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International Business Machines Corp  (NYSE:IBM)
Q3 2018 Earnings Conference Call
Oct. 16, 2018, 5:00 p.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

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 Patricia Murphy with IBM. Ma'am, you may begin.

Patricia Murphy -- Vice President of Investor Relations

Thank you. This is Patricia Murphy, Vice President of Investor Relations for IBM, and I'd like to welcome you to our third 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 may be characterized as forward-looking under the Private Securities Litigation Reform Act of 1995. Those statements involve a number of factors that could cause actual results to differ materially. Additional information concerning these factors is contained in the Company's filings with the SEC. Copies are available from the SEC, from the IBM 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.

James J. Kavanaugh -- Senior Vice President and Chief Financial Officer

Thanks, Patricia, and thanks to all of you for joining us. In the third quarter, we delivered $18.8 billion of revenue, $3.6 billion of operating pre-tax income and $3.42 of operating earnings per share. And over the last 12 months, we generated $12.2 billion of free cash flow with realization over 100%.

As compared to last year, our revenue was flat at constant currency, though down 2% with the impact of the stronger dollar. Gross profit margin was flat, which is the best year-to-year performance in years. The improvement was led by services margin expansion. We expanded our overall operating pre-tax margin and we grew operating profit and earnings per share.

We continue to see strong client demand in the emerging high-value segments of the IT industry. And our performance this quarter was driven by the offerings in hybrid cloud, in security, in digital, and in analytics and AI, a testament to our ability to deliver differentiated value to our clients through innovative technologies with the skills and expertise to implement these technologies. We see the results in our strategic imperatives revenue growth of 13% over the last 12 months. We also see this playing out in higher operating margin over the last few quarters, which supports both our long-term investment and return to shareholders. With our success in these higher value areas and our focus on delivering consistent operational performance, we remain on track to our full-year expectations of earnings per share and free cash flow.

Coming into the second half, we said we expected to improve our services revenue trajectory and to expand total services margins for the half. We also said we face some headwinds as we wrap on the new mainframe launch and our strongest software performance in the third quarter of last year. And so now this quarter, we delivered revenue growth and gross margin expansion in both services segments. In Global Business Services, our revenue growth accelerated , driven by consulting as we help clients with their digital transformations.

And we grew revenue again in Technology Services and Cloud Platforms driven by hybrid cloud implementations. And I should mention that my revenue comments here and throughout will be based on constant currency. In Systems, our IBM Z revenue grew despite a wrap on new mainframe launch resulting in what is now the most successful Z program in our history.

And then looking at our software revenue which spans our segments, we had growth in integration software driven by offerings that help clients modernize applications and enable hybrid cloud adoption. In solutions software, we had good performance in several areas including security, key offerings and analytics like data science and our Watson Health vertical, as we embed AI into more of our offerings. At the same time, we continued to deal with challenges in a few horizontal solution areas and a tougher compare in transaction processing software, both of which impacted overall software revenue growth.

Across our segments, our Strategic imperatives revenue has grown to $39.5 billion over the last 12 months. Within that, our cloud revenue is $19 billion and we exited the third quarter with an as-a-service annual run rate of $11.4 billion, which again was up 24%. While that's already a significant revenue base in the emerging high value segments of the IT industry such as cloud and AI, it's still early in the adoption of these technologies.

For example, it's estimated that enterprise are only 10% to 20% into their cloud journey with progress slowed by the lack of interoperability across cloud environments and concerns about the ability to manage data privacy and security in multiple cloud environments. And so clients need a cloud partner that can offer a hybrid cloud for workloads that cut across public, private and traditional, a secure cloud for mission-critical workloads and highly sensitive data, and an open cloud to run complex, multi-cloud environments.

12 months ago, we launched IBM Cloud Private which is the starting point for many companies as they embrace a hybrid, multi-cloud strategy. Already more than 400 global companies have embraced this platform to manage mission critical business processes in the cloud and nearly all of these are competitive wins.

Just yesterday, we announced a series of innovations that will help clients scale their cloud, AI and cyber security initiatives. These include IBM multi-cloud manager, which is the industry's first service to deploy and manage complete applications in any cloud environment. We also announced IBM's AI OpenScale technology, the first open interoperable AI platform to manage the life cycle of all forms of AI applications and models. This includes the management of bias, security and provenance of models and data which are the issues clients are facing with scaling AI in the enterprise. These are just a few examples of how we're building our technology innovations and industry expertise with trust and security to help our enterprise on their journey to cloud and to AI.

Before getting into the financial metrics, I'll lay out the drivers of our operating earnings-per-share growth. As I said, our revenue is flat at constant currency. But with the continued strengthening of the dollar, revenue was down 2%. And at constant margin, this was a headwind to profit and earnings-per-share growth. Our actions to reposition our cost base and drive operating efficiencies resulted in pre-tax margin expansion of 50 basis points, despite a headwind from mix. And so we had modest growth in our pre-tax income. Our tax rate was down driven by a discrete benefit in the quarter and finally a lower share count contributed to growth. Putting it all together, our operating EPS was up 5%. Year-to-date through September, our operating EPS is also up 5%. And you can see on this chart the contributors to earnings-per-share growth, consistent with how we presented it over the last three quarters.

Looking at our underlying profit and cash metrics as I said our gross margin was flat compared to last year which is an improvement in the year-to-year trajectory. We had solid gross margin improvement in the services segments, together up 160 basis points. And as I talked about last quarter in services which is a human capital base business, value is instantiated in gross margin. This was offset by the mix headwinds we discussed 90 days ago, in the z14 mainframe and software.

Our operating expense was down 4% year-to-year with half due to currency and half due to the base operational performance. When currency hurts the top line, it generally helps the expense line due to both translation and the benefit of hedging contracts. The base expense reduction of 2 points was driven by operating efficiencies including acquisition synergies. We deliver productivity across our business by using automation, leveraging agile processes and changing the way we work. This provides flexibility to increase investment to deliver innovations in areas like hybrid cloud, AI, cybersecurity and blockchain while also dropping some to the bottom line.

Within our expense decline, we also absorbed a lower level of IP income. We expanded both operating pre-tax and net income margins and net income was up 3%. Our operating tax rate was down 2 points from last year while our underlying rate of 16% is up slightly. As I said, the year-to-year dynamic is driven by a discrete benefit in the quarter.

Looking at our cash metrics, we generated $2.2 billion of free cash flow in the quarter and $5.4 billion through September which is down year-to-year. As expected, our year-to-date decline is driven by cash tax headwind and growth in CapEx. As always, trailing 12 months is the best way to look at our cash flow performance. And on that basis, we generated $12.2 billion which is a 108% free cash flow realization. We've returned about 70% of that to shareholders while increasing our capital investment.

Turning to our segments. Cognitive Solutions had $4.1 billion of revenue which was down 5%. The segment is comprised of a broad set of offerings. So let me take a minute to break it down. Solutions software includes offerings in strategic verticals like health, domain specific capabilities like analytics and security as well as our emerging technologies of AI and blockchain. We had good performance across these areas this quarter and I'll come back to these in a minute.

Solutions also includes offerings that address horizontal domains and over the last three quarters I've been talking about challenges in a few of these areas, specifically collaboration, commerce and talent where we're dealing with secular shifts in the market. We've been taking actions, including modernizing our offerings, infusing AI and enhancing the digital experience.

While these three areas continue to weigh on the segment's overall performance, we've made some progress. For example in commerce where we infused AI into offerings like customer experience analytics, SaaS signings grew double digits this quarter. And in collaboration we've had very positive reaction to the recent introduction of Notes Domino Version 10 which is optimized for mobile and supports JavaScript and Node.js. So we're starting to see some green shoots but because the time to value is longer in SaaS, we will start seeing this play out as we get into 2019.

Cognitive Solutions also includes transaction processing software. This includes software that runs mission critical workloads leveraging our hardware platforms. While much of the revenue is annuity based in any quarter the performance reflects the timing of larger transactions that are tied to client buying cycles. We have a good pipeline in transaction processing software as we enter the fourth quarter which supports a return to growth.

So now let me turn back to a few of our high value areas where we continue to scale new platforms and high value solutions. This quarter we had growth in industry verticals like health, key areas of analytics and security. In Watson Health where we've been infusing AI the longest, we had broad based growth including in payer, provider, imaging and life sciences.

In the area of life sciences, we've been working with Medtronic to leverage data and apply intelligence into their glucose monitors. In June, the Sugar.IQ app with Medtronic went live, and initial demand and patient results are very strong. In our underlying analytics platform, we had growth in our data science and IBM Cloud Private for data offerings. We continue to invest in advancing data and AI. We announced bias detection services and introduced new Watson services on the IBM Cloud Private platform as clients seek the benefits of AI and the cloud behind their firewall.

Security growth in the quarter was led by offerings in orchestration, data security and endpoint management. Our momentum is driven by our unique market position, comprehensive integrated portfolio, and differentiation with AI. In the emerging area of blockchain, this quarter, our IBM Food Trust network for food safety went live, and Carrefour, one of the world's leading retailers, joined the network.

We also jointly announced TradeLens with Maersk. Together we will apply blockchain technologies to address inefficiencies in the global supply chain and signed up over 50 ecosystem participants and we now have over 75 active blockchain networks.

Looking at profit this quarter, we expanded pre-tax margin by over a point year-to-year. This was driven by operational efficiencies, including acquisition synergies while continuing to invest at high levels in key strategic areas.

Looking at services, our Global Business Services revenue grew 3%, building on the progress from first half. Consulting revenue growth accelerated to 7%, led by strength in offerings within the Digital Strategy and iX, as well as Cognitive Process Transformation.

And in application management, a decline in traditional enterprise application managed services is being mitigated by the continued strength in areas such as Cloud Migration Factory and cloud application development. Our consulting performance reflects the fact that enterprises are undergoing a digital transformation and reinvention, leveraging technology to transform the way they operate, to attract the best talent, and to improve engagements with their customers.

Customers are turning to GBS as we are uniquely positioned to infuse IBM's leading-edge technology and partnerships with our industry expertise to enable clients' digital transformation. For example, we are partnering with Sally Beauty to provide an innovative digital and in-store customer experience, influenced by deep understanding of the brand, consumer and retail industry.

We are creating virtual assistants for Lloyds Banking Group to enhance the way they communicate with and serve customers. And at the US Open, GBS provided the digital fan experience, which included several innovative features. AI Highlights enabled the tournament's digital team to view and find the most exciting shot of the day or match for distribution. And the AI powered virtual concierge answered fans' questions on a range of topics.

Turning to gross profit, GBS gross margin expanded 270 basis points year-to-year. We are shifting our revenue mix toward higher value offerings such as digital and cognitive and capturing that price for value. Additionally, we have aligned our resources to key skill areas and are seeing productivity and utilization benefits. Putting it all together, GBS delivered a solid quarter. They are executing well and delivering value to clients in key strategic areas.

In Technology Services and Cloud Platforms, we delivered $8.3 billion of revenue and grew for the second consecutive quarter. Growth was led by hybrid cloud implementations with cloud revenue up 22%, and we exited the quarter with a $7.5 billion as-a-service annual run rate. This reflects IBM's differentiated value proposition to address cloud for the enterprise.

As I said earlier, clients are early in their cloud journey and their needs are evolving initial cloud projects focused on the productivity economics of renting IT infrastructure at scale. More and more however, clients want to move beyond that model and start to shift mission critical business processes and apps to the cloud. They recognize that cloud can help drive real business value in those processes, launch new applications rapidly and enter new markets. And this all needs to be optimized across public, private and on-prem, where many of the workloads will remain. This is why IBM's approach to cloud is hybrid, secure and open. I mentioned our announcements yesterday. It's important to note that we are bringing new, open and interoperable approaches to cloud. This is consistent with our heritage as a leader in open standards and governance. From the early days of Linux and Java to Kubernetes and Hyperledger for Blockchain, we're bringing the same open approach to cloud and AI, which will also help clients overcome the complexity of proprietary technology and vendor lock-in.

Within this segment, we see results of this shift in infrastructure services and integration software, with strong cloud performance contributing to revenue growth in both of these areas. I mentioned earlier the strong adoption of IBM Cloud Private, with 95 new companies alone this quarter around the globe. For example, Aflac in Japan is trusting IBM Cloud to help speed the development of new business products and services. Brazil's Fidelity National Information Services, a global leader in payment processing solutions, has adopted IBM Cloud Private to help streamline credit card chargebacks for its Brazilian operations and CNH Industrial, a leader in the capital goods sector, will use IBM Cloud Private and Watson artificial intelligence to transform its business processes across manufacturing, supply chain, sales and marketing, and financial services.

And now turning to technical support services, revenue was down 3%, which is a modest sequential improvement from second quarter. Similar to last quarter, this area continues to be impacted by the dynamics of our hardware product cycle, moderated by continued growth in our core multi-vendor services offerings.

Moving on to gross profit for the segment, margin expanded 120 basis points. This improvement was driven by scale efficiencies in our cloud business, as well as a lift in our productivity initiatives. As we continue to drive value in technology, services and cloud platforms, we are making investments to capitalize on the shifts to cloud by adding capacity and expanding our datacenter footprint around the world as well as expanding our go-to-market capabilities to capture the opportunity in hybrid.

We're also investing in development to drive hybrid cloud innovation, that means both private and public technologies. You see this in the introduction of IBM Multicloud Manager and AI OpenScale. We're also adding functionality and enhancements to IBM Cloud Private and IBM Cloud.

Before moving on to Systems, let me give you some perspective on our combined services business. As we entered the year, we saw improved revenue from opening backlog, which pointed to an improving revenue trajectory. And the actions we've been taking to remix our offerings to higher value, improve price realization, and drive productivity and workforce optimization combined with scale efficiencies in the cloud are designed to improve gross profit performance, which in a human capital base business is where the value is instantiated.

In the third quarter for Services, the revenue trajectory and gross margins continued to improve with combined revenue up 1% and gross margins expanding 160 basis points. In Systems, we grew revenue again this quarter, driven by a combination of a strong z14 and newly introduced POWER9 adoption. This quarter, IBM Z revenue grew 6% year-to-year and 20% MIPS growth, and margins expanded. The z14 program continued to track ahead the prior cycle, and in fact program to-date in terms of shipped capacity is the most successful in our platform's long history.

The z14's pervasive encryption continues to be a key differentiator. For instance, governments are selecting z14 to protect their sensitive data, including a large US government agency this quarter. The z14 adoption spans many industries and countries and we added new clients to the platform again in this quarter including several new clients to our new single-frame z14 designed specifically for cloud environments.

Our Power revenue was up double digits driven by strong growth in Linux and traction across our new POWER9 based architecture. In the third quarter we released our next generation POWER9 processors for mid-range and high-end systems and we've seen strong adoption. These systems are designed for handling advanced analytics, cloud environments and data intensive workloads in AI, HANA and UNIX markets.

We also introduced new offerings optimizing both hardware and software for AI. Offerings such as PowerAI Vision and PowerAI Enterprise will help drive new customer adoption. And we continue to deploy our supercomputers at U.S. Department of Energy labs in the quarter. Storage hardware was down this quarter with declines in mid-range and high-end mitigated by strong growth in all-flash arrays. Storage is an increasingly competitive environment with continued pricing pressures. So to differentiate in this environment requires additional investment in innovation.

We've been releasing new functionality like Safeguarded Copy for cybersecurity to protect critical client data from cyber attack and we signed our first large deployment of this technology with a major bank this quarter, and our new flag systems with next generation NVMe technology was announced earlier this quarter. We will continue to roll out NVMe across the portfolio.

Turning to profit, systems pre-tax margin was down over 6 points reflecting a mix headwind and lower level of IP income and ongoing investment to drive innovation across the brands. Turning to cash flow and balance sheet in the quarter, we generated $3.1 billion of cash from operations, excluding our financing receivables and $2.2 billion of free cash flow. This brings our year-to-date free cash flow to $5.4 billion which is down $800 million year-to-year. The decline is driven by a combination of higher capital expenditures and cash taxes. You'll recall at the beginning of the year we said we expected three headwinds to our free cash flow growth this year, higher CapEx, higher cash taxes and our strong working capital performance at the end of last year driven by the IBM z introduction.

The combined impact from cash taxes and capital investments is in line with what we expected at this point though we spent a little more on CapEx and a little less on cash taxes. Looking at uses of cash, over the last three quarters we returned $6.6 billion to our shareholders including $4.2 billion in dividends and we bought back 16 million shares with $1.4 billion remaining in our buyback authorization at the end of September.

Looking at the balance sheet highlights, we ended September with $14.7 billion in cash and non-financing debt of about $16.5 billion. We had just over $30 billion of debt in support of our financing business which continues to be leveraged at 9 to 1. Our financing portfolio remains strong at 55% investment grade. That's a point better than December and 2 points better than a year ago. So I'm confident in the strength of our balance sheet. We've got plenty of flexibility to continue invest while returning value to our shareholders as evidenced by 23 consecutive years of dividend increases.

So let me wrap it up. Our performance through the first three quarters reflects the investments we've been making over the last couple of years and actions to reposition the business. We've been rebuilding our innovation pipeline to address what our enterprise clients value in an IT industry that has been rapidly reordering. Technologies like AI, blockchain, cybersecurity delivered in hybrid cloud environment. And we've taken actions to further align our skill base to this opportunity and to drive operating efficiencies.

And so now on a year-to-date basis our revenue is up. Our gross margin trajectory has been improving and in the third quarter it was flat year-to-year. Our operating profit is up modestly and we've returned a lot of value to shareholders. These all reinforce the fact that we're a high value company. As we look forward, as always there is more work to do. And the fourth quarter seasonally has a large transaction base. But with the performance in the first three quarters and our focus on consistent operational execution, we continue to expect to deliver at least $13.80 of operating earnings per share. Regarding our free cash flow with the headwinds we expected in cash taxes and capital expenditures largely behind us we are maintaining our view of about $12 billion of free cash flow for the year which is over 100% realization.

And with that, let me turn it back to Patricia so we can get started on Q&A.

Patricia Murphy -- Vice President of Investor Relations

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 I'd ask you to refrain from multiple questions and multi-part questions so that we can make the best use of the time we have today.

So, operator let's please open it up for questions.

Questions and Answers:

Operator

Thank you. At this time we will begin the question-and-answer session of the conference. (Operator Instructions) Our first question comes from Amit Daryanani from RBC Capital Markets.

Amit Daryanani -- RBC Capital Markets -- Analyst

Thank you. Jim I guess when I think about this quarter there were multiple crosscurrents that IBM dealt with across the portfolio. So I guess it would be helpful just to hear how you would characterize IBM's performance in September quarter versus what you guys were expecting 90 days ago. And importantly, the sustainability of some of the trends that you're seeing, especially on gross margins which were flat on a very difficult compare, I think versus last year and then on the other your Cognitive was down somewhat more than I thought. So if you could maybe just characterize the performance and sustainability of some of these trends versus what you thought 90 days ago that would be really helpful for us.

James J. Kavanaugh -- Senior Vice President and Chief Financial Officer

Okay thanks, Amit. And it's a good place to start here talking about the characterization of our quarter now that we're three quarters of 2018. But I guess from my perspective I would say first we had a solid quarter. We delivered $18.8 billion of revenue which was consistent with our guidance of a typical quarter-to-quarter seasonality even in light of a strengthening US dollar which continues to go against us. But the headline overall would be we fundamentally have taken the actions to reposition our business entering 2018. And you see that play out as we enter the second half where we grew operating profit, we expanded operating pre-tax margin by 50 basis points, we grew EPS 5% consistent with the first half and we continue to drive strong free cash flow realization to deliver value back to our shareholders.

Now some of the underpinnings behind that. One, we still see strong demand in key high value segments and you see that play out in our third quarter performance and we think that will continue moving forward, areas like hybrid cloud where we're winning with our hybrid cloud value proposition in the marketplace, data and AI, security, digital, all of these are instantiated in our strategic imperatives which now from a trailing 12-month perspective were at $39.5 billion, pretty close to that $40 billion target that we put in place well over three years ago when the IBM company had less than 25% of its portfolio in strategic imperatives. Today we are roughly at 50%. That's a massive transformation over a period of time and that's led to significant improvement in trajectory of our revenue growth overall whereas year-to-date we're up 2%. But underneath that, you see some of the areas of growth around cloud, $19 billion growing 20%. And within that, it's being driven by our high value as-a-service content driving our cloud component, that's up now to $11.4 billion on an annualized exit run rate growing consistently at 24%.

But if you put all that together, yes we're seeing the underlying fundamental shifts of our top line. We've done the tough work to transform our portfolio. But really what I would call is an inflection point as we enter the second half of the year is what's happening with our operating leverage. And you see that play out in our gross margin performance which is the best we've had year-to-year in over three years.

Now let's talk a little bit about that because each of you as analysts and more importantly as I go out meet with many of our investors, it is a very critical signpost in a high value base business model, and they've been talking about our gross margin performance and when are we going to stabilize and how are we going to get back to expansion toward our model. And we talked about as we entered the year, we knew we had headwinds coming into the second half, predominantly around mix, mix around our successful mainframe launch, but also mix is starting to hurt us from a currency perspective as we talked at length 90 days ago, and how currency and the strengthening of dollar is actually hurting our product base businesses in hardware and software, where you have a disconnect between your cost base which is in US dollars versus your actual revenue in local currency. So we knew that headwind. And now, what we've been able to do is we've been able to reposition our services base of businesses and you see not only do we return both units back to growth, we actually delivered 160 basis points of margin improvement year-over-year. That's the best year-over-year in our services business in over five years. And we see that continuing and we expect that to continue to accelerate as we move into fourth quarter.

So you combine that margin with our continued enterprise productivity and you see that we're able to deliver strong operating pre-tax margins and you couple that with our strong free cash flow without trailing 12 months it's still in excess of $12 billion and a free cash flow realization over 100% and that gives us confidence to reaffirm our expectation of at least $13.80.

Patricia Murphy -- Vice President of Investor Relations

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

Operator

Our next question is from Katy Huberty from Morgan Stanley.

Katy Huberty -- Morgan Stanley -- Analyst

Good afternoon, Jim. I want to get your early thoughts as you think about planning for next year, in particular because you face a number of headwinds. Services backlog is down, the mainframe comps get more difficult, the dollar is strong, question of what tariffs due to demand, and so in the context of all those headwinds can you talk about what some of the offsets are as you start to plan for 2019, and whether there is the potential to continue to grow PTI as you go into next year, even as some of these headwinds don't(ph). Thank you.

James J. Kavanaugh -- Senior Vice President and Chief Financial Officer

Sure, Katy. Thank you very much for the question. Obviously, we still got a lot of work to do. We're 16 days into a very important fourth quarter. We are focused on delivering consistent operational performance to deliver value for our clients in the marketplace and also for our shareholders. So with that said, we'll give updates and guidance in January. But let me give you -- to your point, let me give you a kind of what we see as a trajectory of our business in the connotation of a headwind, tailwind as we move forward. So let me first start with Services.

You see, as we enter 2018, we talked about we had a much better position on our backlog near-term run out and you've seen that play out throughout 2018, and I think that's a combination of us taking some very bold actions about repositioning our services business and capitalizing on a differentiated services model, services practices, and services value propositions to capture the growth in digital, cognitive and cloud, and we see great momentum in our GBS base of business both on top line and on bottom line as we move forward. In our GTS business, again we continue to make progress the acceleration in revenue through the third quarter, we are leveraging our differentiated hybrid cloud value proposition. Our clients value our incumbency. They value it because we understand their infrastructure, their workloads and they trust us to move them to the future. And we talked about in the beginning of the year when you look at our outsourcing backlog, we were hovering around 25% of a $90 billion outsourcing backlog while(ph)right now exiting third quarter that $90 billion backlog, give or take, we are now in about 30% to 35% cloud content. So we are winning in the marketplace and our clients are choosing us to move them to the future. So I continue to see both of our services business.

Now with that said, we got a big fourth quarter on signings. We fell short in the third quarter on signings and as you know signings can vary and really all signings are not equal. The reality is the duration, the mix of signings, and also new logo versus just extensions, all can impact overall. But when we look at our fourth quarter, we got the strongest lineup and greater than $100 million deals lined up that we've got a chance to exit the year with a very strong position in our services base of business. And when I couple that with our margin leverage that we're getting out of that business, once you get the revenue growth you see the fundamental operating leverage, I definitely see that playing out into 2019. Now on Systems, Systems as you talked about, we're into our fifth quarter on mainframe.

By the way in terms of shipped, MIPS as I said in prepared remarks, this is the most successful mainframe program that we've ever had, and we still grew into third quarter albeit mid single-digits. Now we know we wrap on that in the fourth quarter coming off of a 72% growth last year. But you see the underlying innovation playing out in our systems portfolio as we rolled out our new POWER9 architecture, and we grew nicely in the third quarter by 17% if I remember correctly, and we see that continuing to play out as we rolled out the mid-range and high-end late in the third quarter we see that playing out in fourth quarter and next year also. And we've got also innovations coming out in our all-flash systems in storage, which is where we're share and winning in the marketplace. So the innovation of continually modernizing those platforms and systems, power in storage, we should see some continued growth as we move into '19, but we will wrap on some very tough compares in mainframe, which leads me to cognitive, and we've focused on cognitive throughout this year.

One, in the third quarter, we dealt with some enterprise client buying seasonality. And as I said earlier, that will come back in the fourth quarter just given where clients are at in their buying cycles about committing to the platform. But we've been dealing with some issues around our horizontal apps. And as I said, that's a function of the secular shift in client value and consumption models as-a-service and we'll see that play out as we get into 2019 and throughout 2019. So our focus has been on the key high value emerging areas of cognitive around our industry verticals and around our domains like security, blockchain, which we see great opportunity and we're very pleased with that portfolio overall. So kind of a posture around headwinds, tailwinds, but we'll give a lot more color as we get into January.

Patricia Murphy -- Vice President of Investor Relations

Okay, thanks Katy. Can we please go to the next question?

Operator

Next question is from Toni Sacconaghi from Bernstein.

Toni Sacconaghi -- Bernstein -- Analyst

Yes, thank you. I was wondering if you could talk, Jim, a little bit about free cash flow for this year. You mentioned that it will be greater than 100% of GAAP net income this year despite the fact that you have some headwinds in cash taxes and higher CapEx. And that number is higher than your longer-term guidance of 90% to 100% realization. So I'm wondering if you can help us understand what are the positive tailwinds that you're seeing that are enabling free cash flow to be higher than 100% of GAAP net income. And can you explicitly comment on what are your expected cash pension and retirement contributions are this year and whether receivables factoring will benefit your free cash flow and to what extent?

James J. Kavanaugh -- Senior Vice President and Chief Financial Officer

Okay, Tony thank you very much. And as always many very good questions that you bring up but I hope I can capture many of them. If not Patricia can get to all of you after the call. But first of all let me start at the big picture. Free cash flow, as we enter 2018, we enter 2018 coming off of a very strong fourth quarter in 2017 where we drew -- we actually contributed significant working capital efficiency through the launch of our mainframe product cycle. And we said in our January call that we expected about $12 billion of free cash flow in 2018 and the drivers of that from 2017 were really going to be centered around, one, incremental cash taxes that will be a headwind to us in '18, and by the way that is playing out and all of that is behind us now as we exit the third quarter.

Number two, that we work on a plan on driving that strong working capital efficiency with the introduction of our mainframe as we exit the fourth quarter of 2018 and that would be a headwind. And then third, we said we were going to continue to invest in our business to capitalize on our innovation and differentiated value around our hybrid cloud. And we've continued to invest actually invested more this year because we're seeing accelerated growth in our cloud overall. Our CapEx is up I think year-to-date 21%. So when you put those three headwinds in play that's what you're seeing play out in our free cash flow through nine months. And by the way we still feel comfortable and expect about $12 billion for the full year based on any metric I look at attainment(ph)wise and our trailing 12 months is at $12.2 billion et cetera.

Now let's get the free cash flow realization. First of all as you know appropriately so we draw a free cash flow realization compared to GAAP earnings and GAAP net income because we believe that's the best way of doing realization overall. And you know within that you've got not only our core operating profit but you got working capital efficiencies, you got CapEx, you got tax, you got pension. All of those can be variables in that free cash flow realization. But if you looked at the last couple of years we've seen positive impact to our stated goal of at least 90% free cash flow realization driven by working capital efficiency, it's been driving that free cash flow above 100% and then also tax and pension, tax about 6 points, pension a couple of points year-over-year. So when you take a look at those pieces we feel comfortable in 2018 looking at both our expectation for non-GAAP and our expectation for GAAP that we will be well north of our realization here in 2018. And on factoring, I would tell you our factoring there's no difference from 2018. We use that appropriately as a risk mitigation strategy to manage credit, to manage concentration and collection risk overall. And we'll continue to use that judiciously but I wouldn't see any major change in that year-over-year.

Patricia Murphy -- Vice President of Investor Relations

Great. Can we please go to the next question?

Operator

Next question is from Tien-tsin Huang from JP Morgan. I'm sorry, our next question is from Wamsi Mohan from Merrill Lynch.

Wamsi Mohan -- Merrill Lynch -- Analyst

Thank you. Jim I was wondering if you can talk a little bit about the strategic comparative performance within Cognitive including the cloud revenues and as a service both of which declined versus overall strategic strategic imperative growth. Can you maybe talk about some of the puts and takes there and some color on what you think drove that client buying seasonality that you mentioned to a prior question? And if I could how do you think that some of these new announcements around AI OpenScale and multi-cloud could change the trajectory for cognitive and when? Thank you.

James J. Kavanaugh -- Senior Vice President and Chief Financial Officer

Okay Wamsi. Thank you very much for your questions. There's a lot there to compact into one answer but let me talk about strategic imperatives first and then I'll get into cognitive next. But let's put the strategic imperatives into perspective. So as I stated on the call trailing 12 months, $39.5 billion we talked about three years ago, we put the signposts out there to hit $40 billion. At that point in time the IBM contribution was less than a quarter of IBM's revenue. Now we're approaching 50%. We're growing in the mid-teens, 13% I think if I remember correctly, over the trailing 12 months and that has lifted IBM's overall revenue growth.

As you've seen year-to-date we're growing 2% at the IBM level. But within that strategic imperatives our cloud business, to your point, is at $19 billion right now, up 20%. And the high value as-a-service component underneath that is up 24% consistent with where we've been in the first half of the year. And I think that's an attestation to we are capturing the new and emerging workloads as the secular shift to as-a-service world is happening overall. Now when you take a look at our strategic imperatives, let's put this in perspective where we were 90 days ago. We knew to hit that $40 billion that we needed to be at basically mid to high single digit growth in the second half and we knew similar to how we laid out our expectation for guidance that we were going to wrap around the most successful mainframe product program that we've had in history. So as we entered the second half we knew we had to focus on driving that underlying high value as a service content and continue to accelerate that to offset the impacts on that mainframe wrap around on product cycle. And you see in the third quarter our strategic imperatives basically accomplished that. We did what we expected.

So as we look going forward then in the fourth quarter we have to repeat what we just did in the third quarter. In the underlying acceleration in our base services businesses I talked about, the expectation as we have a great pipeline lined up for our software entering the fourth quarter based on those buying cycle seasonality that impact us in third quarter we do expect to hit the $40 billion at the end of the year. And I'll remind you when we set that $40 billion target in 2015 we've lost over $2 billion of revenue due to the strengthening of the US dollar. So you've seen what it's done to transform our portfolio. It's changed the mindset of how we run our Company, how we allocate capital and investment and you see how that's playing up with regard to the improved trajectory.

Now getting the cognitive and I'll just talk about Cognitive SI because to be honest with you it's a simple answer. We talked about last 90, 120 days about the challenges and headwinds we're facing with regards to our horizontal application areas of talent, collaboration and around Watson -- excuse me marketing and commerce. We've been making progress and I'll talk a little bit about that. But those three areas are still depressing our revenue. And as you know there are secular shift to SaaS and consumption models, they hurt our as-a-service run rate. So while we've been maintaining rounding up and down $2 billion of as-a-service for the last couple of quarters, you're seeing strength in areas like security, in our industry verticals like healthcare, in blockchain and Watson but it's getting depressed by those three horizontal app areas and that will not play out until that time to value throughout 2019.

Patricia Murphy -- Vice President of Investor Relations

Thanks Wamsi. Let's go to the next question please.

Operator

Next question is from Tien-tsin Huang from JP Morgan.

Tien-tsin Huang -- JP Morgan Chase & Co -- Analyst

Thanks. Can you guys hear me now?

Patricia Murphy -- Vice President of Investor Relations

We can hear you now.

Tien-tsin Huang -- JP Morgan Chase & Co -- Analyst

Sorry about that. Don't know what happened. Good to hear from you guys. Just one clarify, I guess, on the $13.80, at least $13.80. Trying to better asses the at least in that comment and what's required or how much cushion there is on the transactional side to achieve the outlook because if we use $13.80, that suggests 4Q earnings looks like a little below consensus and below each of the last two fourth quarters. So just trying to understand the at least piece at this stage. Thanks.

James J. Kavanaugh -- Senior Vice President and Chief Financial Officer

Sure, Tien-tsin, and thank you very much for the question. I think the -- a little bit below when you're doing the math. I mean, we just beat third quarter by $0.02. But let's put that aside right now. As always, when we take a look at our following quarter and most importantly for the year, and it's one of the same right now. We always have multiple scenarios, taking into account, one, the trajectory of our business and also the fundamentals and the operational indices that we see. And all support our expectation of the at least -- excuse me, at least $13.80 of earnings per share.

So if you put that in perspective, how are we entering fourth quarter? Well, if you look at the fundamentals of our business profile, through third quarter, we're growing revenue, we're growing operating profit, we're growing earnings per share consistently, and we're still driving that strong free cash flow realization. So kind of -- let me walk down the I&E and give you a perspective. And again, there are multiple variables here. But the way we kind of see it, you know, triangulating each of these pieces. First on revenue, and revenue, as you've seen on our supplemental charts, the dollar continues to go against us and strengthen against foreign currencies. And right now, on revenue, we see about a 2 point currency headwind here in the fourth quarter, pretty consistent, by the way, with the third quarter.

But we would expect a normal historical quarter-to-quarter seasonality, probably in the range of somewhere around three to five years of an average seasonality of 3Q to 4Q. But putting that in perspective, year-to-date grown at 2% and where we think fourth quarter can be, we continue to feel that we expect full year revenue at current spot rates that we will grow. And again, I'll make the statement we've been saying that throughout the year and from the trough of the US dollar to FX, we've lost a $1.5 billion of revenue since that period of time. But we still feel, based on the fundamentals and our underlying business, that we will see growth moving forward with regards to that content.

So now let's turn to margin. Margin though is where we made the most progress. It is how you instantiate value. And when you take a look at, again, 90 days ago, nothing is different. We expected a headwind on product mix and now we're dealing with a headwind on currency with regards to our product base businesses. And we're more than offsetting that with services. We delivered our best year-to-year margin performance in the third quarter, led by services up 160 basis points year-over-year. The tough work we've done around shifting the higher value, we're starting to see the realization in our margin on that. The momentum that we've got on our hybrid cloud value proposition, we're starting to see the scale efficiencies, and the productivity benefits are playing out as we move forward.

So when you take a look at margin, we see our margin continuing to accelerate and approaching our model here in the fourth quarter. And then you combine that with the work we have done about fundamentally changing the way we operate this company and our enterprise productivity. I'm talking about things like embedding agile into all of our methodologies, transforming the way we work, embedding automation, AI becoming a cognitive enterprise. With that enterprise productivity, we see our fourth quarter operating pre-tax margins expanding significantly as we move forward.

So the last thing I'll bring up is tax. And as you know, on tax, in third quarter, our underlying rate was still 16%. We did have a discrete in the third quarter. But if you look at our fourth quarter, we continue to expect our underlying rate to be 16% plus or minus 2 points. And I'll tell you, when you take a look at fourth quarter, fourth quarter always has the biggest variability in tax. Go look at the fourth quarter over the last five to 10 years. Why is that the case? Because one; it's our largest transactional quarter. So the product mix and geographic mix has a major implication on our underlying rate, but also, tax events typically happen in the fourth quarter. Tax closures, audit closures, statute expirations, each tends to drive variability overall. But with that said, consistent with what I've said all year long, we expect on a full year basis that our tax rate, all imprinted (ph), will be a headwind. So you put all of those elements together, we expect a full year guidance of at least $13.80, and as I said earlier about $12 billion of free cash flow.

Patricia Murphy -- Vice President of Investor Relations

Excellent. Tien-tsin, thanks. Mark, can we go to the next question please?

Operator

Next question is from John Roy from UBS.

John Roy -- UBS -- Analyst

Thanks so much. So, Jim, I know obviously the mainframe has done very well. Is there any chance you'd continue to see, you know, slower moderation as you go through, or is -- are we back to the regular mainframe cycles? Thank you.

James J. Kavanaugh -- Senior Vice President and Chief Financial Officer

Thank you, John. I appreciate it. Very good question. And to be honest with you, I haven't talked enough about mainframe because we couldn't be more pleased with how we've been able to leverage our high value innovation technology, which really is instantiated in, I would argue, one of the most enduring platforms that delivers tremendous value to our clients overall. But with that said, you know, mainframe -- we had a good quarter in mainframe. It is the fifth quarter we wrapped. We grew 6% and a successful z14 launch. And again, I'll remind you, that's off a 62% growth last year. We had double-digit growth in MIPS, 20%. And by the way, as you get to the back half of the mainframe cycle, we drive margin expansion, and that happened here in the quarter.

So again, best program ever against the prior cycle. We are still well in excess of that prior cycle, and I would expect us to continue to be well in excess of that prior cycle here in the fourth quarter, although I'll caution you in a GA plus five or six quarter in, we do -- we typically do not grow. And again, we're coming off a 71% growth last year on a strong launch. But we are very pleased with the platform. The pervasive encryption value proposition is really resonating. Now, as we get into the back half of the cycle, we drive margin expansion and now we start seeing the rest of the platform stack play out with regards to our maintenance base or IGF base, our software base, that's on top of it.

Patricia Murphy -- Vice President of Investor Relations

Great. Thank you, John. Can we go to the next question please?

Operator

Next question is from David Grossman from Stifel Financials.

David Grossman -- Stifel, Nicolaus & Company, Incorporated -- Analyst

Thank you. You know, Jim, you touched on this briefly in one or two other questions, but is there anything you can share beyond the quarterly data points that will help us better understand the growth trajectory of the -- excuse me, the Cognitive segment going forward? I think I understand the issues, but they seem somewhat open ended and really having a hard time gauging how to model growth of that segment going forward.

James J. Kavanaugh -- Senior Vice President and Chief Financial Officer

Okay, David. Thank you for the question. Cognitive, so you know from a net perspective, then I'll expand. You know, we were impacted by enterprise client buying cycles as I said in prepared remarks, and also challenges that we've talked about in the last quarter around our horizontal laps in particular, you know, talent collaboration and marketing and commerce, where we're seeing some green shoots. But again, time to value in that as you shift to SAS all you know quite well will play out as we get into 2019. But let's take a moment and really unpack this segment.

To your point, and part of this I think is on us, but there are many different pieces of this segment. So we have a strong portfolio of high-value areas around domains like security, analytics, blockchain. We've got industry verticals like healthcare, our FSS portfolio and IoT, we've got horizontal apps as I talked about like talent, collaboration and marketing and commerce and then we have transaction processing software. So let me unpack this. But I'll remind you this segment is high value, high margin and we continue to expand even in the third quarter and third quarter year-to-date we're expanding our pre-tax margins overall. But let me give you the different dynamics on how they're playing out and I'll do it kind of headwind, tailwind. First in terms of headwind, as you could see through the prepared remarks, we were impacted by TPS and by our horizontal apps.

So let's talk TPS. TPS, high value business, strategically important to our clients. By the way it encompasses mission critical systems that run many industries like banking, like airlines, like retail, and there is seasonality to this business. And what you saw play out in the third quarter was tied to enterprise client buying cycles that really reflect the time of when they commit to choose to go to the platform. And what we see right now, when you look at the last couple of years by the way, a two-year CAGR(ph)kind of is within our long-term model expectations. We had a strong growth last year, down 8% this quarter. But when we look at our fourth quarter, we actually see a very strong pipeline because we're in a sweet spot of what that client buying cycle is here in the fourth quarter. And with that we expect growth in this part of the portfolio here in the fourth quarter and that will lead to much better software performance overall. Around our horizontal apps, again we talked 90 days ago, what do we say. We were going to strategically invest and we were going to take action around revitalizing our portfolio to be more digitally consumable, around investing, around high value embedding AI and Watson to differentiate and around actions we were going to take around portfolio simplification and repositioning our platforms for further innovation.

And we've made progress I'll tell you. In collaboration, as I said in the prepared remarks, we've had our biggest release ever of Notes Domino Version 10 focused on mobile, supporting javascript, Node.js more open than ever, integrated with other platforms like Salesforce, ServiceNow, Watson weather and we expect that to play out as we get into 2019 with that innovative technology. And in commerce and talent, we've been making innovation in investments on embedding AI so we can differentiate our value proposition in the marketplace to win. And I would tell you early signs, we got some green shoots. Our SaaS signings are growing and in particular in commerce and in talent collectively they're growing significant double digit in the third quarter. So there are some good green shoots starting out, but again that will play out as we get later into 2019 and we can ramp and scale.

And then finally I'll wrap up on our high-value industry verticals and domain areas. We had good growth in security, we have a differentiated value proposition, we're gaining market share with the industry leader, we expect that to continue. And in health, we had strong growth in health, pervasive across the platforms and we're scaling. We're scaling new emerging areas like blockchain where again we've got 75 active blockchain networks in production, and we've got engagements in over 500 clients around global trade, universal payments, around trade finance, around food safety et cetera. So we see that part of the portfolio continue to improve. So when you bring it all together, we expect with a strong pipeline that we would return IBM software back to an expectation of modest growth in the fourth quarter. And we'll see as we get through fourth quarter how that momentum will continue in '19 and we'll talk in January.

Patricia Murphy -- Vice President of Investor Relations

Thanks David. Let's go to the next question please.

Operator

Next question is from Keith Bachman from BMO.

Keith Bachman -- BMO -- Analyst

Hi. Thank you so much for taking my question. I wanted to ask about Technology Services and Cloud Platforms, a little less focused on Q4, but more focused on the outlook, say, for CY '19 and the simple question is can it grow? The backdrop to that question is your backlog is down a little bit, but I think your duration is also down. But against that context is Technology Services support declined meaningfully this quarter, down 3%. With presumably being a harder mainframe cycle next year, can that grow and enable the whole business unit to grow? So if you could just talk more broadly about the outlook for Technology Services and Cloud Platforms with particular bias to CY '19? Thank you.

James J. Kavanaugh -- Senior Vice President and Chief Financial Officer

Sure. Thank you very much for the question. I appreciate it. Remember, within this segment we got multiple components. And I think you want to get to the services aspect of Technology Services and Cloud Platform. But let me start first with the integration software, which is essential part of our integrated value proposition around our hybrid cloud strategy which differentiates us in the marketplace. You've seen consistent growth over the last couple of quarters and we think given that differentiated value proposition that we've got momentum in that space, we've always focused on being open, a secure platform and driving differentiation around multi cloud as we move forward, that integration software is going to be a critical component of that moving forward, so that's that.

Now let's go out to our technology services or GTS part of the business. Remember, that's made up of two primary offerings segments, one TSS, which has been a drag on us throughout 2018 and that is entirely aligned to what our expectations would have been with a mainframe product launch cycle. Typically, we'll see that cycle hurt us in the first five to six quarters, and then it comes back and accelerates, especially coupled with our extension into multi vendor service where we've been doing quite well as we move forward, and the margin dynamics by the way are very strong in that portfolio. So as we start accelerating growth, we'll see better operating leverage in that segment as we go forward.

And then finally, you have your core infrastructure service offering and that ties right back to our overall outsourcing backlog that you quoted and it ties back to our success in moving our enterprise clients to the cloud. And I talked earlier about over 30% of our backlog now sits in cloud and new SI content is approaching 45% overall. Durations, you're right, have been reduced as we continue to execute, and again fourth quarter is huge. We expect a good quarter and that will position 2019 as we execute to deliver that value for our clients.

Patricia Murphy -- Vice President of Investor Relations

Okay. Thank you Keith. Mark let's take just one more question.

Operator

Our last question is coming from Joseph Foresi from Cantor Fitzgerald.

Joseph Foresi -- Cantor Fitzgerald -- Analyst

Hi. I think you've given a mid single digit long-term growth target in Cognitive Solutions. Is that still a target and can you hit it in '19? And then how do you feel about the portfolio at this point? Could you be divesting other pieces? Thanks.

James J. Kavanaugh -- Senior Vice President and Chief Financial Officer

Thanks, Joe. I appreciate the question overall. Obviously, we'll get into 2019 in January. We got a lot of work to do ahead of us. Again as I said, we're 16 days into arguably the most important quarter given the amount of large transactional business that we've got to get done. I talked about my answer on Cognitive. We see a good opportunity pipeline ahead of us right now. We believe in the portfolio, the strength of it, the offerings we have to deliver differentiated value to our enterprise clients overall, and we expect as I stated IBM software to return to modest growth here in the fourth quarter. And as we play fourth quarter out, we'll see as we get into January when we move forward, you're right, our model is mid-single-digit growth. We believe we've got the right portfolio for that. But as always, portfolio optimization has been a critical strategy to our overall business model and our financial model. And you've seen that play out over time, not only on where we invest our capital organically, but where we leverage M&A and how we create value for our clients and for IBM shareholders and also where we divest in areas that either didn't meet our strategic fit or our financial requirements on where we see growth and more importantly profit pools move forward. So we'll continue to evaluate that and we'll update you in 2019 on where we're at.

So with that, let me close off the call and I would like to thank all of you for joining us here today. So our results through the third quarter reflect the work we've been doing collectively across 366,000 IBMers(ph)around the world, around how we reallocated capital, how we've taken bold actions around where we place our investments and how we've repositioned our business. And then we've done all the work on how we transform the way we operate and our operating model overall and you see that play out in our margins and our level of operating leverage and productivity here in the third quarter which we expect going into fourth quarter and beyond. You see those results. Profit margins are strong. You see it in the innovation and differentiation that we're bringing into the market, especially in areas like hybrid cloud how we're winning in digital with our GBS business and around data and AI and security.

So with that said, we'll talk more about hybrid cloud in particular at the end of this month when Arvind and Martin Jetter will host the next webcast in our investor webcast series. So I'd like to thank you all for joining us today and as always it's back to work for all of us. Take care.

Operator

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

Duration: 76 minutes

Call participants:

Patricia Murphy -- Vice President of Investor Relations

James J. Kavanaugh -- Senior Vice President and Chief Financial Officer

Amit Daryanani -- RBC Capital Markets -- Analyst

Katy Huberty -- Morgan Stanley -- Analyst

Toni Sacconaghi -- Bernstein -- Analyst

Wamsi Mohan -- Merrill Lynch -- Analyst

Tien-tsin Huang -- JP Morgan Chase & Co -- Analyst

John Roy -- UBS -- Analyst

David Grossman -- Stifel, Nicolaus & Company, Incorporated -- Analyst

Keith Bachman -- BMO -- Analyst

Joseph Foresi -- Cantor Fitzgerald -- Analyst

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