International Business Machines Corp (IBM) 2013 Q3 法說會逐字稿

Welcome and thank you for standing by.

(Operator Instructions)

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.

The 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 their related GAAP measures in accordance with SEC rules.

You will 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 $23.7 billion in revenue, expanded gross and net operating margins and increased operating earnings per share by 10% to $3.99.

For the year, we're maintaining our full year 2013 expectation for operating EPS of at least $16.25 on an all-in basis, or $16.90 excluding the second-quarter workforce rebalancing charge.

Looking at the results by business, our total services business returned to modest revenue growth at constant currency, led by 5% growth in GBS.

Our backlog was up 2% or 6% at constant currency, with another strong performance from GBS.

Software delivered mid single-digit growth at constant currency in key branded middleware.

In hardware, growth in System z mainframe was more than offset by declines in power, System x and storage.

Two-thirds of the overall hardware decline was driven by the growth markets.

Across IBM, we delivered strong performance in our growth initiatives that addressed key market trends, Smarter Planet, Business Analytics and Cloud, leveraging both organic investments and acquisitions.

Our Smarter Planet solutions are up more than 20% through September and Business Analytics is up 8% year-to-date.

In Cloud, we closed the acquisition of SoftLayer in July, which significantly improves our capabilities in public and hybrid Cloud.

For the first time, we delivered more than $1 billion of Cloud revenue in a quarter, of which $460 million is delivered as a Cloud service.

Through the first three quarters, our Cloud revenue was up more than 70% year to year.

From a geographic perspective, our challenge this quarter was in growth markets, where revenue was down 9% or 5% at constant currency.

Our performance in growth markets has historically out-paced major markets by 8 to 10 points, but this quarter for the first time the growth markets trailed the majors.

I'll get into the specifics and actions later in the call.

For the quarter, IBM's revenue was down 4% or down about 1.5 points at constant currency, so the currency impact to revenue was about 2.5 points.

Currency also impacted our profit performance.

As we've discussed in the past, a weakening yen drops largely to the bottom line.

This quarter we improved gross and net margins.

Our operating gross margin expanded by 1 point, driven by an improvement in services margins and the relative strength of software and mainframe.

The net margin improvement also reflects savings from the second-quarter workforce rebalancing activity, tough-minded spending actions and a better tax rate.

There are three drivers of the lower tax rate.

First, discrete benefits associated with recent foreign tax audits.

Second, a reduction in the ongoing effective tax rate, which we now expect to be in the range of 23% for the year, and through 2014.

And third, last year's tax included a higher rate on the gain from the divestiture of our RSS business.

Bottom line, we delivered operating EPS of $3.99, which was up 10% year to year.

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.

I'll start with a few comments by major geography and then provide a perspective on the major versus growth markets.

Americas' revenue was flat year to year, which is a 3-point improvement from last quarter's rate.

The improvement came equally from the US and Canada, and once again we had strong performance in Latin America.

Our EMEA revenue was down 2%, fairly consistent with last quarter.

Western Europe in particular showed some stability, while Eastern Europe led by Russia had double-digit declines.

In Asia-Pacific, revenue was down 4%.

Within that, Japan's revenue was up 5% with good performance across hardware, software and services.

This was the fourth consecutive quarter of revenue growth with good execution by the team in Japan.

Consequently, the AP decline was driven by the growth market countries.

So now let me comment on the major markets versus growth markets globally.

Major markets' year-to-year performance improved by almost 2 points from last quarter.

In fact, this is the best major market performance since the first quarter of 2012.

Our challenge this quarter was in the growth markets, which were down 5%.

Though we continued to gain share and deliver strong growth in Latin America as well as Middle East and Africa, we fell short of our objectives in the market in other regions.

Our performance in growth markets was driven about half by execution and half by a pause as China moves through the process to develop its new economic plans.

China was down 22%.

We experienced a slowdown in demand across the board, but most significantly in hardware, which was down about 40%, and which makes up about 40% of our business in China.

While we had some execution problems during the third quarter, we were impacted by the process surrounding China's development of a broad-based economic reform plan which will be available mid-November.

In the meantime, demand from state-owned enterprises and public sector has slowed significantly as decision making and procurement cycles lengthened.

We believe the changes will take time to implement and do not expect demand in China to pick up until after the first quarter of next year.

Now let me put this in context.

The hardware performance in China accounted for all 5 points of the constant currency decline in the growth markets, and for 1.2 of the 1.6 points of constant currency decline for all of IBM.

Regarding execution in the growth markets, we understand the issues and have already taken management actions to improve performance.

Looking forward, we have confidence that we can get this back on track.

We expect a change in trajectory starting in the fourth quarter, and will be back to growth early in 2014.

Turning now to IBM's revenue by segment.

In GBS we improved our year-to-year constant currency growth rate to 5%, led by consulting and systems integration.

Our GTS performance is a modest improvement from last quarter's rate, reflecting the addition of SoftLayer to our portfolio.

Our software revenue grew 2% at constant currency, led by key branded middleware at 4%.

Performance was stronger in the infrastructure layer, including solutions for data management, application servers, security, mobile, and rational development tools.

As I said earlier, in systems and technology, the deceleration in our performance was primarily driven by the growth markets.

In global financing, we had growth in both financing revenue, which was driven by client asset growth as well as new sales.

The return on equity in our financing business was 38% this quarter.

Turning to gross profit.

Our operating gross margin improved 1 point, driven by a combination of margin expansion in both services segments and an improving segment mix.

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 flat year to year.

Acquisitions over the last 12 months drove 2 points of expense growth.

Currency contributed 1 point of decline, driven by translation.

So consequently, our base expense was better by 2 points.

Now I'll comment on a few items that had year to year impacts.

Last year we had a significant charge for workforce rebalancing activity.

We also had a significant gain from the sale of our retail store solutions business.

So looking at the year-to-year dynamics, in SG&A workforce rebalancing is down nearly $400 million year to year, and in other income and expense divestiture gains are down over $450 million.

Next, parts of our business didn't perform as expected and as you know, IBM has a pay per performance culture.

Accordingly, performance-related compensation across both cost and expense was down about $175 million year to year.

Finally, I want to comment on the impact of currency this quarter.

In the third quarter, the hedge activity was fairly neutral in the period, though on a year-to-year basis hedging gains were down about $80 million, with about three-quarters in expense and the balance in costs.

While there have been a number of currency movements year to year, we have been significantly impacted by the depreciation of the yen.

Because our business in Japan is dominated by local services, without cross-border cash flows to hedge, the impact falls largely to the bottom line.

The year-to-year profit impact was more significant than the third quarter, and would continue at current spot rates through the first quarter of next year.

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

This quarter the two services segments generated $14 billion in revenue, declining 3% as reported, but at constant currency returned to growth of 1%.

Pretax profit was up 17% and pretax margin expanded by 3.3 points.

Total backlog was $141 billion, up 2% at spot rates and up 6% at constant currency.

Backlog again grew across both the transactional and outsourcing businesses.

Turning to the two segments, Global Technology Services revenue was $9.5 billion, down 4% or down 1% at constant currency.

This represents a 1 point improvement over last quarter's year-to-year performance.

In outsourcing, we continued to see a decline in revenue from sales into existing base accounts, and from the structural work we did previously on low margin contracts.

Our integrated technologies services revenue was up 2% at constant currency and grew in both major and growth markets.

GTS delivered 12% pretax profit growth in the quarter and expanded pretax margin by 2.8 points.

Margin expansion was driven by lower year-to-year workforce rebalancing charges and some savings from second-quarter rebalancing action, along with tough-minded spend actions and continued efficiency improvements.

Turning to Global Business Services, revenue of $4.6 billion was flat as reported, and up 5% at constant currency.

That's up from 2% last quarter.

With this performance, GBS gained share.

From a geographic perspective, there is growth across the portfolio, led by North America and Japan.

Europe returned to growth for the first time since the beginning of 2012.

Looking at the GBS business by our two major categories, we had good results across the portfolio.

Within the digital front office, we delivered double-digit growth across the initiatives, Business Analytics, Smarter Planet and Cloud.

And within our back office solutions that we call the Globally Integrated Enterprise, we again grew in implementation services that support the traditional packaged applications.

Turning to profit.

GBS grew 28% year to year and PTI margin expanded by 4.4 points.

The year-to-year profit drivers included lower year-to-year workforce rebalancing charges, savings from second-quarter rebalancing, and tough-minded spend actions.

So to wrap up services, we returned to revenue growth this quarter.

Our growth initiatives continued to perform.

We grew pretax profit and expanded profit margins.

And we're entering the next quarter with solid backlog growth of 6% at constant currency.

Software revenue of $5.8 billion was up 1% or 2% at constant currency.

Segment pretax income of $2.4 billion was up 2%.

Our strategic key branded middleware revenue grew 3%, or 4% at constant currency, and held share.

I'll take you through the drivers by brand.

WebSphere was up 1% at constant currency.

Within WebSphere we saw strength in mobile and good performance in application server.

Information management software grew 3% at constant currency.

Our distributed database had a good quarter with double-digit growth.

Tivoli Software was up 3% at constant currency driven by storage growth and our portfolio of security solutions.

Our security business delivered another quarter of double-digit growth.

The acquisition of Trusteer in the third quarter extends our data security capabilities further into cloud and mobile environments.

Rational grew 14% at constant currency.

Rational's DevOps solution leverages IBM's Cloud capabilities for the rapid and iterative deployment of software.

Social Workforce Solutions grew 15% driven by Kenexa, which provides cloud-based recruiting and talent management.

Looking forward to the fourth quarter, we have a strong pipeline in software.

Consequently, we expect improvement in software revenue growth and double-digit growth in profit.

Systems and technology revenue of $3.2 billion was down 17%.

The growth markets' performance drove two-thirds of the revenue decline, about half of which was China.

This impacted each of the hardware brands.

System z grew 7% at constant currency, with double-digit growth in the major markets.

MIPS were up 56%, driven again by specialty engines, which were up more than 90%.

During the quarter we successfully launched the new zEnterprise mid-range server, with over 50% more capacity than its predecessor.

Power revenue was down 37% at constant currency.

High performance computing accounted for 10 points of the decline.

To improve future performance, we're continuing to invest to expand our Power platform to go after the Linux opportunity, which is now larger than Unix and growing more rapidly.

System x was down 16% at constant currency.

Storage Hardware revenue was down 10% at constant currency.

The decline was driven by the growth markets.

In the major markets, storage revenue was up.

Our Storwize products again delivered double-digit growth and we also continued to grow our flash solutions.

These were offset by declines in our legacy OEM mid-range offerings and softness in the high end.

PureSystems continued to gain momentum.

In the major markets we grew more than 30% sequentially.

Globally, we shipped over 2,000 systems in the third quarter, with over 8,000 total shipments since announcement.

Moving on to the cash flow analysis.

We discuss our free cash flow performance excluding the change in global financing receivables.

We do this because we consider the financing receivables as an investment to generate returns, not as working capital that should be minimized for efficiency.

As I mentioned earlier, our global financing business is delivering a terrific return on equity.

This quarter we generated $2.2 billion of free cash flow, down $900 million year to year.

There were three key drivers of the year to year decline.

Higher workforce rebalancing payments for the second-quarter program, changes in sales cycle working capital, and our operational performance.

Through the first three quarters of the year we generated $6.6 billion, which is down $2 billion year to year.

Looking at the uses of our cash through September, we spent $2.6 billion to you acquire seven companies, including four in the third quarter, the largest of which was SoftLayer.

We've returned just over $11 billion to shareholders this year.

We paid out $3 billion in dividends and spent over $8 billion in gross share repurchase to buy back almost 40 million shares.

At the end of the third quarter, we had $5.6 billion remaining in our buyback authorization.

Turning to the balance sheet.

We ended the quarter with a cash balance of $10.2 billion.

Total debt was $36.2 billion, of which $25.8 billion was in support of our financing business which is leveraged at just over seven to one.

Our non-financing debt was $10.4 billion, effectively flat year to year, and our non-financing debt to cap was 39%.

We continued to have a high degree of financial flexibility with a strong balance sheet to support our business objectives.

When you look at the year to year drivers of our operating EPS performance, the 4% decline in revenue at constant margin impacted profit growth by $0.15 per share.

Margin expansion was the largest contributor to our growth.

Within that, we had positive contribution from gross margin expansion and the lower tax rate, mitigated by a higher E to R. Our ongoing share repurchase program contributed to the balance at a level fairly consistent with last quarter.

So to wrap up, in the third quarter the combination of continued momentum in key growth areas, better business mix, yield from productivity initiatives, reductions in spending and compensation, discrete tax benefits, and effective use of cash all enabled us to deliver 10% operating EPS growth.

Clearly, we need to improve performance, predominantly in the growth markets.

And keep in mind that we're dealing with a couple of substantial headwinds.

We absorbed a significant impact from currency in these results and are affected by the pause during the development of China's new economic plans.

As far as the growth markets are concerned, we will be dealing with the China impact for another couple of quarters.

More broadly, in growth markets, we're taking management actions to improve execution and are confident we can get it back on track and improve our performance starting the fourth quarter, driving to mid single digit performance in growth markets in 2014.

Looking to the future, we expect continued strong performance in our growth initiatives, Smarter Planet, Business Analytics and Cloud.

These not only address key market trends, but they drive a higher mix of software and consequently a higher margin.

We'll continue our transformation over the long term to a higher-margin annuity base and even stronger business profile.

And so with this improved operational performance, continued momentum in our growth initiatives and the flexibility in the financial model, we're maintaining our view of at least $16.25 of operating EPS in 2013, and remain confident in our ability to achieve at least $20 in 2015.

Now, Patricia and I will take your questions.

Thank you, Mark.

Before we begin the Q&A I'd 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 from 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'd like to begin the question-and-answer session of the conference.

(Operator Instructions)

The first question comes from Steve Milunovich with UBS.

You may ask your question.

(Technical difficulty) -- pipeline and maybe mid single digit revenue growth and a return to growth in Services --

Sorry, Steve.

Steve, can you start at the beginning?

We missed the beginning of your question.

Can you hear me?

Now we can, yes.

Okay.

Sorry about that.

Coming into the quarter, Mark, you talked about mid single-digit revenue growth in software and somewhat stronger services growth than you posted.

So even aside from the hardware issues in China, it seems like things are a bit weaker.

What do you attribute that to?

Is it just demand, as we're hearing at a lot of enterprise companies?

How much of it is execution?

Because in the third quarter last year, you had some software execution problems.

You're talking about some growth market execution problems.

How much is under your control?

How much isn't?

Well, let me answer your question in stages, just as you asked it.

So let's start with software.

I agree, we did not have the software quarter we were looking for.

If you look historically, both for the IBM Corporation and certainly for the software business, third quarters tend to be difficult for us.

Fourth quarters tend to be strong.

So I would expect, based on all of the work we've done, to look at their pipeline going into the fourth, that we would maintain that relative characteristic, and see our key branded middleware with growth rates in mid single-digits and double-digit profitability in the fourth quarter.

If you look at the characteristics, once we get to the end of the year, obviously quotas close out December 31, so there's an awful lot of energy in the sales organization as we close the year.

But we have typically had this same pattern as you have seen, if you go back the last number of years, with a difficult third followed by a stronger fourth quarter.

And I think that has a lot to do with our overall software performance.

Now, when you go to the services organization, however, I would say that first of all with backlog up 6%, that's pretty good performance.

And if you look at the GTS business, GTS did improve revenue, albeit on a more marginal base.

But the GTS are long extended contracts.

It is kind of the battleship to turn here.

On the other hand, GBS, at 5%, I think that's pretty good.

And if we look back on the GBS profile over the last four quarters, they've taken that business from a minus 2, to a plus 5. As we look at their strength as they have built that backlog, we see closer to plus 7 as we go into the fourth quarter.

And in both cases returning services as we had said, to growth in the third quarter, and both third and fourth generating double-digit profitability.

So I do think we saw the cadenced improvement on our services business.

I think on the software side, we wrestled with this typically weaker third followed by what we are looking to be a stronger fourth.

Thanks, Steve.

Can we go to the next question, please?

The next question comes from Toni Sacconaghi with Sanford Bernstein.

You may ask your question.

Yes, thank you.

I wanted to follow up on the first question, but a bit more broadly.

I understand some of the specific issues this quarter around China, but if we step back and think about what's been happening to IBM over a longer period recently, you've had six straight quarters where revenue growth has been negative.

You've missed consensus revenue expectations for seven straight quarters.

If it weren't for a huge tax benefit this quarter, it would have been a very significant EPS miss, which has occurred to IBM in the last couple of quarters and hadn't occurred in seven or eight years.

If we step back beyond the current quarter, we see a pattern of financial performance that is way out of whack with your historical model.

Lower revenue growth and operating profit growth that is dramatically lower, but has been buttressed by tax rate, and not including workforce rebalancing charges.

My simple question is, what's changed in the last six or seven quarters?

Has there been less of a focus on execution that had to do with the change in leadership at the top?

Are you seeing new secular forces?

I think it's very easy to explain away a given quarter, but six, seven, eight quarters in a row begin to make a trend.

And so perhaps you can try and address what you think is happening more broadly, and whether we should be thinking about a financial model that is more like 0% revenue growth, and something less than double-digit earnings growth on a sustained basis.

Okay.

Toni, as always, a very good question.

Let me answer your question by giving you a framework for how I would look at that in 2013, then moving into 2014 to give a framework for the dynamics and how we intend to deal with them.

So first of all, to state the obvious, we never said that the road map progression would be a straight line.

We're assessing our progress on a year-to-year basis versus the $16.25 at least for the year.

I will say that to me, and I think we have stated this repeatedly, that tax and shares are operational cadence for us.

But I do not debate your point that we have had some very discrete difficulties as we've gone through the quarters, which I want to address now.

I would say broadly that plus or minus, the software and services portion of our business has been marching down the field in the structure that we're looking for.

We talked a little bit earlier, GBS has made very good progress.

We got backlog up at 6% at constant currency.

We did get some lift in our GTS business, both generating profitability.

So I don't think the services businesses have shown a substantially different vector, and in fact, are improving as we go forward.

Software, I agree with the point, difficult third quarter.

I got to say in that software organization just like for the broader IBM, we tend to have more difficulty in third quarters and stronger fourth quarters.

But to be specific to your question, what's changed, we had two major headwinds that really hit us hard this year.

So on a year-to-date basis, we had $1 billion of year-to-date decline in profitability from our hardware business.

Now, that is quite substantial.

That is quite substantial as a headwind.

And on top of that $1 billion of profit decline in our hardware business, we had a $500 million year-to-date, year-to-year impact from currency.

Now, that's clearly the theoretical upper limit.

But given the fact that the bulk of that impact is from the movement of unhedged currencies like the impact from the yen, that presented us with a pretty stiff challenge.

So in a way, if you look at the bottom line performance in 2013, the elements of financial flexibility, whether that be tax, both the discrete items that we recognized in the third quarter, or the improvement of the rate which extends through 2014, or the benefit of share repurchase, has helped along with the operational performance that we did see from software and services, helped mitigate, absorb and partially offset this very strong headwind we had in the hardware business and the currency.

If you looked at currency, currency at current spot rates should right itself as we go into the second quarter of next year.

Obviously, we'll all be tracking that over time.

That's what the math would say.

So that leaves us with the impact from hardware.

If you look at the Hardware content, the point we were making in the third quarter performance, that in that hardware base of business, the kind of nexus of erosion that we had, was really in China.

China, broadly in a year, accounts for about 5% of IBM and about 40% of that business is hardware.

But the hardware business across those elements of the product line excepting z series performance, it was down substantially.

I mean, we're talking 40%, 50%, enormous reductions on a year-to-year basis in a geography where we had tended to see growth rates.

You could see that in the compare we had to China last year, up 19%.

So up 19% last year, driven heavily by really strong performance on hardware base, this year down.

And you've got to look at that and say -- what significantly accounts for that?

And I would say quite honestly, if you look at the elements in China and as we have worked with the team in China, there simply has been a substantial impact as the process surrounding China's development of a broad-based economic reform plan takes shape.

That is going to be announced and available, we think in November, probably will take some time to implement.

I think we're looking at a couple of quarters.

But once that economic plan is announced, adds clarity to the market, we should see, I think, and certainly within our team, a recovery in the demand pattern for state-owned enterprises in the public sector.

If you look at the profile that we would be counting on that generating next year, we'd be looking for the growth markets with that new economic plan in China to recover and generate something mid single digits.

And in fact, if you took that hardware impact that we saw in China, frankly that hardware impact in China is all of the decline in our growth markets unit.

So I think that's a rational set of objectives.

And with that performance in our growth markets unit, next year again back to mid single-digits as we get the better definition on the economic plan in China and improved performance across the other regions in GMU, that too should help us suspend the erosion that we're seeing in our hardware business.

So on a year-to-year basis, I frankly think we have set a pretty low bar to establish our financial structure and our operations objectives for our other business units, expecting only flat year-to-year profitability, which clearly this year is a loss.

One would think we could do even better than that.

But on a flat basis for the STG business in 2014, compared to 2013, with our new p series POWER8 product set to address the Linux opportunity, which you know is larger than Unix opportunity and growing.

Better growth and volume behind our pure flex business which is picking up steam and broader exposure to our flash memory content within storage, that should help us right-size it even though in the mainframe side of the house we'll be driving more towards the micro code upgrade, part of the z series cycle.

All of that clearly complemented in 2014 by the benefit on a year-to-year basis of the workforce rebalancing yield that we've already taken, which in '14 will be more than enough to offset the year-to-year challenge from the tax discrete items that we saw this year, complemented additionally by the financial flexibility that we have to drive share repurchase.

Thanks, Toni.

Let's go to the next question.

The next question comes from Bill Shope with Goldman Sachs.

You may ask your question.

Okay, great.

Thanks.

On the growth markets challenges, I think you've been very clear on the macro drivers and the government issues within China.

But looking at the execution component you mentioned, as we think about the normalization process here, could you give us some more granularity on exactly what the execution issues are?

And I think when we look at this longer term, given how sharp some of the downturn, or how sharp some of the shortfalls are in this segment for you, what gives you confidence that the problems in Asia-Pac in the growth markets specifically aren't secular in nature for IBM?

Yes.

Let me give this framework for the explanation.

First of all, if you look at the performance that we saw this quarter in growth markets, revenue at constant currency down 5% compared to the IT growth rate in growth markets of plus 5, we've got about a 10 point gap there.

We did a very simple back of the envelope analysis on that to distinguish what was macro and what was execution.

And we said well, if we took that big STG erosion that we saw in China, that we could conclude is highly related to the process of developing the Chinese economic policy, if we snap that out the growth markets would have been flat.

And so to us that sounds like about 5 of that 10-point gap to the industry coming from a macro environment issue.

The other 5 we think is pure execution.

Now, I would argue that you've seen our ability to put leadership teams on the ground to turn our performance in geographic.

The hallmark in that respect for us, is Japan.

Japan has really turned around in a very big way under the leadership of Martin Jetter and his team that engage quite broadly.

And we've seen that perform quarter after quarter with that leadership capability.

So in the growth markets organization, the leadership team that established that to begin with and drove that organization is now back in the cockpit, led by Bruno Di Leo and his leadership team.

They know how to get this done.

They helped build this to begin with.

So I think that's an explanation on the macro environment impact that we saw that we would say accounted for about half that differential to the industry as well as the leadership differential and the actions that IBM has taken to address those on the execution element.

Thanks, Bill.

Can we go to the next question, please?

The next question comes from David Grossman with Stifel Nicolaus.

You may ask your question.

Thank you.

I wonder if we could just turn to free cash flow for a minute, Mark.

Is the free cash flow year-to-date in your view, a good proxy for the 2013 decline?

Or do you think you go up or down in the fourth quarter?

And then secondly, are you still comfortable given where we are and where the fundamentals of the business are with the free cash flow target outlined in the 2015 road map?

Yes, a very, very good point.

Let me address that, starting with where we see ourselves in 3Q and year-to-date basis.

So year to date, we are down $2 billion in free cash flow.

And if you looked at the drivers behind that, that would be broken down into the operational performance, obviously, of the business, our performance on sales cycle, working capital.

Those two I would say are execution-based and then the complement being the impact that we've seen on cash tax.

We do see that now as more in the little over $1 billion range.

We originally thought more like $2 billion.

We now think it's more like $1 billion.

And the cash side of our workforce rebalancing.

But that's only the elements of that year-to-date performance.

I think more importantly is how we see that full year 2013 free cash flow which will be down on a year to year basis, how we see that moving through the road map to 2014 and 2015.

In 2014, based on that same structured model that I described to you, we would see our free cash flow, excepting the impact of cash taxes, growing at a rate of about 15% to 20%.

Cash taxes, we believe now in 2014, will be a headwind of about $2 billion.

But even including cash taxes, we would see our free cash flow growing by a little over $1 billion.

The operational profile within that, in that 15% to 20% range and on that basis free cash flow growing faster than net income.

Going to 2015, we would see that free cash flow now including the inclusion of cash taxes growing at about 15% to 20%.

Again, free cash flow growing more rapidly than net income.

And in 2015 that cash taxes should be a tailwind, as opposed to the headwind that we've been wrestling with in 2014 and 2015.

If you took that back and say -- let's structure that around the financial road map, as you remember, the road map we detailed what we saw in the usage of free cash flow and said we expected to spend about $90 billion between share repurchase, dividends, and acquisitions.

That $90 billion on a gross basis, is about $85 billion, $86 billion on a net basis.

And the free cash flow that we see across the road map is also in that range of $85 billion plus or minus.

So over the road map, those two relatively balance, and that's not including cash in-flow that we would think would be likely from potential divestitures.

With that basis, even though we had a disappointing free cash flow performance this year, we still see the overall construct through the road map supporting those original objectives.

Now, across those elements of share buyback, dividends and acquisitions, there's fungibility.

You've seen that even in our to-date performance on the first 2.5 years of the road map, more share repurchase, a little less acquisition.

I don't think the category or the cadence across the years will be linear.

But I think the aggregate is still very, very relevant and the best guide for you to use as you look at our usage of free cash flow.

Thanks, David.

Can we go to the next question, please?

The next question comes from Ben Reitzes with Barclays.

You may ask your question.

Yes, thanks.

I appreciate it.

Mark, I wanted to ask you about the $20 road map and the philosophy behind it.

I think what our challenge tonight is going to be when we go back to investors and we look at the base of 2013 and we exclude all the tax benefits, we're talking about a number that might be around $16.

We're talking about trailing free cash flow of around $14.60.

Eventually free cash flow and earnings tend to migrate to each other and then let's just forget free cash flow and start at a $16 base.

You got to grow 12% each year to get to $20.

I'm just thinking with the acceleration, that we've got to convince people that you're getting there.

So I'm wondering what is the confidence level in the $20, based on that kind of a conversation that we need to have with investors to get you there?

And how do we get them there?

And what your confidence level as of today?

Thanks.

Yes.

Really, the basis for that trajectory to 2015 involves, number one, in 2014 stabilizing our STG, our hardware business on a profitability basis, to be relatively flat on a year-to-year basis.

We've absorbed this year that $1 billion decline on a year-to-year basis.

I showed how I thought that really did correlate based on the work the team has done to the issues we had in China.

We believe it should be a very reasonable objective to stabilize on a year-to-year basis relatively flat profitability with STG.

We're able to do that, the vehicle for that being new product announcements across our STG businesses, as well as returning growth markets to mid single-digit growth on a constant currency basis, once we get through this process surrounding China's development of a broad-based economic reform plan.

Those two capabilities are the primary elements to stop the erosion in profitability in that part of our business and then have the operational profile for software and services show through the bottom line.

Additionally, this impact that we've wrestled with on currency, again, Ben, on a year-to-date basis, a $500 million headwind, at a theoretical limit, that should reverse and actually be a tailwind in the second quarter of next year.

And then lastly, if you look at the complement to help offset the year-to-year headwind from the discrete tax benefits that we have in 2013, really the flow-through of the workforce rebalancing yield that we've already completed should be more than enough to neutralize that \and allow us to take really the financial flexibility, the strength of the balance sheet to complement that operational performance and maintain that trajectory in 2014 on our way to at least $20 in 2015.

Thanks, Ben.

Let's go to the next question, please.

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

You may ask your question.

My question is also how do you get there in terms of 2015?

Mark, I was hoping you could specifically address how you're thinking about revenue growth, which has been, not only from a currency perspective, from an absolute dollar perspective, how you're thinking about next year.

If we focus on services for the second, how does the pipeline and the backlog you mentioned is up 6%, if you're thinking about services for FY 2014, if you provide any dimensions about how you're thinking about the growth profile there, is it 1%, 2%?

Or is it small single-digits?

And the second part of that question is, can hardware really be a flat revenue number as you think about CY 2014?

Because seems like there will still be extraordinary pressure on the market overall.

Even with normal products, just curious if you think that could be a flat number with all the currency assumptions that you've already outlined.

Yes.

First of all, on the hardware base, my point was to drive the STG hardware business to flat profitability.

I agree with you, I don't think that's going to be necessarily flat revenue, but flat profitability based on all the work that we've done.

I will say in that skew in 2014 for our hardware business, that would probably be driving in the first half down $200 million, in the second half up $200 million but relatively flat profitability, not revenue, on the STG side of the business.

I'd point out that's a relatively low bar given the level of profitability the hardware business will have generated in 2013.

On the services side, I do think it's worth clearly recognizing the real contribution that the GBS team has driven by constantly improving that backlog performance, and then yielding that backlog performance right to the revenue line.

Let's go back on that four-quarter march that they've been on.

They've been methodically driving a couple of points improvement every quarter.

That's why we feel it's a very confident basis for us to look at 7% revenue growth for GBS in the fourth quarter.

And if we have 7% revenue growth for that platform with ongoing improvement in the backlog, given the momentum they've been able to drive, with the faster take-up of backlog to revenue for GBS, that should really assist us as we go into 2014.

But I think within that, the linchpin assumptions that we need to drive for 2014, and 2014 being the platform for moving into 2015, is stabilize that STG business at the low-level of profitability we see this year.

Return GMU back to mid single-digit growth as we get through the process surrounding China's development of their broad-based economic reform plan, allowing the improving momentum we see on the services business as well as a return to their more consistent profile in software business to help drive that operational performance.

Thanks, Keith.

Can we take the next question, please?

The next question comes from Amit Daryanani with RBC Capital Markets.

You may ask your question.

Yes, thanks a lot.

When I think about the implied December quarter expectations you have and given the commentary you made about the growth market headwinds, I'm actually curious.

Do you need the execution issues to get resolved and see normal seasonality to achieve the implied December quarter expectations?

Or could you get there if one of those two events did not happen?

And then specifically on the software side, I think it was up 1% year over year.

I would have thought it would have been up more like 4% or 5%.

Was it any China-centric headwinds on the software side as well for you this quarter?

The way I would frame the software performance is not around China.

The China issue was predominantly an impact to our hardware business.

The software issue, I think, is this ongoing challenge that we typically have in third quarters going into a stronger fourth quarter.

So that's the way I would look at this.

If you look at the magnitude of improvement that we're looking at for our growth markets content, going to the fourth quarter and then into next year, that profile going into 2014, remember about half of it we said we thought was macro-driven.

That should resolve itself, we believe, as China establishes this broad-based economic reform plan in March of 2014.

And the second half of that's really driven by the leadership.

And we do need to see that trajectory improve as we go into the fourth quarter to get back to mid single-digit performance in 2014, consistent with the industry.

Thanks, Amit.

Can we take the next question, please?

The next question comes from Rob Cihra with Evercore.

You may ask your question.

Thanks very much.

If I could ask a more strategic question, particularly in services.

You just closed on the SoftLayer acquisition this quarter and beyond adding whatever point of revenue or whatever to GTS, what does that mean for your go-to-market strategy?

Does it change the look of GTS?

And particularly given that it's coming at the same time you also announced the planned divestiture anyway of the Customer Care BPO business for a relatively low multiple.

When you combine those two things, are you driving a more aggressive change to the look of GTS?

Or is it just the fact that one's high growth, high multiple, one's low growth, low multiple?

Thanks.

Let's separate those two.

The divestiture was really a divestiture that was complementary to IBM and to the partner that we're working with.

For us, it was an area that we thought we could get better capability out of the partner and the partner's capability, then we would apply our energies to broader intellectual property capability.

If you look at the cloud content and the SoftLayer content that we see within cloud, we crossed a milestone for us this quarter with over $1 billion of cloud revenue.

Now, content within that, about $610 million of it was the hardware and software and implementation services for us to establish cloud-based operations within our customer set.

And then $460 million of that was cloud-delivered services and solutions, including SoftLayer.

Now, if you look underneath the dynamics in that cloud-delivered services and solutions content, most of those customer engagements for us turned out to be incremental.

You remember, when we started the road map content to drive cloud to be about $7 billion by 2015, we said that we thought only about $3 billion of that would be incremental due to the cannibalization of base.

So we're always using that as kind of a checkpoint.

Actually, we didn't see that in our own profile.

Most of that content was indeed new and incremental.

So it does provide a very strong platform for us within GTS and a platform for moving to the market for other business units.

I will tell you that since we have made that acquisition, I have heard nothing but very positive statements from our business units on the capability and the added dimensions that it applies to IBM and to GTS.

Thanks, Rob.

Can we go to the next question, please?

The next question comes from Katy Huberty with Morgan Stanley.

You may ask your question.

Thanks.

Mark, do your comments about growth and execution improving in the fourth quarter consider the risk of delayed US federal spending and any impact that may have on enterprise sales cycles in the US?

Sure.

Let me talk about that explicitly.

If you look at our US federal business, Katy, our US federal business is a little less than 3% of our total revenue mix.

So as you look at the risk within that 3%, it turns out that really the bulk of our federal business is either not exposed, or even if it is in a category that is exposed, it's been deemed essential.

So as we look at it, it's kind of a time dimension.

So if we close on that issue in October, it really shouldn't be much of an impact to IBM.

If it extends through to November, then it will be an issue but something we ought to be able to deal with and manage through.

If this extends into December, then it's going to get to be a meaningful number, say around a nickel, that we would probably not be able to contain.

But it is a time-based exposure that we're tracking quite carefully.

The advantage that we do have to keep that total down, is how much of our business is in fact deemed essential.

Thanks, Katy.

Operator, can we take one more question, please?

The last question comes from Jim Suva with Citigroup.

You may ask your question.

Thank you very much, Mark and Patricia, for your details.

As a quick clarification, you'd mentioned tax rate of 23%.

Is that what you mean going forward for every quarter or for the full year, which means Q4 then have to go up to something like 30%?

The bigger question is, following up on the last question about the federal government, did that also impact your signings and bookings in new businesses coming in also, as I would imagine there's a big pause there of new business being handed out.

Yes.

Let's take the bookings issue first.

If you look at the business unit that would be most impacted by that exposure, it would be our GBS business.

But I have nothing but very positive observations of their performance, both on driving performance on a global basis, generating profitability from that growth and increasing their backlog.

Though that would be the area most exposed, you sure wouldn't see it in the results.

As far as the tax rate, what I'm referencing is the average tax rate that we would assume before discrete items.

And that tax rate would be the tax rate for the year and for the quarter going forward for 2013 as well as 2014.

But again, that's a tax rate before discrete items.

So let me now just take the opportunity to wrap up.

I want to thank you for the questions and the time on the call.

Obviously, this was a tough quarter for us, especially in STG in the growth markets.

But we're on track to deliver at least $16.25 for the year on an all-in basis.

We believe with the actions we're taking, we'll have stronger operational performance as we go into 2014.

In STG we're going to wrestle with the mainframe wrap in the first half of next year, but should return to profit growth in the second half and stabilize hardware profit on a year-to-year basis for the year.

That's the game plan.

And in growth markets we'll improve the trajectory to get back to mid single-digit performance for the 2014 full year, especially after we get through the broad-based economic reform plan that's developing in China.

Consistent I think, on that trajectory basis for growth markets, consistent with the overall industry.

We'll continue to use the overall flexibility of our financial model, including productivity and share repurchase.

I think we're going to see that ongoing operational performance in our software and services business show through then to drive the bottom line.

So this keeps us on track to our 2015 objective of at least $20 of operating EPS.

I want to thank you again for joining us and you now as always it's back to work.

Operator, can I turn the call back to you to close it out?

Thank you for your participation on today's conference call.

You may disconnect.