Patricia Murphy - VP IR Martin Schroeter - SVP & CFO

Katy Huberty - Morgan Stanley Wamsi Mohan - Bank of America Merrill Lynch Steve Milunovich - UBS Ingin Wang - JPMorgan Toni Sacconaghi - Bernstein David Grossman - Stifel Financial Amit Daryanani - RBC Capital Markets Jim Suva - Citi

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, 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 their related GAAP measures in accordance with SEC rules. You will find reconciliation charts at the end of the presentation, and in the Form 8-K submitted to the SEC. So with that, I'll turn the call over to Martin Schroeter.

Thanks, Patricia. In the second quarter, we delivered $19.3 billion of revenue, operating pretax income of over $3 billion, operating earnings per share of $2.97, and free cash flow of over $2.5 billion. The quarter played out as we expected with continued solid growth in our strategic imperatives which now really reflects organic growth. We wrapped on the acquisitive content and we're at the stage where we can start to get some efficiency as a result of bringing them into IBM while we build on the new content. Our gross margin is up over 2.5 point sequentially and positions us for the continued improvement over the course of the year we talked about 90 days ago. And we had good free cash flow performance all again as we expected. In the second quarter we signed a number of large contracts in global technology services and again, grew our global business services signings, both of which will start to contribute in the second half. And since the quarter ended, we announced our new IBM Z system which will be available later this quarter. With all of this we expect improved performance in revenue and gross margin in the second half and we continue to expect at least $13.80 of operating EPS and free cash flow consistent with last year. I'll spend time on the first to second half dynamics a little later and you will see it's very similar to what we talked about in April. We've been focused on helping our enterprise clients transform their businesses to leverage their data for competitive advantage and to improve the efficiency and agility of their IT environments. Our strategic imperatives performance has been an indication of our progress in moving to these areas. As you know, our strategic imperatives are in separate businesses but signpost that represent the revenue across our business lines that work together to address demand for analytics, cloud security, mobile and social. Our clients are taking the productivity savings we're delivering to them in the more traditional areas of IT and reinvesting those savings to move into these new areas; these are the dynamics you've seen in our revenue. In the quarter, our strategic imperatives revenue was up 7% at constant currency which as I said is pretty much all organic growth. Over the last twelve months, revenue from our strategic imperatives was up 12% to over $34 billion and now represents 43% of IBM. As is typical, I'll focus on constant currency growth rates throughout. A large part of our strategic imperatives are delivered as a service. Our as a service revenue was up over 30% in the second, and we exited the quarter with an $8.8 billion annual run rate. IBM's cloud revenue on a trailing twelve month basis is now over $15 billion, that's nearly 20% of IBM's revenue. Let me spend a minute underscoring how we've been able to build cloud to a $15 billion business, and why enterprises are increasingly moving to the IBM cloud. In the second quarter we added more leading companies to the IBM cloud. For example, Lloyds Bank has chosen the IBM cloud. Lloyds is one of the most advanced digital banks in the world and they expect to become even more agile by leveraging IBM's unique combination of private and public cloud capabilities. American Airlines is also using the IBM cloud as the foundation for this broadbased cloud transformation. Clients are choosing the IBM cloud for a number of reasons. First, our cloud is hybrid, built for the enterprise, that's public and private, and integrated with on-prime [ph] data and workloads. Second, they want to leverage our expertise in industry and their existing business processes and systems, and we know how to migrate them from one era to the next. Third, they trust IBM and the IBM cloud to protect and preserve not only their data but also their insights and AI training engines to ensure all of the value from their data accrues to them versus going to educative central knowledge graph. And of course, we continue to add state-of-the-art tools and technologies to exploit enterprise data in the cloud; this includes Watson and blockchain. You see this last point cloud as companies deploy IBM blockchain and Watson solutions in the cloud. Recently, we announced an agreement with a consortium of seven of Europe's top banks to create a new blockchain service for trade finance for the small and medium business market. And in Australia, we're working with banks to launch new commercial property leasing services based on blockchain. And remember, we're already working with many others including DTCC, CLS and Northern Trust. Beyond financial services we're working with industry leaders like Walmart and Food Safety and Maersk in shipping. It's still early but we see a lot of opportunity leveraging block chain in the cloud and across multiple industries. Similarly in the second quarter we saw Watson deployments continue to expand globally. The cognitive opportunity is a global one, it's not centered in New York or Boston or Silicon Valley; but you can't just look and listen in those places. In healthcare alone, you'd miss that this quarter the first healthcare provider in Latin America is deploying Watson for oncology, and Baheal Pharmaceutical Group is bringing Watson for genomics to clinicians across China. In fact, 80% of the hospitals who've adopted Watson for oncology are outside of the U.S., and that's just healthcare, we have Watson deployed with other leaders like Berdasco [ph], Honda and Vodafone as well. So across industries and around the world our clients realize that data, in fact their own data is the route of competitive advantage for all companies. Remember, 80% of the worlds data is owned by enterprises, it's not searchable on the worldwide web, it's customer data, and patient data, clinical data, supply chain data, transaction data and companies want to unlock and exploit that data; and so that's why enterprises will move to cognitive on the cloud with someone they trust who has leading tools and industry expertise and a data model and business model consistent with their goals, that is the IBM cloud plus Watson. I want to also remind you of the importance of the underlying technology stack. We've continued to reinvent the mainframe and our power platform to address the most contemporary enterprise workloads. Our new z14 mainframe is a great example. With a breakthrough in data encryption, IBM Z is capable of encrypting all data associated with any application, service or database all of the time and with no application change and no performance impact. Think about what that means for addressing global data breaches, the increase in government regulations and block chain opportunities. It's the biggest reinvention of our mainframe technology since the reinvention for Linux and open source software 15 years ago. I'll touch on additional progress and examples of where we're winning in these areas and more details on our new mainframe capabilities as I go through the segment discussions. But first, I'll walk through our financial metrics. Our revenue for the quarter was $19.3 billion, which is down 3% at constant currency. As expected, we had a larger currency headwind to revenue growth, it was about twice the impact of the first quarter. I mentioned earlier that we ramped on the acquisitions we completed in early 2016. We had two points of benefit in the first quarter from acquisitions and only about 40 basis points in the second. So excluding the acquisitive content, our year-to-year revenue performance was a modest improvement over last quarters rate. When you look at our revenue performance by geography, in the Americas, revenue in the U.S. was down while we had solid growth in Canada and Latin America. Our overall performance in Europe declined centered in Germany and the UK. You will recall, last quarter I talked about the impact of the conclusion of services contracts in those countries which will continue through the year that will get some benefit from the new deals we signed in the second half. We had sequential improvement in Asia Pacific with growth in several markets including Japan which is our second largest country. I'll come back to the revenue trajectory later in the call. When you look at our gross profit, our margin was down year-to-year but significantly better than the first quarter year-to-year performance. The year-to-year margin decline reflects both the mix and invests. From first to second quarter we got substantial leverage from our high value model. We added $1 billion gross profit from first to second with $1.1 billion of additional revenue, while last year we had similar gross profit improvement from first to second but we needed more revenue to do it. So that of course resulted in improved trajectory in the year-to-year margin dynamics; in fact, we had sequential improvement in the year-to-year gross margin performance in each of our five segments. We'll talk more about the drivers and trends in the segment discussions. Our expense was down 6% versus last year with about half of that due to currency and the balance reflects an increased focus on driving efficiency in our spend base. As I said, we've been shifting and adding resources as we invest to build solutions and platforms. In fact, in the first half of this year we hired 20,000 people into the business; so our cost and expense profile reflects a balance between investing in key areas and driving efficiency across the spend base. Our operating pretax profit was nearly $3.1 billion which is up about a $1 billion from the first quarter. Our tax rate for the quarter reflects an ongoing operating effective tax rate of just under 15% consistent with last quarter. We also had discrete tax benefits in the second quarter of about $170 million or $0.18 of operating EPS. We generated $2.8 billion of operating net income in the quarter and net income margin of 14.5% which is up 50 basis points year-to-year. On the bottom line, our operating EPS was $2.97. We generated over $2.5 billion of free cash flow in the quarter which is up year-to-year, and over the last twelve months our free cash flow is 94% of our GAAP net income. So now turning to our segments, cognitive solutions had $4.6 billion of revenue, continued growth in annuity content led by SaaS and an improved margin profile. Our annuity content which represents 80% of cognitive was up 2% year-to-year driven by roughly 4.5% growth in solution software. We had strong SaaS performance with strong double-digit growth in signings and revenue again this quarter. Revenue was up nearly 30%. As our SaaS business grows, we continue to invest to build scale. The software transaction revenue was down double-digits due to declines in some of our license based offerings and as you know, this was a larger impact in the second quarter given the seasonality of our transactions. As we've said before, many of our license-based offerings are high value but in declining markets. We also wrapped on most of our acquisitions and are focused on investing to combine organic and acquired content to build cloud-based cognitive offerings. Let me talk about the progress we're making in parts of the solution software portfolio. In analytics, we saw good growth in Watson health and Watson financial services and in BI and data discovery lead by Cognos. We announced the partnership with Hortonworks to combine our data science experience in machine learning with Hortonworks data platform to allow developers to access data science and cognitive tools and create intelligent apps. We also had strong growth in our Watson platform which underpins our enterprise AI strategy as we build scale. Conversation API usage and the number of active users are up strong double-digits quarter-to-quarter as we helped clients embed cognitive into their workflows. For example, credit mutual is live with multiple used cases including virtual systems for insurance and savings. These cognitive applications were rolled out to over 20,000 agents across France enhancing their quality of service for 12 million customers. In this quarter we added new partners like LivePerson which provides a conversational platform used for the customer care needs of over 18,000 businesses. Given the growing relevance of AI in digital channels, they announced a new offering called LiveEngage with Watson to transform the customer care space. LiveEngage can offer intelligent personalized digital support to each customer; this is an appealing market, the value Watson provides depends on the complexity of the conversation, so the number of API calls can vary but we have the potential to deliver value from every digital conversation. This will scale as more of today's 270 billion customer support phone call shift to digital interactions. Within our vertical strategy, Watson Health had strong growth, particularly in the areas of state and local government agencies and oncology as we continue scaling. While market uncertainty persists, government agencies still face the realities of having to deliver services more efficiently; and our analytics and social program management offerings can help clients make better informed decisions to reduce healthcare costs and reduce outcomes. Both offerings drove strong growth this quarter; oncology is also scaling and is now in over 50 hospitals on five continents. Through the first half Watson has worked with nearly 40,000 patients and doctors and this will grow to approximately 100,000 by year end and many of these have life-threatening diseases such as cancer. Watson for oncology alone has a potential to reach millions around the world based just on the hospital systems we've engaged to date. So we're just at the beginning of scaling, we continue to add new cancer types so our patient reach continues to grow. We're not just scaling our business into new areas but also improving deployment; for example, we implemented Watson for oncology at Baheal Pharmaceutical Group in less than a month. This quarter as I mentioned earlier, we expanded with Baheal into genomics. We also announced the new collaboration with Hackensack Meridian Health, a prominent U.S. provider to combine Watson for Oncology with their real world data to help oncologists improve cancer treatment and reduce costs. For another industry example, Watson for Financial Services which includes the [indiscernible] acquisition, also contributed to growth this quarter. We launched industry expert trained AI risk and compliance solutions including anti-money laundering and know your customer. Beyond verticals, security, including security services which is reported in technology services and cloud platforms grew again this quarter. Offerings like QRadar and Resilient had strong growth as customers look to strengthen their ability to both the tax and respond to security threats. This quarter we announced the partnership with Cisco to address this growing threat of cyber crime. We will collaborate on threat intelligence research by sharing data, integrating our offerings and coordinating on major cyber security incidence. Turning to profit, cognitive solutions gross margin is down year-to-year though improving sequentially driven by the continued investment into strategic areas including acquisitions and the mix towards SaaS. Cognitive pretax income is up year-to-year and this segment has very high PTI margins which expanded again this quarter, even with a high level of investment as we continue to embed cognitive into offerings, build and scale platforms and drive vertical solutions. In global business services, we grew signings for the second consecutive quarter and had modest improvement in the year-to-year revenue performance as compared to first. As we've talked about, we've realigned our practice model to improve productivity and focus our strategy around three growth platforms. The first platform is where we help our clients build and execute digital strategies. Next is where we help our clients re-engineer their core processes. And the third platform is where we modernize our clients applications and move them to the cloud. This differentiated strategy is beginning to take hold as we accelerated our signings growth in GBS this quarter. Our cloud, mobile and analytics practices delivered strong revenue growth. Though consulting revenue was down 1%, our trajectory improved again this quarter with strong growth in our digital offerings. We continue to decline in traditional enterprise application work as we shift resources away from these areas to new areas such as SAP HANA, Workday and Salesforce. We've talked about the path to improvement in GBS which starts with consistent signings growth which adds to the backlog and then ultimately revenue. Our consulting backlog this quarter was nearly flat year-to-year after several quarters of declines. We expect the consulting trajectory improvement to continue in the second half. Our mobile practice continues to expand with a portfolio of cognitive enabled enterprise iOS apps that can redesign our clients workflows. This quarter we announced new initiatives at several different clients including Lufthansa Group and Singapore Airlines. Application management was down 1%, that's been relatively stable over the past several quarters. Clients continue to look to us to manage the lifecycle of their critical applications. We help them move to new cloud architectures that improve the speed and agility of their operations by leveraging the value of their current systems and data. Turning to profit; GBS gross profit margin was up over a point sequentially. On a quarter-to-quarter basis, we added more gross profit dollars than we did a year ago, and we were able to do this on less incremental revenue. This was evidenced for the turnaround that we expect in GBS as we move forward. We continue to shift to higher value work while focusing on improving productivity. We yield at savings from workforce actions and continue to invest to remix our skills. While we're seeing pricing pressure in the areas that are not as differentiated, we continue to focus on capturing the value of our new offerings. We've streamlined our practice infrastructure and are driving efficiencies in our delivery model for new methods and project management approaches. In summary, in GBS this quarter we continued many of the improving trends that started in the first quarter. As we've said before, the starts with consistent signings growth and we grew signings for the second consecutive quarter. We continue to shift to our high value strategic imperative and we're starting to see the benefits from a redesign practice model and refocused growth strategy. We have a strong pipeline of opportunities; put all this together, and we expect to see continued improvement in GBS in the second half. In technology services and cloud platforms, we delivered a $8.4 billion of revenue. While revenue performance decelerated, our margin profile improved compared to last quarter and we signed a number of contracts that will contribute to improved performance in the second half. The deceleration was driven by infrastructure services as we ramped on some acquisitive content and shifted away from lower value work. While this shift impacted our revenue, it contributed to the improved gross margin trajectory. We also continue to be impacted by some large contracts that concluded, particularly in Europe, which we talked about last quarter. Our business model and infrastructure services is one where we're constantly delivering productivity to our clients. Our clients trust us with their most critical IT operations as we continue to leave this space. The way that we expand our footprint is by helping clients move to cloud and drive new workloads by acquiring new scope and new clients. This quarter we were able to close some substantial new transactions including a six-year $700 million agreement with Bombardier; we'll move them to the IBM cloud and help integrate their operations globally. This will drive productivity, improve their agility and ultimately provide competitive advantage. I mentioned Lloyds where we signed a 10-year cloud agreement valued at around $1.5 billion. We'll move the bank to the IBM cloud and migrate their application suites to this infrastructure. And earlier this quarter, we entered into a definitive agreement for the large Telco to acquire it's cloud and managed hosting business. This transaction is expected to close in the second half of 2017. We're working with them on a number of other strategic initiatives including networking and cloud services. These transactions will help improve our revenue trajectory in the second half. Technical support services revenue was down 1%, a point better than last quarter's rate. We continue to grow in our multi-vendor support services where we provide wall-to-wall support for our clients IT operations. Integration software revenue was down 1% which is nearly two points better than the first quarters rate. Our annuity base remains stable with strong growth in SaaS across our offerings including webs for your application server and our hybrid transformation and connect the cloud offerings. Transactional revenue within integration software declined as more of this portfolio shifts to the IBM cloud which will benefit us overtime. Across the segment we delivered strong growth in cloud analytics, mobile and security. The service run rate for the segment increased to $5.8 billion. Clients are moving to the IBM cloud because it's built for the enterprise and can optimize workloads across hybrid environments. The underline architecture protects our clients data and insights and is optimized for cognitive workloads to help our clients create new business models. The American Airlines example I referenced earlier is a great example where we're building on the partnership we signed last year. American Airlines announced this quarter they will move to the IBM cloud and use it as the foundation for their digital transformation. They will migrate critical applications including AA.com, their customer facing mobility app and their global network of kiosks. Looking at profit, gross profit margin for the segment was down year-to-year but up a point sequentially. On a quarter-to-quarter basis, we added about the same gross profit dollars we did a year ago on less than half of the incremental revenue, so you can see the leverage you can get in this business. We drove efficiencies and services delivery and yielded savings from workforce actions. We've been investing in our automation capabilities and launched the IBM services platform with Watson last week. This platform offers next-generation enterprise IT services using cognitive technology and will drive operational efficiencies and improve delivery performance for our clients. We also continue to invest in our IBM cloud capabilities. We announced the opening of four new cloud centers in the U.S. extending our capacity with centers in key local markets across 19 different countries. This provides enterprises with the ability to run their data and applications locally and meet regulatory requirements. Clients can provision cloud infrastructure when in where they needed. In summary, for technology services in cloud platforms, infrastructure services revenue decelerated given the ramp on some acquisitive content and the shift away from lower value work given some of the significant transactions we closed this quarter and strong demand for our cloud services, we expect our revenue trajectory to improve in the second half. We also expect the improved trends in profit to continue. In systems this quarter we had a significant improvement in our year-to-year revenue trajectory and an improved margin profile quarter-to-quarter. This is the second quarter in a row with growth in storage. Our power declines moderated and our mainframe business is consistent with what you would expect at the end of the cycle. Mainframe and storage margins grew year-to-year and power margins improved sequentially. Our overall systems margin was down year-to-year reflecting mix largely due to product transitions. In Z systems as I mentioned, our results are reflective of being in the tenth and final quarter of the z13 product cycle. Revenue declined year-to-year, gross margin expanded and we added four new clients this quarter for a total of 91 since the launch of z13. We continue to deliver innovation on the platform in support of our clients evolving workload needs. For example, a large bank in Europe selected Linux One as the strategic platform for their BPM deployments which will help the bank achieve significant savings over the next five years. Few large government clients expanded their mainframe capacity helping them drive down the operating cost for these agencies. In the areas of new workloads, we had wins in both blockchain and instant payments. The blockchain wins were geographically disperse as we help our clients around the world tackle business challenges with the emerging blockchain technology. We closed three instant payment deals in Europe to help our banking clients comply with the EU payment modernization initiative. I want to spend a minute on our new z14 mainframe that we announced yesterday. After three years of development and working with more than 150 clients, this is the world's most powerful transaction system capable of running more than 12 billion encrypted transactions per day and provides breakthrough pervasive encryption. This data encryption engine encrypts all data associated with any application, cloud service or database all of the time without the possibility of human intervention, and that's with no application change and no performance impact. We took on this challenge to address both the global data breach epidemic and the need to operate within government regulations. In fact, of the 9 billion records breached in the past five years, only 4% were encrypted. Even with the rise of cloud data centers, little real progress have been made encrypting data at any scale because it's hard, expensive and it impacts performance, that is until now. Our new z14 system encrypts data 18 times faster than x86 platforms and the x86 platforms are 20 times more expensive. The reason why 92 of the worlds Top 100 banks rely on the mainframe is for it's high value, secure and scalable platform. The reason they stay on it is because of it's appeal in new workloads and the advances we continue to make in the underlying technologies to address these. Like the new z14 with this unprecendented encryption capabilities, and we do this with increased performance at lower cost which is really valuable to our enterprise clients. So we can deliver all of this within an economic equation that works at the scale required by our clients. The power growth rate improved sequentially but was still down, the improvement reflects our transition to our growing Linux market while continuing to serve a high value but declining Unix market. Our Linux on power revenue grew and we gained share. We again had double-digit growth in Linux workloads. HANA on Power continues to play an important role in that success. By contrast in Unix, the clients were driven by our low end and mid-range systems, high-end systems grew. Our power portfolio is focused on cognitive and cloud opportunities and we continue to expand capabilities and partnerships. During the second quarter we announced new integrated offerings with Hortonworks designed to help everyone from data scientists to business leaders better analyze and manage their data and accelerate decision-making. And we announced integrated offerings with new 10X [ph] to deliver hyper-converted solutions targeting critical workloads in large enterprises. We also announced the new version of Power AI which paired with IBM Linux HPC servers reduces training of deep learning from weeks to hours. I'll remind you that will bring the next-generation Power 9 to market in the fourth quarter starting with two U.S. department of energy funded national labs. There are three labs of this type but no vendor can win more than two, so we won over-aloud [ph]. These will be the worlds most advanced data-centric supercomputing systems and we'll rollout Power 9 across the power portfolio throughout 2018. Storage hardware was up again this quarter increasing 8% led by strong double-digit growth and our all-flash array offerings. Flash was the growth catalyst in our storage mid-range and high-end offerings. Storage hardware margins increased both, year-to-year and sequentially. So to summarize systems, our year-to-year revenue and gross margin trajectory improved with consecutive quarters of revenue growth in storage offset by the expected cycle driven declines in Z systems and Power. While we face some shifting market dynamics and product transitions, our portfolio remains optimized for cognitive and cloud, and we continue to expand our footprint and add new capabilities. Our recent z14 launch and the upcoming Power refresh beginning later in the year, will drive further improvements in second half performance. Turning to cash flow and the balance sheet, in the second quarter we generated $3.3 billion of cash from operations excluding our financing receivables. We invested about three quarters of $1 billion in capital expenditures focused in our Watson and cloud platform areas, as well as in support of our services and systems businesses. And so we generated $2.6 billion of free cash flow which is up almost $350 million year-to-year; this reflects continued strong collections performance for the second consecutive quarter. For the first half our free cash flow was $3.6 billion and over the last 12 months our cash realization rate is 94%, four points higher than last quarters trailing 12 months rate. The first half free cash flow of $3.6 billion is down $900 million year-to-year. However, you will recall in the first half of last year we had a $1.2 billion Japan tax refund. As we look forward to the full year, we continue to expect free cash flow to be roughly flat with last year with the first half year-to-year headwind switching to a tailwind in the second half from taxes and workforce rebalancing payments. And of course, this reflects the level of profit consistent with our full year view of earnings per share. Looking at uses of cash in the half, our acquisition spend was relatively light after a significant number of acquisitions in 2015 and early 2016. We're focused on investing and integrating these acquisitions as we expand our solutions and cloud capabilities. In the last six months, we've returned $5.5 billion to shareholders, including $2.7 billion in dividends. In April, we again raised our dividend and with that we've more than doubled our dividends since 2010. In the first half we bought back over 60 million shares and we ended June with 932 million shares outstanding and $2.4 billion remaining in our buyback authorization. Moving on to the balance sheet, we ended June with $12.3 billion in cash and $45.7 billion in total debt. Both of these are up from year-end, primarily driven by the timing of this years term debt issuances and maturities. $29 billion of our total debt was in support of our financing business. The leverage in our financing business remains at 9:1 [ph] and the portfolio remains strong at 53% investment grade. We've got more in our financing business and our supplemental charts at the back of the presentation. Our balance sheet remains strong and with our newly reorganized financing entity, we're even better positioned to support our business over the long-term. Let me start to wrap up by putting some additional perspective on our revenue trajectory, and we'll look at it by segment because our businesses are at different stages of transformation. In global business services, we've said for sometime that the progression is driven by improvement in signings leading to backlog and then ultimately revenue. I plant the flag to mark the beginning of an improvement and the revenue growth trajectory for GBS back in the fourth quarter of last year. And we've now had two consecutive quarters of signings growth, substantial improvements in the consulting backlog and a modest 20 basis point improvement in GBS revenue performance from first to second. This is what improving momentum in the services business looks like. So now with this momentum and a more focused set of offerings and improvements in execution, we've seen improved trajectory in GBS in the second half. In global technology services with decelerating performance over the last two quarters, we're planning to flag now at the end of the second quarter. With the ramp in some of our new contracts, we do expect improved performance in the second half but we're not counting on a return to revenue growth this year, just an improved revenue trajectory. And at systems, storage had been declining but you will remember we plant the flag as we got all flash into the product line towards the end of last year and we've now had two consecutive quarters of revenue growth. Power, I'd similarly plant the flag back at the end of last year; and for systems Z mainframe, growth is tied more to the nine to ten quarter product cycle which will refresh later this quarter. Finally, in cognitive solutions, we've now wrapped on our acquisitions. Our annuity content continues to grow, this was driven in large part by our SaaS offerings and as we've talked about in the past, they ramp and build scale over a longer timeframe. Put it all together and we expect improvement in the constant currency growth rate through the rest of the year. Now when we look at gross margin, I mentioned three drivers of our year-to-year performance in the first half. We've seen some moderations in the headwinds from mix and investments already from first to second and I'd expect that to continue. We're always driving productivity in the business and much of that gets returned to our clients in the form of price, or it offset cyclical impacts or it goes to the bottom line. In the first half, the net of these factors was an impact to our margin but as we move to the second half with new product introduction and improved services dynamics, I'd expect this to be a benefit to our margin. With that altogether, and just as we expect improvement in our revenue trajectory, we also expect an improved gross margin profile in the second half as compared to the first. So in total, those drivers of our first to second half performance improvements are consistent with what we talked about 90 days ago. We'll have a new IBM Z product out by the end of the quarter which will drive an improvement in gross profit from first to second half. Related to that, we'll also benefit from lower systems development spending. The new services contracts and global technology services will start to contribute and with the cost savings we're driving, we'll have better performance in GTS. In global business services we expect the momentum to deliver a better second half. We've essentially wrapped on last year's larger acquisitions which are dilutive to profit and we're not at the stage where we can start to yield more benefits from operational synergies. Our ongoing operational tax rate assumption continues to be 15% plus or minus three points driven by our anticipated mix. As always, this is without discrete items but the rate is dependant on the mix of business because just like every dollar of revenue doesn't result in the same amount of gross profit, every dollar of gross profit doesn't drive the same amount of after-tax profit. But at the bottom-line, we continue to expect to deliver at least $13.80 of operating earnings per share for 2017 and free cash flow that is consistent with last year. And with that, we'll 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, as always, I'd ask you to refrain from multi-part questions. So operator, lets please open it up for questions.

Thank you. We will now begin the question-and-answer session. [Operator Instructions] Our first question is from Katy Huberty with Morgan Stanley. You may ask your question.

Yes, thank you, good afternoon. I appreciate the second half versus first half color but if you can comment more specifically on the third quarter because of the mainframe launch; consensus is modeling both better revenue and better EPS growth sequentially than last year. Are you comfortable with those boggies? And maybe in regard of that just talk about how you think this mainframe cycle will compare to past cycles? Thank you.

Sure Katy, thanks, and thanks for joining the call. I guess a couple of things, I'll start actually where you finished on mainframe because we have in the past said that the economics for the mainframe for us, what we're looking for is that the overall economic equation cycle-to-cycle kind of holds and we saw for the last four mainframes, including the one that we just finished and now we expect the overall economic equation to be fairly stable, that doesn't map to a calendar period of it because we announced them at different times but we would expect the overall economics of the mainframe to hold cycle-to-cycle the cycle amount to the fifth cycle, we could have gone back further but let's just say that mainframe is roughly consistent with the past. In terms of third and fourth quarter, I guess there are couple of things. I think you're interested in revenue and we'll talk about EPS as well and then where does the mainframe fit. On the revenue side of that typically we see about -- for seasonal reasons, we see about $1 billion 2Q to 3Q reduction for seasonality. Now we're only going to have a month or less of the new mainframe, we're going to have a month of some of these new contracts, not the full quarter, those will come in the fourth and so that typical $1 billion impact will be helped a little bit, $200 million to $300 million by mainframe or the services contract but that's about it for the third and then obviously the rest will be in the fourth. And then from an earnings perspective, given the power of the mainframe and the profit equation, how it helps mix plus our typical -- you know, typically we have a lot of our transaction business in the fourth. When you look at our EPS guidance, we're up a little bit for the year; we're up even less than the full year now through the first half. And then third quarter I wouldn't expect to drive much growth at all. I think most of the growth rate is going to be in the fourth, again, given the cycle dynamics and quite frankly, given the fact that the benefit really is only a month now and three months of the fourth. Thanks, Katy.

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

Thank you. Next question is from Wamsi Mohan with Bank of America Merrill Lynch. You may ask your question.

Yes, thank you. Martin, your cognitive solutions, pretax margins were up nicely, both on a quarter-on-quarter and year-on-year basis despite some continued weakness on the transactional business. Can you address what the main drivers there were for cognitive margins and PTI specifically was at lower drag from M&A, better contribution from the SaaS assets and do you see that sustained continued sort of year-on-year improvement in the second half for cognitive PTI margins? Thanks.

Yes, thanks Wamsi. Well, you've kind of answered your question, so well done. No it is -- it really is a reflection of a few things. One is sequentially we've got a benefit from scale, now that's annual, that's year-to-year as well as sequential, but we're getting a benefit from scale as we build those service businesses. And then just like when we wrap on an acquisition and the revenue benefit, at the same time that allows us -- not allows us but what we start to do is we start to build the consolidation if you will and the efficiency in getting those acquisitions onto our own platform; so we get kind of local expense savings if you will from doing things once as opposed to a number of times around a unit. So better scale, ramping acquisitions, not only on the growth but then we get an opportunity to get a bit more productivity out of them. And yes, those -- I would expect that margins in cognitive solutions while on a year-to-year basis we still see -- because of mix we still see a year-to-year decline, sequentially we'll continue to improve on those things, the things I identified; the scale will last forever and then the wrap on the acquisitions will start to deteriorate in another three or four quarters.

Thanks, Wamsi. Can we please take the next question.

Our next question is from Steve Milunovich with UBS. You may ask your question.

Thank you. Martin you made a number of positive comments about the trajectory of services but the supplemental slides, the signings overall are down 14% year-over-year and the backlog is now down to 4% year-over-year. What's going on there and why do you think that's going to improve?

Yes, couple of things Steve. First, let's pull signings, we'll talk about backlog because the impact of signings on backlog, as you know we've talked about it is different when it's a renewal versus when it's new business and siginings, they don't playout as we said in the past on a 90-day period, obviously the longer you get, the more it looks like your backlog but you got to get over a pretty long timeframe in order to have the signings translate directly into backlog. So in the first half of this year we had one of the biggest new contract signings we've had for any six month period as big as it was; last year it was bigger than the year before. So what happens in our backlog is those new contracts come on once we go through the transition period, as I mentioned earlier and that for us it will start to be September, once you get through that transition period, all of that translates to revenue rather quickly, that's different from a backlog or signing that goes into backlog as an extension of a contract that's ten years old and is about to expire because that is not going to drive any incremental growth. So yes, on GTS the backlog is down, the new signings go in though at a rate that will drive revenue in the near-term and so the backlog being down is something we obviously have to work on a few years out because those contracts are going to come due and we have to get them renewed because it's not going to drive any growth but we need the backlog. And on GBS, we had second quarter in a row of good signings, performance, in fact an acceleration from the first and within their backlog now, as we noted in our prepared remarks, our consulting business now has gotten itself back to kind of a flat backlog which in the near-term that tends to yield pretty quickly as we deliver; so they were battling double-digit declines in backlog for a while, they worked their way out of that spiral; and so we'll see a near-term yield on the consulting side as well.

Thank you, Steve. Operator, can we please take the next question.

Thank you. Next question is from Ingin Wang with JPMorgan. You may ask your question.

Hi, thanks for the update. Just on the strategic comparative, it's up 7%; is high single digit a good proxy for organic growth and strategic comparative for the year because you hired the efficiency I think. Martin, [indiscernible] and the focus was due more towards maybe margin, then revenue acceleration within strategic comparatives?

Thanks, Ingin. A couple of things I think worth noting. Yes, we certainly ramped on the acquisitions and so this is a pretty good proxy for the organic piece and it is mostly as a service, right, so it's not going to drive the same impact on our big base of business as it would if you ramped on an on-prime business because it didn't have the same impact to begin with. Now -- by the way we're not out of the acquisition business, right, we're still active acquirers, we just happen to ramp on and are getting our feet under us on everything we did in the past 18 months but we are still active acquirer. So that will drive some of the growth but when we think about strategic imperatives, going forward I would expect that we get a bit of an acceleration from the new mainframe, power will drive a bit and quite frankly, the services contracts, particularly the new ones that we signed and we talked about, they are cloud contracts, they are to help our clients build and run clouds and move them onto the cloud. So just like we've encouraged everyone to look at the strategic imperatives on a trailing 12 month basis which they we're at 11% on a trailing 12 month basis; with the acceleration now through the back half of the year, when we get to the end of this year, I'd expect us to be still on that same trailing 12 months, so the whole calendar year I'd expect us to be in that 10% to 11% range on strategic imperatives as well.

Thank you, Ingin. Can we go to the next question, please.

Our next question is from Toni Sacconaghi with Bernstein. You may ask your question.

Yes, thank you. Martin, I was wondering if you could just quickly clarify, I think you said you didn't expect EPS growth in Q3. Consensus is looking for $0.09 year-over-year improvement in Q3; are you suggesting that's not something that's appropriate? And then more specifically, my question -- for strategic imperatives, it sounds like you feel organic growth is 7%, are you still confident overall growth will be 10% plus which is something you articulated at your investment day? And if you are, is the proper implication to think about three points of strategic imperative growth coming from acquisitions which is about $1 billion a year in acquisition revenue; is that sort of the framework by which we should think? And are you still confident in that double-digit sustained growth for strategic imperatives? Thank you.

Sure, thanks Toni. So first on the non-question clarifying piece; look, we've got a base $3 plus on a base, we're roughly flat, I think we're at a level now where it's just too fine a number in order to say am I talking about $0.09 on a three -- almost mid-three, anyway, it's a big base, $0.09, too fine for me. On strategic imperatives, again, you know, I do expect us to accelerate in the second half for the year for the reasons we've talked about, right; we get new mainframe, a lot of the new contracts are coming on. And then the other elements within this and you can actually see it in the segment charts, we've got good growth in technology services and cloud platforms on the strategic imperative base, that is organic. We have good growth in GBS, that is by large organic. We have slower growth in the cognitive solutions but that's a massive base. And then obviously what -- where we'll accelerate the most in the second half is the systems business which was down dramatically in the quarter but again, we're at the part of the cycle here where we would expect it to be down, so we gave the segment view already when we changed the segment reporting, we gave the segment view so you could try to put together now where we see that shift of business coming from. And as we go into second half, I think the most profound shifts are going to be in the systems business, we'll see continued good growth in the technology services cloud platforms unit, we could see continued good growth in GBS. And then cognitive; you know, we have made investments, we're getting growth out of that part of the business, it is as a service primarily and therefore it's impact on the overall is more muted but if we were to acquire something it would go -- it would likely go back in there. But again, it's more muted because it's via the service business.

Thanks Toni. Can we go to the next question, please.

Our next question is from David Grossman with Stifel Financial. Your line is open.

Thank you. And perhaps Martin you addressed some of this in the last question but I was hoping you could help us better understand the growth dynamics in the cognitive and GBS segments. It looks like the strategic imperatives are well over 50% of the revenue mix in both of those units but they both are experiencing revenue declines; so if I've got that math right, can you help us better understand that dynamic and what that implies for the overall mix as strategic imperatives increase the greater percent of IBM's overall revenue mix?

Sure, David. So we'll do it kind of piece by piece and I'll give you two words trying to describe both of them. One is magnitude, and I'm going to put that against cognitive; we've got -- it's a big, big business and obviously the service that we're building, it has a smaller impact and so we see growth but it's going to take -- and we're getting growth and they as a service portfolio but it's going to take time to build that and part of that portfolio, TPS, our transaction processing business as we have on the slide is down four, so that's a very high value business but it's a big on-prem [ph] business that it's going to take a while to outbuild if you will from as a service perspective. And then on GBS, the word I'd give you is the transition. So I described a bit on our consulting business where we got the backlog back and back to flat and the consulting business has accelerated, the signings in consulting are good, the things that the growth is quite strong, the things that we're engaging with our clients on digital offering, those are resonating. So the consulting business comes back pretty well than the application management business; it's a fairly stable business and yes, we're helping our clients move those into clouds, we're helping them contemporize if you will, the way those applications work but that's not a big growth engine, it really is kind of a very stable base. And then in GPS, in our global processing systems business, that's not high content of strategic imperatives but it is important work for our client and it's quite valuable to us. So in GBS as we make this transition, you know, the overall will be lifted and as we said we planted the flag on revenue growth back in the fourth quarter, now we've seen a moderately improving trajectory now and we would expect -- as I said the prepared remarks that third and fourth would be better again in terms of trajectory and revenue.

Thanks, David. Let's take the next question.

Thank you. Our next question is from Amit Daryanani with RBC Capital Markets. Your line is open.

Perfect, thanks a lot, good afternoon guys. I guess just trying to understand the gross margin discussion Martin, I realize 180 basis points decline in June is much better than the 300 basis points decline you had in the March quarter; but at what point do you see gross margins from a year-over-year perspective starting to stabilize and does stability in gross margin have to come in-line with strategic revenues essentially decelerating a little bit?

Well, we do see as we said in the prepared remarks that we do see continued improvement in the trajectory, right. So down three in the first, down 18 in the second and then second half, driven by both mix and driven by the work we have underway in delivering productivity across our services platform, the work we have in improving our GBS margins which is now starting to come -- to show up in the ledger. So we see both, a mix of kind of structural benefits from productivity, we see a mix of execution benefits from realizing if you will the higher value of the solutions we're selling and we see a mix from just the fact that we're in high value systems business which is going to mix more strongly. So yes, we do see continued gross margin improvement on a sequential basis and improvement on a year-to-year basis sequentially, and that would position us pretty well I think then for 2018 but we've got work to do here in the second half to put that on the table but we do see it in the third and the fourth.

Thanks, Amit. Let's go to the next question please.

Our next question is from Brain White [ph] with [indiscernible]. You may ask your question.

Martin on the z14, it sounds like it will have an impact, a positive impact in the second half of the year; do you think it will have a more favorable impact in 2018? And if you could give us just some guide post around the attach rate of the z14 or any mainframe cycle to both sales and profits of IBM, obviously it's a small direct percent of IBM's total sales and profits but if you look at the overall portfolio and the software and services that it ranks through that would be great. Thanks.

So first, I think what you started by saying was z14 not much impact in second half and I think what we're saying is that it's going to have quite an impact in the second half, right. It was announced yesterday, it will become publicly available in September and so we'll get a month in the quarter but we'll get three months of it in the fourth quarter. So just to make sure we're clear, we do see a pretty good impact here in the second half from Z. Now the timing that impact will be most profound in the systems space because the hardware is what obviously goes out first. We also provide as you know, we provide maintenance for that but the warranty period is on, so that's not going to be sold for until after the warranty period expires, that's in 12 months plus. There is a software that goes with it but that tends to be driven by usage, not by a placement of hardware and so that also isn't going to be in the second half. We financed these, right, that happens overtime and so we get that money back overtime. So the -- and then we sell storage, there is a little bit of tailwind in the hardware side but again a lot of it is software defined storage, so the benefit in the second half is systems driven, the rest of the platform if you will, will continue to drive profit overtime and a lot of that will been dependant on the workloads that it can attract and the workload is running [ph] now and how people scale which we feel quite good about. You know, one of the things we haven't spend a lot of time on, on the mainframe because the interest has been around security, the interest has been around in-line machine learning but one of the elements of the new mainframe is new software model which will allow our clients to partition off parts of the mainframe and run new workloads and test new workloads in a much more economic way so they will attract new workloads onto the platform again. So in overtime, again, we're not relying on the mainframe as a platform to be anymore valuable it has in the past but I'll tell you what this mainframe solves a lot of problems at clients who don't use it today, have; and it provides a lot of new on-ramps for other workloads.

Thanks, Brian. Can we please take the next question.

Our next question is from Jim Suva with Citi. You may ask your question.

Thanks very much, it's Jim Suva from Citi. Martin, you had mentioned [indiscernible] several times in different parts of the businesses which is greatly appreciated. The question I have for you is, is there any correlation to cash flow and cash flow generation regarding those black [ph]. Like for example, if signings result from positive services growth, is there any impact of future cash flow as they start [ph] and how should we think about the cash flow with your sign-post or flag-post comment? Thank you.

Sure, Jim. I think I heard it but you are -- you must be on mobile, so it was little bit hard to hear it. But I think the question was is there a correlation between planting the flag on some of the revenue trajectories and cash flow. So broadly speaking, the answer is obviously yes but it's kind of at the margin if you will. So as we turn our GPS business and we start to bring on all these new clients that we have and put them on the IBM cloud, of course, we expand the capacity of the cloud but that's already in our plans, right. So at the relationship level, everything that has to do with driving revenue is going to have an impact with cash but the way we have planned and talked about our cash flow all year has been flat year-to-year, we've recognized already that we're driving capacity into the cloud that we have to build the capacity in the scale we need and so it doesn't have an impact into the way we've guided it but obviously there is a correlation between what kind of growth we get and the cash demands if you will of the business but not different from what we've talked about all year.

Thanks, Jim. Let's take one more question please.

Our last question is from Meena [ph] with Wells Fargo. You may ask your question.

Hi, thanks. If you look historically at sort of the make up of the different quarters for the full, the last six years you generated roughly about 23.5% of your earnings for the full year in the third quarter. Is that based on your comments about the mainframe and the fourth quarter; is that still the right way to think about the third quarter and then you get the bulk of the benefit from the mainframe really driving the fourth quarter earnings profit?

Well, again, I think we talked a bit about the EPS Q [ph] and we talked where I think we're going to land. But as we said for the third -- but as I said, in the fourth is where we see most of the growth begin because the mainframe in the fourth is where the bulk of it is going to sit. So you do the SKU math in terms of percentage in the third but yes, the answer is yes, we're going to see the bulk of the growth from the mainframe in the full quarter mainframe in the fourth, as well as the services signings that will have a full quarter impact. And then obviously as we go through time and we talked a bit about this on the prepared remarks and you've seen some of our announcements about for instance the cognitive delivery platform that we're building; those build as you go through time as well, and so all of that will have more of an impact in the fourth quarter. So just to wrap up, again, quickly; we finished the first half kind of spot-on where we said we would, we've positioned ourselves now to have the second half, that we're confident we'll deliver. The path from here though as we said is pretty -- at a high level, it's an improved revenue trajectory, it's an improved GP margin trajectory, and it's an improved expense trajectory and we have now I think in the second quarter shown that the GP margin trajectory is there; we've obviously got the ability and we've showed good expense management and disciplined investments. And then on the revenue we've going to go through it piece by piece to talk about where we planted the flag and the most recent again, second quarter we'll plant the flag on GTS, so we'll drive an improved revenue trajectory. So thank you for joining the call. We look forward to talking to you in 90 days.

Operator, let me turn it back to you to close up the call.

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