International Business Machines Corp (IBM) 2015 Q2 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 today with Martin Schroeter, IBM's Senior Vice President and Chief Financial Officer.

I'd like to welcome you to our second-quarter earnings presentation.

The prepared remarks will be available within a couple of hours and a replay of the 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 their 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.

Thanks, Patricia.

In the second quarter we delivered $20.8 billion of revenue and operating EPS of $3.84.

With that, our revenue for the first half was over $40 billion, operating net income was $6.7 billion and operating EPS was $6.75.

Our revenue was down less than 1% in the quarter and essentially flat for the first half, excluding the impact of currency and the divested businesses.

Our overall revenue performance includes the continued translation impact from a strong dollar and the impact of divested businesses.

Together, these reduced our reported revenue growth by 12 to 13 points, both for the quarter and the half.

I'll focus on our revenue performance excluding the impact of currency and divestitures for the balance of the presentation.

Let me give you a quick overview of different parts of our business.

Revenue in our strategic imperatives, those that address the market trends in data, cloud and engagement, is again up more than 30% in the second quarter and so up over 30% for the first half.

This is an acceleration from roughly 20% growth last year.

As we've said before, we're able to grow at a rate significantly faster than the market because of the industry perspective and deep insight we have from working with our clients on their core businesses to help move them to these strategic areas.

We're clearing seeing this in analytics where our revenue is up more than 20% in the first half, well above market rates.

This is terrific growth on a large revenue base.

Recall, we generated $17 billion of analytics revenue last year.

The growth is led by GBS and by systems hardware, reflecting the new z13 and POWER8 systems where they specifically address analytics workloads.

And we're developing new markets with the advanced cognitive capabilities of Watson.

Our cloud revenue was up over 70% year to year in the first half.

And over the last 12 months our cloud revenue was $8.7 billion.

We had strong growth in both our private foundations revenue and our as-a-service offerings, and we exited the second quarter with an annual as-a-service run rate of $4.5 billion.

Our cloud business is substantial and growing rapidly.

The market continues to evolve beyond pure infrastructure toward higher value process, data, and analytics-as-a-service engagements, in the same way the Internet evolved from browsing to a full transactional business platform.

Our clients are finding value in the combination of public, private and hybrid implementations we're able to provide.

Our security business was up 10% for the half, social more than 40%, while our mobile business quadrupled.

From a segment perspective, we saw an increase in demand in our services business, with 22 deals over $100 million this quarter, the highest number in over two years.

This contributed to a backlog that is up year to year for the first time since the end of 2013, which is certainly an encouraging data point.

In our systems business, we've been delivering innovation and repositioning the portfolio, and this quarter we again had solid revenue and profit performance.

Our System z revenue was up about 50% year to date, the z13 performance is in line with previous cycles.

Power grew in the first and second quarters, led by strong growth in scaleout systems which are capturing both the Unix and Linux opportunity and a return to growth in the high end this quarter.

Then there are parts of the business that are impacting our second-quarter performance but the transformation will pay off over the longer term.

Parts of our services business aren't delivering sufficient productivity in the base to fund the investments we're making and to offset the impact of currency.

Now we'll get return on the investments over time but it's impacting profit growth now.

We are making the shift in our offerings as evidenced by our signings and backlog growth but we need to drive more productivity to improve the profit profile.

Some of the geographic regions, specifically the BRIC countries, are impacting our overall performance.

I'll expand on that when we discuss the geo performance.

Our first-half performance also reflects major portfolio actions we've taken to continue to shift to higher value.

Late last year we sold our x86 business.

You can see the benefit in our 50 basis point improvement in gross margin.

And we recently completed the divestiture of our semiconductor manufacturing business, while we continue to focus on advanced semiconductor research.

In fact, just two weeks ago we announced that an IBM research-led alliance produced the industry's first 7-nanometer chip, another milestone in our contributions to semiconductor innovation.

At the same time we're making significant investments in our strategic imperatives.

For example, we've created Watson Healthcare, we're continuing to build out cloud data centers, and we launched important new partnerships in analytics, mobile, social and cloud.

So, to sum it up, our second-quarter and first-half results are a reflection of the transformation in our business as we move to where we see the longer-term value in enterprise IT.

The actions and investments are delivering strong growth in our strategic imperatives and continued innovation across our portfolio, and we're able to drive overall margin improvement on a fairly stable revenue base.

I'll move on to the financial metrics but first let me remind you of some of the items we mentioned on our call back in April.

We said we'd grow our pretax income by $1 billion quarter to quarter.

We said that we'd have more workforce rebalancing than last year and we said we'd have lower gains in our I&E since last year we had a gain associated with the sale of our customer care business.

And we expected the stronger dollar to continue to have a significant impact to our revenue and profit.

As always, we've included a view of the currency translation impact to our revenue in a chart in the backup and you'll see that at current spot rates its impact continues to be substantial.

Now, turning to the results for the quarter, we delivered $4.6 billion of operating PTI which is up $1 billion from the first quarter.

The year-to-year performance in PTI reflects the impact of currency, higher levels of investment, and higher workforce rebalancing than last year, although the workforce rebalancing charge wasn't as large as we had initially expected.

We also had lower divestiture gains year to year.

Looking at our margins, we had a 20 basis point improvement in gross margin driven by our portfolio actions and the relative performance of System z. Our pretax and net margins benefited from this shift to higher value, as well, but they also reflect the dynamics I just mentioned in investments, workforce rebalancing and gains which impacted expense.

Our ongoing effective tax rate remains at 20%, though we did benefit from a few discrete items.

On the bottom line we reported operating EPS of $3.84.

We generated $3.4 billion of free cash flow in the quarter, which is up $400 million from last year.

Over the last 12 months we've generated $13.2 billion of free cash flow though our realization of GAAP net income is in the high 80s.

Over the last 12 months we reduced our share count by over 2%, and increased our dividend, returning about two-thirds of our free cash flow to shareholders.

Now turning to the revenue by geography, in total our performance in the major markets was consistent with last quarter, while the growth markets decelerated driven by the BRIC countries.

To put it in perspective, the BRICs impacted IBM overall growth rate by 2 points in the second quarter.

Or said another way, our revenue excluding the BRICs would have been up 1%.

So, let me start there.

Within the BRICs, only India had modest growth, building on improved operational performance in services.

The other three countries were down at a double-digit rate.

Brazil was down 16%, though our revenue in Brazil last year was up over 20% so it was a very tough compare.

The volatility of our results in Russia continued.

And our revenue in China was down 25%, with fewer large transactions in the quarter.

Outside of the BRICs, many countries improved their performance sequentially.

In fact, outside of the BRICs our growth markets revenue was up 5%, a 4 point improvement from last quarter.

Looking at the major markets, revenue was flat year to year.

The year-to-year performance in many of the major market countries also improved sequentially including Canada, Germany, Italy, France and Japan.

Two of our largest countries, Japan and Germany, posted the strongest growth.

In the US, overall revenue was down low single digit though we once again had good System z performance and we signed substantial new services business.

Turning to the segment perspective, our total revenues was down less than 1% and gross margin improved 20 basis points.

I'll spend more time on the revenue and profit drivers in the segment discussions but let me just make a couple of top-level comments.

Revenue in three of our five segments grew this quarter including our largest segment, GTS.

This quarter systems hardware posted solid growth with double-digit growth in z and mid single-digit growth in power.

And our global financing revenue was up driven by equipment sales.

In the other two segments, GBS and software, our year-to-year performance was fairly consistent with the last few quarters.

Our total margin improvement was driven by a shift to higher value.

Remember the last quarter, the shift was driven by portfolio actions and the relative strength of System z.

The reported operating expense and other income is down 9%.

At this level of spend, our expense to revenue ratio was up 1.5 points year to year.

As we've discussed in the past, within our large operational expense base, we've got a shift going on, driving productivity in some areas while significantly increasing our investment in the strategic imperatives.

This investment is to build capabilities, much of which will be consumed as-a-service in areas like Watson, Watson Health and Bluemix and so we'll see the benefits over the longer term.

The reported decline in expense this quarter is again driven by currency and the divestiture of System x. This quarter we also had a higher level of workforce rebalancing and lower divestiture gains.

I'll comment on each.

11 points of the decline was driven by currency between the translation of non-dollar spending and the hedging gains that are reported in other income and SG&A.

2 points of the decline are due to the fact that we no longer have the expense of the System x business in our run rate.

And this quarter we took a charge of nearly $200 million for workforce rebalancing, nearly all of which is an increase year to year.

This drove expense higher by 3 points.

And then divestiture gains were down $100 million year to year driven by last year's gain associated with the sale of our customer care business.

This added about 1.5 points to expense growth.

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

Combined service revenue was $12.4 billion, with the year-to-year revenue trajectory a little better than in the first quarter.

We closed 22 deals greater than $100 million, balanced between renewals and new scope or clients.

This is the third consecutive quarter of signings growth and with it our total backlog was up more than 1% year to year.

Global Technology Services revenue of $8.1 billion was up 1% with growth in all three lines of business.

This is a 2 point improvement from the first-quarter year-to-year performance driven by a combination of revenue from backlog and in-period revenue.

GTS outsourcing returned to growth, improving 3 points sequentially due to several large deals signed last year that are now completing transition.

We're seeing good traction in the contracts that combine traditional IT outsourcing with the integration of mobility, hybrid cloud and analytics workloads.

Integrated Technology Services also returned to growth this quarter with strong performance in our cloud, security and business resiliency services.

Growth in SoftLayer accelerated as we significantly increased capacity in new data centers since the beginning of last year.

And we now have 41 cloud data centers on five continents.

Maintenance grew 2% driven by growth in our multi-vendor support services.

This is our hardware maintenance offering for third-party platforms which leverages our global distribution and inventory capabilities.

Our pretax profit in GTS was down.

Let me spend a minute on this.

Currency drove the largest year-to-year impact given the strengthening dollar.

We continue to generate significant profits and cash flow in local currencies, but the translation of those currencies back to US dollars significantly affects our reported profit growth.

The divestiture of the System x business impacted our maintenance profit and margin.

And we took a workforce rebalancing charge in the quarter, essentially all of which resulted in a year-to-year impact.

We continue to invest for growth in our strategic imperatives offerings such as bringing additional SoftLayer capacity online and increasing our security and mobility go-to-market skills.

We're also opening new resiliency data centers and expanding our global delivery capabilities.

As you would expect, we look to productivity as a way to fund our investments.

We didn't drive that productivity this quarter, as we were always balancing the timing of our transformation with the dynamics of running our clients' most critical processes.

Global Business Services revenue was $4.3 billion, down 3%.

Revenue declined in the practices focused on traditional back-office implementations.

Customers are migrating away from large ERP projects towards smaller initiatives with cloud, mobility and analytics as their main focus, which are often contracted in an as-a-service model.

We've been shifting skills and work from these declining practices to the new opportunity areas.

We've had strong growth rates in our strategic imperatives, but we need to shift more aggressively to improve our overall GBS business results.

We're also seeing that long-term application management is becoming more important to enterprise clients as the IT environment grows more complex.

Clients are integrating public and private cloud networks, deploying new mobile capabilities into their employee and customer base and deploying analytics around these solutions.

These ongoing changes in clients' needs drive both shorter-term systems integration as well as long-term management requirements, and performance improved across our application management services in the second quarter.

Looking at GBS profit, there were a few drivers of the decline.

The largest impact was from the customer care divestiture which drove 9 points of the year-to-year decline in profit due to the sizable gain in last year's results.

Also, we increased the level of investments to further enable our partnerships and we hired or reskilled additional go-to-market and delivery practitioner resources for our fast growing strategic imperative offerings.

For example, we've hired over 2,000 incremental resources into our mobility practices and shifted almost 1,000 to analytics projects.

The remaining profit decline was driven by the lower revenue on what is a relatively fixed cost base in the short term.

We remain focused on our cost competitiveness through alternate labor models, more aggressively shifting resources to higher value offerings and enhancing our global delivery capabilities.

Our software revenue of $5.8 billion was down 3%.

With that, our first-half revenue was down 2%, which is consistent with the performance in the second half of last year.

Key branded middleware was flat but total software performance reflects a headwind from operating systems and other middleware.

Profit performance in software is a reflection of the overall revenue performance, a higher level of investments in areas like Watson and Bluemix and an impact from currency translation.

We had growth across the solution areas, including security, commerce and social.

And within that we saw strong growth in our software-as-a-service offerings.

Our security software revenue returned to double-digit growth.

Our security solutions bring together intelligence, integration and expertise that are essential in the world of advanced threat.

As an example, one of the top 10 global energy firms was looking for an analytics-based approach to protect tens of thousands of systems and devices globally from advanced threats.

IBM brought together its security solutions and services expertise to establish a security operations center to monitor billions of logs and events on a daily basis.

This intelligent approach to threat management has allowed them to focus their resources on only the handful of high priority threats that warrant further investigation.

In another of our solution areas, our commerce software grew.

Our commerce solutions are allowing clients to get unique insights about their customers.

9 of the top 10 US retailers and each of the top 10 global banks run on IBM's commerce solutions.

IBM commerce now powers 30,000 organizations globally.

Our social solutions again grew double digits, driven by strong performance in both Kenexa and advanced collaboration offerings.

We're continuing to bring innovations to our solutions areas and deepen our industry focus.

Watson is an example of where we're creating a market around cognitive computing and building an as-a-service business.

Last quarter I talked about expanding the Watson ecosystem.

This quarter I want to focus on another aspect of our progress.

Watson's being deployed across nearly 30 countries and in 20 industries.

We are currently working on hundreds of projects to expand industry domain knowledge as well as teaching the system new languages such as Spanish, Portuguese, Japanese and Arabic.

We continue to expand Watson's reach by forging additional partnerships.

And just last week we announced the formation of a joint venture with Mubadala to bring IBM Watson to the Middle East and North Africa with focus on healthcare, retail, education, banking and finance.

Our focus in software continues to be innovation, partnership, and aligning to the needs of our customers and the industries in which they operate.

Turning to our systems hardware segment, revenue of $2.1 billion was up 5% and pretax income was up 26%.

These results are a reflection of both our ability to continue to deliver innovation across our high-end systems and the significant actions we've taken.

This quarter z System's revenue was up 15% and through the first half we grew about 50%.

Power revenue grew 5% this quarter.

We saw growth in both the low end and the high end where we've introduced new POWER8-based systems.

The capabilities of both mainframe and power systems are resonating well with our customers and we continue to add new customers to the platforms.

During our investor briefing earlier this year, I talked about the mission-critical nature and expansion of banking transactions that our mainframe supports.

Our z System offers the most secure, reliable and scalable platform with the best price performance.

So, when a leading managed service provider in Europe was looking to create a cloud platform for independent software vendors serving financial services clients they opted for mainframe.

This is another new IBM mainframe customer.

In that same Investor Day presentation, we talked about the explosion of data and transaction volumes in the telecommunications industry.

So, when a leading telco solutions provider in China was looking to offer a customer experience solution to its global clients, it selected Power on Linux over x86.

The power platform provides both higher capacity and better performance than x86, allowing them to incrementally scale out their solution.

Our OpenPOWER strategy continues to take hold globally.

In June the UK government joined the United States as the second major government to turn to OpenPOWER for its high performance computing priorities.

The UK government will utilize IBM's latest OpenPOWER high-performance computing and Watson-based cognitive technologies to obtain valuable insights from a variety of data sources to boost productivity and drive growth.

This is a similar class of IBM OpenPOWER systems that the United States Department of Energy selected for the Lawrence Livermore and Oak Ridge National Laboratories.

I believe our Power results through the first half show that the power strategy is working.

Our storage hardware revenue was down 4%.

We again saw strong growth in our flash systems with our new generation offerings introduced in the first half.

This growth was once again offset by the wind-down of our OEM business and continued weakness in high end disk.

Our systems hardware segment revenue growth and profitability improvement is a clear result of the actions we've taken to position our systems business for the future.

Moving now to cash flow in the quarter, we generated $3.4 billion of free cash flow, which is up $400 million year to year.

Of course, this is after nearly $1 billion spent in CapEx, consistent with last quarter and with last year.

Through the first half, our free cash flow of $4.5 billion is up over $800 million year to year.

The primary drivers were lower cash tax payments and an improvement in our sales cycle working capital.

This was partially offset by the remaining working capital impact to cash flow from our System x divestiture, payments for performance-based compensation which were accrued last year, and operational performance.

As you know, our annual free cash flow generation is skewed to the end of the year.

And our first half results are in line with that skew.

You'll remember we said that we'd improve our free cash flow realization from 2014 to 2015 and earlier this year we expected realization in the mid to high 80%s.

We now expect the full year to be about 90%.

So, even at the low end of the profit guidance, this reflects a modest year-to-year improvement in free cash flow for the year.

Looking at uses of cash, we spent $700 million on acquisitions.

We've acquired five companies in the first half.

These add to our capabilities in cloud and analytics and deepen our industry domain expertise to further differentiate our solutions.

For example, the two acquisitions made by Watson Health strengthened IBM's leadership in healthcare analytics and support our effort to apply cognitive computing to drive healthier patient outcomes.

In the last six months we've returned $4.7 billion to shareholders.

This includes $2.4 billion in dividends and $2.3 billion in gross share repurchases to buy back over 14 million shares.

At the end of June, we had 987 million shares outstanding and $3.9 billion remaining in our buyback authorization.

Turning to the balance sheet, we ended the quarter with a cash balance of $8.8 billion, up $300 million from December but down from a year ago.

Total debt was $38.7 billion, of which just over $26 billion was in support of our financing business.

The leverage in our financing business remains at 7 to 1. Our non-financing debt of $12.6 billion is down $4.5 billion from a year ago.

Our non-financing debt to cap was 55%, which is down 4 points from December and almost 1 point lower than a year ago.

We continue to be well positioned to support our long-term growth strategy.

Now let me wrap it up and talk about our expectations for the full year.

You've seen us move aggressively and decisively to reshape our business to best address the long-term value in IT.

We've been shifting investments and resources, building partnerships and ecosystems, and introducing key innovations.

Since the beginning of the second quarter we launched Watson Health, acquiring Phytel and Explorys, and partnering with other leading healthcare companies.

We finalized the divestiture of our semiconductor manufacturing business to GlobalFoundries while we introduced a breakthrough in 7-nanometer technology.

We announced that we'd embed Spark into our analytics and commerce platforms, and formed an innovative new cloud partnership with Box.

Each one of these actions contributes to our transformation and improves our hand for the long term.

Let's talk about what it means for 2015.

In the first half, our revenue in the strategic imperatives grew more than 30%.

Those markets are also growing but with our performance we're clearly gaining share.

The core portfolio continued to decline in a declining market.

So, together the strategic imperatives in core delivered revenue at an IBM that was roughly flat.

For the full year, we continue to expect to deliver operating EPS of $15.75 to $16.50.

And even at the low end of the range we now expect a modest year-to-year improvement in free cash flow for the year.

We've said from the beginning of the year the primary variable between the high and the low end of the guidance is our software revenue trajectory.

From a margin perspective, for the full year we continue to expect to expand margin driven by portfolio actions.

We also said we'll continue a high level of investment and we'll continue to return value to shareholders through both share repurchase and dividends.

For the third quarter, if you look back over the last few years, we typically see about $1 billion decrease in revenue from second to third quarter.

There's no reason to think this year would be different than our typical seasonality.

So with $1 billion less quarter to quarter, third-quarter revenue would be about the same size as the first.

Now, what is different is the mix of business relative to what we've seen historically.

But even with that, we'll continue to expand margin in the third quarter driven by our portfolio actions.

When you look at some of the other dynamics in the third from a year-to-year perspective, currency impact, investments, and workforce rebalancing, the third-quarter profit trajectory looks a lot like the second.

Now, there are some differences -- like we don't have a gain in last year's third quarter results.

But on balance, the year-to-year profit would be pretty similar to 2Q.

This is true for the EPS trajectory, as well.

Through the first half, relative to the low end of our guidance, we are at the same point as last year and ahead of the year before.

In the third quarter, given the profit trajectory I just described, we expect to finish the third quarter with 63% to 64% of our low-end EPS guidance achieved, consistent with prior years.

And then where we finish within the range for the full year really depends primarily on whether we have a change in trajectory in our software business.

Importantly, as we progress in our transformation, we'll exit the year a higher value business.

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 on the quarter.

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

Operator, can you please open it up for questions.

(Operator Instructions)

The first question comes from Toni Sacconaghi with Bernstein.

You may ask your question.

Yes, thank you and good afternoon.

I was wondering if you could talk a little bit about software.

The business was down 3% at constant currency.

I think other than the financial crisis in 2009, that's the lowest software growth rate in the last 15 years.

You also had a significant accompanying pressure on margins.

I'm wondering if you can step back.

At the beginning of the year you were hoping for an improvement.

In talking about the guidance, it looked like perhaps you're not as confident.

You're saying we could end up at the low end of the range if we don't improve, maybe we'll do better than that if we do improve.

But I'm wondering if you can step back now that you're halfway through the year.

The results seem to suggest that there is something structural impacting your software business.

Now, whether that's the decline that we've seen in Unix over the last couple years or whether it's the migration to as-a-service, there seems to be an inflection point over the last four quarters in your software business for the worst.

And I'm wondering if you can step back and tell us if you agree with that and what do you think is driving this.

And do you have confidence, like the same level of confidence as you did six months ago, that the software business will improve throughout the year?

Sure.

Thanks, Toni.

Good afternoon.

A few comments I think on software.

And some of these themes are going to be consistent with what we've talked about, and then some of them will be observations as we go through the year.

First, relative to guidance, as we've said since the beginning, the primary difference in our guidance range for the year is driven by the trajectory of software.

So, when we went through in the prepared remarks and pegged third quarter to the low end, I wasn't suggesting that we don't see that difference still.

In fact, we do still see software driving the difference between the low and the high end, but when you have a range you do have to pick one side to anchor your analysis.

So, we chose, in this case, to anchor to the low side.

With regard to software, there are some consistent themes here that we've been observing now for a while.

We do still have in our overall growth rate a headwind from the operating system element of our business.

That was about a point.

Additionally, what we saw in the BRIC countries' impact on IBM, and I mentioned this in my prepared remarks, even though the BRICs are relatively small, only about 7% of our revenue, they had a 2-point impact on the growth.

That same phenomenon translated into key branded middleware.

So, ex the BRICs our key branded middleware segment, software segment would have had 2 points of growth, as well.

So, when we look underneath that, I think the consistency here is that we have two phenomenon.

Within our top 250 clients, and we've talked about the substantial both investment and commitment those clients have made to the software platform, within that client base we continue to offer and they continue to utilize flexibility so that they can fully deploy our middleware across their environments.

And that phenomenon hasn't changed.

Outside of that top 250 clients, we do see growth.

We've been growing there and we continue to grow.

So, it really is this flexibility that we're providing to our clients, which we still think for the long term is the right thing to do as they commit to the platform.

The next question comes from Tien-Tsin Huang with JPMC.

You may ask your question.

Great.

Thanks.

Good afternoon.

Just on the strategic imperatives, up 30% again, so up 30% for the first half.

I'm curious if that growth rate is sustainable into the second half.

Martin, I know you suggested it could come down to the 20% level of last year, but checking to see if that's still the case for the second half of the year.

Thanks, Tien-Tsin.

It was quite a good acceleration, as we mentioned in the last call, from the fourth into the first.

And as you noted and as we just talked about in our prepared remarks, we were able to maintain that trajectory into the second quarter.

So, we finished the first half in a very strong position in strategic imperatives.

And given our growth rates and where we think that market growth rate is, as I mentioned in my prepared remarks, I think we're growing share across that space, as well.

When we look forward in those strategic imperatives and we look forward at the overall revenue trajectory of IBM, we have not assumed a dramatic improvement, if you will, in the overall revenue trajectory at the low end of our guidance.

At the high end, obviously, as we just talked about in the last question and in the prepared remarks, the high end we assume an improvement in the software trajectory, some of which will be in the strategic imperatives, obviously.

In fact, the weighting of our software business in strategic imperatives is larger than the overall business, so I would expect that we would see an improvement in that.

But, again, our current guidance at the low end does not assume a dramatic improvement in the overall revenue trajectory.

So, so within that, the mix between the strategic imperatives, again, which have a lot of momentum versus the core, we're not suggesting that we have to grow or we have to change the trajectory at the low end.

Next question comes from David Grossman with Stifel.

You may ask your question.

Thank you.

Last quarter, Martin, we discussed cash tax as a tailwind this year, but offset by other headwinds.

And then as of April it appeared that cash taxes would be actually free cash flow headwind in 2016.

Is that still the case?

And if so, are there known tailwinds next year that would offset that and allow the free cash flow conversion rate to remain in that 90%-plus range that you talked about for this year?

Sure.

Thanks, David.

A few things.

There are a number of metrics here.

I want to make sure that we triangulate to the right answer and that we don't confuse or we don't mix some of the data points.

Cash taxes, as you know, last year were a substantial year-to-year headwind and this year they are not a year-to-year headwind.

And the amount of cash tax tailwind that we're getting this year is the same as we thought it was going to be at the beginning of the year, so no change to that.

Now, let's switch for a second to the realization metrics.

Cash taxes were about a 10-point headwind to realization last year, a very dramatic headwind to our realization.

This year, they are still a headwind, although much reduced.

So the realization impact is only about a point or two.

So, when you think about the relationship of what's going on, our cash tax rate will still be a little bit higher than our book rate, although not as high as it was last year.

This year cash taxes will be a little bit higher than the book rate.

So there's still a realization impact, but there's a year-to-year tailwind in terms of payments.

Now, next year we still have a lot of work to do and a lot of planning to do.

And while we have a small headwind in realization this year, we do see a headwind in realization next year.

And how that translates to a year-to-year, I think we have to spend the next six months trying to figure that out, and then we'll have more guidance in January for you.

But again, there are different elements here.

From a realization, cash taxes are still a headwind this year, although smaller than last year.

And next year we expect them to be a headwind, but we'll have to translate as we get closer into what that means on a year-to-year base for 2016.

But as we just mentioned in the prepared remarks we do see now a modest improvement in free cash flow for this year.

The next question comes from Lou Miscioscia with CLSA.

You may ask your question.

Can we circle back to the services side, in the sense that consulting and systems integration was weak again and you had talked about having to shift some of your resources?

Maybe if you could go in and say if it's cloud or ERP deployments are going down or being replaced by SaaS deployments?

And maybe you're not winning as many programs there, given that others are growing actually consulting pretty well here in the beginning of 2015.

Sure, Lou.

Good afternoon.

A few things.

Our GBS, and when we talk about consulting systems integration I'll just focus the answer on our Global Business Services segment.

GBS was, as you noted, down again in the quarter, although quarter to quarter we had about a 1 point improvement in the trajectory.

Still down, but a bit better than the first.

And the dynamics within that, I think, are similar to what we saw in the first, which is the shift that we're undertaking -- and what you noted in your question -- the shift that we're undertaking is pretty dramatic.

And we are seeing very strong double-digit revenue growth within the strategic imperatives, within the GBS business alone.

Now, we also have a pretty substantial -- think about it as a traditional ERP implementation kind of consulting business.

And the net of the shift to those strategic imperatives and obviously the reduction in our resources applied to those larger implementations, that engineered shift is not yet at the point where the revenue growth coming from those imperatives is offsetting, if you will, our reduction in the areas that address those traditional ERPs.

The core is still the largest part of the portfolio, those traditional parts of ERP implementations.

And while we engineer that shift, we are going to see declines in that part of the business.

But as I mentioned, that shift is driving growth in the strategic imperatives.

We just have to continue to be as fast as we can to get to those areas so we can see growth overall for the GBS business.

The next question comes from Steve Milunovich from UBS.

You may ask your question.

Thank you.

A couple non-operating items, Martin.

Last quarter you suggested currency could hit EPS about $0.80 for the year.

I was curious if that's still the number.

And it looks like your expectations for the next few quarters on currency, it's similar to a little worse than in the April quarter, and I'm a little surprised given the move in the euro.

Then also was curious about the 17% tax rate.

Should we carry that forward or does that go back to 20%.

Sure, thanks, Steve.

A few things.

First on tax -- we'll start at the back on tax -- we still see a 20% rate for IBM.

That's the right operating rate, if you will, for us.

We did have, as I noted in the call, a couple of discrete items in the quarter but those were discretes in the quarter.

Now, we do have discretes throughout the year, but 20% is the right number for tax.

On currency impact -- I'll come back to earnings in a moment, the first part of the question -- currency impact is now a little bit worse for the year relative to what we expected, just 90 days ago.

You may remember, we include, as we always do, a supplemental chart on the impact of currency.

And we had on that chart in April that the third quarter would be about an 8-point impact and the fourth quarter would be about 5 year to year.

And now we see 8 to 9 and 5 to 6 in terms of the currency impact.

And that data, again, is in the supplemental chart.

So we are seeing a slightly increased currency impact for the second half of the year.

Now, our view of currency and its impact on profit is, and can be, as you would imagine, the translation impact could be quite substantial.

We did say that the impact to earnings would be about $0.80 for the year.

And we still see, while it's gotten a little bit worse, we still think that's probably a little bit worse, as well.

But we can hold that within the guidance we've given.

So yes, the impact to EPS is probably a little bit worse than what we had assumed.

We do have actions under way to try to navigate through whatever currency environment we're in.

But the year-to-year impact is still fairly substantial in our guidance.

Now, of note is that the guidance, as you know, reflects an EPS of flat to down 5, and the currency impact is 5 points, roughly, in terms of earnings.

So, if we were in a benign currency environment -- we'll discard the idea of it being an actual tailwind at some point -- but if we were in a benign currency environment our guidance would reflect flat to up 5. And that's the kind of impact I think that you would expect to see in a company that has more than 60% of its revenues and cash flows and profits, a dramatic part of its profits, operating in currencies other than the dollar.

The short answers to your questions, tax at 20% is still the right thing in terms of operating.

The currency impact is a little worse than what we assumed from 90 days ago.

And it is a dramatic year-to-year impact on our profitability.

The next question comes from Brian White with Cantor Fitzgerald.

You may ask your question.

Yes, Martin.

It sounds like services you got some bigger deals in the quarter.

I know services in aggregate beat our number.

When can we start to see margins improve back to levels that we saw two, three years ago in the services business?

Thanks.

Sure.

Thanks, Brian.

We did see, as you saw, we had a very strong signings quarter which, as we noted in the prepared remarks, drove our backlog to 1% growth ex currency.

It's the first time we've had backlog growth in a couple of years.

So, obviously, very encouraging to get the services backlog growing so we can start to see a more consistent delivery of revenue growth.

Obviously, within that, revenue growth in that business does drive profit leverage.

But keep in mind that we continue to invest quite heavily, as well, in order to make sure we're building the right cloud platforms, the right skills around that services business.

So, while the single largest impact year to year in our services profitability -- not on margins, but services profitability -- is the translation of those profits back to dollars, given the dollar strength, we do see an opportunity to continue to invest quite heavily in our services business.

We do see opportunities to continue to move not only the GTS business, but the GBS business to higher value.

And over time, that will drive margin improvements.

But for now, we're not relying on margin improvements in our guidance for this year.

But, again, the single largest impact on a year-to-year basis is currency.

So, we continue to invest, if we were to continue to grow revenue in GTS, for instance, that will drive some leverage in the profit model.

We are going to continue to invest pretty heavily going forward.

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

You may ask your question.

Hi, Martin.

I wanted to follow up on that last point.

I understand currency impact on the services segments.

But as you look out beyond the next quarter or two, won't you need to, A, continue to invest in these businesses on both GBS and GTS, and, B, as you make that adjustment to the higher growth areas, is there a mix impact that will continue to weigh on margins even as you look out a bit further than the near-term quarter?

So, both the investment side and the mix side, as you think about both sides of services, please.

Sure.

A couple of things, Keith.

First, we will continue to invest.

So, let's assume we'll get through at some point the year-to-year impact of currency and we'll just take currency out of the equation for a second.

When we look at our model we see a few elements that will continue to drive profit growth within services, while at the same time continuing to invest.

First, we will continue to drive capacity utilization into our cloud business.

Remember, we're investing pretty heavily in cloud and I would say that those businesses are not yet at scale.

So, as we get those and utilize that capacity and get to scale, then we'll see margin improvements in the services business.

Secondly, we continue to shift that overall portfolio to the most contemporary highest value offerings that our clients are demanding.

And I think you can see that both in the signings we had, for instance, in our services business and the backlog growth.

You can see it in the strategic imperative performance within GBS.

So, we continue to shift those offerings to higher value.

And then underpinning that, the delivery side of this, the delivery elements of this, including much broader deployment of intellectual property, leveraging our software and our research ability to put automation into our delivery content.

So, we do still see opportunities to keep a balance between -- we'll keep investing but we'll also be able to drive a more efficient delivery platform as we get out of this currency environment.

And then, finally, I think it's important to note that while we do make use, pretty heavy use in some countries, like the US, we have a pretty good global delivery platform within the US, that's not the same everywhere in the world.

In some regions in the world our use of global delivery is still under 30%.

So, we still have opportunities in those regions to move more of our delivery into a global delivery format.

I still see, between the shift to higher value, between getting cloud to scale, and the move to automation and getting more of our regions into a global delivery environment, we still have room to improve margins in services.

The next question comes from Jim Suva with Citibank.

You may ask your question.

Thank you very much, Martin.

In your prepared comments you mentioned a little bit about operating expense as a percent of sales had increased due to the mix shift, which I believe is understandable.

And I assume you're referring to the mix shift to more strategic imperatives.

And if so, that's manifesting itself in nice growth.

I think you said up 30% year over year which is good.

Can you help us understand the time frame or the milestones for judging and assessing those strategic imperatives and the investment in them of when we really start to see leverage to the model of leveraging that growth into a lot more profitability?

Or, in other words, how much longer do you have to keep really investing a lot more ahead of the fruit of all that?

Sure, Jim.

Thanks for the question.

A few things.

In the prepared remarks on expense, what we talked about was a slightly higher E to R in the quarter.

And we wanted to go through and make sure everyone understood that the 9% year to-year improvement in expense was driven heavily by just the translation, the currency impact, which was actually 11 points a year.

So, currency obviously has an impact on the expense side, as well.

We also talked a bit about the impact of having the expense from our System x divestiture now out of our run rate.

That was a couple of points.

So, we wanted to make sure that everyone understood, our investors understood, that we continue to invest.

And that's why the E to R is up in terms of the second quarter.

Now, when do we get through that?

Boy, we see an industry where innovation, where industry skills and knowledge are the differentiators in many of our engagements.

A lot of our investments are focused on, yes, the strategic imperative, as you said, which is a combination of shifting out of things that we were doing into new things.

It's also part of growing that overall investment pool.

But within those investments, yes, there's strategic imperatives but it's also a lot of investments around building industry skills, industry talent, because more and more our clients are looking for that industry point of view.

I don't know that we get through, if you will, the bow of the ship through the wave in terms of expense, in terms of investments, when do they slow down.

Now, I do think they're paying off.

We had tremendous growth in cloud again.

We had tremendous growth all across the strategic imperatives.

Shifting this expense, as we talked about in the beginning of the year, is absolutely the right thing for us to do for the long term.

We see that payoff in terms of market share we're growing in those strategic imperatives.

Now, those will continue to pay dividends for a long time.

Within that, as you know, we're building a number of as-a-services businesses including Watson.

I think that those investment levels are important.

I think we'll continue to maintain those investments because we're building some very appealing businesses underneath those strategic imperatives.

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

You may ask your question.

I was wondering if we could get some sense of what percentage of revenue the strategic imperatives are.

And how do they impact your visibility on the business?

And then just one last one -- have we hit a positive inflection point on the services backlog?

Thanks.

Sure.

A couple things.

Have we hit a positive inflection on the services backlog -- we'll start with that.

The backlog is $120 billion-plus, so it's hard to make it move, if you will.

We had a very good signings quarter, as we talked about -- 22 deals greater than $100 million.

We still see a lot of opportunity in terms of additional services opportunity.

But getting that substantial backlog to move, it takes a lot of services, signings over a consistent period of time.

So, while we see very good demand, it's tough to predict on a 90-day basis where the backlog is going to be, given it's $122 billion that we're trying to move.

Now, as a percentage of revenue, last year at Investor Day we talked about on a full-year basis at about 27%.

And we said in Investor Day that we're going to grow that to about 40% -- be more than $40 billion, about 40% of our revenue by 2018.

Now, I think, even though there's seasonality in this number, I would say we are certainly ahead of the 27%, given the growth, and we're making tremendous progress toward that 2018 goal of 40% of our business.

But given the seasonality, I'm not sure that where we are within that range is all that insightful.

We will take our temperature again on this at the end of the year so that you can get a data point without much seasonality or without any seasonality.

But, again, from 27% last year, we're on our way to 40%.

And I'd say the two data points that we have of 30%-plus, 30%-plus, first and second quarter, are in very good shape.

Remember, we showed at Investor Day, we showed a chart that said these had been growing at about 19% fairly consistently over the last few years.

So, you should assume, and I think we're comfortable, that we're making very good progress on that longer-term goal.

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

You may ask your question.

Thanks a lot.

Good afternoon.

Just want to get back to the software segment.

Can you just talk about, do you think the business performed in the June quarter in line to your plan, or was it ahead or below?

And then when you look at the PTI margin decline you saw in software, is that a reflection of the flexibility you're providing to your customers as they move to strategic imperatives and it should get back to a more normalized level once you get beyond that initial transition?

Or does that really reflect more of the reality that some of these strategic imperative revenues may be at a lower margin than your legacy revenues are?

Sure, Amit.

A couple things.

In terms of in line with the plan, we've said since the beginning of the year that at the low end of guidance we don't assume a change in trajectory and at the high end we do.

And that's, by the way, to oversimplify a nearly $100 billion corporation.

But we'll oversimplify it for the purpose of this question.

And right now, given that the trajectory in software has not changed, I'd say that we are right in line with our plan, but we're right in line with that low end of guidance.

I don't think that would surprise anybody.

With regard to the margin, a couple of things.

One, software is a very high-margin element and continues to be a very high-margin component of our overall mix.

Now, when we look at margins, I think there are two things I would disaggregate.

On a gross profit level margin, the only real shift we see is a slight shift to our SaaS properties.

So, while they come in at slightly lower margins than our traditional on-prem business, they are still highly accretive to the overall IBM model, because, bear in mind, these are new spaces for us.

We're not taking and converting an on-prem business to an as-a-service business.

We are building new revenue streams in spaces where we're not today.

So, slightly lower gross margins on the SaaS business, but all accretive to the IBM model.

And then the net margins in our software business reflect a lot of the investments that we've talked about, both in strategic imperatives.

And, remember, we continue to invest in our core businesses because as we talked about at Investor Day and in other venues, the contemporary nature of those, while they are products that have been in our clients' sights for many years, and they're committed to those products, those products evolve into the latest, most contemporary needs, as well.

Those products now have to live in and support our clients in a mobile world, in a social world and they have to have analytics capability, as well.

So, the old products are also part of that investment.

From an investment standpoint, I would say that you're seeing the investments in our software business on the net margin line.

Let me take a few minutes to wrap up the call.

We're halfway through now a transformation year.

And you can see in our results with the investments, and, of course, the shift in our business, we're seeing good progress as we move more of our business into the strategic imperatives.

We've been very active in reinventing our hardware business, and I think that's paying off.

And the investments and the added focus we've put on the solution areas are contributing to some pretty strong growth in those strategic imperatives.

With six months behind us, we've maintained our full year of EPS, even though, as I mentioned in the remarks and in the Q&A, that currency's probably a little worse than it was at the beginning of the year.

But we're maintaining our EPS guidance.

And, as we talked about in our prepared remarks, we've taken up our view of free cash flow modestly, so modest growth free cash flow for the year.

We said from the beginning that this will take some time.

We continue to manage the business for the long term and we're confident that we're on track to that longer-term trajectory.

Thanks very much, everyone, for joining us today.

Christine, we'll 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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