Original URL: http://www.theregister.co.uk/2009/05/13/ibm_investor_day/

IBM puts future profits in the bag

2009 and 2010 a done deal, thanks

By Timothy Prickett Morgan

Posted in Financial News, 13th May 2009 22:37 GMT

IBM is hosting its annual investor conference today, and the top brass of Big Blue's numerous business groups spent many hours walking the assembled Wall Street analysts through the models that show the company did the right things over the past few years.

Those smart moves, according to IBM, included divesting commodity IT businesses and positioning itself for bigtime profits in services, software, and massive infrastructure projects.

You'd almost think that IBM was happy about the economic downturn, given its ability to re-balance its workforce - a euphemism for firing employees in the United States and Europe and replacing them with employees in cheaper labor markets - and then chase deals around the globe. IBM can do this because it has built a single accounting system, a single supply chain, and a single customer support and management system that can be fired up and shut down in any geography where IBM wants a business unit to play.

The only part of IBM that is local anymore is sales. And in a lot of cases - particularly with servers and storage excepting the largest 2,500 accounts - that function is performed by the company's reseller channel.

But IBM didn't want to appear too cocky, because an economic downturn is a time for stern contemplation and tough decisions. "It was not an easy environment for us to operate in," said Sam Palmisano, IBM's chairman, president, and CEO, in his opening presentation. "We had a good year in a difficult environment."

IBM's 2008 went like this: $103.6bn (£68.3bn) in sales, up 5 per cent; $16.7bn (£11bn) in pre-tax income, up 15 per cent; $14.3bn (£9.4bn) in free cash flow, up $1.9bn (£1.3bn) over 2007. And $8.89 (£5.86) in earnings per share, up 24 per cent.

Those numbers, said Palmisano, were the result of decisions his team made to live up to the International part of the company's name and to start thinking globally and delivering its own internal systems that are truly international, not regional or national. Palmisano said that this kind of globalization of businesses was "obvious," and did not give Big Blue much credit for catching that wave.

He did give IBM credit for its decisions to ditch disk drives, PCs, printers, and other commodity businesses as the company predicted the future of IT and consolidation in that part of the business.

"We divested commodity businesses that do not recover capital no matter how well you execute," Palmisano explained, and said that one epiphany that IBM had is that the integration of these components was not where the profits would be, and that the company had to focus less on hardware and software sales and more on helping companies - not just IT shops - achieve particular outcomes.

That meant focusing less on hardware sales - something that has taken IBM some years to get used to - because IT hardware is, according to Palmisano, the first thing to get cut after the advertising budget.

"Obviously, the world is different from what it was in 2006, but I would argue that because we have done all of these things, we're not in bad shape," Palmisano said, adding that IBM was able to get ahead of the downturn and start preparing for it. "Call it insight. We did it. It is done," he bragged.

Perfect timing

Palmisano then added that it's a "perfect time to prudently invest," which IBM has been doing, and then seemed to diss IBM's own near-acquisition of Sun Microsystems and HP's actual acquisition of Electronic Data Systems, adding that IBM doesn't "do crazy deals just because they are available."

He mumbled something about services to try to cover his tracks about almost talking explicitly about the Sun deal, and then talked a while about the business-analytics business that IBM expects to be bigger than the ERP software racket within the next five years.

He then came back to his recurring theme about how IBM is a mature company with mature management, trying to get Wall Street to see that Big Blue can and will make profits in this tough economic climate.

"We are not like the other companies in the IT industry," Palmisano said. "We are not crazy kids. We don't throw numbers out just to throw numbers out."

He joked that IBM had exited the Indian IT market more times than any other companies have entered it, and that Big Blue doesn't have to enter markets so much as emphasize them.

He also trotted out Big Blue's familiar "annuity-like revenue stream" differentiator - which a cynical person might call z/OS heroin and OS/400 crack - to get across the message about just how addictive legacy applications really are for the Global 20000. More than two-thirds of IBM's quarterly revenue stream coming from monthly software and services fees. "We don't have the dependency on transactional deals at the end of the quarter that others have," he said.

IBM also does not have as much dependency in terms of revenues and, more importantly, profits when it comes to hardware.

IPalmisano showed in his presentation how in 2000 - well after IBM was in its transition to a services and software company - hardware accounted for 24 per cent of pretax income, software accounted for 25 per cent, services for 40 per cent, and financing 10 per cent. IBM's overall pre-tax margins were at 12 per cent and pre-tax income came in at $10.2bn (£6.7bn).

Fast-forward to 2008. Pre-tax margins were 16.1 per cent (thanks in large part to shedding commodity hardware businesses) and pre-tax income was $16.7bn (£11bn). And in 2008, hardware only contributed 9 per cent of pre-tax income, compared to 40 per cent for software, 42 per cent for services, and 9 per cent for financing.

And given that IBM has a lock on mainframes and is the only software distributor for them (for the most part), has the largest market share in the Unix space, is by far the largest and most complex services organization, and has a software business that is basically a money printing machine thanks to the mainframe, AIX, and i bases, you can understand why IBM has said repeatedly in the past several months that it can post at least $9.20 (£6.07) in earnings per share in 2009 and at least $10 (£6.60) per share in 2010.

"We are comfortable with our model," Palmisano declared. "We are not exuberant. We are not over-caffeinated."

A self-inflicted stress test

At the end of all the presentations by all of the heads of IBM's business lines - Global Business Services, Global Technology Services, Systems and Technology Group, and Software Group - CF Mark Loughridge went over the numbers and made it clear that IBM was not offering revenue projections for 2009 or 2010.

Loughridge joked that IBM had merely done its own "stress test" on its models and worked backwards to prove that cost-cutting measures already implemented in 2008 would bear fruit in 2009 and 2010, and that ongoing cost-reduction measures and other initiatives would allow Big Blue to hit its numbers, which the company originally laid out at its investor meeting in May 2007.

The $3bn (£2bn) in cost reductions that IBM achieved in 2008 will yield $1.51 (£1) in incremental earnings per share in 2009, and $6bn (£4) in share repurchases would yield another 31 cents per share.

IBM could, Loughridge added, do more if it wants to - or, I say, if it needs to if the economy heads more southward. IBM's model shows that it can sustain a 7 per cent revenue decline for all of 2009 and still make the $9.20 EPS figure. And in the first quarter, sales were down 3.8 per cent, and two-third of the decline was attributed to x64 commodity servers where IBM doesn't have much margin.

"In this kind of environment, I wouldn't trade this hand with anybody," said Loughridge, saying that IBM's annuity-like businesses - monthly license fees for software on mainframes, service and support for its hard and soft wares, outsourcing and business process services, and maintenance on all of its products - were "relatively sticky, relatively resilient, and relatively stable."

Here's the important part. Those annuity-like sales might have only comprised about half of IBM's overall sales in 2008, but they accounted for 62 per cent of its pre-tax income. IBM's transactional products - consulting engagements, one-time software licensing fees, systems integration gigs, hardware sales (both new and used), and other services - can decline by 13 per cent and IBM can still hit its $9.20 EPS number if the annuity-style sales stay flat. And Loughridge says IBM can hit the $10 EPS minimum target for 2010 if overall sales are down 7 per cent in 2009 and stay flat in 2010.

Now, if you're a Wall Street analyst who is being paid to call IBM's EPS numbers correctly, or an IBMer whose stock and other compensation is also tied to EPS, this is about as rosy a situation as any IT vendor is going to hand you in the next decade. IBM can - and will, if necessary - buy its EPS numbers.

And as an ace up its sleeve, Big Blue has its fingers in the $5 (£3.3) trillion pot of stimulus money the world's governments are ponying up - mostly in the United States and China, but elsewhere as well. IBM is selling what governments have been convinced through heavy lobbying by IT vendors that they want to buy.

Big Blue calls the idea Smart World and the IT behind it Dynamic Infrastructure, and it is creating the opportunity as much as it is chasing it.

"Opportunities change, and we are not going to stand still," explained Loughridge. "We went through our painful near-death experience and we have learned to follow opportunity."

Or, to make it where none exists, just like Big Blue has learned to manufacture EPS growth in a market where real profit growth is increasingly difficult.

At some point, the efficiencies gained through automation and offshoring run out. And that's why IBM is working to position itself less as International Business Machines and more as Infrastructure Business Monopoly.

But that's another story for another day. ®