International Business Machines Corp (IBM) — Q3 2016 Earnings Call Transcript

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 their related GAAP measures in accordance with SEC rules. You'll find reconciliation charts at the end of the presentation and in the form 8-K submitted to the SEC today. So with that, I'll turn the call over to Martin Schroeter.

Thanks, Patricia. In the third quarter, we generated $19.2 billion in revenues, $3.7 billion in pre-tax 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 and sectors like banking and the attractiveness of investment in the emerging markets, all of these topics have the capacity to drive some volatility and 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 have strong growth in cloud, security, mobile, and across our analytics portfolio reflects this. In total, we continue 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 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 were up 5% and within that solution software was up 8%. Technology services and cloud platforms 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 to digital offerings. Our systems revenue was down this quarter. The z Systems performance reflects the fact that we are seven quarters into the product cycle where POWER reflects the secular decline in UNIX mitigated by growth in Linux. There is a tremendous amount of change in our industry and we are 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 are investing organically and we are acquiring key capabilities. We are remixing their 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 of that, we continue to have a very high-margin business and we generate a lot of profit in cash. Our results reflect the success we are having and helping our clients to leverage cloud for speed and innovation and become cognitive businesses. You 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 increases organic. So we are building scale in these businesses. We also had strong revenue performance in security and mobile and we had strong growth in our analytic offerings which were up 14% this quarter with contributions 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 are 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’ve 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 are training Watson for cyber security, expanding the amount of security data Watson is injecting. 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 are 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, ones in financial services and blockchain solutions. We believe blockchain has the potential to do for trusted transactions what the internet did for information. We are 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 the blockchain innovation center in Singapore to accelerate blockchain adoption for finance and trade and we now have blockchain garages opened 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 regulations and their risk management requirements in financial services. I’ll 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 U.S. was also flat. Latin America was up 5% led by Brazil. While the environment remains uncertain, double-digit growth of Brazil this quarter reflects the importance of our z Systems platform to the banking sector. Europe performance improved four points sequentially, driven by the U.K., 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 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’ll 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’ve 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 five points of expense growth. As we look at our investment levels, we want to allocate our skills to where we see the most opportunity in growth. Some of our assets are high value, but not necessarily in growing markets, so we are 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 years’ hedging gains. This drove a three point impact to expense, so while currency is a modest help to the top line, we continue to have a meaningful impact on 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 discreet benefit for the closure of our foreign tax audit which lowered the tax rate in the quarter by two 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 was 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 repurchases. 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 SAS performance with double-digit growth in revenue. Overall, gross margin was down due to the mix shift to SAS and the acquisition content. Our pre-tax 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 solution 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 setup and tooling developers without deep machine 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 Chatbot for customer service. The Chatbot will help seamlessly route customer service requests through the correct channels and answer specific banking queries. Turning to our vertical plays, we are 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 launched new offerings, such as Watson for drug discovery which is a cloud-based scalable platform that helps life sciences 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 health care providers deliver value-based care to patients with chronic conditions such as heart disease and cancer. With Siemens, we’ll focus on accelerating U.S. adoption of Watson’s population health management offerings. Siemens will use the Watson Health Cloud as its preferred global technology platform. We’ve also been growing our geographic footprint, expanding it to China, South Korea, Finland, and the United Kingdom this quarter alone. Hospitals in both China and South Korea announced plans to adopt Watson for our 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 and trusting 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 progress 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 in 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 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 clients' businesses we are becoming down to the ball bearing 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 one-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 implement 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 went down and clients continue 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 continue to see strong double-digit growth in our enterprise mobility that are helping clients redesign workflows with specific industry context. Our growing collection of mobile first for our 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 in Peru, and Amica Insurance here in the U.S. We also opened a new IBM mobile first garage in Bangalore, part of the network of centers that helps clients around the world achieve mobile-led digital transformations, at speed and at scale. Turning to profit, GBS gross profit margin was down 90 basis points. We expanded margins and application management as we mixed in new cloud and digital platforms. And with the benefit from our workforce rebalancing actions, we are driving productivity in our delivery model. Consulting gross profit margin was down reflecting the investments we are 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 margin. We are 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 skills around Workday and Salesforce.com. We’ve also expanded the IBM Interactive experience in our digital design capabilities. We are 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 continue 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-of-service run rate up over 60%. Looking at the lines of business, infrastructure services was up 2% as our hybrid cloud 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. And moving to the cloud, our clients need to be sure that 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 service while meeting their data sovereignty and regulatory requirements. At JFE Steel, one of the largest steel manufacturers in the world, we announced the five-year outsourcing agreement that will migrate core systems to the IBM cloud through a 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. Italy has adopted this new object storage service to more quickly and easily analyze data that’s being produced by the more than 10 million clicks it processes each month. Looking at the software component of our hybrid cloud solutions, integration software grew 4%. We saw a 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 the WebSphere application server. We continued to shift more of our portfolio to another service model to 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 Monitise. We are helping organizations extend existing workloads to the 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 and infrastructure services as we see the benefit from productivity actions we’ve taken and continue to streamline our processes. We are 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 are making to build out our cloud platforms. Turning to our systems segment, there are some important market shifts in this business like spinning disc to flash, the rising importance of the hyperscale data market and new opportunities in blockchain. We are shifting our business, delivering innovation in our 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 and POWER and storage and in product cycles more broadly our revenue and profit is down after a strong 2015. Our z Systems results reflect a product cycle dynamics, seven quarters into the z13 cycle; revenue was down while margins continue to expand. We continue to add new clients to the platform and we are 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’s been engineered to run on multiple platforms but is optimized for scale, security and resilience on both the IBM mainframe and the IBM cloud. As 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 are currently working with over 40 clients on pilot blockchain use cases running on z. Our POWER performance reflects both our performance in a declining UNIX market as well as our growth in a 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. It now comprises over 15% of our POWER revenue. Supporting that is their success with HANA where we are bringing in new clients and were 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 and 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. And finally, at the end of September, we introduced new POWER midrange 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 are shifting to Linux while continuing to serve the high-value UNIX base, but this is a long transition. In the near term we are focused on stabilizing the margin base. Storage hardware was down 9% this quarter reflecting the ongoing shift in value towards software. Gross margin is down reflecting both volume and price pressure. The hardware decline was mainly driven by low-end and mid-range traditional disc storage. Our high-end disc storage grew this quarter. All flash array revenue grew as we have expanded our flash technology across our product portfolio. We recently rolled out new products and transition to a full suite of flash offerings making us competitively positioned, and while now in our system segment, we also continue to see double-digit revenue growth in software-defined storage. So across system, we're facing product cycle headwinds and some transitions in POWER and storage while continuing to deliver important technologies and capabilities to address cognitive and cloud. So 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've 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 environment, our software is open, running on IBM and non-IBM environments. From a business area perspective this quarter, we had solid growth in cognitive solutions and integration software, while operating systems continue to be a drag in line with a longer term secular trend, across software, software annuity revenue was up mid-single digits led by our SAS offerings. Acquisitions contributed to our SAS growth, but SAS was up organically as well. Our transaction revenue decline mid-single digits which is a significant improvement in the trajectory as compared to the last several quarters, as it’s typically 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 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 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 months 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 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've 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 7:1 and the portfolio remains strong at 51% investment grade. Our non-financing debt to cap was about 54.5% which is essentially unchanged from December and down about four points from a year ago. Our balance sheet continues to be well-positioned to support our business over the long term. As I said upfront 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 in declines in our core businesses, remixing our skills and adding new capabilities through organic investments, acquisitions, and partnerships. You'll 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 view with the fourth we'd say the 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're 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. And so with that, we'll take your questions.

Thank you, Martin. Before we begin the Q&A, I'd like to mention a couple of items. First, we have supplemental charts at the end of the slide deck that provide additional information on the quarter. And second, I'd ask you to refrain from multi-part question. So let's please open it up for questions.

Thank you, Martin. I have a clarification to ask and then a question. Regarding the year-over-year IP gains, they were about $340 million or $0.30. I understand that this comes from licensing real software IP, but should we consider this more of a one-time gain rather than a continuous source of IP income? Also, could you clarify the tax rate? I noted it as 14:2, and you mentioned that two points were assisted by a discrete tax item. Was there anything else affecting the tax rate that brought it down closer to 14% according to my calculations? Clarifying these two points would be helpful. Now, concerning free cash flow, this year it is expected to be at the high end of your range, likely exceeding 100% of GAAP net income. Given your guidance for next year, which is usually lower, should we anticipate a decline in free cash flow in absolute terms for 2017?

I believe I've addressed all your points, Toni. We'll start with the clarifications as a multi-part clarification rather than a multi-part question, and then we'll discuss free cash flow. Regarding IP income, it's been stable to slightly declining over the past few years, and we are considering ways to enhance it. Historically, we enjoyed IP income as high as $1.07 billion, primarily due to our advancements in semiconductor manufacturing and licensing technology. We're looking to revitalize our IP income business, and currently, it stands at approximately $340 million year over year. Our year-to-date results show about $1.01 billion, which is relatively flat. While we don't anticipate setting a new annual record compared to the $1.7 billion from 15 years ago, we remain focused on this area. Keep in mind these relationships are often long-term and some partners prefer to keep their activities private, but those who are public engage in multi-year agreements that can yield market value. We license this technology rather than sell it, allowing us to benefit from future upsides. So, we see a promising model with potential for growth in the upcoming years. For the clarification on tax, your notes were correct regarding the two points from the discrete portion. Our outlook for the year reflects an operating ongoing effective tax rate of around 18%, consistent with what we anticipated at the year's start. In terms of free cash flow, we've been exceeding our expectations. We won a tax case earlier this year, resulting in a significant inflow. However, there have also been considerable outflows related to workforce rebalancing. As noted in our guidance, we expect to finish at the high end of our range, which we stated 180 days ago. We are confident in our cash generation capabilities. Looking ahead to next year, we don't foresee any fundamental changes affecting our cash realization, which typically ranges from 90% to 100%. We anticipate this trend to continue, barring any unforeseen changes in our current situation or the fourth quarter. We'll provide more detail about our absolute figures after the fourth quarter reports, but we expect our realization to remain consistent next year.

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

Thanks. Good afternoon. You didn't close any major acquisitions this quarter and yet cognitive growth margin fell 400 basis points year on year, 200 basis points sequentially. Should we not expect to see improving margins as-a-service revenue 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 tracking the plan, can you maybe touch on why that it is? Thank you.

Sure. I'll start with the second question first. When we discussed the business outlook for the second half, one aspect we highlighted last quarter was the impact of software mix and as-a-service margins, which we anticipated would result in a modest positive outcome. However, I would now categorize that as more neutral. There's not been a significant change; it largely relates to our business mix. We are achieving the growth rates we expected, as indicated by a 3% increase in software in the third quarter, which represents an acceleration from the previous quarter. Additionally, we are witnessing strong momentum in our cloud platforms business, so the current situation reflects a mix issue rather than a shift in our software margins. Regarding the cognitive margin, your observation is spot on. As we reduce those investments, we expect to see the as-a-service margin improve, and we are indeed seeing the as-a-service business begin to scale. However, there remain significant opportunities, and we plan to continue investing. We have not yet reached a point where scale surpasses investment levels in the as-a-service sector.

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

Great, thanks. Good afternoon. Just on the transactional sales down 5% in the third quarter, curious if there's any line of sight here into this fourth quarter and what you might expect there in relationship to – in relation to which is on the third quarter maybe this is a question. Do we start to think about transactional sales and for the IP income, maybe together, I don't know if there is any correlation between the two in any way? Thanks.

Thanks, Tien-tsin, so a couple of things. The transactional business as we noted in the third, down five 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 and 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 we look at – when I look at the revenue streams in the fourth, our annuity business which again smaller pieces in the fourth. Our annuity business has been growing pretty consistently quarter to quarter, and 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 pull, we'd say that looks about like what we'll get done in the fourth as well, but there is some uncertainty in the environment and here in the U.S. we've got an election to get through, but right now I'd 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 can take the next question, please?

Thank you. You talked quite a bit about Watson. You've been running many Watson ads. I just wonder if you can give any updates from the Analyst Day on Watson. How much revenue are you generating? The revenue you do generate is it in the software or consulting buckets kind of relatively speaking that you expect going forward? You mentioned I think four, five ways, you're looking to monetize Watson at that meeting, I guess which ones are working. And you talked about it as a platform as well and I'm wondered if you consider running Watson on someone else's platform like on AWS?

Okay. Steve, I'll start with the last question first and 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're seeing, we've talked a bit about and you've seen many of our announcement 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's where our Watson Health business is, that's where our IoT business is, and that’s where the Watson platform is. So, I'd say that with the cognitive solutions business we talked about it in total at plus five, the sub-segment of that where the Watson content shows up which we also provide is up eight, so good growth in that software solutions space. But keep in mind that we're also building new markets here and it's 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, and 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?

Hello.

Well, there you are. Now we can hear you.

Okay. I hope it’s coming through okay. So 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 with flexible pricing situation that you've been obviously dealing with from a negative growth standpoint for a couple of quarters or actually maybe about two years now?

So, regarding organic growth, as you mentioned, software increased by 3%, and the impact of acquisitions remained consistent with last quarter, contributing about 2 points across all businesses. Many of these businesses fall under software, so there was an impact this quarter, but it was not significantly different from what we observed previously. Our annuity business continues to grow, and we are still seeing good performance in that area. The ongoing conversations with our largest customers revolve around how they view the deployment of their licenses and the effective use of our technologies to optimize their workloads and projects. It's crucial for us to ensure they continue using our software and making timely renewals. Our renewal rates have remained high and stable through the third quarter, which gives us confidence in the appeal of our software to clients, as they keep utilizing it on a significant scale. While discussions may vary with large customers, the overall software performance was strong this quarter, with some benefits from acquisitions, and I anticipate our annuity base will keep growing as well.

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

Yes, thank you. I have a quick clarification and a question as well. So, Martin when you alluded to sort of moving into 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 2013 and 2015 guidance, that's my clarification. And for my question, if you think about sort of the unique one-time benefits in 2016 you had tax which was the big driver for first quarter. I know you had associated investments and then now you look at the third quarter there are some significant IP other income and I appreciate your comments around the increasing nature and sustainability of this. And I know you're not guiding it to 2017, but conceptually these elements make it seemingly tougher to grow earnings in 2017 especially at a time when base 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 taking through at a high level maybe some puts and takes and what potentially will be positive drivers are offsetting some of these headwinds in 2017?

Sure, Wamsi. Regarding the revenue from quarter to quarter, we generally see approximately $2.5 billion in transactional revenue during the quarter. This can vary based on numerous scenarios we expect for the year, but that figure is certainly the main expectation for our fourth quarter. As for 2017, I understand you've listened to my comments on intellectual property. This is not a one-off event. IBM has recognized as much as $1.07 billion from intellectual property in our income statement, which is one of the ways we monetize our intellectual property. It's just one aspect, as we also sell and license technology as part of our business model. Therefore, you shouldn't view this as a one-time occurrence. We intend to continue pursuing this revenue stream and are optimistic about growth. We've engaged with various clients and partners who want to license our technology, reinforcing that it's not merely a one-off situation. Looking into 2017, we have a significant transactional quarter approaching in 90 days. We'll discuss the environmental conditions and how they position us for next year. We already have some insights, such as the positive momentum in our strategic imperatives and how our investments align with market needs. We expect strong performance in strategic imperatives, which, while requiring some investments, will free up substantial spending next year compared to this year. We are also seeing positive sign-ins and backlog performance in our GTS business, particularly within infrastructure services, which is also enhancing margins for us. In addition, we observed margin growth in our GBS and application management sectors as we focus on productivity. Therefore, we have seen good performance and momentum in our strategic initiatives and backlog growth in our GTS business, along with margin improvements in certain services. For currency, we anticipate it will remain neutral over the next 75 days, which is a significant change from the billion-plus impact we faced this year. While we don't have another tax case on the horizon for next year, most of the previous gains were reinvested and did not reflect positively on the bottom line. It’s still early to speculate, so we’ll assess the fourth quarter and share insights in 90 days. However, there are positive trends in parts of our business that we will focus on more closely.

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

Thank you. So, Martin, if we look at the organic growth rate of the imperatives, it looks like that began decelerating in the fourth quarter of last year and through the second quarter of this year. And then they look at least, if my math is right, they bounce back this quarter, and you did a good job of telegraphing that last year's growth was not sustainable. That said, the numbers seem 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 months basis. You know, we recently started giving this on a quarterly basis. It’s a good disclosure and the sense that everyone asks for it and we try 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 and how best to interpret this I had interpreted on a 12 months trailing basis. Our clients aren't making big, big investment decisions like who do I trust with my data and what cloud am I going to move on to? That's 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 months basis and you can see the trend.

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

Hi. Thank you very much. I also want to ask about cognitive solutions, you mentioned that the rollout of SAS if you will or software service is impacting the margins, yet you had still a very small part of the total, it's perhaps 100% of the current revenue base. As that ramp what that continue to place pressure on your margin structure? Or to say it different way, could you characterize that we look at 2017 would margins and cognitive solutions be at a minimum flattish. How are you thinking about that? And one clarification also just, did you mention what the total revenues in organic sources were or was M&A about two points I hope this quarter as well?

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

Okay. Yes.

So, 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's 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's going in, it 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 and again this is a very, very high-margin segment at north of 80% here so.

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

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

Sure, Jim. I'd say that given, yes, we'll 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 businesses, I know that we are seeing margin expansion in some of those. So yes, we will continue to invest and I think that some of these markets require this level or the 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. And we’ll spend more time in 90 days on how all of that plays out for 2017, but again we made a lot of room for investments for ourselves for next year.

Thank you. Can we please take one last question?

Thanks. I’ll keep to one clarification and one question up. I guess you know the question really is when I look at your free cash flow usage over the last four quarters; it’s been you know more skewed towards acquisition versus what one would have thought in the past. As you look at 2017, do you think it optimizes more i.e. buybacks to be much more than you know the $1 billion run rate you guys are running at and acquisitions could be small, just help us on this on the mix as you 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 of a GAAP or non-GAAP number?

Sure, I’ll provide some clarification first, Amit. Our GAAP net income realization has been consistent, making it straightforward for everyone to understand. The free cash flow realization data aligns with our GAAP net income. Regarding how free cash flow will be influenced next year and our capital allocation, you can be assured that we will utilize all our capital effectively, as always. We do not retain excess capital after making organic investments, acquiring what we consider necessary, and paying dividends. Any surplus capital will be returned to shareholders over the long term through share repurchases. As we have mentioned, we anticipate reducing our share count by 2% to 3% over time, acknowledging our ongoing acquisition strategy. As we look to 2017, we will continue to invest organically, pursue acquisitions, and grow our dividend. Any excess capital will be returned, and the expected share repurchase remains at a 2% to 3% reduction over the long term. In conclusion, we are pursuing a unique approach, building advanced cognitive capabilities that surpass individual AI services. We are developing platforms to support this initiative and making our offerings available on the IBM cloud. As discussed, Watson will only operate on the IBM cloud, supported by our deep industry expertise, which is what our clients seek. This expertise is evident in sectors such as health, IoT, and the recently announced financial services. We are excited about our initiatives and the businesses we are creating, ultimately enabling our clients to transform into cognitive businesses. As we do this, we remain integral to their operations and the critical work they perform. They trust us with their data and as their partner in becoming cognitive businesses, ensuring our long-term success. Thank you for joining our call today.

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