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'll turn the meeting over to Ms. Patricia Murphy with IBM. Ma’am, you may begin.

Thank you. This is Patricia Murphy, Vice President of Investor Relations for IBM, and I want to welcome you to our Second Quarter 2019 Earnings Presentation. I’m here with Jim Kavanaugh, IBM’s Senior Vice President and Chief Financial Officer. We’ll post today’s prepared remarks on the IBM Investor website within a couple hours, and a replay will be available by this time tomorrow. Some comments made in this presentation may be considered forward-looking under the Private Securities Litigation Reform Act of 1995. Those statements involve factors that could cause our actual results to differ materially. Additional information about these factors is included in the company’s SEC filings. Our presentation also includes non-GAAP measures to provide additional information to investors. We’ve provided reconciliation charts at the end of the presentation and in the 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 $19.2 billion of revenue, $2.8 billion of operating net income and $3.17 of operating earnings per share, which was up 3%. We expanded operating gross margin by 100 basis points, which is the largest increase in over five years and operating net income margin by 60 basis points. And we had solid free cash flow performance, with $12.7 billion of free cash flow over the last year. These results reflect improving fundamentals of our ongoing business. And now with this performance through the second quarter, we remain on track to deliver at least $13.90 of operating EPS and about $12 billion of free cash flow for the year. This excludes Red Hat and related activity, but we believe this remains a relevant perspective as it provides transparency into our underlying business performance and is on a base that’s consistent with our previous guidance and first half performance. But to be clear, Red Hat is not included in any of the operating results we're discussing today and we will update our full year expectations to include Red Hat during our Investor webcast on August 2. Over the last few quarters, we've talked about strong performance in the areas that help our clients with their digital transformations and journeys to cloud. This continued in the second quarter, as evidenced by strong revenue performance across the high-value segments of Cloud & Cognitive Software and Global Business Services. Our results also reflect significant actions we've taken to improve our position over time. For example, at the end of the second quarter, we completed the divestiture of select software assets that didn't leverage our integrated value proposition and we took workforce actions to continue to revitalize our skill base and address stranded costs associated with the divested businesses. And as you have likely seen just eight days ago, we completed the acquisition of Red Hat. This acquisition is an important milestone for IBM and one that will significantly impact the cloud landscape. It is clear that the next chapter of cloud will be about shifting mission-critical work to the cloud and optimizing everything from supply chains to core banking systems. This requires a hybrid, multi-cloud, open approach to provide portability, management consistency, and security for these enterprise workloads. We've been building hybrid cloud capabilities across our business to address this opportunity and to prepare for this moment, bringing to market innovations like IBM Cloud, IBM Cloud Private, the Cloud Migration Factory, Cloud Application Innovation, IBM Garages, IBM Multicloud Manager, and Cloud Optimized Systems with tens of thousands of cloud architects. These innovations helped to drive IBM's $19.5 billion of cloud revenue over the last 12 months, which is up 8% led by mid-teens growth in our as-a-service capabilities all at constant currency. This is why leading enterprises across industries that range from banking to transportation, to telecom are using IBM's hybrid cloud capabilities to improve the management and delivery of their data. You saw in yesterday's announcement, IBM will modernize and move AT&T's business solutions applications to the IBM Cloud, while collaborating on an edge computing platform for their enterprise clients. AT&T will also leverage Red Hat's open-source platform to manage workloads and applications in AT&T's network cloud. And so now with the acquisition of Red Hat, we'll be combining the power and flexibility of Red Hat's open hybrid cloud technologies with the scale and depth of IBM's innovation and industry expertise. In short, IBM and Red Hat will be better together, accelerating our clients' journey to the cloud and lifting all of IBM as we grow Red Hat and sell more software and services. You'll see our cloud capabilities contributed to our broader segment results in the second quarter. As usual, I'll use constant currency growth rates throughout. Our Cloud & Cognitive Software revenue performance this quarter was strong, up 5% at constant currency. Our Cloud & Cognitive growth was broad-based across all three business lines led by hybrid cloud offerings and security. Global Business Services grew about 3.5%, and here too, we had good growth across all three lines of business, as we help our clients on their digital journeys and to modernize and migrate applications to the cloud. In Global Technology Services, our profit dynamics continue to improve with gross margin up 120 basis points and modest pretax profit growth, excluding workforce action. The margin expansion reflects our focus on exiting lower-value content in driving productivity and cloud scale efficiencies. While GTS revenue declined due in part to this portfolio focus, we had good growth in the services that help our clients implement and manage hybrid multicloud environments. As expected, our Systems revenue was down, reflecting the product cycle dynamics in IBM Z and the related high-end Storage, while Power continued to grow. When we bring all this together, our revenue was $19.2 billion, which was down about 1.5% and that includes a 40 basis point impact from the divested businesses, which had been declining. As you look at our key financial metrics, you can see the improved fundamentals of our business with revenue growth in the higher value segments, gross and net margin expansion and solid free cash flow generation. Our operating gross margin was up 100 basis points, driven by a combination of our strong software revenue growth, services productivity and cloud scale efficiencies. And our operating expense was flat year-to-year. We continue to drive efficiency and productivity in our spending, so our base expense was up this quarter as we invested ahead of Red Hat and in development ahead of our next generation IBM Z later this year. And so, now looking at our pretax income, the year-to-year performance is driven by the operational declines in our now divested businesses. Excluding these impacts, we delivered solid pre-tax operating leverage, reflecting our gross margin expansion, partially offset by the investments I just mentioned. Our operating tax rate in the quarter was 11% including discrete items. This is right in line with the full year all-in tax rate of 11% to 12%, we talked about in January. Pulling it all together, our operating earnings per share was up 3% and that includes a $0.15 year-to-year impact from the operational declines of our now divested businesses. Looking at our cash metrics, the $2.4 billion of free cash flow in the quarter is up $500 million over last year. As I've said, we generated $12.7 billion over the last 12 months, so good solid cash generation. Now, let me come back to expense to talk about a couple of items. First, currency helped our year-to-year expense dynamics due to both translation and the benefit of hedging contracts. In fact, $120 million of the year-over-year change in other income and expense was due to hedging benefits. As always, these hedging gains mitigate the currency impacts throughout our P&L. Second, within expense as expected, we also had gains and charges that together were effectively neutral to the bottom line. I just mentioned the operational impact of our divested businesses in the quarter. Let me comment on the transactional impact. We closed the two software divestitures at the end of the second quarter, resulting in about $575 million of one-time gains in other income. This is within the range of $500 million to $700 million we provided back in April. Within SG&A, also as expected, we took actions to revitalize skills and address structure and stranded costs associated with these divestitures, resulting in a workforce related charge of about $500 million. We also took a charge for an unfavorable legal ruling received in late June on a case that has been under dispute for nearly a decade. And so together, these gains and charges were essentially neutral to our total expense and to our profit growth in the period. So as I have said in the past, the divestitures will improve our revenue and profit profile on a go-forward basis. Turning to our segments. Cloud & Cognitive Software delivered strong revenue performance this quarter, up 5%. We had growth across all three areas with cloud and data platforms up 7%; Cognitive Applications up 5%; and transaction processing platforms up 4%. Our software offerings helped our clients securely deploy, run and manage data and applications on-premises and on private and public clouds. In cloud and data platforms, we had broad-based growth led by several newer offerings throughout the portfolio that help clients modernize their applications for hybrid cloud environments and their data for AI. We continue to see good hybrid cloud growth this quarter, as client's leverage our reliable and scalable IBM Cloud Private solution built on open-source frameworks like Containers and Kubernetes. SK Group in South Korea turn to IBM Cloud Private to quickly and easily package applications as Containers and re-factor them with IBM micro services across their businesses. Their new SK telecom portal used by customers to buy mobile services is now running on the IBM Cloud Private platform. And our IBM Cloud Private for Data offering, which collects, organizes and analyzes data for AI also delivered strong growth this quarter. We launched this solution just a year ago, and we've had strong client adoption, in fact, growing our installed base nearly 40%, since first quarter. Cognitive Applications' revenue growth was led by strong performance in our integrated security software and services portfolio, and growth across many of our industry vertical solutions. Let me spend a minute on security. We continue to see strong performance in our threat management software and services offerings, including QRadar and Resilient, as well as in managed security intelligence solutions like X-Force Threat Management. And as clients look to safeguard critical data and data warehouses and big data environments, we had good traction in our Guardium data security solutions. With 95% of the top global companies leveraging IBM Security solutions, we are well positioned as an industry leader. Turning to transaction processing platforms. Growth was driven by strong performance in IBM Z middleware, as clients continue to predictably manage IT spending for their growing IBM Z mission-critical workloads. And then moving to profit for this segment, pretax margin was up 2 points year-to-year, and that's excluding the impact from the workforce actions this quarter. Margins reflect strong transactional performance in high-value areas offset by ongoing investment in key strategic areas, including the preparation for the Red Hat closing. Moving to Global Business Services, revenue was up 3%. We again had good growth as enterprise continue their digital reinvention journeys to become Cloud & Cognitive enterprises. GBS is at the epicenter of IBM, bringing both business and technology transformation solutions to clients. They bring together deep industry expertise, IBM's innovative technology portfolio, and third-party information technology architectures to deliver differentiated value to enterprises. We see evidence in this in all three areas of GBS, as consulting revenue grew 5%, application management grew 2% and Global Process Services grew 3%. In consulting, growth was led by sustained performance in our next-gen enterprise apps like S/4HANA and in Digital Strategy and iX offerings. At Wimbledon, our Digital Strategy and iX team delivered a differentiated and personalized digital experience to on-site media, players and fans around the world, leveraging AI and running on the IBM Cloud supported by GTS. Clients are also leveraging the IBM Garage to help them power their digital reinventions with hybrid cloud and artificial intelligence, while going from idea generation to enterprise scale adoption. ADP used IBM Garage method to infuse AI across the enterprise. ADP and IBM jointly developed an AI-powered digital agent that handles over 20% of ADP's chat traffic, which helped drive Net Promoter Scores to all-time highs. Today, ADP continues to work with GBS to help create its digital onboarding process, streamlining and enhancing their new client’s first impressions. In the past 18 months, IBM has helped more than 500 leading global companies use the IBM Garage, to drive digital transformations with data in AI on the cloud. GBS is becoming the provider of choice for clients across the various phases of their journey to cloud, whether it's advising, moving, building or managing their applications and processes. For example, GBS is working with another leading telco provider to advice on their digital transformation journey to the cloud. As part of this, IBM will develop and manage a center of excellence that will power an enterprise-wide Red Hat Ansible implementation for hybrid and multicloud platforms. This will enable them to transform their product and technology organization, support an agile DevOps culture for its developer teams, while moving its application portfolio to the cloud to reduce complexity and accelerate delivery and time to value. And at Fortum, a Finnish energy company, we're leveraging our Cloud Migration Factory to advise the company on its cloud strategy, as well as helping to migrate and manage its applications to the cloud. Cloud Migration Factory is one of the areas contributing to our growth in application management revenue this quarter. Turning to profit. GBS gross margin was essentially flat, with contribution from continued mixed shift to higher-value offerings and from currency given our global delivery mix. This was offset by a higher level of skill capacity investments to capture demand around Red Hat and digital reinvention. In Global Technology Services, revenue declined 4%, with infrastructure and cloud services down 4%, and technology support services down 2%, while gross margin for this segment expanded 120 basis points. As we said over the last few quarters, we are managing this business for increased margin, profit and cash contribution to better position it for the long-term. As part of that, we have been taking actions to deemphasize lower-value contracts and third-party content and focus our investments on the higher value segments of the IT market such as hybrid cloud. This contributes to lower GTS revenue in the short-term, but will enable us to deliver sustained margin improvement. You saw this play out again in the second quarter with our gross margin expansion driven by scale efficiencies in our cloud, productivity improvement as we infuse AI and automation into our service delivery models, and the shift of our business to higher value areas. This quarter, GTS delivered just under $0.5 billion of pretax profit and modest PTI growth, both adjusted for the workforce-related charge. We are going to leverage this improved profit position to continue to invest in our go-to-market and delivery capabilities to capture this high-value and growing market. Enterprises continue to turn to IBM to navigate and manage the increased complexities of a hybrid multicloud world. IBM services is in a unique position to help our clients in chapter two as we have been running these workloads and we know their processes as well as their IT and regulatory environments. As I mentioned earlier, at the end of June, we signed an agreement with AT&T which spans both of our services businesses. In this multiyear strategic agreement, IBM will modernize and migrate AT&T business solutions and applications to the IBM Cloud and will help manage the entire IT infrastructure on and off-premises and across different clouds, private and public. By leveraging a hybrid multicloud approach, enterprises can not only reduce costs and complexity, they can modernize, build, deploy, and run core business applications in a faster and more secure way. This approach will enable AT&T business to build and deploy any app or workload anywhere and deliver new innovative services to its business customers. This is a great example of how we're helping clients accelerate their journey to hybrid cloud. And now turning to Systems, revenue was down 18% this quarter. We again had growth in Power. This was more than offset by declines in IBM Z and storage, reflecting the late stage of our z14 product cycle. In the second quarter, IBM Z revenue declined 41%. I'll remind you that this is compared to a very strong performance in the second quarter last year, where we grew 112%. We announced the z14 program two years ago now and our revenue is tracked ahead of the prior program throughout that period. We continue to see clients take advantage of the value of z14 such as pervasive encryption and connecting to the cloud. And so from a Malaysian bank securing and improving performance on core banking workloads to a European tax office implementing a private cloud solution on Linux to manage new applications, clients appreciate the z14 innovation. In today's environment, there's a lot of demand for technology underpinned by data protection and resiliency with the ability to integrate across cloud environments and we will continue to innovate in these areas, which are core to the IBM Z value proposition. Power revenue was up 3%, again led by POWER9. We had continued growth in high-end offerings and in Linux with HANA on Power, leveraging our performance of POWER9. This is the same architecture used with Summit and Sierra, which are among the world's largest scientific and AI computing systems. As a reminder, we started the delivery of these supercomputers for the U.S. Department of Energy Labs in the second quarter of last year and essentially completed the deployment through the second half of 2018. This quarter, we also announced that IBM Power Systems virtual servers are now available in the IBM Cloud, providing clients with hybrid, cloud scale of compute for AIX and IBM i workloads. Our enterprise clients are increasingly looking to adopt hybrid cloud strategies, backed by their performance, resiliency and security capabilities of IBM POWER9 to help optimize everything from supply chains to sales. In Storage, revenue was down 21%, reflecting the clients on our high-end, which is tied to our mainframe cycle and the ongoing competitive dynamics and pricing pressures in the midrange. Looking at Systems profit, gross profit margin expanded across the portfolio, while pre-tax margin was down, reflecting where we are in the Z product cycle. Turning to cash flow and the balance sheet. We've now generated $12.7 billion of free cash flow over the last 12 months. Our normalized free cash flow realization over that period remains high at 118%. In the second quarter, we generated $2.8 billion cash from operations excluding our financing receivables and $2.4 billion of free cash flow. That brings our free cash flow for the first half to $4.1 billion, which is up about $900 million year-to-year. These results reflect our operational performance and effective capital management. Our strategy to deemphasize lower value content across our services and financing portfolios continue to play out in cash and contributed to our CapEx spending decline for the half. Capital expenditures also reflect the benefit from a real estate sale of about $270 million, although there was effectively no P&L benefit. I'll remind you that the proceeds from the divestitures are considered an investing activity, so are not included in our free cash flow. Looking at uses of cash. So far this year, we returned over $4 billion to our shareholders. $2.8 billion of that was dividend and in April, we again raised our dividend. That's now the 24th consecutive year; we've taken our dividend up. Through the first half, we spent $1.2 billion on gross share repurchases buying back more than 9 million shares. With the closing of the Red Hat transaction, we suspended our share repurchase program on July 9th. Looking at the balance sheet. We ended the quarter with $46 billion in cash, approximately $34 billion of that was used to close the Red Hat transaction earlier this month. Our total debt was $73 billion including incremental debt raised to fund the Red Hat acquisition. About a third of our total debt is in support of our financing business, which continues to be levered at a ratio of 9:1. Our global financing debt is down over $6 billion from December, reflecting the portfolio decisions we made regarding the financing of third-party content. These decisions also led to further improvement in the credit quality of our financing portfolio, which is now 57% investment grade, 3 points better than a year ago. So to sum this up, we continue to generate strong free cash flow. And together, with the portfolio actions we've taken, and the suspension of share repurchases positions us to return to our targeted leverage ratios within a couple of years. In the meantime, our balance sheet is strong with the flexibility to support our business. So I'll make a few summary comments in the quarter, before we move on to Q&A. In the second quarter, our performance reflects the value we provide in helping our clients with their digital transformations and journey to cloud. We see this across our business in our hybrid cloud offerings and services, our data and AI capabilities, and in areas like security. We had significant gross margin expansion and solid free cash flow, a reflection of the improving fundamentals of our business. And we continued our focus on investment prioritization and portfolio optimization, closing the pending software divestitures, deemphasizing lower-value content in GTS, and continuing to wind down our OEM commercial financing portfolio. All of these improved our profit profile going forward. And of course, just eight days ago, we completed the acquisition of Red Hat, a landmark acquisition that has important implications to the cloud landscape and to IBM. Now, let me make a few things very clear before we go into Q&A. This quarter, we're in a unique position due to the timing of the Red Hat acquisition. And so today, I won't address any questions on forward-looking guidance. As mentioned, we will be updating our full year 2019 expectations on August 2, which will include the impact of Red Hat. As you would expect with a highly profitable software business, the non-cash purchase accounting adjustments result in the acquisition being dilutive to full year 2019 earnings per share. We have said this, and also that we continue to expect Red Hat to be accretive to operating earnings per share by the end of the second year, and accretive to free cash flow in the first full year. And so now, I'm happy to take your questions about our second quarter performance and the trends we are seeing in our underlying business excluding Red Hat.

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.

Yes, the phone lines are now open for questions. [Operator Instructions] The first question in queue is from Amit Daryanani of Evercore. Your line is now open.

Thanks a lot. I was wondering, Jim, since I know we'll touch on Red Hat and the aggregate IBM in more detail on August 2, perhaps we'd spend some time on the services business. And when I look at the trajectory of services, I think GBS was up 4% in the first half, GTS was down 3%. How do you see the services business transpire as we go forward through 2019? And finally, maybe help me understand, what changed in your perspective on the company’s services versus [Technical Difficulty] ago?

Okay. Thanks, Amit, and it's a very nice to hear from you again and welcome back. Let's talk about services and allow me to break it into two, because you're asking both the GTS side of the business and the GBS side of the business, because they have two fundamentals that are happening against each other. On one, we've been talking about -- let's talk about GTS first. We've been talking about the portfolio prioritization work that we've been doing about exiting lower-value content, which we've said all along would impact revenue in the near term, but result in higher margins in a better business profile going forward. And I think you're seeing that play out in our first half performance. Revenue in the second quarter, pretty consistent with the first quarter overall, but our margins, our operating leverage we are seeing substantial leverage in that business as we move forward because we said we were going to shift that business to higher value margin, profit and cash. And we were up 120 basis points, really led by that mix shift to getting away from lower-value content deemphasizing that, but also with our productivity initiatives which are executing well and delivering very good return on investment. Now with regards to GTS, what do we learn about the first half performance? And how does it impact the trajectory going into second half with regards to what did we learn? Well, I would tell you right now, based on where our backlog dynamics are and in particular, our backlog run-out, we see an inflection point as we enter the second half in GTS. We're coming off the first half down 3.5%. Most of that being driven by conscious strategy as I talked about, but now we're going to wrap on that strategy as we enter later half of the second -- second half of 2019 and we're also beginning to ramp on a very strong large deals signings at the end of 4Q 2018 as we move forward. So, we feel very good about our book of business in GTS. We got through this conscious strategy. It's given us tremendous margin leverage, tremendous free cash flow leverage and we returned that business back to profitability in the first half and we see both margin improvement and sustainability. And we see that inflection point with an improvement in sequential year-to-year performance. On GBS, the team has done a great job. We have repositioned the portfolio, redesigned our service lines. We are driving growth across all three platforms, digital, cloud, cognitive as we enable our clients to really drive their digital reinvention journeys for the cloud and journeys to the cognitive enterprise. As we look at the end of the first half, when we look at our backlog run-out, our backlog run-out says, we’re going to have consistent growth as we move into third quarter. We're coming off of a pretty good signings quarter with GBS and a very strong continuation in small and mid-sized deals that are fueling our revenue in period. So, we feel pretty good about sustainability of that growth coming off the first half in GBS. And we see that marked inflection on a sequential year-to-year improvement in GTS as we exit the second -- enter the second half.

Thanks Amit. Ted, can we please take the next question?

Yes. The next question is from Matt Cabral with Credit Suisse. Your line is open.

Thank you. Really robust growth in cloud and data platforms in the quarter. You talked about that a little bit in your prepared remarks, just wondering if you could dig deeper on what drove the acceleration, and how we should think about some of the buckets underneath there and how they performed? And then just the sustainability of that strength going forward?

Okay Matt. Thank you very much. Yes, we're obviously very pleased with our Cloud & Cognitive Software business here in the second quarter. And most importantly, as you all know quite well we'll spend a lot more time on August 2nd talking about IBM plus Red Hat and how we're better together and how it's going to change the cloud landscape in this $1 trillion hybrid cloud market. Red Hat will be part of this segment overall in Cloud & Cognitive Software. But if you look at the second quarter, I think there's a perfect instantiation of where client demand is going. And when you got a differentiated value propositions and strong portfolio and offerings and a lineup and you execute well, you start seeing the leverage in acceleration and that's what we got out of the quarter. We're helping our clients as they move their hybrid cloud applications to the cloud and also on data and AI. So, cloud and data platform, strong growth, up 7%, strong adoption in our ICP IBM Cloud Private, up 50% quarter-over-quarter in adoption rates. But we're also seeing very good growth in our integration offerings and our hybrid cloud data platforms that are driving both our data, our analytics, and our AI capability going forward. But also across the other platform Cognitive Applications, we saw a good growth of 5% driven by a very good quarter in our integrated security software and services business as we launched new offerings around identity management, around threat management. And we've got a very differentiated value proposition and we're executing well, but we also had very good growth across in some industry verticals led by supply chain in IoT; offerings around Maximo, which we've got a very strong incumbency with our clients in delivering value and also in weather. Weather has consistently driven good growth for us. And I would tell you this quarter the Weather app in India became the number one downloaded app for the first time ever in India and that couples with already being number one downloaded app in the United States here. So, we're seeing good growth across many of our verticals and across our cloud and data platform and this really establishes the foundation and we couldn't be more excited with Red Hat coming onboard July 8th.

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

Yes. The next question in queue is from Wamsi Mohan from Bank of Merrill Lynch. Your line is now open.

Yes. Thank you. Jim, can you talk about the overall enterprise demand environment as we look into the back half of the year, given some of the global uncertainties around?

Wamsi, we lost you there. Wamsi? Operator, it sounds like we lost him. Can we please go to the next question?

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

Yes. Thank you. Jim, I'm wondering if you can talk a little bit more about GBS particularly on the profitability side. That business includes tech support services, which historically have had extremely high margins. And if you back that out, it's pointing the infrastructure and cloud services margins that are probably pretty close to zero. You have peers like DXC who have double-digit margins in that business, peers like Accenture who have double-digit margins in that business. So one, can you address why the margin gap is so significant? And two, I heard your earlier comments about an inflection point, but I struggle a little bit given that signings are down 17% in the first half. Your backlog is down 4%, which I think is the worst in the last 20 years year-over-year. And so if I look at leading indicators, they actually don't look really good from a revenue perspective. Going forward, I realize your comps get a lot easier, but is -- are you really seeing an inflection? And what's the disconnect between the backlog and signings data that we're seeing and your optimism? And how do margins improve when the business is de-scaling?

Okay, Tony, thank you for your questions, multiple part. Lot packed in there, but let me just try to hit some of these head on. First of all, when you look at our GTS segment, it fits into the overarching integrated value of the IBM portfolio. There's components within our TSS segment that play to our Systems platforms in our business and drive tremendous integrated value. And our Infrastructure Services segment, obviously, plays a tremendous value to IBM's integrated model with their deep client relationships where we leverage the value of incumbency and we actually drive as channel high-value software and hardware into those businesses. So I'm not going to talk about the individual profitability of those two pieces, because we manage this as an integrated play across IBM. But what I will talk about and I did see your report is that I view this as we have tremendous headroom to grow our margins, which is what we are maniacally focused on in this business about selling high-value, which is part of our conscious strategy of exiting and deemphasizing our low-value third-party OEM; and by the way in the first half you see how that has played out in our results. Our margins are up very strong, 120 basis points, and our pre-tax margins x the charges, so you can look at it on a sustainable basis going forward are up in the second quarter, and they're up through the first half. And I didn't even talk about the level of cash contribution that this business now is spewing off. So we are very pleased with the business model, the trajectory and the value of what GTS brings to us. And I would agree with you completely, that we got headroom and that's what the teams focused on driving moving forward. Now with regards to your services, signings and backlog. We've been talking about at least for multiple quarters about the changing dynamics of signings and backlog in this environment. Part of that is the changing client demand and buying behaviors. Part of that is a shift to as-a-service in cloud. But as you stated, our signings were down in the quarter. Our backlog, absolute backlog is down, but I will remind everyone its $111 billion overall, that backlog is down mainly driven by large deals to your point. Now, when you look at large deals, our large deals in the quarter were down by 20%. But, over the trailing 12 months, our large deals are actually flat, up in GTS as we sell that integrated outsourcing value, and actually down in GBS as the application management service is moving much quicker to the cloud, which is why we've been re-architecting our offerings around application management, modernization, migration services. But as I said before, and I'm giving increased transparency and disclosure for our investors, signings are not all equal. Signings vary and they vary based on how they influence backlog duration, erosion, mix of signings, new logo. And for increased disclosure, when we look at our backlog run-out, which is right in front of us right now, that gives us confidence to talk about the inflection point in GTS as we wrap on this de-emphasis on lower-value content and we start ramping up our large deals from fourth quarter, which will start in the second half. So we see that inflection on a sequential year-to-year. And around GBS, we see continued momentum as we move forward.

Thanks. Ted, can we please go to the next question?

Yes. Katy Huberty from Morgan Stanley. Your line is now open.

Yes, thank you. Jim, this is the second quarter of strong gross margin expansion. I know, there is a number of factors helping you on that front. But if you isolate the cloud business, is it fair to say that you have escaped velocity, meaning cloud margins are improving sequentially with scale every quarter? Or should we think about cloud still having some lumpiness and seasonality around margins?

Thank you, Katy. Yes, very good question overall. Last year, we talked about in the beginning of 2018, how we were investing significantly in building out our cloud architecture. In fact, our capital spend last year was up 70% as we built out six new MZR's around the world in which today our cloud architecture is very competitive and it covers 95%-plus of the demand from a cloud market overall. But as we talk about throughout 2018, and now definitely into the first half of 2019, we are seeing continued scale efficiencies around our cloud as we generate more and more scale, as we're starting to drive the utilization around our cloud pods around the world and as we've – obviously, leveraging the differentiated value proposition and growing our cloud business, which is now $19.5 billion over a trailing 12 months. So we feel pretty good. And you see that play out in our GTS segment, which is consistently been accelerating their year-over-year margins up 110 basis points in the first quarter and up 120 basis points in the second quarter. And as you all know, that's well in excess to their model, but my answer to the last question, we believe we've got a lot of headroom.

Okay. Thanks. Can we please go to the next question?

Yes. The next question is from Tien-Tsin Huang with JPMorgan. Your line is now open.

Tien-Tsin are you on mute? Tien-Tsin Huang: …transactional sales. How did that -- or transaction activity how did that perform versus planned versus the first quarter? Curious if it had any positive contributions to segment and obviously gross margin as well? Thanks. A – Jim Kavanaugh: Thanks, Tien-Tsin. I appreciate the question, because obviously given a seasonality of our business, as you all know, the transactional component is a very important part of our second quarter and also fourth quarter, overall. But let me put it in perspective. 90 days ago, we sat here and we talked about coming off of first quarter, that we were going to grow sequentially $900 million to $1 billion of revenue and that was going to be driven off of the back of our transactional-related business. We actually delivered at the high-end of that coming in at roughly the $19.2 billion overall. But the underpinnings are a little different. To the earlier question, we had very strong growth in our Cloud & Cognitive Software segment that was pervasive across each of our platforms and that was mainly driven by leveraging our differentiated value proposition and strength of our offering portfolio and accelerating that through the transactional component. So I would tell you from 90 days ago, we actually executed better in the software space. Now on the flip side, our hardware base of business, which carries tremendous value from a platform perspective. As you all know, we are in the back end of our mainframe cycle. We're eight quarters in to arguably one of the most successful mainframe programs that we've had to-date and that's driven by the differentiated value proposition and our ability to continue building out and enduring platform. 90 days ago, compared to where we ended up today, we fell a little short on our Systems hardware and where we're at. Now, as you heard in the prepared remarks, we have invested and you've seen in our development expense, overall in the first half, which has been up. We had been investing in driving the teams very hard, because as we all know, the Systems segment follows innovation cycles. And as we said in the prepared remarks, we are going to come out with new innovation on our high-end mainframe and our high-end storage later in 2019.

Thanks, Tien-Tsin. Can we go to the next question please?

Yes. Wamsi Mohan from Bank of America. Your line is now open.

Yes. Thanks for squeezing me in again. Apologies, I guess, I might have been routed through Huawei network before. Jim, can you talk a little bit about the overall enterprise demand environment as you look into the back half of the year, there are a lot of macro issues around trade, Brexit, China. Just wondering what you're seeing through a broader macro lens. And more specifically, some of the workforce rebalancing was targeted towards Cloud & Cognitive. Obviously, you've demonstrated some really strong growth over there in the quarter. So curious, what specifically you're doing in that segment around the workforce rebalancing? Thank you.

Okay, Wamsi, I'm glad you got back in. Thank you. Obviously, all of us, we operate in 170 countries around the world. We are constantly monitoring information around market dynamics and in particular around the client buying behavior, which I think is at the core of your question. Now, we would tell you, the IT industry is still growing in excess of GDP. And in particular, as you see play out in our results, around key high-value areas data and AI, cloud, security, digital where there's tremendous value proposition to allow our clients to differentiate their competitive positioning as they move along their digital reinvention journeys to the cloud and journey to cognitive enterprise and we see that continuing to play out. Now, with that said, the IT industry is always been predicated in my mind on effective balance between leveraging technology for growth and leveraging technology for productivity, and at certain times, things change and that balance changes. And I would tell you today what we're seeing on client buying behaviors is a slight shift more and more to productivity, to quick payback ROI. And more importantly, as the CFO, I could tell you directly in uncertain times, you want predictability. And our value equations really played to that especially in our software part of our portfolio and our services. But I would tell you, when you look across the world, we had pretty good growth around both major markets and around components of emerging markets. U.K. Canada, Japan, Spain grew very nicely and consistently. And from an industry perspective, we're seeing pretty good pervasive growth still in insurance, in financial markets, in health care, life sciences, education, on travel transportation, but we see pretty good perspective overall.

Thanks. Ted, can we please take one last question?

Yes. The last question is from David Grossman with Stifel Financial. Your line is now open.

Thank you. Jim maybe you can just touch on free cash flow and free cash flow conversion. I think in your prepared remarks, you've mentioned a couple of items. One was the gain on sale of the software assets. The other was the real estate gain. Are there any other known headwinds or tailwinds that we should keep in mind that may impact the comparison next year excluding obviously any impact from Red Hat?

Yeah. Thank you, David. I appreciate the question, because free cash flow is obviously front and center right now with all of us around continuing to shift this business model to higher value. We're very excited about the Red Hat acquisition. We do think it's a game-changer where we're going with regards to helping our clients in Chapter 2 and we're also prudently driving the financial discipline and manage it -- management in this company around delevering the company and around getting back to our targeted leverage ratios within a couple of years. But if you take a look at free cash flow, first of all, we're very pleased in the first half. We delivered over $4 billion of free cash flow in the first half. That's up $900 million driven by continued working capital efficiency, offset by operating profit here in the first half, but we got very good, sound capital management. And we talked about a couple of those components in the prepared remarks as you called out. Now, with the Red Hat acquisition, we're going to talk much more about this on August 2nd and put it in perspective of why we're better between IBM and Red Hat together and share with our investors our business profile, our synergies, our capabilities, our financial model and the investment thesis going forward. So, we look forward to talking to all of you in about 10 days from now plus or minus as we move forward. And we'll give some discussion about guidance on free cash flow as we forward. So with that said, I just want to make a few comments to wrap up the call. Our performance this quarter, I think is a great basis from, which to move forward in the future. We set the foundation and now one that includes Red Hat effective July 8th. On August 2nd, as I just said in the last question we're going to host our Investor webcast. We'll talk about how IBM is addressing what we call chapter two of our clients' digital reinventions. We'll have several of our senior leaders lay out our strategy and show how IBM plus Red Hat is ideally positioned to address the opportunity ahead of us. And then I'll wrap up with our financial view of IBM and also not only talk about 2019, but more importantly, give a perspective about where this business is going in the medium-term as we move forward. So as always, thank you for joining us today and we look forward to continue the dialogue in early August.

Thanks. Ted, let me turn it back to you to wrap up the call.

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