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Executives

Patricia Murphy - VP of IR

Mark Loughridge - SVP and CFO

Analysts

Toni Sacconaghi - Sanford Bernstein

Ben Reitzes - Barclays Capital

Kathryn Huberty - Morgan Stanley

Chris Whitmore - Deutsche Bank

David Grossman - Stifel Nicolaus

Mark Moskowitz - JP Morgan

Louis Miscioscia - Collins Stewart

Jason Maynard - Wells Fargo

Keith Bachman - Bank of Montreal

International Business Machines Corp. (IBM) Q3 2010 Earnings Call October 18, 2010 4:30 PM ET

Operator

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

Patricia Murphy

Thank you. This is Patricia Murphy, Vice President of Investor Relations for IBM. I’m here with Mark Loughridge, IBM’s Senior Vice President and Chief Financial Officer, Finance and Enterprise Transformation. Thank you for joining our third quarter earnings presentation.

The prepared remarks will be available in roughly an hour, and a replay of this webcast will be posted to our Investor Relation’s website by this time tomorrow.

Our presentation 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 will find reconciliation charts at the end and in the Form 8-K submitted to the SEC.

Let me 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.

Now, I’ll turn the call over to Mark Loughridge.

Mark Loughridge

Thank you for joining us today. This quarter we improved our revenue growth rate, expanded gross, pre-tax and net margins and delivered earnings per share of $2.82 up 18% year-to-year and this EPS growth was on top of a very strong performance in the third quarter of 2009 which was also up 18%. We achieved all of this while investing to drive future growth and delivering strong shareholder returns. Revenue growth of 4% at constant currency was up two points from our second quarter growth rate, continuing the trend of improving business performance.

Growth markets had a great quarter, up 13% at constant currency. We've been investing to expand in the new regions and build out IT infrastructure in support of the economic growth. Since the technology had its best revenue growth in six years up 10% and profit was up 46%, capitalizing on new product introductions and continued strong growth in

System x, midrange Power, and storage. We had good growth in Global Business Services. Revenue was up 5% year-to-year. Our transactional signings returned to growth and we’ve been investing in resources in key opportunity areas like business analytics. Across IBM, which includes services and software, business analytics revenue was up 14% year-to-year.

Overall, we delivered $24.3 billion of revenue; that’s up 3% as reported and 4% at constant currency. And once again we had good profit and margin performance. We expanded gross margins by 20 basis points, driven by better margins in Software and Systems and Technology. Our expense was up 1% year-to-year. Underneath this, our operational expense performance was better by a point. We increased pre-tax income by 7%, and pre-tax margin was up 70 basis points to 19.3%. Our third quarter tax rate reflects an updated view of the full year rate to 25%. Our net income was up 12%, and margin expanded over a point to 14.8%. Finally, our ongoing share repurchase activity drove a reduction in our share count of 5%.

All of this contributed to earnings per share of $2.82, up 18% from a year ago. We’ve now had 31 consecutive quarters of EPS growth.

Based on this performance, and our view of the fourth quarter, we are increasing our expectation for the full year of 2010 to at least $11.40 of earnings per share. That’s up $0.15 from our previous view of at least $11.25 in July and represents a 14% year-to-year increase over 2009.

Now I’ll turn to the revenue details starting with a geographic view where I’ll focus my comments on constant currency.

We again had an improving trend in year-to-year revenue growth rate from the second to the third quarter across our geographies, with the Americas better by a point, Europe by two points and Asia Pacific by four points.

In the major markets, we significantly improved the year-to-year growth rate in Canada, France, Germany and Italy and continued our strong performance in the U.K. So we’re encouraged by what we’re seeing in several of the major market countries. The U.S. growth was consistent with second quarter levels and Japan posted very modest growth for the first time in 12 quarters.

As I mentioned in the opening, our growth markets had terrific performance, up 13%, which outpaced the majors by 12 points. The combined revenue in the BRIC countries was up 26%, with strong growth in each of the four countries. Brazil was up 15%, Russia 56%, India up 15%, and China, up 36%.

A few years ago we established a play to capture the opportunity in the growth markets and our investments are really paying off. We have three growth strategies that were aimed at creating new markets. Now you may recall that Bruno Di Leo, our General Manager of the Growth Markets discussed these at our Investor Briefing in May, and I want to spend a minute describing our results this quarter in the context of these strategies.

First, Market Expansion, which is about reaching new clients and new enterprises, expanding into new countries and into new territories. We’ve prioritized 16 countries for investment beyond the BRICs. Together with the BRICs, the “Growth Markets 20” grew 13% this quarter and we had 32 countries within the growth markets that grew double digits.

Historically, the vast majority of the revenue within these countries came from relatively few cities. To increase coverage in new territories, we have a systematic approach to opening branch offices in new cities while leveraging the global infrastructure. Year to date, we have opened 40 branch offices bringing our total to 103 in the Growth Markets. This quarter, the fastest growth came from these new expansion territories.

The second strategy is IT Infrastructure Development in support of economic growth. Each year tens of millions of people are moving from rural areas into cities. This creates a demand for banking, telecommunications, transportation, and energy. Our strategy is to provide the IT that supports the build-out of this infrastructure. That means high-end systems, software solutions and large services projects.

Now here are a couple of examples of the kind of work we’re doing. In China, IBM and Peking University People’s Hospital have built an evidence-based, patient-centric care system to enable resource sharing among service providers for improved patient care. And in India, IBM has delivered to Keonics a mainframe-based education solution to enable the government client to offer a more sophisticated, advanced technical curriculum to their corporate clients. We’re seeing the benefit of the IT infrastructure work in our systems results. This quarter, we had 25% growth in total Systems and Technology, with almost 30% in servers. This led to share gains in Systems and Technology as well as our Growth Markets overall.

The third strategy is to develop Industry Leadership in selected industries which we believe are most relevant in the growth markets; Banking, Energy & Utilities, Healthcare, Transportation & Rail and Natural Resources.

We’ve been investing in industry specific skills by both hiring, and deepening our employee skill sets. In the third quarter, we had 21% combined growth in these industries and double-digit growth in four of the five.

With this strategy and the investments we’re making, we expect performance in the growth markets to continue to outpace the major markets and to continue to grow faster than the market overall.

Turning to revenue by segment, as expected, the services business continued to improve its revenue growth at constant currency. The biggest lift came from Global Business Services. The growth rate is up 3 points from second quarter to 5% year-to-year growth in the third. Global Technology Services which has a higher percentage of long-term annuity content, improved to 1%.

Our software growth was in line with last quarter. Software grew 6% at constant currency excluding the divested PLM operations, a view that best represents our ongoing business.

Software growth continues to be led by key areas like business analytics, storage management and business integration.

The strongest growth came from our Systems and Technology business, up 10%. Our System z mainframes were up 15%, capitalizing on a new product introduction and strong performance in the growth markets. Midrange Power had double-digit growth. Storage had double-digit growth in disk, and System x once again posted very strong growth. I’ll get into more details when we discuss the segments.

Turning to expense, our Total Expense and Other Income was up 1%. With a 3% increase in revenue, our expense-to-revenue ratio improved a half of a point year-to-year.

The expense increase was driven entirely by acquisitions, which drove a 3 point year-to-year increase.

We’ve been investing in acquisitions to build our skills and technology in support of our growth initiatives such as business analytics, and cloud computing. Through the third quarter, we’ve closed 11 acquisitions for a total of about $3 billion. This higher level of acquisition expense was mitigated by currency, which improved expense by one point.

And finally, we had a 1 point improvement in operational expense. With our ongoing focus on driving more productivity and efficiency in our spending base, this is now the ninth consecutive quarter of operational expense improvement.

Underneath this, we’ve been increasing investment in several areas. I’ll give you a few examples. We’re investing in industry sales skills to support Smarter Planet. We’re building sales capabilities for business analytics and have established eight analytics solution centers around the world. We’re investing in development, sales and marketing to support our new high end technology introductions. And we’re continuing to deploy sales resource and build sales enablement to drive growth market performance. This quarter the SG&A and the growth markets excluding currency and acquisitions is up 7% year-to-year while overall IBM is flat.

Bottom line, we’ve been able to drive a higher level of investment in these initiatives while still expanding margin. To wrap up the expense discussion this quarter there are no items that provide significant impacts or benefits to our profit growth. The year-to-year change in other income and expenses driven by the combination of charges in the third quarter of last year for investment losses and a gain this quarter associated with the disposition of a joint venture; none of these items are material. We had no significant gains or losses from our hedging programs either into period or year-to-year.

Now before turning to the segment discussions, we’ve got a snapshot of our margin and price segment. Once again our margin expansion was broad based both services segments improved pre-tax profit margin, software gross margin was up a point and pre-tax margin was flat at 32.1%. Systems and technology expansion was driven by improvements in microelectronics and storage, and global financing margin improvement reflects the interest rate environment and higher margin on equipment sales.

So now moving on to the segment details, the two services segments delivered $14.1 billion of revenue up to 2% at constant currency. Global business services grew 5% at constant currency and global technology services grew 1% at constant currency. Both segments had sequential improvement in the year-to-year constant currency revenue growth rates versus second quarter and both segments grew pre-tax income and expanded pre-tax margin year-to-year.

Transactional Signings were $5.4 billion up 4%, this was driven by Global Business Services which was up 7%. Outsourcing signings were $5.7 billion down 14% at constant currency. Including a deal we signed on October 8, we would have reported outsourcing growth of 14% at constant currency and this would have increased the total signings reported from $11 billion to $12.7 billion. It’s very difficult to predict precisely when these deals will close and 8 days is not going to make any difference in the yield to this contract which kicks in quickly in the fourth quarter. Back log was 134 billion worth a very low level of erosion; this is up $5 billion from the second quarter and flat year-to-year at actual rates.

At constant currency backlog is also flat year-to-year and down 2 billion quarter-to-quarter. This quarter we signed ten deals over $100 million. Now let’s move on to the two segments, in Global Technology Services revenue was $9.5 billion, GTS outsourcing revenue was up 2% at constant currency in the quarter and Integrated Technology Services revenue was down 1% at constant currency.

Both of these represent an improvement over the second quarter. Global Technology Services pre-tax income was up 4% and pre-tax margin expanded to 15.5%. Turning to global business and services revenue was $4.6 billion up 5%. This was the best growth since the third quarter of 2008. We delivered improved revenue growth in many areas of the business with sequential improvement in the growth rates of both the major markets and the growth markets and across our key offerings of core consulting, application management outsourcing and systems integration.

In fact, we gained share in consulting, held share in AMS and gained share for total GBS. We’re getting good traction in smaller deals in GBS, particularly in areas that help customers drive global integration, drive efficiency and standardization, and deliver cost savings. These smaller deals are helping to fuel near-term revenue performance.

We had good performance in our growth initiatives in GBS. We grew revenue and transactional signings in the growth markets and GBS had revenue growth of almost 40% in Business Analytics. With increased client demand for a specific industry knowledge, we’ve added 2000 consultants in the last two quarters and now have over 7000 dedicated consultants in our Business Analytics practice.

Global Business Services pretax profit was up 5% year-to-year with margin expanding to 14.6%. The continued rollout of our globally integrated capabilities and good delivery performance are adding to margin. At the same time, we are increasing resource spending to support future growth. To wrap up Services, GTS improved revenue growth to 1% of constant currency and at 5% GBS had the highest level of revenue growth since 2008, and gained share.

Software revenue of $5.2 billion was up 1% year-to-year and 2% of constant currency. Software grew 6% of constant currency adjusting for the divestiture of PLM, which is a more appropriate view of our ongoing business. Key Branded Middleware grew 7% at actual rates and 8% at constant currency and gained share for the 12th straight quarter as we continued to enhance our lead in the middleware market. We gained share in four of our five Key Branded Middleware brands. Gross margin was up over a point and pretax margin was flat at 32%.

Now, let me take you through the brands. WebSphere had another terrific quarter growing 14% or 16% at constant currency. The WebSphere software portfolio connects business processes and delivers application infrastructures in an SOA environment. ILOG, which provides business rules management, grew about 30%. WebSphere Commerce provides a scalable, unified platform to drive sales into retail, B2B and business partner marketplace. We had real strength there with strong double-digit growth. With our recent acquisitions of Sterling, Coremetrics and Unica, we expect continued market momentum in this space.

Information Management also had a strong quarter growing 5%, or 7% of constant currency. Relational Database was up 5% of constant currency, driven by a 7% constant currency growth in distributed database. Information Management provides the foundation for IBM’s Business Analytics and Optimization offerings. We continue to expand our Information Management capabilities both organically and through acquisitions. We expect to close on the purchases of Netezza and OpenPages in the fourth quarter.

Tivoli had another good quarter, growing 9%, or 11% of constant currency. Tivoli provides an integrated approach to service management. This quarter, we had solid growth in two elements of our Integrated Service management strategy. Storage management, which was up 20%, and Security, also up double digits. Lotus returned to modest constant currency growth. Rational also grew at 1% of constant currency and gained share. Our software business had a solid quarter, and is well positioned as we enter the fourth quarter.

Systems and Technology revenue was $4.3 billion, up 10% year-to-year or 11% at constant currency. Revenue was driven by double-digit growth in System z, mid-range power System x, disc storage and microelectronics. We had very strong performance in the growth market, up 25% at constant currency. BRIC countries grew over 40% with double-digit growth in all brands. Gross profit margin expanded 1 point and PTI margin expanded almost 2 points with 46% growth in pre-tax income.

Now let me take you through more details on the brands. System z revenue grew 15% year-to-year and gained share. MIPS grew 54%, the highest growth in six years. Late in the third quarter we shipped to zEnterprise 196 server which delivers 40% more performance than the z10. This performance is driven by the world’s fastest processor which operates at more than 5 gigahertz. In the fourth quarter we will began shipping the zBX, IBM’s first system of systems. zBX extends mainframe governments to select Power7 and System x blades. Power system’s revenue declined 13% year-to-year and continued to be the market leader by a wide margin.

We first introduced Power7 into the mid-range during the first quarter and in the third quarter mid-range systems grew 11%. We continued the rollout of Power7 with the high end and entry products in mid September. Shipments were limited though with just two weeks of general availability in the quarter. Our competitive takeouts continued in the third quarter. We drove over 250 competitive units displacements which resulted in approximately $225 million of business. Storage hardware revenue grew 7% year-to-year or 8% at constant currency and held share. Storage revenue in our growth markets was up 23%. This grew 14% driven by a continued strength in high end storage, DSA1000 and XIV. We added more than 130 new customers to our XIV platform in the third quarter and XIV hardware revenue nearly doubled, tape declined 8% but gained share this quarter.

Taking a broader look at our storage performance, our storage hardware together with storage software grew 10%. System x revenue grew 30% year-to-year and gained share, this is the fourth consecutive quarter of year-to-year revenue growth of 30% or better. The high end of System x was up 27% and gained share. Microelectronics OEM revenue was up 28% year-to-year. We had strong revenue growth from our OEM customers in networking and wireless communications infrastructure. Overall this quarter’s systems and technology delivered double-digit revenue growth, expanded margins and grew profit 46%.

Turning to cash flow, we generated $3.2 billion of free cash flow in the quarter, down $200 million year-to-year driven by increased receivables associated with a higher level of revenue. Our collection performance remained strong. Through the first three quarters our free cash flow of $7.6 billion was $300 million year-to-year driven by higher capital investments for new hardware products and semiconductor technology and a year-to-year impact of over $700 million for unique one-time tax refunds as previously disclosed.

Adjusting for this unique tax refunds free cash flow would have been up over $400 million year-to-year. Looking at the year-to-date uses of cash, we spent $3 billion in acquisitions in support of our growth strategy. In addition, we had returned over $14 billion to shareholders, $2.4 billion in the form of dividends and $11.8 billion in share repurchases. We have $2.3 billion remaining in our buyback authorization.

Turning to the balance sheet, we ended the quarter with a cash balance of $11.1 billion more than two-thirds of which was in the US. Total debt was $27.5 billion. $22 billion of debt was in support of our financing business which is leveraged at 7.1 to 1. $5.5 billion was non-financing debt that was up from $2.5 billion a year ago.

Non-financing debt-to-cap was 22%, up from 16% at the end of last year and 14% a year ago. With this amount of leverage, we continue to have a high degree of financial flexibility to execute our strategy.

The balance sheet remains strong and positioned to support the business over the long-term. I’ll start to wrap up with a brief discussion of the drivers of our earnings-per-share performance. This quarter all categories positively contributed to our earnings growth. Our revenue growth, at constant mix and margin, contributed $0.07. Operating leverage contributed $0.21 and a 5% reduction in share count contributed $0.14. So once again, our growth was delivered through a combination of revenue growth, margin expansion, and an effective use of cash.

I said at the beginning of the call that our 18% earnings growth was on top of a strong 2009. If you look back further to the third quarter of 2006, we delivered $1.45 of earnings per share. So we’ve almost doubled the level of earnings per share in four years. And based on our expectations for 2010, we'll almost double full year EPS over the last four years as well. So it’s pretty clear that we have consistently delivered strong earnings growth.

This quarter, we continued the trend of improving business performance. By segment, the improvement was led by Systems and Technology and Global Business Services, up 10% and 5% respectively. From a geographic perspective, we had outstanding performance in the growth markets with 13% growth as we execute our market expansion plans.

We again expanded margins, gross up two-tenths of a point, pre-tax seven-tenths, and net margin up 1.1 points. We continued a strong pace of investment; in SG&A to capture the growth in emerging markets, in R&D and capital to support product introductions, and in acquisitions to add to our capabilities in areas like business analytics and cloud computing. Bottom line, we delivered $2.82 of earnings per share.

So, to sum up the quarter, we continued our steady improvement in the business, in both revenue growth and margin expansion, and we used our strong profit and cash position to invest for future growth, while returning capital to our shareholders through dividends and share buyback. All of this supports our expectation of at least $11.40 of earnings per share for the year.

Now Patricia and I will take your questions.

Patricia Murphy

Thank you, Mark. Before we begin the Q&A I’d like to remind you of a couple of items. First, we have supplemental charts at the end of the deck that complement our prepared remarks. And second, I’d ask you to refrain from multi-part questions. When we conclude the Q&A, I’ll turn the call back to Mark for final comments. Operator, please open it up for questions.

Question-and-Answer Session

Operator

Thank you. At this time I would like to begin the question-and-answer session of the conference. (Operator Instructions). The first question comes from Toni Sacconaghi with Sanford Bernstein. You may ask your question.

Toni Sacconaghi - Sanford Bernstein

Mark I was hoping you could address two likely concerns that investors may have from your results this quarter. The first one is that your lower tax rate I think adds about $0.16 relative to your prior tax rate to earnings in the second half. You raised guidance by $0.15. How should we think about that in terms of your confidence relative to a quarter ago?

And the second issue I would like you to try and address is the quarterly signing. For your last three quarters worth of signings, year-over-year you are down 7%. You have missed your signings estimate effectively for three straight quarters. Should investors be worried given that signings growth is often a good leading indictor of future services growth? Can you address this question as well?

Mark Loughridge

Yes, let me take your first question Tony on the lower tax rate. The benefit of the lower tax rate in the quarter was $0.10. The benefit over the balance of the year will be another $0.05, so its $0.15. So we raised the guidance consistent with that tax rate benefit. And we view tax rate as an operational line item like any other.

And I'd add that as we look at our tax position, we see that extending into the 2015 roadmap. If you remember, the tax rate that we looked at an operational basis was 25.5% and we see that now closer to 25%. So, operational execution on optimizing our tax position not only for the year but extending into the 2015 roadmap. At $11.40, we were up 14%. That’s a very strong year, and it's against some very strong years historically. So if you look at it since announcing the road map at $11.40, and that’s an at least number, Tony, that's almost doubling the $6.05 that we quoted when we closed out 2006. I think the roadmap has been effective, I think it caps of the year at pretty strong position, and I think we got a very good play as we move into the fourth quarter.

So now let me go to your second question on quarterly signings. First of all, let's look at the shorter term content. In short-term signings, we are really pretty good. They are 4% and the GBS content was up 7%. So this is consistent with our expectations. As you saw, we had much better revenue performance this quarter of our GBS business. We expect that to continue as we go into our fourth quarter.

The real issue is around outsourcing. Signings are down 14% but with the big deal on October 8th, this would have been up 14%. So now we are talking about eight days. Had this signed on the 30th, we frankly wouldn’t be having this conversation. And though the contract does have good yield in the quarter because a lot of that contract is absolutely new content that kicks in the fourth quarter, it's not an extension that the extension in the time-wise and an extension in scope that we get to [start quoting]. Initially about half of that is actually new content for us.

The performance now that we get in the fourth quarter isn’t going to be any different whether we have signed it in September 30th, October 8th. And the reason it delayed out to October 8th was frankly pretty good reasons as we expanded scope and got lot more opportunity; very successful deal for us.

You know if you look at outsourcing dynamics overall, you see that at the beginning of the quarter the revenue is really driven more by backlog and signings are really just one input to backlog. In addition to duration mix of new versus extension, the mix of new within extension like the deal that I was discussing, erosion growth in the base here, there is a lot of content that goes in to that backlog, but it’s really backlog that establishes where you are going to be in that next quarter more than signings.

I look at signing as an impact of that broader perspective not that the base driver. So going into the fourth there is really only by 5% to 6% of outsourcing revenue coming from new perspective signings. And it’s IBM that represents less than 1% of IBM’s profit. So if you look at the role the way I look at it for our outsourcing business, its big, its powerful; annuity base business provides real stability throws off a lot of profit in cash but it moves more slowly. You just don’t see big swings like you would in transactional businesses.

So the signings number report has really very low impact on the revenue in near term and even less influence on profit. So it’s really that annuity characteristic or the portfolio over the longer term gives you a lot of time to deal with changing revenue dynamics and your game plan to exploit your opportunity of deals and we do have a strong deal list for outsourcing business going into the fourth quarter and add in addition to the large deal we signed on the 8th. We have the big Bharti deal in Africa that now expands into a new continent.

But in the fourth quarter our performance, as we look forward, is going to continue to be driven by the more dynamic elements of our product portfolio and the transactional elements of the business like hardware which is up 11% in the third, software that was up 6%, consulting that was up 6%, North America consulting rose up 9%, and we expect to see those trends continue and if anything I think though GTS, GBS and hardware will probably be consistent growth rates of the fourth compared to third, I do think that we are going to see an acceleration in our software business and our software growth rate going in the fourth to the cap of a strong year.

Patricia Murphy

Thank you Tony let’s go to the next question please.

Operator

The next question comes from Ben Reitzes with Barclays Capital, you may ask your question.

Ben Reitzes - Barclays Capital

Hey thanks a lot I appreciate it. Mark, during the quarter that pretty cautious comment and…

Patricia Murphy

Ben can you speak up a little bit, it’s hard to hear you.

Ben Reitzes - Barclays Capital

Okay, can you hear me now?

Patricia Murphy

Yes sir

Ben Reitzes - Barclays Capital

I just wanted to talk about the economy in the IT market how are you seeing things, there was some talk during the quarter was, did those things slow down, your hardware business actually picked up that lot better. How would you say you feel about your prospects into the fourth quarter from the macro standpoint where IBM fits in?

Mark Loughridge

Yes, good question Ben, now if you look at the performance in the quarter let’s start with the major markets, in north America we are up 2%, that was improvement in the growth rate compared to the second quarter over point. In Europe we are up 1%, that was improvement of 2 points compared to the growth rate in the second quarter, Japan returned to growth for the first time in a long time. So the major markets did improve, there was lower rate of improvement compared to growth markets. The real slugger in the quarter was GMU, growth markets up 13%, that’s 4 points stronger than we had seen in the second quarter and that gives us a differential.

Now to the major market are 12%, now we have been quoting that number for sometime, do you remember through 08’ and 09’ our growth markets were generally about 8 points plus or minus point better than major market performance but growth markets now 12 point better that’s very, very strong, BRICs up 26% they were nine points better then we saw in the second quarter. So, looking at that data I would have to conclude that one; we called the right play going after the growth markets with strong investment content lets play that opportunity and I think on the recovery basis you know the growth markets are simply out of the box faster than the majors.

Operator

The next question comes from Kathryn Huberty with Morgan Stanley, you may ask your question.

Kathryn Huberty - Morgan Stanley

Thanks, good afternoon Mark, how would you characterize the impact you’re expecting from the P&Z systems product cycle versus the revenue impact you’ve seen impact cycles and then in the same regard what inning do you think the industry is in as it relates to just the overall general refresh of IT systems that we’ve seen this year?

Mark Loughridge

Okay, well let’s talk about the Z series and P series content. You know Z series had a really strong quarter I mean Z was up 17% mix were up 54% that’s the highest level of mix growth we’ve had in six years out of our mainframe business, so very strong performance and I say as we look at the fourth we should have another very strong quarter for our Z series content, now we would have an entire quarter of availability.

In addition we are going to announce the new system or systems of Z series get that gives you the ability to use mainframe governance and apply it to other technologies which will really position us for market leadership. So I think we’ve got a very exciting play on a Z series a basis and if you look at that to your later part of your question on a longest term kind of cycle they are really parts of the cycle on a Z series business the first four or five quarters are more structured around you know volume growth in base placement and then the ladder half of that cycle with micro code upgrades, less revenue but much higher profitability. So we should have to be able to exploit this over a longer period of time. We are quite excited about it I thought the results were really terrific.

You look at the P series business I mean lets got to the content that was announced in Power7 in January, that’s now been available for times we could build our place in the market place it was up 11% in the third quarter much like the second quarter mid range P was up 11% very strong performance there.

If we look in the quarter about competitive displacements again we’re talking 250 customers, $225 million of business there so are continuing that strong position in the market. And as we now go into the fourth quarter with the full quarter of availability for the high end in the entry we should see an improvement in the overall growth rate for the total platform I mean you can expect that I think in the third quarter again we only had a couple of weeks of availability for both the high end and the entry.

So I think we’ve got a very strong position and I would not limit it just to our Z series and P series content, we had strong performance out of our storage base, it was up 8% within that disk was up 14, 15% in disk you know going forward we had third quarter real strength with XIV real strength with our DSA 1000 now going into fourth we’ll announce our new store wide 7000 mid range system with a lot of new content from our research division so we are quiet excited about that as well.

Operator

The next question comes from Chris Whitmore with Deutsche Bank you may ask your question.

Chris Whitmore - Deutsche Bank

It’s a follow-up on Katie’s question. What kind of software and services pull through do you anticipate with both the high-end p and the zSeries ramping simultaneously?

Mark Loughridge

Well if you look at the pull through, there is a relationship as you establish more platforms for the software business and in some respects there is some relationship directly going into the fourth because in the fourth quarter as we look at the pipeline that deals in opportunity we see an acceleration in our software business going into the fourth. So I think there is a relationship, it’s a longer term kind of a relationship, but we will start to see improvements in our software business coming out of the third quarter which I frankly felt was pretty good at 6%. We said it was going to be 6%.When we closed out the second quarter we came in right on target and I expect the fourth to be a pretty good acceleration of that base.

Operator

The next question comes from David Grossman with Stifel Nicolaus. You may ask your question.

David Grossman - Stifel Nicolaus

Mark due to the past few years, we've enjoyed visibility on margin expansion as a result of specifically identifying class actions and if that's an accurate statement the last major cost action I think was taken in the first quarter which we will anniversary early next year. Should we assume that the operating leverage and mix shift in addition to the day-to-day step you always do to take cost out will be the primary margin driver next year or is there more to think about and then also how should we think about levels of investment spending as the revenue growth accelerate?

Mark Loughridge

To answer your question I want to put it in context of the total model frame around the third quarter to better illustrate that. So if you look at the model, we were pretty clear I think at the Analyst Day that it’s going to be a combination of revenue performance, leverage from both mix and spend optimization as well as share repurchase and this quarter frankly on a revenue basis coming in at a 4% and remember that was impacted by about a point from PLM, I think we came pretty close to the model, right. I mean 4% one point impact PLM we had said, we were shooting at this at a more like a 5%, very close to the model.

On a leverage standpoint what we were counting on, on a kind of an annual base that would compound over the model period was really about 4/10th of a point at net income and so you look at this quarter, I mean we have got 7/10th of a point of leverage at PTI and 1.1 points at net. So if you want to compare either pretax or net for objective of 4/10th we did very, very well.

And of course we had a lot of momentum in our share repurchase well. So going forward we are very focused on long-term achievement of that 2015 model and that’s going to be a combination of ongoing attention to our revenue growth rate as the economies recover and we see the fruits of our labor to expand and GMU that was up 13% or in Business Analytics that was up double digit as well.

Ongoing focus on driving for that 4/10th or 5/10th of a point improvement in our leverage and as always we pay trading a value to our shareholders to ongoing share repurchase and dividends.

Operator

The next question comes from Mark Moskowitz with JPMorgan. You may ask your question.

Mark Moskowitz - JPMorgan

I wanted to follow-up on the commentary around the software acceleration. I heard the comments of the previous question as far as being related to the server platforms. But how should we think about just the inorganic piece? I mean, is that also a part of it, or are we just seeing the broader software cycle just starting up here post the hardware and the security installations we've seen across the IT land in the past three quarters or so?

Mark Loughridge

Well, my comments are really directed towards the confidence in my statement. Let me say it differently, it is really based on a pipeline of deals and the kind of characteristics of those deals that we see going in the fourth quarter. So we have a pretty darn good deal less as we do and that's going to drive both organic and inorganic performance in our software business. So as we look at it having recorded 6% in the second and 6% in the third, we think that should accelerate meaningfully as we go into the fourth quarter based on that pipeline of opportunities and the kind of progression of those deals and the characteristics of those deals.

Patricia Murphy

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

Operator

The next question comes from Louis Miscioscia with Collins Stewart. You may ask your question.

Louis Miscioscia - Collins Stewart

When you look at the acquisitions that you've done, mostly obviously you've focused on the middleware and some other areas. Is that area starting to get a little bit less rich as you've got many companies Oracle, yourselves, ENT and so on trying there, and do you think that you all will switch your strategy and start to go more in the application area?

Mark Loughridge

Well, the last thing I'm going to do is tell my competition where we're going to start hunting, right. So, I think that would probably not be good judgment on my part. But I think your point really is, what do we see as the opportunity set across this for in an accelerated kind of a pace and I would make a couple of comments there: Number one, if you look at since 2000 I believe we’ve spent about $33 billion. So, if we annualize that say $3.3 billion. So, do we think in the next five years or 10 years there is not going to be $4 billion a year. I mean I find that hard to believe. Number two, we are hunting just to use that terminology in a lot of different spaces and we did have a number of acquisitions in the software business. But I’d remind you we’ve had some very powerful acquisition performance in our hardware business.

Now that performance if you look at the content we acquired, it really wasn’t left for property, but within the hardware content. So frankly XIV has turned it to be one of the best acquisitions we’ve done very, very strong performance on that low latency part of the market. De-duplication, that was a very strong place for us to acquire and they’ve had real synergies, not only within that business equation but for the rest of the organization. We now have broader plays cut across our segments that pull us into opportunities I think that have broader scope. And as always I remind of a point that we made at the Analyst Day. I mean intellectual property and the opportunity for acquisitions to have a meaningful impact on the business are not constrained to the borders of the US, right. This is a global opportunity set and the three acquisitions that we chose to highlight on Analyst Day, Cognos, ILOG, XIV, those are all acquisitions that we made outside the US borders. So I think it’s a pretty rich ongoing to save opportunities that as I said initially I think the last thing I'm going to do is start telling our competition where we're hunting.

Operator

The next question comes from Jason Maynard with Wells Fargo. You may ask your question.

Jason Maynard - Wells Fargo

Hi, good afternoon. Actually I wanted to follow-up again on the outsource piece of the business and specifically was there any change above and beyond what you're expecting around contract duration or potential sizing of transaction, I mean other than obviously the volatilities on the one large deal?

Mark Loughridge

No, not really. Not that I would remark on, no, not really.

Jason Maynard - Wells Fargo

How do you think about then sort of next year this playing out. Are we going to speak on a continued sort of level trends around that duration that we've seen in the past couple of quarters?

Mark Loughridge

I got to say this is difficult to predict, its so deal dependant. You can see how much one deal can re-characterize a quarter and now we see big opportunities now in new growth markets and I don’t want to overemphasize it but we're quite excited about the new opportunity we see with Bharti in Africa. That does open up a new continent of opportunity for us. So, pretty deal dependent there and I really would not remark on significant changes driving different performances in the future.

Operator

The next question comes from Keith Bachman with Bank of Montreal. You may ask your question.

Keith Bachman - Bank of Montreal

Good afternoon. Mark I was hoping in the past couple of quarters you've given some quantitative direction to what you thought constant currency growth rate would be and so as we look at December versus the constant currency growth rate you did this quarter call it 4%, will the be up or down relative to that number? And I had a follow-up if I could.

Mark Loughridge

Well let's go through the revenue discussion first on the GTS business. The way I would look at it I think in the fourth quarter, we probably have a very similar rate of revenue growth that we had in the third. On GBS, I think will continue that ongoing higher way to growth that we saw in the third, looking at the deals they have, how they've lined up the resources, their investment in new resource to drive and continue growth and expansion in their organization. So I think they have a good platform for the fourth quarter and the growth rate should be again similar to what they saw in the third.

On a hardware standpoint, again I think the hardware group did a great job; revenue up 11%. Now that’s the best growth rate we’ve had from SNTG in six years, and I think that should continue at a pretty high rate of growth.

So I think GTS, GBS, hardware going into the fourth will probably will have very similar growth rates we saw on the third. And I'd remind you on the GTS, that’s pretty big statement because the seasonally biggest quarter for our hardware is us. On the software growth however, I think that should accelerate as we go into fourth. And I think we should see some meaningful improvement in the growth rate, again based on the deals and the characteristics of the deals that we see in the fourth quarter.

Keith Bachman - Bank of Montreal

Okay, helpful. If I could, on the follow-up Mark, the same type of question. Again, in the past you've given some direction on what you think bookings will be, up double digits, up in single digits, how are you thinking about bookings in the Q4 and if you want to just give us the context or including the large deal that crept over into Q4.

Mark Loughridge

As I looked at the bookings and kind of the momentum we see in bookings on the transactional content I do think we have some ongoing momentum there that’s going to be consistent as we exploited over the opportunity. It’s going to be dependent on the outsourcing business on ability to exploit these larger deals, they have some very good deals. So I am optimistic that we should see some good performance on our bookings as we go into fourth.

Patricia Murphy

Thank you Keith let’s go to the next question please.

Operator

At this time ma’am there are no further questions in queue.

Mark Loughridge

Okay, well let me just wrap up then and make a few comments. First of all we delivered another good quarter. We had revenue growth of 4% and as I said earlier when you adjust for the PLM divestiture, revenue growth was very close to our model. Looking ahead of the fourth quarter GTS revenue growth should be pretty consistent with the third, I think GBS will continue its strong performance somewhere to the third quarter.

With new product introductions and STG in mainframe with our new systems and our ongoing mainframe announcement, three quarters of opportunity across P series, new announcements in our server product line we are going to have another good hardware quarter in the fourth as well.

And in software based on our pipeline of deals we should see improvements in the revenue of growth rate and therefore so overall constant currency revenue growth should be pretty somewhere the quarter’s strong performance with software providing some more opportunity.

On a margin basis I would have to say, we are above the model level. The model was about four tenths, five tenths of a point per quarter on a net basis and we exceeded that on a pretax basis up 7/10ths and certainly on a net basis of 1.1 points. We are leveraging, our profit and cash delivering good shareholder returns and investing for the future and with all that we delivered EPS of $2.82 up 18%, that’s on top of 18% growth last year. So we are increasing our full year EPS to at least 1140 and I would remind you that’s an at least so over there the last four years, whether you look at the third quarter or the full year we’ve almost doubled our earnings per share since we introduced the 2010 road map. So thanks very much for joining us today and now as always back to work.

Operator

Thank you for participating on today’s call, this conference is now ended you may disconnect at this time.

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