International Business Machines Corp (IBM) 2016 Q3 法說會逐字稿

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 third-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 today. With that, I'll turn call over to Martin Schroeter.

Thanks, Patricia. In the third quarter, we generated $19.2 billion in revenue, $3.7 billion in pretax income, and $3.29 of operating earnings per share.

As we think back to the discussion 90 days ago, it was around Brexit, and its impact on Europe, global spending in sectors like banking, and the attractiveness of investment in the emerging markets. All of these topics have the capacity to drive some volatility in results, but what you see in our third-quarter results is stability in our revenue, with continued strong growth in strategic imperatives, and a top and bottom line consistent with what we expected.

Our revenue was essentially flat, relative to last year. Looking at the revenue dynamics, I want to point out a few things. Our clients are focused on becoming digital businesses, and our strong growth in cloud, security, mobile, and across our analytics portfolio, reflects this.

In total, we continued to deliver double-digit revenue growth in our strategic imperatives, led by our cloud business. Cloud delivered as a service is part of a solid recurring revenue base across software and services, and our annuity revenue continued to grow.

Of course, the acquisitions we've made in the last 12 months contributed to growth, about the same amount as last quarter, and for the first time in quite a while, currency was a modest tailwind to revenue growth. I'll talk to our revenue at constant currency going forward.

Looking at revenue from a segment perspective, we had very good performance in both cognitive solutions and technology services and cloud platforms. Cognitive solutions was up 5%, and within that, solutions software was up 8%. Technology services and cloud platform's revenue also grew, with continued strength in our infrastructure services, and growth in integration software, as we help our clients build hybrid cloud capabilities.

And with another quarter of signings growth, our GTS backlog is up year to year. Global business services made some progress this quarter in revenue trajectory, as we continue to shift and mix toward digital offerings. Our systems revenue was down this quarter.

The z Systems performance reflects the fact that we're seven quarters into the product cycle, while power reflects the secular decline in UNIX, mitigated by growth in Linux. There's a tremendous amount of change in our industry, and we're continuing to invest where we see the best opportunities. With this, we are addressing new opportunity areas and building new markets, as well as delivering innovation in our existing businesses.

We're investing organically, and we are acquiring key capabilities. We are remixing our skills, and we've had success in rebuilding our IP income base, utilizing partnerships that enable us to continue to innovate in some of the more traditional high-value areas of the business. With all that, we continue to have a very high-margin business, and we generate a lot of profit and cash.

Our results reflect the success we're having in helping our clients to leverage cloud for speed in innovation, and become cognitive businesses. We see this in the growth in our strategic imperatives, which were up 15%. Over the last 12 months, strategic imperatives delivered nearly $32 billion in revenue, and now represent 40% of IBM.

We had strong performance in our cloud offerings, which were up over 40%, led by our as-a-service offerings. We exited the third quarter with an as-a-service run rate of $7.5 billion. That's up from $6.7 billion last quarter, and the bulk of the increase was organic, so we're building scale in these businesses.

We also had strong revenue performance in security, and in mobile, and we had strong growth in our analytics offerings, which were up 14% this quarter, with contribution from the core analytics platform to cognitive offerings including Watson Platform, Watson Health and Watson IoT. We are building the industry's broadest and deepest cognitive solutions and cloud platform portfolio, and we're extending our capabilities.

For example, this quarter, we continued the global expansion of our cloud footprint, and we now have 49 cloud centers. We formed a partnership with Workday, where IBM cloud will become the foundation for Workday's development and testing environment. And we extended our partnership with VMware, to enable easy hybrid cloud adoption.

As we have talked about in the past, cognitive is about using data and adding intelligence into products and services, to help clients make better decisions. It's about augmenting human intelligence. This quarter we introduced and expanded Watson platform offerings, including Watson Conversation Service, and Watson Virtual Agent for customer service. We're training Watson for cyber security, expanding the amount of security data Watson is ingesting.

In Watson Health, we launched Watson for drug discovery, and Watson Health Core. And in Watson IoT, we added new capabilities around Blockchain and security, to draw insights from billions of sensors embedded in everything from machines, to cars, to drones, to ball bearings, to buildings, and even to hospitals.

Where we're seeing real value is in providing cognitive capabilities in the IBM cloud. The third critical element of our strategy is our industry focus, and in the third quarter, we introduced an industry platforms business that integrates cloud, cognitive, industry and ecosystems capabilities, to provide targeted solutions in specific industries.

Initially, industry platforms will address two substantial opportunity areas: Watson Financial Services, and Blockchain solutions. We believe Blockchain has the potential to do for trusted transactions what the Internet did for information. We're building a complete Blockchain platform, and are now working with over 300 clients to pioneer Blockchain for business.

Including CLS, who settles $5 trillion per day in the currency markets, to implement a distributed ledger in support of its payment netting service. And Bank of Tokyo Mitsubishi, for smart contracts to manage service level agreements and automate multi-party transactions. And in the third quarter, we opened a Blockchain Innovation Center in Singapore, to accelerate Blockchain adoption for finance and trade, and we now have Blockchain garages open in New York, London, Tokyo, Singapore, and San Francisco.

In Watson Financial Services, just a couple of weeks ago, we announced the acquisition of Promontory Financial Group, a leader in regulatory compliance, and risk management consulting. So just as we trained Watson on clinical research and medical guidelines to work with doctors treating cancer, we will apply the expertise of Promontory to train Watson to directly address escalating regulation and the risk management requirements in financial services.

I will expand on some of these solutions and go into more detail on our strategic imperatives performance in the segment discussions, but first let me walk through our financial metrics for the quarter. Our revenue for the quarter was $19.2 billion. As I just mentioned, currency was a modest tailwind to growth, about 80 basis points this quarter.

On a geographic basis, we had sequential improvements in both the Americas and Europe. The Americas revenue was flat, as compared to last year, and the US was also flat. Latin America was up 5%, led by Brazil. While the environment remains uncertain, double-digit growth in Brazil this quarter reflects the importance of our z Systems platform to the banking sector.

Europe performance improved 4 points sequentially, driven by the UK, Germany, France, and the Nordics. Asia-Pacific decelerated, including a decline in Japan, and weaker performance in China. India continued to post strong results.

Our gross margin was down this quarter. Across the business, the decline is driven by a higher level of investments, including the acquisitions we have made, and the mix to as-a-service businesses that aren't yet at scale. I will address the margin dynamics that are segment-specific within the segment discussions.

Our expense overall is down versus last year. I want to spend a minute on a few of the expense drivers. We have been investing at a higher level, both in organic capabilities like cognitive, security, cloud and Blockchain, but also through acquisitions. When we look at the acquisitions we have done over the last 12 months, this drove about 5 points of expense growth.

As we look at our investment levels, we want to allocate our skills to where we see the most opportunity and growth. Some of our assets are high-value, but not necessarily in growing markets. So we're licensing, not selling, our intellectual property to partners who are allocating their skills, to extend the value of these assets. This quarter, we signed three such agreements, resulting in a higher level of IP income.

Licensing as a part of a broader partnership, to drive future innovation, is a relatively new model for us. It allows us to retain and potentially grow the revenue stream, while shifting our spending profile to a more variable cost structure. IP income is just one way that we monetize our technology. Sometimes selling our intellectual property, other times, licensing IP.

The last thing I want to mention relative to expense is that we continue to have a year-to-year impact from currency, not only from the translation, but also as we wrap on last year's hedging gains. This drove a 3 point impact to expense. So while currency is a modest help to the top line, it continued to have a meaningful impact to our year-to-year profit. Put it all together, and our reported expense is better 2% versus last year.

Our tax rate for the quarter reflects an ongoing effective tax rate of 18% for the year, which is in line with the expectation we discussed at the beginning of the year, of 18% plus or minus a couple of points. It also includes a discrete benefit for closure of a foreign tax audit, which lowered the tax rate in the quarter by 2 points. From a cash perspective, we generated $2.4 billion of free cash flow in the quarter, and nearly $13 billion over the last 12 months. This is over 100% of our GAAP net income, and over the same period, we returned about two-thirds of our free cash flow to shareholders through dividends and share purchases.

Now turning to our segments, our cognitive solutions revenue was up 5%, which is a sequential improvement from the second quarter's rate. Our solutions software revenue was up 8%, while transaction processing software was down 2%. Analytics was a growth driver, and we grew revenue in all spectrums of Watson.

We saw strong SaaS performance, with double-digit growth in revenue. Overall, gross margin was down, due to the mix shift of SaaS and the acquisition content. Our pretax income performance also reflects ongoing higher levels of investment in strategic growth areas, like our Watson businesses.

Our analytics business, which is the largest portion of the solutions software portfolio, grew again in key areas, such as information integration, big data, and Watson. Watson underpins our cognitive strategy, and continues to gain momentum. Watson's conversation service, launched in July, provides developers a simple and easy entry into the next generation of engagement. Through quick set-up and tooling, developers without deep machine learning expertise can leverage the science of Watson to develop engagement experiences across multiple channels.

We introduced our Watson Virtual Agent for customer service, building on our conversational capability, to provide a cognitive repeatable application trained for customer service. For example, we recently announced that the Royal Bank of Scotland will begin using a Watson-powered chat bot for customer service. The chat bot will help seamlessly route customer service requests through the correct channels, and answer specific banking queries.

Turning to our vertical plays, we're focused on scaling our Watson Health business. We have over 7,000 employees and target four major areas: life sciences, oncology, imaging, and value-based care. We have launched new offerings, such as Watson for drug discovery, which is a cloud-based scalable platform, that helps life science researchers discover new disease pathways, new drug targets, and additional drug indications. We had several major client wins, including UPMC and Best Doctors.

And earlier this month, we announced a strategic alliance with Siemens, to help healthcare providers deliver value-based care to patients with chronic conditions, such as heart disease and cancer. With Siemens, we will focus on accelerating US adoption of Watson's population health management offerings. Siemens will use the Watson Health Cloud as its preferred global technology platform.

We have also been growing our geographic footprint, expanding into China, South Korea, Finland, and the United Kingdom, this quarter alone. Hospitals in both China and South Korea announced plans to adopt Watson for oncology.

And in Finland, we announced a partnership with the Finnish government, that will utilize Watson cognitive computing to help doctors improve the health of its citizens. Their vision is to build an open healthcare ecosystem, based on compliant and efficient utilization of healthcare data. So Finland will put their healthcare data on our Watson Health cloud.

When you think about an entire country entrusting us with its healthcare data, this should give you some perspective as to how clients believe we have the right technology, and consider us a trusted partner to drive healthcare innovation. This builds on a similar announcement we made with the Government of Italy earlier this year.

We also made great process in Watson IoT. We opened our German location, where we will co-create with our clients. We added new capabilities to our offerings, so now you can share IoT data from connected devices on a Blockchain, proactively identify potential security risks, and protect devices and tap the Watson IoT platform to develop new voice interfaces for customers, all by leveraging these capabilities.

IBM's leadership and IoT was recently highlighted by IDC. We more than doubled the number of new clients on our IoT platform in the quarter, including Schaeffler and Thomas Jefferson University Hospital. Schaeffler, one of the world's leading automotive and industrial suppliers, based in Germany, is using Watson IoT to transform its business from its supply chain, through to manufacturing and sales.

This is a good example of how deeply embedded into our client's businesses we're becoming, down to the ball bearings themselves. We are seeing exponential growth in both devices and developers, and now we are expanding our industry differentiation, and our reach with Watson Financial Services. As I mentioned, last month we announced plans to acquire Promontory. Together, we will create cognitive solutions for risk and compliance.

Global business services delivered $4.2 billion of revenue, with a 1 point improvement in growth trajectory from last quarter. Our digital practices, which now make up more than half of GBS, were up double digits, with strong growth in cloud, analytics, and mobile. Our cloud practice was up nearly 70% this quarter, as we build and implemented digital strategies to move our clients to the cloud.

By line of business, we grew 2% in application management, driven by growth in our digital foundation and mobile platforms. This was offset by a decline in consulting revenue, as some larger contracts wound down, and clients continued to move away from on-premise enterprise application work to new business models focused on digital and cloud.

Enterprises are looking for new ways to reach their customers, and empower their employees to make faster decisions. We continued to see strong double digit growth in our enterprise mobility solutions, that are helping clients redesign workflows with specific industry context. Our growing collection of mobile first for iOS applications are delivered on the cloud, and can connect back to their core systems and infrastructure.

This is reinventing the way employees make real-time decisions, by putting the power of the enterprise in their hands. We continue to bring new customers onto the platform, including VU University Medical Center in Amsterdam, RIMAC Insurance on Peru, and Amica Insurance here in the US. We also opened a new IBM mobile first garage in Bangalore, part of a network of centers, that helps clients around the world achieve mobile-led digital transformations, at speed and at scale.

Turning to profit, TBS gross profit margin was down 90 basis points. We expanded margins in application management, as we mix the new cloud and digital platforms. And with the benefit from our workforce rebalancing actions, we're driving productivity in our delivery model.

Consulting gross profit margin was down, reflecting the investments we're making to grow our digital practices. Also, there were some accounts that required additional spending to deliver on important commitments. These dynamics are also reflected in our PTI margins.

We're continuing to shift the business, as we've added nearly 10,000 resources over the past year to our strategic imperatives. The acquisitions we have done over the last year impact our near-term profit, but add important capabilities, like cloud consulting scales around Workday and salesforce.com. We have also expanded the IBM interactive experience, and our digital design capabilities.

We're focused on integrating and scaling these new skills, as we continue to expand our digital practices. Technology services and cloud platforms delivered $8.7 billion of revenue, and grew 1% year to year. Global technology services again grew signings and backlog, and has now grown revenue for six consecutive quarters.

As we shift from systems integration to services integration, we continued to see momentum in our new offerings. Across the segment, our strategic imperatives were up over 40% with cloud up over 50%, and the as-a-service run rate up over 60%.

Looking at the lines of business, infrastructure services was up 2%, as our hybrid strategy continues to resonate with our clients. We provide enterprise grade cloud solutions that are secure, agile, and leverage the data and investment in their core systems. We continue to expand our cloud infrastructure, announcing the opening of new cloud centers in South Korea and Norway this quarter. We now have 49 centers around the world, enabling low-latency connectivity to cloud infrastructure.

In moving to the cloud, our clients need to be sure their data is secure. Those in regulated industries need to know where their data is, and many need to keep it in-country. Our cloud infrastructure allows clients automatically to provision virtual with bare metal servers, while meeting their data sovereignty and regulatory requirements.

At JFE Steel, one of the largest steel manufacturers in the world, we announced a five-year outsourcing agreement that will migrate core systems to the IBM cloud, through hybrid solution that will consolidate their infrastructure and streamline business operations. This will allow the company to speed up system development and services deployment, strengthen IT governance and reduce costs.

And last week, we announced a new cloud object storage service, that will enable clients to scale large unstructured data volumes across hybrid cloud environments. Bitly has adopted this new object storage service, to more quickly and easily analyze data that is being produced by the more than 10 billion clicks it process processes each month.

Looking at the software component of our hybrid cloud solutions, integration software grew 4%. We saw continued strength in our connect products, that integrate applications, data and processes, for on-premise and cloud environments.

We also grew in some of our mission-critical offerings, such as Webster application server. We continued to shift more of our portfolio to an as-a-service model through our Bluemix cloud platform, which continues to scale across a broad catalog of high-value services, including cognitive, weather, Internet of Things and Blockchain APIs.

We continue to build our partnerships and ecosystems to help clients move to the IBM cloud. Through our partnership with VMware, nearly 1,000 clients have begun moving their VMware environments to the IBM cloud, including Marriott International, Clarient Global, and Monetize. We're helping organizations extend existing workloads to cloud in hours versus weeks or months.

Turning to profit, our gross margin for technology services and cloud platforms was about flat year-to-year. We expanded margins in infrastructure services, as we see the benefit from productivity actions we've taken, and continue to streamline our processes. We're investing in our technology, and using our cognitive capabilities to shift to a more automated delivery model to improve performance and drive efficiencies.

Our technical support services margin declined, driven by the mix to our multi-vendor support offerings. Our PTI margin also reflects these dynamics, as well as the continued investments we're making to build out our cloud platforms.

Turning to our systems segment, there are some import market shifts in this business, like spinning disc to flash, the rising importance of the hyperscale data market, and new opportunities in Blockchain. We're shifting our business, delivering innovation in their offerings, and introducing significant new capabilities. As always, our performance in the period is based on product cycle dynamics and portfolio transitions, and given where we are in the transitions in power and storage, and in product cycles more broadly, our revenue and profit is down after a strong 2015.

Our z Systems results reflect the product cycle dynamics. Seven quarters into the z13 cycle, revenue was down, while margins continued to expand. We continue to add new clients to the platform, and we're introducing new technologies like Blockchain.

We announced new services to make it easier to build and test Blockchain networks in a secure environment. As we build our Blockchain platform, it is being engineered to run on multiple platforms, but is optimized for scale, security, and resilience, on both the IBM mainframe and the IBM cloud. Our z Systems are well-suited for these new workloads, due to its advanced security features that help protect data, and ensure the integrity of the overall Blockchain networks. We're currently working with over 40 clients on pilot Blockchain use cases, running on z.

Our power performance reflects both our performance in the declining UNIX market, as well as our growth in the growing Linux market. While our margins were relatively stable at the high end of power, mid and low-end margins were down, driving a decline in overall power margins. We've been shifting our platform to address Linux, and in the third quarter, Linux grew at a double-digit rate, and faster than the market, that now comprises over 15% of our power revenue.

Supporting that is our success with HANA, where we are bringing in new clients, and we're replicating this strategy with others. This quarter, we expanded our Linux-only server portfolio, leveraging OpenPOWER partnerships, to deliver a new high performance computing chip in system, with NVIDIA GPU acceleration, and new data optimized servers.

And our power architecture had another win, this time for a major hyperscale data center, with one of the world's largest internet providers based in China. Finally at the end of September, we introduced new powered mid-range and high-end systems designed for hybrid cloud computing and flexible consumption models to transform on-premise IT to the cloud.

So in power, we're shifting to Linux, while continuing to serve the high-value UNIX base, but this is a long transition. In the near term, we're focused on stabilizing the margin base.

Storage hardware was down 9% this quarter, reflecting the ongoing shift in value toward software. Gross margin was down, reflecting both volume and price pressure. The hardware decline was mainly driven by the low-end and mid-range traditional disk storage. Our high-end disk storage grew this quarter.

All flash array revenue grew, as we have expanded all flash technology across our product portfolio. We recently rolled out new products, and transitioned to a full suite of flash offerings, making us competitively positioned.

And while not in our systems segment, we also continued to see double-digit revenue growth in software defined storage. Across systems, we are facing product cycle headwinds and some transitions in power and storage, while continuing to deliver important technologies and capabilities to address cognitive and cloud.

Now, let me wrap up the segment discussion with the performance of software across our segments. Our total software revenue was $5.7 billion, up 3%. This is the third consecutive quarter of improvement in our software revenue growth trajectory.

We have got a broad software portfolio, from solutions that provide cognitive analytics and security solutions, to core transaction processing, to connecting on-prem data and processes to private and public cloud environments. Our software is open, running on IBM, and non-IBM environments.

From a business area perspective this quarter, we had solid of growth in cognitive solutions and integration software, while operating systems continued to be a drag, in line with the longer-term secular trend. Across software, software annuity revenue was up mid single digits, led by our SaaS offerings. Acquisitions contributed to our SaaS growth, but SaaS was up organically, as well.

Our transaction revenue declined mid-single digits, which is a significant improvement in the trajectory, as compared to the last several quarters. As is typical in the third quarter, our transactional software content was less than 20% of our software revenue. But remember in the fourth quarter, due to seasonality, transactions represent a larger portion of the software revenue.

Moving on to cash flow and the balance sheet, we generated $3.3 billion in cash from operations, excluding our financing receivables. After $850 million of CapEx spend, we generated $2.4 billion of free cash flow in the quarter. Through the first three quarters of the year, our free cash flow of $6.9 billion was a little lower than last year, with lower tax payments largely offsetting the year-to-year operational performance.

Through September, our CapEx spending is consistent with last year. As I mentioned earlier, on a trailing 12 month basis, our free cash flow was over 100% of our GAAP net income. This performance continues to 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 includes the expected cash payments related to the workforce rebalancing charge taken earlier in the year, as well as the expected tax payments in the fourth quarter.

Looking at the uses of cash, so far this year, we have invested nearly $5.5 billion in acquisitions. We've acquired 12 companies, the largest being the digital assets of The Weather Company, and Truven Health Analytics. In the last nine months, we've returned $6.6 billion to shareholders, including nearly $4 billion in dividends, and we bought back almost 18 million shares. We ended September with just over 950 million shares outstanding, and $3 billion remaining in our buyback authorization.

Moving on to the balance sheet, we ended September with $10 billion in cash, and $42.5 billion in total debt. About $26 billion of our debt was in support of our financing business. The leverage in our financing business remains at about 7 to 1, and the portfolio remained strong, at 51% investment grade.

Our non-financing debt to cap was about 54.5%, which was essentially unchanged from December, and down about 4 points from a year ago. Our balance sheet continues to be well-positioned to support our business over the long term.

As I said up front, in an environment where there are a lot of open questions, our business is showing a lot of stability. That stability is driven by the kind of work we do for our clients. We're applying deep industry skills and innovative technologies to change real business processes and outcomes. This supports our ability to invest to create new offerings in markets, and our ability to find new ways to monetize our intellectual property.

In the third quarter, we made progress across our business, with continued strong growth in our strategic imperatives, some moderation and declines in our core businesses, remixing our skills, and adding new capabilities through organic investments, acquisitions, and partnerships. You will recall in July, we said that we expected our second-half EPS dynamics to be improved over the first, and we laid out a half a dozen or so areas where we expected to drive that.

Now, based on our third-quarter performance, and our view of the fourth, we say this second half improvement is pretty much in line with our view 90 days ago. While we may see a little less improvement from software revenue mix, we are more successful in monetizing our software through IP income.

So bringing it all together, and as we look at the full year, we continue to expect to deliver at least $13.50 of operating EPS, and free cash flow at the high end of the range we provided at the beginning of the year. So with that, we will take your questions.

(Operator Instructions)

Toni Sacconaghi, Bernstein.

Martin, I have a hopefully straightforward clarification, and then a question, please. Just on the clarification. The year-over-year IP gains were about $340 million, or $0.30, and I appreciate that you're licensing real software IP to get that. But how we think about this as being more one-off rather than ongoing IP, and should we be thinking of IP income increasing on an ongoing basis?

And similar, if you could clarify the tax rate? I have 14.2% as your tax rate. You talked about 2 points being helped from a discrete tax item. Was there something else that was impacting the tax rate, that appeared to get it down to -- at least by my model, something that's closer to 14%? If you could clarify those two, that would help.

Then, the question is just around free cash flow, and how to think about it. This year, you are going to be at the very high end of your range, probably free cash flow being 100% or more than 100% of GAAP net income. As we look forward next year, given your guidance is typically lower than that, should we not be thinking about free cash flow declining, and then on an absolute basis in 2017?

Okay. I think I got them all, Toni. We will do the clarifications first, and we won't count that as a multi-part question. We'll count that as a multi-part clarification, and then we'll talk about free cash flow.

A couple things, on IP, and this is actually a really important point, I think, Toni. Our IP income has been flat to down over the last say, three, four, five years. We've been thinking about how do we continue to drive IP income.

If you look back, and I'm sure you have by the way, you have all the data as well. If you look that 15 years ago, we had as much is $1.7 billion of IP income. A lot of that was driven from the fact that we developed really good semiconductor manufacturers, and really good semiconductor manufacturer processing technology, and our ability to license that technology drove a lot of income.

We have been thinking about how do we reinvigorate, if you will, the IP income business. And part of it is what you're seeing now, is we are realizing some of these. So the clarification that you asked about, is it about $340 million year to year? Yes, that's right. That's about $340 million year to year.

But more importantly, we are going to continue to drive IP income. Now, we got a good third quarter on a year to date basis, we're about $1.1 billion, so we're kind of flat. I don't think that we have enough to set a new annual record, when we look back at the $1.7 billion that we printed 15 years ago or so. But it is certainly a focus.

Keep in mind, I think that the - these are relationships. They are long-term relationships, right? So they are not all public, as some of our partners don't want to talk about what they are doing. Those that are public, they are multi, multi-year relationships, where they can drive now some of the value that they see, they can capture within the marketplace.

Again, we license it to them. We don't sell it to them. We have an interest going forward, as well, and can get some of the upside here.

So this is a terrific model. It has got a lot of legs. We see an opportunity for this over the next few years, to continue doing this. I think that handles your clarification on tax.

The 2 points -- your notes were right. 2 points were from the discrete piece of it. Then, we are, our view of the year now, because of the mix of our business, has an operating ongoing effective rate of 18 plus or minus, which is where we were at the beginning of the year. It's really a view of where the mix of our businesses looks for the rest of this year.

On free cash flow, your question. We have been running at a realization, which is above our model. Now, keep in mind we won a tax case earlier in the year. That means we got our money back. That was a pretty substantial inflow, though we also had some pretty substantial outflows in terms of our workforce rebalance payments and things through the year.

As we said in our guidance, we would expect to finish at the high end of the guidance. We said that already 180 days ago. We still feel confident about our ability to generate cash. As we start to look at next year, we don't see anything that fundamentally changes our realization from where we are in our model.

So our model, as you know, is in the 90%s, somewhere between 90% and 100% realization. We don't see anything. Knowing, again, everything we have now, everything we have now year-to-date, plus what is coming in the fourth, we don't see anything that would say our free cash flow realization is going to change. And so when we get through now the fourth, and we see where we are for 2017 in 90 days, then we will talk more about the absolutes, but we don't see anything in the realization that's going to drive our realization to be anything other than, again, 90% to 100% for next year.

Thanks, Toni. Can we go to the next question please?

Katy Huberty, Morgan Stanley.

You didn't close any major acquisitions this quarter, and yet cognitive gross margins fell 400 basis points year on year, 200 basis points sequentially. Should we not expect to see improving margins, as the service revenues scale on the fixed cost base of data centers? And then Martin, just connected to that, you mentioned that the one variance to your plan for the year is that the software business margins are not tracking to plan? Can you maybe touch on why that is? Thank you.

Sure. So I will address actually the second one first, Katy. When we talked about first half to second half, and we laid out where we saw the business in the second half, one of those elements we had on that chart last quarter was the idea of software mix, and as-a-service from our software mix and as-a-service margins, and it would go, it would turn into a modest positive.

I would say that's more neutral now. So not a dramatic change. And it really has to do with the mix of business. We're getting the growth rates we would expect.

You saw third quarter, we had software up 3, which is an acceleration from the prior quarter. But it really is - we are also seeing good momentum in our cloud platforms business. It's really a mix statement that is driving that, as opposed to something happening within our software margins.

On the cognitive margin component, you are -- the phenomena you described is absolutely accurate. As we slow down those investments, we will see the as-a-service margin scale. We're starting to see the as-a-service business scale, but we still see so much opportunity, we're going to keep driving the investments. And so we haven't gotten to that point yet, where the scale overtakes the investment levels in that as-a-service business.

Thanks, Katy. Can we go to the next question, please?

Tien-tsin Huang, JPMorgan.

Just some of the transactional sales, down 5% in the third quarter, I'm curious if there's any good lines of sight here into the fourth quarter, and what you might expect there in relationship to what you saw in the third quarter? Maybe this is a stupid question. Should we start to think about transactional sales and IP income, maybe together? I don't know there's any correlation between the two in any way. Thanks.

Thanks, Tien-tsin. A couple things. The transactional business, as we noted in the third, at down 5, was an improvement from where we were in the second. So we had reasonable transaction closing rates.

Now the thing to keep in mind, as we go into the fourth, it is a much bigger transactional quarter for us. So while we have what I would call a good opportunity pipeline, we have got now 85 days or 75 days to see how the environment holds up, and that will obviously drive the fourth quarter, and drive the full year. When I look at the revenue streams in the fourth, our annuity business, which again, smaller piece in the fourth, our annuity business has been growing pretty consistently quarter to quarter to quarter. I would expect that growth to continue into the fourth.

That transactional business, which is again much larger, tends to get a pretty good quarter-to-quarter sequential bump, if you will, about $1.5 billion. And based on our opportunity pool, we would say that looks about like what we will get done in the fourth, as well. But there's some uncertainty in the environment, and here in the US we have an election to get through. But right now, I would say that my line of sight into 4Q says that quarter to quarter, impact in third to fourth, is about $2.5 billion as we had, just for that transactional business.

Thanks, Tien-tsin. Sam, can we take the next question, please?

Steve Milunovich, UBS.

You talked quite a bit about Watson, you've been running many Watson ads. I just wonder if you could give us any updates on the analyst day on Watson. How much revenue are you generating? The revenue you do generate, is it in the software or consulting buckets? Relatively speaking, what do you expect going forward?

You mentioned I think four or five ways you were looking to monetize Watson at that meeting. Which ones are working? And you talked about it as a platform, as well. I wondered if you would consider running Watson on someone else's platform, like on AWS?

Steve, I will start with the last question first, and the last answer to that question is no. Watson runs on our cloud, and our technology, and Watson will run on the IBM cloud.

With regard to the progress we are seeing, we have talked a bit about, you've seen many of our announcements around where Watson is showing up and the kind of work it's doing. All of that, as you know, gets reported within our strategic imperatives, and all of it goes into the cognitive solutions space, that is where our Watson Health business is, that's where our IoT business is, and that's where the Watson platform is.

I would say that with the cognitive solutions business, we talked about it in total at plus 5%, the sub-segment of that, where the Watson content shows up, which we also provide, is up 8%. So, good growth in that software solutions space. But, keep in mind that we're also building new markets here.

It is going to take some time for us to take the technologies and the processes that we bought, for instance in our Watson Health business, and now layer on the Watson technologies to get the ramp in growth that we expect to get out of some of them. So yes, good progress, yes, it's a long-term investment. Again, all within that cognitive solutions segment. And, no, it's not going to run on anything but the IBM cloud.

Thanks, Steve. Can we go to the next question, please?

Lou Miscioscia, CLSA.

Lou, we can't hear you. Are you on mute?

Hello.

Now we can hear you.

Okay. Let's hope it's coming through okay. On the software area, which was up 3%, maybe can you go in there, and just share with us what is organic, and would you say that we've actually gotten past the flexible pricing situation that you've been obviously dealing with from a negative growth standpoint from a couple of quarters? Or actually maybe about over two years now?

A couple of things, Lou. On organic, as you said, software up 3% and acceleration from where we were, there is across IBM, the acquisition impact was about the same as it was this quarter, it was about 2 points across all of the businesses.

Now, a lot of those businesses are software. So obviously, an impact in software in the quarter. But not dramatically different again, from what we saw in the second.

We continue to have good annuity content performance. Our annuity business continues to grow. The phenomenon that we have talked about, with regard to our largest customers, is still part of the discussion, with every large customer. It is a question of, how do they best view the deployment of their licenses. How do they best view the use of our technologies, in order to make sure they are optimizing their own workload, to make sure they are optimizing the projects they have going on.

One of the things and an important thing to us is are they -- to make sure they are still using our software, and are they still, for instance, paying us, and are they renewing that? Our renewal rates have stayed very high, and very consistent through the third quarter as well. We're confident that our software business has the right appeal, if you will, to our clients, because they continue to use it, they continue to deploy it.

On any large customer basis, any large customer, the discussion could be a little bit different. But again, good software performance in the quarter, some benefit from acquisitions. But I would expect that our annuity base would continue to keep growing as well.

Thanks, Lou. Sam, can we go to the next question, please?

Wamsi Mohan, Bank of America Merrill Lynch.

I have a quick clarification, and a question, as well. So, Martin, when you alluded to moving to this high transactional quarter in the fourth quarter, I think you alluded to about $2.5 billion sequential improvement quarter on quarter in that business. Is that the baseline that is needed to achieve the 30 and 15 guidance? That's my clarification.

For my question, if you think about the unique one-time benefits in 2016. So you have tax, which was a big driver for first quarter. I know you had associated investments, and then now you look at the third quarter, there's some significant IP other income. I appreciate your comments around the increasing nature and sustainability of this.

I know you are not guiding yet to 2017. But conceptually, these elements make it seemingly tougher to grow earnings in 2017, especially at a time when the pace of buybacks are moderating at sub $1 billion for the last four quarters and gross margins continue to compress. So maybe you can help us think through at a high level, maybe some puts and takes, and what potentially the positive drivers are, offsetting these headwinds in 2017?

Sure, Wamsi. And again, the multi-part clarification with a question is an interesting approach. First, on the revenue quarter to quarter. Yes, so when we look at our third to fourth, as I said, we typically get about $2.5 billion in transactional revenue in the quarter, and that's built into one of -- we have got a lot of different scenarios on what the year might look like. But that is certainly the predominant, if you will, scenario, on how the fourth comes in.

On the view of 2017, which I will come back to in a moment. Again I know, and you said it, I think, you did listen to my answer on IP. This is not a one-time thing.

Again, IBM has had as much as $1.7 billion of IP in our income statement. It is one of the ways we monetize all of our intellectual property. It's only one, right? We also obviously sell a lot, too.

But we license our IP as part of our business model. It is -- I don't think about it as one time. We're going to continue to drive this and hopefully grow it. We have got a reasonable pool in the fourth of clients and partners who want to license our technology, so you shouldn't think of it as one-time at all.

Now as we go into 2017, with our big transactional quarter coming up, obviously in 90 days, we will talk about what we saw in the environment, and what positions us for 2017. But I do think we know a few things, as we head into next year already today. So we know, for instance, we have got good momentum in our strategic imperatives, and we continue to see with our investments and our view of the market, how that resonates with clients, and I think we would expect to continue to see good strategic imperative performance.

Which, also, by the way, will drive some investments, but keep in mind that with everything we got done this year the bulk of the spending, the bulk of the investment dollars we freed up next year, that's a much bigger number next year. So we have freedom and an ability to invest more heavily, given what we have gotten done so far this year. That is one thing we know.

Secondly, we're seeing good signings and backlog performance in our GTS business. That was both signings and backlog up again. And within the GTS business, the biggest part of that, our infrastructure services business which drives, by the way, that backlog, also expanded margins in the quarter. So that is a big deal for us, obviously.

We also saw expanding margins in parts of our GBS business, and our application management business. Again, as we drive productivity. So we know, again, good performance and momentum in strategic imperatives, we have good signings and backlog growth in our GTS business with margin expansion in some of our services business. And then at this point, we will see where currency winds up in the next 75 days.

At this point, it is neutral-ish, if you will. It is certainly not the $1 billion plus impact we took this year, as we wrapped on all of the hedging from last year. So is far more neutral next year.

Now at the same time, as you said, we don't have another tax case that we are going to close next year, but at the same time, most of that was reinvested, if you will, or consumed elsewhere. It didn't show up in the bottom line. So yes, too soon to tell. We will get through the fourth, we will talk about the 90 days when we see. But there's momentum here in parts of this business that we will be spending more time on.

Thanks, Wamsi. Can we please take the next question?

David Grossman, Stifel.

So Martin, if we look at our organic growth rate of the imperatives, it looks like it began decelerating in the fourth quarter of last year and through the second quarter of this year. And it looks, at least if my math's right, it bounced back this quarter. You did a good job of telegraphing that last year's growth was not sustainable. That said, the number just seems to be a little bit more volatile than expected. Is there any way you can help us parse this disclosure, and just help us better understand what drove the deceleration, and then what drove the subsequent rebound this quarter?

Sure. I think the best thing to do, David, is to look at all of this on a trailing 12-month basis. We recently started giving this on a quarterly basis. It's good disclosure in the sense that everyone has asked for it, and we tried to provide the components of our strategic imperatives within each of our new segments, and I think in general, people appreciated having that level of detail.

But to your point, if you're looking for my advice on how best to interpret this, I would interpret it on a 12-month trailing basis. Our clients aren't making big investment decisions, like who do I trust with my data, and what cloud am I going to move onto? That is a decision that is going to last much longer than, say, a 90-day reporting cycle. So in any given reporting cycle, there will be volatility. My advice, look at it on a trailing 12-month basis and you can see the trend.

Thanks, David. Can we go to the next question, please?

Keith Bachman, BMO.

I also wanted to ask about cognitive solutions. You mentioned that the rollout of SaaS, if you will, or software-as-a-service, is impacting the margins. Yet it is still a very small part of the total. It's perhaps 10% of the current revenue base.

As that ramps, won't that continue to place pressure on your margin structure? Or to say it a different way, could you characterize, if we look at 2017, would margins in cognitive solutions be at a minimum flattish? How are you thinking about that?

One clarification also. Did you mention what they total revenues in organic sources were, or was M&A about 2 points of help this quarter, as well?

So in total, Keith, our acquisitions contributed about 2 points of growth, same as second quarter.

Okay.

On our cognitive solutions and our margins, so first keep in mind, this is our highest-margin business. It is primarily software, and within that, it has got very heavy high-value content in the on-premise category, if you will, right? And so these margins, which are very high, we want to, and we're moving some of this business and investing in the as-a-service, so as that moves into the margin profile, the cognitive solutions, could it see a little bit of margin pressure over the long term? Yes, but it's coming from a very, very high base.

And the as-a-service component that is going in is still better margin than all of the other segments in general. So yes, the as-a-service component of cognitive solutions may have a bit of an impact just on that segment. But overall, it will still help IBM. Again, this is a very high margin segment at north of 80% here.

Thanks, Keith. And we go to next question please?

James Suva, Citigroup.

Martin, thanks for the explanation about the additional investments you are doing that impacts gross margins. Can you help us understand, incrementally going forward, so not say year-over-year, but incrementally going forward, the efforts you've been doing this year, should we expect the same type or incrementally, do you feel like you are going to have to incrementally do more investments forward, or at this level? Thank you very much.

Sure, Jim. I would say that given, one, yes, we will continue to invest. Do I think the rate of growth of investment has to continue? Well, the short answer is it may, but again, remember how much we got done this year in terms of making room in the overall IBM equation, and the productivity we are driving in parts of our services business. As I noted, we're seeing margin expansion in some of those.

So, yes, we will continue to invest. And in fact, I think that some of these markets require this level of investment, in order to be at the leading edge with our clients. But we do make a lot more room, if you will, in the overall IBM equation, given everything we got done this year. We will spend more time in 90 days on how all of that plays out for 2017. But again, we have made a lot of room for investments, for ourselves, for next year.

Thank you. Can we please take one last question?

Amit Daryanani, RBC Capital Markets.

I will keep to one clarification and one question. The question is, when I look at your free cash flow usage over the last four quarters, it's been more skewed towards acquisitions versus what one would have thought in the past. As you look at 2017, do you think it optimizes more? I.e., buybacks could be much more than the $1 billion run rate you are running at, and acquisitions could be more? Just help us understand the mix is we go forward. And then just to clarify, when you talk about 90% to 100% conversion of net income to free cash flow in 2017, is that off the GAAP or non-GAAP number?

I will do the clarification first, Amit. That's our GAAP net income realization. We have just kept it consistent in terms of GAAP net income. It was the most straightforward for, we think, for everyone to understand. So the free cash flow realization data is GAAP net income.

On how free cash flow skews next year, and the application of our capital, I can say first, you can be assured that we're going to put all of our money to work, as we have. We don't tend to -- we don't keep capital here, to the extent that it is excess. After we have invested it organically and after we have purchased what we think we need to through acquisitions, and after we have paid the dividend, we do return capital to shareholders.

Over the long term -- in the form of share repurchase. Over the long term, as we have said now pretty consistently, we think over the long term we can reduce our share count by 2% to 3%, and that obviously recognizes that we will continue to be acquisitive. So I would say that, Amit, again, we will talk more about what we have assumed when we get to 2017, but we will absolutely continue to invest organically.

We will absolutely continue to be acquisitive. We will absolutely continue to grow the dividend, and then to the extent that we have excess capital to return, we will return it. And over the long term, that number from a share repurchase would be a 2% to 3% reduction.

So let me conclude by reminding you that we are running a highly differentiated play here. We're building obviously cognitive capabilities well beyond what others are doing, with individual AI services, if you will. And we're building the platforms to help deliver that. We're making all of that available on another platform, the IBM cloud.

It came up, as you heard on the call, will Watson run on someone else's cloud? No, it won't. It will run on the IBM cloud. We're doing all of that with deep industry expertise, and that is what our clients are looking for, that cognitive capability on the IBM cloud, with deep industry expertise.

You could see that in our Health, you can see that in our IoT, you can see now in financial services, which we just announced a couple weeks ago. So we are very excited about what we're doing, and we're very excited about the businesses we're building. Of course, we are very excited with the help, and what are allowing and enabling our clients to become, which is cognitive businesses.

As we do that, we will continue to be deeply embedded in the fabric of how they run their businesses, in the most important work they do. They trust us with their data, they trust us to be their partner in becoming cognitive businesses, and quite frankly, that's how we make sure we're successful over the long term. Thank you for joining our call today.

Thanks, Sam. Can I turn it back to you to close up the call?

Thank you for participating on today's call. The conference has now ended. You may disconnect at this time.