International Business Machines Corp (IBM) 2017 Q3 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 we'll turn the meeting over to Ms. Patricia Murphy with IBM.

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 third quarter earnings presentation.

The prepared remarks will be available within a couple of hours, and a replay of this webcast will be posted by this time tomorrow.

I'll remind you that certain comments made in this presentation may be characterized as forward looking under the Private Securities Litigation Reform Act of 1995.

Those statements involve a number of factors that could cause actual results to differ materially.

Additional information concerning these factors is contained in the company's filings with the SEC.

Copies are available from the SEC, from the IBM website or from us in Investor Relations.

Our presentation also includes certain non-GAAP financial measures in an effort to provide additional information to investors.

All non-GAAP measures have been reconciled to the related GAAP measures in accordance with SEC rules.

You'll find reconciliation charts at the end of the presentation and in the Form 8-K submitted to the SEC.

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

Thanks, Patricia.

In the third quarter, we delivered $19.2 billion of revenue, operating pretax income of $3.6 billion and operating earnings per share of $3.30.

Our revenue trajectory improved, and revenue was roughly flat year-to-year.

This includes a modest benefit from currency, and so we were down 1% at constant currency, which is 2 points better than last quarter's growth rate.

Our growth in pretax margins again improved sequentially, and we again had good free cash flow performance.

With this performance, we continue to expect at least $13.80 of operating EPS for 2017 and free cash flow consistent with last year.

From a geographic perspective, our trajectory improvement was broad based, and from a segment perspective, we had significant improvement in Cognitive Solutions and in Systems.

Cognitive Solutions grew year-to-year, led by security, IoT and our analytics and cognitive offerings as well as growth in our transaction processing software, so broad-based improvement across cognitive.

In Systems, we had strong growth, driven by the third consecutive quarter of growth in storage and a solid launch of our new z14 mainframe, which was available for the last 2 weeks of the quarter.

And in services, the revenue performance in both Global Business Services and Technology Services & Cloud Platforms was very similar to the second at constant currency.

We had good signings performance this quarter, which were up year-to-year in both segments, including strong double-digit growth in GTS signings.

Across our segments, our strategic imperatives revenue was up 11% or 10% at constant currency with strong double-digit growth in cloud and security.

While there's not much difference between our constant currency and reported revenue rates this quarter, I'll continue to focus on constant currency growth rates throughout.

The revenue performance in the quarter was pretty much all organic.

Revenue from our strategic imperatives over the last 12 months was also up 10% to $34.9 billion and now represents 45% of IBM.

We're embedding cloud and cognitive capabilities across our business, and our strategic imperatives, as we said, are signposts of the progress we're making in helping our enterprise clients to extract value from data and become digital businesses.

And so our strategic imperatives are in separate businesses with a view of the revenue across our segments that provide our clients with analytics, cloud, security, mobile and social capabilities.

This quarter, our cloud revenue was up 20% and over the last 12 months, has grown to a $15.8 billion revenue base, which represents 20% of IBM's revenue.

Our as-a-service revenue was up 24% in the third, and we exited the quarter with a $9.4 billion annual run rate.

We're able to drive these results because we're focused on helping our enterprise clients transform their IT.

Keep in mind, the IBM Cloud is built for the enterprise.

It is the only cloud that integrates public, private, multi-cloud and traditional data centers through a single architecture and is designed for cognitive workloads.

So as our clients look to use AI to extract value from data, Watson on the IBM Cloud is the AI platform for business, differentiated by vertical domain depth and in how it protects our clients' data and insights because for enterprises, data matters and industry matters.

And that's why we've built industry-specific, cloud-based cognitive solutions in areas like oncology and life sciences in Watson Health and risk and compliance in Watson Financial Services.

They address new opportunity areas outside of traditional IT.

Our analytics revenue includes these new vertical businesses as well as established horizontal offerings like DB2 that are being transformed, are high value and play a critical role in our clients' environments.

In total, analytics revenue was up 5% this quarter to nearly $5 billion.

So this business is large, and it's growing.

In security, we've recently embedded cognitive into many of our offerings.

This quarter, across our segments, security grew about 50%, driven by our security software solutions and strong demand for their pervasive encryption capabilities in our new z14.

The mainframe is a great example of a core platform that we've continually modernized, and now with new capabilities like Machine Learning on z and pervasive encryption, it's been reinvented again for the cognitive and cloud era as well as an ideal platform for blockchain.

As we build and scale new businesses, partnerships and ecosystems play a critical role, and so in the third quarter, we continued to launch new blockchain partnerships and networks, including an initiative with a group of leading food retailers and suppliers, including Walmart, Kroger, Dole, Nestlé and Unilever, to address food safety.

And we're partnering with UBS and several global banks to build a blockchain-based platform to support trade finance.

In the area of big data, in partnership with Hortonworks, we announced new capabilities that allow data scientists to do big data analytics using IBM products on the Hortonworks Data Platform.

And in the third quarter, we formed a new partnership with MIT to create the MIT-Watson AI Lab.

We'll mobilize the talent of more than 100 AI scientists, professors and students to advance AI hardware, software and algorithms and increase AI's impact on industries and enterprises.

So across our business, we're embedding cloud and cognitive capabilities into our offerings, which is fueling the shift to strategic imperatives.

In many cases, we're building new businesses that address new markets, while in others, we're investing to reinvent existing businesses with these same technologies.

This is what you see in our revenue and profit dynamics.

So now let me move on to our financial metrics for the quarter.

Our revenue was $19.2 billion, and when you look at our revenue performance by geography, we had sequential improvement in the year-to-year performance in all 3 major geographic regions, so as I said earlier, broad-based improvement.

EMEA revenue performance improved 3 points from last quarter to down 1% in the third.

We had year-to-year growth in Germany, France, Italy and Spain, mitigated by declines in the U.K. We recently signed large services engagements to provide cloud and digital services to clients in the U.K., Germany and Spain.

I'll touch on a couple of them later.

Our Asia-Pacific revenue growth improved nearly 4 points and was up 2% year-to-year with good growth in Japan and China.

The Americas year-to-year performance improved nearly a point, driven by the U.S.

Looking at our margin performance.

Our gross margin was down 40 basis points year-to-year, which is another significant sequential improvement.

Last quarter, we talked about the margin dynamics for the second half, and we said we'd get some improvement from mix and from productivity, which we did.

And we said the impact from investments would moderate, so our margin came in as we said.

Our operating expense was down 1% versus last year with little impact from currency and acquisitions this quarter.

Our expense dynamics reflect the continued efficiency we're driving in our underlying spending base while continuing to invest to build and reinvent our platforms and solutions.

Included within the 1% reduction, we had about $220 million less IP income year-to-year and absorbed an impact of about $100 million year-to-year in SG&A associated with some commercial disputes.

Our operating pretax profit was $3.6 billion, and pretax margin was 18.8%, which is down just 20 basis points year-to-year and up sequentially.

Our tax rate for the quarter reflects an ongoing operating effective tax rate of just under 15%, consistent with last quarter, and we had no discrete tax items in the quarter.

On the bottom line, our operating EPS was $3.30, essentially flat year-to-year.

We generated $2.5 billion of free cash flow, which is similar to last quarter and last year's third quarter, and we continue to expect our free cash flow for the full year to be relatively flat year-to-year.

Over the last 12 months, our free cash flow of nearly $11 billion was 96% of our GAAP net income and supports both a high level of investment and shareholder returns.

Now turning to our segments.

Cognitive Solutions revenue was up 3%, and pretax income was up 5% so better than balanced performance this quarter.

Both solutions software and transaction processing software grew 3%, and we had growth in both our annuity content and our transactional businesses.

Within our annuity content, our SaaS offerings had double-digit growth in revenue and signings again this quarter, and we also had continued growth in our software services, which support our solutions offerings through industry and product expertise.

We also had good software transactional performance as clients commit to the platform for the long term.

Our Cognitive Solutions revenue growth is driven by organic performance as we've wrapped on most of our acquisitions.

And we continue to invest to combine organic and acquired content to build cloud-based cognitive offerings.

Within solutions software, growth was led by offerings in security and analytics.

Our analytics growth was broad based, including business intelligence and data discovery, where we had triple-digit SaaS growth, led by Cognos Analytics.

We also had strong growth in data warehousing, where we're continuing to reinvent these offerings.

For example, in September, we launched our new unified data system, which leverages our DB2 technology and is built on IBM Power.

Also in analytics, we had strong growth again this quarter in Watson, our enterprise AI platform.

Conversation API usage again had strong double-digit growth quarter-to-quarter.

Clients have embedded cognitive into their workflows and are seeing compelling returns.

For example, in January, the Royal Bank of Scotland launched Quora, leveraging both our conversation and discovery services.

Quora now deflects nearly half of the calls from traditional channels while improving customer experience, significantly cutting down waiting times and freeing up time for call center staff to deal with more complex problems.

And we're benefiting from cognitive ourselves.

IBM's client support teams use Watson to help drastically reduce response time on more than 3.5 million service requests per year.

Watson's trained on 7,000 IBM products and provides instant resolution based on what it has learned from previous similar requests.

Watson has contributed to a 30% reduction in problem determination time across our technical support services business.

We're embedding cognitive into our security offerings as well.

Security software grew double digits this quarter and is clearly a hot market for us.

We had strong growth across our security portfolio in areas such as endpoint protection, incident response and security intelligence with offerings like Resilient and QRadar.

Our clients using QRadar Advisor with Watson are seeing measurable results.

For example, clients found threats 60x faster than manual investigations, and complex analysis went from an hour to less than a minute.

As you would imagine, nothing matters more than time in these situations.

Acceleration in the number of cyber security threats, the increasing requirements of regulatory compliance, including the upcoming GDPR or General Data Protection Regulation and our collaboration with Cisco and other partners on threat intelligence drove strong demand this quarter.

Looking at IoT.

Our revenue was up double digits this quarter.

We introduced new offerings like IoT for Connected Products as well as key enhancements around security and risk management.

We signed nearly 40 new clients to the IoT platform, including a shipping logistics provider, a global electronics components distributor and a leading provider of wireless networking solutions.

And the number of developers grew at a strong double-digit rate.

As we've said, an industry lens is key to our cognitive strategy, and this quarter, Watson Health continued to drive double-digit growth with strength in government, oncology and life sciences similar to last quarter.

We continue to expand the number of patients touched by Watson across our global ecosystem as well as expand the number of countries.

We also had strong growth in Watson Financial Services as clients look to evolve their financial systems to make better informed risk and compliance decisions as well as modernize their core systems like their payment gateways.

Turning to transaction processing software.

We had a strong quarter with revenue up 3%, reflecting our clients' ongoing long-term commitment and the value our platform provides to them.

This portfolio predominantly runs on-premise mission-critical workloads in industries like banking, airlines and retail running on z Systems.

So for the Cognitive Solutions segment, we're embedding cognitive, scaling platforms and building high-value vertical solutions.

We grew revenue in the quarter, which drove total IBM software revenue growth, and we expanded the Cognitive Solutions pretax income margin.

Global Business Services delivered $4.1 billion of revenue this quarter.

The year-to-year performance is similar to last quarter as we continue to transform the business.

We're investing to shift our practices to where we see the opportunity, which is around digital, cognitive, cloud and automation.

Over the last 2.5 years, we've added tens of thousands of resources to these areas.

We grew double digits in our strategic imperatives, and overall, GBS signings grew for the third consecutive quarter.

With modest growth in signings, it takes time for our progress to be reflected in revenue and profit.

Consulting revenue grew 1%, led by our Digital Strategy and iX platform, which is up over 40%.

The consulting backlog also returned to growth this quarter.

IBM iX is helping clients digitally reinvent themselves.

IBM iX was an early mover in the digital space, and we've built a global network where clients can cocreate with us.

We now have 36 studios around the world, which gives us unmatched reach.

We recently announced the intention to acquire Vivant, a digital agency based in Australia.

This adds to the acquisitions we did last year in Europe and North America to bring in new skills and rapidly expand our global iX capabilities.

We're also leveraging strategic partnerships and investing in emerging technologies.

In the third quarter, we signed a 5-year collaboration with Volkswagen to develop new mobility services that will utilize our cloud and cognitive capabilities to create highly personalized digital experiences for drivers.

We also launched our blockchain services practice that will include more than 1,500 consultants who can help enterprises implement blockchain-enabled business models.

Application management revenue declined 3%.

We grew in the practices that help clients implement new cloud-centric architectures in their critical applications.

We're leveraging our incumbency to modernize their application suites by implementing cloud-based micro services and helping them build cloud native applications into their environments.

Overall performance was impacted by areas that are not as differentiated, where we're seeing pricing pressure and driving productivity for our clients.

Turning to profit.

Our Global Business Services gross profit margin declined with similar to last quarter.

The GBS PTI margin of 10.8% is up 3 points sequentially, and the year-to-year performance improved by over 1 point.

The GBS margin has been impacted by the investments we're making to drive our transformation.

We're acquiring to bring in important new skills and scale them across the organization.

We're investing in the enablement of our practitioners, shifting resources to new areas while also hiring top talent.

The margin dynamics also reflect pricing and profit pressure in the more traditional IT services such as back-office implementations of on-premise applications and parts of the global processing services business.

As we go forward, we're focused on improving our productivity with a streamlined practice model and new project management approaches.

So in summary, for GBS, the revenue and profit trajectory was similar to last quarter.

Consulting returned to growth, while application management decelerated.

We continue to grow in our practices around cloud, analytics and mobility services, and we're investing in our skills to continue to drive our GBS transformation.

Technology Services & Cloud Platforms generated $8.5 billion of revenue with year-to-year performance similar to last quarter.

We continue to grow revenue double digits in our strategic imperatives led by cloud.

The annual as-a-service run rate for the segment is now $6.2 billion.

With good momentum in our cloud offerings, we grew overall GTS signings by over 25%.

Our total services backlog trajectory improved by 2 points compared to last quarter as we returned to backlog growth in infrastructure services.

GTS continues to be the market share leader and is nearly 2x the size of our largest competitor.

Looking at the lines of business.

Infrastructure services revenue was down 5%.

This reflects the fact that we haven't yet wrapped on the year-to-year headwinds that we talked about earlier this year, and we're not yet yielding the full benefit from some of the new contracts we signed in the first half.

In addition, we're shifting away from some lower-value work.

We had strong signings performance in infrastructure services this quarter as clients look to implement hybrid cloud environments.

They turn to the IBM Cloud because it's designed for data, AI and security, and it's the only cloud that integrates public, private, multi-cloud and legacy data centers through a single architecture.

For example, at BBVA, the second largest bank in Spain, we signed an agreement to transform their current infrastructure.

This will create the foundation for them to move ahead with their cloud strategy.

We'll work with BBVA to optimize their infrastructure while enabling them to maintain control of their data and operations.

Technical support services revenue was down 2%.

We're focused on driving our multi-vendor support offerings, which provide our clients with a single source of expertise and visibility across different vendor solutions.

For example, we're working with HSBC to support data center maintenance of banking locations across 60 countries.

In the U.S., we're providing an integrated solution to Walgreens that includes retail analytics and IBM Cloud infrastructure to improve the efficiency of field service support at over 8,100 drugstores nationwide.

And in South Korea, we're deploying a multi-vendor support solution with Hana Financial Group to standardize the IT maintenance systems at 3 of Hana's subsidiary groups.

Looking at the software content within the segment.

Integration software revenue was down 3%, and within that, we continue to have strong growth in SaaS across the portfolio as we help our clients implement hybrid cloud environments.

This was offset by declines in areas like on-premise DevOps and IT service management.

Turning to profit.

Gross profit margin for Technology Services & Cloud Platforms was down 1 point year-to-year, consistent with last quarter's performance.

The PTI margin of 13.8% is up 2 points sequentially, and the year-to-year performance is also about 2 points better than last quarter.

We're yielding savings from actions we've taken, and we continue to focus on delivering productivity to our clients.

We're investing to expand our cloud infrastructure, which is currently impacting our margin.

With nearly 60 cloud centers across 19 countries, the IBM Cloud provides our clients with the flexibility to store data however and wherever they choose.

We're also focused on scaling the IBM services platform with Watson that we announced in July.

This is a delivery platform that is designed to identify and predict potential problems and self-heal.

The platform will redefine service delivery and quality, providing significant competitive advantages to our clients.

So to summarize Technology Services & Cloud Platforms, the revenue and profit declines this quarter were similar to last quarter.

We continue to see momentum in cloud, grew signings double digits and improved our services backlog year-to-year performance.

We're continuing to invest in our cloud infrastructure, and we're transforming our services delivery platform with Watson.

In Systems, we had a strong quarter with double-digit revenue growth and margin expansion.

Performance was driven by a combination of strong z14 acceptance and growth in storage.

Power declined, consistent with where we are in that product cycle.

Our systems margin was up year-to-year and sequentially as mainframe and storage margins grew while Power margin was flat.

IBM z revenue grew 62% year-to-year on 33% MIPS growth, and margins expanded after a successful launch of the z14 program in mid-September.

This success is due to the strong demand for technology that helps address the growing threat of global data breaches and the need to operate within regulated environments.

Our new z14 mainframe, with its unprecedented encryption capabilities, encrypts all data associated with any application, cloud service or database all the time without the possibility of human intervention.

And that's with no application change and no performance impact.

So the appeal is obvious, and we had good traction across a broad mix of industries and geographies.

And across the z platform, we're addressing emerging workloads in areas like blockchain, machine learning and new payment systems.

For example, when banks are trying to figure out how to manage new requirements within the EU's payment modernization initiative, they come to us.

Given the critical nature of the European financial services backbone, IBM z provides the necessary reliability, scalability and security, and that's why we had key wins in instant payments this quarter.

The Power revenue was down 8% year-to-year, driven by declines in UNIX, though UNIX high-end systems grew again.

We continue to have good growth in Linux, and with double-digit growth in Linux workloads, Linux on Power now represents over 20% of our Power portfolio.

Later this quarter, we will deliver our next-gen POWER9 to market, starting with 2 U.S. Department of Energy supercomputing centers.

This is strong evidence of the importance of Power to the high-performance computing market, and we'll roll out commercial POWER9 solutions throughout 2018.

So in an era of cognitive and AI, where data is fundamental to our enterprise clients, Power is demonstrably better for Linux machine learning and deep learning workloads, the workloads of the future, and that's why we're committed to the Power platform.

Storage hardware was up 4%, and as I said earlier, this is the third consecutive quarter of storage revenue growth.

We had growth across our major hardware product areas, including in key mid-range and high-end product lines, which grew double digits.

Our all-flash array offerings, once again, grew strong double digits, in line with the high-growth market.

And our storage software, which is reported in Cognitive Solutions, also had double-digit growth in software-defined storage, reflecting the shift in value to software.

So to summarize Systems, our year-to-year revenue grew double digits, and gross and pretax margins expanded with strong performance in z Systems.

This reflects our focus on continually reinventing this portfolio to address new workloads.

Turning to cash flow and the balance sheet.

We had another good quarter.

We generated $3.3 billion of cash from operations, excluding our financing receivables.

After nearly $800 million in capital investments, we delivered $2.5 billion of free cash flow, and that's up modestly, reflecting strong working capital performance and lower workforce rebalancing payments as well as higher cash taxes year-to-year.

We're continuing to convert our net income to free cash flow at a high rate with our free cash flow realization at 96% over the last 12 months.

Through the first 3 quarters of the year, we've generated $6.2 billion of free cash flow, which is down just under $800 million.

You'll recall that in the first quarter our free cash flow was down $1.2 billion year-to-year, driven entirely by the foreign cash tax refund we received last year.

Now with free cash flow growth in the second and third quarters, we've reduced the year-to-year decline.

As we generate profit consistent with our EPS guidance and with a tailwind in both our workforce rebalancing payments and cash taxes in the fourth quarter, we continue to expect our full year free cash flow to be relatively flat year-to-year.

In terms of uses of cash, over the last 9 months, we've returned $7.8 billion to our shareholders, including $4.1 billion in dividends and $3.7 billion to buy back almost 23 million shares.

At the end of the third quarter, we had 926 million shares outstanding and $1.5 billion remaining in our buyback authorization.

Looking at the balance sheet.

We continue to have the strength and flexibility to support our business over the long term.

We ended the quarter with $11.5 billion in cash, and total debt was $45.6 billion.

Both are higher than year-end, driven by the timing of our term debt issuances.

About 2/3 of our debt was in support of our financing business and includes our first public debt issuance of $3 billion in the third quarter out of our newly reorganized financing entity.

This business continues to be leveraged at a debt-to-equity ratio of 9:1.

The credit quality of our financing receivables remains strong at 52% investment grade.

That's flat versus December and 1 point better than a year ago.

And as always, we've included more information on our financing business in the supplemental charts in the backup.

Now let me wrap up with a quick summary of the third quarter and some comments on considerations for the fourth.

90 days ago, I talked about planting the flag to mark the beginning of an improvement of the trajectory of our business, which would result in a second half that was improved over the first.

Now in the third quarter, we've improved our year-to-year revenue and margin trajectory.

This was led by strong performance in our Cognitive Solutions and Systems segments.

And our strategic imperatives revenue across our segments grew at 10%, reflecting our success in embedding cognitive and cloud into more of what we offer.

As we look to the fourth quarter, as always, we've got a range of scenarios, especially when you consider the typical large transactional base in our fourth quarter.

Last year, we increased revenue by $2.5 billion from third to fourth quarter.

This year, we'd expect stronger sequential performance due in part to the mainframe cycle, so perhaps, $300 million to $400 million more.

And of course, that, quarter-to-quarter, will depend on currency, too.

Now looking at gross margin.

We've had good progression over the last couple of quarters, driven by mix and some moderation in the headwinds from investments.

In the fourth quarter, again, we have a number of scenarios, but all are consistent with the sequential improvement we've seen over the last few years, so an increase of 2.5 to 3.5 points in gross margin from third to fourth quarter.

For expense, we've been driving efficiency in our spend base, and we'll continue to do that.

But keep in mind that with a weaker dollar, currency hedges will impact the expense line.

And regarding IP income, we have a great list of opportunities, and we expect to close some of them.

But as always, we're certainly not relying on all of them.

And then finally, let me comment on tax.

As we've discussed in the past, our tax rate reflects our mix of business, both country and product mix.

As we enter the fourth quarter with a seasonally large transaction base, we continue to see an ongoing operational tax rate of 15%, plus or minus 3 points as the right range.

And as you know, that's not changed since we provided EPS guidance back in January.

Remember, we widened the range in 2017 because of the tax reform discussions currently underway at a political level.

In common with many companies, those tax reform discussions could still result in IBM taking planning actions this year.

We also may have discrete tax items in the fourth quarter.

At this point, we don't know if or how much and then how much will be absorbed by other actions.

However, as we sit here today, entering the fourth quarter, our views on tax remain unchanged.

So you put all of this together, and we continue to expect to deliver at least $13.80 of operating earnings per share for 2017 and as I mentioned earlier, free cash flow that is consistent with last year.

And 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 deck.

(Operator Instructions)

So operator, let's please open it up for questions.

(Operator Instructions) And our first question is coming from the line of Ms. Katy Huberty from Morgan Stanley.

Martin, you made nice progress on gross margin in the quarter, but a lot of that did come on the back of the z14 product cycle.

Do you see a path to year-on-year gross margin expansion at some point over the next year?

And do you think that you can achieve that even as the mainframe contribution slows in a couple of quarters?

Sure.

Thanks, Katy.

So a couple of things.

One, while the mainframe improved a bit of the mix, it's also software mix that helped in the quarter.

So I wouldn't attribute it all to mainframe.

And as you know and as we've been talking about, we've been focused on the productivity in our services business.

So there are multiple contributors coming out of the third, which will also drive in the fourth some improvement.

So what we said in the -- in our prepared remarks is we have a range.

At the low end of the range, we'd say a very similar kind of a trajectory that we saw in the -- year-to-year trajectory we saw in the third.

But at the high end of the range, we would show some more -- an improved trajectory, if you will, relative to the year-to-year.

Now as we go into next year, we'll talk more about 2018, obviously, in January when we can see what kind of momentum we have in our software business.

We can see what kind of signings momentum we have to drive our services platform.

But our model, as you know, is to grow margins.

We're not talking about 100 or 150 basis points.

Our model is to grow 30, 40, 50 basis points of margins, and I would say that we are going to get there in the next year.

Our next question is coming from the line of Mr. Amit Daryanani from RBC Capital Markets.

I guess, Martin, nice to see some positive growth in Cognitive Solutions.

Could you just help us understand what is enabling the growth over there?

And as you think about December quarter and potentially beyond that, how sustainable do you think this growth is as you go forward?

Sure.

Thanks, Amit.

So a couple things on the historical side.

We saw good growth, pretty broad-based growth in the solutions software categories, and that includes, obviously, our analytics business.

It includes our security business, and we got good double-digit growth across many industries, including health and FSS and our Watson Health and FSS categories as well so pretty good, broad-based improvement in solutions software.

As you know, also within that segment is our transaction processing software business, which was also up in the quarter so good execution in quarter.

As we go into fourth now we're not relying on growth coming out of the TPS part of that business.

Now that business, it's important for us to make sure we maintain high renewal rates in our S&S categories, for instance, which we have.

That drives then this kind of strong transactional performance, but we're not relying on that to continue.

We do expect, given that our solutions software business has attracted a lot of investment, I think that, that team has positioned itself pretty well to continue to see growth going into the fourth.

Our next question is coming from Toni Sacconaghi from Bernstein.

You obviously had a very positive contribution from the mainframe on the system side, but I was wondering if you could maybe help us understand how the mainframe might be -- might have helped financial results in the quarter more broadly.

I think, historically, at your Analyst Day, you said that 45% of mainframe revenue is actually strategic imperatives, and you commented about how transaction processing software was -- a lot of it was mainframe related.

So to that end, maybe you could tell us what strategic imperative growth would have been ex mainframe in the quarter and also, for Cognitive Solutions, how we would think about growth ex software that runs in the mainframe in the quarter with the intention of really trying to understand, given that mainframe cycles are pretty cyclical, how much of the growth that you're seeing in strategic imperatives and cognitive was aided by mainframe in the quarter?

Sure, Toni.

I'll -- I think I got it all.

I'll try to address them kind of piece by piece.

So from a mainframe perspective, and we've talked about this in the past, the hardware part of the cycle is quite profound, and we spent a lot of time explaining what we expect to see on the hardware side.

The software side is not as tied to a cycle.

The software side has obviously tied to the platform, but the cycle for software does not coincide or isn't tied in any way to the hardware cycle.

And then the other part of the business that I would say -- or 2 other parts of the business that I think are important, on the maintenance side, the maintenance business is impacted by the hardware cycle because of the warranty period that kicks in with new mainframes.

Now the bulk of that hasn't obviously happened yet because we're only 2 weeks in here at the end of the quarter.

So no real tie on software.

Maintenance gets impacted.

The other business that benefits from the mainframe cycle is our Global Financing business.

And most -- I think all -- nearly all mainframes are financed through Global Financing, certainly, 90% or so attach rate in that business, so that will help the volumes.

But given that the business itself probably had the volumes before it, it maintains its position as opposed to grows the asset base dramatically.

So GF volumes will improve in the quarter.

With regard to the strategic imperatives, and we've talked a lot about how 12 months or trailing 12-month period is the right way to look at it, given that we, in the cycle for the hardware side, have been -- our strategic imperatives growth has been held back, if you will, by the mainframe cycle, obviously, was helped a bit -- has helped a little bit in the third.

But on a trailing 12-month basis now the mainframe really has become a neutral with regard to the strategic imperatives, really no impact to the growth rate on a trailing 12-month period.

So ex mainframe trailing 12 months, strategic imperatives are the exact same number.

Now they'll contribute a bit as they become -- when we get to the biggest quarter in the fourth, but on a trailing 12-month basis, no impact.

Our next question is coming from the line of Mr. David Grossman from Stifel Financial.

So Martin, I know it's been a while since you've had an FX tailwind and that there are several factors related to currency that can impact margins.

However, are there any tools or historical reference points that you can provide that, a, help us better understand how currency tailwind may impact the margins over the next 12 months?

Sure, sure, David.

So well, first, I'd like to thank you for pointing out that we have had a pretty dramatic headwind.

In fact, I think, from the time I have been in this job now this is my 15th call.

I think, I've only had one other call where it was a small tailwind.

And this was a small tailwind as well in the quarter, and hopefully, we've wrapped on some of the big, more profound FX.

When we look at a dramatic impact like what happened in 2015 and the strengthening of the dollar from a cash perspective, that cost us, just on the translation, if you will, of translating all that cash back to U.S. dollars.

It was like a $2 billion impact.

Now we hedge our cash flows, and so that helps defer the impact if you will.

But when you have a dramatic move like that, the impact is still more than $1 billion from a cash perspective.

Now the margin impact is a little bit different, and depending on the broad-based nature of a dollar move, it will be anywhere from a small positive to a small negative.

But the real impact again is the absolutes in terms of what it's doing to profit and what it's doing to cash.

Our next question is coming from the line of Wamsi Mohan from Merrill Lynch.

Can you address what is driving the 35% growth of cloud within GBS specifically?

And given that strategic revenues in GBS are greater than 60% of overall segment, is it the pricing issues you noted earlier that is causing this gross margin rate still to be down year-on-year basis?

And can you just confirm that the strategic imperatives gross margins are actually higher than segment average for GBS?

Sure, Wamsi, no problems.

We'll talk about each of those pieces.

Maybe I'll start from the most recent, not just because I remember that one the best, by the way, because you just said it.

But -- so first, from a strategic imperative margin perspective, our margins in strategic imperatives, this is across IBM, remain higher than the margins in -- outside, if you will, the strategic imperative revenue streams.

And as we've always said, that's a good indication that the future is obviously better than the past.

Now that has a couple of elements to it.

In the case of the IBM -- broad IBM businesses, some of that's driven by mix because we have a better software content in those strategic imperatives than we do in the core.

In the case of GBS, it is actually that the pricing is -- we're better able to differentiate and capture the pricing, if you will, in those strategic imperative areas.

So you think about the design studios we built around the world and you think about how we bring skills to help our clients transform their digital interactions with their clients, that is -- it's important work.

Clients value it highly, and when you have good skills and global capabilities, you can earn good returns.

The GBS team, I think, has positioned themselves pretty well for getting the benefit, if you will, of that shift and moving more and more into their strategic imperatives.

And our work says that the margins are, in fact, higher as they move into those new areas.

There is still, though -- we still have some labor focused on some of these older areas that are less differentiated, and as we noted in our prepared remarks, those see margin pressure.

And this is a competitive industry, so it's not only competitive where there's less differentiation.

We're not confused by the competition in even in the newer areas.

So we know we have to keep moving our teams and re-skilling and making sure that we are at the forefront of those new areas.

But those older areas are also very competitive, and a lot of our competitors would look at those as kind of access points where they haven't developed yet the most robust skills.

They look at those as access points to get into our clients.

So we're still experiencing that phenomena.

Our next question is coming from Steve Milunovich from UBS.

Martin, I wanted to touch on your tax situation.

I think you got $4 billion plus of tax credits and NOLs remaining.

So it feels like you could see a number of discretes over time and perhaps see a tax rate consistently below 15% even if it's not always predictable.

How do you think about that?

And how much cash impact is there with these tax credits and NOLs going forward?

Sure, Steve.

So a few things.

On the rate itself, we're at, as we said, 15% -- from the way we've been thinking about it and talking about how it's embedded in our guidance, we're at 15%, plus or minus 3 ex discretes.

And that's been consistent since we started the year.

Now we just came out of the third quarter when -- and quite frankly, kind of a rare 90-day period when you do business in 162 countries.

We had no discrete tax events, so somewhat rare, but it is what it is.

We can neither predict nor necessarily predict the magnitude or the timing of discrete tax events by their very nature.

Now we do take, as you know, which causes the $4 billion or so of deferred tax liabilities or assets, we do take a pretty conservative view on how we book -- how we run a book against our tax, and that's what's creates these discrete tax events, which, by and large for us, tend to be -- tend to come back into the income statement as opposed to finding that something's going to flow out because discretes, let's face it, discretes can go either way.

They can be helps or hurts.

For us, by and large, because we're pretty conservative, they tend to be helps.

We don't know in terms of what could happen in the fourth quarter.

Again, the 90-day period we just went through was somewhat rare, and we don't know if and we don't know when and we don't know how much they might be.

But yes, we do -- our principle of how conservative we are has not changed, and therefore, I would expect that the discretes will be more credits than debits.

But it was, again, a kind of a unique period.

So we'll see where we go through the fourth.

From a rate perspective, as we mentioned in our prepared remarks, the 3 -- the plus or minus 3 points is the right way to think about it given the discussions going on around tax reform.

And then, obviously, we don't know -- we have assumptions about the mix of the business, but the assumptions change, particularly when you're in the biggest part of the year.

And then we'll see what happens as we go through the quarter on discretes.

Our next question is coming from Jim Suva from Citigroup.

Martin, the press and reviews of your mainframe have been very positive and impressive.

Is there the view that within IBM and externally that the demand for this product could be -- take us out of the slow and steady decline that mainframes have been doing?

Is it that good of a product?

Or how should we kind of think about it as far as the mainframe cycle, which typically last kind of 3 to 4 years?

Yes.

So a couple of things, Tim.

So first, this new mainframe -- and the mainframe's always redesigned, rebuilt for the most contemporary workloads.

This new mainframe addresses what is probably top of mind in every board discussion.

It is top of mind for every CIO, and it's top of mind for the whole C suite, which is the problem of cyber security.

So it addresses it in a way that nobody else can address it, and it's been, as we said, very well received by the marketplace.

Now the mainframe was reinvented in the last instantiation to address mobile and cloud and analytics.

And before that, it was reinvented to address the performance and the capacity needs to help our clients optimize their own data centers.

So we've gone through -- as we always do, we go through a process by which we work with our clients to address how we can make sure that the mainframe retains their most important workloads, and included in that discussion is bringing new workloads onto it.

And we've done some of that.

We add new clients.

So the long-term outlook for the mainframe and the model for the mainframe is to be a very stable business, very high value and one that's going to obviously be cyclical on the hardware side because of the cycle.

But we actually see, given how we've reinvented it this time, that -- and the teams are working on this to try to figure out, yes, we're not just talking about new workloads, which we obviously have within our existing clients.

There are not too many businesses out there.

In fact, you'd be hard pressed to find one that isn't -- that doesn't have workloads that can benefit from being rewritten and run on the mainframe given the capabilities it has.

Now that is not a process that's going to sort itself out in 2 weeks.

Things that run in an x86 environment and things that run on other platforms have to be reworked.

They have to come into the mainframe platform.

We've got a terrific group of developers and lab services that help the teams do that not only for existing clients but can do it for new clients as well.

So given the problems this mainframe solves, I do think that there is an opportunity for us to further expand the market by further expanding the kind of workloads and the relevance that it plays in new environments.

Our next question is coming from Jim Schneider from Goldman Sachs.

Martin, it's good to see that the services signings were up 25% -- or excuse me, at least, the GTS signings up 25%.

Can you maybe give us some sense about, given the customer-specific issues, whether you see growth -- a return to growth in GTS for next year?

And can you maybe comment on the kind of bookings trends you're seeing in the GBS in particular?

Sure, sure.

Thanks, Jim.

So a couple things.

The team did, in GTS, they did a nice job in delivering pretty good signings growth.

Now this is a big backlog of business, and they've managed in the infrastructure services side to get that backlog back to be flat for the -- now coming out of the quarter.

And they -- when they look at their opportunity pool, they see a pretty good quarter in terms of signings.

All of that's going to determine whether or not we see how quickly they come back to growth in 2018, and we'll talk more about that in January.

Within that, I think it's important to note that the reason they're -- they've been successful not only in the most recent quarter but over the long term, the reason that backlog's holding up so well and we would expect it to get back to growth with a strong signings execution is because they are doing the most contemporary work for our clients.

They are taking our clients and new clients into the kinds of cloud environments that they want.

So they're being successful because they are moving to the future not because they're doing the same things that they've always been doing for clients.

And I think the GTS team has done a nice job, again, in third quarter in executing some large deals, but their value proposition is as robust as it ever has been.

On the GBS side, we did see growth again in the signings in the quarter.

It was only 2%, which was a slowdown from where we've been.

But 3 quarters of growth now and what that's been able to do for the GBS team is get that consulting backlog back to growth in the quarter.

And the team has been very focused on delivering high value to our clients and rebuilding the skills in that consulting base in order to do that.

So the consulting backlog being up is certainly a good starting point, but the backlog in total is still down.

And so as we've said in the past, consistent signings growth will get to backlog growth, which will get to revenue growth.

And I still think they're on that path, although we are going to have to accelerate from the low single-digit signings in order to make that go faster.

So they've positioned themselves well in the fourth to have a lot of opportunities to try to close.

We'll see how the fourth quarter goes for GBS as well, and that, too, like GTS, will determine how we enter 2018.

Our next question is coming from Tien-tsin Huang from JPMorgan.

Just I'll ask on the transactional software side, so pretty good performance there in the third quarter.

Did you feel good about that carrying into the fourth quarter given the demand environment as you see it today?

I think you said that you're not counting on transactional revenue in the fourth quarter.

Does that mean we could see upside potential if 3Q trends persist?

Just wanted to clarify that.

Sure, Tien-tsin.

So no, what you heard was a fair reflection of what we're counting on, which is we're not counting on continued strong growth in parts of that portfolio, things like transaction processing software.

But make no mistake, the team is working on driving transactional performance in parts of that business, which, quite frankly, we have a pretty hot hand in.

We have got a hot hand in security.

We've got a hot hand in some of the IoT space.

So we will continue to see good growth in parts of the business.

And then for software in total, our as-a-services business continues to grow quite well, and we would expect to continue to see the as-a-service performance continue to grow.

As-a-service in total was up to a $9.4 billion run rate when we exited, and that's pretty good sequential improvement from where we were in the second.

And we'll -- we would expect that the fourth will also drive some growth.

But again, the -- we're not relying on the TPS part of the business necessarily to grow, but our customer engagement business, our security business, these are businesses that have drawn a lot of investment.

And they've got a hot hand, and they'll continue to perform.

Our last question is coming from Keith Bachman from Bank of Montréal.

Martin, I also want to revisit on GBS if I could.

And the results relative to the rest of the businesses are still demonstrating challenges, both on top line and on the margin profile.

And the context of the question is, as you mentioned, application management is still experiencing challenge, and all participants in the industry seem to be echoing the same thing.

So if application management continues to experience challenges, what are the conditions that allow GBS to improve?

And in particular, as you look at FY '18, is it -- how should we be thinking about expectations if we just isolate on the margin profile?

If application management continues to experience those challenges, is it reasonable to assume that margins could flatten out?

But any comments there on broadly on the role of ADM within the context of GBS.

Sure.

I mean, for us, this business is all about helping our clients move to the cloud.

So where we're helping clients implement cloud-centric architectures, we're moving them to next-gen apps like Salesforce and Workday, and we've built terrific skills.

We've even acquired skills to help accelerate this.

There is plenty of room for us to both differentiate, to get growth and to have good margin performance.

So in those areas, which are -- where we're more able to differentiate, I think there is a good future there, and that's what the team is focused on.

And then in the other parts of the business, as I mentioned, the other parts of that business where it's more difficult to differentiate and where others who haven't built the kind of skill base that we have are trying to get inroads, yes, then there is some price pressure.

But that's not the future.

The future for us is helping our clients move to those cloud-centric architectures and the cloud -- the next-gen apps, which is what the team has positioned themselves well to continue to do not only in the fourth but going into 2018.

So let me wrap up the call and first by saying thanks for joining us today.

As we said at the start of the year and then we reiterated again in July, we said we'd see improved trajectories in the second half of the year relative to the first half.

Then, we talked about the drivers of that change.

Our third quarter performance certainly reinforce that.

And while we have more to get done in the fourth, it shows we're on the right course.

And it also shows, quite frankly, that our confidence in our strategy is very well placed.

So thanks again for joining us today, and we'll talk to you in January.

Thanks, Jay.

Can I turn it back to you please to close out the call?

Thank you for participating on today's call.

The conference has now ended.

You may disconnect at this time.

Thank you.