Patricia Murphy - VP, Investor Relations Martin Schroeter - SVP and Chief Financial Officer

Toni Sacconaghi - Bernstein Tien-tsin Huang - JPMC David Grossman - Stifel Lou Miscioscia - CLSA Steve Milunovich - UBS Brian White - Cantor Fitzgerald Keith Bachman - Bank of Montreal Jim Suva - Citibank Joseph Foresi - Janney Montgomery Scott 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, Vice President of Investor Relations. Ma'am, you may begin.

Thank you. This is Patricia Murphy, Vice President of Investor Relations for IBM. I'm here today with Martin Schroeter, IBM's Senior Vice President and Chief Financial Officer. I'd like to welcome you to our second quarter earnings presentation. The prepared remarks will be available within a couple of hours and a replay of the webcast will be posted by this time tomorrow. I'll remind you that certain comments made in this presentation may be characterized as forward-looking under the Private Securities Litigation Reform Act of 1995. Those statements involve a number of factors that could cause actual results to differ materially. Additional information concerning these factors is contained in the company's filings with the SEC. Copies are available from the SEC, from the IBM Web site 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 will find reconciliation charts at the end of the presentation and in the Form 8-K submitted to the SEC. Now, I will turn the call over to Martin Schroeter.

Thanks, Patricia. In the second quarter, we delivered 20.8 billion of revenue and operating EPS of $3.84. With that, our revenue for the first half was over $40 billion. Operating net income was 6.7 billion and operating EPS was $6.75. Our revenue was down less than 1% in the quarter and essentially flat for the first half excluding the impact of currency and the divested businesses. Our overall revenue performance includes the continued translation impact from a strong dollar and the impact of divested businesses. Together, these reduced our reported revenue growth by 12 to 13 points, both for the quarter and the half. I will focus on our revenue performance excluding the impact of currency and divestitures for the balance of the presentation. Let me give you a quick overview of different parts of our business. Revenue in our strategic imperatives, those that address the market trends in data, cloud and engagement is again up more than 30% in the second quarter and so up over 30% for the first half. This is an acceleration from roughly 20% growth last year. As we’ve said before, we are able to grow at a rate significantly faster than the market because of the industry perspective and deep insight we have from working with our clients on their core businesses to help move them to the strategic areas. We are clearing seeing this in analytics where our revenue is up more than 20% in the first half, well above market rates. This is terrific growth on a large revenue base. Recall we generated $17 billion of analytics revenue last year. The growth is led by GBS and by systems hardware, reflecting the new z13 and POWER8 systems where they specifically address analytics workloads. And we are developing new markets with the advanced cognitive capabilities of Watson. Our cloud revenue was up over 70% year-to-year in the first half. And over the last 12 months, our cloud revenue was $8.7 billion. We had strong growth in both our private foundations revenue and our as a service offering, and we exited the second quarter with an annual as a service run rate of $4.5 billion. Our cloud business is substantial and growing rapidly. The market continues to evolve beyond pure infrastructure towards higher value process, data and analytics as a service engagements. In the same way the Internet evolved from browsing to a full transactional business platform. Our clients are finding value in the combination of public, private and hybrid implementations we're able to provide. Our security business was up 10% for the half, social more than 40% while our mobile business quadrupled. From a segment perspective, we saw an increase in demand in our services business with 22 deals over a $100 million this quarter the highest number in over two years, this contributed to a backlog that is up year-to-year for the first time since the end of 2013 which is certainly an encouraging data point. In our systems business, we have been delivering innovations and repositioning the portfolio and this quarter we again had solid revenue in profit performance. Our System z revenue was up about 50% year-to-date and the z13 performance is in line with previous cycles. Power grew in the first and second quarters led by strong growth in scale out systems which were capturing both the Unix and Linux opportunity and return to growth in the high end this quarter. Then there were parts of the business that are impacting our second quarter performance but the transformation will pay off over the longer term. Parts of our services business aren't delivering sufficient productivity in the base to fund the investments we're making and to offset the impact of currency. Now we'll get return on the investments over time but it’s impacting profit growth now. We're making the shift in our offerings as evidenced by our signings and backlog growth, but we need to drive more productivity to improve the profit profile. And some of the geographic regions specifically the BRIC countries are impacting our overall performance. I will expand on that when we discuss the geo performance. Our first half performance also reflects major portfolio actions we've taken to continue to shift to higher value. Late last year we sold our x86 business; you can see the benefit in our 50 basis point improvement in gross margin and we recently completed the divestiture of our semiconductor manufacturing business while we continue to focus on advanced semiconductor research. In fact just two weeks ago we announced that an IBM Research led alliance produced the industry's first 7 nanometer chip, another milestone in our contributions to semiconductor innovation. At the same time, we're making significant investments in our strategic imperatives. For example we've created Watson healthcare, we're continuing to build out cloud data centers and we've launched important new partnerships in analytics, mobile, social and cloud. So to sum it up, our second quarter and first half results are a reflection of the transformation in our business as we move to where we see the longer term value in enterprise IT. The actions and investments are delivering strong growth in our strategic imperatives and continued innovation across our portfolio and we're able to drive overall margin improvement on a fairly stable revenue base. I will move onto the financial metrics but first let me remind you some of the items we've mentioned in our call back in April. We said we grow out pretax income by $1 billion quarter-to-quarter. We said that we'd have more work-force rebalancing than last year and we said we'd have lower gains in our I&E since last year we had gain associated with the sale of our customer care business, and we expect that the stronger dollar would continue to have a significant impact to our revenue and profit. As always we've included a view of the currency translation impact to our revenue in a chart in the back up and you will see that at current spot rates its impact continues to be substantial. Now turning to the results for the quarter, we delivered 4.6 billion of operating PTI which is up $1 billion from the first quarter. The year-to-year performance in PTI reflects the impact of currency, higher levels of investment and higher workforce rebalancing than last year although the workforce rebalancing charge wasn't as large as we had initially expected. We also had lower divestiture gains year-to-year. Looking at our margins, we had a 20 basis point improvement in gross margin driven by our portfolio actions and a relative performance of System z. Our pretax and net margins benefited from the shift to the higher value as well but they also reflect the dynamics I just mentioned in investments workforce rebalancing and gains which impacted expense. Our ongoing effective tax rate remains at 20% but we did benefit from a few discrete items. On the bottom line, we reported operating EPS of $3.84. We generated $3.4 billion of free cash flow in the quarter which is up 400 million from last year. Over the last 12 months, we've generated $13.2 billion of free cash flow though our realization of GAAP net income is in the high 80s. Over the last 12 months, we've reduced our share count by over 2% and increased our dividend returning about two-thirds of our free cash flow to shareholders. Now turning to the revenue by geography in total our performance in the major markets was consistent with last quarter while the growth markets decelerated driven by the BRIC countries. To put it in perspective, the BRICs impacted IBM's overall revenue growth rate by 2 points in the second quarter or said another way our revenue excluding the BRICs would have been up 1%. So let me start there, within the BRICS only India had modest growth building on improved operational performance and services. The other three countries were down at a double-digit rate. Brazil was down 16% though our revenue in Brazil last year was up over 20%, so was a very tough compare. The volatility of our results in Russia continued and our revenue in China was down 25% with fewer large transactions in the quarter. Outside of the BRICs many countries improved their performance sequentially in fact outside of the BRICS our growth markets revenue was up 5%, a 4 point improvement from last quarter. Looking at the major markets, revenue was flat year-to-year. The year-to-year performance in many of the major market countries also improved sequentially including Canada, Germany, Italy, France and Japan. Two of our largest countries Japan and Germany posted the strongest growth. In the U.S. overall revenue was down low single-digit but we once again had good Systems z performance and we've signed substantial new services business. Turning to the segment perspective, our total revenue was down less than 1% and gross margin improved 20 basis points. I'll spend more time on the revenue and profit drivers in the segment discussions. But let me just make a couple of top level comments, revenue in three of our five segments grew this quarter including our largest segment GTS. This quarter systems hardware posted solid growth with double-digit growth in Z and mid single-digit growth in Power and our Global Financing revenue was up driven by equipment sales and the other two segments GBS and Software our year-to-year performance was fairly consistent with the last few quarters. Our total margin improvement was driven by a shift to higher value. Remember the last quarter, the shift was driven but portfolio actions and the relative strength of System Z. The reported operating expense and other income is down 9% to this level of spend our expense to revenue ratio was up a 0.5 year-to-year. As we’ve discussed in the past within our large operational expense base we’ve got a shift going on, driving productivity in some areas while significantly increasing our investment in the strategic imperatives. This investment is to build capabilities much of which will be consumed as the service in areas like Watson, Watson Health and Bluemix. And so we’ll see the benefits over the longer term. The reported decline in expense this quarter is again driven by currency and the divestiture System x. This quarter we also had a higher level of workforce rebalancing and lower divestiture gains, I’ll comment on each. 11 points of the decline was driven by currency between the translation of non-dollar spending and the hedging gains that reported another income in SG&A. Two points of the decline are due to the fact that we no longer have the expense of the System x business in our run rate. And this quarter we took a charge of nearly $200 million for workforce rebalancing, nearly all of which is an increase year-to-year, this drove expense higher by three points. And then divestiture gains were down a 100 million year-to-year driven by last year’s gain associated with the sale of our customer care business, just added about 0.5 to expense growth. Now let's turn to the segments and we’ll start with Services. Combined service revenue was $12.4 billion, with the year-to-year revenue trajectory a little better than in the first quarter. We closed 22 deals greater than $100 million balance between renewals and new scope or clients. This is the third consecutive quarter signings growth and with it our total backlog was up more than 1% year-to-year. Global Technology Services revenue of 8.1 billion was up 1% with growth in all three lines of business. This is a two point improvement from the first quarter year-to-year performance driven by combination of revenue from backlog in period revenue. GTS outsourcing return to growth, improving three points sequentially due to several large deals signed last year that are now completing transition. We’re seeing good traction in the contracts that combine traditional IT outsourcing with the integration of mobility, hybrid cloud and analytics workloads. Integrated technology services also return to growth this quarter with strong performance in our cloud, security and business resiliency services. Growth in SoftLayer accelerated as we’ve significantly increased capacity in new data centers since the beginning of last year and we’re now 41 cloud data centers on five continents. Maintenance grew 2% driven by growth in our multi vendor support services. This is our hardware maintenance offering for third-party platforms which leverages our global distribution and inventory capabilities. Our pre-tax profit in GTS was down, let me spend a minute on this. Currency drove the largest year-to-year impact given the strengthening dollar. We continue to generate significant profits in cash flow in local currencies, but the translation of those currencies back to U.S. dollars significantly effects our reported profit growth. The divestiture of the System x business impacted our maintenance profit and margin and we took the workforce rebalancing charge in the quarter essentially all of which resulted in the year-to-year impact. We continue to invest for growth for in our strategic imperatives offering such as bringing additional SoftLayer capacity online and increasing our security and mobility go-to-market skills. We’re also opening new resiliency data centers and expanding our global delivery capabilities. As you would expect, we look to productivity as a way to fund our investments, we didn’t drive that productivity this quarter as we’re always balancing the timing of our transformation with the dynamics of running our clients most critical processes. Global Business Services revenue was 4.3 billion, down 3%. Revenue declined in the practices focused on traditional back office implementations. Customers are migrating away from large ERP projects toward smaller initiatives with cloud, mobility and analytics as their main focus, which was often contracted in and as of service model. We’ve been shifting skills and work from these declining practices to the new opportunity areas, we've had strong growth rates in our strategic imperatives, but we need to shift more aggressively to improve our overall GBS business results. We’re also seeing that long-term application management is becoming more important to enterprise clients as the IT environment grows more complex. Clients are integrating public and private cloud networks; deploy new mobile capabilities into their employ and customer base and deploying analytics around these solutions. These ongoing changes in clients needs drive both shorter term systems integration as well as long-term management requirements and performance improved across our application management services in the second quarter. Looking at GBS profit, there were few drives of the decline. The largest impact was from the customer care divestiture which drove nine points of the year-to-year decline in profit, due to the sizeable gain in last year’s results. Also we increased the level of investments to further enable our partnerships and we hired a rescaled additional go-to-market and delivery practitioner resources for our fast growing strategic imperative offerings. For example, we've hired over 2,000 incremental resources into our mobility practices and shifted almost 1,000 to analytics projects. The remaining profit decline was driven by the lower revenue on what is a relatively fixed cost base in the short-term. We remain focused on our cost competitiveness through alternate labor models, more aggressively shifting resources to higher value offerings and enhancing our global delivery capabilities. Our software revenue of 5.8 billion was down 3% with that our first half revenue was down 2% which is consistent with the performance in the second half of last year. Key branded middleware was flat but total software performance reflects the headwind from operating systems and other middleware. Profit performance in software is a reflection of the overall revenue performance, a higher level of investments in areas like Watson and Bluemix and an impacting currency translation. We had growth across the solution areas including security, commerce and social and within that we saw strong growth in our Software-as-a-Service offering. As security software revenue returned to double-digit growth. Our security solutions bring together intelligence, integration and expertise that are essential in the world of advanced threat. As an example, one of the top 10 global energy firms was looking for an analytics based approach to protect tens of thousands of systems and devices globally from advanced threats. IBM brought together a security solutions and services expertise to establish a security operation center to monitor billions of logs and events on a daily basis. This intelligent approach to threat management has allowed them to focus their resources on only the handful of high priority threats that want further investigation. And another of our solution areas our commerce software grew. Our commerce solutions are allowing client to get unique insights about their customers. Nine of the top 10 U.S. retailers and each of the top 10 global banks run an IBM’s commerce solutions. IBM commerce now powers 30,000 organizations globally. Our social solutions again grew double-digits driven by strong performance in both Kenexa and advanced collaboration offerings. We’re continuing to bring innovations to our solutions areas and deepen our industry focus. Watson as an example where we’re creating a market around cognitive computing and building an as a service business. Last quarter I talked about expanding the Watson ecosystem, this quarter I want to focus on another aspect of our progress. Watson’s being deployed across nearly 30 countries and in 20 industries. We are currently working on 100s of projects to expand industry domain knowledge as well as teaching the system new languages such as Spanish, Portuguese, Japanese and Arabic. We continue to expand Watson’s reach by forging additional partnerships and just last week we announced a formation of a joint venture with Mubadala to bring IBM Watson to the Middle East and North Africa with focus on healthcare, retail, education, banking and finance. Our focus in software continues to be innovation, partnership and aligning to the needs of our customers in the industries in which they operate. Turning to our systems hardware segment. Revenue of 2.1 billion was up 5% and pretax income was up 26%. These results are reflection of both our ability to continue to deliver innovation across our high end systems and the significant actions we’ve taken. This quarter’s Z Systems revenue was up 15% and through the first half we grew about 50%. Power revenue grew 5% this quarter. We saw growth in both the low end and the high end where we’ve introduced new POWER8 based systems. The capabilities of both mainframe and power systems are resonating well with our customers and we continue to add new customers to the platforms. During our investor briefing earlier this year I talked about the mission critical nature and expansion of banking transactions that our mainframe supports. Our Z System offers the most secure, reliable and scalable platform with the best price performance. So when a leading managed service provider in Europe was looking to create a cloud platform for independent software vendors serving financial services clients they opted from mainframe. This is another new IBM mainframe customer. In that same Investor Day presentation, we talked about the explosion of data and transaction volumes in the telecommunications industry. So when a leading telco solutions provider in China was looking to offer a customer experience solutions to its global clients it selected power on Linux over X86. The power platform provides both higher capacity and better performance on X86, allowing them to incrementally scale out their solution. Our open power strategy continues to take hold globally. In June, the UK government joined the United States as the second major government to turn to open power for its high performance computing priorities. The UK government will utilize IBM’s latest open power high performance computing and Watson based cognitive technologies to obtain valuable insights from a variety of data sources to boost productivity and drive growth. This is a similar class of IBM open power system that the United States Department of Energy selected for the Lawrence Livermore Oak Ridge National Laboratories. I believe our power results through the first half show that the power strategy is working. Our storage hardware revenue was down 4%. We again saw strong growth in our flash system with our new generation offerings introduced in the first half. This growth was once again offset by the wind down of our OEM business and continued weakness in high end disk. Our systems hardware segment revenue growth and profitability improvement is a clear result of the actions we’ve taken to position our systems business for the future. Moving on to cash flow in the quarter. We generated $3.4 billion of free cash flow which is up 400 million year-to-year. Of course this is after nearly $1 billion spend in CapEx consistent with last quarter and with last year. Through the first half, our free cash flow of $4.5 billion is up over 800 million year-to-year. The primary drivers were lower cash tax payments and an improvement in our sales cycle working capital. This was partially offset by the remaining working capital impact to cash flow from our system x divestiture payments for performance based compensation which were accrued last year and operational performance. As you know our annual free cash flow generation is skewed to the end of the year, and our first half results are in line with that skew. Do remember we said that we'd improve our free cash flow realization from 2014 to 2015 and earlier this year we expected realization in the mid to high 80s we now expect the full year to be about 90% but even at the low end of the profit guidance this reflects a modest year-to-year improvement and free cash flow for the year. Looking at uses of cash we spent 700 million on acquisitions. We've acquired five companies in the first half. These add to our capabilities and cloud and analytics and deepen our industry domain expertise to further differentiate our solutions. For example the two acquisitions made by Watson Health strengthen IBM's leadership and healthcare analytics and to support our effort to apply cogon of computing to drive healthier patient outcomes. In the last six months we've returned to $4.7 billion to shareholders, this includes 2.4 billion in dividends and 2.3 in gross share repurchases the buyback over 14 million shares. At the end of June we had 987 million shares outstanding and $3.9 billion remaining in our buyback authorization. Turning to the balance sheet, we ended the quarter with a cash balance of $8.8 billion, up 300 million from December, but down from a year ago. Total debt was $38.7 billion, of which just over $26 billion was in support of our financing business. The leverage in our financing business remains at 7:1. Our non-financing debt of $12.6 billion is down $4.5 billion from a year ago. Our non-financing debt-to-cap was 55% which is down four points from December and almost a point lower than a year ago. We continue to be well positioned to support our long-term growth strategy. But now let me wrap it up and talk about our expectations for the full year. It's been us move aggressively and decisively to reshape our business to best address the long term value in IT. We've been shifting investments in resources building partnerships and ecosystems and introducing key innovations. Since the beginning of the second quarter we launched Watson Health acquiring Phytel and Explorys and partnering with the other leading healthcare companies. We finalized the divestiture of our semi-conductor manufacturing business to global foundries while we introduce the breakthrough in seven nanometer technology. We announced that we had embedded spark into our analytics and commerce platforms and formed an innovative new cloud partnership with Box. Each one of these actions contributes to our transformation and improves our hand for the long-term. So let's talk about what it means for 2015. In the first half our revenue in the strategic imperatives grew more than 30%. Those markets were also growing, but with our performance we're clearly gaining share. The core portfolio continued to decline in a declining market. So together the strategic imperatives and core delivered revenue at an IBM level that was roughly flat. But for the full year we continue to expect to deliver operating EPS of $15.75 to $16.50 and even at the low end of the range we now expect the modest year-to-year improvement and free cash flow for the year. We said from the beginning of the year the primary variable between the high end and low end of the guidance is our software revenue trajectory. From a margin perspective for the full year, we continue to expect to expand margin driven by portfolio actions. We also said we'll continue a high level of investment and we'll continue to return value to shareholders through both share repurchases and dividends. For the third quarter if you look back over the last few years we typically see about a billion dollar decrease in revenue from second quarter to third quarter. There is no reason to think this year will be different than our typical seasonality so with the billion dollars last quarter-to-quarter third quarter revenue would be about the same size as the first quarter. Now what is different is the mix of business relative to what we've seen historically. But even with that will continue to expand margin in the third quarter driven by our portfolio actions. When you look at some of the other dynamics and the third form a year-to-year perspective currency impact investments, workforce rebalancing, the third quarter profit trajectory looks a lot like the second. Now there are some differences like we don’t have a gain in last year's third quarter results but on balance the year-to-year profit would be pretty similar to 2Q. This is true for the EPS trajectory as well. Through the first half relative to the low end of our guidance we are at the same point as last year, and ahead of the year before. In the third quarter given the profit trajectory I just described we expect to finish the third quarter with 63% to 64% of our low end EPS guidance achieved consistent with prior years. And then where we finish within the range for the full year really depends primarily on whether we have a change in trajectory and our software business. Importantly as we progress in our transformation we’ll exit the year a higher-value business. Now Patricia and I will take your questions

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

Thank you. [Operator Instructions]. The first question comes from Toni Sacconaghi with Bernstein. You may ask your question.

I was wondering if you could talk a little bit about software, the business was down 3% at constant currency, I think other than the financial crisis in '09 that's the lowest software growth rate in the last 15 years. You also had a significant pressure, accompanying pressure on margins. And I am wondering if you can kind of step back. At the beginning of the year you were hoping for an improvement and talking about the guidance, it looked like perhaps you are not as confident, you were saying we could end up at the low end of the range if we don’t improve, maybe we'll do better than that if we do improve. But I am wondering if you can kind of step back now that you are half way through the year. The results seem to suggest that there is something structural impacting your software business. Now whether that’s the decline that we've seen in UNIX over the last couple of years or whether it's the migration to as a service, there seems to be an inflection point over the last four quarters in your software business for the worst. And I am wondering if you can step back and tell us if you agree with that and what you think is driving this and do you have confidence like the same level of confidence as you did six months ago that the software business will improve throughout the year?

A few comments I think on software and some of these themes are going to be consistent with what we've talked about and then some of them will be I guess observations and we go through the year. So relative to, first relative to guidance as we said since the beginning, the difference, the primary difference in our guidance range for the year is driven by the trajectory of software. And so when we went through in the prepared remarks and pegged third quarter to the low end I wasn’t suggesting that we don’t see that difference still, in fact we do still see software driving the difference between the low and the high end but we do have to when you have a range you do have to pick one side to anchor your analysis. So we chose in this case to anchor to the low side. With regard to software there are some consistent themes here that we've been observing now for a while. We do still have in our overall growth rate a headwind from the operating system element of our business, so it was about a point. Additionally, what we saw in the BRIC countries' impact on IBM and I mentioned this in my prepared remarks even though the BRICs are relatively small, only about 7% of our revenue, they had a two point impact on the growth. That same phenomena translated into key branded middleware. So ex the BRICs our key branded middleware segment, software segment would have had 2 points of growth as well. So when we look underneath that I think the consistency here is that we have two phenomena. Within our top 250 clients and we've talked about the substantial both investment and commitment those clients made to the software platform, within that client base we continue to offer and they continue to utilize flexibility so that they can fully deploy middleware across their environments. And that phenomena hasn’t changed. Now outside of that top 250 clients we do see growth. We have seen growth, we have been growing there and we continue to grow. So it really is this flexibility that we are providing to our clients which we still think for the long-term as the right thing to do as they commit to the platform.

The next question comes from Tien-tsin Huang with JPMC. You may ask your question. Tien-tsin Huang: Just on the strategic imperatives I guess up 30% again, so up 30% I guess for the first half. I am curious if that growth rate is sustainable into the second half. Martin I know you suggested it could come down to the 20% level of last year, but checking to see if that's still the case for the second half of the year?

So it was quite a good acceleration as we mentioned in the last call from the fourth into the first and as you note and as we just talked about in our prepared remarks, we were able to maintain that trajectory into the second quarter. So we finished first half in a very strong position in strategic imperatives. And given our growth rates and where we think that market growth rate is, as I mentioned in my prepared remarks, I think we're growing share across that space as well. When we look forward in those strategic imperatives and we look forward at the overall revenue trajectory of IBM, we don’t have assumed, we have not assumed a dramatic improvement if you will in the overall revenue trajectory at the low end of our guidance. At the high end obviously as we just talked about in the last question and in prepared remarks, the high end we assume an improvement in the software trajectory, some of which will be in the strategic imperatives obviously. In fact the weighting of our software business and strategic imperatives is larger than the overall business. So I would expect that we would see an improvement in that. But again our current guidance at the low end does not assume a dramatic improvement in the overall revenue trajectory. And so within that the mix between the strategic imperatives again which has a lot of momentum versus the core, we're not suggesting that we have to grow or we have to change the trajectory at the low end.

Christine, can we take the next question please?

Next question comes from David Grossman with Stifel. You may ask your question.

Last quarter Martin we discussed cash taxes as a tailwind this year but offset by other headwinds. And then as of April it appeared the cash taxes would be actually free cash flow headwind in 2016. Is that still the case and if so are there known tailwinds next year that would offset that and allow the free cash flow conversion rate to remain in that 90% plus range that you've talked about for this year.

A few things, so and there are a number of metrics here I want to make sure that we triangulate to the right answer and that we don't confuse or we don't mix some of the data points, so cash taxes as you know last year were substantial year-over-year headwind and this year they're not a year-to-year headwind and the amount of cash tax tailwind that we're getting this year is the same as we thought it was going to be at the beginning there, so no change to that. Now let's switch for a second to the realization metrics, so cash taxes were about a 10-point headwind to realization to last year, very dramatic headwind to our realization. This year they're still a headwind although much reduced, so the realization impact is only about a point or two, so when you think about the relationship of what's going on our cash tax rate will still be a little hit higher than our book rate although not as high as it was last year. So this year cash taxes will be a little bit higher than the book rates so there still a realization impact but there is a year-to-year tailwind in terms of payments. Now next year we still have a lot of work to do and a lot of planning to do and while we have a small headwind in realization this year, we do see a headwind in realization next year and how that translates to a year-to-year I think we have to spend the next six months trying to figure that out and then we'll have more guidance in January for you, but again there are different elements here. So from the realization cash taxes are still a headwind this year although smaller than last year and next year we expect them to be a headwind but we'll have to translate as we get closer and to what that means on a year-to-year base for 2016, but as we just mentioned in our prepared remarks we do see now a modest improvement in free cash flow for this year.

Can we go to the next question please?

The next question comes from Lou Miscioscia with CLSA. You may ask your question.

So can we step a back to the services side in the sense that consulting system integration was weak again and you had talked about having to shift some of your resources maybe you can go in and say the cloud or ERP deployments are going down or being replaced by SaaS developments maybe you're not winning as many products they're giving that others are growing actually consulting pretty well here in beginning of 2015?

So a few things, our GBS and when we talk about consulting systems integration, I'll just focus the answer on our global business services segment. GBS was as you noted down again in the quarter although quarter-to-quarter we had about 1 point improvement in the trajectory still down but a bit better than the first and the dynamics within that I think are similar to what we saw in the first which is the shift that we're undertaking and what you've noted in your question, the shift that we're undertaking is pretty dramatic and we're seeing very strong double-digit revenue growth within the strategic imperatives within the GBS business alone. Now that we also have a pretty substantial -- think about it as a traditional ERP implementation kind of consulting business and the net of the shift to the shift of those strategic imperatives and obviously the reduction in our resources applied to those larger implementations the engineered shift is not yet at the point where the revenue growth coming from those imperative is offsetting if you will our reduction in those the areas that address those traditional ERP. So the course is still the largest part of the portfolio that was traditional parts of ERP implementations and while we engineer that shift we're going to see declines in that part of the business, but as I mentioned that shift is driving growth in the strategic imperatives we just have to continue to be as fast as we can to get those areas so we can see growth overall for the GBS business.

Could we take the next question please, Christine?

The next question comes from Steve Milunovich with UBS. You may ask your question.

A couple of non-operating items, Martin, last quarter you suggested currency could hit EPS about $0.80 for the year I was curious if that's still the number and it looks like your expectations for the next few quarters on currency at similar to a little worse than in the April quarter and I am little surprise given the move in the Euro than also was curious about the 17% tax rate, should we carry that forward does that go back to 20?

Sure, thanks, Steve. Few things so first on tax, we'll start at the back on tax. So we still see a 20% rate for IBM that's the right operating rate if you will for us, we did have as I noted in the call a couple of discrete items in the quarter but those were discretes in the quarter. Now we do have discrete throughout the year but 20% is the right number for tax. On currency impacts, I'll come back to earnings in a moment the first part of the question, currency impact is now a little bit worse for the year relative to what we expected just 90 days ago. So you may remember we include as we always do we include a supplemental chart on the impact of currency and we had on that chart in April that the third quarter would be about an 8-point impact and the fourth quarter would be about 5 year-to-year and now we see 8 to 9 and 5 to 6 in terms of the currency impact and that data again is in the supplemental chart. And so we are seeing an increased -- a slight increased currency impact for the second half of the year. Now our view of currency and its impact on profit is and can be, as you would imagine the translation impact can be quiet substantial. So we did say that the impact to earnings would be about $0.80 for the year and we still see, while it's gotten a little bit worse we still think that’s probably little bit worse as well, but we can hold that within the guidance we’ve given. So, yes the impact to EPS is probably a little bit worse than what we had assumed. We do have actions underway to try to navigate through whatever currency environment we’re in, but the year-to-year impact is still fairly substantial in our guidance. Now of notes -- of note is that the guidance as you know reflects a EPS of flat to downsize and the currency impact is five points, roughly in terms of earnings. So if we were in benign currency environment, we’ll discard the idea of it being an actual tailwind at some point. But if we were in a benign currency environment, our guidance would reflect flat to up five and that’s the kind of impact I think that you would expect to see in a company that has more than 60% of its revenues, and cash flows and profits, dramatic part of this profits operating in currencies other than the dollar. So the short answers to your questions tax 20 is still the right thing in terms of operating, the currency impact is a little worse than what we assumed from 90 days ago and it is a dramatic year-to-year impact on our profitability.

Let's go to the next question please Christine.

The next question comes from Brian White with Cantor Fitzgerald. You may ask your question.

Martin it sounds like services you got from bigger deals in the quarter, minor services in aggregate beat our number. When can we start to see margins improve back to levels that we saw two, three years ago in the services business?

Yes, we did see as you saw a very strong signings quarter which as we noted in the prepared remarks drove our backlog to 1%, ex-currency is the first time we’ve had backlog both in a couple of year. So obviously very encouraging to get the services backlog growing, so we can start to see a more consistent delivery of revenue growth. Obviously within that revenue growth in that business does drive profit leverage, but keep in mind that we continue to invest quite heavily as well in order to make sure we’re building the right cloud platforms, the right skills around that services business. So while the single largest impact year-to-year and our services profitability not on margins, but services profitability is the translation of those profits back to dollars given the dollar strength. We do see an opportunity to continue to invest quite heavily in our services business. We do see opportunities to continue to move not only the GTS business, but the GBS business to higher value and over time that will drive margin improvements. But for now, we’re not relying on margin improvements in our guidance for this year. But again the single largest impact on a year-to-year basis is currency. So as we continue to invest while that revenue grow -- if we were to grow we continue to grow revenue in GTS for instance that will drive some leverage in the profit model, we’re going to continue to invest pretty heavily going forward.

Can we take the next question please?

The next question comes from Keith Bachman with Bank of Montreal. You may ask your question.

Martin, I want to follow-up on that last point, I understand currency impact on the Services segment. But as you look out beyond the next quarter or two. Won't you need to A: continue to invest in these businesses on both GBS and GTS? And B: as you make that adjustment to the higher growth areas is there a mix impact that will continue to weigh in on margins even as you look out a bit further than the near-term quarter. So both the investment side and the mix side as you think about both sides of services please?

So couple of things Keith; first, we will continue to invest. So let's assume we’ll get through at some point, the year-to-year impact of currency and we’ll just take currency out of the equation for a second. When we look at our model, we see a few elements that will continue to drive profit growth within services while at the same time continuing to invest. So first we will continue to drive capacity utilization into our cloud business, so remember we’re investing pretty heavily in cloud and I would say that those businesses are not yet at scale. So as we get those and utilize that capacity and get to scale then we’ll see margin improvements in the services business. Secondly we continue to shift that overall portfolio to the most contemporary highest value offerings that our clients are demanding and I think you can see that both in the signings we had for instance in our services business and the backlog growth you can see it and the strategic imperative performance within GBS. So we continue to shift those offerings to higher value. And then underpinning that the delivery side of this, the delivery elements of this including much broader deployment of intellectual property leveraging our software and research ability to put automation into our delivery content. So, we do still see opportunities to keep a balance between we’ll keep investing but we’ll also be able to drive a more efficient delivery platform as we go through -- as we get out of this currency environment. And then finally, I think it’s important to note that while we do make use pretty heavy use in some countries like the U.S. we have a pretty good global delivery platform within the U.S. that’s not the same everywhere in the world. So, in some regions in the world our use of global delivery is still under 30%, so we still have opportunities in those regions to move more of our delivery into a global delivery format. So I still see between the shift to higher value between getting cloud to scale and the move to automation and getting more of our regions into the global delivery environment. We still have room to improve margins and services.

Christine can we please take the next question.

The next question comes from Jim Suva with Citibank. You may ask your question.

In your prepared comments you mentioned a little bit about operating expenses as a percent of sales have increased due to the mix shift and my belief is understandable and I assume you’re referring to the mix shift in more strategic imperatives and it can’t -- and so that manifesting itself a nice growth I think you said up 30% year-over-year which is good. Can you help us understand the timeframe or the milestones for judging and assessing the strategic imperatives and the investment in them of when we start to really start to see leverage to the model of leveraging that growth into a lot more profitability? Or in other words how much longer do you have to keep really investing a lot more ahead of all that?

So a few things, in the prepared remarks on expense what we talked about was a slightly higher E to R in the quarter and we wanted to go through make sure everyone understood that the 9% year-to-year improvement in expense was driven heavily by just the translation the currency impact which is actually 11 points a year so currency obviously has an impact on the expense side as well. We also talked a bit about the impact of having the expense from our system ex-divestiture now out of our run rate so that was a couple of points. So we wanted to make sure that everyone understood, our investors understood that we continue to invest and that’s why E to R is up in terms of the second quarter. Now when do we get through that? Boy, we see an industry where innovation where industry skills and knowledge are the differentiators in many of our engagements. And so a lot our investments are focused on yes the strategic imperatives as you said which is a combination of shifting out of things that we were doing into new things it's also part of growing that overall investment pool but within those investments yes there’re strategic imperatives but it’s also a lot of investments around building industry skills, industry talent because more and more our clients are looking for that industry point of view. So I don’t know that we get through if you will the bow to shift through the wave in terms of expense in terms of investments when do they slow-down. Now I do think they’re paying off. We had tremendous growth in cloud again we have tremendous growth all across the strategic imperatives. So, shifting this expense as we’ve talked about in the beginning of the year is absolutely the right thing for us to do for the long-term. We can see that pay off in terms of the market share we’re growing in those strategic imperatives. Now those will continue to pay dividends for a long-long time within that as you know we’re building a number of as a services businesses including Watson, so I think that those investment levels are important I think we’ll continue to maintain those investments because we’re building some very appealing businesses underneath those strategic imperatives.

Christine can we please take the next question?

The next question comes from Joseph Foresi with Janney Montgomery Scott. You may ask your question.

I was wondering if we could get some sense of what percentage of revenue the strategic imperatives are and how do they impact your visibility on the business? And then just one last one have we had a positive inflection point on the services backlog?

Sure. So a couple of things that we hit a positive inflection on the services backlog we’ll start with that. So, the backlog is $120 billion plus, so it’s hard to make it move if you will. We had a very good signings quarter as we talked about 22 deals greater than 100 million we still see a lot of opportunity in terms of additional services opportunity. But getting that substantial backlog to move it takes a lot of services, signings of our consistent period of time. So while we see very good demand it’s tough to predict on a 90 day basis where the backlog is going to be again given it’s a 122 billion that we’re trying to move. Now as a percentage of revenue we've talked about last year in Investor Day we talked about it on a full year basis had about 27% and we said in Investor Day that we’re going to grow that to about 40, be more than 40 billion about 40% of our revenue by 2018. Now I think even there is seasonality in this number I would say we are certainly ahead of the 27 given the growth and we're making tremendous progress toward that 2018 goal of 40% of our business but given the seasonality I'm not sure that whether where we are within that range is all that insightful. We will take our temperature again on this at the end of the year so that get a data point without much seasonality or that any seasonality but again from 27 last year we are on our way to 40 and I'd say the two data points that we have of 30 plus first quarter and second quarter are in very good shape remember that we showed at Investor Day we show the chart that said these have been growing at about 19% fairly consistently over the last few year. So you should assume and I think we're comfortable that we are making very good progress on that longer term goal.

Christine, can we please take one last question.

The last question comes from Amit Daryanani with RBC Capital Markets. You may ask your question.

Just wanted to get back to the software segment. Can you just talk about -- do you think the business performed in the June quarter inline to your plan or was it ahead of the low and then when you look at the PTI margin decline you saw in software is that reflects to the flexibility you are providing to your customer when they move to strategic imperative and it should get back to more normalize level once you get beyond that I guess initial transition or does that really reflect more of the reality that some of these strategic imperative revenues maybe at a lower margin than your legacy revenues are?

Sure. You made a couple of things. So, in terms of in line with the plan we've said since the beginning of the of the year that the at the low end of guidance we don’t assume a change in trajectory and at the high end we do and that's to by the way to over simplify up nearly 100 billion corporation but will over simplify for the purpose for this question and right now given that the change the trajectory in software has not changed I'd say that we are right in line with our plan but we are right in line with that low end of guidance. I don’t think that would surprise anybody. With regard to the margin a couple of things one software is very high margin element and can continue to be a very high margin component of our overall mix. Now when we look at margin if I think there are two things I would disaggregate on a gross profit level margin the only real shift we see is a slight shift to our SaaS properties. And so while they are coming at slightly lower margins than our traditional on plunders business they are still highly accretive to the overall IBM model because bear in mind these are new spaces for us were not taking and converting the non-prem business to it and as a service business we are building new revenue streams and spaces where in spaces where we are not today. So slightly lower gross margins on the SaaS business but all accretive to the IBM model and then the net margin in our software business reflect a lot of the investments that we've talked about both in strategic imperatives and remember we continue to invest in our core businesses because as we talked about it at Investor Day in other venues that contemporary nature of those while they are products that have been in our client sites for many-many years and they are committed to this products those products evolve into the latest most contemporary needs as well. So those products now have to live in and support our clients in a mobile world in a social world and they have to have analytics capabilities as well so the old products are also part of that investment and so. From an investment standpoint I would say that you're seeing the investments in our software business on the net margin line.

So let me take a few minutes to wrap up the call. We're half way through now of transformation here and you can see in our results that the investments and of course the shift in our business we're seeing good progress as we move more of our business into the strategic imperatives, we've been very active in reinventing our hardware business and I think that's paying off and the investments and the added focus we've put on the solutions areas are contributing to some pretty strong growth in those strategic imperatives. So, with six months behind us we've maintained our full year of EPS even though as I mentioned in the remarks and in the Q&A that currency is probably little worse than it was at the beginning of the year but will maintain our EPS guidance and as we talked about in the prepared remarks we've taken up our view of our free cash flow modestly, so modest growth free cash flow for the year. We said from the beginning that this will take some time, we continue to manage the business for the long-term and we're confident that we're on track to that longer term trajectory. So thanks very much everyone for joining us today.

Christine we'll turn it back to you to close out the call.

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