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

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

Thanks, Patricia, and thanks to all of you for joining us. In the second quarter, we delivered $20 billion of revenue, $3.4 billion of operating pretax income and $3.08 of operating earnings per share. Overall, it was a good quarter. We grew revenue, operating gross profit, pretax income, and earnings per share with strong pretax margin performance. Our revenue was up 4% as reported with growth in all four of our major segments and our constant currency revenue growth was 2%. This is our best constant currency growth in seven years. And our pretax income was up 11%, reflecting good operating leverage on that revenue growth. Looking at our performance at constant currency. The revenue trajectory improved in both services segments and both returned to modest growth. This is important to our overall revenue growth profile as services represents about 60% of our revenue on an annual basis. In Cognitive, we had good performance in analytics and in our industry verticals, driven by financial services, and IoT. Growth was mitigated by the same three areas I told you about on our last call as we continue to focus on repositioning these offerings. And we had strong performance and gained share in our Systems business, which was up over 20% with growth across all three hardware platforms. Across our segments, we had continue momentum in our strategic imperatives revenue. Over the last 12 months, our strategic imperatives revenue has grown to $39 billion, which represents 48% of IBM's revenue. And within that, cloud is now $18.5 billion. Our strategic imperatives revenue in the quarter was up 15% and accelerated to 13% at constant currency. Revenue performance this quarter was led by security and cloud. Security was up about 80% this quarter, driven by strong demand for the pervasive encryption of IBM…

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

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

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

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

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

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

Yes. So, thank you, Steve. Many questions there. So, let me take each one individually. First of all, yes, we had a very strong Systems quarter overall, both on revenue and on operating leverage where we grew pretax income over 10 points year-over-year. But, let’s put the quarter in perspective. We delivered 4% revenue overall, 2% at constant currency. It was our strongest constant currency revenue growth rate in over seven years. And it was led by our continued acceleration in our strategic imperatives which were up 15% at actual, 13% at constant currency. That was an acceleration from the first quarter. And within that our cloud business $18.5 billion, up 23%; our as-a-Service annualized run rate now over $11 billion, that’s up 24%; and our services businesses returned back to growth at constant currency, both GBS, which had a great quarter and TS&CP. But even if you take our Systems business and to your question around mainframe, and if we take mainframe out, you would see those same dynamics in the quarter-to-quarter acceleration of our strategic imperative business. And as you all know, in our as-a-Service acceleration of over $11 billion growing 24%, that doesn’t have any Systems business within it. And the last point I’ll bring up around top-line, then I’ll get to your other questions. We had broad-based geographic and sector growth across our business, probably the best breadth and growth across a number of countries that we’ve had in quite a period of time. 60 plus countries grew at constant currency, and that represented over 80% of IBM’s revenue. And if you extract out the mainframe cycle, we still had over 60% of our -- or excuse me, 60 countries that actually grew. And those are large countries like Japan, like UK, like Germany, France, Spain,…

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

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

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

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

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

There is a lot you compacted in a multiple parts question, but let me try to address each piece. So, let’s start with Cognitive. In terms of our Cognitive Solutions, we have a strong portfolio in the key strategic areas around analytics, around industry verticals, around security and around IoT, and we continue to see good performance overall. But, I’ll remind you, this portfolio is a high-annuity content. Over 80% of the business is annuity with strong renewal rates we continue to drive, but that SaaS has a longer time to value and longer time to realization. But, let me unpack the segment because you got to understand the piece parts because they each fit different purposes within the overarching IBM strategy and purpose. One is around TPS. TPS declined 2% overall, and it’s about what we would expect in this area and you’ve even commented on this in the last couple quarters. We been riding the wave of the mainframe product cycle over the last three quarters and saw a pretty good growth that was unusual. Now we’re back to down 2%. This is high-value, high-profit, strategically important to our clients overall, but it’s in stable to declining businesses, and it wasn’t unexpected. And when you look at our software solution portfolio, we’ve got growth in analytics as we revamped that portfolio coming off of a pretty disappointing fourth quarter. We grew in first quarter, we grew again in second, and we got good double-digit growth in our industry verticals like financial services and IoT, and we’re seeing good growth in Watson Health. We got growth in life sciences segment, imaging, payer and we’re seeing good SaaS signings in our government segments within that business. Yes, we are driving acquisition synergies, and you’re seeing that play out; it’s well…

The next question comes from Tien-tsin Huang of JPMorgan. Your line is now open.

So, consulting accelerated, which is encouraging. I am curious is that starting to pull in some other services revenue around it or behind it? I saw -- or you mentioned, the large [indiscernible] were good again. So, again is this enough to drive the positive FX neutral revenue growth in services in the second half, just trying to piece all those things together and think about future revenue growth for services overall, in the second half?

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

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

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

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

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

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

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

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

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

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

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

Okay, Keith. So, thank you very much for just giving a better perspective of entirety of your multiple-part questions, so we can put this in perspective. So, let’s talk about -- I’ll drive you back to 180 days ago, when we were sitting here in January. We talked about the position where we were at. We talked about what’s going on with the dynamics of our backlog overall. And we talked about the backlog realization run-out that we saw over the 2018 period. And we said entering 2018 that we had a much stronger backlog realization or run-out I should say that we are starting with that we did entering 2017. And you’re seeing that play out as we go through the first half where we have made sequential year-to-year improvement over the first quarter and now returned both of our services businesses back to growth. Now, within that, as we stated earlier, in the human capital base services business, you got to continue fueling those signings that delivers backlog and more importantly, you got to drive the right composition of backlog that drives your backlog realization and yield, and also drives duration. And obviously what you’re seeing over time is you’re seeing I think a secular shift with regards to what’s happening to duration in long term contracts. You’re not seeing that anymore. So we’re getting higher yielding revenue, where also the composition of our backlog with consulting, which accelerated to 4%, that composition is much more shorter term and higher value, as we move forward. So, over the long run, you’re right. You got to continue to fuel signings to fuel that backlog. But I would tell you, outer years of six, seven, eight, nine, ten are very -- in today’s world, much less relevant than in period…

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

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

Hey, Jim. Thank you very much for the question. It’s good question overall. Let me take a look at it. I’ve said from January, as we look at we obviously have multiple scenarios, how do we make at least $13.80. And what I look at and the team and the entire management team looks at is the trajectory of our business, the operational indices and the drivers as we see going forward of headwinds and tailwinds on how we deliver that guidance for our shareholders of at least $13.80. But, when you take a look at revenue growth, I said we would have revenue growth at current spot rates for the full year and that we would have pretax operating margin expansion and operating leverage in our business. So, to your question, what do we look at and what are the trends that are driving that. So, let’ unpack it, and I’ve talked about this the last couple of calls. And the way I look at margin expansion really centers around three or four major areas. Number one, margin expansion is going to be delivered through us continuing to leverage the momentum in our enterprise cloud and our as-a-Service-based business. Why? Because it’s going to generate scale efficiencies for us to deliver on what we’ve said at our Investor Day, which is margin accretion as we move through to the cloud. So, scale efficiencies, we are seeing that improvement in the first quarter, we’re seeing the improvement in the second quarter and it’s all being built off of the momentum around our cloud and our as-a-Service-based business. Second, we talk about mix, mix being another lever. So, you look at the mix of one within our each of our segments and how we’re shifting to higher value, which we’re making…

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

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

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

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

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