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International Business Machines Corporation (NYSE:IBM)

Q3 2007 Earnings Call

October 16, 2007 4:30 pm ET


Patricia Murphy - VP, IR

Mark Loughridge - SVP & CFO


Richard Gardner - Citigroup

Ben Reitzes - UBS

Laura Conigliaro - Goldman Sachs

Bill Shope - JP Morgan

Chris Whitmore - Deutsche Bank

Lou Miscioscia - Cowen

Andrew Neff - Bear Stearns

Katy Huberty - Morgan Stanley

David Grossman - Thomas Weisel Partners


(Operator Instructions). Now I will turn the meeting over toMs. Patricia Murphy, Vice President of Investor Relations. Ma'am, you maybegin.

Patricia Murphy

Thank you. This is Patricia Murphy, Vice President ofInvestor Relations for IBM. I'm here with Mark Loughridge, IBM's Senior VicePresident and CFO. Thank you for joining our third quarter earningspresentation.

By now, the opening page of the presentation should haveautomatically loaded, and you should be on the title page. The charts willautomatically advance as we move through the presentation; but if you prefer tomanually control the charts, at any time you can uncheck the “synchronize”button on the left of the presentation.

The prepared remarks will be available in roughly an hour,and a replay of this webcast will be posted to our Investor Relations websiteby this time tomorrow.

Let me remind you that our presentation includes certainnon-GAAP financial measures in an effort to provide additional information toinvestors. All non-GAAP measures have been reconciled to the related GAAPmeasures in accordance with SEC rules. You'll find reconciliation charts at theend and in the Form 8-K submitted to the SEC.

I will also remind you that certain comments made in thispresentation may be characterized as forward looking under the PrivateSecurities Litigation Reform Act of 1995. Those statements involve a number offactors that could cause actual results to differ materially. Additionalinformation concerning these factors is contained in the company's filings withthe SEC. Copies are available from the SEC, from the IBM website, or from us ininvestor relations.

Now I will turn the call over to Mark Loughridge.


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Mark Loughridge

Thanks for joining us today. This quarter, I want to giveyou an assessment of the quarter right upfront. We'll discuss what went well,where we could have done better and what it means for the full year.

Let me start with areas where we had really strongperformance. Both services businesses were outstanding, with the best overallrevenue growth in four years. Performance was broad-based in all categories,with growth in every geography, every sector and every line of business.

Global Technology Services revenue was up 13%; profit was up26%. Global Business Services revenue was up 16% and profit was up 29%. Theseresults reflect a number of actions that we have been taking to accelerate ourrevenue growth while improving our profitability, and we expect this momentumto continue into the fourth quarter. So we had a great quarter in our servicesbusinesses.

In software, we had good performance in small andmedium-sized transactions, but several large contracts didn't close at the endof the quarter, so frankly we could've done better here. In the fourth quarter,we expect improved software revenue performance and double-digit profit growth.

In Systems and Technology, we were impacted by producttransitions and tough compares in System z. Revenue was down 10%, or 6%excluding the divested printer business. We will look for a typical sequentialimprovement from third to fourth quarter, but relatively flat performance yearto year without printers, and then a return to growth in the first quarter of2008.

Growth by sector varied. Public sector was very strong, butfinancial services sector experienced a slowdown in September. We will talkabout this more, later in the call.

The performance across our geographies was more balanced. Asia'sstrong performance continued, up 9%. Europe's growth wassolid, up 11%, and Americaswas up 4%. Overall, the IBM business model delivered earnings per share growthof 16%.

As we saw the quarter develop, we took the right actions tomanage our way through an uncertain economic environment, including adisciplined focus on spending and productivity while maintaining investments inhigh-growth areas. All in all, we feel good about meeting our earningsobjectives in the third quarter and we remain on track for the full year.

Now let's turn to the income statement. First of all, wedelivered revenue of $24.1 billion, an increase of 7% as reported and 3% atconstant currency. Our gross margin was down 0.7 points. About two-thirds ofthis decline is due to mix shift among the segments and about a third is due tolower margin in our software business.

Expense was up 6%. This is a substantial improvement fromour recent quarters and the result of the actions we've taken to managespending and drive productivity. Pretax income was up 3%, but up 8% excludingthe additional interest expense for the ASR.

We recorded a tax rate of 28% and net income up 6%, and ifyou exclude the additional interest expense, net income was up 11% and marginup four-tenths. Our share count was down 8%. There was no incremental sharerepurchase in the quarter, obviously, following a significant ASR in the secondquarter. Bottom line, we delivered $1.68 of EPS, growth of 16% year to year.That puts us on a year-to-date basis through September with earnings per sharealso up 16% and a solid contribution delivering on our roadmap for 2010.

Now let's start peeling back our revenue, and we will startwith geographic revenue and then look at the sector dynamics. The Americasrevenue growth was 3% at constant currency. Our U.S.growth was also 3%, with differentiation by sector. We had strength in publicsector, which was up double-digits. However, we had weakness in financialservices sector, down year to year.

Europe had more steady performance.It was up 11% as reported and 4% at constant currency. Most major countrieswere up at constant currency led by Germanyand Spain,which were each up over 5%. The market environment continues at a moderate ITspend.

Asia Pacific again had our best performance at constantcurrency, up 9% as reported and 6% at constant currency. Asia Pacific economyremains strong, led by India,China andAustralia/New Zealand. We had solid contribution from all of these regions,where we continue to accelerate our investment.

Japan'srevenue, at approximately one-half of Asia-Pacific revenue, was essentiallyflat. In Japan,the growth that we have seen in services and software continues, but it wasmitigated by declines in our systems business.

Emerging countries are leading growth in the global economies.In the third quarter, our revenue in Brazil,Russia, Indiaand China grew19% as reported and 10% at constant currency. Three of the four countriescontinued very strong growth. Chinaand Russia wereboth up over 20% at constant currency, and Indiaonce again was up over 30%. Brazildeclined, however this quarter at constant currency after double-digit growthin third quarter last year; so it was more an issue of compares thanperformance.

We remain committed to driving growth in excess of the marketrate in these emerging countries over the long term, with an objective ofdoubling the revenue by 2010. Given our performance this year, we are on trackto this objective. IBM's geographic mix provides diversification and theability to capitalize on these fast-growing emerging markets.

Now let's spend a minute on revenue by sector. I think thedynamics provide some perspective on our overall revenue performance. We haveseveral key sectors, the largest of those being the financial sector, SMB andpublic. The strongest performance came from public sector, and growth has beenfairly consistent over the course of the year. We had solid growth ingovernment, health care and education, with broad-based strength in government,which is the largest of the three. We're seeing increased demand as federal,state and local government agencies are investing in IT for operationalefficiencies.

The weakest sector performance was in the financial servicessector. By geography, the impact was most pronounced in the U.S.By brand, the largest impact was in System z, facing a difficult compare.Outside of this, financial services sector revenue performed in a more typicalrange.

As we move into the fourth quarter, the focus will be onclosing deferred deals and new fourth quarter opportunities, and we will alsocapitalize on opportunities in other sectors, leveraging our broadercapabilities.

So now let's move on to expense. Total expense and otherincome increased 6%, but we had modest year-to-year improvement in our expense torevenue ratio. There was substantial improvement to growth rates over the lasttwo quarters however; the result of actions we've taken to manage spending inthe current environment. Now last quarter I told you that we expected between7% and 9% growth in expense in the second half, but we frankly did even betterthan that in the third quarter with 6% growth. If you peel back the 6% growthin the third quarter, you will see that approximately 3 points of the growthwas due to currency; I estimate about 5points from the growth is acquisitions, so as a result, what I will calloperational expense was 2% better year to year. Remember, this includes theincremental interest expense from the ASR.

So how did we do that? Well, first, in the middle of lastyear, you know we started to ramp investments and resources in software and servicesand emerging markets. But I think in a sense we funded these investmentsthrough a very disciplined approach to expense management. We focused ondriving productivity from our sales teams as well as our support functions.

If you take my function, by the way, the finance area, 40%of our resources will be in global support centers by the end of next year. Wehave also tightly managed our discretionary spending, while continuing toinvest in areas that will drive growth over time, especially in emergingcountries.

I want to mention one item that significantly impacted ourprofit growth this quarter; our retirement-related plans generated about $650million of cost and expense in the quarter, an increase of almost $60 millionyear to year.

Finally, our tax rate was 28% this quarter, down slightlyfrom the first half rate.

Moving on to cash flow, our year-to-date free cash flow was$5.2 billion, a $1.2 billion increase from last year. Our year-to-year cashperformance was driven by growth in net income and lower funding actions forretirement-related plans. In the quarter, our free cash flow was $2.6 billion,down about $100 million sequentially, but we maintained our capital investmentsrequired for our long-term growth.

Year-to-date through September, we returned $20 billion toinvestors through share repurchase and dividends. Share repurchase is obviouslyon hold during the quarter as the ASR remains in the covering period. Wesettled our first of the three contracts this quarter for outflow of about $150million, and our average diluted shares year-to-date were $1.5 billion, down6.2% from a year ago. We also distributed $1.6 billion in dividends.

So now let's turn to the balance sheet. Cash on hand is$13.8 billion, driven by continued strong earnings, with no share repurchasethis quarter. Two-thirds of the $35.3 billion of debt is to support our globalfinancing business leverage at an appropriate 6.8:1. The other third of ourdebt, the non-global financing debt, decreased $300 million. This brings ourdebt to cap from 47% to 40% in one quarter. Now, we expect to maintain thatleverage on a long-term basis in the range of 20% to 30% debt to capital, andwe have made good progress towards managing leverage to our target range.

This quarter, we paid off $500 million of the $11.5 billionterm loan associated with the ASR and refinanced $4.6 billion, with $2.6billion of term debt and $2 billion of commercial paper.

We have very good access to the credit markets and webenefit from the market's flight to quality. Let me give you an example. We canissue one-month commercial paper now at 30 basis points below LIBOR. Ourability to access long-term debt in the capital markets also remains strong.For example, this quarter we issued a $3 billion, ten-year bond. It is thelargest single debt issuance for IBM, and credit investors were very supportiveof our issue. It was oversubscribed by a multiple of two. The balance sheetremains strong, and we are positioned to support the business over the longterm.

Now, before going into each of the segments, I want to giveyou an overview. You can see the strength in the services segment mitigated bydeclines in the systems and technology segment. Our pretax margin for the sumof the segments is up three-tenths of a point year to year, excluding theincremental interest expense for the ASR, which is held at the IBM level.

We will now start with the segment details, starting withGlobal Services. Both services segments delivered powerful results for thisquarter: double-digit revenue growth, profit growth of 27% and pretax marginapproaching 11%. Total services revenue was $13.7 billion, up 14% as reportedand 10% at constant currency.

Signings were $11.8 billion, up 12% year to year. Long-termsignings were up 29%, while short-term signings were down 5%. Nine deals werelarger than $100 million, and the backlog remains at $116 billion, up $7billion year to year. This was a very good quarter for services, and we've madeconsiderable progress implementing our strategies across our global offerings.

Starting with Global Business Services, revenue was up 16%as reported and up 12% at constant currency. Transformational actions we'vetaken over the past two years are paying off in a big way, and drivingprofitable growth. We're benefiting from trailing 12-month short-term signingsgrowth of 6% and long-term growth of over 80%.

We had growth in all geographies and all sectors. Looking atthe sectors we saw the strongest performance in Communications, Distribution,Public and SMB. From an offering perspective, Financial Management Services,Human Capital Management and Supply Chain were the strongest. We're also makinggood progress in our AMS business, and we continue to have success building outour global capabilities. We believe we've gained share this quarter in bothcore consulting and application management services.

Global Business Services pre-tax profit was up nearly 30%and margin was 10.7%, -- an improvement of 1.3 points year-to-year. This is theninth consecutive quarter of margin improvement. Margin expansion was primarilydriven by ongoing productivity and utilization initiatives, and good expensemanagement.

Now, turning to Global Technology Services, total revenuewas up 13% and 9% at constant currency. It was the best performance in sometime. GTS delivered double-digit revenue growth across all geographies, allsectors and all lines of business.

Strategic Outsourcing revenue was up 10%. Signings were up46%. Revenue growth is benefiting from three areas: good signings performanceover the past 12 months, continued lower erosion which is a reflection of ourfocus on delivery capabilities, and sales of new business into our existingaccounts.

Business Transformation Outsourcing is up 27% as reported,though signings were down 66%. As mentioned in the past, these signings can bevery inconsistent by quarter.

Our Integrated Technology Services revenue is up 15% whilesignings were down 3%. The revenue growth we've seen the last few quarters hasbeen driven primarily by signings growth in 2006 and the first half of 2007.The acquisition of Internet Security Systems also contributed to the revenuegrowth in the quarter.

Our Maintenance business was up 13%. This growth includesthe services provided to Ricoh InfoPrint, which contributed about 7 points ofgrowth in the quarter. Our Global Technology Services pre-tax profit was up26%, and margin was 10.8%, up 1.2 points year-to-year and up 2.2 pointssequentially. A very strong performance. When you look at margin expansion, itwas really driven by benefits from restructuring, productivity improvements andgood revenue growth.

Let's conclude with a discussion of the broad-basedimprovements that the services teams have made in the past few years. WithinGlobal Technology Services, we revamped the ITS business around the globe,driving improved revenue performance. We strengthened the SO business; this isreflected in signings growth, lower levels of erosion and growth from ourexisting customers, creating a much stronger portfolio of business. And morerecently, GTS tackled the margin issue, not only improving year-to-year butgetting overall margin above 10%.

Within Global Business Services, over the past few years theGBS team has implemented a transformation of their operations, designed toimprove profitability and position the business for profitable growth. Thisincluded restructuring actions in under-achieving regions, deployment of globalresources management tools, rapid growth of our Global Delivery Centers,and increased focus on deal selectivity.

The result has been consistent improvements in utilization,better contract quality and increased profit margins. And as we've seen in thepast few quarters, profitable growth. We feel great about how this business isnow positioned. This is the best all around Services performance that we'veseen in a long time.

Systems and Technology revenue of $4.9 billion was down 10%year-to-year, or 13% at constant currency. Without the divested printerbusiness, revenue was down 6% year-to-year. In the third quarter, many of ourservers were impacted by product transitions: System z is well into a verysuccessful product cycle, Systems p and i are transitioning to POWER 6, andSystem x awaits new quad-core processors from Intel and AMD.

Let me take you through the brands. The biggest change fromrecent performance was in System z, with revenue down 31% and MIPS down 21%. LikeI said upfront, we were up against a particularly strong third quarter of 2006,which had revenue growth of 25%.

We knew we had tough compares going into the quarter, and wehad opportunities lined up to drive better performance, but a number of these largedeals simply didn’t close in September.

We have had a long and successful technology cycle in Systemz, with eight consecutive quarters of MIPS growth. We continue to work with ourcustomers to help them manage their computing requirements, and provideattractive migration offerings to transition to the next generation. System pgrew 6% and really did pretty well, with particular strength in Americasand AP.

Strength in the new POWER6 midrange server helped drive thefifth consecutive quarter of growth. System p continues to leverage POWERtechnology leadership, gaining 11 points of share since 2001.

System x servers grew 6%, and blades grew 8%. Customers in the high-end of x are evaluatingthe new quad-core processors which are scheduled for fourth quarteravailability. In addition to these new high end servers, our recently announcedBladeCenter S for the SMB marketplace will be available in the fourth quarter.

In Storage, tape had another good quarter, up over 7%, whiledisk declined 3%, primarily in the midrange. Total Storage revenue was up 1%.Storage hardware is really a part of a larger total storage solution, and someof the value in these solutions has been evolving in other segments. As anexample, storage software, which is in Tivoli,grew 16% this quarter.

With 29% growth, our market leadership in Retail StoreSolutions was extended again this quarter. This is the seventh consecutivequarter of share gains.

Microelectronics revenue was down, driven again by gameprocessors. We continue to pursue opportunities in other high growth segments.

When you look at gross profit margin in Systems andTechnology, it was up three tenths of a point, with the largest contributioncoming from System p. We also had margin expansion in Systems z and x.

In System z, we’ve reduced cost, as well as driving a moreprofitable product mix, to improve our gross profit margins despite the revenuedecline.

Gross margin expansion in System x was driven by improvedsupply chain execution, which also resulted in faster delivery times and lowerinventory.

Pre-tax margin was up quarter-to-quarter but down slightlyyear-to-year.

So to sum up Systems and Technology: we have producttransitions underway and, in addition, we had a number of deals that did notclose in the quarter. In System z, we are helping our customers move to the newtechnology by developing attractive migration offerings. With these actions andproduct enhancements, we are looking for more stable performance in the fourthquarter, and improved performance in the first quarter of 2008.

Software segment revenue of $4.7 billion was up 7% asreported and 3% at constant currency. Branded middleware grew 8%, 4% atconstant currency. Now remember that branded middleware faced a strong compare;the prior year was up 20%.

So let me peel back the performance by transaction size. Ifyou look at small deals, under a half million, and medium-sized deals, $500K toa million, we had good success in closing these transactions. But a number oflarge deals did not close in the quarter. Even a handful of these would havemade a difference in the quarter. Now, we're still pursuing these and theyremain opportunities for us in the fourth quarter.

Now, let me go through the brands. WebSphere grew 10% drivenby deployments of web-enabled applications and SOA, while InformationManagement grew 9%. Tivoli grew 5%against 44% growth in 3Q06. Storage virtualization software did particularlywell, and customers are benefiting from significant storage efficiencyimprovements.

Lotus grew 9% with double-digit growth in our Notes Dominoproduct family. This is the 12th consecutive quarter of revenuegrowth for our Lotus group. Our latest version of Lotus Notes, Lotus Notes 8.0,was delivered this quarter. Rational grew 3%; the performance and functionaltesting software did well, reflecting the strength of our internally developedproduct set.

We're also continuing to invest in software as we'vecompleted four acquisitions this quarter: Watchfire in Rational, PrincetonSoftech and Data Mirror in Information Management, and WebDialogs in Lotus.Software PTI margin declined reflecting the impact of acquisitions.

With our strong product set and deal pipeline entering thequarter, we expect significant improvement in the fourth quarter.

Let me wrap up with a simple variance analysis of ourearnings growth starting with revenue. We had exceptional performance inServices with double-digit growth in both Global Technology Services and GlobalBusiness Services. Software performance in smaller transactions was solid, butoverall growth was impacted by the deferral of a number of large transactionsat the end of September.

Systems and Technology declined with weakness in September,particularly in System z transactions and resulted in performance that wasfrankly below our expectations. Now, overall, revenue growth was 7% and atconstant mix and margin this would contribute $0.10 of the $0.23 ofyear-to-year EPS growth.

Next, let's look at margin and expense performance. Whilegross margin declined primarily due to mix, it was more than offset by animprovement in our expense-to-revenue ratio. We took appropriate action tomanage our expense this quarter, and to address efficiency of our sales forceand our support functions while continuing to invest in our growth initiatives.And while we had additional interest expense related to our Accelerated ShareRepurchase, for an impact of $0.07 per share, this was more than offset by theshare repurchases bolstered by the ASR which contributed $0.14 to growth forthe quarter.

Finally, our tax rate was down 200 basis points for a $0.04 impact.

So to net it out, even in an uncertain economic environment,by leveraging the strength and breadth of the business model we delivered verystrong earnings per share growth of 16%. With our year-to-date performance, andassuming a stable economic environment, we believe the current average ofanalysts' earnings per share estimates for the fourth quarter is reasonable at15% growth, and results in a full year that is consistent with our full-yearobjectives.

Now, before going to the Q&A, I want to give you a senseof why we feel confident in our business in this type of environment. We havesubstantial global reach and presence. We operate in 170 countries, and morethan 60% of our revenue is outside the U.S. Asia Pacific remains ourfastest-growing geography, and Europe performance hasbeen steady. We continue to invest aggressively in emerging countries tocapture the growth in these markets and tap into their skill base to deliverglobal solutions.

We have a broad mix of businesses. Our hardware, softwareand services businesses provide a strong and balanced base of operations. Wehave strong annuity businesses. These businesses, like Strategic Outsourcing,and Software, and Maintenance, represent about half of IBM's revenue. Theseprovide stable sources of profit and more importantly, cash.

We currently have momentum in these businesses with strongServices backlog, improving Services profitability and leading Softwarecapability. These annuity businesses provide a tremendous advantage.

We've got a very solid balance sheet. We have substantialfinancial flexibility. As an example, look at this quarter. We were able toreduce our debt-to-cap from 47% to 40%, and we still ended the quarter with$13.8 billion of cash on hand.

Finally, we take a very disciplined approach to cost andexpense management as we continue to invest in key growth opportunities.

Now, this business model is designed to drive sustainableprofit and cash performance over the long term. So let me put our 2007performance in the context of our 2010 roadmap. For the first three quarters ofthe year, we have delivered 7% revenue growth, grew net income 9% and expandedmargin. Earnings per share grew 16%, and free cash flow was up over 30%. It's agreat start towards our 2010 objective.

Now, Patricia and I will take your questions.

Patricia Murphy

Thanks, Mark. Before we begin the Q&A let me comment ontwo items. First, we have supplemental charts at the end of the deck thatcomplement Mark’s prepared remarks.

Also, as always, I’d ask you to refrain from multi-partquestions to allow us to take questions from more callers.

Operator, please open it up for questions.



(Operator Instructions) Your first question comes fromRichard Gardner - Citigroup.

Richard Gardner - Citigroup

First on the software deferrals that you mentioned, I washoping you could give a little bit more detail in terms of what types ofproduct lines were affected and in what vertical markets? What gives youconfidence that these deals will close in the December quarter? You did mentionthat you expect a significant improvement in performance in the Decemberquarter. How can we be confident that this is simply a deferral and notsomething that is deferred for a longer period of time or lost entirely? Thankyou.

Mark Loughridge

First of all, as we exited the quarter, we had a number oflarge deals that we said that we were right at the goal line on, and they didroll over into the next quarter and we do expect those to close. I do want toadd though, that it is interesting in the software base, if you look at by sizeof deal and deal size category. If you look at deal sizes of $500,000 and below or $500,000 to $1 million, actuallythose had very sustained momentum through the third quarter. They are verysimilar to what we saw in the first quarter. It was really a large deal issue.

As we look at those large deals going through the fourthquarter, we know that more deals will be event-driven in the fourth quarter ; inother words, renewal-based actions. We have a lot more confidence in thecontent and the software base of business as we go through it, looking at thepipeline, looking at the quality of those deals, looking at the metricsassociated with logical renewal content. As I look at that balance and withexchange rates where they are, I would think it would be very logical for softwareto record double-digit revenue at actual rate, and I think we ought to be in apretty strong double-digit PTI growth as well. So I think we have a very goodbook of business.

Richard Gardner - Citigroup

Mark, you alluded acouple times to this type of environment and this uncertain economicenvironment. There were several indicators that suggested that spending mayhave weakened over the quarter. Your short-term signings were down year overyear for the first time in several quarters. You had strong deferrals in softwareand in hardware at the end of the quarter.

So the question is, are we seeing a weaker economicenvironment actually start to affect technology spending? Are the signs that wesaw in the quarter not consistent with that?

Mark Loughridge

A very fair question. If you break down the performance inthe third quarter, I think from an economic standpoint to your question, thedifference that we saw in the third quarter was really in the financialservices sector, and within the financial services sector it was predominantlyin the U.S.

Now to put this in a context, financial services sector inthe first six months of the year has contributed about 1 point of growth toIBM's growth. If you look at that on a constant currency basis in the firsthalf, IBM did about 5%. If you look at financial services sector contributionin the third quarter, it hurt us for about 1 point of growth. So in otherwords, outside of financial services sector we are fairly constant, 4% overthat period. So I would not look at this and say this was a general economicdecline.

Now, within financial services sector I would go moretowards the U.S.In fact, if you look at it, the U.S.was the major geography affected from a brand standpoint. zSeries was the majorbrand affected. I think that's logical, zSeries has about 50% of their businessin FSS, so I don't think that is a surprise, given the sector dynamics. But ifyou exclude those and outside of those particular areas, we had fairlytraditional performance for the balance of the FSS business. In fact, it wasabout 8%. So I don't think this is a general economic issue.

I do think we did have an FSS slowdown, if you looked at themonthly rate. The first month of the quarter we had growth of 9%, and then itdeclined from there in the U.S.So I do think we did see an FSS phenomenon, it was mostly localized to the U.S.It was not a general economic environment. I think the broader story here is even in theface of a very important sector at IBM, we still achieved the objectives wewere looking for, with strong growth and strong EPS growth of 16%.

I would also, just to calibrate the services sector framework, the U.S.runs about 30% of global FSS and FSS is about 28% of IBM. So we're talkingabout something about 7% to 8% of the IBM base of business.

Richard Gardner - Citigroup

Outside of financialservices, can you comment on the linearity in the quarter?

Mark Loughridge

As we looked outside of the financial services sector andlooked across the three quarters and the progression, there wasn't something inthose other sectors that had a similar kind of a profile at all to FSS. This ismostly contained to FSS, the FSS mostly contained within the U.S.We did also have, if you looked at the product line most affected, it waszSeries, and we've gone through eight quarters of pretty strong growth there sowe're now working on migration offerings for the fourth quarter. I'm sure thatplayed a part as well. But you did not see this kind of portrayal in the othersectors that we saw in FSS, predominantly U.S.


Your next question comes from Ben Reitzes - UBS.

Ben Reitzes - UBS

Good afternoon. Could you just talk a little bit more abouthardware and the visibility, why that could get better, to go to flat and thengrow? We have to navigate through a $250 million hit from the printers beinggone, we know. Could you just elaborate? I think that segment was about $500million below people's estimates and particularly the pSeries, going throughthe product transition, the xSeries, and what we should expect for the fourthquarter in terms of push outs and the new products?

Mark Loughridge

Let me firstcalibrate the overall hardware in the fourth quarter. I portrayed that in the script, and just toexplain that, we said more stable performance, and I think it would berelatively flat on a year-to-year basis on revenue and profitability. Nowwithin that, as we move from the third quarter, obviously hardware did not meetour expectations in the third quarter. But as you go from third to fourth inzSeries, we're now going to be working on the migration offerings to assist ourcustomer base to move to new technology content. I think that will make a difference as we gointo the fourth quarter performance. We also had some large rollover deals thatI think will also close as well. So, that would be zSeries.

When you look at pSeries, I think pSeries had a pretty goodquarter. At this growth rate, it picked up 2 points of growth. As you know, wehave POWER6 now in the midrange in pSeries, and that midrange pSeries withPOWER6 grew 26% in the quarter. So that was pretty strong performance from thatnew technology base.

If you look at xSeries, xSeries as we go into the fourthquarter is now going to have the quad-core technology, which I think will be avery good technology for us. On a blades basis, we're going to have theBladeCenter s. BladeCenter s is specifically for SMB, and it's really, when youthink about it, it's like a data center in a box, ready to set up for your SMBmarketplace. We will also have our core blade offering as well, which is apretty impressive offering.

So I think we have a number of technologies out there, andtechnologies that will drive improved performance as we go into the fourthquarter, but I'm not drawing a point about the third. We were disappointed inthe third, and I know we can do better in that base of business as we go intothe fourth.


Your next question comes from Laura Conigliaro - GoldmanSachs.

Laura Conigliaro - Goldman Sachs

First of all, given what's going on with bond yields, therecent moves in bond yields, can you update or give us an update on yourconfidence that you still think you will see the $800 million benefit in '08that you have talked about before?

Continuing on the same line, i.e. confidence levels, lastquarter you did indicate that you expected to see your full-year signingsgrowth equal to what it was last year. Are you still thinking the same way?

Mark Loughridge

Let me answer yourfirst question. We just did some analysis since we updated the pensionportfolio and again, we update this on a global basis for both the short endand the long end of the yield curve, and it still has roughly that same $800million of benefit as we go into '08. In fact, it was just a little larger than that as we didthe analysis.

You know that we don't formally update those rates until weget to the end of the year. So we will have to see where that turns out. Butright now, it's a very similar curve and I would expect that we would get aboutthat same benefit as we go into 2008.

As far as full year signings growth, we did 12% in the thirdquarter. We've got 10% going on a year-to-date. You are quite correct, asyou've pointed out, we face a big hill as we look at the compare in the fourthquarter. But as I look at a balanced case, a balanced case, I think we haverelatively flat signings for the year, but within that growth in short-termsignings.

Now I want to reassure you, when we run our pipeline, whenwe run our quotas, when we run our measurements, we are all driving for growthfor the full year, but I think on a balanced basis, flat signings performance isreasonable, within that short term would be up.

Where does flat signings put us for services? As we exit thequarter, we will still have growth in our backlog on a year-to-year basis. Onthat basis, we should still, in the first half of 2008, see growth within our servicesbusiness within the model range of 6% to 8%.

So I couldn't be more impressed with the job that our servicesunits did as they went through the third quarter. You remember as we did thesecond quarter, I had said with both of them at 10% growth, it was thestrongest performance I had ever seen. Imagine now we've got 13% and 16%; so alot of velocity, a lot of momentum out of those units as well, driving bettermargins and profitability.


Your next question comes from Bill Shope – JP Morgan.

Bill Shope - JP Morgan

Great, thanks. Mark, I want to dig in to the zSeriesperformance a bit more. In past quarters, you have noted that the volatility inthe mainframe cycle was being muted somewhat by nontraditional workload growthand some other factors. What has changed with this argument, and are weentering a period of sustained volatility again, or should we look at this as ashort-term blip?

Mark Loughridge

I think the way to characterize this is we're now going intoa transition. Again, I want to reiterate that we've gone through eight quartersof sustained growth on this zSeries, because this has been a very successfulplatform. I would also remind everybody that it's facing a pretty tough comparein third quarter last year. The revenue for zSeries last year was up 23%.That's a big number to compare to.

So I don't think this to me looks like real volatility, andI don't expect there to be more volatility going forward. We are going to begoing through the transition with our customers and helping them solve theircomputing requirements and move to migration offerings to help them move to newtechnologies.


Your next question comes from Chris Whitmore - DeutscheBank.

Chris Whitmore - Deutsche Bank

Thanks very much. I was hoping to get a little more clarityon profitability and margin pressure in the software business, hoping that youcan provide more color there. Secondly, can you comment at all about 2008earnings expectations, assuming the current environment continues through nextyear? Thanks a lot.

Mark Loughridge

Yes. I think as I said earlier, as we move from the thirdquarter to the fourth quarter in our software business, we expect to seedouble-digit profit growth on a year-to-year basis. Remember now, we began towrap in the fourth quarter on the large acquisitions that we did last year thatcarried with them a lot of amortization of intangibles. So, as we wrap on that,it helps us balance our cost base with our revenue. So again, in the fourthquarter I expect to see double-digit profitability out of the software base.

As far as 2008 is concerned, we generally comment on 2008 in the January meeting. We dothat because a big component is pension and we've got to see where the ratesturned out the last day of the month of December and everything. So that's whenwe generally give guidance. But there's nothing that I have seen so far thatwould generally change our view of '08. Ithought the context that we try to provide to demonstrate that was an update onour 2010 model that we gave at analyst day.

If you look at the model and you said, well, what kind of agrowth rate would you need in EPS to get to your objectives of $10 to $11? I mean, you've got to be in those mid-teens. Soon a year-to-date basis, for us to be at 16%, I conclude we're on track tothose set of objectives in 2010. We will certainly say more about 2008 when weget to January.


Your next question comes from Lou Miscioscia - Cowen.

Lou Miscioscia - Cowen

Thank you. Maybe you could spend a minute or two on the diskarea, which seemed to be weak. Was it that you're seeing weaker ASPs,competition, virtualization, product transition? Maybe you could you share alittle bit more color there.

Mark Loughridge

If you look underneath the storage business, we continue tohave pretty good performance out of our tape business. We didn't do as well onthe disk business. If you look behind the disk business, it was reallymid-range disk where we had more difficulty. If you looked at the high end,actually the high end did quite well on a volume basis when you look at thegrowth there.

So this was confined more to the mid-range disk profile.Tape did well, high-end disk did well, and as we go into the fourth quarter, weexpect to see improvement in midrange. But we also expect to see ongoingperformance and strength continue in tape and high-end disk.


Your next question comes from Andrew Neff - Bear Stearns.

Andrew Neff - Bear Stearns

I just wanted to goback and clarify some of your comments on the software side. Were you sayingthat the deferrals, were they mostly related to the financial sector or werethey more broad-based? Can you give us a better sense about what the reasonsfor those deferrals were and why you are confident those are going to close?Were there technical issues, or can you give us a little more color on that?

Mark Loughridge

Sure. If you look at the deals that deferred -- and again, Iwant to explain that even a handful of these deals would have made a prettysubstantial difference in software performance in the quarter, but if you lookat the deals that did defer, about 70% of those deals were in fact in thefinancial services sector. Now however, they were pretty far advanced. As wemove those deals into the fourth quarter, as I had said earlier, we've got avery good pipeline. We know the progression of those deals and we're prettyconfident in them. We also have more event-based metrics and milestones as weenter the fourth quarter. By that, I mean logical renewals that we will see.

So we're pretty confident that we'll see improved revenueperformance out of the software business, with currency at actual rates thathave come in, I think, a more double-digit revenue growth and as we ramp on theacquisitions from last year, we will see, I believe, double-digit profit growthas well.


Your next question comes from Katy Huberty - Morgan Stanley.

Katy Huberty - Morgan Stanley

Mark, what were the buckets of SG&A spend that you wereable to pull back on in order to meet the EPS targets this quarter? Howsustainable is that level of spend?

Mark Loughridge

When you look at SG&A, we have been doing a veryconcerted effort for some time now to drive globalization of our structuralspending and move spending to grow areas, move spending to emerginggeographies. As you say, what do I mean by structural SG&A? I mean likefinance. I mean the other staff functions on a global basis. What is a goodmetric? Well, imagine this: 40% of my finance organization is going to be inthese globalized centers of excellence by the end of '08. That is a veryconcrete set of actions that we're moving.

We are also being, I think appropriately, tough on spendingin areas where we do not see the same opportunity for growth. But with all ofthose, we're moving that expense into areas that we see bigger opportunitiesfor sustained, ongoing growth like emerging markets.


Your final question comes from David Grossman - ThomasWeisel Partners.

David Grossman - Thomas Weisel Partners

Thank you. Mark, could you just expand a little bit more onthe decline in GBS bookings, particularly in the face of such strongcurrent-quarter revenue performance, and perhaps talk a little bit of how weshould think about margin expansion going forward in IGS, given again, suchstrong performance in the third quarter?

Mark Loughridge

First of all, as I looked at the GBS bookings on a trailingbasis, short-term signings were up 7%. On a year-to-date basis, they were up4%. As we look out for the year and close out the full year, we see short-termsignings coming back in the fourth, and it's closing on a full-year basis atapproximately that same range of growth.

So I think the short-term impact we saw in short-termsignings in GBS was just that, a short-term impact. I think it should come backas we go into the fourth quarter.

As far as margins are concerned, you remember that as wewent through the analyst review, we were talking about our view that marginsacross services could grow 2 points by 2010, and here we're sitting here withboth sides of this equation generating growth of 1.2 points and 1.3 points on anet margin basis. That's pretty strong performance.

Especially, remember GTS, they had a lot of work to do. Soit's not only an acknowledgment that both organizations are really focusing onthe bottom line profitability of their businesses, but GTS really showed strongimprovement with the actions that they took in the second quarter. As youremember, we did the math in the second quarter and explained that that oughtto be able to hit 10%. Sure enough, what did they come in at? They came in at10.8%. So I'm quite encouraged by this performance. Both of our services groupshowed a real, real momentum here, and I couldn't be more appreciative of sucha great job they did.

Let me just take a moment now and summarize the third quarterperformance and give you a consolidated view of the fourth. First of all, per thelast question, I will start out with services. GTS and GBS have just showntremendous momentum, with revenue up 13% and 16%, profit up a substantial 26%and 29%. I mean really, when is the last time we had profitability in bothsides of the services business off such a strong double-digit base? These keybusinesses delivered PTI margins of 10.8% and 10.7%; very balanced, withyear-to-year improvement of 1.2 and 1.3 points year to year.

These are like very large cruisers; once you get thatmomentum going, you're not going to change that much as you go forward. So weexpect to see continued momentum for both GBS and GTS as we go into the fourthquarter. As you all know, that makes up more than half of our revenue.

Our hardware business, as we said earlier, did not meet ourobjectives in the third as we wrestled with product transitions and toughcompares in z. We expect to see typical quarter-to-quarter growth from thethird to the fourth quarter, with relatively flat year-to-year performanceexcluding printers in the fourth quarter; then returning to growth in firstquarter of '08. So more work to do on the hardware side of the business.

Our software business grew 7% in the third quarter. However,we could have done much better in large deal closure at the end of the quarter,and we intend to as we go into the fourth. For the fourth quarter for software,we expect double-digit revenue growth at current exchange rates anddouble-digit profit growth, with the strongest margins among our businesses,even against difficult compares.

So I think all of this should put us in good shape to meetour objectives for the fourth quarter.

Now, I would also ask you to step back and say, let's lookbeyond the fourth. First of all, our financial base is rock solid. We havealmost $14 billion of cash; our non-financing debt to cap came down quarter toquarter from 47% to 40%. We accessed the capital market at 30 points belowLIBOR for 30-day commercial paper, and the largest bond offering in IBM'shistory was oversubscribed by a multiple of two.

I think the strongest strength we see is the diversificationof this business. We are a global business, with 60% of our business outsidethe U.S. We arewell positioned in high growth markets. Our year-to-date EPS performance was up16%, and we're on track to meeting our 2010 objectives.

So I thank you for joining our call today; and now, it'sback to the fourth quarter.


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