International Business Machines Corp (IBM) 2016 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'll 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 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.

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

Thanks, Patricia.

In the second quarter we generated $20.2 billion in revenue, $3.5 billion in pretax income and $2.95 of operating earnings per share.

90 days ago we told you what we expected for the second quarter.

We said we'd continue to see strength in the strategic imperatives and we delivered 12% revenue growth led by cloud.

We said we'd continue to build as-a-service capabilities.

Our cloud-as-a-service revenue was up 50% and we exited the quarter with an annual run rate of $6.7 billion in our cloud-as-a-service businesses.

That's up from $5.4 billion last quarter.

Certainly we have a benefit from the acquisitions recently closed, but we had solid organic growth as well.

We said we'd continue a high level of investment as we move into new areas and build new markets.

And we did that, both organically and through acquisitions.

And we said that given seasonality and actions we took in the first quarter, we'd grow our pretax income by about $2 billion quarter to quarter.

And we grew a bit more than that.

In total, we got done what we set out to do and we saw some improvements in trajectory relative to long-term trends.

Though as always, the rate and pace varied by business unit and geography.

Let me touch quickly on some of the drivers for the quarter.

As I said, we continued to deliver double-digit revenue growth in our strategic imperatives.

Over the last 12 months, strategic imperatives delivered $31 billion in revenue and now represent 38% of IBM.

Growth was led by cloud, where our revenue was up 30% to $3.4 billion in the quarter and over $11.5 billion over the last year.

So good progress in cloud.

Looking at revenue from a segment perspective, the strongest growth came from cognitive solutions, led by our analytics and cognitive capabilities and security.

In technology services and cloud platforms, our infrastructure services revenue continues to grow, while integration software declined as we shift those offerings to cloud.

And our GTS backlog grew on the back of strong signings.

Our systems business again reflects the product cycle dynamics in terms of revenue and margin.

And global business services continues to reflect a shift in our business.

We're continuing to deliver double-digit growth in the strategic areas led by mobile and cloud and our application management business is stable.

Though pressure in the more traditional areas of consulting and some inconsistency in our execution continue to impact the GBS results.

As we shift IBM's business overall, it's important to understand that we're not only moving into new spaces but in fact creating entirely new markets.

So as I said, we're investing at a high level, both by growing organic investment in areas like our Watson platform capabilities and our cloud data center capacity and getting acquisitions into our run rate.

Our investments, together with currency, product cycle dynamics and the actions we took in the first quarter, are reflected in our profit performance in the first half of this year.

I'll talk about how the second half plays out relative to the first later in the call as we continue to expect to deliver at least $13.50 of operating earnings per share for the year.

Let me spend a minute on what we got done as we move into new areas and become a cognitive solutions and cloud platform Company.

Clients are looking to become digital businesses and our cognitive solutions bring together digital business with digital intelligence to improve decision-making and add intelligence into all products and processes.

For example, companies such as Kimberly-Clark, the ISS Group and Sesame Workshop announced in the second quarter they're working with IBM on innovative Internet of Things solutions for everything from facilities management to early childhood education.

Healthcare organizations, such as the UK's National Health Service, the US Department of Veterans Affairs and the American Diabetes Association were among many in the quarter that announced they are leveraging Watson to create new approaches to treatment and patient care.

And in the second quarter we announced Watson for cyber security, a new cloud-based version of our cognitive technology, trained on the language of security.

What these innovative client initiatives have in common is that they are industry-based cognitive solutions enabled by the IBM cloud.

And all of this is supporting the movement of our clients to hybrid environments.

This quarter we extended our cloud innovations available on Bluemix, including the first Apache spark development environment for data scientists to more quickly and easily analyze big data.

We delivered new IoT services using Bluemix OpenWhisk, our event-driven programming model to speed development of IoT applications on the IBM cloud.

We announced block chain agreements with banks such as Mizuho and Credit Mutuel Arkea.

And we opened a Bluemix garage in New York City to help financial services clients rapidly design, build and pilot their own block chain solutions, as well as other emerging fintech applications and services.

We leveraged recent acquisitions in Clearleap, Cleversafe and Ustream to announce new video-on-demand services deals with major brands such as Mazda, the Canadian Broadcasting Corporation and Comic Con.

We also continued to partner with major IT industry players, leveraging IBM's unique hybrid platform to grow and extend their own offerings and client migrations.

For example, we announced that IBM cloud would be a strategic partner of Box Zones in Europe and Asia.

Box Zones and the IBM cloud will uniquely enable clients to store and manage data across hybrid environments in the country of their choice.

And we expanded our global partnership with VMware to deliver desktop services in a security-rich environment on the IBM cloud.

We also announced a breakthrough in making quantum computing available in the IBM cloud.

The IBM quantum experience is a great example of how cloud is making emerging technologies available that wouldn't have been accessible in the past.

This kind of open innovation will allow for the next stage of development in quantum information technology and help push a universal quantum computer to reality even faster.

Now, quantum isn't a new idea.

Researchers have been working on it for a long time but it's not a niche either.

On the day we announced it, it generated 138 million Twitter impressions.

And to give you a sense of that level of interest, it's fewer than Andy Murray when he won Wimbledon, but it's more than the impressions generated by Phil Mickelson's record-tying score in the first round of the Open last Thursday.

Since the launch in May, we already have active users in nearly 150 countries that have run more than 175,000 experiments through the IBM quantum experience.

As we move into new areas, we're also continuing to deliver innovation in the core.

For example, in infrastructure services, we're shifting from being a systems integrator to a services integrator, connecting and streamlining multiple environments and delivering as-a-service solutions to our clients.

You see this in our recent engagements with Pratt & Whitney and Emirates.

To help systems innovation, this quarter we acquired EZSource to help developers quickly and easily update mainframe applications.

In software, we entered into an agreement with a strategic partner to license the intellectual property of some of our assets within our core software portfolio to accelerate product innovation and extend the capabilities to hybrid cloud.

I'll expand on some of these solutions and go into more detail on our strategic imperative performance in the segment discussions.

But first, let me walk through our financial metrics for the quarter.

Our revenue for the quarter was $20.2 billion.

While there was a lot of movement in individual currencies in total, currency translation had a 20 basis point impact to revenue growth.

I'll talk to our performance at constant currency.

Our revenue was down 2.5%.

On a geographic basis, Americas was down [2%].

This was an improvement from last quarter's rate across the US, Canada and Latin America.

Europe was weaker, due primarily to Germany and Switzerland.

And Asia-Pacific was down about 2%.

With strong growth in India once again and sequential improvement in all of the BRIC countries, the BRICs returned to growth.

Our gross margin performance reflects higher levels of investment, especially in cognitive solutions and the fact that we're building scale in our as-a-service businesses.

Looking at expense on a year-to-year basis, there are a few items to note.

First, there's an increase in investment levels.

We also have a higher level of IP income this quarter due primarily to the licensing partnership I just mentioned.

And while not an impact to this year, we did have workforce rebalancing charges last year, as well as some gains that mitigated those charges.

Finally, we have a year-to-year impact from currency as last year's hedging gains roll off.

In fact at a PTI level when you consider both the hedge and the translation impact, currency impacted profit growth by about $250 million.

Our tax rate for the quarter was 19% all in, at the higher end of the range we provided at the beginning of the year, which you remember was 18% plus or minus a couple of points, without discrete items.

From a cash perspective, we generated over $2 billion of free cash flow in the quarter, and more than $13 billion over the last 12 months.

This is over 100% of our GAAP net income.

And over the same period we returned about 70% of our free cash flow to shareholders through dividends and gross share repurchases.

As we get into the segments, remember our strategy and point of view is that to be successful, you need to bring together cognitive solutions to improve decision-making and outcomes.

To approach that with an industry context and skills, and to enable that in a hybrid environment to get the agility of the cloud while leveraging the breadth of an enterprise's data and processes.

Now I'll talk about how each of our segments plays a critical role in how we capture these opportunities, starting with our cognitive solutions segment, where revenue growth accelerated to 4% in the second quarter.

We had sequential improvement in both solutions software and transaction processing software.

Our solutions software revenue was up 6% for the quarter.

Our strong performance in SaaS continued with double-digit growth in revenue.

Growth was led by analytics and security, and acquisitions clearly provided lift.

Our analytics business is the largest portion of the solutions software portfolio.

Analytics grew in key areas including, Cognos, information integration and big data, and of course Watson as we add to our capabilities.

The Weather Company acquisition is off to a good start as we integrate it with Watson technology.

In June we introduced Watson ads, leveraging the weather platform which delivers as many as 26 billion forecasts daily.

Consumers will be able to interact with IBM Watson through advertising by asking questions and receiving relevant product information.

Campbell, Unilever and GSK Consumer Healthcare will be the first marketers to collaborate with The Weather Company on Watson ads.

Security had strong revenue growth, and together with our security services we outpaced the market by 3X.

Our momentum is driven by our unique market position.

We have built an extensive security portfolio, tailored to the needs of our clients for integrated security across their entire operations.

As a result, we're the number one enterprise security software and services provider and hold a leadership position in 12 of the 14 segments, according to Forrester, IDC and Gartner.

This quarter we closed our Resilient acquisition, adding leading incident response technology and expertise to our portfolio.

We had strong demand for our Guardium offerings, as we saw clients moving to our database security offerings across a range of industries, including information services and banking.

And in May we announced Watson for cyber security, a new cognitive system we've been training and will make available in a beta program later this year for use by our customers.

As part of this announcement, eight leading universities will also train Watson in the language of security.

We're growing and broadening the reach of Watson with new capabilities, partnerships and engagements to accelerate adoption.

Clients across industries are expanding their Watson engagements, moving from pilot use cases and consulting engagements into long-term production.

As an example, in the second quarter design software leader Autodesk signed a multi-year production SaaS agreement with Watson to leverage Watson Engagement Advisor.

This engagement builds on the value and strong usage proven during the pilot to resolve customer inquiries.

This is one demonstration of our focus on the core conversational service for client applications and the developer community.

We also introduced new offerings such as Watson Company Analyzer, which helps companies reduce the time and effort required to collect, digest and synthesize information for building strategic business relationships and understanding competitive market spaces.

And in Watson Health, we continue to capitalize on our differentiated ability to understand, reason and learn with industry specialization.

We launched Watson Care Manager which provides structured programs and tools to support care coordinators in delivering care to patients.

This offering enables patients to avoid rehospitalization.

In the second quarter, we extended partnerships with the American Cancer Society and the American Diabetes Association, which are examples of the strong support and momentum Watson Health has with leading clinical and research communities.

And at the White House Cancer Moonshot Summit we made a commitment to utilize our cognitive solutions to help doctors offer personalized care to 10,000 veterans fighting cancer.

We're working with Teva, a large pharmaceuticals client, to improve drug efficacy for millions of patients with complex and chronic diseases by leveraging the IBM Watson Health cloud solution.

We formed a medical imaging collaborative with 15 industry leaders to put Watson to work extracting insights from invisible unstructured imaging data.

And in April we closed the Truven acquisition.

The data and insights from Truven will be integrated into our Watson Health cloud.

So now looking at the profit results for the segment.

Gross margin was down, largely driven by mix shift to SaaS and higher investments, including acquisition content.

Pretax income performance continues to reflect our higher level of investment in strategic growth areas like Watson Platform, health, and IoT again this quarter.

Global business services delivered $4.3 billion of revenue.

Our performance was similar to recent quarters with continued growth in our strategic imperatives, offset by declines in the more traditional consulting areas.

We saw double-digit growth in our digital practices around cloud, analytics, mobility, security, and cognitive.

And we continue to aggressively shift resources and investments to drive these businesses.

Our GBS team leads the industry mission for IBM, as we've amassed over 100,000 industry resources.

Our consultants build strategies that help our clients gain new insights on data and launch new business models for competitive advantage.

We're scaling the industry's first cognitive consulting practice which draws on the expertise of more than 2,000 consulting professionals, spanning machine learning, advanced analytics, data science and development.

We continue to ramp the IBM Interactive Experience.

We've opened over 30 digital studios around the globe, including new studios in Singapore and Seoul.

We also completed the acquisition of Aperto, a digital agency in Berlin with over 300 employees and a roster of enterprise clients such as Airbus and Siemens.

We're shifting away from traditional on-premise ERP to cloud-based application management and consulting.

We closed on the acquisition of Bluewolf this quarter, a top sales force partner and recognized leader in cloud consulting and implementation services.

We're also growing our services on Workday applications, leveraging the skills we brought on through our Meteorix acquisition last year.

Overall, we delivered 60% growth in our cloud practice this quarter.

Application management remains stable, as clients look to us to manage the life cycle of their applications and bring new applications to market faster through digital cloud platforms.

Turning to profit.

GBS gross profit and PTI margins are down year to year.

These margin declines reflect the investments we're making in our digital practices as well as some issues in our execution.

And in some of the traditional service areas that are not as differentiated, we're seeing price and profit pressure.

We continue to invest and shift resources to our higher-value services around digital and cognitive.

We're also taking actions to improve our delivery efficiency and execution while remaining focused on our commitment to our clients' success.

Technology services & cloud platforms delivered nearly $9 billion of revenue with growth in infrastructure services offset by declines in technical support services and integration software.

Across the segment, our strategic imperatives were also up strong double-digits.

We had strong signings performance in GTS and the backlog for the segment continued to grow.

We saw continued momentum in infrastructure services, as clients turned to us to optimize their IT environments and move them to cloud.

We again had strong growth in the IBM cloud.

Our point of view is that clients can unlock the most value for their businesses by moving to hybrid cloud infrastructures, which provide agility and enable new business models while at the same time tie back to their core systems of record.

We always said that hybrid capabilities are critical for an enterprise-grade cloud and we continue to lead in the rapidly growing hybrid cloud market.

We're shifting from systems integration to services integration as we connect multiple environments and build out hybrid infrastructures delivered as a service to the client.

Our as-a-service revenue for the segment was up over 50% for the quarter.

We continue to sign transformative agreements with clients to optimize their infrastructure and help digitize their operations.

At Pratt & Whitney, we'll move their business, manufacturing and engineering enterprise systems to a fully-managed environment on the IBM cloud.

They're expecting to double their engine production by 2020 and we'll provide them with the means to manage, analyze and grow their infrastructure dramatically to accommodate the Company's growth.

And this quarter we signed a seven-year, $1.3 billion agreement with CSC to expand our cloud partnership and build a secure, scalable and flexible mainframe infrastructure that will enable CSC to economically scale up and down demand to address current and future client needs and reduce its capital outlays.

This builds on an announcement earlier this year that integrated Bluemix into their cloud management platform.

Bluemix provides our clients with speed and agility in launching new business models and applications in the cloud and along with the rest of the integration software portfolio, is at the heart of our hybrid cloud strategy.

Overall, integration software revenue declined.

From a product perspective, we had continued strength in our Connect products, as clients integrate applications, data and processes for both on-prem and cloud-based applications.

Across integration software, our annuity content is growing and we accelerate the shift to an as-a-service consumption model through new cloud capabilities delivered on our Bluemix cloud platform.

For example, this year Kaiser Permanente began its move to the IBM cloud and Bluemix as the strategic platform for their transformation to a more agile, data-driven organization engaging with millions of individual members and patients.

This will allow them to take advantage of new technologies, existing data and back-end systems in a hybrid model.

Turning to profit.

Our gross profit was down year to year, driven by the mix of businesses within the segment.

Our PTI margin also reflects this business mix impact as well as the investments we're making to build out our cloud platforms.

Additionally, this quarter we entered into an agreement with one of our strategic business partners where we will license the intellectual property of select assets within the integration software portfolio while jointly going to market to ensure our clients' success.

This will shift our spending profile for these assets to a more variable cost structure going forward.

Systems revenue was down, consistent with the cycle.

Our systems hardware revenue was down 28%.

Operating system software revenue was down 4% this quarter which is a modest sequential improvement in year-to-year performance.

But as we said, we expect operating systems to continue to be a drag on growth.

Revenues for our z Systems declined 40% in the second quarter while margins improved, consistent with where we are in the product cycle.

We're continuing to expand the z client base, adding 13 new clients in the quarter and nearly 70 since the beginning of the cycle.

We had our first major z13 win in China this quarter with a large Chinese bank migrating its mainframe installed base to our latest technology.

We're continuing to drive innovation in the z Systems platform.

As I mentioned earlier, we acquired EZSource, which will help our clients modify applications for their digital transformation while also supporting agility and hybrid cloud.

Power revenue was down in the second quarter with growth in the mid-range offset by declines in the high and the low end.

The Unix market is a high-value space that's been declining and we represent the majority of the market.

Our performance here reflects the replacement dynamic, following strong performance in the high end of POWER8 in the second quarter of last year.

While the mid range has been growing year to year, we will see a similar replacement dynamic in the third quarter as we wrap on the mid-range POWER8 introduction.

We're also addressing the growing Linux market and this quarter we grew year to year and quarter to quarter with our Linux on Power strategy.

It is becoming a more meaningful part of our business with over 10% of our power revenue in the second quarter.

We've seen particular success with HANA, a play that we started a year ago.

We will expand the Linux-only portfolio.

By leveraging OpenPOWER, we plan to bring two new servers supporting cloud-enabled big data and cognitive applications to our portfolio and release our second generation HPC server with POWER8 processors connected to an NVIDIA GPU acceleration.

Turning to storage.

As we said in the past, storage value is shifting to software which is reported in our cognitive solutions segment.

In storage software, we're continuing to grow software-defined storage which includes object storage and our newly introduced Spectrum Suite offerings.

Storage hardware revenue decreased 13% which continues to reflect weakness in the traditional disk storage market.

We released the new all-flash DSAK storage offering during the second quarter, giving us competitive differentiation with plans to deliver all-flash offerings across the entire portfolio.

Our systems gross profit and pretax income declined, reflecting the revenue performance.

Our systems gross profit margin was flat, with margin improvements in both z Systems and POWER, offset by lower storage margins and the impact of mix.

Now after going through the segments, I want to address the performance of software across our segments.

Our total software revenue was up 1%, driven by an acceleration in the annuity content.

Subscription and support revenue was up, reflecting increased deployment by our clients and steady renewal rates.

And the investments in new areas are paying off with growth in SaaS.

Acquisitions contributed to that growth, and we also grew our annuity base on an organic basis.

I'll remind you that while the SaaS acquisitions add to the top line, they're a drag to profit in the first year.

Looking at annuity growth by business area, we had strong growth in cognitive solutions as well as integration software, while the annuity content in operating systems declined.

Turning to cash flow and the balance sheet.

We generated $3.1 billion of cash from operations, excluding our financing receivables.

After $1 billion investment in CapEx we generated $2.1 billion of free cash flow in the quarter.

For the first half, free cash flow of nearly $4.5 billion is essentially flat year to year, with lower cash taxes offsetting the year-to-year operational performance.

These first half results support our expectation that we will deliver the high end of the full-year free cash flow guidance range we provided earlier this year.

This takes into account the cash payments related to the workforce rebalancing charge taken early in the year as well as the timing of tax payments in the second half.

Looking at the uses of cash in the first half, we've invested $5.4 billion in acquisitions.

So far this year, we've acquired 11 businesses, including Truven Health Analytics and the digital assets of The Weather Company.

In the last six months we've returned $4.4 billion to shareholders, including $2.6 billion in dividends.

In April, we again raised our dividend, and with that, we've now doubled our dividend per share since 2010.

In the first half we bought back over 12 million shares and we ended June with 956 million shares outstanding and $3.9 billion remaining in our buyback authorization.

Moving to the balance sheet.

We ended June with $10.6 billion in cash.

Our total debt was about $44.5 billion, of which $26.5 billion was in support of our financing business.

The leverage in our financing business remains at 7 to 1 and the portfolio remains strong at 52% investment grade.

You can see more on this topic in our supplemental material in the backup.

Our non-financing debt was $18 billion and our non-financing debt to cap was 59%.

The increase in both reflect the timing of our debt issuances relative to maturities this year.

Our balance sheet continues to have the financial flexibility to support our business over the long term.

Now let me wrap up and talk about our view of the second half and put it in context of the first half performance.

We thought we'd lay it out on a slide for you.

You'll recall in the first quarter we took significant actions to transform our workforce and change the way we work, resulting in significant workforce rebalancing and real estate charges.

As we've said, this is about rebalancing skills more than capacity reduction, and so these actions free up spend that can be reinvested to build capabilities as well as contributing to the bottom line.

We started to see some savings already but the majority of the gross savings we'll see in 2016 will come in the fourth quarter.

We mapped all of that out in our last call and we're right on track.

As expected, our mainframe product cycle also had an impact to our EPS growth in the first half.

As we enter the second half, our mainframe compares will get easier.

In fact, we expect mainframe to be fairly neutral to EPS growth.

Over the last 12 months we've been investing at a high level both organically and through acquisitions as we build cognitive and cloud capabilities.

The organic investments had a mid single-digit impact on our EPS growth.

As we ramp on the higher level of spend in the back half of last year, this will have less of an impact on EPS growth over the next two quarters.

We've completed 20 acquisitions over the last year.

The acquired content is contributing to our top line and will continue to do so in the second half.

Because these are primarily as-a-service capabilities and require additional investment as we create new spaces, they have a return profile with a longer payback.

The acquisitions we've completed to date had a low single-digit impact to our EPS growth rate in the first half.

They'll continue to be dilutive in the second half, though at a lower level.

Many of these new capabilities are delivered as a service.

As these ramp, it will benefit our second half relative to the first, not only from a software mix perspective, but adding scale will also help our margins.

And of course, we've talked about the impact of currency on our profit growth in 2016 due primarily to the roll-off of last year's hedging gains.

We can't predict where currency will go from here, but at current spot rates the impact from currency will moderate in the second half due to year-to-year hedging dynamics and a slightly better translational environment.

And finally, you'll recall we had a significant discrete tax benefit in the first quarter.

Relative to the ongoing effective tax rate, we continue to expect to be in the range we provided at the beginning of the year.

Put it all together, and we expect our second half EPS dynamics to be significantly improved over the first and continue to expect to deliver at least $13.50 of operating EPS for the year.

With that financial context to our second half, from a business perspective we'll continue to focus on using cognitive to help clients get value the from their data, to improve decision-making and outcomes, moving our clients to hybrid cloud environments and with a strong industry dimension.

As we do that, we're moving into new spaces and in some cases creating entirely new markets.

We'll continue to shift our business toward our strategic imperatives with strong growth in our as-a-service offerings and continued growth in software.

And we'll continue to invest to add capabilities and to deliver innovation across the business, all while returning value to shareholders.

So with that, we'll 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.

So please open it up for questions.

(Operator Instructions)

Katy Huberty, Morgan Stanley.

Thanks, good afternoon.

You didn't mention the UK in your commentary around EMEA.

How did the headlines around Brexit impact the month of June?

Did it have any impact on not raising the full-year outlook despite beats in the first and second quarter?

Thank you.

Sure, Katy, thank you.

We certainly don't think -- I don't think that Brexit coming at the end of the quarter helped us at all.

But we obviously finished right where we expected to finish.

When we look at our full view of the year, we don't see an impact if, you will, that has any real materiality on us, and that's why we continue to hold our operating EPS.

So it certainly didn't help, but again, nothing that said we should change our operating EPS for the year.

What I typically observe in these kinds of instances is that our discussions with our clients have to go through a process of reprioritization, if you will.

Remember, the extent of the discussions we have with our clients is about their most important processes.

So as they reprioritize, the length of time that takes depends a lot on how much uncertainty they're faced with.

Obviously the political leadership in Europe and the UK can help reduce that uncertainty, but we didn't see -- again, we don't think it helped, but it didn't cause us to change our guidance.

Thanks, Katy.

Can we go to the next question, please?

Toni Sacconaghi, Bernstein.

Yes, thank you.

Martin, I estimate that software acquisitions helped about $350 million to $400 million in terms of the revenue impact year-over-year.

If that's the case, then Company revenues declined about 4% or a bit more and software revenues declined about 5% or a bit more.

I was hoping you could clarify if those numbers are correct.

Because if they are, it actually suggests that both Company revenue and software revenue decelerated from Q1, even though the compare was actually a bit easier.

So I was wondering if you could address this notion of what appear to be some deceleration in the business on an organic basis.

Sure, Toni.

Couple of things.

First, the acquisitions are part of IBM.

So when you say Company revenue, I think of the total as Company revenue.

Within the total, as we've talked about -- we did it at Investor Day, and I think this is generally true, given the volume of acquisitions we do, we generally over the long term see about 1 point help.

And as I said in my prepared remarks, we got about twice that, we got about 2 points of help in total.

Now, that's not all software.

Obviously there's also, as you know, we've been acquiring some businesses for our GBS business.

So on a acquisitive impact across IBM it was about 2 points.

What we saw in software in the second quarter, I would describe the dynamic as very similar to what we've seen over the past few quarters.

Which is, in our largest clients we see continued deployment and therefore we continue to grow the annuity base on those large clients.

Outside those large clients, we continue to see growth in total.

And then, again, the transaction business, which tends to have an outsized impact in the second and the fourth quarter because of our mix of transactional versus annuity, also plays into this when you start looking at it sequentially.

They're not fully comparable, if you will.

The mix is a bit different.

Acquisitions clearly a benefit to us.

About 2 points, as I said in total, a mix of software and services and a set of software dynamics underneath that, that suggest to us continued deployment, continued growth in the annuity base and still some transactional growth pressure, if you will, in some of our largest clients.

Thanks, Toni.

Rowena, can we please take the next question?

Tien-Tsin Huang, JPMorgan.

Thank you, good afternoon.

Just on the services side, I saw that signings were up nicely.

Anything unusual there, and can we see an eventual pull-through with consulting, maybe following behind it?

And Martin, you did mention some inconsistency on execution, I think, a couple times.

Can you elaborate on that?

Thanks.

Sure, Tien-Tsin, thanks.

So we did have pretty good signings and that signings kept the backlog, in total, flat year to year.

What we're seeing in the marketplace, if I start to disaggregate between GTS and GBS for a moment, we continue to see very strong growth in GTS.

You saw that in the signings numbers, and you see that in the growing backlog.

That profile, if you will, of what we're working on for our clients, is very consistent with what we've talked about in the past, which is our clients are looking to move to hybrid clouds.

Our clients are looking for us to help them develop and deploy and run some of the latest technologies, such as mobile.

So that trend continues.

The size of those deals continues to be quite substantial.

Not every deal is a big deal, but we haven't seen any reductions, certainly, in deal sizes.

In fact, we've had some of the biggest deals -- some of the volume of biggest deals that we've seen over the past few years, continue in the GTS business.

And when we look forward at that GTS relationship, if you will, over the last now, call it, 10 quarters, over 2.5 years or so, we've had pretty good, consistent book-to-bill greater than 1. So the booking rates, as you know, are the signings we report.

And then on the billings side in GTS you have our maintenance business as well.

So obviously that doesn't go into the bookings side of the equation.

So you've got to do the math right.

But book-to-bill in GTS has been, over the last 10 quarters, very consistent.

Again, it reflects, I think, the strong value we bring to clients.

On the consulting side in GBS we did have a good signings quarter.

There is plenty of business out there.

We see good uptake of our most advanced offerings, if you will, those that help digitize our clients.

We continue to pull back at that enterprise-wide application installation.

When we say pull back, by the way, that means we're moving resource and we moved, again, more than a third of our resource out of that part of the business.

So it's not a surprise that part of the business is declining.

So the consulting opportunity is certainly there.

When we talk about execution -- when I talk about execution issues, the way I'd say it is, look, we take on, and our industry skills take on, some pretty complex projects for our clients.

Sometimes we have to spend a bit more money that we would have thought in order to make it all working properly and making sure our clients are satisfied.

So that's on us.

That's on execution.

The teams, they'll work through these things.

But I wouldn't call it widespread.

Thanks, Tien-Tsin.

Can we go to the next question, please?

Greg McDowell, JMP Securities.

Great, thank you very much.

Martin, one quick question I wanted to ask about the EPS trajectory in the second half.

I know you reiterated at least $13.50 in EPS.

But in light of the macro headlines, I was wondering if you're thinking about weighing Q3 and Q4 any differently in the second half of the year.

Thanks.

Thanks, Greg, sure.

We included a pretty detailed chart, I think, on some of the first half to second half trajectory changes.

I think the one point to make across the board on that chart is that everything there, it gets either the same or better in the fourth.

And so when we look at all of the impacts, as an example, we've got the chart that shows as-a-service scale helping and a chart that shows the actions we took in the first quarter helping in the second quarter.

All of those have a bigger impact in the fourth than they do in the third.

And the rest do as well, but those are just, again, two examples.

The way I think about third versus fourth in a total perspective, in total third quarter for us tends to be in a fairly tight range.

Our annuity business plays a bigger role in our overall revenue streams than our transactional business does in the third.

So in that EPS range in the third we've typically been 22% to 24% of the full year.

And when we look at that with the momentum we have on the things that are on that chart, I'd say that we're more in the middle to the high end of that range in the third and then the rest obviously in the fourth.

So while those statistics are good indicators in total, when we're going through a transformation like this, at the margin, again, in the third, we'd say mid to high end of the historical range for third-quarter EPS.

Thanks, Greg.

Can we go to the next question, please?

Joseph Foresi, Cantor Fitzgerald.

Hi.

I wanted to build on the margin question.

I was wondering, how should we think about the impact to the margin profile of the strategic imperatives through their transformation over the long term?

Do you think we're through the heavy CapEx there?

And will the exit of this year and the margin profile there be a good proxy for 2017?

Thanks.

Sure, Joe.

A couple of things on margins.

First, we've talked a bit about what drives margin in the IBM financial model at length.

As you'll remember, we talked about mix of our business.

We've talked about productivity in our services business.

We've talked about portfolio actions.

And then this year we started talking about as-a-service based on scale.

And you can see three of those four elements in our more detailed list of what changes first half to second half.

The one that's not there, obviously, is portfolio actions, because we don't have any big divestitures planned here that are going to drive portfolio.

In effect, the way I'd say it is that when we look at the portfolio we think each of the elements can drive value for our clients and we still see high value in the elements.

Part of the way we get comfortable with each of those elements driving value is that when we look at the margins on the strategic imperatives content relative to the rest, the margins on the strategic imperatives content has been, and second quarter again, higher than what we see on the core business.

I interpret that as the places we're moving to, the places we're building value for our clients, looks like a pretty high-value marketplace and it's one that's worth us continuing to serve.

So we think we build on margin with three of those four components that we typically have.

From an as-a-service perspective, I don't think we're through the capital requirements by any stretch.

We'll continue to shift our capital to the cloud business to make sure that we've got the right scale that we need for our model.

So we're not through it, but again, I don't think IBM's becoming more capital-intensive overall.

A lot of times it's just a shift from one to another.

And then obviously we'll keep investing in the capital we need to drive our acquisitions as we integrate those as well.

Thank you, Joe.

Rowena, can we please take the next question?

Steve Milunovich, UBS.

Great, thank you.

The strategic imperative revenue growth, I think is slowing.

I think it was 17% year over year last quarter, 12% this quarter.

Analytics is a big piece of that; I think that went from 9% to 5%.

Could you talk about what kind of growth you see going forward as these numbers get bigger?

And conversely, what was the decline in the core franchise revenue and what's been the trend there the last few quarters?

Thanks.

Yes, sure, thanks, Steve.

On the core, if you will, everything outside the strategic imperatives, that's been flattish.

It's been flat quarter to quarter, I should say.

It's down, but it's flat quarter to quarter.

So no change in trajectory on that part of the business.

In the strategic imperatives, when we started talking about this 1.5 years ago at our Investor Day, and we put on the table at the time that business would grow to $40 billion or 40% of our revenue at the end of 2018.

We think, and we draw that plumb line, we think we're, I'd say, probably a little bit ahead of the track that we need to get there.

We're certainly ahead on the percentage mix because 38% of our business was already there and we got 2.5 years to go from a timing perspective.

So we're on track to the $40 billion because with $31 million now trailing 12 months, we actually don't even have to grow at this rate to get over the line.

Now, the acquisitions will play a role in this and we see continued momentum here, but we don't even have to grow at this rate in order to get where we set out to get 1.5 years ago.

Thank you, Steve.

Can we please take the next question?

Brian White, Drexel.

Martin, on the cloud business, so cloud it looks like grew 30% year over year.

Has the cloud business reached the bottom in the margin profile and is on an upward trajectory?

Or do we still have a little bit more of a decline?

And if you could give us some type of an idea, where are you in cloud margins versus where you hope to be optimally in, say, four or five years?

Thank you.

Sure, Brian.

So two things.

Remember, our cloud business we're really -- if I had to over-simplify it, we have part of our business helping our clients build their own clouds.

And that includes hardware, it includes software as some services as well.

And when we do that with our clients, the margins we see in those businesses are exactly what we see in the rest.

That's the demand profile of where some of that business is going.

The margins don't look any different from that perspective.

To the extent the mix is different between how much hardware, how much software and how much services go in, there may be a different margin on the solution.

But as I mentioned, in total our strategic imperatives are mixing a bit richer so we're seeing better margins in total across the imperatives.

That's the help our clients build their own cloud.

On the as-a-service side of this, I think that as we put on the chart, the as-a-service component, even though we're going to continue to drive a fair bit of investment here, the as-a-service component will start to be accretive to our margins on a year-over-year basis, starting in the second half already.

Now, we'll see where the marketplace goes and we'll see how much we rely on getting -- or keeping, if you will, that margin growth as opposed to reinvesting.

But we see, again, on a big part of -- some of that cloud business we see margins that are consistent with what we see in other parts.

And the as-a-service business we start to see year-over-year accretion in the margins from that, even though, again, we'll continue to invest quite heavily.

Thank you, Brian.

Rowena, can we please take the next question?

Wamsi Mohan, Bank of America.

Yes, thank you.

Martin, for overall IBM strategic imperatives grew to 38% of revenues.

But in GBS strategic imperatives was already over 50% of segment revenue.

But yet overall GBS revenue was down 3%.

So I think there's a notion of people expecting aggregate IBM to eventually get to growth as you see strategic imperative mix increase over time.

But I was wondering if you could comment more specifically with respect to GBS, what some of the offsets were on that revenue line.

I think execution you were alluding to margins.

But more specifically on the revenue line, which caused deceleration, what would imply strong deceleration in the core on GBS?

Yes, thanks, Wamsi.

That's right, we did see some pretty strong deceleration or declines in the core of that.

As I said, we're continuing to shift our skills and our resources out of that part of the marketplace.

So in a business, which if you oversimplified it, is really about how do industry experts charge or bill for their time, your billing is going to be limited or constrained by how much resource you have applied to it.

That won't surprise you.

And then as I mentioned, we moved about 35% of our resource applied to those core parts of the business over into the strategic imperatives.

So that has two effects.

One, it obviously reduces the ability of us to grow revenue in those places when you constrain the resource.

And two, because the productivity is not one for one.

Someone who's billing on an implementation in an enterprise resource kind of an application doesn't immediately become a cognitive expert or doesn't immediately become a mobile expert.

So there's a productivity impact.

And what we give up, while we give up 100%, let's say, of that billing capability, we don't get 100% back right away.

And that's really what we're seeing in our consulting business.

In GBS, outside of the consulting, the application management, the global process services businesses, they're fairly stable within the overall GBS equation.

But the consulting business continues to go through this transition as we pull resources off and we put them into, and devote the resource or the investments if you will, to the strategic imperative areas.

Thanks, Wamsi.

Can we take the next question, please?

Jim Schneider, Goldman Sachs.

Good afternoon, thanks for taking my question.

Just a follow-up on the GBS segment.

It sounds, given what you just said about the continued pricing headwinds that you're seeing in the traditional ERP implementations and maybe the execution issues, that that's going to be persistent headwind even in the back half of the year.

Could you give us some commentary around when you would expect at least the impact of the runoff of some of that more commodity-like business to start to not be a headwind anymore?

And can you see the end of the execution issues in terms of the cost of some of those implementations that might have been overrun?

Sure, Jim.

A couple of things.

One, when do we work our way through this, one thing to look at here is the signings performance in the quarter.

And GBS did grow signings in the quarter.

Now, there is obviously a lag that sits in the backlog, and as you saw, in our total backlog is flat.

I mentioned earlier that GTS was up in backlog and obviously, therefore, the GBS component of that is down a little.

So while we are growing signings, which are a pretty good leading indicator of the kind of business, and that's a function of all the people we've moved into those new areas while we pull back some of the others, that total signings equation is now starting to work.

We grew signings in total, right?

So the new stuff is offsetting, if you will, the old stuff.

But not enough yet to get the backlog back to growth.

And we got to get that backlog back to growth in order to have turned the corner for that signings equation, which we got back to growth to get the revenue equation, if you will, back to growth.

Thanks, Jim.

Let's take one last question.

David Grossman, Stifel.

Thank you.

So Martin, there's several factors that are impacting the free cash flow conversion this year.

Can you help us understand what known factors there are today, headwinds or tailwinds, that we should consider for conversion next year?

Sure, David.

Thanks.

As we said, we reiterated our you view of free cash flow.

At the end of the first, we were comfortable at the time and remain comfortable to be at the high end of what we had originally provided.

So within that, realization for us is a pretty good measure of how we're converting our cash.

Our model is to be in the [90s] and I think with the headwinds-tailwinds we see within free cash flow for the year, I'd say we probably are more likely to wind up in the high 90s in 2016.

Now, as we get into next year, there's a lot that we have to get through in order to understand what next year's going to look like.

But I am comfortable that while we'll finish, again, probably high 90s this year, I'm comfortable that our model is right, even for next year, that we'll be in the 90s again next year when we look at all of the pieces.

So let me conclude the call by reminding everyone that we're running our clients' most critical process and that puts us in a pretty unique and a terrific, quite frankly, position to move them to the future.

And it's not just about the infrastructure, which is obviously important.

We've always felt that important and we think it's important today, but it's also about helping them become digital businesses and helping them inject cognitive into everything they do.

It's what they're asking for and it's, quite frankly, been our perspective on where the world is going.

We're not only doing that with our existing clients and not only doing that in a traditional IT, but in some cases we're building entirely new businesses and entirely new markets.

And so that, for many, is beyond what some of you would focus on in terms of infrastructure, but it's becoming a bigger and bigger part of what IBM is becoming.

Again, it's our view of where value will be created for clients and for our investors.

And so as we make those shifts and as we build these new markets, we take our temperature, if you will, at the end of June and we'd say we're right on track with what we wanted to get done for the year.

So with that, thanks for joining the call.

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

Thank you for participating on today's conference.

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