IBM (IBM)

International Business Machines Corporation (IBM) was incorporated in the State of New York in 1911 as the Computing-Tabulating-Recording Co. (C-T-R), changing its name to International Business Machines Corporation in 1924. IBM is a globally integrated innovative company, serving the needs of enterprises and institutions worldwide. The company engages in the development and manufacturing of the advanced information technologies, including computer systems, software, storage systems, and microelectronics. The company's major operations include Global Technology Services (GTS) segment, Global Business Services (GBS) segment, Systems and Technology segment, Software segment, and Global Financing segment.

Global Services is an important component of the company's strategy of providing IT infrastructure and business insight and solutions to clients. While solutions often include IBM software and hardware, other suppliers' products are also used in case client solution requires it. Within Global Services there are two reportable segments: GTS (36.6% of fiscal 2007 revenue) and GBS (18.3% of fiscal 2007 revenue). GTS segment primarily reflects IT infrastructure services and business process services, delivering value through the company's global scale, standardization, and automation. GTS capabilities include strategic outsourcing services, business transformation outsourcing, integrated technology services, and maintenance. GBS segment primarily reflects professional services and application outsourcing services, delivering business value, and innovation to clients through solutions, which leverage industry- and business-process expertise. GBS capabilities include consulting and systems integration, and application management services.

Systems and Technology segment (21.6% of fiscal 2007 revenue) provides IBM's clients with business solutions requiring advanced computing power and storage capabilities. Approximately 55% of the Systems and Technology's server and storage sales transactions are through the company's business partners approximately 45% are direct to end user clients, more than 40%, of which are through the Internet at ibm.com. In addition, Systems and Technology provides semiconductor technology and products, packaging solutions, and engineering technology services to clients and for IBM's own advanced technology needs. Systems hardware is also deployed to support services solutions.

Software (20.2% of fiscal 2007 revenue) consists primarily of middleware and operating systems software. Middleware software enables clients to integrate systems, processes and applications across a standard software platform. IBM middleware is designed for open standards, which allows the integration of disparate client applications that may have been built internally, or provided by package software vendors or system integrators. Operating systems are the software engines that run computers. In addition, Software includes Product Lifecycle Management software, which primarily serves the Industrial sector. Approximately two-thirds of external software segment revenue is annuity-based, coming from recurring license charges and on-going subscription and support from one-time charge (OTC) arrangements. The remaining one-third of external revenue relates to OTC arrangements, in which the client pays one up-front payment for a perpetual license. Arrangements for the sale of OTC software include one year of maintenance. The client can also purchase ongoing maintenance after the first year, which includes product upgrades and technical support. Its software includes WebSphere software, Information Management software, Tivoli software, Lotus software, Rational software, and Operating Systems (OS).

Global Financing (2.5% of fiscal 2007 revenue) invests in financing assets, manages the associated risks, and leverages with debt. Global Financing comprises three lines of business: Client financing, Commercial financing, and Remarketing. Client financing provides lease and loan financing to end users and internal clients generally for the term of two to seven years. Internal financing is predominantly in support of Global Services' long-term client service contracts. Commercial financing provides primarily short-term inventory and accounts receivable financing to dealers and remarketers of IT products. Remarketing sells and leases used equipment to new or existing clients both externally and internally. This equipment is primarily sourced from the conclusion of lease transactions.

IBM operates in 170 countries, with about 65.0% of its employees outside the U.S., including about 30.0% in Asia Pacific. Excluding original equipment manufacturer (OEM) revenues, which accounted for only 3.5% of 2007 revenues and which is reported separately by IBM, the Americas generated 41.6% of revenue, the Middle East and Africa (EMEA) 35.1%, and the Asia/Pacific region 19.8%. The majority of IBM's revenue, excluding the company's OEM technology business, occurs in industries that are broadly grouped into following six sectors: Financial Services - Banking, Financial Markets, Insurance Public - Education, Government, Healthcare, Life Sciences Industrial - Aerospace and Defense, Automotive, Chemical and Petroleum, Electronics Distribution - Consumer Products, Retail, Travel and Transportation Communications - Telecommunications, Media and Entertainment, Energy and Utilities Small and Medium Business - mainly companies with less than 1,000 employees.

Investment Thesis

IBM's strategy is to focus on the high-growth, high-value segments of the IT industry. In addition to producing hardware and software products, IBM innovations are a major differentiator in providing solutions for the company s clients through its growing services activities. The company s investments in R&D (approximately $6.0 billion) also result in intellectual property (IP) income of approximately $1.0 billion annually. To focus on high-growth segments, IBM exited commoditizing businesses like Personal Computing (sold to Lenovo) and hard disk drives (sold to Hitachi), and strengthened its position through strategic investments and acquisitions in emerging higher value segments like service-oriented architecture (SOA), Information on Demand, business process services, and open modular systems for businesses of all sizes. This has changed its business mix toward higher-value segments of the industry.

To date, IBM has announced 25 strategic acquisitions in support of its global Information on Demand effort. Since the beginning of 2008, the company announced the completion of acquisitions including Arsenal Digital Solutions, Cognos, AptSoft Corporation, Telelogic AB, InfoDyne Corporation, FilesX, and Diligent Technologies. With Arsenal's comprehensive suite of on-demand data protection solutions, IBM can provide global clients with security-rich information protection services designed to handle increasing data retention requirements. Cognos has been among IBM s largest acquisitions at a price of $5.0 billion, and will accelerate IBM s Information on Demand strategy, providing the company with an entry into the Business Intelligence market. AptSoft's business event processing software further illustrates IBM's commitment to pursuing the SOA market opportunity and will complement IBM's business process management (BPM) offerings and existing SOA software and related services offerings that span the WebSphere, Information Management, and Tivoli brands as well as RFID and Web 2.0 capabilities and industry-specific solutions. As per Gartner Dataquest, SOA is a $160 billion market. With more than 6,550 customers and 5,000 Business Partners, IBM has doubled its SOA client and partner base in less than one year. The acquisition of InfoDyne will provide a high-speed market data delivery platform designed to help accelerate the speed and increase the throughput and reliability of financial data transmission. FilesX enterprise-level continuous data protection solutions complement IBM's existing file-based software called IBM Tivoli Continuous Data Protection for Files, which is targeted at SMB customers and individual PC users. The Diligent acquisition will be an important part of IBM's New Enterprise Data Center model, which helps clients improve IT efficiency and facilitate the rapid deployment of new IT services for future business growth.

In 2007, IBM completed twelve acquisitions for approximately $1.1 billion, of which six were in the Software segment. These included Consul Risk Management International BV, Vallent Corporation, Watchfire Corporation, WebDialogs Inc., Princeton Softech Inc., and DataMirror Corporation. Strong demand for key branded middleware products, which includes WebSphere, Information Management, Lotus, Tivoli, and Rational products, was up 15.5% in 2007, leading to overall software growth of 10.0% during the year. Through internal investments and targeted acquisitions, IBM expects the majority of its software revenue growth to come from this portion of the product portfolio. Under its long-term revenue model, branded middleware is expected to grow 12.0% to 16.0% versus 2007 growth of 11.0%, while total software is expected to grow 7.0% to 10.0% versus 2007 growth of 6.0%. The key to continuous software growth stems from IBM's ability to capitalize on industry trends such as SOA and Information on Demand. As a result, this segment has emerged as a strong source of revenue growth and was the largest contributor to the company's profit in 2007. According to analyst firm IDC, IBM is the leading provider of identity and access management security software globally, and the March 2008 acquisition of Encentuate further strengthens its position. Encentuate technology will be offered as part of the IBM Tivoli Access Manager suite and IBM expects to integrate Encentuate with its broad set of security management offerings such as IBM Tivoli Identity Manager, IBM Tivoli Federated Identity Manager. According to a February 2008 Forrester Research report, the identity and access management opportunity will grow from $2.6 billion in 2006 to more than $12.3 billion in 2014. In addition, IDC ranked IBM as the leader in storage software market for Q108. This marks the 13th consecutive quarter that IBM storage software revenue outpaced the storage software market.

Global Technology Services or GTS, the largest revenue contributor to IBM's revenue base, improved its competitive position with six acquisitions - Softek Storage Solutions Corporation (Softek), DM Information Systems, Ltd. (DMIS), Novus Consulting Group, Inc., Serbian Business Systems, Arsenal Digital Solutions, and u9consult. Softek augments the company's unified data mobility offerings and worldwide delivery expertise for managing data in storage array, host, and virtualized IT environments, while DMIS complements the Technology Service offerings. Novus CG, a storage solution company, will provide improved access to business information, enable stronger regulatory and corporate compliance and improve overall IT performance. Serbian Business Systems establishes the company's maintenance and technical support services business in Serbia. Arsenal provides global clients with security rich information protection services designed to handle increasing data retention requirements, while u9consult complements the company's existing capabilities in value chain consulting. In the Global Business Services segment, IBM added IT Gruppen AS, which complements the company's presence in the retail and media sectors. IBM had targeted long-term revenue growth of 6.0% to 8.0% for Global Business Services, which the company achieved in 2007 with 9% growth. Global Services signings were $50.0 billion in 2007 versus $49.0 billion in 2006 while the backlog was estimated to be $118.0 billion at December 31, 2007 versus $116.0 billion at December 31, 2006.

Large-scale adoption of IBM's unified communications and collaboration platform and services is growing. IBM GTS is assisting clients such as, Avaya, Forterra Systems, VBrick, and IDEA Cellular, around the globe to exploit the convergence of voice, video, and data. IDC estimates the unified communications market will reach $17 billion in global revenue by 2011, growing at 38.0% compounded annually from 2007. As such, IBM sees unified communications as the next significant frontier for technology growth. To meet these demands, IBM is investing significantly in a range of resources, including software, services, and research. IBM has a growing number of social and collaborative software research projects with more than 70 researchers and more than 1,300 IBM software developers and technical experts contributing to unified communications. The company has also partnered with ShoreTel, a leading provider of Pure IP Unified Communications solutions, to integrate ShoreTel's distributed unified communications solutions with its unified communications and collaboration platform, IBM Lotus Sametime. IBM is also expanding its Lotus Sametime software products, where work has begun on blending IBM's social software expertise into the real-time environment. The new Lotus Sametime Advanced software includes community tools that help users reduce time spent trying to solve problems, by reaching out to a community of colleagues or experts instantly. In 2008, IBM announced the availability of the latest version of Lotus Quickr, web 2.0-based software that helps to find, access, share and work with everyday business content such as documents, photos and videos.

IBM's Systems and Technology segment has also been growing. The company is currently focusing on its investments on differentiating technologies with high-growth potential including POWER6, BladeCenter QS22, BladeCenter-S, Systems z10, high-performance computing, virtualization, and energy efficiency as part of its long-term target for 2010. IDC expects virtualization to be a $60 billion server market in 2010, and blade is an important part of this segment as bladed deployments of servers are virtualized twice as often as non-bladed. As virtualization drives richer server configurations, IBM expects that it will contribute an additional $1.0 billion in gross profit in Systems and Technology between 2006 until 2010, and is targeting $9.3 billion in gross profit for 2010. The company completed its transition to POWER6 technology in April 2008. IBM announced new POWER-based virtualization offerings to extend the company s lead in UNIX virtualization. According to IDC, IBM is the world's leading provider of UNIX solutions and has led the market for the last 10 quarters on rolling four-quarter average of revenue. Last year, IBM gained in revenue share again and maintained UNIX leadership with a 33.8% share. IDC forecasts that this market will continue to grow, with combined UNIX and Linux server spending increasing $1.2 billion between 2007 and 2011, to a total opportunity of $27.4 billion in 2011, 45% of all projected customer spend. The next generation mainframe product should show a benefit to the company although the transition quarter could show revenue disruptions. This product will have 50.0% more capacity than the current system and will extend the company's leadership in energy efficiency, security, and resiliency. This should give IBM a competitive advantage over Hewlett Packard, whose next-generation chip due in 2009 is not expected to catch POWER6 Processor speed.

IBM also held onto its number 1 spot in the worldwide server systems market with 36.7% market share in factory revenue for 4Q07 as well as for 2007 with 31.9% market share. This growth was driven by solid performance from its System x and System p servers. Also, IBM was a close second with 30.0% of the high performance computing (HPC) server market in North America. IBM has also entered into a licensing deal with Lenovo allowing the latter to manufacture and sell some Big Blue x86 servers. IBM hopes that the agreement, the company's first foray into the worldwide server market outside China, will help expand its footprint in the server market, particularly in SME segment. The company introduced new Intel processor-based servers, providing increased application choice and reduced energy and administration costs.

IBM's December 2007 acquisition of XIV will strengthen its storage portfolio and position the company to address emerging storage opportunities, such as Web 2.0 and digital media. Solutions based on XIV architecture are expected to be announced during 2008. In the total worldwide disk storage systems market, IBM was the leader with 22.9% during the fourth quarter of 2007, according to IDC. IBM outperformed storage software vendor EMC in the fourth quarter, growing storage software revenue more than three times the growth rate of EMC, as reported by IDC. Additionally, the IDC report indicated that IBM outgrew all competitors in Data Protection and Recovery, Replication Software, and Storage Management Software, and Storage Infrastructure Software categories.

According to a new report from analyst firm Gartner, IBM led all vendors worldwide in IT operations management software revenue in 2007. For the seventh consecutive year, IBM grew its revenue share to 24.5%, nearly double the share of its nearest competitor. The Gartner report shows that IBM grew 14.1%, faster than the overall market which grew 13.5%, to more than $12.9 billion in total revenue in 2007. Gartner once again named IBM as the world's number one vendor based on market share for application infrastructure and middleware (AIM) software for 2007. IBM grew its AIM business at 15.1% for the year, faster than the overall market which only grew at 12.9% for 2007, and now holds 28.9% share of the overall market, more than three times the market presence of its closest competitor. IBM was also declared the leader in the application development software market, with 37.8% market share, greater market share than its three closest competitors combined. IBM was also recognized for its overall leadership based on total software revenue for 2007 across application development market sub-categories, including SCCM Distributed, Object Oriented Analysis & Design, and Java Platform AD Tool.

To focus on its core businesses, IBM divested 51% of its interest in InfoPrint Solutions Company, a wholly owned subsidiary in the Printing Systems Division, to Ricoh Company Limited in June 2007. As of December 2007, its ownership in InfoPrint was 40.8%. Thus, the company's long-term business model is to derive revenue growth in the 4.0% to 5.0% range (excluding printers) from the -3.0% in 2007 in its Systems and Technology segment.

With the strength of its global on-demand model, IBM is experiencing strong revenue growth in all geographies, with robust growth in emerging markets worldwide. Capitalizing on the opportunities in the global economies, the company generated 63.0% of its 2007 revenue outside the United States. The emerging BRIC countries of Brazil, Russia, India, and China (representing 22% of 2007 revenue) together grew 26.3% (18.0% adjusted for currency), with India being the major growth contributor with a 37.9% growth rate in 2007. To further bolster its presence in India, the company announced the opening of a new Global Delivery Center (GDC) in Pune, India to provide clients with business consulting and application services. According to IDC, emerging countries are expected to grow at a CAGR of 14% through 2011. This compares favorably with the 6% expected CAGR for developed regions. IBM added 18 new major clients in 2007, 13 of which are outside the U.S. The company plans to open eight new IBM Innovation Centers in South Africa, Turkey, Ukraine, and several other emerging markets. In response to growing customer demand for software and solutions, IBM established global Information on Demand Technical Centers of Excellence one in Kanagawa, Japan and the other in Stuttgart, Germany. IBM plans to continue to expand the number of resources focused on customer engagements in these facilities throughout 2008 and beyond. As part of the company's regional expansion, IBM opened a client center in the city of Perm in the Russian Federation. To address the worldwide digital archive capacity demand, IBM recently opened its Global Archive Solutions Center in Guadalajara, Mexico to help clients across the globe to develop and implement long-term plans to manage and archive massive amounts of business information.

With continuous innovative solutions and a strong portfolio of products and solutions, the company announced a road map to deliver earnings per share (EPS) in the range of $10 to $11 during 2010, or 14% to 16% compound growth rate from 2006 levels. IBM's plan is to generate EPS growth through a combination of revenue growth, net margin expansion, growth initiatives, acquisitions, the current projected benefit of retirement-related costs, and effective capital deployment to fund growth and provide returns to shareholders through dividends and common stock repurchases. The acquisitions of Cognos and Diligent Technologies supports both IBM's acquisition strategy and capital allocation model, and will contribute to the achievement of the company's objective for EPS. Moreover, with an expected launch during the third quarter of 2008, the Business Partner Skills Program for the New Enterprise Data Center will focus on helping IBM Business Partners.

IBM is also working on its restructuring plans announced in May 2005 to improve the company's efficiencies, strengthen its client-facing operations, and capture opportunities in high-growth markets. These actions primarily included voluntary and involuntary workforce reductions, with the majority impacting the Global Services segment, primarily in Europe, as well as costs incurred in connection with the vacating of leased facilities. These actions were in addition to the company's ongoing workforce reduction and rebalancing activities that occur in each quarter. As such, operating margin improved to 14.7% in 2007 from 11.3% in 2005. Meanwhile, IBM's gross profit margins improved 210 basis points from 2005 to 42.2% in 2007, with the fourth quarter achieving the highest margin of the year at 44.9%. This strong growth reflects a shift to higher value offerings and continued benefits from productivity initiatives and the transformation to a globally integrated enterprise. The company's supply, manufacturing and logistics, and customer fulfillment operations are integrated in one operating unit that has reduced inventories, improved response to marketplace opportunities and external risks and converted fixed costs to variable costs. Simplifying and streamlining internal processes have improved operations, sales force productivity and processes, as well as client satisfaction. As a result, the company's EPS grew at a compound annual rate (CAGR) of 17.6% from fiscal 2003 to 2007. This reflects strong growth in net income and the benefits of the common stock repurchase program.

In 2007, IBM repurchased approximately $18.8 billion of its common stock, including a $12.5 billion ASR in the second quarter. IBM's Board of Directors recently authorized $15.0 billion in the company's stock repurchase program, and has approximately has $8.9 billion available at the end of June 2008. The company expects to spend $12.0 billion in 2008 for share repurchase. In addition, IBM generated $16.1 billion from operating activities in 2007 versus $15.0 billion in 2006 through its efficient cash generation business model. IBM ended the second quarter of 2008 with $9.8 billion in cash and marketable securities. This provides the company with the financial flexibility for investments in changing business environments. The company also has significant annuity content in its business which reduces its business risk versus more transaction-dependent business models. Over the past five years, the company generated over $50.0 billion in free cash flow available for investment and distribution to shareholders. As a result, during that period the company invested $9.9 billion in strategic acquisitions, received $1.4 billion from divestitures and returned over $53.0 billion to shareholders through dividends and share repurchases. Recently, the Board of Directors increased the company's quarterly stock dividend to $0.50 per share from $0.40 per share. IBM has increased its quarterly dividend by 150% since 2006. This is the 13th year in a row that IBM has increased its quarterly cash dividend. IBM's return on shareholder equity also improved to 36.6% in fiscal 2007 from 30.8% in 2006. Considering the company's strong cash position and focus on improving profitability, we believe IBM's quarterly dividend is safe.

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Strategy:

• According to Sam Palmisano, the CEO, IBM is building the "globally integrated enterprise", which puts people and jobs anywhere in the world "based on the right cost, the right skills and the right business environment. And it integrates those operations horizontally and globally. Work flows to the places where it will be done best." [15]
• India is at the core of IBM's globalization strategy with 53,000 of IBM's 330,000 employees. The Indian market has become one of the fastest growing in the world for IBM, with revenues rising 40 - 50% per year. IBM plans on investing another $6B in India in the next 3 years. [15]

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The company bought back $27 billion of stock between 2003 and 2006, and is authorized to buy another $16.4 billion. This is expected to add $1.10 to per share earnings by 2010. [20] On May 29, 2007 They announced the purchase of 8 percent (118.8 MM shares) of their outstanding shares at an average cost of $105.18 per share and raised its 2007 earnings-per-share forecast to reflect the smaller number of shares. They expect the $12.5 billion repurchase to boost 2007 earnings-per-share growth to between 13 to 14 percent from an earlier forecast of 11 percent. IBM said it bought the shares with $1 billion in cash and $11.5 billion of borrowed funds from three banks. IBM reported 2006 profit of $6.06 per share from continuing operations, the number most analysts use for their estimates. On that basis, earnings per share would increase to about $6.85 to 6.91 in 2007 based on the updated forecast. [30]

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