Patricia Murphy - VP, IR Jim Kavanaugh - SVP and CFO

Wamsi Mohan - Bank of America Merrill Lynch Steve Milunovich - UBS Katy Huberty - Morgan Stanley Toni Sacconaghi - Bernstein Tien-tsin Huang - JPMorgan Jim Schneider - Goldman Sachs David Grossman - Stifel Financial Keith Bachman - Bank of Montreal Jim Suva - Citibank Amit Daryanani - RBC Capital Markets

Welcome and thank you for standing by. At this time, all participants are in a listen-only mode. Today’s conference is being recorded. If you have any objections you may disconnect at this time. Now, I will turn the meeting over to Ms. Patricia Murphy with IBM. Ma’am you may begin.

Thank you. This is Patricia Murphy, Vice President of Investor Relations for IBM, and I’d like to welcome you to our second quarter earnings presentation. I’m here today with Jim Kavanaugh, IBM’s Senior Vice President and Chief Financial Officer. Our 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 also remind you that certain comments made in this presentation maybe characterized as forward-looking, under the Private Securities Litigation Reform Act of 1995. Those statements involve a number of factors that could cause actual results to differ materially. Additional information concerning these factors is contained in the Company’s filings with the SEC. Copies are available from the SEC from the IBM website or from us in Investor Relations. Our presentation also includes certain non-GAAP financial measures in an effort to provide additional information to investors. All non-GAAP measures have been reconciled to the related GAAP measures in accordance with SEC rules. You’ll find reconciliation charts at the end of the presentation and in the Form 8-K submitted to the SEC. So with that, I’ll turn the call over to Jim.

Thanks, Patricia, and thanks to all of you for joining us. In the second quarter, we delivered $20 billion of revenue, $3.4 billion of operating pretax income and $3.08 of operating earnings per share. Overall, it was a good quarter. We grew revenue, operating gross profit, pretax income, and earnings per share with strong pretax margin performance. Our revenue was up 4% as reported with growth in all four of our major segments and our constant currency revenue growth was 2%. This is our best constant currency growth in seven years. And our pretax income was up 11%, reflecting good operating leverage on that revenue growth. Looking at our performance at constant currency. The revenue trajectory improved in both services segments and both returned to modest growth. This is important to our overall revenue growth profile as services represents about 60% of our revenue on an annual basis. In Cognitive, we had good performance in analytics and in our industry verticals, driven by financial services, and IoT. Growth was mitigated by the same three areas I told you about on our last call as we continue to focus on repositioning these offerings. And we had strong performance and gained share in our Systems business, which was up over 20% with growth across all three hardware platforms. Across our segments, we had continue momentum in our strategic imperatives revenue. Over the last 12 months, our strategic imperatives revenue has grown to $39 billion, which represents 48% of IBM's revenue. And within that, cloud is now $18.5 billion. Our strategic imperatives revenue in the quarter was up 15% and accelerated to 13% at constant currency. Revenue performance this quarter was led by security and cloud. Security was up about 80% this quarter, driven by strong demand for the pervasive encryption of IBM Z and growth in our integrated software and services business. Cloud revenue was up 20% or 18% at constant currency, driven by our as-a-Service offerings. We’re exiting the second quarter within as-a-Service annual run rate of over $11 billion, which is up about 25%. This reflects our success in helping enterprise clients with their journey to the cloud and we’re becoming the destination for mission-critical workloads in hybrid environments. We’re capturing this high-value growth with our unique differentiation of the innovative technology combined with deep industry expertise underpinned with trust and security, all through our integrated model. You saw that this quarter in a long-term partnership with the Australian government, valued at about $740 million to automate and digitize government services, leveraging IBM systems, software, and cloud-based solutions. We expanded our work at Crédit Mutuel, who is using the IBM Cloud, security, IBM Z and Watson to drive its next wave of transformation across its business lines. We delivered the world’s most powerful supercomputer to the U.S. Department of Energy. We had competitive cloud wins at leading companies like ExxonMobil, Amtrak and Telefónica de España. We signed a deal with Anthem where we will help them drive their digital transformation to deliver an enhanced digital experience for millions of health plan consumers. And in total, we signed 13 services deals over a $100 million this quarter. These are just a few of the new client engagements that will play out over the coming quarters and years. And putting this together with our first half performance, we continue to expect to deliver at least $13.80 of operating earnings per share for the year. Before getting into the detailed financial metrics, I want to provide a perspective on the drivers of our operating earnings per share growth for the quarter. What it shows as we deliver 5% growth, despite a significant tax headwind? So, let me break it down. Our 4% revenue growth contributed $0.10 of earnings per share growth at constant margin. We realized good pretax operating leverage on that revenue growth with 11% growth in pretax income and we expanded our pretax margin by 110 basis points. About two thirds of that pretax income growth came from gross profit dollars, which were up 2%, driven by profit growth in Global Business Services and Systems. Gross margin was down 60 basis points year-to-year, about half was due to mix and half from the continued investments we’ve been making to build out our IBM Cloud. Productivity was fairly neutral to the year-to-year gross margin dynamics in the quarter. And as we discussed last quarter, the benefit from actions we took earlier in the year will ramp up in the second half. The remaining third of the pretax income growth came from efficiencies we’ve been driving in our expense structure. And then, as I said, tax was a significant headwind, driven primarily by discrete tax benefit last year. Finally, a lower share count contributed to growth. Putting it all together, we delivered the 5% growth with good contribution from revenue, pretax margin expansion and to a lesser extent, share repurchases. Looking at our key financial metrics. As I said, revenue was up 4%. Currency contributed 2 points, which is about half the contribution, based on the spot rates at the time of our first quarter earnings call. And I’ll remind you, the significant volatility in currencies has implications across the income statement, not just revenue. Constant currency revenue was up 2%, which is essentially all organic. I’ll talk to revenue on a constant currency basis going forward. Our revenue growth was broad-based across geographies and sectors. We had growth in more than 60 countries, representing over 80% of IBM’s revenue. EMEA growth accelerated to 4%, led by Germany, the UK, France and Spain with pervasive growth across business areas. Looking at our operating pretax income growth of 11%, I said that about one-third of that was from operating expense, which was better by 2%. This includes a 2-point impact from currency, which is significantly less than the first quarter impact due to the dollar strengthening. And so, our base expense was better by 4%. As we continue to invest to build our innovation pipeline in areas like AI and security and blockchain, we’re also realizing acquisition synergies and driving operational efficiencies by streamlining our management system, scaling agile and implementing new ways of working. I talked about some of these in our webcast back in March. And we’re seeing the benefit not only in improved speed and responsiveness, but also in a more efficient structure. Within expense, we also absorbed a lower level of IT income, which was down $115 million year-to-year in the quarter, and about $240 million in the first half. Our operating tax rate of 16% was up nearly 7 points with just over a point from the underlying rate and the balance from last year’s discrete tax benefits of a $170 million. Looking at the cash metrics. We generated $1.9 billion of free cash flow in the quarter and $3.2 billion in the first half, which is down $400 million year-to-year. Our solid working capital performance was more than offset by a cash tax headwind and growth in capital investments, consistent with what we discussed earlier in the year. Remember, there’s a lot of seasonality in our cash generation. And over the last 12 months, we generated $12.6 billion, that’s 111% of GAAP net income. Now, turning to our segments. Cognitive Solutions had $4.6 billion of revenue, which was down 1% at constant currency. We had continued growth in our as-a-Service revenue, exiting the quarter within annualized run rate of $2 billion. Within Solutions Software, we’re scaling new platforms and solutions with growth in several key areas, I’ll name a few. Growth in our underlying analytics platform was led by DB2 portfolio, our data science offerings and our new IBM Cloud Private for data offering, which makes data ready for AI across the clouds. In our Watson platform, the AI platform for business, growth reflects strong demand for our new virtual assistant offering with triple digit growth in our conversation service usage. Clients using Watson Assistant include Bradesco, Orange Bank, Autodesk, Royal Bank of Scotland, Vodafone and LivePerson, to name a few. Watson is both a platform on its own and a driver of growth in differentiation in several of our industry verticals. Our industry verticals continue to scale, led by IoT and Watson for Financial Services. IoT growth was driven by Maximo, which is the number one asset management solution, and Tririga, the number one facilities management solutions. Financial services reflect strong performance in our risk and regulatory business and financial crimes portfolio, leveraging our promontory skills and AI technologies. In Watson Health, we had good performance in areas like payer and life sciences. And in emerging areas like blockchain, we’ve now seeded the market with over 60 active blockchain networks. This quarter, we launched We.trade with nine large banks including Deutsche Bank, HSBC, KBC and Natixis. This is the first live blockchain-based bank-to-bank trading platform. Growth in these areas is offset by a transition in some areas I talked about in April, specifically, talent, collaboration and commerce, which today are a combination of on-perm and SaaS offerings. We are modernizing our offerings and making investments to address the secular shifts in the market. Keep in mind, the time-to-value of these investments is longer in SaaS. Our Transaction Processing Software was down 2%, driven by declines in storage software. Within TPS, we had growth in IBM Z middleware and Power middleware. Looking at profit this quarter, we grew pretax income 9% and expanded pretax margin by over 2 points year-to-year, driven by operational efficiencies and acquisition synergies, while continuing to invest at high levels in key strategic areas such as AI, security and blockchain. Before getting into Global Business Services, let me give you a perspective on our total services business across the two segments. We continue to make good progress. Our services signings grew, the year-to-year your services backlog trajectory improved from last quarter. Services revenue returned to growth, and we had a modest improvement in the year-to-year your services gross margin trajectory. Our signings were up 6% and within that we had 13 deals over a $100 million. So, we’re clearly winning in a competitive environment. We’re addressing the fundamental shifts in the industry, like helping clients implement hybrid cloud and manage security services. This is driving a shift in our backlog content with nearly 30% of our outsourcing backlog now in cloud. And then looking at the services gross margin, it was down just 25 basis points year-to-year. I’ll remind you again that we have most of the benefits from the first quarter productivity actions still ahead of us. So, now, let’s get into the two segments. Global Business Services returned to modest revenue growth, increased gross profit dollars and expanded gross margins. We’re realizing the improved revenue trajectory from the run-out of our opening backlog for the year. Our strategic imperatives grew 6% with strong performance in the as-a-Service offerings, which were up 25%. We have talked about how we’ve realigned our practice model around three growth platforms, digital transformation, cloud application and cognitive processes. While all are progressing, we have particularly strength in digital, which again grew strong double digits. This was driven by digital business strategy and by our mobile offerings. Across these platforms, consulting revenue growth accelerated to 4% year-to-year, led by our offerings in digital and cloud. Our GBS consulting practice brings business expertise together with technology expertise to unlock value for our clients. For example, this quarter, IBM Digital and Mediaocean launched a blockchain consortium comprised of leading advertisers and publishers, including Kellogg, Unilever, Kimberly-Clark and Pfizer, to set the new industry standard for the digital ad-buying ecosystem. We’re continuing to invest recently announcing the acquisition of Oniqua Holdings, which adds technology and professional expertise and asset optimization. This strengthens our integrated IoT platform across Cognitive Solutions and GBS. Application management services revenue was down 3%, reflecting continued declines in traditional enterprise application managed services. We’re growing in strategic offerings like Cloud Migration Factory and Cloud Application Development. The increased demand in these areas has led to two consecutive quarters of double-digit signings growth in application management. Turning to gross profit. GBS’ gross margin grew 130 basis points year-to-year. We have done a lot of work to transform our portfolio and reposition our offerings to capture improved price for value, and we are also starting to see early contributions from our productivity actions around labor models and structure. In summary, GBS delivered a solid quarter, and we’re starting to see the realization of our initiatives in our results. In Technology Services & Cloud Platforms, revenue returned to growth. Similar to GBS, this performance was driven primarily by our improved opening backlog run-out dynamics. The strategic imperatives revenue in this segment grew 24%. This was led by cloud, which grew 27% and our as-a-Service revenue grew 30%, which is up about 6 points sequentially and is now at an annualized run rate of $7.6 billion. Infrastructure services revenue growth improved to 1% this quarter, as we continue to help clients on their journey to cloud. The IBM Cloud enables clients to migrate, modernize and build new cloud apps, is AI ready and secure to the core. This quarter we completed the migration of Westpac’s core banking applications to the IBM Cloud. It’s just one example of how we’re becoming the go to destination for mission-critical workloads on the cloud. We’re continuing to build capabilities, recently announcing an expansion to 18 availability zones for the IBM Cloud across the world. To expand the global footprint, it is important as clients look to maintain control of their data, as they implement hybrid, especially given the increased data regulations. In technical support services, revenue was down 4%. As is always the case with the Z launch, we’re seeing a short-term impact in our maintenance stream, as IBM Z sales move client from maintenance to warranty for the first year. The impact to maintenance is becoming more pronounced now with the higher adoption rates by existing clients in the strong current Z cycle. This impact was moderated by continued growth in our multivendor support offerings. Integration software grew 1%. We had good performance in offerings that modernize applications and enable cloud adoption. This includes offerings like IBM Cloud Private, which helps clients to develop cloud native applications behind their firewall. We’ve added a 100 new clients in the second quarter and now have over 300 clients since the product was announced at the end of last year. Turning to gross profit. Margin for the segment was down a point from last year. The majority of this decline was driven by the revenue mix away from higher margin TSS in the quarter, with the remainder driven by continued scale out of our cloud. We did have some productivity benefits, but as I said earlier, the actions we took in the first quarter will yield predominantly in the back half of the year. In Systems, we grew revenue again, as we continue to deliver innovative technologies that address today’s most contemporary workloads. All three brands IBM Z, Power and Storage grew and we gained share overall. In this second quarter, IBM Z grew revenues by 112% year-to-year on nearly 200% MIPS growth, again driven by new workload MIPS. The z14 adoption remain broad-based and after four quarters continues to track ahead of the prior program. The value prop benefits existing IBM Z clients who are growing and expanding workloads on z14 this quarter, whether it’s ecommerce sales, mobile banking volumes, machine learning or emerging blockchain services. And we are adding new clients from all corners of the globe from a managed care provider in the U.S., to a University in Canada, to an electronics distributor in Italy, to a bank in Africa. We also had good acceptance of our new single-frame z14 designed specifically for cloud environments, which launched earlier in the quarter. Power revenue was up 4% driven by adoption of our new POWER9 entry level portfolio, and continued growth in Linux. These cloud-ready systems provide leadership capabilities in advanced analytics, cloud environments, and data intensive workloads in AI, HANA and UNIX markets. We continued to roll out our supercomputers at the U.S. Department of Energy labs. As part of our deployment, the U.S. government recently unveiled the POWER9-based Summit, the world’s most powerful supercomputer which is ranked number one in the TOP500 List of commercially available computers. This is the first time in over five years that a U.S. company topped the list. Storage hardware returned to growth this quarter, after facing some sales execution challenges in a competitive market last quarter. This growth was broad-based geographically and led by strong growth in all flash arrays. Flash grew double digits across the portfolio and took share. We are coming out with new offerings, including a new midrange FlashSystem announced last week, with industry-leading performance technology. Turning to profit. Systems pretax income was up about $275 million year-to-year and pretax margin was up over 10 points, so solid performance. Moving on to cash flow and balance sheet. In the second quarter, we generated $2.9 billion of cash from operations, excluding our financing receivables, and $1.9 billion of free cash flow. And so, in the first half, we generated $3.2 billion of free cash flow, which is down $400 million from last year. This reflects solid working capital performance, offset by a $300 million increase in CapEx, as we build out global cloud data centers, and $700 million more of cash tax payments. We’ve now got the entire cash tax headwind that we expect for the year, behind us. Looking at uses of cash for the half. We’ve returned $4.6 billion to our shareholders. In April, we again raised our dividend. And with that, we’ve now tripled our dividend per share over the last decade. In the first half, we bought back nearly 12 million shares, ending June with 913 million shares outstanding and $2 billion remaining in our buyback authorization. Looking at the balance sheet highlights, our cash and total debt levels are pretty consistent with last June. About two thirds of our debt supports our financing business, which is leveraged at 9 to 1. And the majority of our financing receivables, 54% are at investment grade which is 2 points better than this time last year. So, our balance sheet remains strong with plenty of flexibility to support our investments and shareholder returns over the longer term. In summary, our performance this quarter underscores the extent to which we have repositioned our business over the last several years. As I said, nearly half of our revenue is aligned to the strategic imperatives, which represent the emerging, high-value, high-growth segments in our industry. This also reflects a major portfolio shift for IBM, driven as we discussed at our investor webcast in March, by major shifts in our capital allocation and investment strategy. Those shifts reflect our vision of what clients would value in a rapidly reordering IT industry, driven by cloud, data and AI, and that is innovative technology in key emerging areas, the expertise to apply that technology in industry-specific processes and workflows, and a commitment that their enterprise data would be handled responsibly. This is IBM’s differentiation, and we’re seeing it come through in our revenue and profit performance. This quarter, we delivered 2% constant currency revenue growth, 11% operating pretax income growth, and 5% earnings per share growth, capping off a first half where we also grew revenue, operating profit and earnings per share. As always, we have some tailwinds and headwinds as we move into the second half. But with this performance and our continued focus on driving consistent operational execution, we continue to expect to deliver at least $13.80 of operating earnings per share, and free cash flow in the range of $12 billion. And with that, let me turn it back to Patricia for Q&A.

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

[Operator Instructions] Our first question comes from Wamsi Mohan of Bank of America Merrill Lynch. Please go ahead.

Yes. Thank you. Jim, you saw some constant currency deceleration in Cognitive revenues but PTI margins improved nicely. You alluded to a few factors in there. I was wondering if you could provide some more granularity on the drivers of that PTI margin expansion between the operational efficiencies, the acquisition synergies that you alluded to and the relative pace of investment. And secondarily, your base expense decline was quite significant in the quarter. Can you talk about the trajectory of that in the second half, especially given some of the cost actions that you said are yet to be reflected, the cost actions that you took in 1Q, they are yet to be reflected in the back half?

Sure, Wamsi. Thank you very much for the question. Let me address the Cognitive Solutions segment first and talk about constant currency and then get to the operating leverage component. And then, I’ll address your expense question next. Cognitive Solutions, first of all, as you all know, our financial model for the Cognitive Solutions segment is to deliver growth and also deliver operating leverage consistent with that growth. And what we’ve been seeing over the last couple of quarters, as we’ve been driving the acquisition integration synergies across our business, we’ve been seeing that operating leverage well in advance of our actual revenue growth within that segment. We’ve also been driving operational efficiencies and synergies around redefining how we do work, redefining development optimization, applying agile methodologies in getting better speed, responsiveness, cycle time and throughput and output within our organizations. So, we’re getting more value for dollar spend overall. And you see that play out in operating leverage in that segment in the first quarter and you’ve seen it play out in the second quarter with strong profit growth of 9% on that constant currency revenue growth. So, we continue to expect that as we move forward and will continue to leverage and get value out of that business overall. In terms of expense dynamics, you heard in the prepared remarks, our operating expense was better by 2%, but there are many different components within that operating expense 2% better. First and foremost, currency had impacted our operating expense by 2 points. Now, I will tell you that was about half of the impact or even a little bit less than half the impact than we expected 90 days ago, just given the volatility of what’s been happening in the FX markets, in particular around the U.S. dollar appreciation. So, the last couple quarters, currencies impacted by expense by 4 to 5 points, now, it was only a 2-point impact. So, our base productivity was about 4% better. And that is being driven as we continue to drive the operating leverage through our enterprise productivity initiatives around reinventing IBM and how we actually do work, changing our management system, addressing our structure, attacking cost and complexity, aligning decision rights and driving accountability. So, that 4% is a base level productivity that we’re driving and we expect that going forward. And then, I’ll just add one other point and that is on IP income. You see, through the second quarter, our IP income was down by over $100 million -- $115 million I think to be exact; and through the first half, it’s down nearly $250 million overall. So, we continue to leverage and monetize the value of our research and development spending and we continue to invest in those areas, and we’ll opportunistically optimize that through many modernizations models, but IP right now is down a 115. When you bring all that together, it’s delivering substantial operating leverage to our business, as you’re seeing here in the second quarter.

The next question comes from Steve Milunovich of UBS. Your line is now open.

A fair amount of your growth in revenue and even pretax profit came from the hardware area. What are you expecting in terms of second half mainframe compares? Are we going to be down year-over-year in the third and then down pretty severely in the fourth? And then, just to follow up on your currency comments. I assume you’re losing about $2 billion of revenue in the second half relative to what you expected back in April. Have you taken actions to compensate for that to get to your $13.80, to get to your $12 billion of free cash flow?

Yes. So, thank you, Steve. Many questions there. So, let me take each one individually. First of all, yes, we had a very strong Systems quarter overall, both on revenue and on operating leverage where we grew pretax income over 10 points year-over-year. But, let’s put the quarter in perspective. We delivered 4% revenue overall, 2% at constant currency. It was our strongest constant currency revenue growth rate in over seven years. And it was led by our continued acceleration in our strategic imperatives which were up 15% at actual, 13% at constant currency. That was an acceleration from the first quarter. And within that our cloud business $18.5 billion, up 23%; our as-a-Service annualized run rate now over $11 billion, that’s up 24%; and our services businesses returned back to growth at constant currency, both GBS, which had a great quarter and TS&CP. But even if you take our Systems business and to your question around mainframe, and if we take mainframe out, you would see those same dynamics in the quarter-to-quarter acceleration of our strategic imperative business. And as you all know, in our as-a-Service acceleration of over $11 billion growing 24%, that doesn’t have any Systems business within it. And the last point I’ll bring up around top-line, then I’ll get to your other questions. We had broad-based geographic and sector growth across our business, probably the best breadth and growth across a number of countries that we’ve had in quite a period of time. 60 plus countries grew at constant currency, and that represented over 80% of IBM’s revenue. And if you extract out the mainframe cycle, we still had over 60% of our -- or excuse me, 60 countries that actually grew. And those are large countries like Japan, like UK, like Germany, France, Spain, Australia, many which are not mainframe dominant. So, we see continued momentum. Now, with regards to mainframe, I’m not going to apologize. This is the most enduring platform that you’ve seen out there, and we continue to capitalize on gaining new emerging workloads onto that platform. And we delivered substantial growth in the second quarter, over a 100% growth, and we tripled our installed MIPS inventory that we shipped. And we’re [captioning] [ph], over 60% of that MIPS ship is in specialty workloads. So through the first four quarters -- now, it’s a pertinent time to have the discussion, through the first four quarters, we are well in advance of what the prior cycle was. And with regards to your question about second half, I would expect that to continue in the second half as we move forward. We know in the fourth quarter that we got a tremendous compare, and I talked about that 90 days ago. So, we will have an impact, but we’ve got momentum in our services businesses returning to growth. And as you know that’s 60% of our business overall. Now, with regards to currency. I’m glad that you brought that up. We’ve seen dramatic volatility over the last 90 days since our last earnings call. And to put it in perspective, we had stated here 90 days ago that we expected about a 4-point tailwind in the second quarter coming off of a 5-point tailwind in the first quarter. And you see that that only ended up being a little bit over 2 points of a tailwind in the second quarter as the U.S. dollar appreciated significantly against most currencies. Now, when we look at the second half, the second half, we see about a 1 to 2-point headwind, currency will flip, and that’s about somewhere in the neighborhood of the $1.5 billion including second quarter’s $400 million that I talked about. Now, with that said, currency -- you understand the top-line dynamic of revenue, but currency also impacts margins and they impact expense. From a margin perspective, if you look at -- we’ve got two different businesses, we’ve got a product-based business and we’ve got services-based businesses. On product-based businesses, you don’t have a direct alignment of your sources of revenue and your sources of cost. So, that translation revenue impact that you see in our product-based businesses, a hardware, software and services, you will see a gross margin impact on that at the GP line. Services, where you have a much more alignment of source of revenue, of course you have basically a natural hedge, you won’t see a gross profit impact on that revenue translation. But as you all know, we drive a hedging programs to mitigate the foreign exchange volatility at a profit level. Why? Because it gives us time to address our pricing terms, our structure and our sourcing strategies. So, at a PTI level, you see a very de minimis impact in period. Currency doesn’t eliminate -- excuse me, hedging doesn’t eliminate, it only defers it, but at a profit level, it’s a very de minimis impact but it impacts the P&L differently as we move forward.

The next question comes from Katy Huberty of Morgan Stanley. Your line is now open.

Jim, as was mentioned in earlier question, investors are certainly worried about the tougher comps in the back half of this year, and the 2% growth was a nice surprise this quarter, but you’re quite at consistent and meaningful growth across the businesses. And so, my question is whether you and the rest of the management team would consider stepping up, either M&A or divestitures to more meaningfully remix revenue and set the Company on a path in a narrative around much more meaningful and sustainable growth?

Yes. As you stated, we delivered a very solid quarter at 2% constant currency. And I would say, it’s our third straight quarter of growth overall with an acceleration in terms of breadth and depth across geographies, across sectors and across countries around the world. But, let’s take a look at our portfolio. First and foremost, we are very confident in the portfolio lineup that we have here today around each of our segments. We talked about at our investor day the value differentiation of IBM. And that value differentiation is built around innovative technology, around deep industry expertise, and around trust and security, all delivered through an integrated model. And if you take a look at it, we talked about the key value differentiators as we move forward. And the value of bringing that together, I think you’re seeing instantiated now here in the second quarter with very strong growth overall in our systems platform, and the importance they play to our infrastructure, in our integrated model, you see our services base of businesses continue that trajectory improvement that we talked about starting in January of this year, we improved in the first quarter, and now we got both businesses back to growth, and we delivered double-digit signings at actual rates in the first half, which positions us well as we move forward. But, you know our model overall, we’ve done a lot of work around remixing our capital and investment to build out the portfolio that we have today. And we’re very disciplined in our capital allocation strategy. We said 70% to 80% of that capital and investment is going to go back to our shareholders in the form of share buyback and dividend and you saw us raise our dividend here in April this year, our 23rd straight year. But, the remainder is for us to use internally to build out our differentiated capability around investments in R&D and capital to drive leadership in AI, leadership in blockchain, leadership in security and leadership now in quantum as we move forward. But acquisitions are an integral part, and we’re going to continue to evaluate our portfolio and how we capitalize the value of those acquisitions, in light of the integrated differentiated strategy of the IBM Company going forward.

The next question is from Toni Sacconaghi of Bernstein. Your line is now open.

I’m wondering if you could comment a little bit more about the dynamics affecting Cognitive Solutions revenue growth. It was down at constant currency versus a pretty easy comparison. And it’s the business that has the highest percentage of strategic initiatives in it. So, it’s obviously very important for you. Can you maybe comment specifically on what’s happening with Watson Health? There were lots of press reports that a significant retrenchment in that business. And I know you said the acquisitions take time. But, you’ve had them all for at least a year. And so, maybe even comment on why you think we haven’t seen better revenue progress or what specifically happened this quarter. And then, very quickly, if you could just confirm, you talked about flattish gross margins for the year. You’re down in each of the first two quarters year-over-year. So, should we be expecting gross margins to be up about 50 basis points year-over-year in the second half to sort of hit that bogey flattish?

There is a lot you compacted in a multiple parts question, but let me try to address each piece. So, let’s start with Cognitive. In terms of our Cognitive Solutions, we have a strong portfolio in the key strategic areas around analytics, around industry verticals, around security and around IoT, and we continue to see good performance overall. But, I’ll remind you, this portfolio is a high-annuity content. Over 80% of the business is annuity with strong renewal rates we continue to drive, but that SaaS has a longer time to value and longer time to realization. But, let me unpack the segment because you got to understand the piece parts because they each fit different purposes within the overarching IBM strategy and purpose. One is around TPS. TPS declined 2% overall, and it’s about what we would expect in this area and you’ve even commented on this in the last couple quarters. We been riding the wave of the mainframe product cycle over the last three quarters and saw a pretty good growth that was unusual. Now we’re back to down 2%. This is high-value, high-profit, strategically important to our clients overall, but it’s in stable to declining businesses, and it wasn’t unexpected. And when you look at our software solution portfolio, we’ve got growth in analytics as we revamped that portfolio coming off of a pretty disappointing fourth quarter. We grew in first quarter, we grew again in second, and we got good double-digit growth in our industry verticals like financial services and IoT, and we’re seeing good growth in Watson Health. We got growth in life sciences segment, imaging, payer and we’re seeing good SaaS signings in our government segments within that business. Yes, we are driving acquisition synergies, and you’re seeing that play out; it’s well in advance of a year, and you’re seeing that operating leverage play out well in advance of our financial model around Cognitive Solutions. So transaction processing software, pretty much as expected high-value base market, software solutions, the key strategic areas that we have are growing. The focus that we’ve got and we’ve talked about this 90 days ago, three key segments around talent, around collaboration and around commerce where we are investing to modernize our portfolio to address the secular shifts that are happening in both client value and in consumption models. As you know, this business today in these three segments are both the mixture of on-prem and SaaS. And we are investing aggressively to revitalize this portfolio into a SaaS world around driving user interface improvements to make our offerings more digitally consumable, and also about shifting and investing to embed AI to deliver differentiated value for our clients overall. So, that’s Cognitive Solutions. Now, you asked about gross profit margins. So, let me take a step back and give you my perspective. Now, that I’ve been on the job six months as CFO of IBM, and I spent a lot of time with our investors and also with many of you, the sell side analysts, listening and also getting a perspective of our Company, the sentiment and the strategic positioning, and what you would like to see. And in each of those inevitably, the discussion around margin comes up. Why? Because yes, we are value-based stock. Our investment thesis is around value. Value driving profit growth at the end of the day that gives us the free cash flow flexibility to continue to return value to our shareholders and invest in our business. But, the discussion around gross profit margins always inevitably get at services. If service is deflationary and can you grow services margins? And I would tell you, I think that’s at the heart of your question around gross profit. And I’ll answer it in a couple of ways. One, talking about our financial model; and two, talking about how we manage the business. But before I get into that, first and foremost, the net answer is, as I stated 90 days ago, we expect our services gross margins to expand in the second half and we still feel confident coming off of the trajectory improvement of what we saw in the second quarter really led by strong margin expansion in our GBS business and the productivity actions we have in front of us. But, when you look at this from an overall IBM perspective, our financial model, as we talked about is low-single digit revenue growth, mid-single digit profit growth and high-single digit EPS growth. And in 2Q, you saw the instantiation of delivering that model. We grew revenue, we had PTI margin expansion of 110 basis points, strongest we’ve had in years, and we drove operating leverage to deliver 11% profit growth, well in excess of our model. So from a full year perspective, our view at an operating level in terms of profit growth has not changed. We’re going to grow profit, we’re going to grow PTI margins, and that supports our full year guidance. Now, let’s talk about how we manage the business. Because I think it’s important for our investors, and it’s important for each of you as analysts to understand this. Number one, we got two distinct different business models in our company. We got a product-based business model and we got a services based business model. In a product-based business model, hardware, software, and solutions, value is instantiated in delivering returns at a PTI level. Why? Because all the investment we make in a product-based business ends up below the gross profit margin line. And you see in our product-based businesses systems and Cognitive Solutions, we’re growing substantial operating leverage and we’re growing substantial return on investment. Now in services, as I said 90 days ago, in a human capital-based business values instantiated in gross profit margins. And we manage our services business to get a return on our human capital at the gross profit level. And as I said, at a gross profit level in services, we still expect to expand margins in the second half. The only thing that has changed in the last 90 days has been the extreme volatility in the FX world around the U.S. dollar appreciation. And as I stated earlier, we have a hedging policy that mitigates the volatility of currency in our I&E at profit level but it does impact gross margins in particular, at a product level in our product-based businesses; does not impact profit in the near term, it allows you time to then go adjust your pricing terms, your cost structure and your sourcing strategies as we move forward. So, that’s the only thing that’s changed in the last 90 days. We feel confident we’re going to grow revenue for the year at current spot rates, even in light of currency flip into a headwind in the second half, we feel confident we’re going to expand pretax margins, similar to what we did in the second quarter, in the second half, and within that we feel confident we’re actually going to deliver services gross profit margin expansion in the second half of the year.

The next question comes from Tien-tsin Huang of JPMorgan. Your line is now open. Tien-tsin Huang: So, consulting accelerated, which is encouraging. I am curious is that starting to pull in some other services revenue around it or behind it? I saw -- or you mentioned, the large [indiscernible] were good again. So, again is this enough to drive the positive FX neutral revenue growth in services in the second half, just trying to piece all those things together and think about future revenue growth for services overall, in the second half?

Yes. If you take a look at GBS in second quarter, first of all, we’re very pleased with our performance. The work that Mark and the team have done tirelessly to transform our structure, our business models, our growth platforms, the set of initiatives around productivity, we’re very pleased, and you saw that play out in continued trajectory improvement throughout the first half and returning to modest revenue growth and significant operating leverage and margin expansion, which we expect will be a big contributor in our second half services margin expansion that we talked about in the last question. Now, with that said, if you look at that acceleration and what’s been happening in the trajectory of our services business, first, as you all understand the dynamics of that business, you have to get signings that have to yield into backlog, which has to yield into revenue as we move forward. And we’re seeing tremendous momentum in our consulting base of business. We delivered 4% revenue growth, as you stated, in the second quarter. And that’s leveraging momentum around how we redesign our growth platforms, and how we redesign our service lines and offerings and practices. And we’re capturing higher value, value around digital transformation offerings that enable clients to move their journey to the cloud as we move forward, we’re doing great in our CRM practice, our workday practice, and we’re also capturing new emerging areas like blockchain, where we’re seeing good growth in our services base of business at all. And as you know and we talked about extensively at our investor webcast at the beginning of the year, GBS has a very integral part and an integrated model strategy of the IBM Company. They have the mission of bringing business and technology transformation together. So, the long answer to your question around, is consulting and GBS, a key leading indicator of dragging the rest of IBM, the answer is definitely yes.

The next question comes from Jim Schneider of Goldman Sachs. Your line is now open.

I was wondering if you could maybe kind of follow up on that prior question, talk about the ability of the Tech Services & Cloud Platform segment to start to return to growth in the back half. And clearly, we’re starting to get a little bit better signings performance. But, I’m wondering if that’s a realistic expectation for the back half for that segment and whether you can achieve it at the same time as you are expanding margins there?

Sure, Jim, and good to talk to you again. Thanks for the question. Yes. On TS&CP, similar to our discussion around GBS, we’re pleased with the trajectory improvement and the progress that we’ve been making within this business on a top line throughout the first half. We made sequential progress quarter-to-quarter. We have now returned to growth delivering $8.6 billion of revenue. So, let’s talk about a couple of the key components. First, we are capitalizing on tremendous momentum around enterprise hybrid cloud strategy. We are becoming the destination of moving and enabling our clients’ journey to the cloud. And our GTS business is an instrumental part of that strategy as we move forward. So, we got a lot of momentum in our enterprise hybrid cloud that as you see is delivering and as-a-Service annualized run rate of $7.6 billion, that’s up 30% year-to-year, and that has tremendous value as we move forward to continue getting scale efficiencies and the like. But, let’s talk about then the core GTS business overall. Infrastructure services returned to growth 1% in the quarter. And it’s really been built off of a very strong first half where we delivered double-digit signings growth at the GTS and TS&CP segment level. And now, you saw our backlog continues to improve. Our backlog now in total is $116 billion. And within that 30% of that backlog now is cloud as we continue to capitalize on the secular shift and deliver more and more value overall. Our integration software business has grown 1% and continues to grow through the first half. And what we’ve got to work on, and this is part of having an integrated portfolio and part of having success in other areas, our TSS business is down 4% but that’s a function of us significantly overachieving against our last program, our mainframe product cycle. And we see a deceleration in TSS, but we’re seeing the offset in our systems base of business going forward. So, when you look at that trajectory improvement, we returned our backlog back to flat in the second quarter in TS&CP. And again, a lot of work ahead of us. We got a few second half signings, we got a good opportunity pipeline, but I see continued trajectory improvement. And then our focus on margins as we move forward in the second half to deliver second half services gross profit margin expansion are going to be critical to our guidance.

The next question comes from David Grossman of Stifel Financial. Your line is now open.

This year, you are guiding to free cash flow roughly equal to net income, which is above your longer term target. I know it’s way too early to providing 2019 insight. However, are there any factors that are driving the ‘18 free cash flow that may not reoccur next year or even potentially reverse that we should be factoring into our thinking for next year?

Yes, David. Thank you very and good to hear from you again. Before I get to the long-term view, I mean, I think you kind of nailed it. Let’s talk about our free cash flow guidance here through the second quarter and more importantly through the first half. First of all, we talked about entering the year that we expected $12 billion of free cash flow; that was down about $1 billion. If you remember, at that point in time, we talked about we were going to continue to invest in our business in terms of capital, to build out our IBM Cloud architecture. And by the way, in the second quarter, I think you have seen the announcement where we expanded 18 new availability zones around the world. So, we are committed to winning in the cloud space, and we’re investing to go do that. But we also saw we’re going to have a significant cash tax headwind here in 2018. And then, our GAAP profit, as we start turning this business and deliver on our at least $13.80 was going to pretty much offset our strong working capital efficiency that we exited last year on with our mainframe cycle. So, through the first half, we delivered $3.2 billion of free cash flow. That’s down $400 million. But it’s important to understand the underpinnings behind that. Within that we’ve invested $300 million year-to-year, up 20% on capital already through the first half. And we’ve had strong operational pretax -- or excuse me, after-tax profit performance that’s delivered a positive contribution of $600 million to support that investment in capital as we move forward. So, when you do the math then, our entire year-to-year reduction through the first half is all driven by cash tax headwind. And that cash tax headwind is $700 million through the first half, and it’s all behind us now. So, our second half free cash flow, to your point, we’ve always said as a rule of thumb, free cash flow should follow our profit levels. And when you look at our realization, you see a playing out in our realization. We’re well in excess of 100%. And our trailing 12 months is at $12.6 billion and our attainment supports that $12 billion free cash flow level as we move forward. So, it’s too early to look at ‘19, we’ll deliver that in January, but at least hopefully the answer gives you some of the dynamics of what’s playing out within free cash flow.

The next question comes from Keith Bachman of Bank of Montreal. Your line is now open.

Hi. Thank you very much. Jim, I wanted to see if you could talk a little bit about the durability of services. You’ve talked about GBS and technology and cloud outsourcing growing constant currency in the second half of the year. Yet, backlog, total services backlog is down 1% in constant currency. So, once you recheck growth, are you still calling for durable growth in those businesses, even with backlog down? And then, my follow-up -- well, let me ask my follow-up question after that.

Why don’t you ask your follow-up question?

Well, just within GBS, something I wanted to come back to, application management is still under pressure as it is for most of the providers. And is that going to continue within the context of GBS, or you actually see application management within the confines of GBS improving?

Okay, Keith. So, thank you very much for just giving a better perspective of entirety of your multiple-part questions, so we can put this in perspective. So, let’s talk about -- I’ll drive you back to 180 days ago, when we were sitting here in January. We talked about the position where we were at. We talked about what’s going on with the dynamics of our backlog overall. And we talked about the backlog realization run-out that we saw over the 2018 period. And we said entering 2018 that we had a much stronger backlog realization or run-out I should say that we are starting with that we did entering 2017. And you’re seeing that play out as we go through the first half where we have made sequential year-to-year improvement over the first quarter and now returned both of our services businesses back to growth. Now, within that, as we stated earlier, in the human capital base services business, you got to continue fueling those signings that delivers backlog and more importantly, you got to drive the right composition of backlog that drives your backlog realization and yield, and also drives duration. And obviously what you’re seeing over time is you’re seeing I think a secular shift with regards to what’s happening to duration in long term contracts. You’re not seeing that anymore. So we’re getting higher yielding revenue, where also the composition of our backlog with consulting, which accelerated to 4%, that composition is much more shorter term and higher value, as we move forward. So, over the long run, you’re right. You got to continue to fuel signings to fuel that backlog. But I would tell you, outer years of six, seven, eight, nine, ten are very -- in today’s world, much less relevant than in period your first year, your second year, your third year in the composition. So, we do feel confident with that trajectory improvement, we came off in first half delivering good growth double digits in signings in the first half and the composition of those signings as I said, we already have 30% of our backlog that’s sitting in cloud. And by the way, over 40% of our backlog is now in key strategic imperative workloads overall. So, that’s kind of your first question. Your second question, AMS. We talked about AMS. Obviously that’s going through a secular shift in the industry, and you’re seeing that play out against all the competitors that are in the space today. But I would tell you, what differentiates IBM with regards to AMS. One, it’s our value of incumbency. The integrated play, the integrated model of IBM, the value of incumbency and the reason we’re in the AMS business is we understand our clients’ operating models, our clients’ workloads and our clients’ business processes. And we said entering this year that we were seeing success in us leveraging that value of incumbency to be the destination to help our clients with the journey to the cloud and move to the cloud. And we’re seeing that play out in the first half where not only in the first quarter, but also in the second quarter, we had double-digit signings growth in AMS business over time. Again, backlog, yes, is still down overall. Our revenue was down 3%. But, we see this inflection point as we move forward, and we continue to leverage and deliver that value for our clients as they move on their journey overall.

The next question comes from Jim Suva of Citibank. Your line is now open.

Jim, I just had one question for you. As you sit there in the CFO seat and you’re calling now for margins to accelerate or improve or expand year-over-year in the second half of the year, what are the milestones that are hitting to kind of make you call that out the happiness behind the confidence? What’s the milestones that we can then look back and say, oh! That made a lot of sense and it has long-term durability to it? Thank you.

Hey, Jim. Thank you very much for the question. It’s good question overall. Let me take a look at it. I’ve said from January, as we look at we obviously have multiple scenarios, how do we make at least $13.80. And what I look at and the team and the entire management team looks at is the trajectory of our business, the operational indices and the drivers as we see going forward of headwinds and tailwinds on how we deliver that guidance for our shareholders of at least $13.80. But, when you take a look at revenue growth, I said we would have revenue growth at current spot rates for the full year and that we would have pretax operating margin expansion and operating leverage in our business. So, to your question, what do we look at and what are the trends that are driving that. So, let’ unpack it, and I’ve talked about this the last couple of calls. And the way I look at margin expansion really centers around three or four major areas. Number one, margin expansion is going to be delivered through us continuing to leverage the momentum in our enterprise cloud and our as-a-Service-based business. Why? Because it’s going to generate scale efficiencies for us to deliver on what we’ve said at our Investor Day, which is margin accretion as we move through to the cloud. So, scale efficiencies, we are seeing that improvement in the first quarter, we’re seeing the improvement in the second quarter and it’s all being built off of the momentum around our cloud and our as-a-Service-based business. Second, we talk about mix, mix being another lever. So, you look at the mix of one within our each of our segments and how we’re shifting to higher value, which we’re making good progress. The best instantiation of that is GBS where they are getting better price realization and better value around remixing their offerings to better value but also across segments we have a big mix headwind as we talked about 90 days ago with regards to the mainframe cycle. So, we take that into account. But, the third bucket is around productivity. This is around how you transform the way you work, it’s predominantly led by our services base of business but it’s also about how we reinvent and how we run our company around our infrastructure and enterprise productivity. Both are giving us operating leverage as we move forward. We’re seeing the latter play out in our expense efficiency structure here in the second quarter and in our services base of business we talked about the work we’re doing around our workforce optimization, the significant actions we took in the first quarter. I said, it’s predominantly the yield on that is in the second half. And that should accelerate significantly, but we’re also transforming the way we actually deliver service, redesigning it, applying agile methodologies, infusing AI and automation, and driving a differentiated value to our clients to improve the quality in addition to the efficiency and margin. And then, finally, the last point which given services is 60% of our business, human capital-based business, you have to generate revenue to generate operating leverage. It’s tough generating operating leverage when revenue is down. And we’re seeing as that revenue trajectory improves and we’re seeing as we play out here in the second quarter returning services back to growth that we’re going to get the operating leverage as we move forward. And that’s what makes us confident in delivering at least $13.80.

The last question comes from Amit Daryanani from RBC Capital Markets. Your line is now open.

Thanks. Glad, I made it on to the line there. I guess, maybe to start, Cognitive revenue, they’re down in constant currency in the quarter, and as always, there is some amount of transactional business there. But, just help me understand, tampered the growth there? And then, do you think Cognitive can actually grow in the back half of the year because your compare start to get fairly difficult in that business I think in the back half of the year. And then, Jim, just on gross margins, what ‘s leading you to start talking about ‘19, as it was aggregate total IBM gross margins will be flat to stable. And now, it sounds like it’s only in services. So, what’s the degradation in Cognitive or Systems that’s changed that statement on gross margins from a corporate level to only services now?

Okay. On each of them -- Amit, first of all, thanks for getting into the queue. It’s good to hear from you, again. But on each of these, I think I answered them already. But, let me just give the synopsis. On Cognitive, we talked about the different dynamics within our portfolio around TPS, which had been growing, leveraging the mainframe cycle, now is more in line with what our expectations are? And in solutions software, we’ve got strength in key strategic areas of our portfolio, analytics, industry verticals, both FSS, in health, in security and IoT. But, we’ve got work to do on modernizing those key three segment areas of talent, collaboration and commerce, and that as those secular shifts move much more aggressively to SaaS, that time to value gets realized over a longer period of time. So, we do see strength in certain components. We’re making investments in others to transform, as I talked about, modernize those offerings. And that will play out over time. But with that said, we’ve done all the work and are driving the acquisition integration synergies, the operational efficiency savings. So, we feel confident, even at this level of revenue, we can drive operating leverage within that business. And then finally, back to your question on margins. As I talked, first, I think value -- the way we manage this business, values instantiate in the services based business and gross profit margin. Values instantiate in the product based business in pretax income. Because you’ve got to recoup the return on investment of your go-to-market and your development. And I will not say I’m changing, I would say our operating view of the year of our financial model of revenue growth, of profit growth, of earnings per share is exactly the same. The only thing that’s different within that is the FX change in the last 90 days with the significant U.S. dollar appreciation. Now, we hedge, we hedge that mitigates that profit variability, but when you look at currency around the element of the I&E, you see how it plays out differently. And that transparency and credibility is what I feel is important for you and investors to understand, but it has no impact on our bottom line profit contribution and our delivery of our free cash flow and our at least $13.80 for the year. So, thank you, Amit. With that said, let me wrap up the call, where I started, by saying this was a good quarter and we’re pleased. We had solid revenue growth and profit performance. This reflects the work we’ve been doing to reposition our business in terms of our offerings, our people, the way we work and reinventing IBM. Now, as always, there’s more work to do. And I look forward to continuing the dialogue over the course of the year. Thank you all for joining us on the call here this evening.

Okay. Ann, I am going to turn it back to you to close up the call.

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