International Business Machines Corp (IBM) 2012 Q3 法說會逐字稿

Welcome, and thank you for standing by.

At this time all participants are in a listen-only mode.

Today's conference is being recorded.

If you have any objections, you may disconnect at this time.

Now I will turn the meeting over to Ms. Patricia Murphy, Vice President of Investor Relations.

Ma'am, you may begin.

Thank you.

This is Patricia Murphy, Vice President of Investor Relations for IBM.

I'm here with Mark Loughridge, IBM's Senior Vice President and CFO, Finance and Enterprise Transformation.

Thank you for joining our third quarter earnings presentation.

Prepared remarks will be available in roughly an hour, and a replay of this webcast will be posted to our Investor Relations website by this time tomorrow.

Our presentation includes certain non-GAAP financial measures, in an effort to provide additional information to investors.

All non-GAAP measures have been reconciled to the related GAAP measures in accordance with SEC rules.

You'll find reconciliation charts at the end and in the Form 8-K submitted to the SEC.

Let me remind you that certain comments made in this presentation may be characterized as forward-looking under the Private Securities Litigation Reform Act of 1995.

Those statements involve a number of factors that could cause actual results to differ materially.

Additional information concerning these factors is contained in the Company's filings with the SEC.

Copies are available from the SEC, from the IBM website, or from us in Investor Relations.

Now, I'll turn the call over to Mark Loughridge.

In the third quarter, we reported $24.7 billion in revenue, expanded gross, pre-tax, and net operating margins, and increased operating earnings per share by 10%, to $3.62.

For the year, we're maintaining our full year 2012 expectation for operating EPS of at least $15.10.

That's up 12% over last year.

Looking at our third quarter revenue by geography, Europe was fairly consistent with last quarter.

Japan's revenue stabilized.

The BRIC countries in total performed well again, but North America declined.

When I look at our skew of business in the quarter, through the first two months, our revenue was fairly consistent with our second quarter performance.

The third month of the quarter was more challenging.

This quarter, we delivered double-digit operating earnings per share growth, driven by our strength in our solutions offerings, a solid annuity base, and our ongoing work on productivity.

First, we continue to drive very good results in our solutions offerings across software and services that address key demand areas, like Smarter Planet, Business Analytics, and Cloud.

Second, our annuity businesses, which represent about half of our annual revenue and 60% of our profit, provided a solid base of revenue and profit.

And third, we're continuing to execute on our productivity initiatives, on track to deliver $8 billion of productivity over the 2015 road map.

The benefit from these initiatives, together with our mixed and more profitable businesses, helped to drive our margin expansion.

Now, before I get into the financial metrics, I want to remind you that this quarter we closed the sale of our Retail Store Solutions point of sale business to Toshiba Tech in most countries.

The transaction results in a loss of revenue and profit for the divested operations, a gain on the sale, and an impact to our tax rate.

As we go through the presentation, I'll clarify the impact of each of these.

In the quarter, IBM's revenue was down 5%, including a currency headwind of nearly 4 points.

At constant currency, we were down 2%, or down 1%, if you normalize for the RSS divestiture.

But in spite of this revenue decline, we had solid operating profit growth, with pre-tax income up 7%, and net income up 5%.

Our margin expansion was driven by our productivity initiatives, improving business mix, and the overall currency dynamics.

This quarter, we expanded operating gross margin by 1.2 points, with about 60% due to improvements in margins and the balance from mix.

With good expense management, we improved operating PTI margin by 2.5 points.

This quarter, our tax rate was up over a point year-to-year.

The increase was driven by a higher tax rate on a gain from the sale of our RSS business.

We now expect an operating effective tax rate, excluding one-time items, in the range of 24.5% for the year.

Bottom line, we delivered operating EPS of $3.62, which was up 10% year-to-year.

When you look at the year-to-year drivers of our operating EPS performance, the 5% decline in revenue of constant margin impacted profit growth by $0.17 per share.

Margin expansion was the largest contributor to our growth.

Within that, the gain on the RSS divestiture contributed $0.23, gross margin expansion added $0.19, and our expense productivity, another $0.16.

On the other hand, we did have an increase in our work force rebalancing activity, for an impact of $0.24.

Our ongoing share repurchase program contributed the balance, at a level fairly consistent with the first two quarters of the year.

As you can see, the dynamics are very similar to our first half performance.

Now, I'll get into the third quarter details, starting with revenue by geography, where I'll discuss the results on a constant currency basis.

Americas' revenue was down 3%, with declines in both the US and Canada.

In North America, software was up 4%, services was down, and we had a double-digit decline in hardware.

With revenue performance relatively consistent with last quarter, EMEA was stable.

Looking at the performance by country, Germany and Spain grew, the UK was flat, while France and Italy declined.

Turning to Asia-Pacific, last quarter I said that I expected our business in Japan to stabilize.

This quarter, our revenue in Japan was flat year-to-year, so certainly an improvement over the last several quarters.

We had good performance in both Europe and Japan, given the environment.

In our growth markets countries, which we refer to as GMU, the BRICs had another good quarter.

Combined, they were up 11%.

We had double-digit growth in Russia, which was up 11%, India, up 13%, and China, up 19%.

Brazil, however, was down 3%.

Looking beyond the BRICs, Australia and Mexico were down double digits this quarter, while most of the other countries continued to do well.

In fact, this quarter, 35 of the growth market countries grew at a double-digit rate, reflecting ongoing broad-based strength.

Looking at IBM revenue and gross margin by segment, our total services revenue was flat, as modest revenue growth from our backlog was offset by impacts from shorter-term and volume-related activity.

Software performance was driven by double-digit growth across our solutions area, like business analytics, commerce, and social business.

Our Systems and Technology revenue declined each month, though performance in September improved, as we introduced our next generation System z.

Turning to gross profit, our operating gross margins improved 1.2 points, driven by a combination of margin expansion in both services segments, and an improving segment mix, due to the relative performance of software.

Now, let's take a look below the gross profit line to our expense and spending profile.

Our total operating expense and other income was down 10%.

The primary driver was currency, which drove 8 points from both translation and hedging dynamics.

Acquisitions over the last 12 months drove 3 points of expense growth; so consequently, our base expense was better by 5 points.

Now, I'll comment on a few expense items.

SG&A includes a pre-tax charge of over $400 million for work force rebalancing activity, which, at IBM's average tax rate, impacted net income by about $310 million.

Other income and expense had two drivers.

First, a pre-tax gain for the sale of our retail store solutions business, and second, we had a year-to-year impact from our hedging activity.

The pre-tax gain for the RSS sale is almost $450 million.

With a discreet tax rate on that gain based on the countries closed, the transaction contributed about $280 million of net income.

Turning to the hedging activity, we hedge our major cross-border cash flows to mitigate the currency volatility and our global cash planning.

Last year, hedging programs generated losses, resulting in an impact to expense of about $175 million, while this year the programs generated gains of about 100 million in expense, roughly 90% of our hedging activity this quarter was in expense.

The balance is in cost.

As you know, this hedging activity can't be looked at in isolation, as it mitigates translation impacts throughout the P&L.

Looking at how all of this translates into pre-tax margins by segment, we've provided here a normalized view of the profit and margin dynamics by removing the work force rebalancing charges in both years, to give you a better view of the underlying operational performance of the segments.

On this basis, you can see good profit growth and margin expansion in Global Technology Services, Global Business Services, and software.

Now, let's turn to the segments, starting with Services.

The two services segments delivered $14.5 billion in revenue and excluding work force rebalancing charges, grew pre-tax profit 9%, and expanded pre-tax margins by just over 2 points.

Backlog was $138 billion, up 1% year-to-year.

We continued to see strong performance in the growth markets, with backlog up 15% at constant currency, and globally, transactional backlog was up 7% at constant currency.

Turning to the two segments, in Global Technology Services, revenue was $9.9 billion, down 4% as reported, and up 1% at constant currency.

GTS outsourcing revenue was flat at constant currency.

As we've previously discussed, there were three primary sources of revenue in outsourcing.

First, revenue from backlog, which makes up the majority of the revenue in the year.

Second, revenue from new client signings within the year.

And finally, revenue from base growth, which comes from new business sold into the existing accounts and from volumes generated within the quarter.

This quarter, we continued to get revenue growth from our backlog.

However, we did see a decline in revenue from base growth, after growing through the first half.

Integrated Technology Services revenue was up 3% at constant currency, with the growth markets up 13% at constant currency.

Global Technology Services delivered flat pre-tax profit growth in the quarter, though excluding work force rebalancing charges, pre-tax profit was up 9%, with 2 points of margin expansion.

This quarter, there are a number of drivers of margin expansion.

First, increased contribution from the growth markets, which continue to drive higher gross margin than our major markets.

Second, lift from our continued focus on automation and process, primarily through our enterprise productivity initiatives, and finally, we continue to benefit from the work GTS has done to improve performance and a select set of lower margin contracts within Strategic Outsourcing.

Turning to Global Business Services, revenue was $4.5 billion, down 6% as reported, or down 3% at constant currency.

Looking at revenue from a geographic perspective, the growth markets continued to drive the strongest performance.

Japan returned to growth this quarter, with revenue up 2% to constant currency, while North America and Europe were both down 6% at constant currency.

Looking at the GBS business by offering, the growth initiatives continued to drive strong growth.

We had solid double-digit growth in business analytics, Smarter Planet, and Cloud.

Together, these initiatives represent about a third of total GBS revenue.

So we continue to get great traction in these growth initiatives, and we're seeing the benefits across IBM.

The overall growth rate of GBS is being impacted by declines in some of the more traditional packaged application projects.

Turning to profit, GBS pre-tax income declined 5% year-to-year.

However, when adjusting for work force rebalancing, pre-tax income grew 9%, and pre-tax margin expanded 2.5 points.

Margin expansion benefited from prior quarters' workforce rebalancing, yield from enterprise productivity initiatives, and a help from currency.

Software revenue of $5.8 billion was down 1% and up 3% at constant currency.

Through August, revenue was up 5% at constant currency; however, performance in September was weak, particularly in North America and the growth markets.

Our portfolio of solutions offerings was up double digits year-to-year, while the complementary infrastructure portfolio was essentially flat.

Now, let me take you through the drivers for the brands.

WebSphere grew 5% at constant currency and continued to extend its market-leading position.

We had good growth from our commerce offerings, which target not only the CIO, but also the CMO, so we're reaching new buyers.

This performance was bolstered by our recent acquisition of Tealeaf, which enables clients to analyze interactions on websites and mobile devices.

Information Management was up 3% at constant currency.

Performance was driven by strong growth in our Business Analytics offerings, led by Algorithmics, which together with our deep analytics expertise, helps our clients manage risk and better enable faster decision-making.

Just last week, software announced new members of the PureSystems family, the IBM PureData Systems.

These expert integrated systems are optimized to deliver high performance data services for transactional and analytics applications.

Tivoli software was up 9% at constant currency and gained share.

Revenue from our storage portfolio was up 14% at constant currency, reflecting the balance of storage software.

Tivoli Security was up 9% at constant currency, driven by Q1 Labs, which provides next generation security intelligence.

Lotus declined 7% at constant currency in the quarter.

Although Notes declined, we had strong performance in our social business offerings.

In the third quarter, we announced the acquisition of Kenexa, which further expand our solution portfolio for social business.

We expect Kenexa to close late in the fourth quarter.

Software pre-tax income was $2.4 billion, up 6% from last year.

Normalized for the high level of work force rebalancing, software pre-tax income was up 10%, and pre-tax margin expanded 3.5 points.

Systems and Technology delivered revenue of $3.9 billion, down 13%.

Adjusting for the divestiture of retail store solutions, revenue was down 11%, or 9% at constant currency.

System z revenue declined 19% at constant currency and MIPS declined 2%.

Late in the third quarter, we started shipping the Z enterprise EC12 server, which delivers up to 25% improved application performance and up to 50% enhanced capacity, making it the fastest and most capable enterprise system to date.

This new main frame will be ramping through the fourth quarter.

Power revenue was down 1% at constant currency.

We had strength again this quarter in Power high performance computing solutions.

We continued our success in competitive takeouts.

This quarter, we had over 260 competitive displacements, which resulted in over $200 million of business, which came almost equally from HP and Oracle/Sun.

This initiative helped drive our 18th consecutive quarter of share gains in Power.

Early in October, we announced the new Power 7 plus-based servers.

These new systems offer performance boosts of 30% to 40% compared to prior versions and new capabilities for Cloud and Security.

System x revenue was down 3% at constant currency.

Our storage hardware revenue was down 8% at constant currency, while storage software, which is reported in Tivoli, was up 14% at constant currency.

We continue to see value shifting to software.

Earlier this month, we announced the new high-end DS8870, which enables clients to take full advantage of the increased performance in our new high-end enterprise servers.

We're expanding our storage software capabilities, as well.

Last week, we announced the virtual storage center, which integrates multiple software solutions to deliver fast backup and restore in a virtualized storage environment.

As you look to the fourth quarter, we have significantly enhanced our systems portfolio, with our new zEnterprise EC12 main frame, Power systems based on the new Power 7-plus architecture, and new storage systems, including the high end DS8870.

Across all of our segments, we're continuing the strong performance in our key growth initiatives.

In the growth markets, we're expanding into new markets, building out IT infrastructures, and focusing on targeted industries.

For the year, revenue was up 7% at constant currency and we've gained share.

Our Business Analytics solutions help our clients to identify, manage, and predict outcomes by leveraging huge amounts of data.

Our broad portfolio of analytics solutions was up 14% through the third quarter, led by our GBS Consulting practice.

Our SmartCloud portfolio addresses the full scope of enterprise client requirements, with strong growth across the offerings, from private cloud to public cloud to our industry-based solutions, cloud revenue so far this year has already exceeded our full-year revenue for 2011.

All of this comes together in our Smarter Planet solutions.

Through the third quarter, we had revenue growth of more than 20% in the Smarter Planet portfolio, with traction in our Smarter Commerce and Industry solutions.

When you look at our offerings in our Business Analytics, Cloud, and Smarter Planet, about half of the revenue is software, so the success we're having in these areas is improving our business mix and our margin.

Turning to cash flow, we generated $3.1 billion of free cash flow in the quarter.

Now, let me walk through the year-to-year drivers.

Our operating net income was up $200 million year-to-year, and GAAP income is flat.

One of the non-operating items this quarter is a charge for UK pension.

On October 12, the UK court issued a ruling regarding an IBM UK pension plan.

We took a pre-tax charge of approximately $160 million, or $125 million after tax.

Though the charge impacted GAAP net income, it did not impact operating income.

And since it's a non cash item, it's reversed in a free cash flow analysis.

Looking at the items that impacted cash year-to-year, our cash tax payments increased $300 million.

We had an increase of almost $100 million for our workforce rebalancing payments, and our capital expenditures were also up year-to-year.

So though operating profit was up $200 million, free cash flow was down almost $350 million, based on the increased tax, capital, and restructuring payments.

Through the first three quarters of the year, our free cash flow was up $1 billion year-to-year, to $8.7 billion.

Our growth in net income was partially offset with increased capital investments.

As I mentioned previously, in the first quarter of last year, our free cash flow was impacted by income tax payments, driven by audit settlement activity.

Looking at the uses of our cash through September, we spent $2.3 billion to acquire 10 companies, including Texas Memory Systems, which closed in the third quarter.

We've returned almost $12 billion to shareholders this year.

We paid out over $2.8 billion in dividends, and spent $9 billion in share repurchase to buy back almost 46 million shares.

At the end of the third quarter, we had $6.7 billion remaining in our buyback authorization.

Turning to the balance sheet, we ended the quarter with a cash balance of $12.3 billion.

Total debt was $33.7 billion, of which $23.3 billion was in support of our financing business, which is leveraged at just over 7 to 1. Our non-financing debt was $10.3 billion, and our non-financing debt to cap was 36%, consistent with June.

We continue to have a high degree of financial flexibility and our balance sheet remains strong to support the business over the long-term.

Wrapping up our discussion on the quarter, we delivered 10% operating EPS growth and $3.1 billion in free cash flow.

Within our operations, we had solid contribution from our annuity businesses, and strong performance in our growth initiatives, Smarter Planet, Business Analytics, and Cloud.

Our productivity initiatives helped to drive margin expansion, and our solid balance sheet and cash generation supported shareholder returns.

As we move into the fourth quarter, we have new product introductions in our systems portfolio, not just in System z, but also in Power and Storage.

We've just announced PureSystems offerings that leverage our software capabilities, and late in the quarter, we expect to close the acquisition of Kenexa.

Taking all of this into account, we're maintaining our full year 2012 expectation for operating EPS of at least $15.10.

This keeps us on track to at least $20 of operating EPS in 2015.

Now, Patricia and I will take your questions.

Thank you, Mark.

Before we begin the Q&A, I would like to remind you of a couple of items.

First, we have supplemental charts at the end of the deck that complement our prepared remarks.

And second, I'd ask you to refrain multi-part questions.

When we conclude the Q&A, I'll turn the call back to Mark for final comments.

Operator, please open it up for questions.

Thank you.

At this time, we would like to begin the question-and-answer session of the conference.

(Operator Instructions)

The first question comes from Toni Sacconaghi with Sanford Bernstein.

You may ask your question.

Yes.

Thank you.

I was wondering if you could provide some color commentary around the quarter.

Relative to expectations, revenues were short.

Your tone, I think, sounded a bit more cautious, and you made several references to the US being weaker and the third month of the quarter being more challenging.

So specifically on those latter two points, can you help us understand what you think happened Is this being driven by macroeconomic issues?

Are these IBM execution issues?

And if we roll -- if we look forward, are you expecting either the execution or the macro issues to reverse or improve in the fourth quarter?

Yes.

Good question, Toni.

So if you look at the third quarter performance, we did start off the first two months of the quarter on a stronger trajectory than we saw for the full quarter, as we saw a fall-off in our growth rates in the third month of the quarter.

Now within that third-month phenomena, I would point to -- if you look at it from a brand perspective, it was really a fall-off that we saw in our GBS business, number one, and our software business, number two.

And from a geographic perspective, it was really a fall-off that we saw in North America and our growth markets unit, which we refer to as GMU.

Now, elementally as you walk down those, the software content, I would attribute to a handful of deals that fell out of the quarter.

Frankly, we thought we had those right through the end of the quarter.

They rolled to the fourth quarter.

They would have accounted for about two points improved performance, which would have been more consistent with what we saw in the first two months of the quarter.

And those software deals were also part of the GMU performance.

So just as our software business would have performed better in the quarter, with the roll-up of those -- that handful of deals, so would our GMU performance.

Now, as you look at our growth market performance, in addition, they were impacted really by a couple of very large countries that had disappointing performance on a year-to-year basis.

So that would be Mexico and Australia.

They were both down double digits.

Our BRIC countries, as a whole, were up 11%.

And within that plus 11% positive performance, very consistent with what we've seen historically.

Brazil was in fact down 3%.

But on the other countries, Russia was up 11%, India was up 13%, and China was up a very strong 19%.

Now let's look at the countries in GMU outside of the BRIC countries.

Again, if we exclude Australia and Mexico, where we had the double-digit decline, the balance of the countries outside of the BRICs grew double digit.

In fact, we had 35 countries with double-digit performance.

So I would not attribute some broader trend to either of those perspectives.

In our GBS business, GBS once again produced very strong results on a solutions base, but we did have a more challenging environment for the more traditional package solutions.

The other solution content is linked to our key growth initiatives, so it's very important that we do well there.

So now if you take that data forward into the fourth quarter, I think on the software business and the hardware business, outside of the impact of the retail store systems divestiture, we should be seeing mid single-digit performance from both of them and driving double-digit profitability.

I think our services business will have a revenue base similar to what we saw in the third quarter.

But let me add, the services profitability that they each drove at 9% growth was right in the midpoint of their model performance.

And with that, as well as the new announcement content that we're getting out of our hardware business, we have a new Z, we have a new Power 7-plus entry in the high end of our P series, we've got new storage content, we feel quite confident in the at least $15.10 for the year.

Thanks, Toni.

Can we go to the next question, please?

The next question comes from Ben Reitzes with Barclays.

You may ask your question.

Yes.

Mark, you talked a bit about what could get better in the fourth quarter.

In terms of revenue, I believe you said the hardware and software revenue growth rates.

Can you talk about what could get better in the fourth quarter and even next year in costs?

You had a very -- a larger -- well, put in perspective, your workforce rebalancing for us and what cost levers you have going into the fourth quarter and beyond, please.

Thanks.

Sure.

I think the overall opportunity we have in cost really goes back fundamentally to the business model and how we drive that business model over longer periods of time.

The workforce rebalancing that we've done this year, in total, that was about $800 million, predominantly outside the US, and should have a payback of about 15 months.

Now, we are constantly driving workforce rebalancing to tune our population to the best growth opportunities that we have.

If you look at the overall cost and spending improvement that we saw in the third quarter, the first point I would make is that in a period of currency headwind, that impact that has in the overall translational effect of currency, that's mitigated and partially offset, obviously, by the hedge.

And you can kind of see that in the margin performance in our business.

You know, our gross profit margins were up 1.2 points, while our PTI was up 2.5 points.

And that differential, a large part of that is the offset of the hedge helping to offset the impact that we saw on the revenue line and its flow-through to gross profit margin.

The 1.2 points that we had in gross profit, that had a very solid mix component, about four-tenths of a point from mix and a very solid spend component.

And I think both of those are strong ongoing plays that we should leverage as we go into the fourth quarter and 2013.

That mix component is predominantly the mix that we see in the software that we've been driving for a decade.

And the spend efficiencies are part of that overall $8 billion plan that we have for the 2015 road map.

Obviously, you break that down by year, it's $1.6 billion.

By quarter, it's about $400 million.

If we get 30% to 40% to the bottom line, that's an advantage of about $150 million.

The balance, I would remind you, that really goes to making our offerings and our products more competitive on a price basis, given the ability to move spend to more aggressive growth opportunities.

Thank you, Ben.

Can we please go to the next question?

The next question comes from Steve Milunovich with UBS.

You may ask your question.

Thank you.

Given that September month weakness, could you talk a bit more about what customers are telling you in terms of the fourth quarter?

I've seen some CIOs express some concern about not just the election, but the fiscal cliff, and questioning whether we're going to see the normal budget flush.

And maybe you could tie into that what you're seeing in verticals.

It looked like (inaudible) slowed a bit, but it actually held in relatively well for you.

Do you think there's much downside risk in those going forward?

Yes, Steve.

I've got to admit, this was cutting out a little bit.

But I think I heard the substance of your question, so let me answer that.

I think as, you know, I'm not going to comment on the environment as if I were an economist.

But I can tell you the facts that we saw in the substance of the business, which I kind of described so far.

When you look at the overall issue of a fiscal cliff and a budget flush, I've got be honest, Steve, I kind of react to the position, because I don't think it would be a responsible kind of a performance for either public or private sector.

I mean, if we have spending requirements, I don't think people would roll out and maximize their spend rate this budget period to the expense of the overall spend requirements.

I know if it was my business and one of my controllers, the CFO, was quote, driving a budget flush, I would be driving them out of the business.

So certainly the controllers that I have met, in government, they are very responsible.

They are driving to do exactly the right thing and if they see spending pressure, they are doing their work to help respond to that.

To me, on a global basis, we look around the world, governments are under pressure.

Spending is under pressure.

I don't think this is news to anybody.

But I think, Steve, from my perspective, when you look at this proposition that there will be a budget flush, to me, as I had said earlier, I kind of react to that, because it implies, I think, that they wouldn't be responding to the base economic challenges they have.

And I don't think that's the case.

Thanks, Steve.

Can we take the next question, please?

Next question comes from David Grossman with Stifel Nicolaus.

You may ask your question.

Thank you.

Mark, I'm wondering -- I'm not sure if I heard you right, but I thought you said that both the outsourcing and transactional backlog were up this quarter on a constant currency basis.

Can you help us reconcile that with the continued loss of revenue momentum within the Services unit?

Sure.

If you look at the overall backlog, our total backlog for the quarter was up 1%.

Within that, our outsourcing backlog was relatively flat and our transactional backlog, if you just do the math, was up 7% now.

There are some dynamics that are pretty compelling within that.

So when you look at that outsourcing backlog and you break that down by unit, you see much more momentum in our growth market.

So if you take the total backlog for the business and break that down between major markets and growth markets, the backlog in our growth markets is up 15%.

And that's kind of an ongoing momentum that we've seen in our Services business in the growth markets.

If you break this then down by unit, on the GTS base of business, you know, I think they had a pretty good quarter there.

And actually the GTS business is up more than 1%, as we enter the fourth quarter.

I would also analyze the revenue performance in the quarter and remind you that we did take this very specific set of actions on the weak tail of the profitability distribution of our contracts.

And as we took that action on the weak tail, that enhances and improves our overall profitability.

You saw it in the first nine months of the year this year, with the strong performance we got out of the GTS business.

But it does have an impact on the other side, to revenue.

And we knew that, and we made that trade-off, because our objective is to drive real gross profit and real profitability in those contracts in the backlog.

It's not that hard to go through a Services business and drive big signings, but you have to live with that decision over a number of years in your relationship with your customer.

And our objective is to establish a strong relationship right up front, with a profitable set of contracts that we know we can deliver over the longer term.

So I think I would caution you from looking at that GTS business.

You've got to recognize that there was some revenue impact, as we optimized to profitability.

Thanks, Mark.

Excuse me.

Thanks, David.

Let's go to the next question.

The next question comes from Bill Shope with Goldman Sachs.

You may ask your question.

Okay.

Thank you.

I have a question on the Services segment as well.

We're obviously seeing a pretty big dislocation and restructuring effort at one of your largest services competitors, more than we've certainly seen in a while in this sector.

Is that having any noticeable impact on the competitive landscape?

And in outsourcing in particular, are you expecting to see any competitive tailwind as we go into 2013?

Well, I do think as we look at the capability that we're able to put on the field, we've got a pretty strong hand of very disciplined and experienced managers and executives, employees in the Services business.

And I've got to say, the Services business is not like the software business.

It is not like the hardware business.

It is a specific skill set.

So to the point that there is an impact on one of our competitors' profile, that certainly should provide us opportunity.

But, you know, when you look at the broader trends that I think are more significant, I think you got to look at the opportunity we're seeing in the growth markets.

And again, when you look at an opportunity set in growth markets where we have about 20% of our backlog, to be up 15%, that's a pretty strong statement, at very strong levels of profitability, where if you want to see where we can really put talent on the field, differentiated from the competition, there are a lot of examples in the growth markets.

Thanks, Bill.

Let's go to the next question, please.

The next question comes from Mark Moskowitz with JPMC.

You may ask your question.

Yes, thanks.

Good afternoon, Mark.

I want to come to the software business for a second here, if we could.

I know IBM's been pretty active hiring a lot more sales force individuals and capacity.

Has that had an impact on the business in terms of visibility or some of these deal push outs related to the expansion of the sales force?

No, I mean, as we hire -- and we're going to continue hiring as we go through the fourth quarter, you take that resource and you train it and make it more productive and drive it into your overall sales organization.

Now, that period of bringing that sales resource up to speed, takes some time.

But underneath it, if you look at our software business, the solutions content underneath it had a very strong quarter, up double digits once again.

And the solutions content is both organically generated, as well as the implementation of the integration with our acquisition profile, and that's been very strong across the portfolio of offerings.

It was a little more challenging and muted performance on the infrastructure side, but as you look at the fourth quarter, I think we have opportunities across both.

And so again, adjusting for that handful of deals in software that fell out of the quarter, we would have seen performance more consistent with what we saw in the first two months of the quarter.

And I think we have the opportunity to close those deals and get back on a stronger trajectory as we go into the fourth quarter.

So I think we've got a good software play here, and I would look for them to generate mid single-digit revenue growth in the fourth.

Thank you, Mark.

Let's go to the next question, please.

The next question comes from Keith Bachman with Bank of Montreal.

You may ask your question.

Hi, Mark.

I wanted to ask you about GBS in particular, and how you think growth can proceed as we look out.

And the context of the question is GBS on a constant currency basis has been down 1% in each of the first two quarters, was down 3% this quarter on, frankly, an easier compare.

You mentioned that Japan had stabilized, which is usually a positive impact on GBS.

So it continues to disappoint.

How does growth improve?

What causes it to improve?

Or is this the right kind of run rate for GBS as we look out over the next few quarters?

Well, I think we -- I don't disagree with your comments.

I can provide more background.

I do think we certainly do have the opportunity to improve.

I think the business did what we said we were going to drive in Japan and we did stabilize our business in Japan.

I think the team in Japan did a nice job.

What we really wrestled with a little here was the challenge that we had in those more traditional packaged solutions, and they were generally third party offerings and HR supply chain or ERP.

On the flip side of the coin, though, we did a great job in GBS on those key growth initiatives and the solutions attached to those.

So on one hand, I would have liked to have seen, I know the team would have liked to have seen, better performance in those traditional packaged areas.

And we're going to be rebuilding capability as we go into the fourth quarter and 2013.

But I thought they did a very nice job on the Solutions business, which is so important, because it cuts across our business profile into Hardware, Software and Services business.

And let me remind you, as we all know, those solutions drive about 50% mix in overall software business.

So we can do better as we work on that traditional package solutions, but I think they deserve a lot of credit for the work they have done on the Solutions business.

Thanks, Keith.

Can we go to the next question, please?

The next question comes from Katie Huberty with Morgan Stanley.

You may ask your question.

Yes.

Thanks, Mark.

Can you talk a little bit more about what you expect out of the recently announced server and storage products?

Specifically, are you looking for growth across all the server products in the fourth quarter, or do you think growth can carry into next year?

And is there a structural shift towards better margins, just given that your innovation seems to focus on the higher margin categories within servers?

Sure.

I would break the new announcements into three categories.

The first two, we are introducing the new high end Power 7 plus.

And we're -- I think that has a lot of key technology offerings.

It's only part of the product line, however, but it is the high end.

So we look at that as a real margin opportunity within the mix of their product line.

Likewise, in the storage business, we're announcing the new high end content, introducing Power 7 to our architecture, and we think that likely has real opportunity in a high end for not just revenue, but margin contribution within their product line.

But clearly, the big announcement for the quarter is the new Z series.

And as we look at the new Z series, now we have a full quarter of opportunity.

You know, in the third quarter, we're really only shipping the new Z for about 11 days in the very back end of the quarter.

And in front of that ship date, we only had about three weeks of selling time.

So now it gives us the opportunity for a full quarter's worth.

And as I look at it, I think they have a very strong case on a hardware basis for the new Z platform to generate 20% to 30% growth.

So within all of that, that gives us confidence within our objectives that the hardware base of business ought to be generating about 5% revenue growth outside of the impact of the divestiture to retail store systems content.

Now, that divestment has about a 4 point impact to the hardware base of business and about a 1 point impact to IBM.

But I think we do have a good hand on that content and we'll see it improve the overall hardware performance, not just in North America, but as we go through the global rollout as well.

Thanks, Katie.

Let's go to the next question, please.

The next question comes from Jim Suva with Citigroup.

You may ask your question.

Thank you.

And congratulations, Mark, to you and Patricia and your team there.

The question I have is, on your bookings, they were up very meaningfully here, up 8% year-over-year at a constant currency up 11%.

As you look into that, just curious if there's anything in that number that was one-off, such as something that maybe slipped in from Q2 last quarter or pulled in from Q4, or any special big one-time special bookings, and any changes of durations, just that we should be aware of.

Thank you.

No.

I think that was capitalizing on the opportunities with the advantages that we can bring to the marketplace.

Again, if you look at the backlog content, and I think that's the best metric to use here, while backlog was up 1% overall, it was up 15% in our growth markets.

And if you look at the components of total backlog between outsourcing and transactional, outsourcing relatively flat, while transactional was up 7%.

But the more -- I would not say there were some kind of very unique contracts that were inconsistent with our overall rollout contributing to that.

I think one of the very powerful trends that we do see is how well our content and our capability plays in new opportunities, as we look at growth markets.

And I think that's the more substantial trend line we see here.

Thank you.

Thank you.

Congratulations to you and your team.

Thank you.

Operator, let's take one more question, please.

Thank you.

The last question comes from Chris Whitmore with Deutsche Bank.

You may ask your question.

Thanks very much.

I wanted to come back to Services margins one more time, if I could.

What I'm really trying to understand here is the dynamic between the pruning of some unprofitable contracts.

Is that nearing completion?

Is there more room to do on the pruning side?

And then secondarily, are most of the workforce rebalancing efforts targeted at driving Services margins?

And if so, can you frame a medium term margin target for the Services business, say in 2013, do you expect margins to improve further from these levels?

Thanks.

Yes, so let's look at the overall margin dynamics for the corporation.

When you look at it, we are driving that very focused piece of work that Linda Sanford took you through at the analyst meeting, to generate about $8 billion of spend takeout across the business.

And as I had said earlier, if you just mathematically break it down, it's about $1.6 billion a year, or $400 million a quarter, that content is, in some respects, outside of the business unit purview.

And it gets to applied to those business units, based on their metrics and participation.

So in other words, if we take big spend rate out of the back office support organizations, the business units are the beneficiary of that spend take-out, but they didn't have to drive a lot of the content, since we manage on a globally integrated enterprise.

And that's a very structured play that we're driving, not only across our back office content, but now into systematic areas that span across our processes and also spend rates within business units that collectively have more opportunities.

So we intend to continue that overall spend dynamic.

And as I had said earlier, our Services business will certainly be a beneficiary there.

Now, in your question about the overall workforce rebalancing that we do, just given the fact that the Services business have the largest share of our overall population, of course they are going to be the beneficiary of that as well.

But to me, on the longer-term basis, I think that the model base that we provided as part of the 2015 road map is the best criteria, the best content that you can see, as you look at that long-term run rate.

So as you look at how we would attempt to implement those as we go into 2013, I mean, believe me, this team is going to look at the actuals that we drive in 2012, we're going to draw a plumb line to that 2015 objective, and then we're going to base our profitability, our free cash flow, all of those content, our budgets support it, as well as our compensation.

So that's how we'll be driving that.

So let me just take a moment now to wrap up the call.

You know, despite facing challenges, we did deliver 7% growth in profit, 10% growth in our operating EPS.

And I think, consistent with the last conversation, that performance reflects our disciplined approach to delivering profit growth.

The quarter, we had 10% growth in our Software profit, 9% from our Services businesses, both of which benefit from a large annuity base.

We're continuing the move up the value chain, shifting our portfolio to more strategic areas.

Now we had continued momentum in our growth initiatives.

Both Smarter Planet, Business Analytics, as well as our Cloud were all up strong double digits.

And this quarter we completed the divestiture of our retail stores solution business.

The benefits from our ongoing work on productivity showed through to our margin, and we're returning value to our shareholders through share repurchase and dividends.

So looking forward, as we enter the fourth quarter, as always, we need to execute.

And we need the growth market in the Software to close those rollover deals that we discuss and drive an improved trajectory in the fourth quarter.

We need GBS to drive more of that traditional package transactions content, while maintaining the good momentum they have shown in our growth initiatives.

And I think North America needs to capitalize on the great hardware product lineup we have for the fourth quarter, with the new Z, a new P, and storage to drive transactional sales performance in the fourth quarter.

So based on this, we are confident in our plans to achieve at least $15.10 of operating EPS for the year.

That's up 12% from last year, and on track to at least $20 in 2015.

So once again, thanks for joining us, and now, as always, it's back to work.

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