Welcome, and thank you for standing by. [Operator Instructions]. 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 third quarter 2019 earnings presentation. I'm here with Jim Kavanaugh, IBM's Senior Vice President and Chief Financial Officer. We'll post today's prepared remarks on the IBM investor website within a couple 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. These 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. For example, we present revenue growth at constant currency throughout the presentation. In addition, to provide a view consistent with our go-forward business, we'll focus on constant currency growth adjusting for our recently divested businesses for the impacted lines of total revenue, cloud and our geographic performance. We've provided reconciliation charts for these and other non-GAAP measures at the end of the presentation and in the 8-K submitted to the SEC. I also want to remind you that IBM's revenue, profit and earnings per share reflect the impact of purchase accounting and other transaction-related adjustments associated with the acquisition of Red Hat. These adjustments and charges are primarily noncash. So with that, I'll turn the call over to Jim.

Thanks, Patricia, and thanks to all of you for joining us. In the third quarter, we delivered $18 billion of revenue, $2.4 billion of operating net income and $2.68 of operating earnings per share. We continued our strong cash generation with $12.3 billion of free cash flow over the last year, which is 126% normalized free cash flow realization; and we reduced our debt balance by nearly $7 billion since the end of June, maintaining a strong balance sheet. This quarter, we continue to see good performance in the key high-value areas of data and AI, security, cloud and digital. We continue to bring new innovations to the market, launching our z15 mainframe and containerizing our software. And of course, we closed the acquisition of Red Hat where we've had a good first quarter, with Red Hat revenue growth accelerating to 20% on a normalized basis. Let me give you a little more color by segment. Cloud & Cognitive Software was up 8% this quarter led by growth in cognitive applications and cloud and data platforms, including the contribution from Red Hat. In Global Business Services, revenue was up over 2%, and we expanded gross margin. Once again, we had solid performance in consulting driven by next-generation application offerings and an application modernization for the cloud. In Global Technology Services, revenue was down 4%. We continue to have good growth in the services that help our clients to move and manage cloud workloads, and our cloud revenue in the segment was up 10%. But our GTS performance fell short of our expectations due to lower in-period revenue from client business volumes in certain markets. While the volume impact has near-term revenue and profit implications, we had good long-term signings and a solid pipeline of deals that deliver productivity to clients…

Thank you, Jim. Before we begin the Q&A, I'd like to mention a few items. First, I'll remind you, the year-to-year growth rates we're providing today for Red Hat are normalized to provide comparability to Red Hat's historical performance. Second, we have supplemental charts at the end of the slide deck that provide additional information on the quarter. This includes the GTS revenue dynamics chart Jim mentioned a few minutes ago. [Operator Instructions]. So operator, let's please open it up for questions.

[Operator Instructions]. Our first question comes from Wamsi Mohan with Bank of America.

Jim, thanks for the incremental color on the drivers of the GTS shortfall in the supplementals. What do you think is the root cause of the lower volumes in the quarter? Do you think that's a macro pause? And if you fast forward to 2020, do the backlog runoff support flat to up GTS revenue? Or are we exiting too weak in 2019 to call for that right now? And if I could, on the GTS margin front, how much of this -- I think you alluded to the lower volumes being mainly the issue, but was pricing also an issue in the quarter on GTS margins?

Okay. Thanks, Wamsi. Appreciate the question. So let me start with the last part of that multiple-part question because, as I stated in the prepared remarks, when you look at a GTS business profile, as you know, high-value, high-annuity content business. And when we're looking in-quarter, about 90-plus percent of our revenue in-quarter comes out of that backlog. Now you also have a labor-based structure that's relatively fixed in a short period of time in 90 days. And what you saw happened, and hopefully, you have taken a look at the supplemental chart, again for enhanced transparency for all of you so you can understand the dynamics of what's happened to our business, when that in-period revenue, that remaining 10% falls away, it has tremendous de-operating impacts from a leverage perspective overall. So that is high value, high profit, and when it hurts you at the latter part of the month, it definitely falls to the bottom line. So I'm sure we'll get into it. We're taking a lot of actions structurally. We got out ahead of that in the second quarter, and we're well positioned to return back to margins in GTS, as I stated, in the fourth quarter. But let's go back to the first part of your question, which is that in-period 10% activity, that really comes from 2 aspects. One is based on our client business volumes that are embedded in our backlog and two, new selling bill signings that happen within a quarter, the latter being a minor part, the former being a major part. And when you take a look at what happened to us in the quarter, we did get impacted by lower client business based volumes that came out of predominantly 2 markets in Europe, that being United Kingdom and in Germany. But I would tell you, Europe overall, Europe was flat and pretty consistent with second quarter overall. So we still had good performance in our other base platforms or hardware, software. We fell short though in client base business volumes in GTS. So I wouldn't say it's per se macro, but we obviously saw less activity. But we got to improve our execution, period.

Our next question comes from Amit Daryanani with Evercore.

I guess just on the Red Hat side, it's nice to see the robust 20% growth you guys had this quarter with Red Hat. I think the notable uptick then was Red Hat was in standalone at least. What do you think is the longer-term trend line that we should be think about Red Hat's revenue growth as we go forward under IBM both maybe on the subscription and services side? And just to kind of level set this, the 14% pretax margin drop or 14 points drop in the cognitive segment, how much of that is just transaction related versus other factors?

Okay. Amit, thank you very much. And I appreciate you asking the question upfront here on Red Hat because obviously we're very pleased. And I think this is an instantiation and validation of the power of bringing IBM and Red Hat together and how it is better for our clients and for our shareholders overall. We definitely made some significant innovation announcements early August. We talked about our business profile at Investor Day. And I think 90 days into this, we're very pleased, 20% growth overall at a normalized basis to give you a normalized historical comparison. So we're very pleased. But let me talk a little bit about the progress and what we're seeing within that 20% growth. And to your point, I would definitely reference for our investors pre the announcement in October of 2018, Red Hat was growing mid-teens. Just 3, 4 quarters later, at the time of closing in our first 90 days, you see the instantiation of that value given we accelerated it to 20%. But let's talk about some of the other milestones in -- and key indicators. One, you talked about infrastructure. We had strong growth in the infrastructure led by RHEL and that return to double-digit growth of 12% if I'm not mistaken, and it's been a long time since RHEL actually was growing 12%. The application development emerging technology including OpenShift is growing mid-30s. Our OpenShift and now our newly announced containerized software, modernization of our software and Cloud Paks, we have now over an 1,800 installed base client embedded with that. Our backlog on a normalized basis, up 19%, and within the first 90 days, we talked a lot about at the Investor Day the deferred write-down that we had to take, the $2.2 billion. We talked about, over time, the value of Red Hat's platform and technology and the high renewal rates. Well, within the first 90 days, we actually replenished almost $0.5 billion of deferred revenue because we had very strong bookings, and those bookings were led by subscription. We actually had 11 deals over $10 million, which was up threefold. So we're very pleased with Red Hat overall. And I guess I would conclude, most importantly, the confidence in the workforce in IBM and Red Hat. Attrition's stable, and we hired over 1,000 people. And lastly, to your point about operating margin, the entire operating margin impact was due to transactional-related cost.

Our next question comes from Tien-Tsin Huang with JPMorgan.

Maybe to build on that with Red Hat doing a little bit better, just looking at cloud and cognitive overall, that was weighed by softer transaction processing platform revenue. So should we expect, Jim, this dynamic to continue? I'm just looking for clues here on how legacy IBM Software might perform as you execute on Red Hat?

Yes. I mean if you take a look at our third quarter performance, our Cloud & Cognitive Software, we posted 8% growth. We're very pleased with that. Now obviously that normalized Red Hat growth of 20% does not get consolidated into IBM's books as you all quite well know given the deferred revenue adjustment. In fact, as you saw in the supplementals again for transparency as I'd committed to all of you since the beginning of the year, Red Hat delivered $371 million of revenue, a little bit better than around the $350 million that we talked about. And within that, just to call it out right off the bat, the $0.70 dilution that we expected in the third quarter as we stated in prepared remarks, we did about $30 million better on the deferred revenue write-down. By the way, that's a skew over 3Q versus fourth quarter. We still expect about $1 billion still in the second half of '19. So we're very pleased with that 8% overall. By the way, we grew organically, too. Now to your point, we had very good growth in cloud and data platform led by our Cloud Paks off to a nice start. We grew in Db2 and our core offerings. We grew in our organic-based cognitive applications portfolio with very strong growth in security and in some of our industry verticals like Maximo and TRIRIGA, but we actually did fall short in our transaction processing platform. And as you know, as I've said many times, that's high value to us and that's high value to our clients because we run the mission-critical workloads and applications on our systems portfolio, and that's always tied to client buying cycles. Now when you take a look, to your question, what do we see going forward in the fourth quarter? We see pretty consistent performance, high single digit in this segment. A couple of things I would call out. Number one, we have a much tougher compare. Number two, the difference between the amount of transactional activity you do on a fourth quarter versus third quarter is obviously a big hill to climb, but we've got a nice pipeline, and it's all about execution. I would not expect our TPP to come back here in the fourth quarter. We grew I think 6%, 7% fourth quarter last year. So we will not grow in TPP in the fourth quarter, but we will have a strong growth in cloud and data platform and in cognitive apps.

Our next question comes from Katy Huberty with Morgan Stanley.

Jim, just given all the moving pieces with divestitures, Red Hat is at a base rate cycle, how would you expect revenue strength in the fourth quarter relative to the [indiscernible] sequentially over the last year?

Great. Thanks, Katy. Appreciate it. I think I got the heart of your question. You were breaking up there a little bit at least in the room here and on my speaker. As you heard in the prepared remarks, we did reaffirm guidance, at least $12.80 and about $12 billion of free cash flow. As we look into the fourth quarter, we expect revenue to sequentially increase about 3.5 to 3.7, in that range, quarter-to-quarter. And as I just stated on the last question, it's typically our biggest transactional quarter ever -- or, excuse me, within a year. Now a couple points to what you brought up. So it's a little bit higher than what you had asked. One, it's higher sequentially than 2018. And it's more representative of a normal mainframe cycle, which, if you go back to 2017, we were right within that. Now to your point, there's a few things I want to call out and give a little color what's underneath that. Number one, we continue to face a stronger and stronger dollar every quarter. It feels like each quarter I get up here and I talk about that, whereas 90 days ago, we were saying that basically no headwind. We're looking right now about 1 point to 1.5 points headwind in the fourth quarter based on where rates are at today. Second, to your question, we still have a 2 point headwind, give or take, on the divesting of our software and mortgage processing based business, which was $2 billion annually here in the fourth quarter. So those 2 are kind of headwinds. Now when you take a look at our portfolio, our mainframe, we are very pleased with the initial start. We announced it very late in the third quarter. We, in essence, have…

Our next question comes from Toni Sacconaghi with Bernstein.

Jim, you talked about a little bit of a different strategy focusing on cash and profitability for GTS. Given that, that's about 35% of your revenues and you're looking at maybe a more muted growth rate, are you still comfortable in talking about 4 to 5 points of growth and mid-single-digit growth for 2020? And then just related to that, maybe you can just talk about the dynamics of sort of what happened over the course of the quarter. You provided some guidance on the early April call. You fell a little short of that. And it sounds like it was mainly GTS. But at that point, did you not have a good read on what was happening with your workloads during the quarter? And I guess the question I'm asking, did it continue to decelerate from there? And what does that either say about the value proposition of GTS today for existing clients or more just about the health of your clients? So sorry I snuck 2 in there but one, just how we think of revenue growth next year in light of GTS being lower; and then two, what sort of changed from August 5 on.

As always, Toni, thank you very much. At least it was only 2 and not 3 like last quarter, but who's counting? Anyways, let me try to take this in a couple of different components, so we can unpack this, so you can understand fundamentally what's happening to us in GTS, what happened throughout the quarter and then to your first part of your question, what do we see overall for IBM in 2020, which, by the way, we'll spend a lot more time on in January because given the amount of transactional business both on hardware and software but also on services science that we got to get done here in the fourth quarter. We got a very robust pipeline over the next couple quarters, and that will dictate more importantly how 2020 will play out. But if you take a look at -- within the quarter. So let me talk a little bit about -- I'm not going to repeat what's on the supplemental chart. The net message in the supplemental chart is, 90 days ago, we printed down 4%, as you all know, in our GTS technology services revenue. That was basically all out of backlog in our in-period sell and bill activity, and volumes from our clients was roughly muted. It was flat. That has been consistent for quite a while. We saw at that time a backlog that ran out in third quarter but roughly down 3%, and in fourth quarter, it was down 1% to 2%. That was the driver behind calling the inflection point. Now how did the quarter play out? The quarter actually played out through August quarter-to-date, our GTS business was improving off of that down 4% that we exited second quarter. We were hovering about down 3%, give or take.…

Our next question comes from Matt Cabral with Crédit Suisse.

Jim, you called out some headwinds you're seeing in Germany and the U.K. in GTS, but I'm wondering if you'd talk a little bit more broadly about the enterprise spending environment by geography and just if you're starting to see any impacts from a more volatile macro that's in -- across your business.

Sure, Matt. Thank you very much. I mean obviously, we operate in 170 countries around the world. So we are always monitoring and analyzing the market and most importantly to the heart of your question, client buying behaviors. When you look at the IT industry, the IT industry has always been predicated on effective balance of leveraging technology for growth and leveraging technology for productivity. And over time, that balance might shift, and we are seeing a shift, and we have seen a shift by the way. It's not just right in front of us here in the month of September that clients, from a buying perspective, are shifting more and more to productivity to quick payback to ROI and also predictability of spend, which, by the way, plays to the breadth and value of our portfolio overall. And you see how that's played out in our GBS base of business, continued momentum and in our Cloud & Cognitive Software business driving the value because clients are still spending. They're spending in those key high-value areas around cloud, around digital, around data/AI and around security. Why? Because they want to create a competitive advantage to win in the marketplace. So we still see spending in those areas. And when we look around the world -- and I can only give you the lens of IBM. When you look around the world, we had strong growth in many markets around the world: Japan, Canada, Brazil, Mexico, Italy, Spain, amongst many that grow -- that grew very nicely. We did fall short in a couple other areas around the world, and I called out in GTS specifically U.K. and Germany. But I'll tell you, overall, our Europe business was flat. So I would not say per se this is a macro-related thing. And by the way, we're selling hardware, software-based platforms all over the world. So we're acknowledging shifts in buying behavior. We're adapting our value propositions. Clients are still spending in those key high-value areas, and that's where we're placing, as CFO I could tell you, where we're placing all of our investment and capital allocation in our business.

Our next question comes from Jim Schneider with Goldman Sachs.

Jim, a question on the services business. The signings rebounded nicely in the quarter, up 15%. Can you maybe talk a little bit about the composition of those signings, particularly what that means about the sustainability of growth in GBS and to what extent those signings were kind of overweighted towards GTS that would help replenish the backlog?

Sure. Thanks for the question, Jim. I appreciate it. So let me unpack this a little on signings backlog and backlog realization. We've been talking a lot about this, I think, over the last 6 quarters. We had great signings, signings over $9 billion up 15%. We had growth in GTS north of 20%; growth in GBS high single digits, if I'm not mistaken, about 9% growth. Within that, the composition as we all know, signings are not all the same. They're not equal on how they impact backlog, how they impact realization, but we had great signings growth above $100 million, large deals, up 45% overall, and we had small mid-sized deals up high single digits overall. So when you take a look at our signings, that then translated into an improvement in our overall backlog position. Our backlog improved 1 point quarter-to-quarter. And let me break it out then between GTS and GBS, and again, for enhanced transparency, you saw the supplemental chart on GTS. GTS backlog, $80 billion. That backlog is down 2%. That improved about 1 point, 1.5 points quarter-to-quarter. We've seen relatively stable duration in GTS' backlog for a long period of time even as we continue to mix more and more to cloud. And now that cloud is over 40% of that backlog. GBS grew signings 9%. GBS backlog is down 4, and that improved almost a couple of points quarter-to-quarter. It's this phenomenon of signings to backlog to revenue realization has really played out dramatically for the last 2-plus years in GBS. We talked about how Mark and the team have done a great job remixing the portfolio and offerings to capture where value and where spend are going. That is moving more and more to a consulting base and a cloud application modernization base area that's shorter duration. Our duration in our GBS backlog has reduced over 20% to 25% over the last couple years. And that's why you've been able to see an overall backlog that's been down mid- to high single digits, and we're delivering consistent revenue growth anywhere from 1% to 3% to 4% in that GBS base of business. So that is where you're seeing a big change.

Our next question will come from Jim Suva with Citigroup.

I'm definitely not the smartest person on this call. But can you just spend maybe a brief minute going over on Slide 18 when you talk about the GTS service revenue dynamics? You've mentioned in-period business volumes, but then it looks like it continues on to Q4. What I'm more interested in is do these in-period things continue on into Q1 in 2020 or maybe help a person who doesn't fully comprehend everything better understand it.

Sure, Jim, no problem. And hopefully, you appreciate the enhanced transparency in the chart overall. Obviously, Patricia and the team have spent a lot more time on this tonight. But as I stated earlier, the net message is in a GTS outsourcing based business, you have roughly -- you have -- as you enter a quarter, you have about 90-plus percent of that revenue that's under backlog, high annuity content-based business. It's under contract. You have a remaining 10% that is in-period sell and bill activity and also tied to the client business volumes that run off that backlog. And when you look at second quarter, it pretty much played out as we expected, down 4%. That's what the backlog said entering the quarter. Our in-period activity of sell and bill and transactional components were basically muted. As we got into third quarter, you see the way the chart is laid out, that backlog runout said inflection point down 4%, goes to down 3%, goes down -- to down 1% to 2%. Assuming that we consistently execute both in an IBM manner and the market overall. And when you look at the third quarter, the third quarter, our in-period, that 10% was down mid-teens due to less client business volume and also execution on our small deals predominantly in Europe as I stated. That then has a flow-through because now we're starting October 1 looking at fourth quarter. Whereas we thought we were going to be down 1% to 2% in backlog, now we're down 2% to 3%. And to the extent we can go back and execute to that 10% that has a muted effect, we would end up the quarter at that level. If it plays out like third quarter, we're going to be down 3% to 4%. That's why I stated we're going to focus all of our energy at continuing to transform the offerings and portfolio and capture where spend and growth is coming from and getting after the structural cost to drive the margin expansion.

Our last question comes from Keith Bachman with Bank of Montréal.

Jim, I wanted to pick up on the duration comment you made. Does duration normalize in '20? In other words, do you think you can begin to glow -- grow, rather, services backlog? Or do you still feel like there's compression associated with the services signing on duration? And then I'll ask my second question, too. The consulting business in GBS also had a good quarter, 5% growth. Accenture's had some weak bookings frankly on consulting, and I'm just wondering how you're thinking about that business and the economic sensitivity associated with it as we seem to be facing some more headwinds here. Do you think that consulting business that you see today continue to gross low to mid-single digits over the next couple of quarters? And that's it for me.

Okay. Keith, thanks. Good way to wrap up on the part of our portfolio that has delivered consistent operational execution. And as I stated earlier, the team really should be commended because we are capturing and we are becoming the clients' provider and service provider of choice as they embark on their digital reinvention journeys and journeys to cloud. But let me take your second part of your question first if I remember correctly, and that is comparison to Accenture. But more importantly, I'm not going to talk about them. I'm going to talk about our business. Our consulting business continues to execute very well. We delivered 5% growth here. By the way, off of a tougher and tougher compare as we move throughout 2018, we improved that consulting performance in GBS. We delivered 5% growth, great growth in application modernization consulting and also on our next-generation enterprise applications like S/4HANA and in Salesforce. And by the way, I talked about GBS signings up high single digits. We were up significant double digits in consulting signings, so we had a great quarter overall on signings. And that kind of leads me to your first question. When you look at our backlog, our duration has come down, like I said, 20% to 25% over the last handful of years. I don't see that changing right now. As this world moves more and more to cloud, we are moving more and more to shorter-duration, higher consumption-based activity that's going to play to the hand in the portfolio that we've put in place overall. So I think the reason I gave enhanced disclosure between GTS and GBS on duration and overall backlog, I think you see in the fundamental differences between the 2, and the GBS will continue to impact when you just look at the printed number of IBM. But I would focus more on GTS overall as far as looking at the total backlog going forward. So with that, again, I want to thank you for joining our call here today. A few comments just to wrap up. As I've stated, we've been investing and taking bold actions to position our business to win in chapter 2 of hybrid cloud. The acceleration in Red Hat, our early support for our Cloud Paks and modernizing our software portfolio and growth in our digital and application modernization services are all validation the actions we've taken are resonating with our clients and driving that key high-value growth areas in the IT industry. At the same time, we're continuing our disciplined financial management, which should serve us well as we head into fourth quarter and 2020. So again, I'd like to thank you for joining us today, and we look forward to the continued dialogue.

Okay. Sheila, I'm going to put it back to you to close out the call please.

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