International Business Machines Corp (IBM) — Q1 2017 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 First Quarter Earnings Presentation. The prepared remarks will be available within a couple of hours, and a replay of the webcast will be posted by this time tomorrow. I’ll remind you that certain comments made in this presentation may be characterized as forward-looking under the Private Securities Litigation Reform Act of 1995. Those statements involve a number of factors that could cause actual results to differ materially. Additional information concerning these factors is contained in the Company’s filings with the SEC. Copies are available from the SEC, from the IBM website, or from us in Investor Relations. Our presentation also includes certain non-GAAP financial measures, 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 will 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 first quarter, we delivered over $18 billion of revenue, operating pretax income of $2.1 billion and operating earnings per share of $2.38, which is up year to year. This is in line with the view we provided back in January and keeps us on track to our full-year expectations for earnings per share and free cash flow. In the first quarter, we continued to deliver strong performance in our strategic imperatives with revenue up 13% at constant currency. As is typical, I'll focus on constant currency growth rates throughout. Our Cloud offerings were up 35% this quarter, led by cloud as a service, which was up over 60%; Analytics, the largest of our strategic areas, was up 7%; Mobile was up over 20%; and Security was up 10%. We also continued to deliver core capabilities to our clients running mission-critical systems and processes. Many of these products provide the foundation of hybrid environments, enabling our clients to get more value from their on-premise data and applications. Some of these key franchises are growing like WebSphere, while others are declining as they are in declining markets. But all are high value. We’ve been very clear that to be successful with enterprise clients and to solve real problems, you need to bring together cognitive solutions on cloud platforms and create industry-specific solutions. And so we’ve been focused on building a cognitive and cloud platform and assembling the best industry skills and capabilities, all while maintaining our focus on delivering higher value solutions. As part of the transformation, we’ve made significant investments and shifted resources. This level of investment and a longer return profile of the cloud as a service businesses are reflected in our margins. Our foundation is now solidly in place. And while the investments will continue, our focus shifts to improving the returns on these investments by building scale and realizing operating efficiencies, keeping us on track to our full year objectives. And so our first quarter results once again reflect the success we’re having in our strategic imperatives. We grew 13% in the quarter compared to our strongest growth quarter last year. Over the last 12 months, our strategic imperatives together generated nearly $34 billion in revenue and now represent 42% of our total revenue. With over $14.5 billion in cloud revenue over the last 12 months, we’re the global leader in enterprise cloud. We play an important role in running the critical processes of the largest enterprises. And so it's not surprising that each of the 10 largest global banks, nine of the top 10 retailers, and eight of the top 10 airlines are now IBM cloud as-a-service customers. At our investor briefing last month, we spent the day showing how we’ve transformed IBM into a cognitive solutions and cloud platform company, and the importance and value of delivering industry-specific solutions. We talked about the differentiation of our cognitive and cloud platform through specific Watson technologies, through our data-first approach and our enterprise strength cloud. We bring all of this together in one architecture and we’re providing highly differentiated solutions by industry and scaling these solutions. I am not going to recap all of that here, but what I want to focus on today is some of the progress we made specifically in the first quarter with our solutions, our clients, and our partners. In the quarter, we expanded the reach of Watson and the IBM Cloud through our partnership with Visa, where Watson IoT turns cars, appliances, and other connected devices into potential points of sale. Through our alliance with Samsung, where the weather company will be the default weather app on new Samsung devices, powering the weather experience for tens of millions of devices by the end of the year. And through our engagement with H&R Block, where we're now embedded in 10,000 branches, enabling 9 million filers to benefit from the Watson enhanced expertise of H&R Block’s tax professionals. In the first quarter, we announced a strategic partnership with Salesforce to deliver joint solutions designed to leverage artificial intelligence and enable companies to make smarter, faster decisions across sales, service, and marketing. We also partnered with Wanda, one of the largest commercial and enterprise groups in Asia to bring public cloud services to China. We're building emerging technologies on the IBM Cloud like Blockchain and Quantum. In Blockchain, we had over 40 new engagements in the quarter and are working on over 400 more. And as we’ve discussed in the past, the opportunities span multiple industries. This quarter, we announced we're working with Maersk to use Blockchain to transform the global shipping supply chain; partnered with Northern Trust to launch Blockchain for the private equity market; and are collaborating with the FDA to explore how Blockchain can benefit public health. In the first quarter, we also announced the first commercial Quantum system. IBM systems are designed to tackle problems that are beyond the reach of today's computing systems. These are just a few of the examples of the reach and scale we're building with cognitive and cloud, and I'll highlight a few more in the segment discussions. But first, I'll walk through our financial metrics for the quarter. Our revenue for the quarter was $18.2 billion, which is down 2%. Currency was once again a headwind to growth, fairly consistent with the impact in the fourth quarter. At current spot rates, that headwind will be more substantial over the next couple of quarters. On a geographic basis, last quarter I talked about the impact of macro and geopolitical trends on some countries’ performance. In Europe, much of this continued into the first quarter with clients in the UK and Germany, in particular, putting pressure on our growth. Our gross margin performance continues to reflect investments across our business and the mix toward as service businesses. I'll talk about additional drivers in the segment discussions. Looking at our expense, pre-tax profit tax rate, and cash flow metrics, year-to-year dynamics reflect some unique items in last year's first quarter results. A year ago, we had charges that impacted our expense and pre-tax income by nearly $1.5 billion, including a workforce rebalancing charge of $1 billion. In the first quarter of this year, our workforce rebalancing charge was about $170 million, so the year-to-year impact of a lower level of workforce rebalancing accounts for 11 points of the 20% reduction in total expense. Our expense also includes a higher level of IP income, reflecting the success we've had in rebuilding our intellectual property income base through IP partnerships. I'll come back to this a little later. And so our operating pre-tax profit of $2.1 billion was up over 50% this quarter. Our tax rate for the quarter reflects an ongoing operating effective tax rate of just under 15%, in line with the expectation we discussed at the beginning of the year of 15% plus or minus 3 points. We also said we had a discrete tax benefit in the first quarter of $400 million to $500 million, and in the quarter, the net benefit was just under $500 million. This is far less than the discrete benefit we had last year of $1.2 billion associated with the Japan tax refund. And so tax was the substantial headwind to our net income and EPS growth in the quarter. We generated $2.3 billion of operating net income in the quarter and a net income margin of 12.4%, which is up 30 basis points. On the bottom line, our operating EPS was up 1% to $2.38. We generated $1.1 billion of free cash flow in the quarter, which is down year-to-year by the amount of last year's Japan tax refund. As you know, there is a lot of seasonality in the timing of our cash flows, much more so than in our net income. That’s why it makes sense to look at cash realization on a trailing 12-month basis. Over the last 12 months, our free cash flow was 90% of our GAAP net income. Looking at our segments, Cognitive Solutions revenue was up 3% year-to-year and pre-tax income was up double digits. Our solution software revenue was up 5% while transaction processing software was down 1%. Within solution software, growth was again led by offerings in analytics, including our Watson-related offerings and Security. We saw strong SaaS performance with strong double-digit growth again this quarter. I’ll share more on our progress starting with Analytics. We saw good growth in on-premise databases and data warehousing, which includes DB2, Informix, and Netezza. Content and integration offerings were also up this quarter as data ingestion as an important initial step in a cognitive journey. As part of that journey, our Watson platform continues to gain momentum in the marketplace. The Watson platform, built on the IBM Cloud, underpins our AI strategy and is a fast and easy way to embed cognitive into our clients’ workflows. Two great examples are Salesforce and H&R Block. H&R Block went from an idea to fundamentally changing the client engagement experience with Watson, redesigning business processes, and deploying a cognitive solution across 10,000 branches in just a matter of months. Building on the platform, we’ve differentiated with industry expertise across verticals. In Watson Health, we had strong growth, particularly in oncology, government, and life sciences, as we move to scaling Watson in healthcare. Out of the top 25 life sciences companies, nearly half are either using or implementing our cognitive offerings. In an environment of increased regulatory pressure, Cognitive helps to expedite the time to bring drugs to market and to monitor them once in the market. This quarter, we also introduced new cognitive offerings, such as Watson Imaging Clinical Review and infused Cognitive into existing offerings. For example, in Watson Care Manager, we’re bringing organic and acquired content together to build the cloud-based offering that addresses integrated care; we’re then adding cognitive capabilities to extract trends and provide actionable insights. This is the kind of work we can do with our industry-specific development skills. We also had good growth in Watson IoT, where we added over 50 new clients to our IoT platform again this quarter. And we’re incorporating new capabilities into the IoT platform, such as the Visa payment services mentioned earlier. Clients are co-locating for innovation at our Munich center, and the number of developers on our IoT platform had strong double-digit growth. Watson for Financial Services also contributed to growth this quarter. Here, we’re leveraging the skills we acquired through the acquisition of Promontory, the world’s leading regulatory compliance consulting firm, to develop cognitive offerings in areas like regulatory change management. It is a space ideally suited for cognitive because of its expertise and domain-driven; banks aren’t going to automate core regulatory processes with publicly available data alone. By combining industry experts with cognitive capabilities and leveraging industry-specific client data, we’re building solutions that solve the problems in the industry. Remember, it matters who changes your AI platform, on what data, and who owns the insights. By pulling all of this together, IBM will be well positioned as the leader in the reg tech marketplace. Security also contributed to growth in the quarter, driven again by areas such as data security and security intelligence. We’ve had strong traction in Watson for Cyber Security since launching in February, and deployed it in over 50 customers globally. And we embedded Cognitive into another offering, MaaS360 Advisor, using machine learning to analyze and protect devices. We complement our software offerings with security services to offer the broadest portfolio in the industry. Together with our security services, we outpace the market. Turning to transaction processing software, performance improved sequentially driven by Z Systems Middleware and Storage Middleware. While the overall business is declining, we have some areas that are growing, like software-defined storage; other parts are high value and running mission-critical workloads for our clients, but the growth profile is stable-to-declining. Turning to profit, Cognitive Solutions’ gross margin is down, driven by continued investment into strategic areas, including acquisitions and the mix toward SaaS. Roughly a quarter of the Cognitive Solutions business is now services and SaaS offerings, which currently have a different margin profile. Pre-tax income is up for both segments and improving year-to-year even when adjusted for the lower rebalancing charges. This segment has very high PTI margins, which expanded this quarter. So for the Cognitive Solutions segment, we grew revenue and profit in the quarter. We’re embedding Cognitive into more offerings, scaling platforms, and building high-value vertical solutions. Global Business Services was down 2%, which is a two-point improvement in the trajectory from last quarter. Strategic Imperatives grew double digits, led by our cloud and mobile practices. Overall, we had modest growth in signings this quarter, driven by our digital offerings. However, the GBS backlog is still declining. As we talked about last quarter, we need the growth from our new offerings to drive consistent signings growth to improve the trajectory of the GBS backlog. Consulting revenue was down 2%, improving nearly 3 points from last quarter performance. We have good growth in IBM iX, our digital design practice that helps our clients build new customer and employee engagement models around digital. We've built a robust network of 35 design studios around the world where clients co-create with GBS consultants in digital strategy, design, and mobile experience. We’re redesigning our clients’ workflows through integrated solutions and a robust set of enterprise-grade mobility applications. This quarter, we announced agreements with BP Castrol, Bell Canada, and Santander to name a few. In Consulting, we continue to shift resources to our Cognitive Services, Advanced Analytics, and Digital Platform, and away from the more traditional areas, including consulting for on-premise enterprise applications and some migration and process reengineering services. Our consulting revenue reflects this shift. Application management was flat year-to-year and has been relatively stable over the last year. We're innovating our clients’ platforms helping them migrate to new cloud architectures, increasing their speed and agility, and ultimately, improving their competitiveness. Turning to profit, we continue to invest in our strategic imperatives and build out our practices around cognitive, cloud, mobile, and digital design. Over the last year, we've added nearly 8,000 resources to these businesses. There also continue to be accounts where we are investing more to deliver on important client commitments. And in parallel, we're streamlining the practice infrastructure and driving efficiencies in our delivery model through new methods, solutions, and project management approaches. As we talked about at our investor briefing, GBS is aligned and focuses its capabilities around three growth platforms. The first is digital strategy and iX, where we help clients imagine what their businesses should look like in the digital world and then execute a roadmap to build and migrate their capabilities to get them there. The second is cognitive process transformation where we help clients adapt their core processes and integrate cognitive technology to gain insights, drive efficiencies, and create new business models. The third is cloud application innovation where we modernize our systems by putting in place new cloud-centric application architectures tailored to their business and their industry. With deep industry capabilities, we're executing a strategy that is client value-led and powered by IBM assets and leading third-party platforms. We're refocused on our practice model to ensure we're building deep skills in the right areas and increasing our sales and delivery capacity. We're starting to see the benefit of this focus and are expecting improved performance over the course of the year. Technology services and cloud platforms revenue was down 2%. We continue to have strong double-digit growth in our strategic imperatives, particularly in cloud which was up over 40% as we build out hybrid cloud environments for our clients. As enterprises move to the cloud, they need help in managing the complexity of integrating multiple environments. We're able to move these enterprises to the cloud in a way that leverages their critical data and IT investments. Our cloud as a service revenue for the segment grew over 50% and our annual as-a-Service run rate was $5.7 billion. Infrastructure services was down 2%. As you know, this is a business model where we drive productivity for our clients. We orchestrate disparate systems and optimize IT operations. We help clients manage their hybrid cloud environment, which can include multiple cloud platforms, on-premise data centers, and mobile environments. When we deliver this productivity to our clients that's less revenue for us, but then we look to create new revenue streams by moving them to new areas, acquiring new scope, and bringing on new clients. So our business model has always been to deliver productivity for our clients and then grow by expanding our scope of work and adding new clients to the platform. While we had some substantial relationships lined up, we did not get them closed by quarter-end, which impacted revenue in the period. The revenue trajectory also reflects that a couple of large clients brought their operations in-house due to regulatory and other unique circumstances. These clients remain on IBM platforms and will continue to be trusted partners. Turning to technical support services revenue, it was down 2%. We continue to shift more to our multivendor support services, which again grew this quarter. We provide end-to-end support both inside and outside the data center including, for example, IoT environments. Integration software was down 3%. We grew in our hybrid integration software that connects and integrates applications, data, and processes across on-premise and cloud environments. In addition, the WebSphere application server grew for the third consecutive quarter, demonstrating the importance of middleware in public, private, and hybrid environments. We declined in our on-prem DevOps tools and IP services management software. While some clients prefer to keep this work in-house, these kinds of workloads continue to shift to the cloud as we're seeing with Bluemix, our cloud DevOps platform, continuing to expand. Looking at profit, gross profit margin was down while PTI margin for the segment was up 5 points year-to-year. This quarter we had a lower level of workforce rebalancing and we recognized savings from productivity actions including last year's transformation actions. Much of this was reinvested in new and existing skills. We are investing as we move to a Watson-based cognitive delivery model. Through this delivery model, we're able to manage complex hybrid cloud environments and provide more insights into infrastructure that is always on, available everywhere and of course secure. In infrastructure services, we're constantly managing resources and investment across our portfolio, and the combination of the winding down of some contracts, signing delays, and some investment ahead of those signings impacted our profit in the quarter. Finally, in TSF, we're shifting more to multi-vendor services and in Integration Software we are mixing more to SaaS, which impacts margins in the near term. In summary, when you look at our performance in technology services and cloud platforms, our clients need help moving to the cloud and managing the complexity of their hybrid cloud environments, and we continue to see strong growth in cloud and our as-a-Service revenue. Our middleware also continues to be important in this environment. Our business model is one where we're constantly delivering productivity for our clients, this is what makes us the market leader. The profit cycle requires that we invest ahead to provide the scale and efficiency that our clients cannot achieve on their own. These dynamics impacted revenue and margin this quarter. As we sign the contracts that didn’t close in March and yield operational efficiencies, we’re expecting better performance in this business in the second half. Our systems revenue reflects declines in z Systems and Power indicative of where we are in the product cycles, while storage grew after repositioning for flash across our portfolio. Systems gross margin was down year-to-year with declines across z Systems, Power, and Storage as we address market shifts and product transition. In z Systems, the mainframe continues to deliver a highly secure and scalable platform that is critical to our clients' needs, addressing both existing and new workloads. We added seven new clients in the quarter and 87 since the beginning of this cycle. We also had five major financial services sector wins this quarter with existing clients, as well as several blockchain engagements. Our revenue and margin performance for the quarter reflects the fact we are nine quarters into the product cycle, and we expect the new mainframe late in the year. Power declines reflect our change over to a growing Linux market while continuing to serve high-value but declining in UNIX market. Linux workload again had double-digit growth, outpacing the market. We're the underdog here and we have a 3% share, so there is a lot of opportunity ahead of us. Our expanded Linux offerings, Power on Linux, are going to surpass double revenue this year, and HANA on Power continues to play an important role in that success. By contrast, in UNIX, declines were driven by our midrange and low-end systems. Power, while critical for cloud and cognitive workloads, continues to be impacted by shifting our platform from UNIX to Linux, both in revenue and margins. Storage hardware was up 7% this quarter, led by double-digit growth in our all-flash array offering. Flash contributed to our storage revenue growth in both midrange and high-end. In storage, we continue to see the shift in value towards software-defined environments, where we continue to lead the market. We again had double-digit revenue growth in software-defined storage, which is not reported in our systems segment. Storage software now represents more than 40% of our total storage revenue. Storage gross margins are down as hardware continues to be impacted by pricing pressure. To summarize Systems, our revenue and gross profit performance were driven by expected cycle declines in z Systems and Power, mitigated by Storage revenue growth. We continue to expand our footprint and add new capabilities, which address changing workloads. What we’re facing some shifting market dynamics and ongoing product transitions, our portfolio remained uniquely optimized for cognitive and cloud computing. New systems product introductions later in the year will drive improved second-half performance as compared to the first. I want to spend a minute on our IP income and put our recent performance into context. Our investment in research and development generates a significant amount of intellectual property and we have a number of different ways we monetize it. Keep in mind that the vast majority of our IP is monetized to revenue stream, with only a small portion coming through IP income. Fifteen years ago or so, much of our IP was associated with our semiconductor manufacturing and design business. At the time, in addition to licensing some of the IP, we used joint development agreements to deal with the economics of our manufacturing scale. These partners essentially helped that scale issue. Since then, our strategy has changed which resulted in a different mix of business. We continue to have joint development and technology licensing agreements through fewer clients who see the value in our IP, but it requires continuous innovation to stay in high-value spaces. And so more recently, we are forming IP partnerships to enable ongoing innovation in our IP while allocating our development resources to where we see the best opportunities for us. In these partnerships, we license, not sell, our source code to a technology or services partner who assumes the development mission and invests to innovate and build new functionality, enhancing the value of the asset, which reinforces and supports our revenue stream. We retain the ownership of the IP and the revenue streams and pay a royalty to the partner for the development mission. And as the partner sells to their clients, they pay a royalty back to IBM from the revenue they receive. The benefits of these IP partnerships to us include the prioritization of our development resources, the continued innovation for our clients based on our high-value assets, and the creation of additional channels, which can expand the client base. So to sum it up, our ability to monetize IP is driven by the amount of IP that we create, which is substantial, not whether a transaction occurs in a particular period. Because our IP is high value and relevant to our clients, it is attractive to a broad range of technology and service partners who can build solutions around the core assets. We had three new IP partnership agreements in the first quarter and now 19 over the last two years. To put that in perspective, we have licensed, on a non-exclusive basis, about 1% of our software code base and these agreements to date, and we are generating more IP every year than we are licensing, so we have a lot of opportunity in this area alone. But as I said earlier, why and how we choose to monetize our IP, for example, whether to address scale issues or resource optimization, reflects our business strategy and so the opportunities and the model will evolve. We are now turning to cash flow and the balance sheet. We generated $1.9 billion of cash from operations excluding our financing receivables, and we invested over $800 million in capital expenditures particularly in our Watson and cloud platform areas as well as in support of our services and systems businesses, and so our free cash flow was $1.1 billion. Over the last year, our cash utilization rate is 90%. Excluding the benefit of last year's tax refund, free cash flow is flat year-to-year, and within that working capital contributed to our cash flow performance driven by strong cash collections. Our first quarter of free cash flow generation is in line with historical trends and we remain on track to deliver a level of free cash flow consistent with last year. Looking at uses of cash in the quarter, we returned over $2.6 billion to our shareholders, about half through dividends and half through share repurchases. We bought back over 7 million shares and at the end of the first quarter, we had $3.8 billion remaining in our buyback authorization. On the balance sheet, we ended the quarter with $10.7 billion in cash and total debt of $42.8 billion. Two-thirds of our debt was in support of our financing business, which now includes the increase in leverage related to our client and commercial financing business, IBM credit. The leverage in this business is now 9:2, which as I described in January, translates to an increase of just over 600 million in global financing debt. The credit quality of our financing receivables remains strong at 52% investment grade, which is flat versus December and a point better than year ago. More information on our financing business is provided in the supplemental charts in the backup. Our non-financing debt was $14.3 billion with a debt-to-cap ratio of 48%, which is a point lower than December. Debt to cap is down 14 points year-to-year as you will recall that we front-loaded our debt issuances this last year. Our balance sheet continues to have the strength and flexibility to support our business over the long term. Let me wrap up by talking about how we see the balance of the year, starting with the progression from the first half and then drivers of our second-half performance. As you know, we typically see a profit improvement from the first to the second quarter. Last year, the sequential improvement was significant because of the charges in the first quarter. Adjusting for these outside charges, we increased our operating pretax profit by an average of $800 million from first to second over the last couple of years. We see a similar level of sequential improvement this year, which means we would finish the first half at about 37% of our full-year operating EPS expectation. Now every year is different and when you look at that 37% attainment compared to history, you will see it's a few points below the last few years. So I'll spend a minute on why this year the first to second half dynamics will be different and why we remained comfortable with our full-year expectations. To do that, I'll give you a couple of examples of things that we know and things that we expect. We know that we will have new system products later in the year and this will drive a significant improvement in gross profit from the first half to the second half. Related to that in the second half, we'll have the investment ramp behind us, so we'll also benefit from lower systems development spending in the second half relative to the first. We also know that we'll wrap on last year's larger acquisitions, which will be less dilutive to profit in the second half as we continue to ramp revenue and realize some operational synergies. Then there are a couple of things that we expect, particularly in our services businesses. We expect that global technology services will sign a few of the larger contracts that didn’t close in the first quarter and that together with the cost savings and the yield on some of the investments we've been making will improve the first to second half profit dynamics. In global business services, our trajectory is starting to improve and we expect this to continue throughout the year. We also expect currency to be a headwind and we put a view of that into the supplemental slides. The translation of our pretax profit to net income will depend on the mix of business and the operational tax rate assumption continues to be 15% plus or minus 3 points. As always, this is without discrete items. To put all that together, we continue to expect to deliver at least $13.80 of operating earnings per share for 2017 and free cash flow net consistent with last year.

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 deck that provide additional information on the quarter. And second, I’d ask you to refrain from multi-part questions. So let’s please open it up for questions.

Martin, as we look at this quarter on a year-on-year basis, we saw PTI dollar improvement of close to about $700 million. Should we expect any more PTI improvement over the course of this year, given that the discrete tax benefit was $500 million? You can pretty much guess your guidance from those two elements. Not sure if there are more discrete items yet to come, but conceptually is there more PTI benefit yet to come or have you seen the PTI benefit already flow through? Thank you.

Yes, thanks Wamsi. The first thing I’ll say is I apologize for my voice, so if I sound kind of croaky, I’ve got a bit of a cold here. But hopefully you can understand. So with regard to what we see from here out, as you noted, we got about 700 in our guidance on a full-year basis, we did about 700 in the first. The thing I would add is that we don’t know what that mix is going to be; it's 15 plus or minus two points. So if you were to take that range, we either have another couple hundred to go if it comes in from a high tax area, or we're already over-solved by a few hundred. So either way, you are in about that right range. Now we have a lot of work underway to drive productivity in our services business; we talked a bit about that in the prepared remarks. We still expect to get the growth out of the acquisitions that we spent some money on. So there is a lot more obviously within the dynamics of our business from here to the end of the year. But if you just wanted to look at those two line items, then yes either we have a little bit left to go if it comes in at a higher tax mix, or we've over-solved already, but yes that’s what the guidance implies.

At the Analyst Day, you mentioned that as we grow the cloud business and the cognitive initiative, we should anticipate margin stability and possibly an inflection. You also indicated a forecast for GBS margin improvement for the full year. However, when we take a broader view of gross margins, which provide a clearer picture of profitability without the influence of insight work pressure balancing and IP income, we have seen a more significant decline this quarter across all those businesses. So, the question is, do you still anticipate seeing stability and even inflection in any of those businesses this year, or is that something we should expect later on?

So a couple of things. When we analyze our performance, one quarter each year typically represents the low point in GP margin, and this trend remains consistent. Consequently, we anticipate sequential growth from there. This year, as we indicated in our prepared remarks, I do expect the services units to contribute to sequential improvements in that sector. Some areas require more time and progress than others; for example, GBS is facing declining revenue and margin impacts. However, we believe that a business can advance past its current constraints, as illustrated by our consistent growth in signings, which will lead to an expansion in backlog and, subsequently, revenue growth. We still have this potential ahead of us. In the first quarter, we experienced a 2% growth in signings, marking the beginning of our recovery in that business. Specifically, for GBS, the margins associated with our new strategic initiatives are outperforming those from previous areas. While we must acknowledge the overall productivity at the model level, we are identifying margin opportunities in those new segments of GBS, and we expect to continue making progress. Sequentially, as we have always done, the margin picture will improve from the first to the second, third, and fourth quarters, and depending on the business mix, that growth could be three to four points higher than the first quarter's margins. In some years, it has reached as high as 10 points. We expect to fall within that range by the end of the fourth quarter, with the first quarter always being the lowest point of the year.

Martin, you talked about the investments that the company has been making the last few years and previously suggested a little more flexibility this year. Could you talk about in dollars, are the investments that you're making into the strategic imperatives flattening out? Should we look for less growth year-over-year in those investments, or are they actually becoming flat? And is there a point in the next couple of years where we could even see them decline year-over-year to help your margins?

We expect that as we progress, the year-on-year impact of our acquisitions will be less pronounced because our run rate is at a higher dollar level. While these businesses will still require ongoing investment, our focus has always been on shifting resources rather than just expanding our portfolio. The phase of significant expansion is behind us, and we will maintain our investment in strategic imperatives, but the growth will not be as substantial as it has been in the past now that they are integrated into our model.

I just wanted to confirm and clarify how you're getting to your full-year $13.80 target. So for Q2, I think given that you expect 37% of EPS in the first half, that would point to EPS of about $2.73. I think consensus is $3.17, so well below Street expectations. Which means that you have to be well above Street expectation for the second half. I'm wondering if you can also clarify what you're assuming on IP licensing for the year. It was up dramatically in the first quarter, I think you said it would be about flat year-over-year. So that implies the rest of the year IP licensing is going to be declining and therefore a year-over-year headwind. Is that the right way we should think about it, and if your IP licensing or your discrete tax benefits are significantly higher than you think today, will you be adjusting your guidance accordingly?

So, a couple of things, Toni. We are not changing our guidance; we still anticipate at least a $13.80 figure for the year, and we expect free cash flow to remain roughly flat as previously stated. In terms of the quarter, it unfolded pretty much as we projected, although we had hoped to finalize a few more service signing relationships. Overall, the quarter aligned with our expectations and our guidance remains unchanged. In the prepared remarks, we outlined some known factors and expectations, which is how I’m thinking about it. We have various scenarios regarding guidance and potential outcomes, but let's discuss a few points from the prepared remarks. Firstly, the announcements of new systems products have a dual impact. There's a need to increase investment before generating revenue to prepare those systems, which is where we are currently and will continue through the first half. Once the systems are announced and released, we will begin to see revenue, and there will be a double benefit: increased gross profit and reduced spending since the ramp-up phase will be over. This will significantly affect the transition from the first half to the second half. We also mentioned the integration of acquisitions. While we continue to seek growth through acquisitions, there are also many opportunities to enhance efficiency in our operations. We expect to see improvement from the first half to the second half as we implement new solutions related to those acquisitions and benefit from operational synergies. In our services division, we anticipate growth throughout the year, both in revenue and margin profile. We have a lot of work ahead to enhance productivity in our services areas, and we believe there are significant opportunities for improvement as we move into the second half. Regarding IP income, similar to our January comments, we have several scenarios to consider. We expect to see our IP income remain flat year-over-year, but this expectation is not central to our guidance. If we assume it stays flat for the full year while seeing an increase in the first quarter, it could indicate a decline later on, which aligns with our expectations for the year. In fact, as I mentioned, it might be a greater headwind than anticipated since many of our scenarios do not project flat results; we had a relatively strong second half last year in IP income, so a decline is possible. Nevertheless, we have multiple scenarios. Overall, the year is shaping up differently in the second half compared to the first, and we included some context regarding our performance in the first half because not every year unfolds in the same manner. It's important to grasp these dynamics, but our guidance remains unchanged, and we expect the year to progress similarly to how we performed in the first quarter.

Just one on the tech services side. It sounds like some delays in deals closing. Is that a macro-cyclical issue in terms of maybe a slow start to the year for some of your enterprise clients? What's the visibility into these deals closing in GPS and also the improvement in GBS that you just mentioned; is that also required improvement in macro environment, or is there something else that's driving that?

Thank you, Ingin. I will focus specifically on GBS since there are no macro factors at play. The work we do is crucial for our clients, essentially the heartbeat of their businesses. This means we don't adhere to a strict 90-day timeline. Our client relationships are unique, and no one else has the same depth of capabilities. Therefore, our clients progress at a pace that reflects the significance of our work. Additionally, factors like regulatory approvals and the complexities of technical requirements are involved, particularly with clients from regulated industries. The delays in signings are not due to macro issues; instead, they relate to the deep partnerships we have, which require careful planning and execution over time. I believe GBS doesn't need an improved macro environment to succeed. In fact, we may perform better when clients are more focused on the future and under more pressure. The transformation occurring within GBS is driven by our ability to adapt to new areas, and we've committed significant resources to these new practices. The positive results from teams entering these practices further support this. Thus, GBS is not affected by macro conditions; instead, its strong client relationships dictate a long-term approach to progress, and I think it will thrive moving forward.

Just wanted to follow up on the earlier services question and maybe ask about the commentary you made about a couple of clients, other clients taking work in-house. Is that a commentary on the infrastructure and cloud piece of the business specifically, or is that a broader comment on the application services and like? And can we maybe just kind of talk about what you're seeing in terms of pricing pressure in the market, because you previously called that out several times, but didn’t this time? Thank you.

Yes, there isn’t anything macro happening. The two instances we discussed regarding companies bringing services in-house are quite unique. For example, we have a client in Germany who renewed a five-year deal for another five years. However, there is a law in Germany that prevents this type of client from renewing the same contract twice, which forced them to bring the service back in-house for regulatory reasons. They managed to bring back the staff, and they still operate their IBM mainframes, so we're still partners regarding the infrastructure. This situation is highly unique and not indicative of broader market trends. In another case, a client planned to split into two businesses but ultimately decided to wind one down based on market conditions. As a result, they no longer needed a large infrastructure for that business. Again, this is a very specific case and not representative of a macro trend. Regarding pricing pressure, these relationships are significant and integral to what these companies require. If I were to simplify it, they are asking us to help them transition to the cloud for greater agility, security, and mobility, similar to what they observe competitors achieving. There are no external pressures influencing our discussions; it's about our capability to meet their future needs in alignment with their business model.

I guess Martin, I just want to go back to the gross margin discussion and perhaps more at the corporate level. I realize that these margins will improve from Q1 to Q4. At what point do you see gross margin starting to stabilize, the year-over-year declines start to abate for the company? And if you were to think about the cost-saving benefits, what cost-saving benefits do you have expected for 2017?

Sure Amit, we are experiencing the benefits of the transformations and actions we initiated last year. When we discussed Q1 '16, we mentioned some measures to reduce capacity, primarily to bring our teams together in collocated offices that foster collaboration and agility. This involved consolidating locations to enhance teamwork. While we implemented capacity reductions, our main goal was to revitalize our skills, which is a continual process for us. We're already seeing positive results in our new skill mix, particularly noted in the growth of GBS signings in the first quarter. Additionally, we have seen increased productivity in our SG&A expenses; although we are investing more in development, our SG&A spending has decreased. This improvement stems from both reduced capacity and increased operational efficiency. From a gross profit margin standpoint, we operate on a high-value model. We consistently evaluate whether the new areas we are pursuing yield greater value and margins compared to our previous focus. The strategic imperatives we’ve discussed traditionally maintain a higher margin profile than our core operations, which aligns with our investors’ expectations for us to invest in these new, higher-margin sectors rather than chasing lower-margin opportunities. This trend has been consistent and suggests that our gross margins will continue to improve as we transition to these more valuable areas.

Martin, if you look over the next 12 to 24 months, I think the strategic imperatives were in the low 40s, the percentage of revenue. What are the main variables that dictate whether the imperatives grow to over 50% of revenue and again to more than compensate for the decline in the legacy core?

Sure, David. A few points to consider. We discussed this briefly in the prepared remarks, and I believe it's significant. We are confidently reinventing the legacy core; we are not under-investing in it or disregarding it. In fact, we value this business highly, even though some of its content exists in declining markets, which means there are fewer opportunities. However, it still holds substantial value. As mentioned earlier, some segments like the WebSphere application server are experiencing growth, signaling that we are expanding in a growing market. It's important to clarify that the core consists of various components, including parts of our power and mainframe businesses. Currently, we are not in a cycle that allows these core segments to grow, but we will reach that phase eventually. We previously stated that strategic imperatives would contribute 40% to our revenue, and we are on track to meet the $40 billion goal by 2018, possibly even exceeding it. The timeline for when those two growth lines will intersect is uncertain. The investment community hopes we can maintain a solid double-digit growth trajectory. There have been concerns each quarter regarding a slowdown, yet we achieved a 13% growth against our toughest comparison from last year. Thus, while the crossover point is a matter of calculation, my focus is on ensuring that the strategic imperatives and the growth derived from them continue to support us in reaching that $40 billion target.

I wanted to ask you, is pruning still on the table? What I mean by that is, if I think about the revenue growth, the core actually decelerated this quarter compared to say the last three quarters. And if I look at some of the areas like GBS, you have application maintenance that’s combined with BPO that’s over 50% of the business and well under company profit levels. And I'm just trying to understand specifically focused on GBS, is how you improve revenue growth, but should you improve revenue growth or is there more pruning that you can do as it relates to the total IBM portfolio, but particularly within GBS.

Sure, Keith. I believe that when I assess our portfolio, we do so with a focus on value. It's clear that we should not consider the portfolio solely in terms of growth; value without growth is not sustainable, and it's important for us to evaluate whether it aligns with our goals. However, I see the current portfolio as having high value. The AMS business you mentioned is indeed a high-value segment. While the revenue is fairly stable, it addresses a crucial need for our clients, allowing us to create value through our industry focus. I view pruning as necessary only when there is a lack of differentiation or long-term value opportunities. Looking at our portfolio today, I believe it is very high-value, and I see that GBS, especially large GBS, plays a significant role in this. Therefore, I do not see any need for pruning at this time.

I think there is no question about the success in the strategic imperatives, how you are ramping those. The biggest question on many of the follow-up calls, well maybe I'll give it one more shot, the investment you are putting forth in the degradation to gross margins, when are we going to see them stabilized or do you have line of sight to that? It just seems like when you give up an investment, at some point, you want to progress the fruits of those efforts and it went out time and time again, so I’ll ask kind of one more time, do you see stabilization and if so, when?

Yes, Jim. This is an interesting question and it's timely. I want to ensure everyone understands that as we move through the remainder of this year, one of our main focuses has always been to achieve returns on our investments. If you were to ask 100 IBM executives, they would all agree that it's time to realize those returns. We have made substantial investments that have influenced our margins, but improving our margins isn't solely dependent on these investments. We have numerous opportunities in our services sector, in our delivery model, and in how we enhance our margins. It is indeed time for us to see the returns from our significant investments. Our strategy is sound, and we hear from our clients regularly about the value of the work we do in core areas and the directions we are taking them. Therefore, the summary is that now is the moment. I want to conclude by highlighting that we have made considerable investments and have added a lot of capabilities to IBM. We have launched new businesses, explored new markets, and, as always, transformed industries and professions, and we will continue to do so. With the business now positioned effectively for the long term, we have the capability to focus on enhancing returns on our investments. Thank you for joining the call today.

And Sam, I’ll turn it back to you to close the call please.