Introduction
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Introduction Thank you. This is Patricia Murphy, Vice President of Investor Relations for IBM, and I want to welcome you to our third quarter earnings presentation. I’m here with Martin Schroeter, IBM’s Senior Vice President and CFO, Finance and Enterprise Transformation. Today we’re also joined by Ginni Rometty. As you know, Ginni is IBM’s Chairman, President and Chief Executive Officer. First, Martin will go through our prepared remarks, and then Ginni and Martin will take your questions. The prepared remarks will be available in roughly an hour, and a replay of the webcast will be posted by this time tomorrow. I’ll remind you that certain comments made in this presentation may be characterized as forward looking under the Private Securities Litigation Reform Act of 1995. Those statements involve a number of factors that could cause actual results to differ materially. Additional information concerning these factors is contained in the company’s filings with the SEC. Copies are available from the SEC, from the IBM web site, or from us in Investor Relations. Our presentation also includes certain non-GAAP financial measures, in an effort to provide additional information to investors. All non-GAAP measures have been reconciled to their related GAAP measures in accordance with SEC rules. You will find reconciliation charts at the end of the presentation, and in the Form 8-K submitted to the SEC. Now, I’ll turn the call over to Martin Schroeter. 3Q 2014 Overview Thanks Patricia. We have a lot to cover today, our third quarter performance, actions that accelerate the transformation of our business, including important announcements that impact our results and the basis of our reporting, our 2014 guidance and what it means as we move into 2015. Let me start with the top level results. We reported revenue of $22.4 billion, which is down 4 percent or 2 percent at constant currency excluding our customer care divestiture; we delivered operating net income of $3.7 billion, and earnings per share of $3.68, all excluding the discontinued semiconductor manufacturing business. These results fell short of our expectations, and I’d attribute the shortfall to three primary drivers. First, our software revenue was weaker than expected. We had some sales execution issues and in addition, we have made it easier for clients to manage their IBM software capacity across new and more traditional workloads, as they invest in our platform for the longer term. I’ll expand on this later. Second, we didn’t get the productivity required in our services business, impacting both our profit and margin. And third, the environment, including currency, isn’t helping. With a sharp movement in currency rates in September, there was some effect in the quarter, and we expect it to have a larger impact going forward. And for the business overall, we did see a slowdown in September, which had a particular impact on us given the skew of our transactional business. I’ll get into the details of the quarter shortly, but let me first describe the actions we are taking, and put them into context. For some time now we’ve been clear about our strategic direction and how we address the market shifts around data, cloud, and engagement. All of this year we have been launching initiatives and making significant investments to drive this shift. We have been very successful, with strong revenue growth in our strategic imperatives and you’ll see in our third quarter results that the strategic imperatives again delivered double-digit revenue growth. But some of these fundamental shifts in the industry are happening faster than we planned. So we’re putting in place a series of actions to accelerate our transformation. I want to address these right up front. First, we are continuing to remix to higher value. We just took a bold step in our transformation, going fabless with the divestiture of our semiconductor manufacturing business. We have world-class technologists and intellectual property, but this is a capital intensive business, which has been challenging for us without scale. With future node progression and the potential transition to larger wafer sizes, the capital requirements will substantially increase. GLOBALFOUNDRIES will acquire our microelectronics business, and will become the semiconductor technology provider for our future systems. This agreement leverages the strengths of each company, IBM’s semiconductor and material science research, development capabilities, and leadership in high-end systems, and GLOBALFOUNDRIES’ leadership in advanced technology manufacturing at scale, and commitment to delivering future semiconductor technologies, enabling them to address new business opportunities. With GLOBALFOUNDRIES operating at scale, we’ll get supply at market-based pricing for the long term. And we’ll exit a business that was not only capital intensive, but also a drag on our profit. Clearly, this is the right move for our business for the long term. Also, in January we announced the sale of our x86 business to Lenovo and earlier this month we completed the initial closing. This was a $4 billion business for us in 2013, with effectively no annual profit. With the transaction, IBM and Lenovo have formed a strategic alliance which includes an agreement for Lenovo to resell selected IBM storage and software products. And to ensure a smooth transition for our clients, IBM will provide x86-related maintenance on Lenovo’s behalf. We’ll continue to remix our portfolio, by investing in higher value areas and making decisions on businesses that no longer support our high-value strategy. Second, we are implementing changes that make it easier to consume our capabilities and innovations and increase our agility. We are creating vertically integrated units to address key growth areas. As we did with Watson earlier this year, we are creating a dedicated business unit for Cloud, and other integrated units to address growth areas like security, and smarter commerce. This enables more focused investment, and improves our integration and speed in bringing solutions to the market, and with our clients. We are also providing more flexibility to clients in the way they buy our software. Specifically, we are accelerating investments to make our software more directly consumable through digital channels. So we will have an end-to-end digital sales and marketing channel, which will improve our reach. Third, we’re taking additional actions to simplify our structure and accelerate productivity. For example, to improve productivity in services, while at the same time providing greater value and innovation to our clients, we’re implementing a number of actions. These include accelerating the use of automation in our data centers, and being more aggressive in our use of global delivery skills and intellectual property across our service lines. Let me tell you what these actions do for our financial model. In the near term our revenue will be down, not surprising since the 3 divestitures this year represent about $7 billion of revenue, with pre-tax losses of about $500 million. So clearly, we’ll have an improved margin profile. These actions also free up our spend and capital to be reinvested to areas that will accelerate our transformation, and these allow us to continue to provide very strong returns to our shareholders through dividends and share repurchases. All of this is consistent with our strategic direction, and while there are impacts in the short term, we improve our position for the longer term. Key Transactions I want to spend a minute on the high level financial implications of the two most recent transactions. We’ve posted additional information in two articles on our investor portal. For the System x business, as I mentioned, this was over a $4 billion business for us last year. Though the business is breakeven on an annual basis, the transactional skew would have driven profit in the fourth quarter. Starting in the fourth quarter of this year, we’ll no longer have the System x hardware revenue and profit, and the related maintenance will be at a lower revenue and profit level reflecting the new relationship. At an IBM level, this will result in about a 4 point impact to revenue growth over the next 4 quarters, but an improved margin profile. Our fourth quarter results will include the gain on sale associated with the countries closed, net of related transaction and performance-based costs. This net gain, as well as the operational profit we lose in the fourth quarter will be included in our view of the full year, which I’ll talk about later in the call. Free cash flow will be impacted by two items: Accounts payable for the balance at closing as well as the future procurement IBM will perform on Lenovo's behalf, and for cash tax payments made in 2015. We estimate this will be a use of cash of approximately half a billion dollars in the fourth quarter, and another half billion in 2015. Turning to the microelectronics business, the 2013 OEM revenue associated with the divested business was $1.4 billion, and our STG segment included pre-tax losses for this business of over $700 million. This is being reported as a discontinued operation. In the third quarter, disc ops will include both losses from the ongoing operations of about $90 million after tax, and a one-time after-tax charge of $3.3 billion associated with the transaction. The transaction had no impact to free cash flow in the third quarter. Now let me spend a minute on the reporting structure. Reporting Format All of our results obviously start with GAAP, which is in the middle of the chart.