that is infrastructure alone.
Second, they have made investments which they think are going to help grow the revenues of their business in the second half of 1996 and 1997, which by themselves would have grown expenses by 9%. There are a variety of other expense items which grew by 3% or so up and down, but those are things that are almost one-shot kinds of things that are not going to be current. Indirect expenses that they reduced: infrastructure headcount, real estate occupancy, and reprioritization of their own internal MIS. Investments included expansion of their third party distribution channels, additional network computing programs, the flow through on expense of acquisitions such as Lotus and Tivoli, and the development of industry specific solutions. And the other category includes some transitional factors the most important of which is the impact of lowering their software capitalization rate that will roll through the whole year (but, will, over the long term, go away).
They did not make as much progress as they had hoped on infrastructure in Europe. They spent only about $80 million in the quarter, less than the $200 million per quarter they had been spending. They actually spent $100 million, but the currency impact helped them by $20 million. These programs were focused outside of North America, particularly in Europe, they are also voluntary in nature and IBM did not get as many volunteers as they hoped. So, they are going to have to reinvite more people. However, they are still intent on completing this task and they are expecting to still spend the $400 million in the second half of the year, but they don't think they are going to catch up the quarter.
On the broader topic of total expense, they are going to continue to trade off indirect and infrastructure expense for investment, in much the same way as they have this quarter, so that they can drive revenue and improve productivity. The total expense growth, however, must and will be contained. A 4% increase in expense in conjunction with an 8% increase in revenue results in a 1 point improvement in their expense-to-revenue ratio. That is roughly what they are going to need to offset the impact on gross margins looking ahead.
COMMON SHARE REPURCHASE
During the quarter IBM spent about $1.3 billion to repurchase about 13 million shares of common stock. At the halfway point in the year, they have bought back 24 million shares and ended the quarter with 527.5 million shares outstanding. They still have about $2.5 billion remaining for additional repurchases with no timetable specified.
HOW THESE RESULTS FIT INTO IBM'S LONGER-TERM STRATEGY
Their portfolio of businesses is strong and is continuing to improve because they are seeing a shift to higher growth segments continuing. They think they are very well positioned to benefit from this move to network-centric computing. And Services, in addition to being an element of growth, are going to increasingly become an element of stability for them. More and more of IBM's revenue is coming from higher growth business segments and they are performing better and better in those higher growth segments. In January, they split out industry segments into two groups where one group was industries growing faster than the overall average and one group where the industry was growing slower. For example, the high growth segment included things like services, middle-size servers, PCs, distributed software, etc. And, lower growth included high-end servers, maintenance, and high end software. Between 1993 and 1995, IBM's revenue in the high-growth segment grew at 18% in constant currency and has grown from 46% of their revenue to 57% of their revenue by year-end 1995. For the first half of 1996 this trend has continued. The higher-growth segment grew 20% at constant currency and was up to 61% of IBM's total revenue. So, there is a very important mix shift going on in their businesses, which they feel is conducive to positive long-term growth.
They see an important area of opportunity in the area of network computing. This is the mode of computing where data and applications are distributed across multiple connected servers and the clients can access any server, application, or database in the network. IBM sees this as "clearly the wave of the future."
By 1996, by the broadest definition, the information technology sector is roughly $800 billion. Growing at about 10% per year this sector will add another $400 billion of revenue by the year 2000. IBM thinks that more than half of this growth (60% of it) will be driven by this network computing phenomenon -- which is growing at over twice the rate of growth of the other IT sectors.
Over 2/3 of the opportunity in network computing is a broad array of services including outsourcing or systems integration (which is about half of the sector), network-enabled application services including online information, network transport services such as servers and network access providers, hardware (about 20% of the opportunity made up of roughly equal amounts of storage, servers, and clients), and the last 10% is software which is both systems software and applications. Services, along with servers and software, are the key components to helping customers develop solutions in this evolving computing mode. IBM is extremely well-suited to participate in this opportunity.
IBM is going to have a session on network computing on September 6th which is going to bring together these themes in a lot more detail.
Roughly one third of IBM's revenue is annuity based. Their portfolio of businesses is not only an element of growth of revenue for them and profits, it also contributes to revenue stability. The consensus estimates for 1996 project services to be 21% of IBM's revenue. A significant portion of this services revenue is the continuation of business contracted in prior years. Thus the growth of their services backlog during Q2 also contributes to this revenue stability.
There is a great deal of concern about the trend in gross profit margins for the whole sector, for IBM's results in the quarter, and particularly in hardware. IBM wanted to offer a longer term perspective on this. Each quarter has things that affect it like DRAM prices or product transitions that create variations on the surface that seem to be counter to this model, but it is useful to remember that in the last eight quarters of hardware profit margins, 5 have gone up and 3 have gone down. IBM's gross profit margins have been pretty stable for the past few years. In fact if you take out the quarterly fluctuations and average them, there's not a lot of difference over the last couple of years.
There is a secular trend for gross profit margins which is a reduction of about 1 percentage point per year. This is simply a result of higher growth businesses, like services and PCs, having a business model of lower gross margins. In the past, they have been able to offset this trend by improving costs, time to market, inventory, etc. so they have not just been working on expense, they have been working hard to improve their gross margin position. And they believe that they have been able to offset it. At some point they think this is going to change. To offset this gross margin trend they must address expense and the tax rate. The business model of high-growth sectors has a lower expense-to-revenue to complement those lower gross profit margins so if they expand these businesses, they naturally get the benefit in terms of expenses.
The second front for expense is for continuing to reduce the infrastructure and reinvest in re-engineering which is what they are doing. Some would have them carefully manage expense-to-revenue on a quarterly basis, but they are spending a little more now because they are relatively confident about the future and about their ability to turn it into good revenue. They can also work progressively on the tax rate and are doing that. So, if you look out beyond quarter-to-quarter -- to an annualized or multi-year basis -- they think they can keep net income margins relatively stable. There will be quarter-to-quarter blips, but no longer-term problems.
They are intent on a disciplined use of cash to add to their growth both in revenue, earnings, and earnings per share. They think a critical aspect of their business is the combination that they have of revenue growth, which may be less than some of the industries, stable margins, and an enormous cash flow and ability to buy back shares and make investments in the business. They see this as an unusual combination of attributes. After getting their house in order in 1993 and 1994, they have generated enough cash to markedly increase both investments and share repurchases in the last year and a half. And they have done that while keeping their debt ratios at conservative levels. Looking ahead, they are fully focused on maximizing their cash generation. The fundamental principles of where they will put that cash to use have not changed. * 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. | |
Copyright 1996,
The Motley Fool |