International Business Machines' (IBM) Management Presents at Credit Suisse Technology Broker's Conference (Transcript)

| About: International Business (IBM)

International Business Machines Corporation (NYSE:IBM)

Credit Suisse Technology Conference

November 29, 2016, 03:15 PM ET

Executives

Martin Schroeter - SVP & CFO

Analysts

Kulbinder Garcha - Credit Suisse

Kulbinder Garcha

Okay. Great. I think we'll get started. My name is Kulbinder Garcha. I’m the IT hardware analyst from Credit Suisse. We’re very pleased to have from IBM Martin Schroeter, who is the SVP and CFO of the company. So Martin, welcome. Thank you for attending.

Martin Schroeter

Thank you, Kulbinder.

Kulbinder Garcha

And there is a lot of questions I have for you, maybe a broad one to start off is, I think you've spoken about as many times over the last two years, IBM are going through their own transformation in a major period of transformation for IT. So, during that period of time like what are the disruptions IBM are facing and what are the opportunities you’re already pursuing trying to reposition the business?

Martin Schroeter

Sure, sure. It is a good high level high question with switch to start Kulbinder. So, our view of enterprise IT is really being forged around this idea that cognitive and cloud computing and I’ll talk more about each of those pieces in a moment, but those two elements are driving the agenda in enterprise.

And the timing if you will is right for both of those, in one sense the amount of data that our clients have already and quite frankly the amount of data they’re creating everyday in order to -- when they run their businesses and in order to help them understand their clients and how they serve their clients best is creating an opportunity for us where we can no longer, nobody can any longer just program a computer to find relationships that you're looking for.

It's just too much data and so in a world where a system has to learn about the data, you have to find a way to interact with it. That's roughly for a non-technical person, that's roughly what we're talking about when we say a system where cognitive will influence and affect every decision that companies will make over time.

So the world of cognitive is here because of the amount of data that our clients and companies already have as well as how much is being created by the world today.

Now all of that requires an amount of compute and amount of power that is not available for everyone to invest in, but that's where the cloud comes in and so there is obviously an economic element to moving into a cloud environment, but more importantly for our clients, we see an ability for access to these kinds of cognitive applications as well as an agility that you get from your business and running in a cloud environment.

So when we think about those two disrupting events, cloud and cognitive, we think that those drive the agenda for our clients. Now for us, within IBM, we've been talking about both of those things now for a number of years, in fact nearly three years ago now we laid out our view of our parts of the business that were focused on those parts of -- on those parts of enterprise IT.

We called them at the time as we did today, we call them strategic imperatives and we started talking about how big they were and their rate of growth and the kinds of things that our clients were doing with them. And then last year, beginning the last year, so nearly two years now beginning of last year we changed and formulated some solution units within IBM as our clients want to consume, have more of solutions offering said if you, will solutions mindset to how they want to consume IBM.

We put together if you will solution units like security, which has both software and services and we put together a solution unit around commerce. Last year we formed the Watson Health Group. So, our response has been let’s build the leading infrastructure play. As you know, we bought SoftLayer and have since developed software quite dramatically into from what it was including acquiring some video capabilities to build the Cloud video platform.

So we built the cloud platform now on top of which we've invested in a set of technology such as Bluemix to build a platform. So our clients can now build their applications the way they’re used to building them with access to their datasets in a secure environment.

And then on top of that, we've added a whole series of data services and quite frankly data, which now brings a cognitive cloud if you will into existence, but it's always done on an industry basis. The Watson Health Cloud is a unique, that’s unique cloud. It runs on that infrastructure, but the data that's available is obviously relevant to -- relevant to an industry, the health industry.

We have just announced Watson Financial Services, which will be focused on obviously the financial services industry, but firstly it will be focused on the regulatory and compliance elements of the financial services industry. So the trends again that we identified a few years ago have evolved the way we run IBM. We changed as you know earlier this year our segment reporting as we've changed the way we run IBM.

Really is to again give our investors a focus on not only the idea of that trend of cognitive and cloud, but just as importantly, how we’re responding to that and where our investments are going and how big those businesses are becoming for us.

Kulbinder Garcha

And maybe two follow-ups and on the strategic imperatives side we're still seeing I think the businesses just over $30 billion in terms of size may be $32 billion and is going still quite well $0.15 in last quarter, but the real growth has slowed and that’s probably naturally comes now to $32 billion business.

It wasn’t keep going to 25% to 30%, but do you think with the investments you’ve made, that level of growth is sustainable and what you know that in getting there is ultimately the real growth there determines when the entire business will actually probably one day start growing hopefully or should we expect deceleration or do you have to see dual acquisitions? How should we think about the growth profile of that segment specifically?

Martin Schroeter

Sure. So within strategic imperatives as you said, we grew about 15% last quarter. When we started talking about them as a part of our business, again nearly three years ago, we said that by the end of 2018 it would be about 40% of our business and it would be about $40 billion in total in size. So both a mix statement as well as an absolute size statement.

As you noted in our last trailing 12 months, we're about $32 billion. So in terms of progress that most recent quarter of growth of 15% puts us what I would say is ahead of the track to get to $40 billion. Just if you do -- just do math, we have to grow between $10 million and $11 million from here in order to get to the $40 million and so I'd say we’re on track in terms of what we need and what we've counted on.

Now the investments we've made are driving that growth and from an acquisition standpoint, clearly some of the rate of growth that sits in their are the acquired content that we bought, but when you think about what we bought for instance in healthcare, we bought four companies, we bought, Phytel, Explorys, Merge and Truven Health and we've put them together.

And so the rate of growth that we're delivering out of those four is really the businesses they were in before. It's only now that our research and our development of solutions on top of that platform are starting to come into market and so while we will certainly wrap on the acquisitive content, we're going to start to see now the acceleration of the solutions we bring to market in Watson Health and that's true in a number of our acquired content.

So we just closed on Promontory Financial, one of the leading regulatory and compliance specialist and FSS. Obviously not yet even in the ledger, but we will take the regulatory and compliance experts that Promontory have and we will turn that knowledge base into a cognitive solution, which will then get delivered in a cloud delivery model through Watson and so the banks will start to consume that, but that's all in front of us still.

Right, so clearly within strategic imperatives, acquisitions have helped, but we're only now getting into that ramping point if you will of the things we build on top of each of those solutions. And so from a rate and pace, as you noted, we do --the growth rate slows because of the magnitude of the business.

We were about $28 billion last year. So we added $3.5 billion in a year and while that $3.5 billion some acquisitions we do see -- we do see the rate and pace to make sure we get to the $40 billion and 40%. We're actually already -- we'll make the 40% this year, I would expect. But the $40 million and 40% by the end of 2018 is certainly a pace that's still ahead of us.

Kulbinder Garcha

I guess then switching to the other side of the business, we sometimes call core is the rate of decline more predictable now in a few years ago I guess for the entire organization of IBM to stabilize and grow? That's what investors are really waiting for I think at some point in the future.

And so could you speak about has the rate of decline accelerated there? It looks like it may have done. Is it now more forecasted in the part of business? There it narrow cannibalization I suppose from one side to the other anyway, but just in terms of getting back to be a more stable entity, are we close to that environment, what needs to happen?

Martin Schroeter

Well a few things about -- again we do call it the core really because we never came up with a better name for it but when we look at that business a few things, one most of those businesses are in declining markets. So we are for instance, we continue to support high transaction processing content on our Power platform, but a lot of that's delivered in a UNIX environment, UNIX is a declining market.

We continue to -- we continue to support our clients in businesses and processes that are vital to the way they run, but those are focused on really on productivity -- on their productivity and our client's productivity is another way of us saying that's a revenue decline for us.

IT -- enterprise IT has always been about delivering productivity and so that's no different now and when we look at our revenue streams then, what our clients are doing, the behavior of our clients is exactly what you said, which is there is not a lot of displacement, it's not like one is going up and it's replacing the other.

Our clients view it as look you run this process for me. It's a really important process, but I need productivity out of that just like I demand productivity out of all my business processes. So I'm going to take the productivity you give to me in that part of the business and I'm going to reinvest it in these new areas. So I can find new ways to engage with my clients. So I can find new -- build new tools to understand -- new models to understand my clients better.

So our revenue streams as the incumbent look very much like the transformation that our clients are going through, which is deliver productivity to me in a set of businesses that I can then reinvest and therefore our revenue streams look as you said, we have one that continues to decline and one that grows fairly rapidly and at some point, the math would just say those will crossover and will get a different overall portal.

Now within the core though, there is -- again their businesses that are in declining markets some of it though is by engineered shift out of certain businesses, so in our global business services business, our consulting business as an example, we have -- we were very big in implementing large scale ERP and we had all the right skills. It was a differentiated marketplace at the time, that our company's ability to implement those was -- your ability was differentiating and because of our client base global clients, we could line up well in a global way with them.

So that was a differentiated marketplace, good margins, that started to shrink, those margins were put under pressure. There is a lot of price pressure in the marketplace because there are fewer of those large ERP deals. So we started pulling our resources away and we started shifting them into other areas and into labor-base business obviously. We have fewer people working on something. You're going to have fewer billable hours and therefore there is an engineered component if you will to that core decline as well.

But the bulk -- again the bulk of the core is in declining markets and it’s a productivity-driven business, productivity for our clients and then it gets reinvested in these new areas.

Kulbinder Garcha

I said the deliberate part on the IBM side with let's say GBS where you've chosen to exit or minimize exposure, that's caused obviously some headwinds to revenues, are we past the hardest part of that on terms of headwinds to your company?

Martin Schroeter

In GBS?

Kulbinder Garcha

Yes.

Martin Schroeter

I think in GBS, we look for a few things. First, the revenue in GBS in any given 90-day period is going to be driven primarily not solely, but primarily by the backlog. The backlog is build by signings.

So we've gone through a process where we've taken again pools of people who are focused on signing clients to big contracts and shift them into other areas. So we did see continuous signings declines in GBS, which meant the backlog was declining. Now we have gotten the signings piece back to growth again first time and so as signings grow, that will build that backlog and when that backlog grows then the revenue will start to grow.

So we've gotten step one of the process if you will through and now we have to build the backlog enough to deliver revenue growth in GBS, but the process from a more operational perspective if you will has a business now that has a little bit more than half of it in these new areas already.

So it's mixed faster than IBM in total right has. As I said, about 40% of our trailing 12 months were strategic imperatives, but within GBS, it's a bit more than half just over half. So they're actually making the transition a little bit faster, but we do have to get through this, signings have to grow, so backlog can grow, so that revenue can grow.

Kulbinder Garcha

And maybe going back to Watson, I guess a lot of profile in the company on the health side I think, can you speak about the building blocks of scaling that business and in getting guys in the healthcare side it kind of settle with the four acquisitions you made over the last year or so, year and half, you're actually buying almost data to then like a lot of business that you apply to a vertical.

Is that the risk to work for financials as well? Do you have to buy in a bunch of talent and resources in their terms, then you apply the Watson and should we think about this timescale wise or when the IBM let's say breaking out Watson and saying it's their significant business is at five years away? Is it longer? Do you think that's a very ambitious business model? I'm just trying to figure out when investors can see the benefit in the actual?

Martin Schroeter

So couple of points first on how we built healthcare because it is a good example, but it's not the only way to build a business like this. So our opinion in having -- we have healthcare clients now. We're doing different work than we are in our healthcare business, but in working with our clients, what was clear that the industry and quite frankly the bet we're making, the industry is going to go through a tremendous upheaval as it converts from to over-simplify a fee-for-service to a fee-for-outcome kind of a model right.

And whether you're a payer with a profit motive like we have insurance companies here or if you're a government who has got to keep its citizens healthy, that pay-for-service to pay-for-outcome is a shift that the healthcare industry is going to.

Therefore in our view the only way to survive, the only way to thrive, the only way to deliver proper healthcare is you have to have a system -- cognitive system that can ingest all of the data that exists today in a way that allows you to get the right method of treatment soon, that allows you to get the right linkages and the right clinical trials early and in a complete way, so that you can put together, you can put together that string of treatment and fit within whatever that envelope happens to be when that payer decides in total how much they're going to allocate.

So that's the environment in which we -- in which we found ourselves. We didn’t have a role there except that as we talked to our clients, we had a role as being trusted by potential partners and we played the role there for that, if we can bring some of our own data into this mix and since they trust us with their data, now we can build a differentiated value proposition as this industry goes through that transformation that allows us to help deliver outcomes with the best most knowledgeable purpose of data that can exist.

So our acquisitions got us into not only the healthcare space, but as you noted, they came with the lot of data and that data has by and large re-used rights. So when we bought Merge Healthcare, Merge Healthcare has billions of images, a percentage of which we get to reuse to train Watson, so that Watson now knows exactly what every broken bone looks like, knows what cancer cells look like, you can read an X-ray right. So when we say we taught Watson to read, we’re talking about reading an X-ray.

When we bought Truven Health that came with analytics and came with data around payer data. So you can link now how much ultimately did the payer wind up having to fund as this person with this kind of condition go through the process. When we bought Explorys and Phytel, similarly they came with care management, patient management data or it came with clinical data couple hundred million lives worth of data.

So again in this view of how healthcare was going to evolve in a pay for outcome world, we have the trust, we had to bring some data into this because otherwise it was just that our clients and our partner's data that was going to come in and that wasn't going to be enough them over the line. So we brought our own data in now our clients and our partners are bringing their data into the equation, but with a really important -- really important element of trust which is their data is giving them insights.

It's not just feeding a giant health cloud for everyone to use. So our health cloud has our data in it and can we get some additional insight from their data, but by and large their insights go to them and so when we think about how that model applies to other industries, at this point I would say maybe. Now nothings like healthcare, right. What I just described is unique to healthcare in the financial and regulatory or in the financial industry it is not like that at all.

There are elements, do banks want to share all their data only to the extent maybe it helps to manage risk, only to the extent it gives them some additional insight, but you need someone who can sit in the middle of all that and then there are single, there are single top of the list, single largest productivity inhibitor right now is trying to get through the regulatory frameworks because they’re so complex and so voluminous.

And so Watson will be applied to help understand and ingest all of the financial and regulatory data, will have experts to help train Watson and then Watson will get deployed to help them navigate regulatory and compliance that's a lot different from building a healthcare business.

So do I think we need to acquire something in every vertical, hard to know, it depends a lot on the industry. Healthcare I think was probably at one extreme because both the industries has to transform and the amount of data that’s there has to be dealt with in a way that preserves insights for our partners and in financial services, it’s a little different. A lot of the data is up in the brain already right and the experts and then obviously there's this big regulatory compliance and we’ll see if we build others, if we have to acquire, but these aren’t like Promontory was in billions of dollars right, Promontory is a much smaller investment for us. Healthcare was a big investment.

Kulbinder Garcha

And in terms of the benefits, the business on the benefits, so it's in the healthcare side to your clients the benefit is less misdiagnosis, significantly influence in their productivity and some of the wastage of healthcare costs around and those are very significant. They reduce some, is that the right way of thinking how they benefit and then how does the business move to IBM working those improvements that say inefficiency of the customers…

Martin Schroeter

Yes, so it’s a little bit different depending on, but the way that at the bottom at the base level of all this, it is a value priced offering. So in some cases we have -- we create value by preventing an expense for an emergency room treatment and so we will capture a piece of that -- of that savings or that cost avoided.

In some cases it is getting through genomics data faster than they can do it today and so it's the number of, it’s the number of patients that go through it that get -- that we price it on. But typically again value-based pricing, cost avoidance, access to the database in some cases but it is very much a value-based pricing idea.

Kulbinder Garcha

And in terms of time horizon before like you think this could be something that what you talk about it very often but whereby it actually starts moving the needle on what's been an $80 billion business in that?

Martin Schroeter

So, Watson as -- the bulk of Watson sits in our software solutions business right, which is growing and as part of Cognitive Solutions. So, that’s a growing business today, but Watson is also -- it's a silver thread that runs through a number of these businesses right.

So Watson Health is a business. Watson Financial Services would be a different business. Watson the platform is a different business again. So our engagement with an insurance company helping their clients which use to Watson helping their clients answer questions about policies and things, that’s a Watson platform element, which is the different from Watson Health. So Watson is sort of a silver thread, it's not a thing if you will.

Now we will talk -- over time, we’ll talk more and more about Watson, but for now I think the way to think about it is how does -- how can IBM best leverage that technology into an ecosystem that makes that cognitive technology the most valuable if you will in these verticals, healthcare and banking and regulatory and that's what we're focused on now is building out that ecosystem and that’s why we've opened up for instance the APIs to Watson.

So that anyone who wants to, anyone who has a dataset, they don't need to come to us. They can plug into the Watson APIs and embed conversation for instance into their work.

They can embed Watson analytics into their work. So the Watson APIs are open and we’ll see how all of that develops over time, but right now it’s really important I think to build that ecosystem around Watson and make sure that it's a silver thread that runs through all of those offerings and then of course we use Watson internally as well for our own work and so it's a -- there is a productivity element for us as well.

Kulbinder Garcha

Do you think at some point you can start sharing more metrics on it or is that still years away?

Martin Schroeter

Well, we do talk about it. Now we’ve talked about it in the context of its capabilities. We talked about it and try to give, we've tried to give examples of our clients are deploying it. Those are I think the important things for people to really its again -- its not a consumer thing right.

So for investors, for client, when you have a consumer thing, it’s easy to understand because you get to use it. So we’re trying to make sure people understand how Watson can be used and the way our clients are creatively using it today and so I think the focus again still has to be for us on grow that ecosystem, make sure it's a silver thread that runs through, but Watson will -- it will be the silver thread through many of these businesses.

Kulbinder Garcha

Great and maybe if we change slightly to workforce or balancing some of the efficiency you’re trying to drive across the organization. When I speak to investors there is still some confusion I believe about how to think about the benefits of this year's workforce rebalancing, which was much larger than we’ve seen some of the previous years.

And I think what you said earlier on the shares can be a $1.5 billion charge, but it's potentially a $2 billion benefit over time. And what I am getting at is, is that more of a direct cost action whereby there is cost through it. If you take out and then you retain a certain amount and hence profitability is higher or do you more see as where you need to change the skill in our organization and so we maybe downsize in a certain area, but we are in effect rehiring into areas that Watson or areas on the growth side and in that drives productivity and in that ultimately helps you on the bottom-line which of those two extremes, how should we think about this year's workforce rebalancing?

Martin Schroeter

Yes, I would think about it in both of those ways actually because and we talked about this when we announced first quarter results and we had gotten -- we had gotten through the announcement if you will of what of what we did, we really did two things. So part of this was remixing our skills base. As you said some skills, the marketplace just doesn't value any more, we don't have demand for them.

So we move those skills out and then we bring on a new set of skills. We were hiring doctors and nurses today. Five years ago, we didn’t hire many doctors and nurses to build their healthcare business. So there is an element of this that is skill shift and reinvestment into skills.

There is also an element of it quite frankly that was, what I would call capacity reduction right, which will ultimately unless we replace the capacity, but we’ll do that when we have the right demand profile. So to the extent we don't see the demand profile capacity reduction will show up in the bottom line and even within capacity reductions, it's not a straight, it's not a straight reduction of spending.

It's really a couple of things, there are not so much in the U.S., but in many of the countries where our services business for instance hasn't been able to work its way through a better delivery models and where there are very difficult labor laws that we have an inflexible labor market. We were able to reduce some of that capacity and put in -- put into place a better delivery, more productive delivery model to service those clients.

And so we’ll get some benefit out of that. It's not a 100% down and therefore you get it all, but you do get some mixed benefit on a delivery model, again not so much in the U.S. but in other places. So the total that we talked about back in April when we did the first, the total was a pretty substantial number and as we get into -- as we get into '17, we will have a better view of how much capacity will actually stay out and how much are we going to reinvest and then how much of the skills that we still need to remix into. So it will be a mix of both of those things.

Kulbinder Garcha

And then also on the another area of investor debate is that every year there is in the IBM earnings as items are one-time in nature, that we might regard as one-time in nature, but tend to be more reoccurring sometimes as well, but this year however, I look as the Japanese tax settlement again or will that happen in Q1?

Martin Schroeter

It was a court ruling.

Kulbinder Garcha

Right and then so there was that and then there was a somewhat lower tax rate than we would expected in Q3 and these seems like more like less recurring items, does that create a headwind for earnings or when you look versus all the things that IBM and the levers you have to deliver earnings are they able to offset or perhaps we're now used to seeing, how should we think about that going forward?

Martin Schroeter

Well first clearly, we're a big company, 162 countries in which we do business. So there are always one-time elements that flow in or non-recurring I guess is the right way. So we do have a -- we do have a pretty long list of recurring non-recurring things, that's probably the best way to think about it.

And the Japan tax case was a good one, right. It's been on the books for a number of years. We were glad we won right, but we we're not going to do that again. We don’t have another case in Japan that we're litigating. So that doesn’t mean that we're not going through audits in the other 161 countries and we got to settle all through that.

So there are always this long series that Japan tax case win will not be repeated next year. Now having said that, the tax rate which in the third we're kind of in the same place where we started the year, 18 plus or minus 2, that's going to be a function of the mix of our business right. Again when you operate in a 162 countries and our income streams aren’t mix the same way as our revenue streams.

So we have two-thirds of our revenue outside the U.S., but not that much of our income, not as much of our income is outside the U.S. We're more split 50-50 right. So we still have higher rate here in the U.S. and we've got the benefit of lower rates in some other parts, but depending on how the business evolves both in the quarter and next year, it's really going to reflect the mix of the income streams in all the countries in which we operate.

It's neither a one time or a discrete element. It's just the flow of the business. To the extent we make more in low tax countries our rate goes down to the extent we make more in high tax countries our tax rate goes up.

So we still think as we talked about on the call we said this year 18 plus or minus 2 and I still think that's what we still see. It depend a lot though on the mix of the business and we have because of the skew of our business, we have a lot ahead of us still and even in the fourth and then next year we will have a new different view of where the mix is for next year.

As far as though other one-time impacts that we've absorbed and we try to talk about these on the call as well, we had to write-down for instance our shareholding in Lenovo earlier in the year. We've taken hits for revaluation in Venezuela. The same list well not everyone as Lenovo stock like we did, but the same list that a lot of others had right one-time and then we of course had a big impact from currency this year as we did last year.

So if touch wood, if the currency environment stayed stable, we would not recreate the billion-plus impact to earnings next year that we had this year, but we don’t know what that impact or that impact might be. We do and I've always said that a weaker dollar is on balance better for IBM.

But we don’t know where it's going to be. So yes there are a series, there are always discrete events that are not repeatable. The Japan tax is a good one, but there are also a bunch of other things that will not likely come back to us next year as well, at least not at the levels that were this year.

Kulbinder Garcha

Is VM on that point, is their workforce rebalancing, would you view it, it looks like a very big number compared to last five years. Is it exceptionally high this year just $1.5 million is that something else that would help for you booking in that obviously?

Martin Schroeter

Yes we'll talk more about next year in total, but right now I don’t see -- I don’t see that size of a charge in our earnings stream next year because it wasn’t just workforce rebalancing. It was also a capacity reduction and modernizing if you will or making more contemporary, the way IBM works.

So we've been shifting our development teams into much more agile environments. We've been shifting our services teams into much closer proximity agile squads if you will and that means you have to change the way your real estate footprint looks around the world. And so in the first quarter in addition to workforce balancing, part of that charge was also to get out of certain sites of real estate that we don't have any more, again to get the teams back together as opposed to so spread out and become more agile.

Do I think we’re going to recreate all of that. That’s an ongoing process, but again I don’t see the same level we saw last year. So at this point, I don't see that magnitude of an impact.

Kulbinder Garcha

Then on intellectual property one thing that in the last couple of quarters in your results, you've talked about more, it sounds like its slightly new intellectual property business model. I know you break this out quite clearly in the filings between I think you call it sales of IP, sales of IP and then custom development and licensing and it looks like there has been more on the sales side.

So can you speak about how the intellectual property strategy has shifted over the course of last year is going very well this year. The sustainability of that number, is there any lumpiness that we should be thinking about?

Martin Schroeter

Yes, we’ve been working on rebuilding their IP portfolio in our IP pool for a while now. It used to be years and years ago. It used to be between $1.5 billion and $2 billion right. Now the mix of that was different, very heavily at the time many, many years ago it was a way for us to continue to invest in semiconductor manufacturing and semiconductor design when we were the subscale provider right.

So even though we're subscale, that doesn't mean that the dollar it takes to be competitive there subscale, you have to invest at the same rate that the others are in order to stay competitive and at the leading edge of microprocessors and so the way we did that at the time was we brought in joint development partners, we brought in licensing partners who paid part of the way right, they paid for us to continue to develop leading as microprocessors and to give them share with them our semiconductor manufacturing technologies.

That's diminished over time both because we've licensed everyone who wants to be licensed and then we divested of the semiconductor manufacturing operation so those aren’t -- bulk of those are in hours anymore, but that's been diminishing.

Now we've always found other ways to monetize our IP and what you're seeing now is both an example of what we've been doing for a while which I'll talk about and then we have some new things that we're building as well.

So today when we license, when we license not sell, but when we license some of our source code, the model we have is we look at the marketplace, we look at the software and we look at the market in which these products operate and if we see a declining market that means, that in order to keep that functionality growing because clients want improved functionality just because we see a declining market doesn't mean they don’t want that solution to continue to have new function.

We see declining market place and therefore we don't want to take these really valuable skills and invest them into a declining market place, but we have partners who view it as a growing opportunity either because they don't have that part in their portfolio or they are in a different part of the world where that marketplace is growing and so they license from us the source code which they then, they invest their skills and they build it into a growing business.

For us we jet in our INE if you will when we get, when we deliver the value, we book something. Both of that's still ahead of us because these business cases for our partners are built on the idea that they’re going to grow the revenue and as they grow it, we’re going -- they’re going to pay us a royalty for it an ongoing royalty.

So we see an opportunity to turn what is really a challenge in how you allocate scarce development skills when you have lots of opportunities that are growing, we can turn it into a future growth stream in terms of royalty by giving -- by licensing them.

These are all non-exclusive, but licensing them the source code and letting them do it, that's not dissimilar to what we've done in the past. We have more that we're working on because it's quite a powerful model for us, but at the same time we are building with our new capabilities a set of intellectual property and royalty streams that don’t even show up yet.

So as an example we have a partnership with a pharmaceutical manufacturer that we haven’t delivered any value yet. So there is nothing in the ledger, but it's really focused on helping them build a new blockbuster drug and the structure of the agreement is if and I will generalize it, but if we help them build a drug that has global sales of $100 million, we get some royalty X percent.

If we help them build a drug that is blockbuster billion dollar, we get like 3X of the royalty. So it's a way for us with our data and what we've built in our health cloud again to monetize the IP of all the data we've collected helps them focus on blockbuster drugs and we'll build a future IP stream, none of that again is in there yet because we haven’t done anything yet.

So we're building these future stream as well. So I would expect again does IP -- to answer your question is IP have -- is there a variability to it certainly. Each of these deals is variable but we have a pretty broad portfolio and we are focused on trying to grow this again.

So while the semiconductor piece will continue to decline, this is still in hundreds of millions, but it will continue to decline. There are new opportunities opening up for us in order to keep that income stream trying to grow.

Kulbinder Garcha

Okay. Maybe one last question on the broad objective companywide margins, over the last two years I think the combination of some revenue pressure, business mix changes, reinvestments in the business, we've seen [bulk] of the PTI business, sorry the PTI margin X rebalancing and X gains. We expect I think a true measure profit of the business, there has been this pressure.

How close are we to the trough in margins and then there is one thing I want you to specifically comment on, has the strategic imperatives margins, has that been coming down over the last year or two? I can't tell frankly by looking at the numbers because there are lots of moving parts in there, but has there been any pressure because of business mix there and if you could comment on that side because that's the growing part of it and margins keep seeing pressure there could be some risk there?

Martin Schroeter

Yes so a couple of things, first on the strategic imperative, the margins, the gross margins in the strategic imperatives, which is a way to try to value how much value add are you adding. The gross margins are actually higher than the rest of the business in total. So the places we're going to remain higher value than the places we're coming from.

Now that shouldn’t surprise you in a high value model you would always expect to be moving into these higher value areas. Now those margins and the margins in total have been impacted by a couple of things. You pointed out level of investment that's absolutely correct. We did ramp up our spend rates in order to build some of these businesses and that's certainly in the margin profile that we have put forward in the last year and half or so.

At the same time, we're investing not only expense to build these, but quite frankly, we're investing a lot of capital to build these as a service businesses, which means you put all the capital in place now, and you start it fairly low utilization on those assets and then as you add volumes, you build -- you build utilization and you have a better unit cost and we're just now getting to the point where we're seeing enough scale on those platforms to start to grow as a service part of the margins.

So when we look at where we were strategic imperative margins already better than the core if you will the rest and that's with the handicap or with the heavy investment levels. So from here, I would say that the model of moving to higher value will still be in those margins, we'll just see better margin performance as we build more scale.

Kulbinder Garcha

On the heavy investment you referenced that impacts gross margins...

Martin Schroeter

And because again we're spending -- we're spending in capital, which drives a higher cost base obviously through your depreciation to build that all these cloud data centers and put these as a service properties on a set of assets, but we're also spending heavily in expense in order to drive the development and get these offerings out and to bring those acquisitions and to make sure that spending and the investment on those acquisitions get into the run rate. So both gross and net margins.

Kulbinder Garcha

Okay. Great. With that, we're out of time. Thank you very much, Martin.

Martin Schroeter

Thanks Kulbinder.

Question-and-Answer Session

Q -

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