“Looking to the third quarter, we expect constant currency revenue growth consistent with the full year.”

In context

“James Kavanaugh : Thanks, Arvind. In the second quarter, we delivered 1% revenue growth, 30 basis points of operating pretax margin expansion and 5% diluted operating earnings per share growth. And through the first half, we generated $4.8 billion of free cash flow. Let me go through what played out in our segments in more detail. Software revenue grew 5% this quarter with flat organic revenue growth. As Arvind discussed in our pre-announcement, in the final weeks of June, we saw a shift in client spending priorities. Many clients redirected spending towards servers, storage and memory purchases to secure supply-constrained infrastructure ahead of expected price increases. As a result, tens of large deals failed to close on the time lines we expected, accounting for the majority of the shortfall. To understand these dynamics, it is important to recognize that many clients purchase mainframe and the associated software stack through our enterprise license agreements, which create a strong incumbency moat for IBM and are generally treated as capital investments. These agreements typically contain a high concentration of transaction processing software, although they may also include data and automation products. As clients prioritize other CapEx investments, the timing of these deals shifted, resulting in transaction processing revenue declining 9%, while data grew 18% and automation grew 3%. In contrast, we continue to see strong underlying demand in our subscription and consumption-based software. Because these are generally purchased as operating expenditures, they were largely unaffected by the CapEx dynamics that impacted some of our ELA transactions during the quarter. Let me take a step back and discuss the composition of our software revenue. We offer customers flexible purchasing options that align technology investments with their business needs, making it easier to adopt and scale solutions across their businesses. About 80% of our annual software revenue is recurring and is made up of subscription and consumption-based revenue like our Red Hat, HashiCorp and Confluent products. It also includes subscription and support revenue that provides customers with ongoing access to software enhancements and support. This revenue grew nicely in the quarter, and our ARR was $24.6 billion, up 8% since last year. The other 20% of software revenue is transactional in nature and is predominantly related to the incumbency with mainframe and the associated enterprise license agreements with transaction processing and other software products in data and automation. ELAs are highly valuable to IBM because they establish long-term strategic client commitments that expand adoption across our software products, creating a multiplier effect. Transactional revenue was down high single digits in the quarter, given the shift in buying patterns we have discussed. On the subscription side of the business, HashiCorp had another record bookings quarter and accelerated revenue growth through the first half of the year. And Confluent is off to a strong start and on track with our expectations after its first full quarter post close. Red Hat growth accelerated 1 point sequentially to 11%, driven by improvement in the subscription piece of the business and stable growth in consumption-based services. OpenShift ARR is now $2.2 billion with strong growth, reflecting demand of our containerization and virtualization products, where we now have about $680 million of contracts signed since early 2024. In RHEL, performance continued to be impacted by constrained hardware availability, similar to last quarter. Infrastructure revenue declined 7% this quarter. While Z performance was below our expectations through the first 5 quarters of z17 availability, revenue is well ahead of the prior cycles at nearly 130% program-to-program. As Arvind said, we see no evidence of clients moving off mainframe. Clients continue to invest in IBM Z to modernize mission-critical workloads with a focus on resiliency, security and increasingly enabling AI on the platform. AI is driving incremental capacity growth and new workloads as clients look to run AI closer to their most sensitive data. We are seeing strong early adoption of our AI innovations with nearly 50% of z17 customers investing in AI capabilities with Spyre Accelerator and clients deploying watsonx Code Assistant for Z are growing MIPS capacity 3x faster than those who are not. In a world where infrastructure costs are rising and efficiency matters more than ever, IBM Z offers a compelling economic advantage. Depending on the size and complexity of workloads, clients can realize a 2 to 15x total cost of ownership benefit versus moving these workloads off the platform, reinforcing why the platform remains central to their operations and positioning us to capture additional value as AI workloads grow. And adding to Arvind's comments on the strength in Distributed Infrastructure, we exited the quarter with approximately $500 million of backlog, our highest on record, supporting continued momentum. In Consulting, signings grew 6%, marking our second consecutive quarter of growth and reflecting continued client investment in business transformation initiatives. Revenue grew 1%, driven by demand for application modernization, data transformation and cybersecurity services as clients balance the needs to increase productivity through AI with the need to strengthen resiliency and manage risk. Revenue growth was balanced with both strategy and technology and Intelligent Operations up 1%. Generative AI represented about 50% of our signings in the quarter and now makes up over 30% of our backlog, underscoring the demand for AI-powered transformations that extend beyond technology modernization into core business operations. As clients move from pilots to enterprise-wide deployment, they are increasingly turning to consulting to reengineer business processes and unlock productivity and new business value through AI, automation and digital labor. Let me now discuss profitability. Operating gross profit margins were down 70 basis points, largely driven by our revenue shortfall and mix. Despite this shortfall, productivity actions were ahead of plan, providing the flexibility to absorb Confluent-related dilution, continued investing for growth and expanded adjusted EBITDA and operating pretax margins by 20 and 30 basis points, respectively. Segment profit margin expanded by 160 basis points in Consulting and 110 basis points in Software, driven by ongoing productivity actions. Infrastructure segment profit margin declined 150 basis points, reflecting the IBM Z mix headwind mitigated somewhat by strong Distributed Infrastructure margins. Through the first half of the year, we generated $4.8 billion of free cash flow, flat year-over-year, driven by about $700 million increase in adjusted EBITDA, offset by inventory, higher cash taxes and net interest expense. Given the constrained infrastructure supply environment, we proactively took actions through the first half to strengthen our supply chain and support anticipated customer demand in the second half, reflecting the strength we see in our Infrastructure business. We exited the second quarter with a strong liquidity position and a solid investment-grade balance sheet with cash of $8.2 billion. We returned $3.2 billion to shareholders in the form of dividends through the first half of the year. Our debt balance ending the quarter was $62 billion, including debt of $13 billion for our Financing business, with the receivables portfolio that is 80% investment grade. Over the last 5 years, we have repositioned our business to higher growth end markets, improved the durability of our revenue and expanded operating pretax margins and free cash flow through disciplined execution and laser focus on productivity. As Arvind mentioned, we are confident in our portfolio and strategy and the growth opportunities we see ahead. Let me now address our expectations for the remainder of the year. We now expect revenue growth for 2026 in the range of 4% to 5% and are maintaining our expectation to grow free cash flow by about $1 billion. We believe the low end of the revenue range appropriately reflects the current environment and is our base case. Given the second quarter shortfall, we are revising our software growth expectation to a range of 6% to 8% for the full year. While several of the deals that slipped from the second quarter have already closed in the first few weeks of the third quarter, the low end of the software range assumes that recent spending dynamics persist through the second half. The high end assumes a more typical conversion of our pipeline. In light of the strong demand environment in Power and Storage, we now expect Infrastructure to grow low single digits in 2026, driven by growth in Distributed Infrastructure and continued strong program-to-program performance in IBM Z through the second half of the year. Demand across Storage and Power remains strong, and we continue to secure inventory and accelerate our supply chain to capitalize on the opportunities we see in front of us. In Consulting, the quality of our backlog and momentum in Gen AI continue to support an acceleration in revenue growth to low to mid-single digits for the year. We continue to see strong fundamentals of our business play out in the second half of the year as we accelerate our productivity initiatives to help enhance our margin and free cash flow commitments while continuing to invest in growth. These actions include deploying AI and automation at greater scale across the company, reducing third-party spend, improving sales and marketing efficiency, using AI to drive more efficient software development, optimizing our supply chain and enhancing services delivery. While revenue dynamics are creating margin pressure for the year, the pace of our productivity actions have exceeded our expectations. As a result, we now expect to deliver 100 basis points of operating pretax margin expansion with productivity more than offsetting the revenue-related headwinds. Our operating tax rate for the year should be in the mid-teens, and the timing of discrete items can cause the rate to vary within the year. For the full year, we continue to expect to grow free cash flow by about $1 billion. The primary driver of this growth will be adjusted EBITDA, offset by cash tax headwinds, higher CapEx and higher net interest expense, the majority of which is behind us. Looking to the third quarter, we expect constant currency revenue growth consistent with the full year. Given the strengthening of the dollar, we now expect currency to be a 1.5 point headwind to revenue growth in the quarter. And for operating pretax margin, we expect similar performance to the second quarter. Our third quarter operating tax rate should be in the mid-teens. Let me close by saying that our strategy has not changed. We are a leader in Hybrid Cloud. We are investing behind an AI opportunity that plays directly to IBM's strengths in data, orchestration and enterprise trust, and we continue to build leadership in Quantum. We remain confident in the growth opportunities ahead of us and our ability to capture them. Arvind and I are now happy to take your questions. Olympia, let's get started.”