International Business Machines Corporation

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 want to welcome you to our first quarter 2019 earnings presentation. I'm here with Jim Cavanaugh, IBM Senior Vice President and Chief Financial Officer. We'll post today's prepared remarks on the IBM Investor website within a couple of hours, and a replay will be available by this time tomorrow. Some comments made in this presentation may be considered forward-looking under the Private Securities Litigation Reform Act of 1995. Those statements involve factors that could cause our actual results to differ materially. Additional information about these factors is included in the company's SEC filings. Our presentation also includes non-GAAP measures to provide additional information to investors. We've provided reconciliation charts at the end of the presentation and in the 8K submitted to the SEC. Before turning the call over to Jim, I want to remind you we recently made changes to our management system and our organizational structure. Our segment reporting for 2019 has been updated to reflect this business structure. We provided two years of historical financial information by quarter on these segments a couple of weeks ago, and this can be found on our Investor website. And today we'll be discussing our first quarter results in this new segment structure. So with that, I'll turn the call over to Jim.

Thanks, Patricia, and thanks to all of you for joining us. In the first quarter, we delivered $18.2 billion of revenue. With significant operating leverage, we delivered $2.2 billion of operating pre-tax income and $2.25 of operating earnings per share. And we've now generated over $12 billion of free cash flow over the last year, with realization well over 100%. We had strong performance in offerings that helped clients with their digital transformations and journeys to cloud. At the same time, we continue to take actions to optimize our portfolio while investing to lead in the emerging high-value areas of the IT industry. You saw this play out in our results. Our cloud growth accelerated to 12% at constant currency. Our cloud and cognitive software was up 2%. And our consulting revenue was up 9%, also both at constant currency. We had significant margin expansion, with operating gross margin up 90 basis points, driven by both services segments. And we had solid free cash flow. Improving margin has been a focus for us. And our performance this quarter is the result of actions we've been taking. Not only are focused on higher value and portfolio optimization, but also driving productivity and operational efficiency, especially in our services business. With this start to the year, we are maintaining our full year expectations for operating earnings per share and free cash flow. In the first quarter, our revenue was down less than a point year to year at constant currency, slightly better than our fourth quarter performance. Our reported revenue, as expected, includes a significant currency headwind. As always, I'll focus on constant currency performance. From a geographic perspective, our year to year revenue growth in the developed markets improved a couple points sequentially, consistent with the expectations we discussed last quarter. That said, we had weaker performance in the emerging markets in Asia Pacific, which impacted our overall revenue performance. Looking at our results by segment, we had continued revenue growth in global business services and in our cloud and cognitive software. In GBS, as I said, we had another quarter of strong growth in consulting, as we helped clients with their digital reinventions. And we again expanded our margins in GBS. In our software segment, growth was driven by our hybrid cloud offerings, security, and solution areas like supply chain and Watson Health. In global technology services, we're continuing to help our clients implement and manage hybrid multi-cloud environments. This is evidenced in the increasing share of our backlog, which is now cloud. At the same time, consistent with our high value focus, we're continuing to take actions to optimize our GTS performance by exiting lower value content. While this contributes to lower GTS revenue, we had higher profit, margin, and cash contribution. Our systems revenue decline, reflecting the IBM Z product cycle dynamics and weaker performance and storage. Across our segments, clients continue to be focused on solutions that deliver innovation and growth. Though, as we mentioned last quarter, we're seeing an increasing bias towards engagements that provide productivity and predictability of spend. And so our results this quarter reflect our ability to deliver both innovation and productivity, helping our clients transition their business models to hybrid cloud. Our cloud revenue growth in the first quarter accelerated to 12%, with our -a-service offerings up 15%. With this, our cloud revenue has grown to $19.5 billion over the last year. Over the last several months, we've talked about the next chapter of cloud, which focuses on shifting mission-critical work to the cloud and optimizing everything from supply chains to core banking systems. To address this opportunity, enterprises need to be able to move and manage data, services, and workflows across multiple clouds and on-prem. And they need to be able to address security concerns, data protection and protocols, availability, and cloud management. This requires a hybrid, multi-cloud, open approach. And so we have been reshaping our business to address this opportunity, investing heavily to build capabilities across our business, like IBM Cloud, IBM Cloud Private, and IBM Cloud Private for Data, the IBM Multi-Cloud Manager, Cloud Garages, Cloud Migration Services, and Cloud Optimized Systems. These are the innovations that are driving our $19.5 billion of cloud revenue. In the first quarter, we introduced additional capabilities that will accelerate hybrid cloud adoption, including Watson Anywhere, which makes IBM Watson available on-premises, as well as on any private or public cloud, and IBM Cloud Integration Platform, which provides a standard way to integrate services and applications across multiple cloud environments. More broadly, we have built a framework of offerings to facilitate our clients' journey to the cloud. It is designed to help our clients across the four key stages of their cloud transformation journey, advise,

move,

build, and manage. These offerings span our cloud and cognitive software, global business services, and global technology services, leveraging the integrated value of IBM. And so we have a strong foundation for the addition of Red Hat. Together, we will be ideally positioned to help our clients shift their business applications to hybrid cloud, while addressing the issues I just mentioned around portability, management consistency, security, remaining open, which avoids vendor lock-in. This will not only enhance the growth of Red Hat's business after closing, but lift all of IBM, as we sell more of our data and AI software on containers across multiple platforms, and more of our services, from app modernization to multi-cloud managed services. At IBM, we're investing and building capabilities to be ready to drive these synergies. We're moving through the regulatory process and continue to expect to close in the second half of 2019. Before getting into the financial metrics, I want to lay out the contributors to our -to-year operating earnings per share performance, especially because there are a couple of larger items in last year's results that impact the dynamics. In fact, these larger items contributed a 32-cent benefit to last year's earnings per share, which of course creates a headwind to this year's growth. And so looking at the drivers, as I said, our revenue was down less than 1 percent at constant currency. But with the stronger dollar, revenue was down 4.7 percent. At constant margin, revenue was a headwind of profit and earnings per share growth. Last year, we took pre-tax charges associated with the actions to realign our skills to key opportunities and better position our systems cost structure. These, together with the benefit of the actions and our ongoing operating efficiencies, resulted in strong pre-tax income growth and pre-tax margin expansion. Last year, we also had a large discrete tax benefit associated with an audit settlement. With a much smaller discrete benefit this year, tax was a significant headwind to our net income. And finally, a lower share count contributed to growth. Putting this all together, we had solid operating leverage and margin expansion offset by a 32-cent impact of last year's significant items, resulting in an operating EPS of $2.25. So now, getting into profit and margin metrics, we continue to drive operating leverage, expanding both gross and pre-tax margins. Our operating gross margin was up 90 basis points. This was driven by strong performance in both services businesses, together up 160 basis points. We also had a -to-year benefit from the charge we took last year in systems, which was offset by the impact of the IBM Z product cycle. Our operating expense was better 11%, which resulted in a two-point benefit in our -to-revenue ratio. Overall, we've been driving productivity in our business, including implementing new ways of working and leveraging automation and infusing AI into our processes. This drives operating leverage and provides flexibility to increase investment in areas like hybrid cloud, AI, and blockchain. But we have a few other drivers of our expense performance this quarter, including currency and lower workforce rebalancing charges mitigated by a lower level of IP income. Regarding currency, while a stronger dollar hurts the top line, it generally helps expense, due both to translation and the benefit of hedging contracts. In the first quarter, currency helped our -to-year expense by nearly six points. Much of this was reflected in other income and expense. In fact, the $200 million -to-year change in other income and expense was entirely due to hedging benefits. Remember, these hedging gains mitigate the currency impacts throughout the P&L. Expense also includes a -to-year reduction of over $500 million for workforce rebalancing, driven by last year's charge. And finally, with an expense, we absorbed a lower level of IP income, as it hurts our PTI growth by over $200 million. Putting this expense performance together with our gross margin expansion, pre-tax margin was up over 300 basis points. Our operating tax rate was 10%, including discreet. This is right in line with our all-in first quarter expectation of 10 to 11% we provided in January. And as I said earlier, this was a significant headwind to our net income growth -to-year. Looking at our cash metrics, we generated $1.7 billion of free cash flow in the quarter, which is up about $350 million over last year. There's a lot of seasonality in our cash generation. And so looking over the last 12 months, we generated over $12 billion of free cash flow. That's 114% of our GapNet income normalized. I'll touch on the cash drivers and uses of cash a little later. And so now, before getting into the segment performance, I want to spend a minute on an overview of our 2019 segment structure. As Patricia mentioned, we shared historical information on this new structure a couple weeks ago. As our clients become digital enterprises, they need tighter integration between hybrid cloud and their data and AI platforms to unlock value. And so we recently made changes to our management system to more effectively address our clients' evolving needs and in preparation for the acquisition of Red Hat. The changes also better align our portfolio to the market and to underlying business models. The business changes resulted in three adjustments to our segment structure for 2019. First, we brought our cloud and cognitive software together in one segment. Second, we combined our security services with security software, consistent with the way we are running that integrated business. And then finally, we moved the results for the businesses we're divesting to the other category to provide better transparency to the ongoing operational performance of our software and GBS segments. This includes the pending sale of our collaboration and on-prem marketing and commerce software to HCL, the pending sale of the balance of our marketing and commerce software to CenterBridge, and the just completed sale of our Sataris Mortgage Servicing business. And so looking at our new segments, we created the cloud and cognitive software segment, bringing software platforms and solutions into one segment. Within this segment, we'll report cloud and data platforms, which brings together software for hybrid cloud management with data and AI platforms. Cognitive applications includes vertical and domain-specific solutions that are built on cloud and data platforms. These offerings are increasingly being infused with AI. And then transaction processing platforms includes the middleware and database software that supports our clients' mission-critical workloads running on ZOS as well as storage software. Looking at our services segments, the scope of global business services segment overall is unchanged, other than moving the divested mortgage servicing business to other. Global technology services is consistent with the services component of technology services and cloud platforms, excluding security services. And then finally, our systems and global financing segments are also unchanged. So now let me get into the segment results, starting with our cloud and cognitive software segment, where revenue grew 2%. Our clients' journey to cloud and AI is now turning to more mission-critical workloads. As I just mentioned, linking the data, AI, and applications together with hybrid cloud in a secure way is critical for any successful digital reinvention. We are uniquely positioned to do this with our comprehensive cloud and data offerings, coupled with a deep understanding of our clients' workflows and security needs. Within this segment, we had good growth in cloud and data platforms and cognitive applications, while transaction processing platforms was flat. I'll break down some of the drivers behind these areas. Our cloud and data platforms grew 2%. We delivered growth this quarter by helping clients build across public and private clouds with IBM Cloud Private, which, as you know, is built on Linux containers and Kubernetes. We helped them modernize and integrate applications and environments with our integration and digital business automation platforms, and then collect and manage data with the hybrid data management platform, all of which grew this quarter. This need for tighter integration across hybrid cloud, data, and AI are also driving traction for our IBM Cloud Private for data offering, as well as Watson Assistant and Watson OpenScale that run on IBM Cloud Private for data. We see the value of bringing together the hybrid cloud and data value propositions at a European tax authority, which is using our digital business automation platform to redesign their tax processes around their data lake and improve the taxpayer experience. In cognitive applications, revenue was up 4%. Growth was led by security, as well as solution areas like health, supply chain, and weather. In security, we delivered strong double-digit growth with our integrated software and services value proposition. In particular, we continue to see good traction with our threat management software and services offerings, including Q Radar and Resilient, and our security intelligent operations consulting services, which detect and respond to security threats for our clients. Panasonic, for example, is leveraging Q Radar and related services to strengthen its threat management posture. Panasonic is also piloting our next-gen X-Force threat management offering. In Watson Health, we had broad-based growth across areas including payer, provider, and government, as clients looked to harness data to create actionable insights. We also had good results from our weather offerings, which grew double digits this quarter and reached a new all-time high in the number of active users. Transaction processing platforms revenue was consistent with last year, as clients continue to commit to our platform for the longer term. Performance reflects the value we provide clients managing these vital workloads and their preference for predictability in IT spend. Turning to profit for this segment, we expanded pre-tax margin by two points year to year. This reflects the lower level of workforce rebalancing this year, mitigated by a headwind in IP income and continued investment in key strategic areas. As we look forward, essentially all of our software portfolio now runs on Linux containers, orchestrated by Kubernetes. We've introduced new offerings like IBM Cloud Integration Platform, the Digital Business Automation Platform, and Watson Anywhere to further accelerate hybrid cloud adoption. And we have ongoing activities to educate all of IBM's employees on the journey to cloud, which includes Red Hat skills. All of this better prepares us for the Red Hat acquisition. Moving to global business services, we continue the momentum from last year and delivered another solid quarter. Revenue grew 4% and gross margin expanded 280 basis points. We again had strong growth in consulting, which was up 9%. As clients embark on their digital journey to a cognitive enterprise, they are turning to GBS to help them with their strategy and implementation, leveraging our deep industry expertise and innovative technology portfolio. The growth this quarter was led by Digital Strategy and IX, as well as consulting for cloud application migrations and our next generation enterprise application practice. Within cloud application migration, GBS Cloud Advisory Services works with enterprises to plan and implement a clear strategy and roadmap for their hybrid cloud journey. We are doing this with Tribune Publishing as they transform from a legacy print company to a digital company. Helping them determine the right environment for each of their applications and optimizing their migration to the cloud. Our next generation enterprise application offerings assist clients as they build and implement cloud native applications in areas such as Workday, Salesforce, and S4HANA. IBM is now leading the market with over 200 S4HANA impact assessments, over 200 implementations, and more than 125 GoLives. In application management, we are shifting our business to cloud-based offerings and continue to have good momentum in our cloud migration factory and cloud application development. Overall, application management revenue was flat due to ongoing declines in the traditional application management engagements. And then global process services had solid performance in first quarter. Revenue was up 5%, with strong performance in risk and compliance, along with financial process services. Turning to GBS profit, our gross margin was 26%, which is up 280 basis points, driven by our mix to higher value offerings, the yield on our productivity and utilization initiatives, and a continuing help from currency, given our global delivery mix. This enables us to make investments as we prepare for the Red Hat acquisition, such as scaling our existing Red Hat practice to enhance our journey to cloud offerings for clients leveraging Red Hat capabilities. We are also creating new offerings around advise, build,

move,

and manage services through industry points of view and platform plays. In global technology services, as I mentioned last quarter, we are taking actions to optimize our portfolio by exiting low value services content to increase margin, profit, and cash contribution, and better position the business for the longer term. GTS plays an important role in IBM's integrated value proposition, building on its deep client relationships to shift our clients to hybrid cloud. As we move through last year, we improved GTS profit and margin, creating operating leverage. This gives us a solid base from which we can de-emphasize lower value contract and third party content, enabling continued investment for Chapter 2 of the cloud and delivering sustained margin improvement. This is where we're focused. We saw this play out in our first quarter results as overall revenue declined, but gross margin expanded 110 basis points, driven by the mix shift to higher value, a lift from cloud scale efficiencies, and productivity improvements. So now looking at the GTS revenue by line of business, infrastructure and cloud services was down 3%, and technology support services was down 2%. Within infrastructure and cloud services, we continue to have solid growth in cloud revenue, which was up 13%. This is driven by the backlog, where cloud is now over 30% of the total services outsourcing backlog. Keep in mind, most of the cloud opportunity is ahead of us. 80% of the enterprise workloads, which represent mission critical work, have yet to move to the cloud. As clients migrate these workloads to a hybrid, multi-cloud environment, they face increased complexity in managing their infrastructure. Because we've been running these workloads, we're better positioned to help our clients to build and manage these new environments. During the first quarter, we announced that we're moving and managing BMP Paribas and Santander, a couple of the largest banks in Europe to hybrid cloud. That's on top of companies like Lloyds, Allianz, Westpac, American Airlines, and Anthem Insurance. The list goes on. That's all mission critical work starting to move, and they're moving it with IBM. The portfolio actions I mentioned earlier create flexibility to invest in additional cloud capabilities to capture this high-value growing market. For example, our IBM Services for Multi-Cloud Management offering provides a single system to help enterprise simplify the management of their IT resources across multiple cloud providers, on-prem environments, and private clouds. And as we prepare for the Red Hat acquisition, we are investing to build on our partnership as a services integrator for Red Hat, to be a leader in hybrid multi-cloud services. In systems, revenue is down 9% this quarter, with declines in IBM Z, reflecting where we are in the product cycle and in storage, driven by market and competitive dynamics. That said, we had good performance and power. This quarter, IBM Z revenue declined 38%. I'll remind you, we are wrapping on strong performance from last year, when we had 54% growth. We are seven quarters into the Z14 cycle, and the program continues to track ahead of the prior program. We had strong growth in volumes, or shift MIPS, and new workload MIPS continue to outpace our standard MIPS. This growth is led by Linux again this quarter, and our single-frame Z14, designed specifically for cloud data centers, remains a growth driver. Power revenue grew for the sixth consecutive quarter, up 9%, driven by Linux and the full rollout of our Power9-based architecture. As clients look to handle more data-intensive workloads in AI, HANA, and Unix, they are turning to Power9 systems. These systems are built to handle advanced analytics and cloud environments. Both the high-end and entry-level offerings posted strong growth this quarter, as clients continue to adopt this new technology. Storage hardware was down 11%, with declines in both the high-end and mid-range, offset by continued growth in all flash arrays. Performance reflects declines in our high-end, which is tied to our mainframe cycle, and the ongoing competitive dynamics and pricing pressures. We are continuing to introduce new innovations and functionality to differentiate in this environment, as we look to manage the portfolio for the market shift to flash. Looking at systems' profit, pretext margin was down a point, driven by a mixed headwind due to where we are in the Z14 cycle. So now turning to cash flow, we generated $2.3 billion of cash from operations in the quarter, excluding our financing receivables. Our free cash flow of $1.7 billion is up about $350 million -to-year. This performance results in free cash flow of $12.2 billion over the last 12 months, and continued strength in our normalized free cash flow realization rate, which is 114%. Our capex decline reflects effective capital management, and the strategy I mentioned earlier to de-emphasize some lower value content. This reduces our capital requirements. And so, free cash flow came in where we expected, and there is no change in our full-year outlook of about $12 billion. Looking at uses of cash, we've returned $2.3 billion to shareholders in the quarter, including $1.4 billion of dividends and over $900 million of gross share repurchases. That's $10.3 billion over the last 12 months. We bought back nearly 7 million shares, and at the end of the quarter, we had $2.4 billion remaining in our buyback authorization. I'll remind you, we plan to suspend share repurchase in 2020 and 2021, as we pay down debt for our red hat acquisition to get back to our targeted leverage ratio. Looking at the balance sheet, we close the quarter with a cash balance of over $18 billion and total debt of $50 billion. Both of these are up from December, as we prepare for the acquisition of red hat later in the year. About 60% of our total debt is in support of our financing business. The leverage in our financing business remains at 9-1, and the credit quality of our financing receivables remains strong at 55% investment grade. That's two points better than a year ago. As a reminder, our financing debt will decrease throughout the year as a result of the winding down of our commercial OEM content. So, to summarize, free cash flow is on track, and our balance sheet reflects the strength required to support our continuing investments and return to shareholders. So let me make a few summary comments on the quarter and our view of the year before we move on to Q&A. In the first quarter, we grew in key high-value segments, led by global business services and cloud and cognitive software. While our overall revenue reflects the IBM Z product cycle dynamics and a focus on de-emphasizing lower-value work and services. Across IBM, our cloud growth accelerated as we help our clients transition their business models to hybrid environments. We had significant margin expansion, with gross margin up over 90 basis points. This reflects our shift to higher value and our focus on productivity and operational efficiencies, what I characterize as improving fundamentals. We're continuing to prioritize our investments and announce additional actions to divest some businesses that aren't contributing to the integrated value proposition for our clients. And we're continuing our planning and preparation for the acquisition of Red Hat. With this performance, we continue to expect to deliver at least $13.90 of operating earnings per share and about $12 billion of free cash flow. I want to remind you what is and is not included in these expectations, and this is consistent with what we discussed last quarter. We continue to expect Red Hat to close in the second half. Because the financial implications to the year are dependent on the timing of the closing, we have not included Red Hat in the expectations. In contrast, the timing of the closing of our two remaining announced divestitures does not have a significant impact on the year. That's because we continue to expect the combination of the foregone profit, the gain on sale, the actions to address the structure and stranded costs, and the resulting benefit from these actions to have minimal impact to our profit and earnings per share for the year. And so our guidance assumes these divestitures. Looking at the skew of earnings per share for the year, we assume we'll deliver about 22% in the second quarter in line with the last couple of years. And then looking at the second half, we would expect the growth in EPS to be skewed to the fourth quarter. This assumes we'll close the software divestitures in the second quarter, with the gain effectively offset by the foregone profit and the charges for actions to address the structure and stranded costs. In other words, we expect essentially no impact to the second quarter. Looking at free cash flow, we do expect an impact from the divestitures, as well as some pre-closing financing costs for the Red Hat acquisition. But with a solid start to the year in free cash flow, we are comfortable that we can absorb these headwinds in the full year expectation of about $12 billion. And with that, let me turn it back to Patricia for the Q&A.

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

Thank you. We will now begin the question and answer session. If you would like to ask a question, please press star 1 and record your name and firm when prompted. Both pieces of information are required to introduce your question. To withdraw your question, you may press star 2. Once again, at this time, if you would like to ask a question, please press star 1. Our first question is from Katie Huberty with Morgan Stanley. Your line is open.

Katie, you there? We can't hear you. Maybe you're on mute.

Okay. It looks like she's no longer showing it. Kim, would you like me to go on to the next question?

Yes, please.

All right. Our next question is from Tony Sacranegon with Bernstein. Your line is open.

Yes. Good afternoon and thank you. Jim, I'm just wondering if you can comment about how the quarter turned out to your expectations 90 days ago. I think at the time in Q4, you delivered minus 1% growth at constant currency, and you stated that revenues would improve one to two points in terms of the growth rate, which didn't occur. And on the margin side, when I back out restructuring expenses, it actually looks like operating margins declined year over year in Q1. And even if I adjust for IP income, it still looks like they were kind of flat year over year. So perhaps you could address each of those, particularly relative to your expectations 90 days ago, and whether there was anything that kind of fell short of where you thought you'd be. Thank you.

Sure, Tony, and thanks as always for your question. There's a lot packed into that. So let me take a step back and just give you a perspective of how we saw the quarter play out. And I'll touch on each of your points here as I go through this. We feel like through the first 90 days of the year, we started out with a solid performance. Why? Because we see the fundamentals of our business model playing out in terms of growth and key high value areas, whether that be cloud and our acceleration there, security, digital, and data and AI. And while we see the growth in those key high value emerging areas, we're also delivering strong operating leverage by expanding margins, growing pretax income, expanding operating pretax margins, and delivering strong free cash flow. So when you look at the quarter, let me start with revenue, because you talked about what we expected 90 days and where we're at. Underneath our revenue, we see continued momentum in our GBS business led by consulting. Strong growth again, 9%, as we're enabling clients to really move on their journey to cloud and drive their digital reinventions and competitive advantage. We also had solid execution in our cloud and cognitive software, where our value propositions around hybrid cloud are playing out very nicely and we're winning in the market. And we saw accelerated growth in our cloud-based business, basically going from mid single digits in the fourth quarter, when you look at our cloud performance, to now exiting first quarter, where in the quarter we grew 12%. And now we have a trailing 12-month, $19.5 billion cloud business that's growing 12%. Now from a geography perspective, and it gets right at the heart of your question, we talked about 90 days ago that we saw about a -two-point sequential improvement. And if you look at our developed markets, we had pretty good execution, and we delivered that accelerated -two-points, in fact over two points when you look at developed markets led by Japan, UK, Italy, Spain, and many others that grew very well. It was in the emerging markets, in particular, as I said in the prepared remarks, around the AP region where we saw deceleration in revenue. And that was really driven by our transactional-related businesses, both systems and cloud and cognitive software, where we had a good transactional pipeline entering the quarter, and just based on client buying decision delays, we did not execute. Those are great value propositions. They're in front of us right now. The team's on the field, and we're focused on closing that sales execution. Now let me go to operating leverage, because you talked a little bit about our operating leverage and with and without charges, but let me set the record straight. One, strong gross profit margins up 90 basis points driven by our services-based business, which is up 160 basis points year over year. And this is the strongest operating margin, gross margin, that we've had in four years from a -to-year expansion. Pre-tax margins, you're right, up 320 basis points as printed. But within that, we did get a benefit by much lower workforce rebalancing last year, but we're also seeing the fundamentals of our enterprise productivity initiatives play out. And when you adjust for the $200 million impact -to-year in IP, our operating pre-tax margins are up. They're not down. So we feel like we started out, we delivered a strong quarter. We should have came up with some more revenue, especially in our emerging markets. The team is focused here in second quarter. But with all that said, for the first 90 days, we think we're off to a solid start, and that gives us confidence in maintaining our guidance.

Okay, Brandon, can we please go to the next question?

Our next question is from Katie Huberty with Morgan Stanley. Your line is open.

Thank you. Good afternoon. Jim, what was the thought process behind not giving strategic imperative segments anymore? And then how are you thinking about cloud and cognitive software growth going forward relative to the 2% growth over the last couple of quarters, and especially in the context of the delayed deals that you referenced in Tony's question?

Okay. Thanks, Katie, and I appreciate the question. Around strategic imperatives, again, let me put this in perspective. We put this signpost out back in the beginning of 2015, if you all remember, at our investor day. Why? Because we had to lay the groundwork on how, as a company, we needed to fundamentally shift our capital investment allocation and transform our portfolio into capturing the shifts in growth in cloud, in data, in analytics, in security, and mobility. Now you fast forward to the end of 2018, and at the time we made this announcement with that signpost, we were about less than a quarter's worth of our business, I think, Patricia. We exited 18, where we were consistently above 50%. And when you take a look at that, that has become more and more, or I should say less and less of a relevant metric as we move forward. And more importantly, as I've spent quite a bit of time over the last quarter, both at Think with many of you as analysts and also with our investors, to talk about as we changed our external segmentation to reposition and get this company focused on Chapter 2 and the journey to cloud and hybrid cloud, the same feedback we got from many of you and many of our investors is the strategic imperative metric has passed its course, and they are looking for now what are the relevant metrics on managing the company moving forward. And that, as we put out in our new segmentation, is going to be around cloud in particular, accelerating our leadership position in the $1 trillion market opportunity around hybrid. That is going to be around as a service and our scale efficiencies and margin. And finally, it's going to be around operating leverage and value. And that is going to be instantiated in gross margin and operating pretax margin. Now to your second question real quick, cloud and cognitive software. Again, as I stated, solid execution again, building on a couple quarters, strong value proposition, strong offerings, team executed well, both across cloud and data platforms where we're up 2%, but also across cognitive applications where we were up 4%. And I talked about in the prepared remarks how we continue to differentiate around our hybrid cloud software value proposition where our integration software had a very strong quarter led by ICP and ICP for data, which has strong adoption. And also our cognitive applications where we're growing both in our domains like security and even emerging areas like blockchain, but also in our industry verticals where we have continued momentum in Watson Health and in supply chain and weather. Weather we hit an all time high, great quarter and first quarter, all time high on the number of active users. So when you take a look at this portfolio, we had a couple quarters of solid execution. Yes, in emerging markets we had some buying decision delays that will come back here in the second quarter, but we feel very confident in this portfolio. We feel very confident in the value proposition and differentiation. And we see pretty consistent performance moving forward here in the second quarter and throughout the year.

Thanks, Katie. Can we go to the next question, please?

Our next question is from John Roy with UBS. Your line is open.

Hey, Jim, I've got a question for you. Really, you were talking about organic constant currency revenue growth and it looks like you're saying that if the transactional business had come through, you really would have had it this quarter. I'm really questioning or want to get an idea how sustainable do you think that is? I mean, if the transactional stuff comes through, can you really continue to see organic constant currency revenue growth?

Yes, if you take a look at it, John, you know, obviously we don't give guidance on revenue, but let me give you some dynamics of how we're seeing the business, both around the trajectory of coming out of first quarter, but also the operational indices we see right in front of us and our business plans and strategies that we're executing on moving forward. First, around GBS. Our GBS business has a lot of momentum. We actually delivered signings growth again for our GBS business. We got great momentum around our consulting business and it's driving the digital reinventions of our clients and our journey to cloud. And we see that business continuing that momentum in growth right in front of us here in the second quarter. But second half is going to be dependent, as you know, in a very short term, fast yielding type of backlog. We got to continue doing the signings in two queue. That's going to feel backlogged. That's going to feel revenue in the second half. But we feel good and we feel consistent growth in GBS. In cloud and cognitive software, as I just answered to Katie, we feel confident in that offering portfolio. And we also feel confident in continued growth here in the second quarter, pretty consistent performance. Around GBS, as I mentioned in our prepared remarks, and I'll go back to what we talked about kind of at length 90 days ago, is we embarked on a very conscious strategy around exiting low value third party OEM content. We said at that time it was going to depress revenue in the near term, but have higher value and higher margins and better position our portfolio for the long term as we go through the acquisition closure of Red Hat and really trying to address the leadership position in a hybrid multi-cloud arena. So I would expect GTS, at least in the near term, to be pretty consistent with what you just saw in first quarter. And then you get to our systems base of business. This business, as you all know quite well, always follows innovation cycles. We are on the back end of our mainframe cycle. We got about one more quarter to go through on that. It's going to be G8 plus seven plus eight, if I'm counting right. It's been our most successful program in a long time, but we got another quarter that's worth a headwind on that. But we've got strong growth and momentum in our power following that innovation cycle. We rolled out our Power9 architecture for the first quarter. We had our high end. We had strong adoption. We continue to win in that space, leveraging our cloud design systems for AI and for data intensive workloads. And then storage. Storage was a weak performance in the first quarter. It was entirely driven again by the high end disk 8000, which was attached to our mainframe. And we see that pretty consistent until we can bring new innovation to market. So if you look at first quarter, we were down about 90 basis points at constant currency. You know, you take the divested content out of that and we were roughly about flat. If you look at second quarter, I would see pretty consistent performance. Again, recognizing we got a big headwind on mainframe in the second quarter, we grew 112 percent last year as we move forward.

Okay. Thanks, John. Can we go to the next question?

Our next question is from Jim Schneider with Goldman Sachs. Your line is open.

Good afternoon. Thanks for taking my question. Maybe, Jim, I just wanted to comment on the overall performance in the services business. Signings were down year over year, but it seems like you're continuing to see very good growth in GBS and maybe a little more temper performance in GTS. So can you maybe just kind of give us a sense about where clients head their at in terms of new services, contracts overall, and maybe any kind of diversions you're seeing in bookings within GBS and GTS right now?

Sure, Jim. Thank you very much for the question. You know, as you stated, yes, signings were down, down 14 percent, if I remember correctly, about $7.5, $7.6 billion overall in signings. But let me take a step back and give you some of the dynamics underneath that because I think it's very, very important because why are signings an indicator that's of interest to all of our investors? Because it leads to backlog that then leads to backlog realization and revenue. And as I've said many quarters, all signings are not equal and they vary. They vary with lumpiness mainly based on the size of signings. And when you look at our first quarter, our first quarter being down 14 percent, our greater than $100 million signings were down over 50 percent. Why? Because we just came off of a fourth quarter, if you remember, 90 days ago where we had one of our strongest quarters in greater than $100 million signings in years, where we signed 19 deals greater than $100 million and we actually had signings growth well north of 25 percent. Also, we had a very strong signings quarter, particularly in greater than $100 million deals last first quarter, where we signed 10 deals and our greater than $100 million signings were up 130 percent. So we had a very tough compare as we both looked at last year and also just on what we executed with solid execution exiting the year. But now let's take a look at backlog. You know, backlog has many factors that influence it, signings only being one of it. The duration, the mix of those signings, erosion, dissatisfaction issues, and also new signings, new logo versus extensions. And when you take a look at our GBS business, to your point, we have strong momentum. We grew signings in the first quarter because while our greater than $100 million signings were down 50 percent plus, we actually grew less than $100 million signings, which is going to fuel that backlog and be better revenue realization in the near term as we move forward. So all in all, GBS is doing a very nice job. We restructured our offering portfolio. We're winning in the marketplace with this digital reinvention and our journey to cloud. And you're seeing a much shorter duration backlog and a better backlog optimization because our quality of delivery as we transform that has led to a much lower level of erosion, which has led to higher realization of revenue. That's what's playing out in GBS. In GTS, that is a function as we're shifting our portfolio to really capture the hybrid multi-cloud opportunity. And that backlog in GTS is flat. It's flat while we transition now in our GTS outsourcing business. Our cloud penetration is over 35 percent. And we're going to continue driving that differentiated value proposition in the near term. But as I said to the last question around revenue realization, we're continuing down the strategy of managing this business for margin, profit, and cash. And we're going to use our balance sheet appropriately and effectively around third-party capital content.

Thanks, Jim. Brandon, can we please take the next question?

Our next question is from Tim Jin Huang with JPMorgan. Your line is open.

Hey, good afternoon. Forgive me for asking another GTS question, but that was the only real delta, I think, versus our model with margins being better, revenue being a little bit lighter. So I heard everything you just said. You mentioned GTS and the near term should be pretty consistent with what we saw on T1. But I'm curious if we want to reconcile your prioritization of margin versus growth, the portfolio cleanup, the deterioration in signings, and maybe even some resegmentation impact on revenue, when might we see an inflection point for GTS to remix back to growth? Because there's a lot going on there, just trying to make sure we can recast this properly.

Okay, Tim Jin, thank you very much for the question. On GTS, I'll remind all of us last quarter, we discussed the portfolio prioritization efforts that we were doing in GTS. Why? To continue to focus and shift this business to higher value for our clients and win in the marketplace. And over the last few quarters, we have been exiting low-value content in our GBS business that we said would have some near-term impact on revenue, but will result in higher margins and, more importantly, a better business profile going forward over the long term. And if you look at first quarter, that's exactly what it played out. Our GTS revenue was down about two points from exiting that lower value content. But, Tim Jin, to your question, our gross margins, where I truly believe in a services-based business, where value is really instantiated, we're up 110 basis points year over year as we continue to drive the value of that mixed shift, our productivity initiatives, and our cloud scale. But let me spend a moment as to why. Why are we doing this? This is part of a very conscious strategy to focus this business on margin, profit, and cash. We've chosen our investment prioritization. In Chapter 2, it was all about leading in hybrid, multi-cloud, high-value market with the acquisition of Red Hat and the combination of – through the combination of cash and debt. You see, we are very focused on maintaining a very strong balance sheet and around maintaining our strong investment-grade profile and paying down that debt and getting back to our targeted leverage ratios in a few years. We've committed that to our shareholders and we are taking the actions, GTS being one action about getting out of low-value third-party content that ties up our balance sheet, that ties up our financial flexibility, and brings little to no profit to it. The second is our IGF business, where we made a decision to get out of our commercial OEM. That, in addition to, as we stated, the intent to suspend share repurchase in 2020 and 2021. So we are serious about our investment prioritization to lead in Chapter 2. We're serious about getting our balance sheet and continuing the strength of that to support our dividend growth policy and continue to invest in our business. And we're serious about driving the innovation and the investments to win in that space. And I'll just conclude to your question. GTS has tremendous value to our integrated model of IBM. You know, 90% of our most strategic accounts – we call them integrated accounts – take advantage of IBM's integrated value through outsourcing. More than 50% of the software used in outsourcing is IBM content, and that's growing. And 60% of our outsourcing engagements include the management of mainframe. So it is a very integral part. We are being selective in our investment prioritization because we've chosen where we want to win and how we're going to win going forward.

Thanks, Tingen. Let's go to the next question,

please. Our next question is from Steve Milonovitch with Wolf Research. The line is open.

Thank you. Jim, you typically take a workforce rebalancing in the first half of the year. You talked about the divestitures not having much net impact. Is that because you're going to include essentially a workforce rebalancing in that beyond just the divestitures and Red Hat and so forth? Or are we going to see a bigger separate charge at some point?

Yeah, thanks, Steve. And it's good to hear from you again. Yeah, let me put it in perspective. From a profit perspective around the announced divestitures, which most recently included the sale of our marketing and commerce remaining products to CenterBridge, that on an annualized basis is about $1.8 billion, right? From a profit perspective, we said very consistent the last quarter that we are going to have a gain on the sale. We're going to have foregone profit and stranded costs. We were going to take actions to address that foregone profit, excuse me, the stranded cost and structure of our business overall. And when you take all of that together, there's going to be minimal impact on our full year. And let me bring this home to second quarter right now, because as we stated, we expect to close majority, if not all of this, by the second quarter. And when we take each of the components, the gain on sale, we expect the gain on sale to somewhere be between $500 and $700 million. And our guidance assumes for right now it's the low end of that range. To your question, we are going to take actions to address the stranded cost and structure that's going to spend a majority, a vast majority of that gain. And then, Steve, as you know, the return on that restructuring and those actions will help us mitigate the foregone profit in the second half of the year, because the second half of the year we are going to have about a two-point revenue headwind with that business gone, and we'll have a foregone profit that we're going to have to manage as we go forward. So both for the full year and in the second quarter, minimal to no impact to our profit overall.

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

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

Thanks. Good afternoon. You know, Jim, obviously you've been active in divesting or exiting certain lines of business that are no longer a quarter year strategy. You know, we certainly understand your reluctance to talk too much about this publicly, but is there anything that you can share with us that they give us some idea of how many other assets in the portfolio may fit this profile and how much of a drag they've been on your growth rate?

Thanks, David, and I think you kind of answered your question yourself already. I'm not going to comment on any further actions, but, you know, I'll just give you the high-level perspective. You know, IBM is a high-value company, and how we remain high-value is through portfolio optimization. We consistently look at our portfolio, and I think we've stated this many times before. We look at many different factors, from market attractiveness to our ability to win and differentiate, to where client value and profit pools are shifting over time, to the value of our integrated model and how all that plays together. And we will consistently do that to make sure that we're optimizing the right level of return for our investors and we can win in the marketplace and deliver the innovative value and technology to our clients to enable them to win and create competitive advantage. And that's what we're focused on overall,

David. Thanks,

David. Let's

go to the next question.

Our next question is from Jeff Crowell with Nomura InstaNet. The line is open.

Yes, a question and perhaps a clarification. I think the question is, could you perhaps help us with the cloud as a service revenue? It seems as though the cloud revenue overall accelerated, but I'm not sure that translates to the -a-service side of things. I wonder if you could help shed some light on that. And then secondly, it seems as though you were indicating the backlog for GDS grew and GDS was flat, but it looks like the overall backlog is down and I'm trying to square that circle. Thank you.

Sure, Jeff. No problem. Thanks for the question. So, actually both kind of clarification questions, so let me just try to address it real quick and directly. Our -a-service business, first of all, our cloud. Our cloud business accelerated in the quarter. First quarter we grew 12 percent overall at constant currency. That comes off mid-single digits in the fourth quarter. If you look at our -a-service business within that, our -a-service business now has an annualized exit run rate of 11.7 billion, and that's up mid-teens, I think 15 percent if I remember correctly. And that is down quarter to quarter, but Jeff, I would tell you that's due to normal seasonality. And also, as we talked about in the fourth quarter, there were specific project milestones that we achieved in our AMS business that drove our AMS business to a four percent growth in the fourth quarter. We said that would normalize back down to about flat. So, when you take a look at normal seasonality from fourth quarter to first quarter, and you take into account the catch-up of those project milestones as we continuously improve our service delivery quality, that was expected from our perspective. And we see that continued momentum building throughout the year as we move forward with the value of our offerings and proposition. And just a clarification question on backlog. Backlog is down two percent at constant currency. I stated that GBS signings grew, and we have continued momentum. And the backlog overall, I did not make a comment about that, but I gave you some color around the dynamics of the backlog. As our GBS business, as we re-architected our offerings, and you see it play out in consulting, our backlog is moving to a much shorter duration, higher, faster yielding content with greater quality, less erosion, and it's driving backlog realization and revenue momentum overall. I did not make a comment about GBS backlog overall.

Okay. Thanks, Jeff. Brandon, why don't we take one last question?

Our last question is from Keith Fockmer with Bank of Montreal. Your line is open.

Hi. Thank you, team, very much for fitting me in. Jim, I also wanted to ask about services and the growth rates, and particularly if I look at GBS. Could you make some comments on the durability of that is the first part of my question. Application maintenance was flat, as consulting was pretty good at nine percent. Should investors be thinking about the three to four percent kind of growth for the year? Then the second part of my question as it relates to services, if you could revisit, since you've had some time since the Red Hat deal was announced, what are your expectations about how the services business, both GBS and really TTS, how the Red Hat business may impact growth or improve growth once that's included into your portfolio? Because I think investors are frankly concerned that GTS may have a long runway of runoff here, but how are you thinking that Red Hat may impact both services business, but particularly of the GTS side? Thank you.

Sure. Thank you, Keith, for the question. You know, GBS overall, as I stated, we have very good momentum in that business. Coming throughout the second half of 2018 and into first quarter where we grew four percent, led by consulting up nine percent, and within that great growth in digital strategy, our cloud migration and implementation services, next-gen enterprise apps growing, so very good momentum overall. And again, we're coming off another quarter of growing signings, especially in small deals. So when we look at right in front of us, we see pretty consistent performance. I think you said somewhere around the three percent-ish, plus or minus. We see that right in front of us. And if we continue, as we stated, winning in the marketplace and driving those signings in the second half, that's going to fuel backlog, that's going to fuel revenue, yeah, we feel pretty confident. As you know, Keith, we run multiple scenarios about our guidance, which, by the way, is on earnings per share. And we're doing that in free cash flow. But we feel pretty confident that we've got a strong hand here, a team that's executing on the field, and we're delivering real value to our clients, and that's why we're seeing the performance overall. The second question I think you asked, if I remember correctly, was around our services base of businesses and Red Hat. First and foremost, we're very excited about the potential combination of IBM and Red Hat, as we've talked about, I think, in a handful of other areas, around us accelerating the leadership in a $1 trillion hybrid cloud market. We believe this differentiates us as we move forward. And we couldn't be more excited when you look at Red Hat's performance exiting fiscal year 19 and what they reported and shared publicly, accelerating revenue up into the high teens, their backlogs up 22 percent, if I remember correctly. Strong margin contribution, and they're delivering very strong cash flow, I think north of a billion dollars in operating cash. But when you look at the services piece, we're expecting synergistic effects across our portfolio of IBM and us leading this next generation of hybrid cloud, both in our software base of businesses, but also services. And when you take a look at services overall, we have spent a lot of time, and I've talked about this in a prepared remark, about re-architecting our offerings to enable our clients on their journey to cloud. And that spans everything from advising to building to moving to managing the journey for all of our clients from an enterprise perspective of really taking the 80 percent of the next phase of the mission critical workloads to provide competitive advantage for them. So we're going to have consulting-based synergistic effects on strategy implementation. We're going to have cloud migration, app development. And there's a whole slew of offerings that our teams are now armed with, and we are ready to go once we close this acquisition overall. So thank you all for very good questions. Let me wrap it up and just make a couple comments. We had a solid start to the year, as I said, and I firmly believe the fundamentals of our business model are playing out in terms of growth in key high value areas like software and GBS while delivering strong operating leverage across our business. We will continue this in the second quarter with revenue dynamics from one queue to two queue, similar to the last couple of years, which is about a sequential dollar increase of $900 million to a billion dollars. And as I said, we expect our second quarter to be about 22 percent of our full year EPS, and that is right in line with what our last three years have been. So from a seasonality, you should expect pretty similar to history. This keeps us right on track for our full year expectations for earnings per share and free cash flow, and we'll continue to take actions to plan for Red Hat acquisition and position this company for the longer term. So with that, I thank you for joining us today. We look forward to continue the dialogue over the course of the year.

Thanks, Brendan. Let me have you close up the call.

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