International Business Machines Corp (IBM) 2016 Q1 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.

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 first-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 and 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.

Before turning the call over to Martin, I want to remind you that at our investor briefing in late February, we discussed a number of changes to our management system and our organizational structure.

As a result, our segment reporting structure has been updated to reflect our business structure.

We provided two years of historical financial information by quarter on these segments a few weeks ago.

This can be found on our investor website.

Today, we'll be discussing our first-quarter results in this new segment structure.

In addition, you'll see that we've updated our earnings presentation slides not only to address the new segment structure but also to provide additional disclosure on our strategic imperatives and to provide more commentary on the business drivers.

So with that, I'll turn the call over to Martin Schroeter.

Thanks, Patricia.

Again this quarter we made a lot of progress in transforming our business and we got done what we set out to do to start the year.

We delivered $18.7 billion in revenue, $2.3 billion in net income, and operating earnings per share of $2.35.

Importantly, we also made significant investments and took significant actions to accelerate our transformation and move our business into new areas.

Our enterprise clients are looking to get greater value from their data and their IT environments.

They're not just focused on reducing costs and driving efficiency but using data to improve decision making and outcomes.

They are looking to become digital enterprises that are differentiated by cognitive.

Our strategy is based on the point of view that this requires a solutions focused, industry expertise, and innovative technology, all supported by leading edge skills.

And so to move our clients to the future, we've been making significant changes to our business.

We're not only transforming our existing businesses, but building new markets and addressing new opportunity areas.

We're creating cognitive solutions that marry digital business with digital intelligence.

We're bringing our industry expertise together with these cognitive solutions, and we're building it all on cloud platforms.

And because we're running our clients' most critical business processes today, we're in a unique position to move them to the future.

We've been shifting investments and resources and as we move our business forward, we've also changed the way we run the business to be more aligned with these opportunity areas.

We have proof points that we're making progress.

This quarter, we continued our pattern of strong double-digit growth in our strategic imperatives.

This revenue was up 17% at constant currency which is consistent with our performance in the fourth quarter and continues to be substantially faster than the market's growth.

I'll talk about our revenue results on a constant currency basis throughout the presentation.

So now over the last 12 months, strategic imperatives delivered $30 billion in revenue, which represents 37% of our total revenue; that's two points ahead of where we were 90 days ago.

In the quarter, our total cloud revenue grew 36% to $2.6 billion with the as-a-service components growing 46%.

Our annual run rate for the as-a-service revenue is now $5.4 billion.

Our analytics revenue grew 9% on a large base.

You'll recall it was an $18 billion business for us last year.

And mobile and security each posted strong double-digit growth.

As we transform our business and move into new areas, we need to transform our workforce, not only the types of skills but how we operate.

This quarter, we took significant actions to transform our workforce and shift our skills base to new areas and to improve our structure primarily outside the US.

This resulted in a pre-tax charge of just under $1.5 billion.

As we discussed in late February, we also had a tax refund in the quarter of $1 billion plus interest.

And so the amount of the tax benefit was essentially equivalent to the charges on an after-tax basis.

It's important to recognize that these actions are impacting our profit and margins this quarter while improving our position for the future.

We're continuing to invest and to add capabilities to build out our cognitive and cloud platforms.

I'll comment in a few items from just the first quarter alone.

We completed the acquisition of The Weather Company's digital assets.

This is not only a source of valuable weather data but a high-volume, cloud-based, inside-driven platform.

We're bringing this together with our organic launching capabilities to form the basis of our Watson IoT platform.

This quarter, we announced a number of partnerships with companies including VMware to accelerate the adoption of enterprise hybrid clouds and GitHub to advance the development of next-gen cloud applications for enterprises.

And we've brought Swift to the cloud, enabling mobile developers to build end-to-end mobile hybrid apps.

We've integrated a portion of our software business into our cloud business, and all of IBM's relevant software is now on the IBM cloud.

We acquired UStream and will bring it together with SoftLayer and our object storage capabilities to extend our leadership in cloud video services.

At the end of the quarter, we announced the acquisition of Bluewolf, a top salesforce partner and leader in cloud consulting and implementation services.

GBS was already the largest digital design agency, and this quarter we extended our capabilities with the announcement of three acquisitions that will be integrated into IBM Interactive Experience.

We're continuing to expand our Watson ecosystem and reach.

Over the last 12 months, the number of developers using Watson APIs is up over 300%, and the number of enterprises we've engaged with has doubled.

Watson solutions are being built, used, and deployed in more than 45 countries and across 20 different industries.

And this quarter, we significantly added to our Watson Health platform with the acquisition of Truven, a leading provider of cloud-based healthcare data, analytics, and insights.

This was announced in February and closed just over a week ago.

I'll expand on these solutions and go into more detail on our strategic imperatives performance in the segment discussions, but first I'll turn to our financial metrics for the quarter.

Our revenue for the quarter was $18.7 billion.

Currency continues to be a headwind to our reported revenue performance, over 2.5 points this quarter.

This is 0.5 point better than the low end of the range we provided in mid-January, or about $90 million translation benefit.

On a constant currency basis, our decline of 2% is consistent with last quarter.

Now within that 2% decline when you consider the impact of the mainframe cycle and the additional content from acquisitions this quarter, our underlying revenue growth rate improved by 2 points versus the prior quarter.

From a geography perspective, our performance in the Americas was consistent with last quarter, with improvement in the US and decline in Latin America driven by Brazil.

We've built a strong business in Brazil over the years, though the last few quarters have been more volatile.

This quarter, Brazil was down in part due to a tough compare but also an economic environment that looks uncertain.

We've taken some action to refocus our business which impacts our growth in the short term.

EMEA posted a modest decline while Asia Pacific grew for the first time in quite awhile.

Our gross margin performance reflects higher levels of investment and a mix impact within our segments.

Our systems margin was up consistent with the product cycle dynamics in our zSystems as well as improvements in power and storage.

You can see our expense was up significantly driven by charges for the actions to accelerate the transformation of our business.

These charges impacted pre-tax income by a $1.5 billion and pre-tax margin by 8 points in the quarter.

I'll talk more about the charges and implications to the future later.

Our tax rate for the quarter reflects an underlying rate of 19% as well as the benefit from the resolution of a tax case outside the US.

This was a discrete item and drove our tax rate negative.

From a cash perspective, we generated over $2 billion of free cash flow in the quarter, about half of that coming from the tax benefit.

Over the last 12 months, we've generated over $14 billion of free cash flow and this is 110% of GAAP net income.

Given the seasonality of our cash flow, it's best to look at realization on that trailing 12-month basis, and in the last year, we returned about two-thirds of our free cash flow to shareholders through dividends and gross share repurchases.

With the changes we've made to our management system and organizational structure, we've implemented a new segment structure.

As Patricia mentioned, we provided historical information on this segment structure a few weeks ago.

Before getting into results for this quarter, I want to spend a minute on the structure.

Our segment discussions will also be a little longer than as typical to address the drivers of performance on this basis and the progress we're making in moving our business to the future.

So looking at the segments, Cognitive Solutions includes the solutions software addressing many of our strategic areas including analytics, security, and social, as well as the transaction processing software.

Many of these are new opportunity areas like Watson Health and Watson IoT opening up revenue and profit pools beyond traditional IT.

Because we're building new businesses in new markets, they will ramp over time.

The scope of our Global Business Services segment overall is unchanged, though we are now providing our revenue results for consulting, global process services, and application management which is aligned with the way we're now organizing and going to market.

GBS has been shifting its business toward the solution areas including creation of a cognitive consulting practice, and earlier this year, GBS strengthened its industry capabilities.

As we bring the industry expertise together with cognitive solutions offerings, we'll put more focus on the combination of these two businesses, which we refer to as cognitive solutions and industry services.

Technology Services & Cloud Platforms includes our global technology services business and IBM's cloud infrastructure and platform capabilities.

This business now includes WebSphere and related software products reflecting the importance of integration software to the enterprise grade hybrid clouds.

Systems includes our hardware offerings of zSystems, power, and storage, and now also the related operating system software.

Global Financing is unchanged consisting of client and commercial financing and used equipment sales.

Now as we've said, the primary driver of the changes to our operating structure and subsequently our segments is the realignment of our software portfolio as software value shifts to new areas.

Software is made up of our Cognitive Solutions segment, integration software, and operating system software.

We've broken out the revenue and gross profit results within the segments but as we transition to the new structure, we'll also provide a perspective on total software.

I'll talk about it after going through the four segment discussions and we've also provided information in our supplemental charts.

Given the solutions nature of our offerings, our strategic imperatives are included in each of our segments and so going forward, we are providing additional information on the strategic imperatives revenue within each segment.

So now let's turn to the segment performance and I'll start with Cognitive.

I mentioned that solutions software includes analytics, security, and social.

To give you some context, analytics is the largest part of our solutions portfolio and includes our traditional analytics platform, industry solutions, commerce, and the Watson related businesses.

Transaction processing software, on the other hand, primarily runs mission-critical systems in industries like banking, airlines, and retail.

This includes our offerings such as CICS, TPF, and IMS running on zSystems which were primarily reflected in other middleware in our previously reported software segment.

Most of it is on-premise and annuity in nature and not a growing opportunity in the software market.

In the first quarter, Cognitive Solutions generated revenue of $4 billion, which was up modestly year to year.

Solutions software grew mitigated by a decline in transaction processing software.

Our solutions software growth of 3% was a significant sequential improvement from the fourth quarter of last year.

Contributing to this growth was strong double-digit performance in our Watson cloud-based offerings and acquisitive content.

From an offering perspective, the growth was led by analytics and security.

In both of these areas, we have highly differentiated strategies and capabilities.

Security isn't just about trying to keep things out.

We approach security as a big data problem.

On average today, organizations use 80 security products from 40 different vendors, and they're looking for us to bring all this together.

We're in a unique position as we not only provide our own leading capabilities but bring it all together for them in an integrated solution.

Security solutions are a mix of on-premise software and software-as-a-service, and we believe we have the largest enterprise security software-as-a-service business.

Our leadership and momentum continued into the first quarter with high-single-digit growth in our security software outpacing the market.

In addition, we continue to invest to build our security platform, and we recently acquired Resilient Systems, which provides leading incident response capabilities.

This acquisition expands our overall leadership and security where we lead the market in four out of six security segments.

With our differentiated strategy and our market leadership, we can attract the best talent in a very competitive market.

We now have more than 7,000 security experts adding more than 1,000 in the last year.

We can attract top talent because we're not just identifying problems and doing audits, we're solving security problems.

Our approach in analytics is also unique and differentiated.

We're building an industrial strength cognitive platform that is cloud-based and leverages Watson.

It's also supported by industry specific data and an ecosystem to help provide new insights in key industries.

This allows us to go after a new $2 trillion market opportunity beyond the $1.2 trillion traditional IT market.

So it's a new and incremental opportunity for us.

Watson Healthcare is our first industry focus area where we are creating a new market.

This is an industry with billions of dollars of new revenue opportunity for IBM.

We started to move into the cognitive healthcare space just about a year ago and have invested $4 billion through four acquisitions.

We're scaling rapidly moving from effectively no employees to more than 6,000 in a year.

Most came to us through the acquisitions but we've also hired nearly 700 employees who are highly skilled healthcare professionals who will now make a difference in millions of lives.

We believe success will be based on building platforms, and we're focused on leveraging partnerships and ecosystems.

We're now working with clients such as the American Cancer Society, the American Heart Association, and Under Armour, in addition to initial partners of Medtronic, Johnson & Johnson, CVS, and many more.

As I mentioned, in early April we closed our Truven acquisition that brings more than 8,500 clients to our Watson health portfolio including employers, health insurers, hospitals, clinicians, life sciences companies, and government agencies that support health programs.

Data and insights from Truven inform benefit decisions for one in three Americans.

We're already seeing the signs of our strategy playing out.

In the first quarter, we closed deals with a few large US healthcare insurers who have millions of members that can use our Watson Health cloud-based solutions.

We believe the healthcare industry is moving to value based care.

It is still early stages but as the market shifts, we're positioned to deliver value.

We're also broadening the reach of Watson as it starts to support an increasing number of decisions.

Let me share a few more examples.

When we first introduced Watson, it could reach a population of 400 million English-speaking people.

As Watson has been taught more languages, it can now speak with another billion people in their native language.

We are working on our Watson oncology solution with a number of hospitals that have a combined reach of more than 3 million patients.

You heard from a few of our healthcare clients on investor day.

Let me comment on another in insurance that has Watson in production.

GEICO is using Watson in 46 states to enhance aspects of their industry leading digital channel.

They are encouraged by the results they have seen with existing and new policyholders in areas including online experience, engagement, and sales.

So now looking at the profit results for this segment.

The gross margin is impacted by our lower level of transactional revenue and the fact that more of our new areas where we are investing are cloud-based and build over time.

The pre-tax income performance also reflects a higher level of investment in areas like Watson platform, Watson Health, and Watson IoT, as well as an impact from workforce rebalancing charges and currency.

Global Business Services delivered $4.1 billion of revenue, which is down 2%.

As I mentioned earlier, global business services segment content in total did not change but within GBS, we are now reporting consulting, global process services, and application management consistent with the way we're running the business.

Our application management business helps modernize a client's application processes and brings apps to market faster through digital cloud platforms like Bluemix.

Our application management revenue represents about 45% of GBS revenue.

Performance was relatively stable last year and that continued into the first quarter.

In consulting, which was another 45% or so of our revenue, the process of shifting to the new areas continues to impact our growth rate, but we did see some improvement versus the prior quarter.

Global process services revenue, which is less than 10% of GBS revenue, was down 1%.

At our investor briefing in February, we spent time on the shift that we're driving in GBS, away from some of the more traditional areas and to the more strategic areas.

This quarter, GBS revenue in the strategic imperatives was up 22% with strong growth across our cloud, analytics, mobility, and security practices.

We're expanding our design capabilities as consumer grade experience is becoming a new strategy for enterprises.

This quarter, we announced three acquisitions that will be integrated into the IBM interactive experience, the largest global digital agency.

Through our experienced design capabilities, we're able to bring clients the distinct combination of industry insight, design thinking, and end-to-end digital transformation.

We are delivering high value digital services in over 25 studios worldwide including a new studio in Dubai that we announced this quarter.

We are investing in expanding our skills in other areas as well.

We recently announced the acquisition of Bluewolf which has over 500 resources across the US, Europe, and Australia.

This will extend our industry consulting leadership with one of the world's leading salesforce consulting practices to deliver differentiated consumer grade experiences through the cloud.

Our Apple partnership continues to redesign workflows and drive productivity for our clients.

We recently announced strategic mobile transformation products with RWE Generation in Germany for mobile maintenance of heavy mining equipment, with Alior Bank in Poland to transform the way clients experience banking services, and with Etisalat in Egypt to deploy the Expert Tech app and transform how its remote site support technicians deliver services to their customers.

Turning to GBS profit, our gross margin was down about 1.5 points as we continued to invest to drive our transformation.

We're engineering the shift of our resources to higher value services which is a near-term impact on our margin.

Our strategy is based on moving to higher value, so we will continue this shift.

We continue to see price and profit pressure in some parts of the portfolio.

Looking at pre-tax profit performance, more than half the margin decline is driven by the structural actions we took this quarter.

At the same time, we continue to invest in our digital and cognitive practices.

These actions will help us progress our transformation in GBS.

Technology Services and Cloud Platforms delivered $8.4 billion of revenue, up 2%.

For the segment, our strategic imperatives revenue was up 45% driven by our cloud revenue which was up 50%.

Our view on cloud is that enterprises see the most value in hybrid cloud solutions that enable new business models while leveraging existing systems and data.

We brought global technology services closer together with IBM's cloud infrastructure and platform capabilities to better position us to deliver these solutions to our clients.

We will provide a view of infrastructure services, technical support services, and integration software.

Infrastructure services reflects our evolution from a systems integrator to a services integrator driven by the move to hybrid cloud.

It includes our previous strategic outsourcing and integrated technology services lines.

Technical support services provides a complete line of support services to maintain and improve the ability of clients' IT infrastructures.

This includes maintenance for both IBM and non-IBM products as well as some support previously reported in integrated technology services.

Infrastructure Services was up 4% this quarter as clients continue to turn to us as the trusted partner to modernize their most critical IT systems and move them to hybrid.

For example, at Chubb, we're implementing a new hybrid cloud model designed to enhance customer service and strengthen their industry practices.

This new agile infrastructure will be designed to fit a wide variety of business needs including enhanced user experience, faster deployment of services, and increased speed to market.

We're also working with Indosat, one of Indonesia's largest telecommunications and services providers that serves 70 million mobile customers.

They need a cloud partner with scale, and we will deliver solutions on the IBM cloud that will help Indonesian businesses drive innovation and agility, streamline their process, and improve productivity.

We continue to see strong momentum in SoftLayer, which again grew strong double digits this quarter.

We continue to invest to build out our global capability announcing a new cloud data center in South Africa to support large regional service provider clients like Gijima and Vodacom.

Earlier this quarter, about 25,000 clients and partners attended our global Interconnect conference where we made some important announcements as we continue to evolve the IBM cloud.

We announced that 100% of our relevant software is now available in the cloud through a series of offerings such as WebSphere connect where more than 200 million global licenses can now access the cloud.

This fundamentally transforms how enterprise clients extend their existing IT investments and capabilities to the cloud.

We also announced we are the first to bring the Swift programming language to the server.

Swift is used by about 11 million developers to build Apple iOS applications to radically simplify the development of end-to-end applications and help enterprises reach new levels of productivity.

We also launched several important strategic partnerships as we continue to build out our ecosystem.

With VMware, we've jointly designed an architecture and cloud offering that will allow nearly 0.5 million VMware customers to extend their virtual machines to the IBM cloud.

And with GitHub, we will be delivering an enterprise offering to the more than 12 million developers that will allow them to build and run applications consistently across public and private environments.

We continue to expand our cloud capabilities with the acquisition of UStream and formation of the IBM cloud video services unit that will provide our clients with a powerful portfolio of video services and digital analytics.

UStream provides cloud-based video streaming and on-demand video to about 80 million viewers per month for customers such as Facebook, Nike, The Discovery Channel, Samsung, and NASA.

Looking at the software content in the segment, integration software was down 2%.

Our annuity content is growing with stability in our on-premise content and acceleration in the adoption of SaaS, specifically in the products to integrate a hybrid cloud environment like application servers and our Connect family of products.

Looking at profit, technology services and cloud platforms' gross margin was down just over 1 point year to year.

Margin is impacted by the revenue trajectory of integration software as we move more of the portfolio to an as-a-service model delivered through the cloud.

Within infrastructure services, we are investing to contemporize our clients' IT systems as we bring on new contracts.

At the pre-tax profit level, our margin decline reflects the continued investment to build out platforms such as Bluemix and SoftLayer as we drive our transformation as well as currency impacts.

This quarter also includes the impact of the workforce transformation actions which is about half of the decline.

Our Systems segment comprises our systems hardware business and operating systems software.

Systems revenue was about $1.7 billion this quarter, which was down about 20%.

Our hardware revenue was down 25% primarily reflecting the product cycle in our zSystems.

Operating systems continued to be a headwind to growth.

This quarter, the revenue was down 7%.

So looking at the hardware performance by brand, our zSystems revenue was down 40% on the back of a very strong performance of up 130% last year when we launched our new z13.

Typically, we see better margins in zSystems as we move into the back half of the cycle, and we did see some good margin improvement this quarter.

After four quarters of growth, power revenue was down double digits as we wrapped on the strong performance in Unix-based entry systems from last year but we had continued momentum in our Linux offerings and expansion of OpenPOWER efforts.

We've been focused on the growth in power based Linux systems and they've now grown to about 10% of the overall revenue base.

We recently signed a deal with a large enterprise in China that is dramatically growing its Linux server footprint and has chosen Linux on power partly because they can do it with half of the footprint they would have required with X86.

The relationship will lead to the installation of thousands of Linux on power systems.

We also continued to see good traction with the OpenPOWER foundation based innovations which will ultimately drive adoption of the power platform and provide intellectual property income.

Just a few weeks ago, Google, a founding member of the OpenPOWER foundation, announced that it is working with Rackspace, an Open Compute Project founding member, to co-develop an open server specification based around IBM's new POWER9 architecture.

The two companies will submit a candidate POWER9 server design to the Open Compute Project.

Turning to Storage, hardware revenue was down 6% which continues to reflect weakness in the overall storage market.

We are well positioned to capture the strategic growth areas of flash, software defined storage, and object storage, which together grew in the quarter.

Our systems gross profit margin was up with improvement across zSystems, power, and storage.

Our pre-tax income decline reflects the improved gross margin on the lower revenue and the impact of the actions we took this quarter, which is about half of the decline.

So now let me come back to the performance of software across our segments.

Our total software revenue was down less than 1%.

This is a significant improvement from our performance last quarter, which was down 6%.

We got the improvement we expected from the higher mix of annuity versus transactional content in the first quarter.

In addition, we've been adding a lot of new capabilities, both organically and through acquisitions, and this quarter software growth reflected the acquisitions which closed over the last year.

These acquisitions contribute revenue growth but impact our profit performance in the first year.

Our annuity revenue was up 2% in the quarter with steady renewal rates and growth in our SaaS business.

From a product area perspective, growth in our solutions software was offset by a continued headwind in operating systems and transaction processing software.

Let me make one other comment on our software performance.

As I mentioned earlier, total software includes cognitive solutions, integration software, and operating systems.

This includes a portion of our software support line revenue that was previously reported in our GTS segment.

The addition of support line did not impact our software growth rate this quarter.

Our software revenue was down 0.8 points including support line and would have been down 0.8 points without support line.

Turning to cash flow and the balance sheet.

We generated $3.3 billion of cash from operations in the quarter excluding our financing receivables and $2.3 billion of free cash flow.

This is up over $1 billion year to year.

This year-to-year increase was driven by the tax benefit of $1 billion dollars plus interest.

As I mentioned earlier, we've taken a number of actions that impacted our profit this quarter and will impact our cash flow over the next several quarters.

Looking at the uses of cash in the quarter, we invested just under $1 billion in capital expenditures with continued investment in cloud capacity.

We closed six acquisitions this quarter, and acquisition spend was over $2.5 billion with the largest being the Weather Company transaction.

The Truven acquisition closed about a week-and-a-half ago and so will be included in our second quarter acquisition spend.

We returned over $2 billion to shareholders including $1.2 billion in dividends, and we bought back over 6.5 million shares.

At the end of March, we had $4.7 billion remaining in our buyback authorization.

Looking at the balance sheet highlights, we ended the quarter with nearly $15 billion in cash and $46 billion in total debt, both of which are up an equivalent amount from year end, driven by the timing of this year's term debt issuances.

About $27 billion of our total debt was in support of our financing business.

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

I want to mention that the credit quality of our financing receivables remains strong at 51% investment grade, which you can see in the supplemental charts.

We had a few point reduction in investment grade over the last couple of quarters driven by rating changes in our existing portfolio, not by changes in how we approach the market.

Now this data is based on the credit ratings of the companies in our portfolio.

We do take actions to transfer exposure to third parties where we then get the credit ratings of the insurance companies.

We've done this for many years and on that basis, our investment grade content increases by 14 points to 65%.

Our non-financing debt was $18.8 billion, up year to year driven by the timing of our debt issuances this year relative to the maturities, and as I mentioned, the increase is equivalent to the increase in cash.

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

Let me spend a minute on some of the larger items that impacted the first-quarter results and give you a sense of the implications of these actions for the balance of the year.

The tax benefit contributed about $1.20 to EPS.

As I mentioned, our underlying tax rate was 19% in the quarter, consistent with the range we provided at the beginning of the year of 18% plus or minus a couple of points.

This of course doesn't include discrete or one-time items.

As we transform our business, we need to transform our workforce and this quarter we took a pre-tax charge for workforce rebalancing of $1 billion or $0.84 of earnings per share.

Some of this charge is used to take action where we've been dealing with under utilization but the vast majority is to shift and rebalance our skills.

As we build new businesses in areas like Watson Health and Watson Internet of Things, this requires different skills and to be in different places.

I mentioned earlier that over the last year, we've added over 6,000 resources in Watson Health and added over a thousand security experts.

These are specialized skills in highly competitive areas.

So this is not about reducing our capacity.

This is about transforming our workforce.

We started the year with just under 380,000 people.

We have people leaving the business but we're also adding large numbers of resources.

We currently have tens of thousands of open positions and we're hiring aggressively.

So if we have similar hiring dynamics to last year, we could end the year with an employee base that is about the same as where we started.

Our hiring will be aligned to where we see demand, by skill area, and by geography.

As we look at the resource actions, about 90% of the spending is outside the US.

Now looking at the returns on this action, we expect we'll save about $500 million this year, maybe a little more, and nearly $2 billion on an annualized basis.

When you look at the makeup of the $1 billion charge, a couple hundred was in the run rate and drives the bulk of the $500 million savings this year.

The balance of the charge was for actions that yield the remainder due to the geographic mix and timing.

But as I said, this is about rebalancing skills rather than capacity reduction and so we think about this as spending that is freed up to be reinvested in building capabilities in our strategic imperatives.

As we transform our workforce, we're changing how we're working, more agile, more collaboratively and this requires different work environment.

So this quarter, we took a real estate charge of over $300 million as we changed the way we work, moving to agile with less space required.

We also took actions to reposition the business in Latin America in light of the macro conditions.

I mentioned earlier that we've refocused our business in Brazil, including reducing exposure in our financing and services portfolio this quarter.

We also reduced our exposure in Venezuela.

As you know, we've always had some unique items in the quarter but we've included here the items that accelerate our transformation.

We didn't include, for example, the nearly $40 million loss from the sale of our remaining equity position in Lenovo.

We have no future exposure there.

So we made good progress in transforming our business this quarter.

We continued strong growth in our strategic imperatives, and as I said earlier, they now represent 37% of our revenue.

We added significant capabilities this quarter through organic investments, acquisitions, and partnerships, and we took significant actions to improve our position for the long term.

As we look forward, we expect much of what we saw in the first quarter to continue.

We expect to drive strong growth in our strategic imperatives.

Our acquisitions are starting to contribute to our top line and while they are a drag on profit in the first few quarters, they will certainly contribute to the profit base over time.

We will continue to invest at a high level.

Much of the capabilities we're building are cloud-based and delivered as a service.

Both the higher investment levels and the return profile puts some pressure on our profit in the near term but we're confident it's right for the long term.

As I just mentioned, we'll start to yield some of the benefits from the actions we just took though we do expect much of it to be reinvested.

When we take all of this into consideration, we continue to expect at least $13.50 of operating earnings per share for the year.

You'll recall last quarter I said that we expect free cash flow realization of GAAP net income in the 90s which implied a range of $11 billion to $12 billion of free cash flow for the year at the $13.50 level.

We have now improved our view of free cash flow for the year and now expect free cash flow to come in at the high end of that range at that same profit level.

As we look at the second quarter, we typically see a profit improvement from first to second quarter.

In fact last year, it was $1 billion increase in pre-tax income.

This year, we expect more given the significant charges in our first quarter.

But we'll also have an impact from the acquisition ramp and quarter-to-quarter impact from currency hedges.

Put it altogether, and we see about a $2 billion increase in pre-tax profit from first to second quarter.

With our anticipated tax rate and our share repurchase at that profit level, we'd achieve between 38% and 39% of the $13.50 of earnings per share by the end of the first half.

So to finish again this quarter, we made a lot of progress in transforming our business, and we got done what we set out to do to start the year.

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.

These too have been updated to reflect the new segment structure and additional information provided.

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

Operator, let's please open it up for questions.

(Operator Instructions)

The first question is from Tien-tsin Huang from JPMorgan.

Thanks, Martin, for all the detail.

Just to build on your closing comment on the original 15% from last quarter, timing-wise, what shifted from what you expected or is there some conservatism to consider because I guess with what you reported, it looks like actual could be around 17.5% of the full-year guidance?

Thanks, Tien-tsin.

So, you're right.

If we were just to line up the math of where we finished relative to the at least $13.50 at that base level, we would be about 17%.

So the first quarter, I would say, I'd characterize a couple of ways.

One on the top line, we got done what we wanted to get done and in fact, the sign posts that we've given to our investor community around driving double-digit growth while we continue to invest in those areas played out pretty much as we expected, and we are growing our revenue in those strategic imperatives faster than the marketplace, which we think is an important element as we transform the business.

On the profit side, the first quarter played out kind of the way we said we would get done what we would in February, which was we were going to get a tax benefit and that we were going to accelerate the transformation.

So we put all of that together and while -- because we had some of the restructuring already in the run rate, if you will, we did better if you will than what the original guidance implied, so the math you're doing is spot on relative to that $13.50.

We are seeing the dynamics in the revenue lines that we had expected, and we're seeing the profit equation come together as we expected, again, given that nuance that we had some of the restructuring in the run rate.

The other thing I'd point out, what's not in yet is obviously some of the newer acquisition content.

We closed on Truven about a week and a half ago.

We closed on The Weather Company's digital assets during the quarter, so not a full quarter.

Those come also with our intent to grow the spending in those to create new solutions so when they come in at whatever profitability they were, we build our business cases around substantial investment in those too.

So we'll get the revenue, but the profit impact will, as we said in the prepared remarks, will last for a couple of quarters.

Thanks, Tien-tsin.

Can we go to the next question, please?

Thank you.

Our next question is from Toni Sacconaghi from Bernstein.

Yes, thank you.

I just wanted to clarify something just because you said it very quickly at the end of the call, and then I have a real question.

So you're guiding for 38% to 39% of earnings in the first half which I think implies $2.85 in EPS for Q2.

That's about $0.60 below consensus and only about 21% increase sequentially.

Historically, I think you're at 30% or 35%, so I just want to be sure I did the math right on that.

That's the clarification, and my real question is, it's really just where you think you are in the transformation.

We continue to see really good growth on the strategic imperatives, but revenue growth at constant currency was minus 2% and I think on an organic basis was probably about minus 3%, and that's at the low end of what you've done over the last eight quarters or so.

So maybe you could help us understand.

Is it just the combination of the transformation still requiring time, or is there something about the move to an as-a-service model, but why aren't we starting?

Why aren't we seeing some gradual improvement in revenue on a constant currency basis, and can you help us understand is there something that you either anniversary or overlap or when investors should think about seeing that inflection point in terms of improving revenues?

Sure, thanks, Toni.

So first on your clarifying non-question.

I think the way you described it is what we said.

We said we would get 38% to 39% of the first half done, and your math was right on.

The one thing though I think it's important to remember, and I know you know this, but I think we also bear in mind, the business looks fundamentally different as we transform it.

And so using first half averages from days gone by when currency was different and the level of transformation and the pace of transformation was different and the levels of investment were different, I would caution our investors to make sure they understand the underpinnings of that.

And so that's why we laid out, if you will, within my prepared remarks, that's why we laid out what we saw happening in this quarter from first to second.

So again, your math was right.

We said 38% to 39%, but again there is a lot more going on within the transformation than just the statistics, and I think it's important to understand the componentry.

In terms of where we are in the transformation, I think I'd make a few comments.

One, continued growth in the strategic imperatives, as you said, good growth and we're pleased with the double-digit growth.

It's a big part of how we are measuring our progress.

The other element that we're measuring and we talked about this at investor day and it holds true as well in the first is, are the spaces we're going to, are they generating higher value than the spaces we're moving from.

And as we showed at investor day, our gross margins in those new areas continue to be higher and they were higher again in the first, so that's an important element for us, again grow those businesses and make sure they are higher value.

At the same time, part of our transformation is to create new opportunities.

And so we spent a bit of time at investor day, as you know, talking about not only the traditional IT opportunity, and I would put things like our new cloud video services unit into that where we get to apply a globally scalable cloud approach on an industry basis with our industry expertise.

And so that's a good example of how we're shifting into new areas in the cloud world and the traditional space.

But part of this transformation is all about moving into businesses that don't yet exist, and so when you mention is it as-a-service, is it something else, these are as-a-service businesses and so they do take awhile to -- we do expect it to take awhile to ramp but we did get to put a lot of money to work over the past 12 months.

In fact, our acquisition activity over the last 12 months if you include Truven now, so we just closed Truven about a week and a half ago.

We've spent about $9 billion now over that time period on acquisitions, which is more than we've spent in any 12-month period in IBM so part of this is also on building those new businesses.

So where are we in the transformation?

It is continued focus on shifting our investments into those strategic imperatives.

It is making sure that the space we're moving to is higher margin and higher profit opportunity for us, and then making sure we're investing aggressively to keep those businesses growing.

Thanks, Toni.

Rowena, can we go to the next question, please?

Our next question is from Katy Huberty with Morgan Stanley.

Yes, thanks, Martin.

The software and the GBS businesses have the highest strategic content and both of those declines improved from what you outlined happened in 2015 at the analyst day.

At the same time, deferred revenue grew for the first time in almost two years, which is tied to at least the software portion of the business.

So just curious if you isolate those two segments where you've had some big headwinds, do you feel like you're moving beyond that and you've seen a sustainable turn in those businesses, or is there something about annuity versus transactional mix in the first quarter where we shouldn't assume that those businesses continue to get better?

Thank you.

Sure, Katy.

So a couple things first on software.

We did talk about in January that we would get an improved trajectory in our software business just from the mix of transactional and annuity.

We did get that, so we did see an improvement from the mix in lower transactional content in the first than in the fourth.

That drove some improvement.

Secondly, we also got a benefit from the acquisition content that closed.

That added about 2 points as well to the software performance.

So with the annuity component of our software business continuing to grow with the acquisition content coming in, I do feel okay about our software business going forward, and the acquisitions that we've completed more recently will also help support that software business.

From a revenue perspective, I feel okay about the investments we've made and the future of the software business.

Now on the profit side, those take spending to create the kinds of solutions that we think will create new markets, so we'll continue to invest heavily, but the improvement we got from the mix was what we said we would get in the first and then we got the benefit of acquisitions as well.

Very good.

Oh, sorry, Katy, you also asked about GBS.

So on GBS, we did see a sequential improvement from fourth to first, and we saw that in our consulting business as well.

Now in the GBS business, the strategic imperatives content continues to do fine in the GBS business, and we'll continue to shift our labor pools and our expertise into those.

And you saw that we made some acquisitions in that digital channel to create, again, to keep our lead, I should say in the world's largest digital agency.

What you also saw us do over the last few months now in GBS is we moved -- we continued to move our business to where we see the greatest consulting opportunities.

And quite frankly, we stayed in these big ERP implementations a bit too long and so now what you saw us buy a few months ago was a company called Meteorix which is really built around helping companies move into workday solutions.

And then you saw us recently announce the acquisition of a company called Bluewolf, which works on salesforce implementations.

And so as the world moves into what we've always said it would which is that the shift to cloud creates consulting opportunities because companies have to fundamentally change workflow, we did quite frankly move a little bit late so we're playing a little bit of catch up in that part of the business.

But with these two acquisitions, we'll drive growth in what are two pretty hot market opportunities and we'll continue then to pull resources away from that commoditizing content and drive more of the shift into the strategic imperatives.

Thanks, Katy.

Can we go to the next question, please?

Next question is from David Grossman with Stifel Financial.

Hi, thanks.

So Martin, can I just quickly follow-up on your software comment?

Based on current visibility, can growth stay on this trajectory in the more seasonally difficult second quarter and will acquisitions actually contribute more in the June quarter given the first quarter activity?

Yes, so the simple answer is that acquisitions that we've gotten done now will add again to the growth rate in the second quarter.

If we look at just the cognitive solutions segment as an example, part of that business, our transaction processing system business, that's a very high value business.

It declined 5% in the quarter but it's in a declining market opportunity space, and so we're providing very high value to our clients.

We run their most important transaction systems.

We'll continue to do that.

We'll continue to refresh those products to deliver some new capability, but quite frankly that is an opportunity that will decline over time but again, we'll decline with it.

We won't lose share.

When we look at the software solutions part of that cognitive segment, you saw that we got back to low-single-digit growth in the first and with the acquisition content, we see that continuing to accelerate even in the second already.

So that acquisition content will help bolster the software result as we go through the rest of the year.

Thanks, David.

Can we take the next question, please?

We can't hear anything from our side, Rowena?

Yes, our next question is from Lou Miscioscia from CLSA.

Okay, thank you.

So going back to GBS again, you have strategic imperatives there at $3.1 billion in that the total category is $4.1 billion, so when we look at the revenue should we assume that that $1 billion that's not in the strategic imperative that's not growing is what's basically got to wind down?

And maybe you could give us an idea as how quickly you think you can transfer that over or maybe do the math on the percent decline if that's accurate.

Yes, I guess the way to think about it is that within the global business services that the areas we're moving out of have a lot of price pressure, so implementing these large scale ERP implementations or we see a lot of price pressure in there.

And the areas we're moving into are continuing to grow pretty well but we're building those, by the way, they are going to take awhile to build.

Some of them are brand new practices, so as an example, we just announced the creation last year at the end of last year of a cognitive practice.

That doesn't exist anywhere.

It's the world's first.

We're building skills there.

So within the GBS segment again, this shift we've been working on we were a little bit late in some parts of it in moving more into, if you will, moving more into the consulting side of this, but we have the total of strategic imperatives is -- within that segment is about $2 billion of the $4.1 billion.

The chart that you may be looking at is not additive, right?

The strategic imperatives are $2 million, the cloud element is $600 million.

That's within the $2 million and then the as-a-service is half.

That's within that as well, so it's not additive.

It's not $3.1 million of the $4 million; it's $2 million of the $4 million with those two as the components.

Thanks, Lou.

Can we go to the next question, please?

Our next question is from Steve Milunovich from UBS.

Great, thank you.

Couple quick ones, number one, the currency impact last quarter you said would be $1.10 hit to earnings this year.

With currency now improved, what is that number like, would it be?

Number two, free cash flow you said $11 billion to $12 billion now at the high end.

Is the only difference the $1.2 billion that you received in the tax rebate or is anything else changed in your underlying view?

And then third, do you expect anymore restructuring charges this year?

Are those in your guidance at all?

Okay, Steve.

Thank you for the non-multi part.

It's okay, Steve.

As you said, they are quick.

They are good questions because it's all-important data.

So first on constant currency, we said that in total, the currency impact would be over $1 billion for us in the year.

Now bear in mind that a big part of that, the bulk of that almost all of it was because of the hedges we had last year which we're not going to get this year, so we had to work our way through that.

Now at current rates, obviously, we still see the same size impact from the hedges because those were there last year.

At current rates, we would get a bit of a translation benefit.

But I think it's really important to recognize that while as much as we'd like to think this is uniform on both sides of a dollar move, and we do believe that a weaker dollar on balance helps us, a weaker dollar also drives renegotiation in price and other things that come into the equation.

The impact at this point, the hedge impact on the currency rates today is obviously exactly the same.

We do a little bit better at this point in profit.

If we were able to keep it, we'd do a little bit better there for the rest of the year.

On free cash flow, I'd say it really is -- I wouldn't attribute it at all to the tax that we got back.

I would attribute it to we're through 90 days.

We've got $100 billion plus balance sheet, and when we look at the ins and outs and the efficiency of that balance sheet, we feel incrementally more positive about the realization for the year.

And then on restructuring, this is something where you -- and we tried to go through this a bit in the prepared remarks, it really is about shifting the workforce from a set of skills that have value in the marketplace today to a new set of skills where we are trying to build new businesses.

The minority of the charge, if you will, is for reductions in useable capacity and most of that's outside the US.

The bulk of this is to get new set of skills so as we build a Watson Health business, as we build out our security practice, we are adding new skills, so we'll see.

We think about our ability to acquire skills.

In many of these sectors, we will hire them as quickly as the world can create them.

We hired 1,000 security experts last year and quite frankly, if the world created 2,000 of the caliber and the kind of talent we needed, we would have hired 2,000.

But the world creates these skills at a certain rate and will hire them as aggressively as we can.

We have some limits in terms of how do we put them to work and where is the demand and does that all match up but we will hire people as aggressively as we can as we build these businesses out.

We are relying on some pretty unique talents in some of these businesses.

Thank you, Steve.

Can we take the next question, please?

Next question is from James Schneider from Goldman Sachs.

Thanks, good afternoon.

I want to ask about the services business, what you're seeing there, specifically as it relates to your customers' discretionary spending outlook for services.

You had a very strong signings quarter last quarter, but that was not so strong this quarter.

I think it was down 17% year over year.

Understanding that can be very lumpy, does it say anything about the discretionary outlook for services among your clients and can you maybe just address when we might expect to see that margin inflection in GBS?

Sure, so a couple things.

On services in terms of signings, as you said, they are -- they tend to be lumpy.

Maybe not the most elegant of words to describe it, but it is an accurate description of what happens in any 90-day period.

Quite frankly, when you look at the kinds of relationships we're building with our clients, neither the IBM teams involved that are building these nor our clients are thinking about these on a 90-day cycle.

These are pretty big transformative partnerships that we build, and they are running and trusting us to run their most important and most critical system.

So it's completely understandable why a 90-day reporting cycle may not work.

We also have looked, and we've told our investors over time to look at the backlog.

And so when you look for instance within the GTS business our backlog, even with the signings performance in that quarter, but because we've had strong signings last year, we grew the backlog 1%.

And I think that's indicative of the kind of demand profile we see for those kinds of services.

Remember within that business, there is certainly an element of productivity, i.e, our clients are asking us to do and manage that for them in a way that gets them to a sustainable economic model which means we tend to deliver productivity quite regularly.

And then it also includes a lot of what they want in terms of moving into hybrid cloud environments and taking advantage of the investments they've already made in their own systems plus getting the agility from us running their cloud.

So that services business, again, the demand profile I see looks more like that low-single-digit kind of growth rate which is evident in the backlog.

And then we'll again given the transformative nature of some of these deals, we'll sign them when they're ready and when they're complete.

In terms of margin on GBS, we've talked a fair bit about what we're going through with GBS.

The only thing I'd add to the comments we made is that again, we continue to see that the areas and the spaces we're moving to are more valuable as measured by gross profit margin, if you will.

They are more valuable than where we're coming from and so we see certainly a bright future.

Now it's just a matter of getting that weighting right and working our way through the transition and the transformation of that where we have a bit of a productivity impact as well.

Thanks, Jim.

Rowena, can we take the next question?

Our next question is from Amit Daryanani from RBC Capital Markets.

Thanks.

Good afternoon, guys.

Could you just talk about the [worfus] transformation that you guys are implementing right now?

What sort of gross savings are you guys targeting to get?

I realize the net number may be fairly modest but what are the gross savings do you think you can get and when does that start?

And then the M&A contribution, can you just talk about what total revenue and strategic growth looks like on an organic basis ex-currency ex-M&A?

Sure, Amit.

A couple of things.

On savings and as you pointed out, we're going to -- we expect that we'll reinvest a lot of this savings as we start to realize them and as we start to achieve the savings.

In the prepared remarks and in the charts we've distributed, we've actually laid out quarter by quarter when we would expect to get about that $500 million or so of savings this year.

And then we've also identified on a full-year basis that this frees up for our spend rates, it frees up about $2 billion that we will now look to shift into these new areas.

That's how we think about it.

Again, this is not about capacity reduction.

It's actually about moving into these new areas where we see new opportunities.

And then from a revenue perspective, as I covered in the prepared remarks, in the first quarter, the contribution from acquisitions in terms of revenue growth was under 1 point.

Now we've since closed Truven in April, and we didn't have The Weather Company, for instance, in the full quarter so we'll get a bit over 1 point as we go into the second.

But we don't see -- it's not adding 3 or 4 or 5 points here.

It really is 1 point to 2 points as we go into the second in terms of acquisition contribution to revenue growth.

Thanks, Amit.

Can we take the next question, please?

Our next question is from Jim Suva from Citigroup.

Thanks very much.

I was taking a look at your supplemental information on slide 20 and you discussed the signings down 17% year over year, and I understand that they are kind of lumpy.

Could you address the service backlog which was down 1% year over year, and help us understand how mathematically if that number is adjusted for acquisitions that are coming in the year?

Thank you.

Sure.

The second part of that, the acquisitions we are making are in things like software businesses.

They are in as-a-service businesses.

There is nothing in the backlog from acquisitions, so in the back up information, and first, Jim, I do want to say since we put so much time into all these back-up charts, I do appreciate that someone is looking at them, so thank you for that.

In services backlog of down 1%, there are really two components.

One is, as I mentioned a couple of questions ago, the GTS component of that continues to grow about 1%, so think of it as low-single digit.

And I think that's a good reflection of the demand environment for the kinds of services integrators that our GTS business is becoming.

The other piece of that is the GBS backlog, which is down 5% so that down 1% is up 1% for GTS, down 5%, and that's a reflection of our shift out of the these large ERP implementations and the need for us to build some of these new businesses like cognitive.

So there's not a lot of obviously cognitive signings in that backlog yet because we created the practice within the last six months and we're building the skill base and we're building the relationships with our clients.

So it's really those two dynamics.

It's pretty good, it's stable growth, stable but growing in GTS and a decline into GBS as we shift into those new areas.

Rowena, why don't we take one last question, please.

Thank you.

Last question is from Wamsi Mohan from Bank of America Merrill Lynch.

Yes, thank you.

Martin, you took the opportunity to invest at a higher rate given the tax refund to accelerate your transformation.

How should investors think about that acceleration?

Will you get to your goals and strategic imperatives revenue faster than 2018?

Because you're now investing at a higher pace and acquiring these skill sets, or perhaps throw off higher cash flow faster?

And if accelerating the transformation is the right move then why not like increase leverage and reinvest more aggressively for the remainder of the year as well instead of waiting for the tax refund?

A couple of things, Wamsi.

So we are investing quite aggressively here and I run the deal committee.

We have pretty active discussions still on what else we should acquire in order to build again new businesses to extend a lead that we have in a business, so we'll keep doing that and we'll think prudently about where we deploy our capital.

Now in terms of spend rates, as I mentioned, investments are shifting our workforce if you will, investing or changing the way we operate.

It's changing the way we engage with one another so if the world created 5,000 cognitive experts, we would hire 5,000 cognitive experts.

We already have, by the way, the largest private math department in the world, and so we are absorbing, if you will, the skills that we need for our business in order to drive these.

But there is a rate at which it doesn't make sense for us to keep putting money into these because the world doesn't create them anymore.

It's not a problem that can be solved by spending more money.

It's a problem that is constrained by the kinds of skills the world's creating, so we have a global search on for talent.

People come to IBM, and we got about 1.2 million applications -- applicants, I should say.

We got more applications, but 1.2 million applicants.

They come here in order to work with the leaders in their fields.

What we find is that skills have gravity and highly skilled people want to work with others in their field who are also highly skilled.

So they come here to work with our unique data sets, with our unique technologies, with our unique industry expertise in order to change the way the world works, in order to change the way industries operate, in order to change professions.

And we'll do that as fast as we can, but you can get a sense.

I think we talked earlier, not in this call but in prior calls that we hired 70,000 people last year out of the 1.2 million applicants.

It takes awhile to find the right people, so we'll invest as fast as the world creates the skills we need.

So let me wrap up the call.

Because we got a lot done in the quarter and quite frankly, I think we're pretty well positioned for the future.

The new structure that we have been talking about which reflects our management system, we expect that it will facilitate our move to a cognitive solutions and cloud platform company.

And it will also help our investors understand where we're making investments and where we're seeing returns.

We introduced the structure just in February.

We provided the history back in March as we said we would, and now it's the first quarter that we're reporting.

So hopefully with what we've done in this transition to this new reporting structure, you found all of the information helpful and helps contextualize the results you're looking at and hopefully, getting some insight into the businesses as we move through the transformation.

So thank you for joining the call, and we'll talk to you again in July.

Rowena, can I turn it back to you to wrap us up?

Yes, ma'am.

Thank you.

Participants at today's conference, the conference has now ended.

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