International Business Machines Corp (IBM) 2014 Q1 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 Martin Schroeter, IBM's Senior Vice President and CFO, Finance and Enterprise Transformation.

I want to welcome you to our first quarter earnings presentation.

The prepared remarks will be available in roughly an hour, and a replay of this Webcast will be posted by this time tomorrow.

I'll 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.

Our presentation also 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 of the presentation and in the Form 8-K submitted to the SEC.

Now, I'll turn the call over to Martin Schroeter.

Thank you for joining us today.

As we get into the first quarter results, you'll see that our performance reflects the actions we talked about in our last call.

We're transitioning to key growth areas and transforming parts of the business.

In the quarter, we announced the $1.2 billion investment to globally expand our SoftLayer cloud hubs.

We launched BlueMix, our new platform as a service to speed deployment of hybrid clouds.

We acquired both Aspera and Cloudant to extend our capabilities in big data and cloud.

We're expanding our ecosystem around OpenPower, and we created an integrated business unit around Watson and announced a $1 billion investment to bring cognitive capabilities to the enterprise.

As we move to these growth areas, we're also taking portfolio actions to divest businesses that no longer fit our strategic profile.

In January, we had the initial closing for the divestiture of our customer care BPO business, and we announced the sale of our industry standard server business to our partner Lenovo.

This quarter, as expected, we took a substantial charge to align our resources and skills to the demand profile we see.

This charge impacts our results this quarter, but it will pay back within the year.

So, we got a lot done this quarter.

Many of these actions impact our top and bottom line in the short term, but have long-term benefits.

For the quarter, we delivered revenue of $22.5 billion and operating EPS of $2.54.

Our software performance was driven by 5% constant currency growth in key branded middleware.

We're continuing to see strong client demand and great results in areas like mobile, cloud and security where we've been targeting our investments.

Our services business was up 2% at constant currency with growth in both services segments adjusting for the sale of the customer care business.

The growth reflects our expanded cloud offerings, the ramp in some of the large outsourcing contracts we signed last year and good performance in both consulting and systems integration.

Looking at hardware, as expected, the combination of secular and cyclical challenges continued.

Last quarter, I talked about business model challenges specific to power, storage and System x. Let me tell you about some of the actions we've taken.

As I mentioned, we're selling our industry standard server business to Lenovo.

We are repositioning power and building an ecosystem around OpenPower, and we've taken actions across power end storage to right-size the business to the market dynamics.

Our System z performance in both revenue growth and margin reflects that we're six quarters into the product cycle, though on solid ground secularly.

Looking at the financial metrics for our operating results this quarter, IBM's revenue was down 4%, or 1% at constant currency adjusting for the customer care divestiture.

That's a 2 point sequential improvement from our fourth quarter rate.

We had constant currency growth in software, services and financing, which was more than offset by a decline in systems and technology.

The currency impact to revenue growth was about 1.5 points.

Currency was also a headwind to our profit performance, reflecting impacts from the yen and the devaluation of the Venezuelan currency.

This quarter we improved gross margin by 90 basis points, driven by services and our ongoing mix to software.

The profit dynamics below the gross profit line are impacted by the charge of nearly $900 million for workforce rebalancing, as well as a gain of about $100 million for the sale of our customer care business, and so are not representative of our future run rate.

Our pretax income was down 19% and net income down 22%.

Within net income, our tax rate was worse by 2.7 points year to year.

The 20% rate in the quarter reflects our view of the operating tax rate for 2014.

This quarter we returned significant value to shareholders, including over $8 billion of gross share repurchases and $1 billion in dividends.

We generated free cash flow of $600 million, which was down $1.1 billion year to year.

In January, we highlighted a substantial cash tax headwind for 2014.

This was skewed to first quarter, and cash tax payments were up $1.4 billion year to year.

So, without the cash tax increase, our free cash flow was up $300 million.

So, now I'll get into the details of the quarter, starting with revenue by geography on a constant currency basis.

Americas revenue was down 2% year to year, consistent with last quarter's performance.

We had strong growth in software, but hardware performance, especially in the US, remains challenged.

Once again, we had good performance in Latin America, led by Brazil.

EMEA was up 1%.

The improvement was driven by a return to growth in both Germany and Italy.

In Asia-Pacific, revenue was down 6%.

Within that, we had another good quarter in Japan.

This was our sixth consecutive quarter of revenue growth in Japan.

Asia-Pacific outside of Japan declined.

In total, major markets were down 1% with improvement from last quarter's performance driven by EMEA.

The growth markets were down 5% and within the growth markets, we had high single-digit growth in Latin America.

But revenue from the Asia-Pacific countries declined at a double-digit rate with continued weakness in China.

Our revenue in China was down 20%, so pretty consistent with the last couple of quarters.

We expect it will take some time for our business in China to improve.

Because we view the bulk of the challenges in the growth markets as cyclical and we still see good opportunity over the long term, we're continuing to invest in these key markets to capture that opportunity.

Turning to the segment perspective.

I've already commented on the revenue drivers and will address those further in the services, software and hardware discussions.

Looking at the gross profit, in total, our operating gross margin improved 90 basis points.

We expanded margins in both services segments, and the relative strength in our software business drove an improving mix.

The improvements are mitigated by a 5 point decline in systems and technology.

The systems decline is driven by a combination of margin degradation in power and storage, and a mix away from higher margin z due to the product cycle.

Consistent with these product cycle dynamics, our margin in System z is up year to year.

Our total operating expense in other income was up 8% year to year.

Acquisitions over the last 12 months drove 2 points of expense growth, while currency was fairly neutral to expense performance.

So, what we've labeled as base expense on the chart, which is total expense less the impact of acquisitions and currency, was up 7 points.

There are a couple of larger items that are impacting this base expense.

First, SG&A includes a workforce rebalancing charge of about $870 million, nearly all of which is a year to year increase.

We expect this to pay back within the year.

The workforce rebalancing activity impacted the SG&A base performance by 16 points.

So, without the charges in both years, our SG&A base expense would have been better 3 points year to year.

And second, within other income and expense, you see the gain of nearly $100 million from the sale of our customer care business.

We anticipate a gain of a similar amount in the second quarter as we complete the country closings.

Adjusting for both of these items, our total base expense would have been better by 4 points rather than worse by 7 points.

The 4 point improvement is more indicative of the productivity in the base expense we delivered in the quarter.

I want to comment on another dynamic in our base expense.

Within the base, we're continuing to shift our spending.

So, for example, $1.5 billion of R&D spending this quarter reflects the shift of development priorities to where we see future growth.

Our recent launch of BlueMix is a great example.

We will be investing $1 billion to deliver unique platform as a service capabilities to connect enterprise data and applications to the cloud.

We'll talk more about how we're shifting investments in our investor briefing in May.

Now, let's turn to the segments, and we'll start with services.

This quarter the combined services segments generated $14 billion in revenue, which was down 2% as reported at modest growth at constant currency.

Adjusting for the customer care divestiture, total services were up 2% at constant currency, the third consecutive quarter of sequential improvement.

Services pretax profit was down 14%, and margin declined by 1.9 points.

Without the workforce rebalancing charges in both years, profit was up 7% and margin expanded by 1.5 points.

Total backlog was $138 billion, which includes a reduction of $3.8 billion for the customer care divestiture.

Backlog was up 1% at constant currency when adjusted for the divestiture.

Turning to the two segments, Global Technology Services revenue was $9.3 billion, down 3% as reported and down 1% at constant currency, but up 2% at constant currency adjusting for the divestiture.

Within GTS, our SoftLayer platform provides a highly differentiated solution for clients looking to deploy across public, private or hybrid clouds unified on one platform.

The range and scope of production workloads has been expanding.

We have good growth in enterprise transformation projects, and the introduction of BlueMix has generated broad interest with application developers.

This quarter, SoftLayer contributed about 1 point to GTS's revenue growth.

As I mentioned earlier, we're spending $1.2 billion to expand our global cloud footprint.

We'll double our SoftLayer centers and with 40 cloud data centers 15 countries, IBM will have cloud centers in every major geography and key financial center.

GTS outsourcing returned to growth at 1% constant currency adjusted for the divestiture.

Growth was driven by the substantial new contracts we brought on during 2013.

GTS pretax profit declined 15% in the quarter.

This includes a 20 point year to year impact from work force rebalancing charges.

GTS pretax profit also includes a gain of about $100 million for the divestiture.

Keep in mind that GTS profit is impacted by the divestiture of those operations.

In addition, we're continuing to make investments in key growth areas such as mobility, security and cloud, and these initiatives are gaining traction, but are not yet at scale.

Turning to Global Business Services, revenue was $4.5 billion, flat year to year as reported and up 2% at constant currency.

Consulting and systems integration grew 5% at constant currency, driven by the practices that address the digital front office.

We delivered growth across cloud and Business Analytics, and we had good success in projects for clients on systems of engagement and helping clients connect these new front end capabilities to their back end systems and processes.

In fact, we are ranked number one in overall business consulting and cloud professional services by IDC and number one in mobility consulting services by Forrester, a good indication of our success in front office transformations.

We're continuing of to invest strategically, and in March we committed $100 million to expand our consulting services capability with 10 new IBM interactive labs and 1,000 employees to address client experience, design and engagement.

Application outsourcing was down 8% at constant currency.

Our performance reflects increased pricing pressure and client contract renegotiations, as well as reduction in elective projects.

Turning to profit, GBS declined 11% year to year.

Without the workforce rebalancing charges, profit would have been up double-digit, reflecting improved productivity in the base.

Software revenue was up 2% to $5.7 billion.

Key branded middleware grew 5% at constant currency.

Our enterprise clients continue to rely on IBM's middleware solutions to transform their infrastructure and handle their business critical transactions.

We deliver this through a combination of on-premise and SaaS solutions.

Our SaaS offerings span our software brands and this quarter, our SaaS revenue grew more than 25% year to year.

Looking at our results by brand.

WebSphere had another strong quarter, up 12% year to year, led by App Server and mobile solutions.

We continue to have strong growth in Mobile First, our comprehensive portfolio of mobile software and services that enables our clients to manage, integrate and leverage mobile devices.

We've been building capabilities to address this space, and we now have over 3,000 mobile experts.

Across software end services, IBM's mobile business doubled from the prior year.

Our application server business delivered strong growth for the fourth consecutive quarter.

This is an example of our clients utilizing on-premise software to manage the infrastructure workloads driven by mobile, big data and analytics.

This is the 13th year in a row that Gartner named IBM the market share leader in application infrastructure and middleware software and with 30% market share, we're nearly double the size of our closest competitor.

Information Management software was up 2% at constant currency.

Growth was led by distributed database and master data management, which are key elements of our big data and analytics solutions.

This quarter, we added database as a service capability with the acquisition of Cloudant.

Cloudant extends IBM's mobile end cloud platforms by enabling developers to easily and quickly create next generation mobile and web applications.

Tivoli grew revenue 7%.

This quarter we had growth in all three of Tivoli's product segments, systems management, storage and security.

Security grew double digits for the sixth consecutive quarter.

Our results are being driven in part by incremental requirements for security as clients expand into cloud and mobile computing.

Our portfolio of security offerings across IBM grew more than 20% this quarter.

Workforce Solutions declined 4% at constant currency.

Strong growth in our SaaS offerings were more than offset by a decline in our on-premise notes business.

We are transforming our business and building up the recurring streams from SaaS.

I mentioned earlier that in the first quarter we launched BlueMix which will make all of our middleware accessible via the cloud.

With BlueMix, developers can efficiently build cloud applications with reusable pieces of code tied to their enterprise systems.

This enables businesses to leverage the flexibility that cloud applications provide.

Systems and technology revenue of $2.4 billion was down 23%.

This reflects both the product cycle of System z and the secular challenges in power, storage and System x. In January, we entered into a definitive agreement with Lenovo to divest our System x business.

And in the first quarter, we continued to reposition offerings in other parts of our hardware business to make them more relevant, and we took actions to align our structure to the demand profile we see.

Looking at our results this quarter, System z revenue was down 40% with MIPS down 19% year to year.

We are in our sixth quarter of the product cycle, and gross profit margin was up year to year, consistent with this point in the cycle.

System z is a core franchise which provides mission critical infrastructure for our customers, and we continue to invest in the platform.

It's worth noting that earlier this month we celebrated the mainframe's 50th year.

Power revenue declined 21% at constant currency.

We are aggressively repositioning this platform with a couple of key initiatives.

First, the OpenPower consortium makes power technology available to an open development alliance.

This quarter we expanded our OpenPower ecosystem.

And second, we are expanding or Linux capables through our POWER8 launch this year.

POWER8 is the first processor built for big data and delivers better cloud economics.

Storage hardware revenue was down 23%.

Our flash solutions contributed growth again this quarter.

However, we saw substantial weakness in high end storage.

As we've discussed, our focus for STG in 2014 is to stabilize the profit base.

The repositioning of the power platform, the announcement of POWER8, new announcements in storage and the right-sizing of the business will all contribute as we move through the rest of the year.

This, together with the divestiture of System x, will result in a smaller and more profitable hardware business going forward.

IBM will remain a leader in high performance and high end systems, in storage and in cognitive computing, and we'll continue to invest in R&D for advanced semiconductor technology.

Turning to cash flow.

We generated $600 million of free cash flow in the quarter, which is down $1.1 billion year to year.

As you can see, our CapEx was up nearly $200 million year to year, which includes investment in additional SoftLayer capacity.

But the real driver of the year to year decline was a $1.4 billion increase in tax payments driven by audit settlement payments and other prior period discrete tax impacts that settled this quarter.

Excluding the increased tax payments, free cash flow would have been up $300 million year to year.

Looking at the uses of our cash, we spent almost $300 million in acquisitions acquiring Aspera and Cloudant.

We returned $9.2 billion to shareholders, including $1 billion in dividends, and we bought back over 45 million shares for $8.2 billion.

At the end of the first quarter, we had $6.3 billion remaining in our buyback authorization.

I want to remind you that our free cash flow generation is always skewed to the back end of the year.

In fact, if you look over the last 10 years, the average free cash flow generated in the first quarter is less than 5% of our full year total.

Turning to the balance sheet.

We ended the quarter with a cash balance of $9.7 billion, which was down $1.4 billion from December.

Total debt was $44 billion, which includes $28.3 billion to support our financing business.

The leverage in our financing business remains at 7 to 1.

Our non-financing debt was $15.7 billion, and our non-financing debt to cap was 55%.

Given the skew of free cash flow, we expect our debt to cap to be in the 50s for the next two quarters and roughly flat year to year at year end.

So, now let me wrap up with discussion on the quarter.

There are major shifts in our industry driven by data, cloud, and changes in the way individuals are engaging.

This quarter we had good performance in our offerings that address these shifts.

Our Business Analytics revenue was up 6% at constant currency on a large base.

Our cloud revenue was up over 50% with doubling of our cloud as a service business and we had strong growth in mobile and security.

Just as importantly, we continue to take significant actions to move to these growth areas.

I talked about some of the targeted investments we're making, including SoftLayer capacity, BlueMix and Watson.

We're focused on allocating our capital efficiently and effectively, which means investing in the right places, as well as moving away from areas that don't support our shift to higher value.

This is an important part of our model.

In fact, over the last few years, including the recently announced sale of our industry standard server business, we've divested over $6 billion of revenue.

The result is a stronger, more relevant business.

As we look to the balance of 2014, we continue to expect good performance in the key growth areas, though our overall revenue growth will be impacted by the challenges in our hardware business and the customer care divestiture.

The currency impact to revenue moderates at current spot rates, but we do expect currency to continue to impact profit.

Our margin will reflect the ongoing productivity initiatives and actions to improve our cost base, as well as the relative strength of software and as always, we reinvest some of the productivity savings to drive our growth areas.

I mentioned earlier that our annual effective tax rate for 2014 is 20%, and that's before any potential discrete tax items.

And of course, we'll continue to return value to our shareholders.

For the year, we expect to deliver at least $18 of operating earnings per share.

This does not include any gain from the sale of our System x business to Lenovo because of the uncertainty of the timing and the amount, but it will ultimately be included in our operating EPS results, and we'll update you later in the year.

Like always, we manage our business and allocate capital for the long term, and along the way, we still expect to deliver at least $20 of operating EPS in 2015.

Now, Patricia and I will take your questions.

Thank you, Martin.

Before we begin the Q&A, I'd like to mention a couple of items.

First, we have supplemental charts at the end of the slide deck that provide additional information.

And second, I'd ask you to refrain from multipart questions.

Chris, 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 Toni Sacconaghi with Sanford Bernstein.

You may ask your question.

Yes, thank you, Martin.

I was hoping that you could confirm that you still expect to meet your free cash flow goal for this year of $16 billion.

And secondly, in terms of goal setting, you now have a much lower tax rate for the full year than you anticipated three months ago.

I think that's going to add about $0.70 to EPS that was not anticipated three months ago.

You also mentioned there may be discrete items.

So, I'd like to understand on that, A, why the tax rate changed so significantly in three months?

And secondly, do you have anticipated discrete items over the course of the year and can you share those with us?

Sure.

Sure, Toni.

I guess first on free cash flow, as we noted in the prepared remarks, our free cash flow was $600 million in the quarter and down about $1.1 billion year to year.

Now, as we noted, that's a -- it represents -- the first quarter always represents a fairly small amount.

Now, to answer your question, I'm going to go through some math in a second, but to answer your question, we still do expect to grow free cash flow year to year, even though we do have a tax headwind this year.

So, the short answer to your questions is yes, we still expect to grow free cash flow.

When we adjust -- when we look at our free cash flow on a year to year basis and we start to put in a more normal, like a model tax rate, if you will, so we had, as you can see in our data big tax headwind, but in total, we paid about $2.6 billion of cash taxes in the year.

So, that's an 80% rate in the quarter.

Obviously, that's not a rate driven by our model.

It's not driven by the way the business runs, but it just reflects, really, the tax audit that we finished in the fourth quarter and the related payments around that.

So, we had a very high rate in the quarter.

Last year we had a rate of about 30%, and so that $1.4 billion year to year which we identified as driving -- would have driven $300 million year to year.

The fact is on a rate adjusted or modeled basis, we would have grown faster again.

I'm very comfortable with the free cash flow generation in the business, and I think we're on track to deliver the full year and the cash flow growth.

Again, we do have a headwind this year, the bulk of it was in the first quarter.

On the tax rate, we were able to improve our expected full year operating rate to 20% with a more favorable mix of geographic income.

And our income -- intercompany dividend plan resulted in higher usage of foreign tax credits for the year.

That's our operating tax rate.

The rate, however, as you noted, as we put in the prepared remarks, excludes any potential discrete tax impacts which may occur.

And those are, as you know, generally for nonrecurring items.

Two examples that could affect our rate from here.

First, we did announce the sale of our x series business.

Now, that hasn't closed, but that could affect the rate.

So, the rate could be higher from the sale of the Lenovo business.

At the same time, I'm sure you're aware that there are bills being discussed in Washington, tax extender bills which could lower the rate further.

Our operating rate of 20% is ultimately going to reflect not only our mix of geographic income and the intercompany dividend plan which rolls into that operating tax rate, but it's also ultimately going to reflect the discretes.

Thanks, Toni.

Could we go to the next question, please?

The next question comes from Bill Shope with Goldman Sachs.

You may ask your question.

I wanted to get a clarification on Toni's question for the full year guidance.

Given the lower tax rate, as Toni mentioned, you're still offering the same EPS guidance.

Without the lower tax rate, it is a net guide down.

If so, could you comment on what exactly changed above the tax line versus your prior expectations and the expectations you gave us in January?

Sure, sure.

We got a lot done in the first quarter.

I mentioned some of those in my prepared remarks, right?

And roughly speaking, if I were to net it down, we continue to move our investments and our resources to where we see the needs of our enterprise clients and we continue to -- we divested a pretty substantial business in X series that didn't fit our high value model.

So, we did get a lot done in the quarter.

Now, we also, as you would expect, look at a trajectory we see coming out of the quarter in order to get the right guidance for the year.

And I guess I'll go through it by segment.

But first, I think it's important to note that we did not see much improvement in the trajectory in the GMU in the quarter.

We were down 5% in the first quarter, we were down 6% in the fourth quarter.

So, we were not seeing a trajectory improvement.

GBS, as an example, just within the GMU, went from high single-digit growth to low single-digit growth.

So, we are not seeing the trajectory improve in the GMU, as an example.

Now, looking at the segments at a higher level, or the complete segment view.

In services, when you adjust for the charge we took, because again, we'll earn that charge back through the year.

When you adjust for that charge, we did expand margin in the first quarter, and we would expect that to continue.

In services, relative to last year when we grew profit in low single-digits, we're really only counting on mid single-digit growth across those businesses.

In software, we continue to see an improving growth rate in software and revenue, which obviously drives profitability.

And then in hardware, hardware was down 23% constant currency, and we expect both the cyclical and the secular challenges that we see in that space to continue.

As we said in the last call, our focus in hardware is really to stabilize that profit base on a year to year basis.

We do see the shifts we're making into the growth areas are absolutely the right things to do.

We are being successful in growing that part of the business.

And our 1Q trajectory really reflects, I think, no real improvement in the GMU.

Thanks, Bill.

Can we go to the next question, please?

Next question comes from Rob Cihra with Evercore.

You may ask your question.

Hi, thank you very much.

If you look at the hardware losses, and with divesting the XA6 business, that will help margins, but it won't necessarily change your cost structure that much.

I'm wondering, is it that this business is now just subscale, particularly including the microelectronics business?

Or do you think you're just unfortunately, at the bottom of mainframe and power cycles?

And when you include the POWER8 and you include the power on Linux, you think you can grow your way out of it, or of do you think it's an actual cost structure that's now just too high for the business?

Thanks.

Yes, I'd say a few things, Rob.

First, we -- the mainframe revenue growth absolutely reflects where we are in the cycle.

There is not a secular challenge in mainframe at all.

The mainframe growth rates are absolutely cyclical, and when we -- it's not a scale issue when we get to announce a new mainframe that will absolutely turn.

In Power, as we said last time, we did have too much structure.

There was a secular issue in Power, particularly at the low end.

Now, we've said we were going to address that with a few different actions.

First, we said OpenPower will be a tremendous benefit to opening up that technology and getting more users on that platform, and we think OpenPower over the long term will have a pretty solid impact in improving that platform.

Secondly, we said that we have POWER8 coming.

We had this in the prepared remarks, and POWER8 is highly relevant to big data workloads, relevant to the cloud.

And so this secular move from low end Power on to industry based servers, we will battle back with POWER8 and a much better offering in that space.

And then thirdly, we did have too much structure in POWER8 -- I'm sorry, in Power, and we did manage to get fair bit of structure out of the business to set a cost base -- get a cost base into the Power platform.

In total on STG, let's go back to the total for a second, there is obviously a GP margin impact in the first quarter, down year to year.

Some of that is obviously driven by the mainframe cycle and its lack of contribution, if you will, lack of mix to the high end.

Some of it's driven by the cost base.

None of the improvements that we've made are really felt in the first quarter.

And then it is, relative to what's going to come next in second through fourth, it is the lowest transaction volume quarter.

There is just a high fixed cost base relative to what we have coming forward in the rest of the year.

I think the STG business is on a path that we will achieve what we set out to achieve at the beginning of the year, which was to stabilize that cost base and that profit base.

Thanks, Rob.

Could we go to the next question, please?

The next question comes from Steve Milunovich with UBS.

Talk about a couple of financial measures.

First, your share repurchase was very large this quarter.

Could you talk about what you anticipate going forward?

I'm assuming it was pretty front end loaded, but what do you see for the full year?

And perhaps related to that, you've roughly doubled your nonfinance debt over the last year.

Did you say that you would take that ratio from 55% down to roughly 39% by the end of the year, which is where you ended last year?

Sure, Steve.

On share repurchase, we did front end load this year's share repurchases.

We would expect on a full year basis to finish probably a little bit less than where we were last year.

We'll continue to return capital to shareholders through the rest of the year, but it will be at a reduced rate relative to the first quarter.

And then on a debt to capitalization ratio, which you noted was 55%, we'll probably run in the 50%s the next couple of quarters, but we will be back down to about where we started the year again by the end of the year.

Okay.

Thanks, Steve.

Let's go to the next question, please.

The next question comes from Ben Reitzes with Barclays.

You may ask your question.

I think investors are focused on this, of so I'm going to just try to clarify it on the free cash flow side.

What I'm really confused about is that the charge was about $100 million lower than I thought, then we have the tax rate impact and the accelerated buyback, which is probably more than I think you guys probably modeled in January.

With all that, you could have almost $1 billion taken out of the net income the Street had and still guide to $18.

And I wanted to know on cash flow, you said in your 10-K that you would grow cash flow by $1 billion year over year, and we just took out almost $1 billion of the net income versus where we were in January.

I actually don't understand how we get to the free cash flow numbers previously guided in that -- taking it in that light.

If you could just explain it that way, that would be really great.

Thanks a lot.

Sure, so Ben, just to clarify again, we said at the beginning of the year we would grow free cash flow by $1billion, and we still feel that we will grow free cash flow by $1 billion, given where we started the year.

Again, the year -- the first quarter of the year is typically quite light in terms of free cash flow.

When we look at now -- when we look at the rest of the year in terms of free cash flow, obviously we have a pretty substantial transactional business that picks up from first to second quarter and also sticks with us then in third.

And then the fourth is also a pretty substantial fourth quarter transactional flow which drives a lot of free cash flow for the year.

In the first quarter, you're seeing a substantial impact to the -- for the in-quarter free cash flow numbers, simply because of the size of the tax payments, the cash tax payments that we had to make in the first.

Those do not replicate for the rest of the year.

In terms of the $18, we said we would get to at least $18.

We said in the first quarter that we would do about 14% of that, and that's where we came in, at 14%.

Now, we said about $1 billion of restructuring, plus or minus 100, and that's kind of where we came in.

Now, we had fewer shares, so on an EPS base, the EPS impact was, I think, right in the middle of where we would have put the original number.

And we did get everything done that we wanted to get done in terms of setting the right cost base.

I think that's fairly consistent.

And then when we look at how the rest of the, at least $18 rolls out, we had a big charge in our results in the second quarter of last year.

And obviously, we're not going to recreate that this year.

So, you're going to he see big growth in the second quarter.

Given that quarterly phenomenon, a charge in the first of this year but none the second versus the prior, we would think that the first half then, given that quarterly phenomenon, that first half is going to look a lot like last year, and we'll probably get about 38% of our full year EPS done by the end of the first half.

And then when we look at the second half, we'll see consistent growth with what we need on a full year basis at 10.5, and given the transactional nature and the momentum in some of our businesses, we would say it would probably be a little bit faster in the fourth than in the third.

Thanks, Ben.

Let's go to the next question, please.

Next question comes from Lou Miscioscia with CLSA.

You may ask your question.

Thank you.

Switching over to the services business, you talked about it a little bit.

It seemed like GBS did slow down somewhat.

Maybe consulting system integration was okay with growth rates comparing last quarter to this quarter.

But maybe if you could go into more detail about the GBS outsourcing business.

Sure.

Sure, Lou.

So, a couple of things.

GBS, 2% growth.

It is slower quarter to quarter.

As I mentioned earlier, we're seeing -- we saw a trajectory in the GMU that was -- that went from high single to low single-digit growth as an example.

The bulk of the slowdown that we noted in the prepared remarks was in the application outsourcing business, which was down year to year.

We have seen pretty substantial price pressure in that space.

And as I noted in my prepared remarks, clients are absolutely focused on cost take-out projects and less focused and have decreasing volumes for what I would consider to be more elective kind of projects.

So, we are seeing a shift in focus.

Now, underneath that, though -- that's the revenue side.

Underneath that, we do have a robust delivery platform that allows us to manage even in that environment.

And so from a GP perspective, gross profit perspective, we're comfortable that we can continue to deliver profit, even in that environment.

You are right, as you saw in the data, our GBS did slow quarter to quarter.

We're not expecting that the environment changes dramatically.

We're not counting on it to change dramatically, and we do have a pretty robust, as I mentioned, a pretty robust delivery platform underneath that.

And then in total, as you saw, even with slower revenue growth, our profit still grew 12% when you take out the charge.

I think it's important to take out the charge because we're going to earn it back during the year.

That's more indicative of the kind of growth we can still deliver, even on low -- profit growth we can deliver, even on a lower revenue trajectory.

Thanks, Lou.

Can we go to the next question, please?

The next question comes from Joseph Foresi with Janney Montgomery Scott.

You may ask your question.

Hi.

I was wondering, the growth markets seemed to be continuing, or continue to be a little bit slow for you.

I know that most of your projects there are larger projects and perhaps more profitable than some of your other businesses.

How do you plan to make that up in your plans going forward?

And any color you can give on a return to steady growth, any of the services business or the aggregate business would be great.

Sure, Joe.

A couple of things.

Growth markets, as you noted, were down 5%.

Now, they've -- we've been experiencing a pretty tough environment in the growth markets for a few quarters now.

And down 5%, as I said earlier, is not the kind of trajectory improvement we are looking for in that business.

Now, when you look at it by region, however, it's not one -- it's not a homogenous answer here.

In Latin America, we had another good quarter of growth.

The Latin America business for us is going really, really well, we were up 8% at constant currency.

In the Mideast and in central Europe, we're about flat.

That's down from growth we had seen before, but about flat is at least hanging in.

And our challenge areas have been in China, which was down double-digit, and in Asia-Pacific, which was down in the mid single-digits.

I think there are a blend here of issues.

There are cyclical issues, there are secular issues, and they are not consistent between the regions.

We've talked in the past about China needing time to return to growth.

We've talked about across the growth markets that we still believe there is a very attractive region for us to invest in.

So, we're going to maintain our investments.

But there is a -- both a mix of secular and cyclical.

Now, we do have very heavy -- a heavier concentration in the growth markets in our STG business than in other parts of the world, and so while the growth markets are certainly impacted by the mainframe cycle, like we are in other parts of the world, that is not the bulk of the challenge in the GMU, even though, again, STG is a bigger proponent.

The STG business does -- I'm sorry, the GMU does get impacted by this secular shift in our Power business, as an example.

There is a very difficult price environment in our industry standard x series business, and I noted earlier that even our GBS business from quarter to quarter slowed down a bit.

So, mix of secular and cyclical issues, some related to our own hardware issues, others related to what the countries themselves are seeing in terms of economic environments, but not a single answer across the region.

Thanks, Joe.

Can we go to the next question, please?

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

You may ask your question.

Hi.

Thank you.

In addition, the software revenue, the constant currency growth was a little bit weaker than we were thinking.

I was wondering if you could talk about what were the forces that impacted that.

And more broadly, as you look at exiting the year on a constant currency basis and excluding dispositions, assuming the X86 business goes, do you think IBM can get to a position whereby revenue growth is flat on a constant currency basis?

Thank you.

Sure, Keith.

A couple things.

In software, we grew 2 points on a segment basis.

Our key branded middleware was up 5.

Right.

We would expect both of those -- we would expect both of those to accelerate as we go through the year.

We still see very good software opportunity for our solutions, and we see very good software opportunity for the platforms that we're building.

In fact, within the key branded middleware, you probably noted on our software chart that WebSphere grew 12%.

That's pretty healthy double-digit growth within our core software business.

We do expect that to accelerate as we go through the year.

Operating systems, particularly Power, do impact that overall software business.

Power operatings, the AIX operating system is sold on as a one-time charge.

As those hardware sales decline, for the reasons we talked about, that does impact the overall software segment growth.

Now, I don't think we're relying on -- I'm not relying on Power to be coming back strongly, but one, as it becomes a smaller part of the overall revenue stream, it has less of an impact.

Then quite frankly, as I mentioned earlier, first quarter is our smallest transactional quarter.

And so as we see improved transactional flow in the rest of the year, that impact to the overall software revenue growth will decline.

In terms of overall revenue growth for the year, so I'd say a few things.

One, we did have an impact from currency in the first quarter, which was about 2 points, and we do see that now being flat for the rest of the year.

Now, interestingly, at least I find it interesting, this is the first time since, I think it's 11 quarters where we have not had a currency headwind at current rates.

As currency moves at least to neutral for us, we won't be battling that headwind.

And again, at current rates, we see that through the rest of the year.

Obviously, we don't know where we might be in 90 days.

Customer care, and I know you said without the dispositions, customer care was about 1 point in the first quarter, but it will be between 1 and 1.5 points for the rest of the year, so we will be dealing with that.

And then I cannot predict when the x series business, the x series divestiture may occur, and so I don't know what the overall impact will be to the top line.

Now, when we look, though, at the rest of the year on more of a segment basis, as I mentioned, software, we would expect to improve the growth rate.

The hardware declines, though, will continue.

And we did set our cost base at a rate that we can achieve our goal of stabilizing the profit on a year to year basis.

But we do not expect that, and we're not counting on those hardware revenue declines, to stop.

And then GTS and GBS, services, we don't see dramatically different rates of growth than we saw in 1Q, which is fine for our model.

Okay, Keith, thank you.

Can we go to the next question, please?

The next question comes from Brian White with Cantor Fitzgerald.

You may ask your question.

Martin, I'm wondering if you could talk a little bit about the mainframe cycle and just remind us how often the mainframe at IBM is refreshed.

You talked about it getting a little long in the tooth.

It's a bit of a drag, so how should we think about a refresh?

And also Power Systems, how should we think about that in terms of improving the performance?

You talked about some things I think on the January call, but where are we in improving that performance?

Will we see it this year?

Okay.

So, a couple things, Brian.

I don't think I said the mainframe was long in the tooth.

I can not imagine those words coming out of my mouth.

I think the mainframe is where we would expect six quarters into the cycle.

This is a very powerful platform for our clients.

This drives a lot of value, and I would say we are right in line with where we would expect it to be.

And there are two -- I'd say there's three metrics to look at when we look at, where are we in the mainframe cycle?

One, we do see -- we do typically see this magnitude of a decline in revenue.

So, that is absolutely consistent.

The other thing we see at this point in the cycle is an improving margin, and we saw that as well in the first quarter, that margin continues to improve and should through the rest of the cycle.

And then the other thing we look at is program to program MIPS growth.

And we see, as we are in prior cycles, at this point we see MIPS growth up about 26% relative to the previous cycle.

Very good usage of that platform in customer environments.

The mainframe is, as I said, exactly where we would expect to be in the cycle.

On the Power side, Power is -- as we've said before, Power is in a bit of a secular -- has a secular challenge here, particularly at the low end.

And we said that OpenPower will certainly help, and we have a few new members that we announced in OpenPower in the quarter.

Now, that is not going to have a profound impact on our Power business in the year, so I don't think you should be looking at Power and I don't think we'll be saying that Power is going to get better in the year because of OpenPower.

We also have moved and made that Power platform much more relevant in the Linux space, which we've talked about in the past as being a key driver of growth down the line.

But again, that takes time.

You have to get the ISVs onto your platform, and we're doing that.

We have over 800 ISVs now in that space writing applications for Linux on power.

Then, the third thing that's important from an ecosystem standpoint is to have the most competitive processor in play in the space that you're targeting.

And for us, we think POWER8, which is going to target that low end certainly initially, is a very powerful processor that is really well suited to both big data applications and cloud environments.

Those three things will all help.

Now, Power's not going to turn around right away.

In fact, I think 2014 is going to be a difficult year for Power, if all you were to do is compare year to year revenue, year to year revenue growth.

But we are absolutely taking the right actions to make that Power platform a sustainable and highly attractive economic model for us.

We've taken cost out of that base, and we are getting the right, both technology and ecosystem, around it to make sure that it has a long-term future.

Okay.

Chris, can we please take one last question?

The last question comes from David Grossman with Stifel.

You may ask your question.

Thank you.

Martin, sorry to revisit the cash flow question, but I'm still confused about the reconciliation of free cash flow growth and your net income growth.

It seems that your EPS guide for the year, if my math is right, implies flattish, maybe even down net income this year.

And last quarter, I believe you indicated that some combination of operational performance and working capital improvements would help drive that billion dollar increase year over year despite the $2 billion headwind from cash taxes.

I understand the working capital comment.

I understand what happened in the first quarter.

However, could you elaborate on the contribution from operation improvement, given what appears to be flat to down net income in 2014?

Sure.

Well, let's deal with -- let's look at this, I guess from a -- I'll try to do it from a pretax income flow and then we'll talk, obviously -- obviously to that then we would add the impact of taxes, which we know is a headwind later in the year and then our capital allocation policy and the EPS driven from share repurchase.

We did, in the first quarter we had $3.3 billion of pretax income.

That had a charge in it, as we've talked about, that $900 million, and I'm going to use big, round numbers.

It would be too hard to do this in millions, so I'll just use billions.

We had $3.3 billion, we had about a $900 million charge in that.

On a base level, that gets us to about $4.2 billion of pretax income.

Now, we have that for, obviously, as a starting point for three more quarters.

And I add back the $1 billion in the charge we took, which we are going to earn back in savings, and the $16 billion then goes to $17 billion.

So, let's use $17 billion as a base in terms of starting from the first quarter.

Now, I also noted that the first quarter is our lowest transactional skew and that what we see as we go through the year is we add about $1 billion in profit growth from transactional business as well as overall volumes in the second through the fourth, relative to what we did in the first.

That, again, was our starting point.

Another $3 billion from that transactional growth as we go through the year.

So, $17 billion as a base, take the base of transactional growth that goes from first to second and carries through fourth, that gets you to $20 billion.

And then in the fourth quarter, which is our big transactional quarter, our biggest transactional quarter, we see transactional growth.

And we see this in across the businesses.

We see it in -- especially the heavily transactional business, obviously.

We see it in software, we see it in hardware as well.

But across the businesses from third to fourth, we add another, typically about $3 billion of pretax income into the business.

Now, we have different dynamics this year than we did in the fourth quarter of last year.

For instance, our hardware business was a much greater drag last year than we would expect it to be this year, given the momentum that we expect out of parts of that business, i.e., momentum being described as less revenue declines, right?

And we see pretty good momentum, as I noted, in our software business.

That profit base, that PTI profit base of about $23 billion with using 1Q as a starting point.

Again, we have a tax rate headwind in the fourth quarter, but we also have a share repurchase benefit here.

That $23 billion of profit growth drives our free cash flow for the year.

And as I said, we still feel like we're going to grow free cash flow by about $1 billion for the year even with the tax headwind.

So, let me wrap up the call.

As I said in the beginning, we did get a lot done this quarter.

We did transition more of our business into big data and analytics.

We continue to move into the cloud.

Our cloud platform is very powerful in the marketplace, good growth in mobile and security.

And we have our Investor Day coming up on May 14th, and we're looking forward to sharing with everyone more about the capabilities and the investments we're making to drive those businesses.

Thanks very much.

Okay, Chris, let me turn it back to you to close out the call.

Thank you for participating on today's call.

The conference has now ended.

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