Highlights From IBM's Q3 Conference Call: Revenues Up 8%, EPS Up 15%; Raises FY Guidance

IBM (NYSE: IBM) reported Q3 EPS of $3.28, $0.06 better than the analyst estimate of $3.22. Revenue for the quarter came in at $26.16 billion versus the consensus estimate of $26.25 billion. Shares are down $8.50 (-4.56%) this morning

Highlights From IBM's Q3 Conference Call:

• Raises its FY11 non-GAAP EPS guidance from at least $13.25 to at least $13.35.
  
• (Mark Loughridge) In the third quarter we drove 8% revenue growth, expanded gross, pre-tax, and net operating margins, and delivered operating earnings per share of $3.28, up 15% year to year.
  
• Looking at the drivers of our performance, our software profit was up 12%, driven by key branded middleware revenue growth of 17%.
  
• Hardware profit growth of 8% was led by Power Systems, where we had outstanding revenue growth and margin performance.
  
• We're continuing to drive competitive displacements and extend our share gains in UNIX. Services delivered strong profit growth, with pre-tax income up 13% in both segments.
  
• Our growth markets performance was terrific across all of our segments. Revenue from these countries was up 19%, or 13% at constant currency.
  
• Turning to profit, we expanded operating gross margin by 1.5 points.
  
• Improvement was broad-based, particularly strong performance in Systems and Technology. With 10% growth in operating pre-tax income and 9% growth in operating net income, we expanded pre-tax and net operating margins as well.
  
• Our strong earnings performance resulted in $3.5 billion of free cash flow in the quarter. And in the last twelve months, we've generated over $16 billion of free cash flow.
  
• Revenue in our major market countries was essentially flat year to year. The U.S., our largest market, was up 4%. And Canada was up 7%, driven by continued momentum in our software business and great performance in Power Systems. In Europe, we had good growth in Spain, which was up 9%, and in the UK, up 5%. We've now had eight consecutive quarters of constant currency revenue growth in the UK.
  
• Turning to revenue and gross margin by segment, the total Services revenue growth rate was 8%, or 2% at constant currency. This constant currency growth was consistent with the second quarter growth rate.
  
• In Systems and Technology, we had double-digit growth in our growth markets, while major markets declined. As I mentioned earlier, we had terrific revenue growth and margin expansion in Power Systems, while our System z mainframe wrapped on new product introductions a year ago.
  
• Our total operating expense and other income was up 12%, with over half of the growth attributed to currency from both translation and hedging dynamics. Acquisitions over the last 12 months contributed three points of the increase.
  
• Another driver of our expense growth is the impact of our hedging programs. We hedge our major cross-border cash flows to mitigate the currency volatility in global cash planning. With the year-to-year change in currencies, hedging programs generated losses in the quarter, which mitigate the translation benefits elsewhere in the P&L.
  
• Of the roughly $250 million year-to-year impact in cost and expense from these programs, $190 million is in expense, almost entirely in other income and expense.
  
• Total outsourcing revenue was $7.1 billion, up 9% as reported or 3% at constant currency.
  
• Our total transactional revenue of $6.1 billion was up 7%, or 1% at constant currency.
  
• Overall growth was again driven by strength in the growth markets, with constant currency revenue up double digits in both the outsourcing and transactional businesses.
  
• Total backlog in the quarter was $137 billion, up almost $2.5 billion year to year.
  
• GTS Outsourcing revenue was up 9%, or 3% at constant currency, and we gained share again this quarter. Growth was led by our performance in the growth markets, with revenue up 10% at constant currency.
  
• Integrated Technology Services revenue grew 11%, or 5% at constant currency. This two point improvement over last quarter's constant currency growth rate was driven primarily by the major markets.
  
• Global Technology Services pre-tax income was up 13% year to year, and pre-tax margin improved to 15.9%. Margin expansion was driven by improved gross profit in Strategic Outsourcing, ITS, and Maintenance.
  
• Turning to Global Business Services, revenue was $4.8 billion.
  
• Application Outsourcing revenue was up 11%, or 5% at constant currency, led by strong performance in the growth markets.
  
• Consulting and Systems Integration, which includes Consulting, AMS Systems Integration, and the U.S. federal business, grew 4% as reported, and was down 1% at constant currency.
  
• Global Business Services did a great job driving profit and margin again this quarter. Pre-tax profit was up 13% year to year, with pre-tax margin up one point to 15.4%.
  
• Software had another great quarter with revenue of $5.8 billion, up 13%, or 8% at constant currency. Key branded middleware grew 17%, gaining share for the 16th straight quarter and extending our leadership of the middleware market. Segment pre-tax income was up 12% to $2.2 billion.
  
• Turning to brand performance, WebSphere had another terrific quarter, with over 50% revenue growth, driven by both our base business and acquisitions.
  
• Revenue from our Smarter Commerce offerings more than doubled year to year as we bring together our WebSphere Commerce business with the Sterling, Unica, and Coremetrics acquisitions. Business Process Management, which helps our customers drive new levels of efficiency and effectiveness in their business, grew nearly 50%.
  
• Information Management was up 12% and gained share. I'll comment on two key contributors to this performance; first, Netezza, which grew 36% over last year. Since its introduction in 2009, the Netezza appliance has won over 80% of the head-to-head proof of concepts against competition.
  
• Tivoli software grew 8%, driven by strong performance in Storage Management.
  
• Lotus grew 6% year to year, with strong growth in our social business offerings. And with 7% growth, Rational gained share.
  
• Overall, Software had another powerful quarter with revenue up 13%, driven by branded middleware growth, gross profit margin up 0.2 point, and pre-tax income up 12%.
  
• Moving on to Systems and Technology, revenue was $4.5 billion, up 4%, or 1% at constant currency. And profit was up 8%. Growth markets grew 12% at constant currency.
  
• We had great performance in Power, up 15% year to year. We've gained share in each of the last 14 quarters. And now, for the third consecutive quarter, IBM's strong performance accounted for all of the UNIX industry's growth.
  
• System x revenue grew 1%. System x revenue in growth markets was up 15% at constant currency. This is the eighth consecutive quarter of double-digit revenue growth in growth markets.
  
• Overall Systems and Technology revenue grew 4%. Gross profit margin expanded over three points, and pre-tax income was up 8%.
  
• Looking at the uses of our cash through the first three quarters, we returned $14 billion to shareholders. We paid out over $2.5 billion in dividends. And we spent $11.5 billion in share repurchase, where we bought back 69 million shares. At the end of the third quarter, we had $5.2 billion remaining in our buyback authorization.
  
• Looking at the balance sheet, we ended the quarter with a cash balance of $11.3 billion. Total debt was over $30 billion, of which $22.8 billion was in support of our financing business, which is leveraged at just over seven-to-one. Our non-financing debt was $7.4 billion, with a debt-to-cap of 28%.
  
• In Business Analytics, we are helping our customers manage and optimize tremendous amounts of data. Through the first three quarters of the year, our Business Analytics revenue is up 19%, reflecting a strong portfolio of integrated software and consulting capabilities.
  
• We continue to have strong growth in our Smarter Planet offerings. Through the first three quarters, we're up 50% over last year.
  
• So now through the first three quarters of 2011, we've delivered revenue growth of 9%, or 4% at constant currency, operating pre-tax income growth of 10%, net income growth of 11%, and operating EPS growth of 18%. We've generated over $7.5 billion of free cash flow and returned $14 billion to shareholders.
  
• With three quarters behind us, we're once again increasing our full-year 2011 expectation for operating earnings per share to at least $13.35, a good start towards our 2015 roadmap.
  
• (Q&A) Hey, Mark, I guess currency is going be a less of a positive impact in the fourth quarter. And should revenue slow markedly, could you remind us of your cost levers not only for the fourth quarter but then maybe some that will continue into next year? And if you want to quantify any, that would be great. (A) Ben, I think when you look at the overall levers, to use your terminology, I would start with the overall business model. The business model is a balanced set of operational degrees of freedom from our base revenue performance mixing into higher revenue choices like our Growth Markets unit, revenue from our acquisition base mixing into higher profit elements of our business, continuing to drive productivity with our spend takeout initiatives, and using our balance sheet to both repurchase our own shares and pay dividends to our customer set. And those same degrees of freedom we apply right down through the business units. So as we look at the business as we go into the fourth quarter and into next year, we'll certainly take advantage of those alternatives. Now I'd also remind you, especially as we talk about the 2015 model, that we are driving our business units towards a higher level of revenue performance. In the spend takeout, you remember, we modeled it in an at-least case that we drive $3 billion of spend takeout to the bottom line. But I can assure you, we're chasing $8 billion, so there's another $5 billion of opportunity there. And lastly, if we achieve our free cash flow objectives by 2015, we'd have another $40 billion of financial flexibility. So those all give us additional options. But I would come back and step back, looking at the fourth quarter and the full year. I think we've got a pretty good hand. As I look at our performance outside of STG, which has a very difficult compare, we should see pretty good performance on a revenue profit base with the balance of our businesses. GTS should have a similar quarter in the fourth quarter compared to the third quarter. GBS should have an improved performance on the top line. And our software base of business has a very strong pipeline, and they should be running for a similarly strong performance in fourth quarter compared to the third. The issue really is on STG, they just have a massive compare. They were up 22% last year. So on an absolute dollar basis, we're going have a good quarter on our STG business. They have a lot of revenue, a lot of profit, and a lot of free cash flow, but they have a very tough compare.
  
• I guess this is somewhat a follow-up to the first one. I'm wondering if you can comment at all on what you're seeing in the macro environment and how we should be thinking about your revenue growth in light of that and the tough compares you face. So I ask that because I see several things here. Major markets growth rate decelerated meaningfully. It was flat this quarter. Financial Services, after quarters of 8%, 10%, 15%, the last three quarters decelerated meaningfully this quarter. And you commented on how public was a big drain in Consulting. So there definitely seems to be some areas that are less strong. Overall, you grew 2.8% in revenues this quarter, including acquisitions, and your comparisons get a lot tougher. So I guess the question, is, can you comment on the macro and can you comment on the things that you're doing? And given the comparisons, shouldn't we be expecting constant currency growth rates to actually decelerate going forward rather than accelerate? (A) Now if you look at the - I think that's a very good question. I'm going to start from where I left off on the last question. First of all, as we look at the fourth quarter, it should look very similar to the third quarter outside of the STG compare. So just to reiterate, GTS should have a very similar quarter. GBS should have improved revenue performance in the low to mid-single digits. And Software should have another strong quarter based on the pipeline that we can see. I don't expect STG to be able to overcome that compare given that they grew 22% last quarter. But they should book a lot of business, a lot of profit, and a lot of cash, as I said. What I want to make very clear, though, as we look at the performance in the third quarter, really the performance on the Software side and the Services side was very consistent with what we saw in the first half of the year. And we're driving those businesses for profit achievement using the degrees of freedom that they have in their individual business models, just as we do at the IBM level. So just to recount, GTS, 13%, profit growth in the quarter. GBS, 13% profit growth in the quarter; 20% year to date. GTS is 13% year to date. Total Services has 15% profit growth on a year-to-date basis. Even in STG that began to wrap on the mainframe cycle drove 8% profit growth in the third quarter. And we had very strong performance once again out of our Software base of business. So I think it's going be another quarter where we'll be driving for similar if not improved level of performance in the Software and Services side of the house. STG does have a difficult compare, but I think we've got a strong book of business. Now to your other question, let's look at it from a geographic standpoint. First of all, the U.S. was up 4%. Canada was up 7%. Latin America was up 17%. Within the overall Growth Markets, Unica was up 13%. I mean 13% is very, very strong, a very strong quarter for us. You mentioned FSS in your question as well, so let's look at FSS. FSS grew 10% in the third quarter compared to IBM at 8%, so a little bit better. If you look underneath FSS, they grew 14% in GMU and 16% in GMU on a year-to-date basis, and those growth rates are at constant currency. So I wouldn't look at the overall financial services sector through a major market lens. Some of the issues we're all reading about in the periodicals that affect the financial services sector in the major markets, we don't see that in the growth markets. We see a very strong book of business growing at a very rapid rate in margin and profit opportunities for us that are very powerful; again, growing 14% FSS and GMU in the quarter and 16% on a year-to-date basis.

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