International Business Machines Corp (IBM) — Q4 2017 Earnings Call Transcript

Thank you. This is Patricia Murphy, Vice President of Investor Relations for IBM, and I'd like to welcome you to our Fourth Quarter Earnings Presentation. I'm here today with Jim Kavanaugh, who was announced last week as IBM's Senior Vice President and Chief Financial Officer; as well as Martin Schroeter, who is now Senior Vice President, Global Markets. Prepared remarks will be available within a couple of hours, and a replay of the webcast will be posted by this time tomorrow. I'll remind you that certain comments made in this presentation may be characterized as forward-looking under the Private Securities Litigation Reform Act of 1995. Those statements involve a number of factors that could cause actual results to differ materially. Additional information concerning these factors is contained in the company's filings with the SEC. Copies are available from the SEC, from the IBM website or from us in Investor Relations. Our presentation also includes certain non-GAAP financial measures in an effort to provide additional information to investors. All non-GAAP measures have been reconciled to the related GAAP measures in accordance with SEC rules. You'll find the 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 Jim Kavanaugh to start us off.

Thanks, Patricia, and hello to everyone on the call today. As a quick introduction, I've been with IBM for 21 years. I was the IBM Controller from 2008 through January of 2015 when I became the Senior Vice President of Transformation and Operations where I've been focused on driving IBM's operating model transformation. In October of last year, I came back to be Senior Vice President of Finance and Operations. I participated in IBM's annual investor briefings for the last 10 years and have met many of you. I'm now looking forward to working more closely with the investment community as IBM's CFO. Given I'm a week into the new role, Martin is going to cover the fourth quarter, and then I'll put into context our 2017 performance and how that positions us for 2018. We'll then take the Q&A together. So for now, I'll turn it over to Martin.

Thanks, Jim. Back in July, we planted the flag for our businesses, and we pointed to an improved trajectory in the second half. Now as we look back on the year, we did, in fact, significantly improve the trajectory in our revenue and our gross margin performance. We did this by ramping our cloud and as-a-service offerings by continuing to reinvent our systems brands, by driving a higher level of software transactional revenue and by improving consulting performance. In the fourth quarter, we returned to revenue growth. Our revenue of $22.5 billion is up about 3.5% and up 1% without the currency tailwind. We also grew our operating net income and our operating earnings per share. As you saw in our press release, our operating net income and EPS exclude a one-time charge associated with the enactment of tax reform because of the unique nature and to provide comparability to the operating expectations we've been providing for 2017. For the year, we delivered $79 billion of revenue, $13.80 of operating earnings per share and free cash flow of $13 billion, which is up over $1 billion year-to-year. Looking at some of the revenue dynamics of the fourth quarter. Our systems results were terrific across IBM Z, Power and storage. This was our first full quarter with the z14. And with pervasive encryption and the ability to address new technologies like blockchain, we're adding new clients and new workloads to the platform. In Cognitive Solutions, we had good growth in several areas, including security, IoT and our industry-based solutions like Watson Health and Watson Financial Services, though we were disappointed by the performance in a few of our more traditional analytics offerings. And in Services, we had our second consecutive growth in consulting, led by digital offerings. Performance in our outsourcing businesses across GTS and GBS was pretty consistent with the last few quarters. From a geographic perspective, we had growth in many countries, including our two largest, the U.S. and Japan. Across all of our businesses, our strategic imperatives revenue was up 17% or 14% at constant currency as we embed cognitive and cloud into more of what we offer. For all of 2017, Strategic Imperatives revenue was up 11% to $36.5 billion, which is 46% of our revenue. I should mention that we'll continue to focus on constant currency revenue growth rates throughout, but any way you look at it, this was a strong finish to the year.

We introduced the Strategic Imperatives framework back in 2015 as a way to show how we're moving our clients to the future. As you know, these aren't separate businesses but the revenue from our offerings that address opportunities in analytics, cloud, security and mobile. This quarter, the 14% growth in Strategic Imperatives revenue was led by cloud and by security. Let me give you a little more on each. Our cloud revenue was up 27% as we help our clients to implement hybrid environments, integrating public and private and traditional IT. For the year, our cloud revenue was $17 billion, and we're exiting 2017 with a run rate in our as-a-service offerings of over $10 billion. To put that $17 billion in perspective, it's up from $7 billion just 3 years ago. As you know, we play an important role in running our clients' most critical processes. And now with the IBM Cloud, which is built for the enterprise, each of the ten largest global banks, nine of the top ten retailers and eight of the top ten airlines are cloud-as-a-service clients. We can help clients with their hybrid environments as well. With the introduction of IBM Cloud Private, we provide clients with the attributes of a cloud behind their own firewall and give them increased portability of workloads across any cloud environment. This is really important for enterprise work. And then in security, revenue across our security offerings more than doubled. This reflects the strong demand for our pervasive encryption in IBM Z as we reinvent that platform for the most contemporary workloads. We also had good performance in managed security services within our GTS business and in our security software.

Over the last several years, we've been making investments and shifting resources, embedding AI and cloud into more of what we offer and building new solutions and modernizing existing ones. These investments not only drive our Strategic Imperatives revenue performance today but will also extend our innovation leadership into the future. I'll give you a few examples. In the third quarter, we formed a partnership with MIT to create the MIT-Watson AI Lab. Through this partnership, we're mobilizing the talent of more than 100 AI scientists, professors and students to carry out fundamental AI research and drive scientific breakthroughs that unlock the potential of AI. In Quantum, we now have a 20-cubit IBM Q system available for all to use, and we have the first working 50-cubit processor, and we launched the Q Network, which is a collaboration of leading Fortune 500 companies, academic institutions and national research labs that can access IBM Q systems through the IBM Cloud as they explore the practical applications to advance quantum computing. And you saw just last week, we announced that IBM led the U.S. in patents in 2017, marking our 25th consecutive year at #1. Nearly half of the more than 9,000 patents in 2017 are for advancements in AI, cloud computing, cybersecurity, blockchain and quantum computing. So now let me move on to our financial metrics for the quarter. Our revenue was $22.5 billion, which, as I said, is up year-to-year. Like last quarter, our performance was pretty much all organic. I'll go into the highlights by brand in the segment discussions, so let me comment here on the geographic performance. Revenue from the Americas was up 4%, with growth across the U.S., Canada and Brazil. This is a significant sequential improvement in the year-to-year performance, 6 points compared to the third quarter, driven by systems and infrastructure services. Our EMEA revenue was down about 1.5%, which is consistent with last quarter's performance. As always, the performance varied within the geography. This quarter, we had growth in France, Spain and the Middle East and Africa region, offset by weakness in the U.K., Germany and Italy. You'll remember that the U.K. and Germany were impacted by the contract dynamics at the end of 2016, and we've now wrapped on those.

In Asia Pacific, we had strong growth again in Japan, which was up 4%. Impacting overall Asia Pacific performance was China where you'll remember we had double-digit growth last year from some large rollouts in Chinese banks. Looking at our margin performance. Our operating gross margin was down a little over a point year-to-year and up nearly 2 points sequentially. This is about 0.5 point behind what we talked about last quarter, with some of the differences due to mix and the rest due to a delay in the yield from some of our productivity actions in our Services business. Our operating expense was up 6%. And with revenue up 4%, our E to R increased nearly 70 basis points year-to-year. Now keep in mind, when currency helps the top line, it also hurts the expense line, not just because of translation but because that's where the majority of the hedges are reported. We mentioned this back in October. And so in the fourth quarter, currency, between translation and the year-to-year impact from hedges, drove 4 of the 6 points of expense growth. We also had a lower level of IP income in the fourth quarter, about $175 million year-to-year, and it was down for the full year about the same amount. At the beginning of the year, we said we weren't counting on IP income being flat year-to-year, though we had the opportunity pool to do so. And as we went through the year, we're delighted with the new IP partnerships we signed. You can see they contributed to the $300 million of IP income in each of the last 3 quarters, and we weren't going to do anything unnatural to drive flat performance year-to-year in this line item.

Without the effect of currency and IP, our E to R improved modestly, reflecting the continued efficiency we're driving in our underlying spend base while maintaining a high level of investment, together with the benefit of growing revenue. Looking at operating taxes. Again, this excludes the one-time charge. We provided a range for our ongoing tax rate at the beginning of the year, and we finished at the bottom end of the range. And so our tax rate for the quarter reflects an underlying effective tax rate of 12% for the year. You'll recall, we had some discrete items in both the first and the second quarter, which took our full year operating tax rate down to 7%. We generated $4.8 billion of operating net income in the quarter, which is up 1%. And with share reduction of about 2.5%, our operating EPS of $5.18 was better by 3.5%. We generated $6.8 billion of free cash flow in the quarter and $13 billion for the year. Now when you look at our realization of GAAP net income, that's over 200%. But when you normalize for the one-time tax charge, it's about 115% for the year. For your awareness, as we show realization of GAAP net income going forward, we'll be using that adjusted view on our charts. Our free cash flow supports both a high level of investment and shareholder returns. And in 2017, we returned three-fourths of our annual free cash flow to shareholders through dividends and share repurchases.

So now let me move on to the segments. Our Cognitive Solutions revenue was flat. Within solutions software, our annuity content, which represents 80% of revenue on an annual basis, was up 3% year-to-year, which is over a point better than last quarter's growth. We had double-digit growth in our SaaS offerings again this quarter as we continue to invest to build scale in our as-a-service businesses. The transactional revenue within solutions was down, driven by weakness this quarter in a few of our more traditional analytics offerings like data integration and content management. As you know, because of the larger mix of transactional content in the fourth quarter, it has an outsized impact on the overall software performance. Within our solutions software portfolio, we continue to focus on building out our industry verticals, and we had strong performance in those areas, including Watson Health, Watson Financial Services and Watson IoT offerings.

In Watson Health, we continue to deliver strong growth, driven by state and local government agencies as well as life sciences and oncology. Watson Health is scaling. We've reached 115,000 people with our cognitive offerings, and oncology is now in over 150 hospitals and health organizations and trained on 13 cancers compared to 4 cancers just over a year ago. Watson Financial Services had another strong quarter as clients look to evolve their financial systems. Growth here was led by our RegTech and commercial payments offerings. Also, within analytics this quarter, we had good growth in areas that provide data management in hybrid environments like our new unified data system, which leverages DB2 technology built on IBM Power, and in our software-as-a-service business intelligence offerings, including cognitive analytics. As I said earlier, security contributed to growth again this quarter. We had good performance, particularly in the areas of data security, with GDPR as a key driver as well as fraud detection. We saw increased interest in uptake and our software-as-a-service offerings, particularly with QRadar on cloud and Resilient on cloud. We also continue to make progress in emerging areas like blockchain. Remember that for us, blockchain is a set of technologies that allow our clients to simplify complex, end-to-end processes in a way that couldn't have been done before. It requires the attributes of immutability, permissioning and scalability, and we're already performing thousands of transactions per second. And we offer some of the most advanced cryptography available to verify transactions. So by running on z, we provide industry-leading technology to help improve security and performance for our clients' blockchain networks. We have engaged in blockchain projects with hundreds of clients, and since the release of our IBM Blockchain platform in the third quarter, we've collaborated on 35 active networks with clients such as CLS, Everledger, KBank, London Stock Exchange and Mizuho. These reflect a wide variety of use cases like cross-border payments and financial services, supply chains in retail, valuable goods authentication in industrials and digital identification for governments.

This quarter, we extended our food safety initiative with Walmart into China. And just this week, we announced the creation of a joint venture with Maersk to provide more efficient, secure global trade using blockchain technology. Transitioning to transaction processing software, we had another good quarter with revenue up 3%, reflecting our clients' long-term commitment and the value our platform provides to them. Growth was driven by middleware as our clients continue to invest and grow their high-value, mission-critical workloads on the z platform. Turning to profit for Cognitive Solutions. PTI margin declined year-to-year, driven by ongoing investment into strategic areas and mix of business into lower-margin offerings, including the shift towards SaaS.

Our SaaS margins continue to expand, though were still not at scale. Moving on to Services. Global Business Services generated $4.2 billion of revenue this quarter, up 1% at actual rates and down 1.5% at constant currency. We had modest growth in GBS signings, marking the fourth consecutive quarter of signings growth. And our GBS revenue was up in several regions, including Asia Pacific and Latin America. We have good momentum in Consulting but continue to see declines in Application Management, particularly in North America and Europe. Consulting revenue grew 1% again this quarter. We've said for some time that the path to revenue growth starts with signings, which then translates to backlog growth. Our Consulting backlog was essentially flat in the second quarter and was up starting in the third. And we've now driven two consecutive quarters of Consulting revenue growth. Revenue in our Digital Strategy and iX business grew about 40%. And we're also seeing good growth in the new practices we've built around our innovative technologies like AI and Blockchain.

The reason we're able to lead in these emerging areas is because of the technology as well as our ability to implement these platforms into our clients' workflows. So GBS plays a critical role in our leadership in these areas. This doesn't apply just to our own technology. We're also building ecosystems and partnerships around other platforms. We've talked in the past about Salesforce and Workday. And now in December, we announced a partnership with Blue Prism that will combine their robotics processing automation software with IBM services to deliver digital workforce solutions that increase productivity and enable automation at scale. Application Management was down 3% this quarter, driven by declines in traditional ERP managed services and the successful completion of some large contracts.

Within Application Management, we grew in our offerings that help clients modernize their critical application suites by implementing cloud-centric architectures and microservices. Turning to profit. GBS gross margin was down about 2 points year-to-year. Half of this was due to currency dynamics this quarter, and it impacted margin by about a point. We're also continuing to invest in our skills and transform our GBS business. As Mark Foster talked about at our investor briefing, our strategy is focused around digital, cognitive and cloud growth platforms, and we've streamlined their practice model to ensure the right skills enablement for practitioners. We're investing to further develop our long-term client relationships with the leading organizations around the world, both with more dedicated senior account leadership and the reinforcement of delivery excellence through methods, automation and widespread rescaling of our practitioners. We're also bringing in new skills through acquisitions. We closed on the acquisition of Vivant this quarter in Australia, which is the seventh acquisition we've done in GBS over the last 2 years. And in some of the more traditional areas in Application Management, we continue to see some price and profit pressure.

Technology Services & Cloud Platforms generated $9.2 billion of revenue this quarter. Our Strategic Imperatives grew at a double-digit rate, and the as-a-service exit run rate for this segment was nearly $7 billion. The IBM Cloud is optimized for cognitive workloads and provides clients with the ability to integrate public, private and managed environments through a single architecture. Infrastructure services was down 4%, which is similar to the trajectory we've seen in recent quarters. As we've talked about, this quarter, we had a more difficult year-to-year compare because of some of the large contract items a year ago. We've now wrapped on those dynamics. Clients are looking to cloud to drive efficiency and agility in their infrastructure and help them create new business models, but they need help getting there and they need someone to manage it for them, given the complexity of their data, environments and industry. When you look at the composition of our infrastructure services signings this year, about 45% was cloud content, which is ahead of the market mix.

I mentioned earlier this quarter, we announced IBM Cloud Private, a platform to help clients unlock their significant IT investment in core data and applications and extend cloud native tools across public and private clouds. The new platform was built on an open-source container architecture and supports both Docker containers and Cloud Foundry. This facilitates integration and portability of workloads as they evolve to any cloud environment. IBM Cloud Private was developed in response to our clients who want more control of their data and processes while leveraging cloud capabilities. The need is obvious in regulated industries, but every client has data residency requirements and is concerned with the security and performance of pure public clouds. This platform will help everyone to better implement cloud infrastructure that aligns with whatever business model they have. Since the announcement of IBM Cloud Private, we've already brought 120 enterprise clients onto the platform. Technical Support Services was up 1% at actual rates and down 2% at constant currency. We grew in our multivendor support offerings, where we drive productivity and scale for our clients with integrated and wall-to-wall support solutions across any platform.

Turning to profit. Gross margin for the segment was down about 2 points year-to-year. Some of the large contract dynamics that we've talked about are impacting margins. There were also new large contracts that came into the portfolio at lower margins as we invest ahead to optimize our clients' environments. We continue to invest to scale our cloud platforms and more of the software content in this segment shifts to as-a-service. We're scaling the IBM Services Platform with Watson, where we've already added over 1,000 clients to the platform in 2017. Additionally, we've wrapped on the benefit from our workforce transformation actions that we took in 2016. We did improve our spending here, but as I mentioned, the yield from some of our productivity actions is delayed. In Systems, we had another strong quarter with double-digit revenue growth. All three brands, IBM Z, Power and Storage, grew. We continue to deliver innovation in our systems to enable them to run the most contemporary workloads. Now roughly half of our Systems revenue in 2017 addresses workloads in the areas of our strategic imperatives.

This quarter, IBM Z revenue was up 71% year-to-year with the highest shipped MIPS in history. The results reflect our first full quarter of z14 and demonstrate the strong client demand for this platform. Our mainframe is an enduring franchise. In fact, it's an enduring and growing franchise. Our MIPS installed base is up 2.5x over the last 10 years. And as long as we continue to innovate and modernize, this platform will continue to be the leading enterprise platform in the world. More than 10 years ago, it was Linux. Five years ago, it was mobile. And now, it's pervasive encryption. The z14 adoption was again broad-based across many countries and industries. We added 14 new clients to the platform across 10 countries this quarter, and we saw especially strong performance in North America where clients continue to leverage traditional IT infrastructure together with the cloud.

We're continuing to address emerging workloads across the Z platform like blockchain, machine learning, DevOps and payments. We closed 10 instant payments deals this quarter across several markets. And in the emerging blockchain space, the Beijing Institute of Technology selected the IBM LinuxONE platform to run their blockchain solution. Overall, the mainframe continues to deliver high-value, secure and scalable platform that's critical in managing our clients' complex environments. Our revenue grew 15%, driven by double-digit growth in our high- and low-end portfolio, with our cloud-enabled offerings serving new clients in deep learning and the HANA markets. We continue to shift into the growing Linux market. And our Linux on Power revenue grew again and gained share. For 2017, this now represents one-fourth of our Power portfolio. We also delivered the first installment of our supercomputers at the U.S. Department of Energy, with more to come later in 2018. There are three labs of this type, and we won two of the three, which is the most any provider is allowed to win.

In this quarter, in our low-end Linux portfolio, we released our next-gen Power system with our new POWER9 processor. These POWER9 systems bring unprecedented speed to AI workloads and enable our clients to compete and win in the data-intensive AI era. Storage hardware was up 8%. This is the fourth consecutive quarter of growth, so obviously, we've got some momentum here. We gained share in a very competitive market while holding margins stable. We had double-digit growth in our high-end hardware products for the quarter, which reflects the demand for flash as well as the capacity increase linked to mainframe demand. Our all-flash array offerings once again grew at a strong double-digit rate and faster than the high-growth all-flash market. In our storage software, which is reported in Cognitive Solutions and a major contributing to our storage business, had strong revenue from our cloud object storage offerings.

Looking at profit for Systems. Our margin was down slightly year-to-year and up sequentially, consistent with product cycle dynamics. And so now I'll go quickly through cash on the balance sheet, and Jim will wrap up with the segments in the context of 2018. We generated $7.8 billion of cash from operations in the quarter, excluding our financing receivables. We invested nearly $1 billion in capital expenditures and generated $6.8 billion of free cash flow. For the full year, we generated $16.3 billion of cash from operations, excluding financing receivables. We invested $3.3 billion in CapEx this year, mainly in cloud, in support of our services business. And so we generated free cash flow of $13 billion. And as I mentioned, our cash realization was strong at 116%. That's up 17 points from last year. You'll recall that we expected our free cash flow to be roughly flat for the year. At $13 billion, we're up $1.3 billion year-to-year, so obviously, we delivered a much stronger number. Relative to what we expected, we were more efficient in the deployment of capital expenditures, which was down about $400 million year-to-year. Additionally, because of the mix of business and the strong working capital performance at the end of the year across collections and our factory program, we drove better cash performance.

With that free cash flow performance, we've returned almost $10 billion to shareholders, including dividends of $5.5 billion and $4.3 billion in gross share repurchases. We bought back over 27 million shares, reducing our average share count by just over 2%. At the end of the year, we had $3.8 billion remaining in our buyback authorization. Now looking at the balance sheet. We clearly have the strength and flexibility to support our business over the long term. We ended the quarter with a cash balance of $12.6 billion, higher than a year ago as the bulk of our 2018 debt maturities will occur earlier in the year. Total debt was $46.8 billion, of which two-thirds was in support of our financing business. The leverage in our financing business is 9 to 1, and the credit quality of our financing receivables remains strong at 53% investment-grade, a point better than both September and last December.

Given that this is the year-end call, I wanted to give you a quick update on our pension plans. Our U.S. plan has been frozen for some time, and we've been remixing our asset base toward a lower-risk, lower-return profile. At the end of 2017, in aggregate, our worldwide tax qualified plans are funded at 100%, up a couple of points from a year ago, so our plans are in really good shape. We provided information on the performance of our retirement-related plans and year-end 2017 assumptions in the supplemental charts. So now let me turn it back to Jim. Thanks, Martin. Let me take a couple of minutes to wrap up. We've been doing a lot of work to reposition our business, to help move our clients to the future, investing, shifting skills and reallocating capital. In short, a lot of heavy lifting. And our results for 2017 reflect that, with an improvement in revenue and our gross profit trajectory in the second half. Let me make a few comments on 2017 by business and how it positions us for 2018. In Cognitive Solutions, we're driving good results across most of our solutions portfolio, including our Watson and security offerings. Most of these new areas have a software-as-a-service delivery model. And so for 2018, we'll continue to build scale in these as-a-service businesses. In our Services segments, we've got some momentum in Consulting, driven by our digital offerings and strong growth in our cloud content as we help our clients to build out hybrid environments. As you know, the majority of Services revenue in any given year comes out of the opening backlog. As we enter 2018, the projected revenue from the current backlog points to an improved revenue trajectory in 2018 versus 2017, and that's in both GTS and GBS.

In Systems, we had a great year. Looking to 2018, we have a strong start to our new z14 and are introducing POWER9 systems and have the most competitive storage offerings in some time. And then across our businesses, our Strategic Imperatives revenue was up at a double-digit rate to $36.5 billion for the year, which is now 46% of our revenue. So when you take all of this together, we're entering 2018 with a stronger revenue profile than a year ago. In 2018, we'll maintain a high level of investment. This is important as we continue to build out capabilities in AI, in cloud, in security and in blockchain, just to name a few. As always, we'll look for more productivity in our spend base, especially in our Services business, where we'll continue to remix our skills to new opportunities. And then let me comment on tax. Tax reform provides additional flexibility over the longer term. Our 2018 rate will reflect the implementation of tax reform, which includes a lower U.S. corporate tax rate, offset by the broader tax base and reduced foreign tax credit utilization. This translates to an ongoing operating rate for 2018 of 16%, plus or minus 2 points, which is a 4-point headwind year-to-year. This, as always, excludes any discrete items we will have. Putting it all together, we expect to deliver operating earnings per share of at least $13.80. I want to briefly comment on two other items with respect to our earnings per share expectations.

First, regarding the skew of our business. We expect to deliver between 17% and 18% of the full year expectation of at least $13.80 in the first quarter, which is consistent with the average over the last 5 years. You'll recall, the last couple of years, we've had a benefit from a discrete item in the first quarter. We anticipate a potential benefit again this year. And as in the past, we will likely take actions that will offset some portion of the benefit. This is reflected in the first quarter skew. And then second, there are two accounting changes that will be effective in 2018 that will affect our results and are included in our expectations. One helps operating earnings per share, and the other hurts. And they essentially offset each other within the $13.80 of operating earnings per share in 2018. Now looking at cash flow. We had a very strong end to 2017. Martin mentioned a couple of the drivers, which provide some context to our 2018 expectations. We were more efficient last year in the deployment of capital and, in 2018, we're allowing for some growth in CapEx. In addition, we had a strong finish in receivables performance in the fourth quarter, primarily because of the mix of business that creates a year-to-year headwind in 2018. And we also expect a headwind from cash tax payments in 2018. At this point, it looks to be about $600 million year-to-year. Put all of that together, and we expect free cash flow of about $12 billion in 2018, which results in free cash flow realization well over 100%. So we're building momentum across our business but, as always, more work to do. And with that, let me turn it back to Patricia for the Q&A.

Thank you, Jim. Before we start the Q&A, I want to highlight a couple of points. First, as Jim mentioned earlier, he and Martin will address your questions together. Second, there are supplemental charts at the end of the slide deck that offer additional details on the quarter and the full year. Now, operator, let's open it up for questions.

Jim and Martin, congrats to both of you on your new roles. Jim, your guidance calls for some revenue growth and margin stability here in 2018. And I was hoping you can share some color on the key puts and takes here as it pertains to your EPS guide. It looks like tax is going to be a big headwind, and if you could quantify sort of that in relation to the operational improvement. And if I could, Martin, could you just comment on what drove the decline in Strategic Imperatives and the Cognitive Solutions segment in 4Q, that would be helpful as well.

Okay, thank you, Wamsi. I appreciate the opening question, and thanks for the comment on the job movement. As you can imagine, when we enter any year, there are multiple scenarios around how we position the full year guidance. And in this year, especially given the improvement that we've seen in the second half of 2017, and taking into account that trajectory of our business and all other operational indices, all of this supports our guidance of at least $13.80. Now as I stated in my prepared remarks, let me first start with tax. Our 2018 operating tax rate of 16%, plus or minus 2 points, incorporates the new tax law. This is a 4-point headwind year-to-year compared to our 2017 operating tax rate of 12%. Both of these are before any discretes. In terms of discretes, like we've had in recent history, we do anticipate some potential benefits from tax discretes. And as in the past, we will likely take action to offset some of those benefits as we always look to position our business for the long term. Taking all of this into account, tax will be a headwind in 2018 year-to-year. Now in terms of the other drivers as you asked. Given our trajectory exiting 2017 and the confidence we have in our portfolio and how we've repositioned it, we do expect revenue growth at current spot rates for 2018. We see stabilization of our margins on a year-to-year basis, driven by the continued scale-out of our cloud business as we drive efficiency, and we're also going to get yield from our services productivity improvements. And this will start in first quarter. And looking at expense, there are many different dynamics here. And I want to make sure we get this right. We're going to continue to invest at a high level to drive the strategic growth areas while we will continue to deliver our base productivity. And as you saw in fourth quarter, we'll continue to see an expense headwind due to currency hedges. And in terms of IP, we're not planning on any year-to-year profit contribution. We continue to have a strong opportunity pipeline. We believe in this model, and we'll continue to be opportunistic in leveraging the monetization of our IP over the long term. Now let me just conclude on a little bit of color on first quarter, and then I'll turn it over to Martin. In first quarter, as I said, we expect our earnings per share skew to be between 17% and 18%. That is on average of the last 5 years, and it's above the last two years. We're maintaining our momentum, as I talked about, but we do see revenue growth, both at actual rate and constant currency, and constant currency similar to fourth quarter. And the annual effective tax rate, as we talked about, we anticipate a potential tax discrete benefit in our first quarter. And similar to the last couple of years, we are evaluating potential actions that will offset some of these, and both of these are included in our guidance overall. So hopefully, that gives you a little color, and I'll turn it over to Martin.

Yes, thanks, Jim. So let me give you a little color on Cognitive Solutions for last year. So keep in mind that the majority of our business in Cognitive is annuity-based. And that includes, by the way, the SaaS offerings, which are growing quite well. Where we saw weakness, as we noted in the prepared remarks, was in a couple of traditional analytics offerings like data integration and content management where we either have to go spend some more time getting those offerings better developed, and we did come out with some new wins at the end of the year, but it wasn't soon enough to have an effect in the year, or we're shifting some of those license models to as-a-service. So we don't see a difference in the secular trends, we still believe Cognitive Solutions is going to be driven by the shift to analytics, the shift to cloud, the shift to security. We see that continuing. We just have a couple of offerings here that either we're shifting aggressively or we have to see how the new offerings perform in the marketplace.

I'd like to just clarify the guidance, please. You keep talking about a tax rate in 2017 of 12% but, with discretes, it was actually under 7%. And so are you saying you believe that your actual reported tax rate can go from 7% to 16% in 2018 and you can deliver $13.80 in earnings? Or do you know now that you have significant discretes and that your real tax rate that will be reported will be dramatically lower? Because it's very difficult to get the bridge, I think, with the tax rate that's really, in effect, almost 1,000 basis points steeper. And then separately, I'm wondering if you can just comment on the erosion in operating profit margins in both GBS and in Technology Services & Cloud Platforms. The margin erosion there was actually the worst we've seen in history on a pretax basis. That did not appear to be an improvement as you expected. I think, if you back out the tax rate, you actually missed your guided EPS by $0.40 relative to a 15% tax rate. And it all seemed to come from the margin erosion in those businesses. Perhaps, you could address that a little more directly, please.

Sure, Toni. It's Martin. I'll highlight a couple of points. When we provided guidance at the beginning of last year, we indicated that our annual effective tax rate would be between 12% and 18%, and we ended up at the lower end of that range. As you mentioned, we experienced a few discrete items in the first half of the year, but nothing new in the second half, which contributed to a lower effective rate. We're aiming to provide clarity on taxes for next year, so I appreciate your patience as we delve into that topic. The annual effective rate increase from 12% to 16% is the headwind Jim referred to, and as always, we expect discrete items to occur. I can't recall a year without them. We anticipate one in the first quarter, which will be mostly offset. From a modeling standpoint, we’re discussing a range of 12% to 16%. It's important to note, however, that the year-over-year tax headwind is significant, and we do not foresee achieving the same number we reached this year at the $13.80 level. The 12% to 16% range is appropriate. Regarding the decline in operating profit margins, we were hoping for sequential improvement in gross profit. We mentioned in July that we would see improvement from the first half to the second half, and we also indicated this in January. By the fourth quarter, we managed to improve by about 2 points, though we believed we could have reached around 2.5 points. The shortfall was primarily due to two factors: a lower mix contribution from our strong Systems quarter, which, while high-margin, is not as high-margin as our Software business, and some of the productivity we expected from Services has been delayed, although we weren't hugely surprised by the TS & CP revenue performance, given the ongoing discussions about contracts. For GBS, we noted that as we achieve consistent signing growth, it would lead to backlog and subsequently revenue growth. We did witness some nominal improvement in revenue trends, but it hasn’t been sufficient for overall growth yet. However, as Jim pointed out, we expect to have a much better backlog as we enter 2018.

And we also expect the margin trajectory in both of those businesses to start off and improve as we move forward to the year.

I appreciate the commentary around the first quarter skew and expecting revenue growth at constant currency in the first quarter. I wonder if you can provide some clarity as well on margin stabilization for 2018. Is that stabilization for the full year? And how would you think the first half versus second half looks like as it relates to year-on-year margin trends?

Yes. Thank you, Katy. This is Jim. So I'll take that. As I stated in my prepared remarks, the skew is 17%, 18% of the full year on EPS, which is on the average over the last 5 years, but it's also above the last couple of years. Embedded in that, we do see the stabilization of margin on a year-to-year basis starting immediately in the first quarter. We entered the first quarter with some good strength, and we feel very good about our portfolio lineup, strength in our transactional businesses coming out of mainframe where we're ahead of the product cycle in the first two quarters, we have enclosed the highest fourth quarter shipped MIPS in history, and it's evident that the market has capacity demands and continues to see the value of that platform. So we see very good performance in our Systems lineup. By the way, Power grew, storage grew. So we had pervasive growth in the fourth quarter, and we feel very strong coming into first quarter. Second, we do see software having growth in the first quarter, and that's just due to the mix between annuity and transactional. As Martin indicated during the prepared remarks, we continue to drive high renewal rates, and we continue to drive the annuity content of our business. And just given the dynamics there, that will give us growth in the first quarter, and it's going to give us mix and margin benefit in the first quarter overall. And then finally, Services, as I stated, we do see revenue from opening backlog, which, in the first quarter, given it's right in front of us, is almost about 90% of the first quarter revenue needed. And it does show improved trajectory throughout 2018. And I'll remind you, throughout '17, we talked about the headwinds we faced in our TS & CP business around some large contract conclusions that was delayed in 2017. We didn't realize it until the very end. We are going to start off 2018 in a much better position on margin, and we see overall stabilization beginning immediately.

I guess, maybe I just want to focus more explicitly on gross margins and how you guys think gross margins will stack up in 2018. I know you've talked about margin stabilization, but it would be helpful if you just talk about how do you see gross margins in 2018. And then what are the levers that you think can enable a gross margin expansion environment in '18 for you guys, given the fact you are talking about revenue growth?

In 2018, we expect our margins to stabilize. This will come from a few key areas: first, the continued growth of our cloud business; second, improvements in the productivity of our services as we leverage completed contracts; and third, achieving operating leverage by returning this business portfolio to growth. We will continue to make strategic investments to position ourselves for success in key growth areas and to ensure the long-term success of the company. We will enhance our base productivity and scale our as-a-service offerings as we move ahead. We saw strong progress and indicators in the second half of last year. Across our portfolio, we will benefit from contributions in our Cognitive Solutions business segment, driven by our product lineup and the strength of our Watson offerings, security features, and industry verticals. We expect to see margin and productivity gains from our services businesses, GBS and GTS, and we will achieve scale efficiencies from our as-a-service and cloud-based segments.

Yes. Additionally, I want to highlight that the margins in our Strategic Imperatives are consistently higher than those in the rest of our business. It's important to note that our entire business operates with high margins, typically around 49% to 50%. We are focused on building these aspects of the business. The areas we are transitioning to are expected to generate higher margins compared to where we are currently, and this shift alone will provide us with additional content. As Jim mentioned, in any scalable business, we have already overcome the most challenging periods, and we are steadily creating more scale every day.

Just one clarification and a question. Did you guys say that the revenue growth for '18 can grow for full year, both reported and constant currency? And then also wanted to understand more on this topic of scale, which has become the common thread throughout the call today. What are kind of the key metrics that you're looking to that your algorithms internally state in terms of the cloud as a percentage of revenue and also Strategic Imperatives as a percentage of total revenue? What do those need to glide to, to get to greater scale, so you can start talking about incremental operating leverage returning to the story, i.e., 50% gross margin and 20% plus operating margin?

Yes. So thank you, Mark, for the question. So yes, a couple of questions. Let me start with the first one around revenue growth. We did state that based on the trajectory in the second half and how we made significant improvement, and the confidence we have in our portfolio and the strength in winning in key market segments, that we see revenue growth for the full year at current spot rates. I also said that starting in the first quarter, we see revenue growth both at actual rates and current spot rates. Now I will tell you, one, we've got a lot of momentum that we built up through the second half. But 2018, there's a lot of work to get done. We have best visibility of what the quarter we're in right now with the 90 days and all of the operational indices around what the profile of our business looks like, and we're very confident that we will grow at both constant currency and at actual rates. And we got a lot of work to do the rest of the year, and we fully expect that we're going to continue that momentum, and we'll update you as we go through the year on that.

In terms of scale, we have a significant backlog of over $120 billion in our Services business that is transitioning to the IBM Cloud. We're currently in the process of this transition, which includes not only the development and migration of new SaaS properties with strong margins but also the creation of a Platform-as-a-Service and surrounding ecosystems. While we have made some progress, we still have a long way to go. Moving our entire services platform to the IBM Cloud will provide the scale necessary for the infrastructure layer, application management, and efficient SaaS delivery, so we anticipate substantial growth in scale ahead.

I know you're always excited to hear my suggestions. One would be to provide a bridge, an earnings bridge, which some companies do, and we're obviously all trying to get at that. But a couple of points I wanted to touch on. One would be currency in terms of a bridge, I assume that's positive to EPS. Another is investments. It's very hard to understand. Are your investments increasing year-over-year at a slower rate than they've been? Are they actually declining year-over-year? And then charges. So you're kind of suggesting there's going to be charges that maybe offset some of the discretes on tax. Can you give us a sense of what charges for the year might be like? And there's obviously a lot of speculation about GTS. You're talking about moving things to the cloud, I'm assuming it'd be related to that in part.

Thanks, Steve. I appreciate it. And believe me, as we get to know each other, I'm always looking for suggestions.

Yes, I was going to say, Steve, we only have a thing about multipart questions, not multipart suggestions. We're happy to get those.

Let's start with currency overall. In the fourth quarter, currency finally became a tailwind for IBM, contributing 2.7 points, which equated to approximately $600 million on the top line. This change is due to various foreign exchange rates in different countries. We maintain financial discipline in our model and hedge currencies to manage volatility in our business. Overall, the impact of currency during the period was minimal, at most just a couple of pennies. However, in the long run, this allows us flexibility in pricing, sourcing, and business dynamics. We have been navigating these challenges for quite some time, and we are pleased that the situation is finally improving, and we intend to leverage this moving forward.

I guess, just a couple of quick ones, if you guys don't mind. I know you got a lot of questions around the stable margin outlook. How much of that is coming from expected productivity versus mix and changes in investments? And the second one, just to better understand the tax point here. Just is your capital allocation going to change at all? I heard a little bit about the CapEx, which makes sense, but just wanted to make sure, any change in assumption around capital deployment post-tax?

Thank you, Tien-tsin. This is Jim. Let me discuss the margin aspect. Throughout this call, we have emphasized our focus on two key areas: restoring revenue growth and stabilizing margins year-over-year. We are confident that we have effective plans in place. When I think about margins, I separate them into a few categories. Firstly, we will continue to enhance base productivity, which is essential to our financial model and meets our clients' needs as we support them in leveraging technology and expertise for their evolving businesses. This should lead to an overall margin improvement of about 0.5 points. On the other hand, we will keep investing in our business to strategically position ourselves for success in key growth segments. I mentioned AI, cloud, security, and new areas like blockchain. Recently, we announced a partnership with Maersk focused on global trade distribution and are actively building and scaling that platform. Our investment efforts will persist. Lastly, the mix will also contribute. This will stem from driving revenue growth in highly profitable sectors, particularly within our Cognitive Solutions area, which will create operating leverage for IBM overall.

We've been strong advocates for fundamental tax reform for a long time, and we're thrilled that it has finally happened. In the short term, we've taken a toll charge to adjust from one tax system to a territorial system that we've supported. We will pay this charge, and as mentioned, it contributes to our cash flow guidance, which includes a cash tax headwind. However, we believe this is a long-term benefit as it allows greater freedom for capital movement. Currently, we have $12 billion in cash globally, but we do not have a large cash reserve outside the U.S. We've always had good access to our cash, and the timing of tax reform did not pose any issues for us, so there will be no changes in capital allocation. Our ability to grow dividends and lower share count comes from having strong cash flow and sufficient funds to reinvest in the business. While we support tax reform and are pleased it occurred, it is not a near-term capital event for us.

Okay, great. I'll ask a question about Systems, and I have a few parts to it. First, I'd like to know how long the mainframe cycle might last, as it typically provides at least two or three strong quarters. Additionally, regarding storage, you seem to be performing very well. Is your all-flash mix now over 50% or 60%, suggesting a good year ahead? Lastly, you've introduced an AI chip, POWER9. Does that belong to the systems sector, and have you seen any traction with it yet, given the current focus on AI?

Thank you, Lou. I appreciate your question. We are very pleased with our overall Systems performance in the fourth quarter, which extends beyond just mainframe. Let’s start with mainframe. I'm very happy with our performance as it demonstrates our ongoing modernization and the establishment of a lasting platform. Our strong value proposition is resonating well in the marketplace, allowing us to handle mission-critical workloads while also opening up new profit opportunities through our pervasive encryption capabilities. We are seeing significant market interest in our new workloads related to Linux, HANA, and emerging areas like Blockchain. In the second quarter, and for a few weeks in September, we achieved 71% revenue growth at constant currency and shipped the largest MIPS in any quarter in our history. Our MIPS installed base has grown by double digits year-over-year and is now 2.5 times what it was a decade ago. This performance exceeds that of the prior cycle and is consistent with the z12 from a few years back. While we have various scenarios in play, we provided guidance of at least $13.80 and have a strong team committed to driving innovation within this platform, aiming for better outcomes than the typical cycle. Our guidance does not depend on any significant changes to that outlook. I’m also glad you mentioned Power and storage, as we were very satisfied with the results in the fourth quarter. Power grew by 15%, and we began shipping the first POWER9 architecture with the Cora win, winning two out of three bids. So we see a strong start for the POWER9 architecture, and we plan to roll out the remainder, particularly our low-end products, starting in the first half and into the second half of the year. We anticipate continued momentum in our Power portfolio. Lastly, on storage, this is the first year in quite some time that we have experienced growth in storage for four consecutive quarters. This success stems from our storage team’s efforts in repositioning the portfolio, increasing market share in flash storage, and focusing on software-defined storage. Importantly, we are also looking to grow in object storage moving forward. Overall, we are very happy with our system portfolio and expect this trend to continue.

It’s an interesting question, Lou. Since this is only about Systems, it doesn’t count as multipart. We often receive questions about what's cyclical and what's secular. When we reflect on why we began discussing the Strategic Imperatives, these represent the secular changes in the enterprise IT landscape. They focus on cloud, security, analytics, and mobile. While your question was about a product perspective, it’s important to remember that the secular trend these products are related to is ongoing. The demand for mainframes is driven by the long-term trend in security. It’s not just that there's a new mainframe that prompts a purchase, nor is it simply about the introduction of POWER9. These machines are designed to handle the most contemporary workloads. We introduced these shifts and secular concepts through the Strategic Imperatives, and all of our offerings align with that trend. The relationship between mainframes and security serves as a solid example, as does POWER9 and analytics. Additionally, as Jim mentioned, storage transitioning to the cloud requires object storage, and our offerings in that area are performing exceptionally well. Thus, distinguishing between cyclical and secular aspects isn’t as straightforward as some may suggest; it really pertains to whether these offerings are connected to long-term secular trends, which our Systems business clearly is.

Welcome, Jim, and congratulations, Martin. I was wondering if you could maybe give us a little bit of color on a constant currency basis for the revenue outlook, and which of the segments' constant currency you would expect to be up versus any that you expect to be down?

Okay, thank you, Jim, for the question. As I stated before, our full year guidance of at least $13.80 is predicated on us delivering revenue growth at current spot rates. I said that earlier because we got a lot of work to do. And while we've got great momentum that we built out in the second half, and we feel very confident about our portfolio across the board, the best line of sight that we have right now is first quarter. And in first quarter, we will deliver revenue growth, both at actual rates and at constant currency. And let me just give you a little color underneath that. If you start with Cognitive Solutions, as Martin said earlier in one of the Q&As, we have repositioned through strategic investments in many different areas that portfolio and have been generating tremendous penetration in our annuity content. Today, in Cognitive Solutions, annuity is about 80% of that portfolio. And underneath that, it's being driven by a strong acceleration in Software-as-a-Service in the mix. Over the last 12 months, our Software-as-a-Service is up 30% overall. So we see, just based on the annuity versus transactional seasonality of first quarter, we will grow Cognitive Solutions at a constant currency level.

In both of our services areas, which, as we talked about earlier, pretty consistent performance throughout the second half, we are actually opening up our backlog with a runout that is showing improvement year-to-year from where we were opening last year. So while our total backlog at $121 billion is up 2% overall, down 3% at constant currency, that backlog and the composition of that backlog gives us much more better confidence and will make sequential improvement in our revenue growth trends as we move throughout the year. And then Systems, coming off of a phenomenal fourth quarter of 28% growth, growth across all 3 platforms, we expect growth to continue, albeit probably not at that rate, but it will continue as we continue to leverage the value of our mainframe proposition and start scaling our Power and the continuation of performance in our storage area.

I believe you may have already addressed that. To clarify, the services are crucial for your outlook in 2018. While both segments are experiencing challenges, the growth dynamics for tech services and cloud are somewhat unclear. Could you discuss customer losses from the first half of 2017 and mention how the backlog is opening up as we transition into the first half of next year? Considering that, apart from the usual execution risks, is there any reason to think that the growth rate of that business won't pick up again as the year goes on, especially as we navigate past the tough comparisons in the latter half of the year?

Thank you, David, for the question. Let me provide some additional details about our Services and specifically about our Services backlog. Our GBS business started the year with a backlog expected to generate about two-thirds of its revenue for the fiscal year. We still have around one-third of the revenue that we need to sell and bill to convert that backlog into revenue, but the two-thirds of backlog reflects a significant improvement compared to the start of 2017, showing progress as the year continues. We've successfully transformed our Consulting business, leading to backlogs that drive revenue growth. We've achieved two consecutive quarters of revenue growth in Consulting and finished the year with GBS signings increasing for four quarters straight. Our current focus is on our AMS business, where we're assisting clients in migrating to the cloud and leveraging AMS's established value. I see GBS improving as we proceed through the year, and if we execute our plans effectively, I believe we can achieve growth in our GBS business by the year's end. For GTS, which has longer project durations, the opening backlog stands at approximately 75% to 80% or slightly higher. Like GBS, we need to complete about 20% of our work to realize that revenue, but the 80% backlog is in significantly better shape than at the start of 2017. To conclude, I'm pleased with the work we've accomplished over the past year to reposition our business, and I hope you’ve noted that we are entering with a stronger revenue and margin profile. While there’s still more work ahead, I look forward to sharing our progress and continuing this conversation as we move into 2018. Thank you for joining the call.

Thank you, Jim. Before we begin the Q&A session, I want to highlight a couple of points. First, as Jim mentioned earlier, he and Martin will address your questions together. Second, we have additional charts at the end of the slide presentation that offer more information about the quarter and the entire year. Now, operator, let's open it up for questions.