International Business Machines Corp (IBM) 2001 Q2 法說會逐字稿

Good afternoon ladies and gentlemen and welcome to the IBM second quarter earnings release. At this time, all participants have been placed on a listen-only mode and the floor will be open for questions and comments following the presentation. It is now my pleasure to hand the floor over to your host, Mr. [Harvey Park]. Sir, the floor is yours.

Thank you [MANDY]. Good afternoon. This is [Harvey Park], Vice President of Investor Relations for IBM. Thank you all for joining us today. Let me quickly give you a few pieces of information. At this time, the opening page of the presentation should have automatically loaded and you should be on chart 1 of the title page. After the last chart in the presentation, we will provide you an index to go back to specifics filed during the Q&A or you can jump to the index at any time by clicking on the index link, located on the navigation bar on the left side of your screen. From the index page, you can download the entire set of charts for printing. In about 45 minutes, you will also be able to link to the prepared remarks on that navigation bar. Also, a replay of this webcast will be available on this website by this time tomorrow. Now, please click on the next button and move to chart 2. Certain comments made by John R. Joyce or by myself during this call may be characterized as forward-looking under the Private Securities Litigation Reform Act 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 filing with the SEC. Copies are available from the SEC from the IBM website or from Investor Relations. Now, please click again on the next button for chart 3 and at this time, let me just turn the call over to John r. Joyce IBM's Senior Vice President and Chief Financial Officer. John.

Thank you [HARVEY]. Good afternoon. We are pleased with our second quarter results with $21.6 billion in revenues, up 5% at constant currency and unchanged as reported, improving profitability to produce a net profit of $2 billion and earnings per share of a $15, up 8% over last year. Year to date, revenue was up 9% at constant currency and earnings per share was up 13%. Our strong results in the first half have enabled us to absorb a year-to-year impact of a $0.11 on earnings per share from currency and another $0.9 from equity writedown. There are two fundamental reasons behind our performance. We have been gaining share in key business areas to offset the weakening business environment and the continued benefit from the strength of our business model. If you move to chart 4, I will expand on this. In this market, we had strong performance in many key segments. Services grew 15% in constant currency. In the second quarter, Global Services revenue surpassed total hardware revenue. Mainframes grew 26% with a 43% growth in MIPS shipments demonstrating that our customers are turning to this most robust server as they build and consolidate their infrastructure. Disk storage was up 35% driven by a 55% growth in Shark, clearly outpacing the market.

WebSphere grew 44% and DB2 grew 19% in a weak software market. And in the semiconductor sector, our OEM microelectronics grew 29%. Most customers have not shut down on spending, but they are very focussed on certain requirements. Some want a quick pay back to help them through the economic downturn. Others are looking to improve their IT infrastructure, so that as the economy picks up they are better prepared to ramp up again on e-business plan and move ahead of their competitors. With our new competitive products and our skills in integrating complex infrastructure, customer focus on these requirements has been playing to IBM's strength. So, we have been winning a growing share of our customer spending. In addition to our strong competitive market performance, the other reason we outperformed our competitors in the second quarter was the strength of our business model. First, and let me emphasize this, about a third of our revenue and nearly half our profit is a newly-like, due to our new growing services business with its long-term contracts and much of our software financing and maintenance businesses which flow from a huge install base. These newly like businesses have a consistency that clearly differentiates us from most of our competitors. Second, the weak economy has revealed the weakness in some of our competitors' business models. Uncompetitive pricing that had supported - gross profit margin and aging technology in their product that cannot meet more demanding customer requirements or excess inventories.

In contrast IBM has been accelerating in technologies. Cutting costs and expense, and managing inventories for several years and in the second quarter, we improved our free cash flow by $1 billion over last year. Yes, we have work to do in PCs and hard disk drives. Revenues for PCs were down 14% at constant currency and HDDs were down 2%. But as you know, the profit margins on PCs and HDDs are small. So, while the effect on revenue was significant, the effect on profit was not material. In sum, these factors, our ability to provide our customers with business solutions that they need in good times and bad times, the growing competitive advantages of our products and services, the consistency of our newly like businesses and our continued focus on operational excellence have enabled us to sustain our performance in the second quarter and they were continue to differentiate us from our competitors in the second half of the year and into 2002. We believe that the second quarter is a good indicator of the issues to be faced for the remainder of the year by the industry and by IBM. But we also believe that the industry trends are clearly coming in the direction of our strategy. We will come back to both of these points in my closing remarks after we review the details of the second quarter. So, lets move to chart 5.

Here is a financial overview of the second quarter. I have mentioned the revenue at $21.16 billion, flat as reported. Currency's impact was 5 points. So, revenue at constant currency grew 5%. I have a couple of charts on currency leader that may be helpful to you in understanding its dynamics over time and its effect on the rest of 2001. Pretax income was up 5% and once again, we saw improving profitability driven by improving gross profit margin. The tax rate was 29.5%, down half a point from a year ago and two-tenths from the first quarter. This brings our year to date tax rate to 29.6. Average diluted shares outstanding for the quarter were 1 billion and 778 million - down 2.2% from last year, and earnings per share were $1.15, up 8%. Now, lets turn to revenue in the second quarter starting with the geographic perspective. Click the next button chart 6. Just over 90% of our revenue comes from our sales to enduser customers, which we break into three geographic areas. Constant currency is the best measure of the comparative business growth. Asia-Pacific continue to have the strongest growth in the second quarter; 10% in constant currency before the 12 points of currency impact. Despite a week economy in Japan, IBM Japan grew 11%, again driven by services. Europe grew 7% in constant currency before an 8-point currency impact.

We saw a little more weakness in demand this quarter due to the economy, although as in the first quarter, this varied by country and by industry. The America was flat in constant currency. However, consistent with IBM's overall results, the America was the toughest economy of the three regions, hit their profit objectives by containing expenses and exceeding cash objective by putting increased focus on the balance sheet. Our OEM business makes up the other 10% of our revenues. OEM revenue grew 12% in the second quarter, down from the 49% in the first quarter. This declining rate of growth reflects industry trends, deceleration in microelectronics sector and sustained weakness in hard disk drives. We will discuss this further in a few more charts. Now, if you click on the next button for chart 7, I will touch on currency. This chart shows our average exchange rate, as well as the year-to-year comparison for the dollar against the three currencies. A negative year-to-year comparison on this chart means that our reported results are hurt by a stronger dollar. In the second quarter, the overall impact of currency on our reported revenue growth was 5 points. As in prior quarters, we have provided current exchange rates as a way of gauging possible future impacts from currency. This is by no means of prediction of what will happen. It simply shows the year-to-year effect if the dollar remains at current levels. Based on current spot rates, the negative effect of currency on revenue for the second half has increased since April.

Currency would hurt third quarter growth by approximately five points; a point more than April rates would have suggested, and the fourth quarter would be hurt by 3-4 points, also a point more. We have added a supplemental chart at the end, which shows the dollar against the Yen and the Euro over several years. While the trends of the Yen and Euro can offset each other at times, currently the dollar is strengthening against both of them and has been for a remarkably longtime. While, we can hedge against these trends to some degree, this sustained strength of the dollar has steadily increased the impact on our operational results. Normally, you would expect the dollar strength head and flow versus other currencies. However, the last year currency helped our results was 1995. Let me a bit more specific. In 1999, we only had to absorb a $0.1 year-to-year impact on earnings per share after hedging. In 2000, that grew to $0.10 a share. This year, we had to absorb a $0.11 in the first half alone and then in the second half, at the current exchange rates the impact could continue to grow and could be as much as $0.14, or $0.25 for the full year. Now, lets look at revenue by major line item, chart 8. Let me stop by drawing your attention to the fact that the top entry on this chart and on our press release is Global Services. The standard practice is to list these in order of magnitude.

On the year to date basis, Global Services has just overtaken hardware. IBM is truly a services led company. But first Global Services. Revenue was a little over $8.7 billion in the second quarter, growing 13% at constant currency. Services with our maintenance grew 15%. Hardware revenue in the second quarter was a little under $8.7 billion and declined 1% at constant currency. Strong performance in the e-series mainframes, disk subsystem, and OEM microelectronics were offset by declines in PCs. Software at $3 billion was flat at constant currency. In general, the demand for software supporting the rollout of new applications was slow across the industry. But, WebSphere and database continued to excel, growing double digits. Global Financing revenue at $845 million picked up a little from the first quarter growing 7% at constant currency. Income generating assets were up 5% over last year and financing originations were $9.5 billion in the quarter. Now, lets review gross profits margins, chart 9. Total gross profit margin for the second quarter was 37.3%, up a four points from last year and more than a point from the first quarter. Global Services gross profit margin improved a half a point. Improvement in out sourcing and maintenance were offset in part by the ongoing need to rebound skills to meet the new needs of e-business. Hardware gross profit margin improved 2.6 points.

The key drivers were our strong performance in high-end service and in storage subsystem. Shark's gross profit margin improved quite a contrast to our largest competitor who is experiencing margin pressures we are focussed on providing the most competitive stored solutions in the industry. However, in the PC sector and related businesses such as hard disk drives and displays, there were significant industry price pressures. But our PC business was able to offset this pricing with a strong focus on cost. Software gross profit margin was about the same as last year and our Global Financing gross profit margin improved three points, helped by the higher margin on our hardware re-marketing. So, overall a good showing for gross profit margin. Now, lets turn to expense, chart 10. Total expense was $5.1 billion, the same as the first quarter and an increase of just 1% from last year. Total expense for revenue increased by three tenths of a point. Again, a major factor was a $106 million writedown of certain equity investments for the other than temporary market declines, which we have absorbed in our reported results. Without this writedown, total expense for revenue would have improved by two tenths of a point. Driving this was a 3% reduction in SG&A. R&D grew just 1%. We continue to build IBM into a premiere e-business. Revenue generated by IBM.com was nearly $3 billion in the second quarter alone, up 29%. This includes PCs, servers, services, and software.

We are addressing existing customers through this more efficient channel and increasingly we are reaching new customers. In e-procurement, IBM is one of the largest private exchanges in the world, purchasing 96% of its goods and services electronically. In e-care for customers, IBM handled an estimated 66 million self-service transactions just in the second quarter resulting in cost of a cost-avoidance of a billion dollars. Now, lets turn to chart 11, cash flow. Our free cash flow performance in the second quarter improved more than a billion dollars over last year. This reflects our ongoing operational focus on working capital. DSO improved year-to-year. Inventory levels remained essentially flat and we continue to tightly manage all other areas of working capital. Capital expenditures were up slightly year-to-year reflecting growth in outsourcing and investments in our future 300 mm capacity for microelectronics that we announced last year. Also in the second quarter, we spent about $1.2 billion to repurchase about 11 million shares. This leaves us with $3.8 billion in our last board authorization at the end of the quarter. Our strong cash flow gives us tremendous flexibility. In the last 15 months, we generated $15 billion of cash from operations on an average, $1 billion a month. We invested our cash where we can generate the best returns for our shareholders, in internal growth such as outsourcing, acquisitions, or share repurchases.

Now lets look at the balance sheet chart 12. The balance sheet remains very healthy. Total debt decreased to $2 billion from the same time last year, roughly a billion each from Global Financing debt and core debt. A $26.1 billion of Global Financing debt, which was 96% of IBM's total debt, was leveraged at a comfortable 6.7-1. And our $1.2 billion in core debt was half of what it was last year. Core debt capital stood a low 6% compared to last year's 15%. The cash on the balance sheet was $3.8 billion, an increase of $500 million over June 2000. As I said back in April, this is not an economic environment; we have growing inventories or accounts receivable problems. The management of our balance sheet in cash flow is a very important component of financial performance and key focus at IBM. As our results demonstrate, we are executing well. Now, let me turn my attention to the discussion of some of the individual businesses starting with Global Services, chart 13. This was another strong quarter for Global Services with revenue up 13% at constant currency. Services grew 15% and maintenance revenue was up 3%. $16 billion of signing added to our backlog, which now stands at $95 billion.

We signed ten deals over a $100 million including three deals greater than a billion dollars. We expect that we outpaced our competitors in our new contract signing and our growing backlog provides the strong foundation for continued revenue growth. Even in this challenging environment, customers continue to spend on IT projects that provide quick pay back and they continue to invest in infrastructure that is critical for e-business. Let me address the three major segments of our services offerings. First outsourcing and e-sourcing, which is about 40% of Global Services, grew 15% at constant currency in the quarter. The Asia-Pacific region again led the way in strategic outsourcing and we continue to see growth in e-sourcing. This is the best basic Web hosting offered by our competitors. But, we provide the added value of running the application themselves, not just the machines. We have signed over a billion dollars of Web hosting contracts already this year, and Web hosting revenue more than doubled. While we were number 2 in this sector at the end of the last year, we have accelerated and number 1 is clearly struggling. Our business model of high-value-added hosting services and managed capacity growth through selected partners has proven successful. Customers can achieve a mediate cost saving by outsourcing and our expertise in delivering value is our competitive advantage. Next is business innovation service, which is about a quarter of Global Services revenue and grew 13%.

Despite a slowdown in this market, customers continued to deploy e-business applications that provide a quick return on investment, like saving operational costs through supply chain management which nearly tripled and an integration of their business prosthesis and multiple applications i.e. IBM Global Services strength. E-business integration was up 24%. So, while there has been some slowdown in more discretionary projects, particularly in the United States, we have continued to see strength in many of our VIS offerings. Next, integrated technology services, which includes product support services and maintenance. It is about a third of Global Services. ITS excluding maintenance was up 19%. Customers have continued to invest in critical e-business infrastructure. Server consolidation and deployment of new hardware generated double-digit growth across all geographies. As customers focus on costs savings and infrastructure, we continue to see good growth in our broad set of Services offering. Click on the next button for chart 14, and I will discuss e-service and storage. IBM e-service continued to take share from our competitors this quarter. A key driver of demand on our high-end e-service was server consolidation. Many of our customers have found consolidation an excellent lever, to drive up utilization and reduce costs. Key components to this effort are LINUX and WebSphere enabling applications to run on any of our platforms on PC-based servers to mainframe.

This ability to develop on one platform, but deploy on other gives customers tremendous flexibility to the benefit of our zSeries. Back in the first quarter, IDC reported that revenue grew in the high-end server market, even though, the overall server market declined our results for the second quarter showed that trend continued. Our partners in the independent software community have helped drive the adoption of LINUX. There are more than 2300 LINUX applications now available from IBM and industry leading ISVs. Shipments of our zSeries measured in MIPS grew 43% this quarter. Revenue grew year-to-year at double digits, the third consecutive quarter of double-digit growth. These mainframe servers deliver unparalleled performance and workload management efficiency. This is the platform of choice for server consolidation. The ability of the zSeries to dynamically address the varying work loads required by the complexity of many Internet application yield tremendous efficiency. These efficiencies translate to reduce cost of ownership for IBM customers. Our high-end performance UNIX platform, the pSeries gained share in a very tough industry environment. Revenue was up slightly in an industry we believe was down about 7% or more. The pSeries remained extremely competitive and are top rated across a range of industry benchmarks. This competitive leadership will increase even further with the launch of [Regatta] later this year.

And in the most recent independent ranking of the top five 500 super computers, IBM captured the number 1 ranking for the fifth time in a row, also for the first time, two IBM of LINUX clusters were in the top fifty systems. The iSeries, our integrated global platform also delivered modest year-to-year growth in revenue coming of a weak first quarter. This quarter iSeries delivered the most expensive new release of its operating system including wireless support and the ability to run LINUX in iSeries partitions. We also announced features that enabled management of Intel-based xServers and associated storage through iSeries systems, and the high-end iSeries-840 established new industry benchmarks on JAVA warming 21% faster than the SUN Fire 68500. Revenue from our xSeries was down, inline with a general downturn in the Intel server market. In enterprise storage, we had a very strong quarter versus our competition. Our disk subsystems revenue grew 35% year-to-year. These gains were driven by strong competitive wins by our Shark system, which grew 55%. Revenue from tape subsystems grew 12% this quarter. We feel good about our progress in storage. In 2000, we will plan catch up, in terms of function. In 2001, we matched the competition. Now, we are heading function that will put us ahead of our competition.

Later this year, we will low out [5-CON] on Shark. This fiberoptic attachment when used with mainframe provides six times faster I/O over longer distances. Increasing both speed and flexibility for customer storage solutions. [5-CON] is already up and running in some customer installations. Now let me turn to software, chart 15. Our software business at $3 billion was flat at constant currency. Middleware had flat revenues. Operating systems revenue grew 1%. While we felt the impact of the general slowdown in the software industry, we expect that we again gain share in key distributed in Middleware. WebSphere grew 44% at constant currency this quarter. Contributing to this strong performance is our new release of the WebSphere for [ZOS and OS 390]. This leads customers realize the value of our cost platform Middleware strategy. They can develop application on any distributed platform and then reduce their total cost of ownership by consolidating operation of multiple applications on high-end servers. IDC reported this month that WebSphere grew two times faster than the application server market in 2000. And we expect to grow faster than the market again this year. DB2 was 19%. Our distributed database growth continues to outpace the industry. Over the past 18 months, more than a 1000 customers have chosen or replaced oracle with DB2. And our recent acquisition of [informax], will double our distributed database business increasing revenue growth potential for the remainder of the year.

We also had continued strong growth in our mainframe database tools. Revenue more than tripled this quarter. Tivoli continued to work on its product transition, but on top of this, customers deferred work in areas like systems management because of its complexity means a longer-term pay back. Now, let me focus on our strategical alliances with independent software vendors ISVs, an important element of our strategy. These ISVs have committed to lead with IBM, Middleware, eServers, and services. As we work them to help our customers to build application. We signed 13 new ISV alliances this quarter, ranging from companies such as SAP to side ware bringing the total to 68. These alliances are important for our future growth. As the ISVs build their applications, on IBM technology and lead with IBM products. When application deployment accelerates and the software market picks up again, these alliances will put IBM at the forefront. But the alliances are gaining traction right now. We have had more than $1 billion of IBM services, hardware, and software revenue from our ISV partners this quarter and we are gaining share of new application placements. For example, DB2 now has a better than a 50% share of all new [PC] replacements. So, while we have certainly felt the effects of the industry slowdown, this quarter, we are well positioned for better performance in the second half.

Now click on the next button for chart 16, Personal Systems. Revenue from personal computers was down 14% year-to-year at constant currency this quarter. These results reflect the modest decrease in volume. However, price erosion has driven the average selling price down across the product set and we expect that our revenue decline will be inline with the industry when the data is available. Despite the challenging environment, our industry leading ThinkPad should gain share sequentially. We are extremely focussed on reducing costs and expense, as well as getting the maximum utilization through our direct procurement channel. This quarter 40% of our PC sales were filled via the direct channel. Now if you move to chart 17, we will cover technology. Our OEM microelectronics grew almost 30% at constant currency, despite the difficult environment; all three of the targeted industry segment networking, pervasive, and enterprise I/T had strong growth. Our leading edge technologies remained key to our competitive leadership and continue to drive design wins with our customers. The latest of these performance improvements are recently announced technology breakthrough called [strain] silicon will help widen what is already a two-year technology lead. Design wins that is one of our customer's use our chips in their product design is a key measurement of our success and a leading indicator of future revenue. These design win uniquely position IBM when the industry recovers. Not all of our chips use these cutting edge technology and we have seen demand for our less complex products impacted by the industry slowdown.

We are the industries number 1 A6 supplier and we will continue to increase our share during the downturn. The other component of technology, OEM, is storage. Our ability to sell hard disk drive is highly dependent on the PC industry. This industry is in turmoil and this is impacting both our HDDs and our PC results. There is extreme price pressure, excess inventory, and manufacturing capacity in this industry. However, we expect that we continue to gain share due to the strong customer acceptance of our mobile and desktop drives. Now, if you hit the next button, let me summarize my remarks. Let me turn to the second half of this year. I want to begin with two non-operating items, namely currency and equity writedown. If the dollar continues to be strong, the year-to-year hit to our earnings in the second half will be $0.14. In other words, a current spot rates we would have to absorb this hit to our earnings above and beyond our hedged position. Of course, we are making no prediction here, but simply giving you the facts based on the assumption that the dollar remained at today's strong levels. It is also impossible to predict equity write offs with certainty, but it would be prudent to make an assumption of roughly half of the level of the first six months; that is $100-125 million for about $0.5 in earnings per share.

Now, as I mentioned earlier, in the first half because of our very strong results, we were able to absorb both currency and equity writedown and still make our financial objectives. Our ability to do this in the second half will for the most part be a function of what happened to our microelectronics business. If demand in microelectronics picks up in the third quarter and continues to expand into the fourth quarter, we would be encouraged. On the other hand, if our major microelectronics customers, those who provide network, infrastructure, pervasive devices, and other hardware products, do not start growing their businesses in the third quarter, then our ability to cover these non-operating items will be problematic and in fact, could even cost us a few cents more than these non-operational items. Now importantly, the rest of our businesses in the second half should continue their strong momentum. We have a services backlog of $95 billion. Our new power 4 base UNIX server [Regatta] customers motivated to consolidate service for cost reductions continued shock enhancements like [5-CON] putting our functionality ahead of our key competitor as well as newly announced network attached storage product, the acquisition of [Informax] which will roughly double our distributed data base revenue, new enhancement for WebSphere and finally we will benefit from the consistency of our newly acquired businesses, financing, maintenance and mainframe software.

As for 2002, we expect to continue to outpace our competitors and here's why. Industry trends continue to come our way. E-business, which will dominate customer IT spending for the next decade is hard business that requires major changes in the business process and company infrastructure. Think of the dramatic changes we have seen just in the past year alone. Whole customer set by dot-coms are coming down. Customers have become more focussed on building scaleable, reliable infrastructure that is capable of integrating many applications on diverse platforms and customers on the forefront of e-business are looking for trusted partners who can help provide business solutions, not just the piece parts. It is increasingly a services-led industry. In addition, open standards simplified by LINUX have accelerated. Increasingly, leadership technology will be the difference between commoditization and profit. The winners in our industry are going to be the services companies that can deliver value to integrated services and host their hardware and software. We have seen other companies trying to reposition themselves for these trends moving into services or software. This is not a capability you simply buy. Many of our competitors have seen their market capital decline dramatically. Yet, many of their PE multiples are at healthy premium to the SMP-500. This must reflect a hope that history will repeat itself. We do not believe history will repeat itself and for years, our entire strategy has been focussed on the new requirements generated by real e-business. As you think about the technology sector in 2002, you will not find a company with greater momentum than IBM. Now Harvey and I will take your questions.

Thank you. The floor is now open for questions.

Excuse me. I would like to go on to the next chart where you will find you can get all our slides that may be helpful during the Q&A. Now, before I turn this call over to the operator to give you polling instructions, let me request that you refrain from multipart questions to give others some time. We are on a tight schedule. Okay, [Mandy], let's get started.

Thank you. The floor is now open for questions. If you have a question or a comment, please press the numbers #1 followed by #4 on your touchtone telephone at this time. If at any point, your question has been answered you may remove yourself from the queue by pressing the pound key. All questions will be taken in the order they are received and we do ask all participants to please pick up their handsets for posing their questions to ensure optimum sound quality. Thank you, our first question is coming from [John Jones] of Salomon Smith Barney. Please pose your question.

Thanks. I want to focus on the services business, if I could. There was an improvement in operating margins in that business. John, can you talk about whether those operating margin improvements are coming out of your more contractually obligated businesses like outsourcing and maintenance or your shorter-term businesses. Is this a trend change or is this a one-time change when you needed it here in this tight quarter?

Thanks John. Actually, it's both. We are working on our shorter term business, or consulting business, and we are working to improve our utilizations in that business, but also as our outsourcing and e-sourcing business becomes larger we do achieve economies of scale as that business continues to grow. I think I would advise you to assume that we should be able to hold these gross profit margins.

Great, thank you.

Next question please?

Thank you. Our next question is coming from [Gary Hameg] of Wit Sound view. Please pose your question.

Ah yes, John, I would also like to ask you a question about services. In the $16 billion with bookings with [p-art] included and looking at their backlog, are you seeing any slowdown in the plain number that backlog to revenues as a result of the economies?

First [p-art] was included and we don't see a slowdown in the revenues flowing out of the backlog and as a matter of fact the backlog as we look into the third and fourth quarter, the third quarter looks pretty strong, so we still have a pretty healthy backlog. We would only add to that that much of our backlog improvement has come from Asia-Pacific and as we look into the third quarter backlog, we are beginning to see a bit more come out of the US which is a good sign.

Thank you, John.

Next question, please?

Thank you, our next question is coming from Laura Conigliaro of Goldman Sachs. Please pose your question.

On microelectronics. You always are talking in terms of microelectronics being a business that is, kind of, an 18-month out business as far as visibility and now you are really looking at that as possibly being the reason for a key turning point in the third quarter. Maybe, if you can talk a little about the split in microelectronics between your design wins at a very long in nature and some of the shorter term business, and why in fact that shorter term business isn't either large enough or input enough to make the kind of difference that you are now identifying as the inflexion point. I'm sorry, John, one more thing and that is why wouldn't you expect, given what is happening with all your customers, to see an impact, you put it as a possibility, but given what is going on with virtually every customer, why isn't it likely or definite?

I am highlighting an issue with microelectronics certainly in the third quarter and let me try to address your question relative to what we are seeing with our customers. There is a fair amount roughly $250 million of IBM inventory with our major customers and you all know who our major customers are in this business. We are looking at a third quarter that we need to work off that roughly $250 million of inventory and then we believe that the microelectronics business will pick up in the fourth quarter. We expect microelectronics to be down quarter to quarter in the second to third, to be down 10-15-20% as we look to these inventories. We are encouraged by our design wins and as we (a) work off those inventories and (b) as our customers' businesses begin to pick up, we think we will begin to grow again.

And can I get back, I'm sorry, the customers' business picking up, do you have any indication at all, either from discussions with customers or what you see elsewhere that you should see some kind of a pick up as early as the fourth quarter?

We think that more importantly, relative to the fourth quarter is the work off for the short-term inventory because once we get past that, we should start seeing some growth. How quickly their businesses pick up? I would only say this that we are not counting on a dramatic uptake in microelectronics in the second half.

Next question, please?

Thank you, our next question is coming from Don Young of UBS Warburg. Please pose your question.

Yes, thanks. First if [Harvey] or John could just clarify again on the equity writedown. I have got it down at one point as 106 million, another point at $0.09 a share and I would like understand better what happened in the quarter, but the question I want to ask about is the seasonal pattern in the second half. It sounds from what John is saying about working off of microelectronics' excess inventory and the timing of the [Regatta] announcement that we could see more of a bigger fourth quarter and a weaker third quarter than we traditionally report at IBM. Is that the right way to think about the outlook now for the second half?

First, let me answer the first part of the question and then we will get to the third and fourth quarter. As far as the equity write offs, we wrote off roughly 106, I believe in the first quarter, [Harvey], and about a 110 in the second quarter. So it is a 106, 110, total is roughly $216 million of equity write offs that we have. It is absorbed in the first half of the year. Now the second question, microelectronics will be a weakness in the third quarter and you are right with your point to [Regatta] in the fourth quarter, but we also in the third quarter will have [Informax] which will start consolidating in our results. We should continue to see good growth in our services business through the remainder of the year. We believe we will continue to gain share in our UNIX business in the third and then hopefully more so in the fourth with [Regatta] and our storage business should continue to do well. And from the middleware standpoint, we would expect continued strength in WebSphere and DB2. But to get to the point relative to what you should expect from the third to the fourth quarter, I would say that the third quarter will be our toughest quarter and we should up take from there in the fourth quarter.

Thank you, John for the points that you made.

Thank you.

Next question, please?

Thank you, our next question is coming from [Kurt Weaver] of American Express Financial Advisors. Please pose your question.

Hi John. Today, a couple of questions if I could for you, please. The [Informax] acquisition was a very, I guess a, studious one we were to use for. What are the gaps, given the free cash flow that you are generating, would you use for acquisitions, just generally to round or out particular product lines or strategically, or is that an approach that you are now going to downplay going forward? That is my first question.

We are always working to round out our portfolio, you know we purchased a services company last quarter, a small services company and we have now purchased [Informax] so we are always looking for opportunities in the market and given the strength of our balance sheet, improving debt levels, improving cash flows, we will continue to look in the market to see if there is something that would add value to our shareholders. You do know what happened to the market, there may be more things that are of interest to us, but I wouldn't speculate on anything pass that.

And just a clarification to your answer to [John Jones] question with regards to margins in the services business as the revenues flow out of the backlog, it is my understanding that the profitability basically is there from the beginning of the contract given the way these contracts have been written, so my question is really you indicated that it was sustainable, is that on the gross margin, are those revenues actually at a higher margin level going forward than what you have had in the past, given the nature of the services you are providing. Thank you.

They are higher given the fixed variable nature as you grow that business and with large data centers we do get the economies of scale in that business and that business is becoming a bigger and bigger piece of the IBM company. And so from that standpoint, it is flowing through, but as I mentioned on John's question, it is also a variable piece, which is on the consulting business on the labour side of it and we are also working hard to improve those, the utilization of those consultants and those employees.

Okay, thanks John.

Thanks.

Next question, please?

Thank you. Our next question is coming from [Tony Sakanade] of Sanford Bernstein. Please pose your question.

Hi John and [Harvey]. I just like to better understand microelectronics, try to keep going there. Was there any sequential improvement in revenues in the microelectronics business from Q1 to Q2?

I believe it was basically flat.

Okay. I guess the question or concern that I have is if you had essentially a flat business sequentially in microelectronics and appear to have experienced pretty significant contraction in profitability because the technology segment was down and operating profit by about 100 million and you said HDD is really, didn't play a big role in changing profitability and you are looking for a sequential decline of perhaps up to 20% in Q3. How can we ever think about your former scenario, John, which sort of suggests if demand picks up, it will be encouraging, we can make EPS, it sounds like if we put those set of assumptions together, we are going to have a very material hit at profitability from microelectronics. So, how do we think about the former situation where things actually get better and profitability stays the same or it doesn't go down at ton.

Thanks Tony, I'm glad you asked that question. First, let's go back for a second, back into the second quarter. The revenue issue in the second quarter is basically all related to PC. Our PC business was down 18% in the second quarter, and as I said in my prepared remarks, that had very little impact on our earnings because as you all know, our margins on the PC businesses as well as the HDDs related to the PCs is very small. And so, we had a very good quarter in the second quarter, although the revenue is a little light-based on the PC segment, it didn't impact us relative to a profit standpoint, but now when you look out into the third and fourth quarter, we see a fairly dramatic falloff in the microelectronics business and I quoted those numbers, somewhere around 15% falloff from the second quarter and that will have a profit impact in the third quarter and the point I made in my prepared remarks is that with that falloff, we are going to struggle to overcome the currency impact and the equity impact through the second half.

If you think about the demand situation picking up, because you sort of painted a picture that if demand picks up, we might be okay in Q3, but if demand picks up 20% and you were flat sequentially, it sounds like operating profit probably wouldn't improve much in the quarters, so even in the scenario where demand picks up a little bit, do you really think that you might be able to overcome the currency and the equity write off issues?

Yes. Let me try it this way. I have provided in my prepared remarks the first half impact of full currency and equity write offs and if you add those two together, okay, it is roughly a $0.38 impact on the full year, with non-operational items, roughly for $0.38 impact on the year. And as you know, we typically try to cover these impacts, for e.g. last year we covered $0.10 on a year-to-year basis, based on the currency impact. But given the size of these two items and the slowdown with microelectronics, we expect to be able to cover $0.15 of the $0.38 based on the strength of our services, our middleware business, and our server business. So what I am saying is that the microelectronics business will hurt us in the second half.

Thank you.

Next question, please?

Thank you, our next question is coming from [Daniel Confer] of J.P. Morgan. Please state your question.

Good afternoon John and [Harvey]. I actually would like to look at the split side of this, there will be other businesses that you say should perform relatively consistently and what I really am trying to gauge is that how speculative that comment actually is. You pointed out, that you have got several items that you singled out and certainly the backlog in services business is easy, but then you thought you have [Regatta], you have the industry trends towards your campus consolidation that enhances the product, database management, how much of that is actually somewhat speculative and as you look at the deteriorating situation in Europe, how should we brace for negatives and pressures in these businesses.

Let me start by, kind of, adding on to the comments I just made on microelectronics. I think that will answer your question. In this environment, we still expect to grow revenues for the full year at or close to our model, which is high-single digit in constant currency. So, I just want to make sure we are clear on that. On the speculative nature of some of these, to use your words, you know [Informax], that is pretty much done, the newly acquired businesses, the services business, the maintenance business, the software business that flows out of our installed base, that is also pretty much assured, nd I would mention that on installed base, based on the increase in MIPS shipment, increased over 20%. So we are going to be able to gain the benefits of that overtime. [Regatta] is a performance enhancement to our UNIX server that many of our customers need in order to attain its scaleability and reliability as they move more and more of their business prophesies on to the net and we also think that [Regatta] or we also believe that [Regatta] will also help our customers in trying to save on the true server consolidation and that is one of the things that we are seeing as we continue to close business, more and more of our customers are looking for a - how can I get to save these, how can I get to save these quickly, and that is why some of our businesses did as well as they did.

A very quick followup on that John, on [Regatta]. Are you saying that regardless, essentially you would drop into the existing application pace and does not really require expanding application development in order to be as successful as you want us to be in the fourth quarter. I know that also we would be expected to be very successful.

The ability to place [Regatta] is not significant and they will go in lead with.

Thank you very much.

Next question, please?

Thank you, our next question is coming from George Elling of Deutsche Bank. Please pose your question.

Thank you. After a poor first half in hardware last year, IBM showed real good growth in its second half. Do you anticipate in this difficult environment that you could see hardware revenues approaching last year or after Q2? Would that be a very long shot? Thanks.

Excuse me, can you repeat that for me. I just want to make sure I answer the right ...

Okay, I basically was making the point that last year IBM had a weak first half in hardware. Sales came back real strong in the second half, but now, we just came off of our Q2 which was somewhat below expectations. What I am asking is, do you think you can get back close to the kind of numbers you delivered in last year's third and fourth quarter in the light of what you just did in Q2.

Okay, first I actually as to how I look at our hardware results, if you take the PCs out, if you look at how we have done in our eServers, our mainframe z900, if you look at how we have done in our UNIX, gaining some shares along slightly, we have had a pretty good quarter, iSeries growing again, and now to your question. PCs were weak, we are not counting on significant PC up take in the second half, but if you look at the third quarter, we should have a good third quarter in our iSeries, we should have a good third quarter in our zSeries and so they will carry the day in the third quarter. As you look in the fourth quarter to your point, we had an unbelievable fourth quarter in the zSeries, the high-end last year. We will have a good fourth quarter in the zSeries, but the year-to-year comparison will be difficult and I would like to think that with the introduction of [Regatta], that would be able to offset that impact. So, I hope I answered your question.

Okay, Mandy, we have time for one more question.

Thank you. Our last question is coming from [Stephen Leber] of S.G. Cowen. Please pose your question.

Yes, John, if you could just take a second, you implied that you expect to grow for the full year in constant currency terms of course, at close to the high-single digit goal, that despite the fact that the compares are tougher. Clearly, you need to get something really rolling, we just talked about the hardware side of the enterprise, what do you think is going pick up steam sufficiently because the second quarter obviously was in high-single digit. To do this and earlier you talked about a good second half or a better second half in software. Maybe you could just expand on that.

Hold on one second. Okay. Thanks, Steve. First on the question of the closure of our model on high-single digit revenue growth and I will answer it this way. Services should continue to grow in the mid-teens in that range. We should still continue to see good growth through storage in our storage products especially with the introduction of [5-CON] which will be later in the quarter, but our storage products have some momentum. As you know, we have basically doubled our sales force in storage and that should gain and continue to hold its growth rates going into the back year after year. PCs, we are not expecting enough kick, but as I stated, not a big profit driver for the company. From the standpoint of the WebSphere and DB2, they should continue to do well and then add [Informax] to that and we should have good software quarters going forward. And then the real issue is what will happen to microelectronics on a year-to-year basis. Microelectronics, you know how far down, what kind of year-to-year decline might we expect. I have already put out there that we think microelectronics could be down as much as 15-20% from the second quarter and that by the way, would be down by about the same amount on a year-to-year basis. So you add that up, we think that we could finish the year at a close to our model, which is high-single digit revenue growth. And we also expect to be one of the very, very few I/T companies that will grow revenues and earnings per share in 2001.

Thank you, great. If I can have just one last question.

Okay, Steve. Thank you all.

Thank you for your participation. That does conclude today's teleconference. You may disconnect your lines at this time.