Oct 19, 2020
International Business Machines (IBM) Q3 2020 Earnings Call Transcript
International Business Machines (IBM) Corp. (symbol IBM) reported their Q3 2020 earnings on October 19, 2020. The firm reported a third consecutive quarter of revenue decline. Read the full transcript of the conference call here.
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Speaker 1: (00:01)
Welcome and thank you for standing by. At this time, all participants are in a listen only mode. Today’s conference is being recorded. If you have any objections, you may disconnect at this time. Now I will turn the meeting over to Ms. Patricia Murphy with IBM. Ma’am, you may begin.
Patricia Murphy: (00:18)
Thank you. This is Patricia Murphy, and I want to welcome you to IBM’s third quarter 2020 earnings presentation. I’m here with Arvind Krishna, IBM’s Chief Executive Officer, and Jim Kavanaugh, IBM’s Senior Vice President and Chief Financial Officer. We’ll post today’s prepared remarks on the IBM investor website within a couple of hours, and a replay will be available by this time tomorrow. Some comments made in this presentation may be considered forward looking under the Private Securities Litigation Reform Act of 1995. These statements involve factors they could cause our actual results to differ materially. Additional information about these factors is included in the company’s SEC filings.
Patricia Murphy: (01:02)
Our presentation also includes non-gap measures to provide additional information to investors. For example, we present revenue and signings growth at constant currency throughout the presentation. In addition, to provide a view consistent with our go forward business, while we have rapped on the majority of the impacts of the divestitures in 2019, we’ll continue to focus on constant currency growth adjusting for the divested businesses for the impacted lines of total revenue, cloud, and our geographic performance. We have provided reconciliation charts for these and other non-gap measures at the end of the presentation and in the 8K submitted to the SEC.
Patricia Murphy: (01:44)
Finally, consistent with our last few quarters, IBM’s year over year revenue, profit, and earnings per share reflect the impact of purchase accounting and other transaction-related impacts associated with the acquisition of Red Hat. With that, I’ll turn the call over to Arvind.
Arvind Krishna: (02:02)
Thanks, Patricia. I’m pleased to be speaking with you again just a week and a half after our strategic update on October 8. Today, we’ll focus on our third quarter performance, which you’ll see is unchanged from the preliminary results we announced.
Arvind Krishna: (02:21)
Well, I want to start with a summary of our strategic discussion. We are redefining our future to the hybrid cloud platform and AI company. Over the last few years, we have built a solid foundation for hybrid cloud. With the acceleration of the Red Hat platform adoption and the changes to clients’ needs for application versus infrastructure services, we are separating our managed infrastructure services into a new publicly traded company. The result is two market leaders with focused strategies and missions and improved growth project rates.
Arvind Krishna: (03:03)
IBM is the number one hybrid cloud platform and AI company. NewCo will become the number one managed infrastructure services company. As separate businesses, each can capitalize on their respective missions. Both will have more agility to focus on their operating and financial models. Both will have greater freedom to partner with others, and both will align their investment and capital structure to their strategic focus areas. All of this will create value for clients, and for you, the investors, with an improved financial profile of both companies. Since the announcement, we have had a comprehensive outreach to our clients. In fact, we have spoken to hundreds of our top clients, and I have personally spoken to dozens. The vast majority understand the strategy and are excited about what it means for them, whether they’ll be predominantly future IBM clients or NewCo clients. Our partners have also had a positive response as they see this as an opportunity to further strengthen our go to market initiatives in the hybrid cloud data and AI spaces.
Arvind Krishna: (04:21)
For IBM, as we look forward, the case for hybrid cloud is clear. Clients see two and a half times more value in a hybrid cloud approach versus a public only, it’s a tremendous opportunity valued at a trillion dollars with most of the enterprise opportunity ahead of us. Our approach is platform-centric. It is differentiated by Red Hat OpenShift, which is our market leading open platform, a vast software portfolio modernized to run cloud native, and our GBS expertise that drives platform adoption and meets clients where they are on their cloud journeys. Over the coming months, we’ll further advance our strategy by taking actions to simplify and optimize our model, increase investments in key areas, and fostering much more of a growth mindset. All of this will contribute to accelerated growth for our company in the future, and we expect to deliver sustainable mid single digit revenue growth upon completion of the separation of NewCo.
Arvind Krishna: (05:38)
Let me shift to some of the recent progress we have made against our hybrid cloud platform strategy from the perspective of our clients, our ecosystem, and the innovations we’re bringing to market. We have great recent examples of clients making large scale architectural commitments to our hybrid cloud platform. [inaudible 00:05:59] is using our platform to make their E&P environment accessible across any infrastructure that their global clients use, on-premise, private, and public clouds. They’ll enable the broader energy community to leverage data analytics and AI to unleash the power of digital innovation in the oil and gas industry. We’re also extending our relationship with Delta to transform their talent and modernize their IT environment. Using Red Hat, Cloud Paks, and leveraging DVS’ expertise, they’ll operate with greater speed and realize longer term business benefits. We’re continuing to expand our ecosystem. Last week, I talked about how we have added hundreds of partners to drive workloads to our platform, including best of breed GSIs and ISVs.
Arvind Krishna: (06:56)
As an example, Ernst & Young is now leveraging our open hybrid cloud platform and AR solutions to help clients transform their businesses. Our teams are also providing joint consulting capabilities to drive business outcomes for clients. Late last week, we announced expansion of a partnership with ServiceNow to bring the power of Watson AIOps to their market leading Now platform. We are also bringing new innovations to market. I’ll highlight just two areas: Red Hat and quantum. Red Hat extended it’s open hybrid cloud portfolio with several new technology introductions, including OpenShift Virtualization, which enables clients to migrate and run their virtual machines natively within Red Hat OpenShift, and advanced cluster management for [inaudible 00:07:50], which delivers the industry’s most robust multi-cluster policy-based compliance and application management system. These capabilities are furthering our client’s abilities to build once, deploy anywhere, with a hybrid cloud architecture.
Arvind Krishna: (08:09)
In quantum, we announced our roadmap to reach a thousand plus qubits by 2023. The roadmap aims to take today’s noisy, small scale devices towards the million plus qubit devices of the future. This kind of progress is essential to help industry and research organizations tackle important real-world problems that even today’s most powerful classical computers cannot tackle. And in making our roadmap public, we are committing to meet a series of aggressive benchmarks that will help our company maintain its leadership in quantum computing and place our clients on the path to groundbreaking achievements. So we’ve made good progress with clients, our ecosystem, and innovation.
Arvind Krishna: (08:59)
Regarding today’s environments, clients continue to balance short-term challenges and opportunities for transformation. In the short term, we are focused on operational stability and cash preservation. We see this especially in our larger software license transactions and delays in some services projects. But more of my conversations with CEOs are around how they become digital businesses. How do they tap into open source innovation? How can they securely deploy and manage their data and applications across various clouds? That’s what we call hybrid cloud. We see this with the continued momentum in Red Hat and the large client engagements that enable a journey to cloud, leveraging both OpenShift and application modernization.
Arvind Krishna: (09:56)
Now I’ll turn it over to Jim Kavanaugh, Who’s going to take you through the results, and then we’ll come back at the end for Q & A.
Jim Kavanaugh: (10:05)
Thanks, Arvin. I’ll start with a view of our overall performance. We delivered $17.6 billion of revenue, expanded gross and pre-tax margins, reported operating earnings per share of $2.58, and generated solid free cashflow while increasing investments. Our balance sheet remains strong, and we continue to have ample liquidity. Our revenue and gross profit performance was fairly consistent with the second quarter and reflects little change in the macroeconomic environment and client demand. As we previously discussed, our broad geographic footprint and client and portfolio mix provide some stability to our revenue, profit and cashflow. As Arvin just mentioned, clients’ near-term priorities continue to include operational stability, flexibility, and cash preservation, which tends to favor OPEX over CAPEX. This is resulting in some project delays and purchase deferrals, which we see in perpetual software licenses and project-oriented and volume-based services.
Jim Kavanaugh: (11:19)
Our transactional performance this quarter also reflects product cycle dynamics in our systems business. At the same time, the last seven months have made it very clear that companies need to modernize their businesses to succeed in this new normal. This is leading to an acceleration in digital transformations. Cloud and AI are at the center of these transformations, and our open platform-centric model delivers greater innovation, higher productivity, and more strategic optionality to our clients.
Jim Kavanaugh: (11:56)
In the third quarter, client adoption of our platform continued to grow with approximately 2,600 clients now using our container solutions. We anniversaried the acquisition of Red Hat in early July, and Red Hat, again, delivered strong results in the period, with normalized revenue growth of 16%. Red Hat leverages IBM’s global reach in large accounting competency. Not only are the number of large deals increasing, but also the size of these engagements is increasing as well, with the total value of these deals doubling over the last 12 months.
Jim Kavanaugh: (12:36)
Within services, this quarter we added about 125 services clients utilizing Red Hat technology, and our GBS cloud-related signings were up over 25%. The platform model delivers compelling economics. Our full stack capabilities drove over $24 billion of cloud revenue over the last 12 months, which is up 25%. We’re investing to expand our capabilities in GBS skills centered on hybrid cloud and intelligent workflows, in Red Hat’s go to market, to drive hybrid cloud adoption, in software hybrid cloud and AI capabilities, including the Spanugo and WDG Automation acquisitions, in IBM cloud capital for MZR buildouts, and in our ecosystem to drive adoption of OpenShift and our broader cloud capabilities. These investments will accelerate in 2021, given the additional flexibility from our structural actions.
Jim Kavanaugh: (13:48)
This quarter, our portfolio mixed with strong software contribution, together with our focus on productivity, drove our operating gross margin expansion of 160 basis points, and operating pretax margin expansion of 140 basis points. With a 10 point year to year headwind in our operating tax rate, our net income margin was essentially flat. Our cash and liquidity positions remained strong, fueled by our cashflow. We generated $1.1 billion of free cashflow in the quarter, and $4.8 billion year to date, which is down over $1 billion year to year. We continue to have strong working capital performance and contribution from Red Hat, net of related interests. These were offset by higher net capital expenditures and workforce rebalancing payments.
Jim Kavanaugh: (14:47)
Over the last year, we generated $10.8 billion of free cash flow, which is 136% of gap net income. We ended September with a cash balance of $15. 8 billion, which is up $6.7 billion since year end, while our debt was up $2.5 billion. I’ll remind you we issued debt earlier this year, out of an abundance of caution and taking advantage of attractive market dynamics. We’re in good shape to fund our upcoming maturities, including $4 to $5 billion in the fourth quarter. We’ll end 2020 with debt down for the year.
Jim Kavanaugh: (15:32)
Now I’ll turn to the segment performance beginning with cloud and cognitive software. Revenue was up 6%, driven by cloud and data platforms. This is a sequential improvement in the year to year performance, despite a four point headwind from the wrap of the Red Hat acquisition in early July. Software has a seasonally smaller transactional base in the third quarter. In a challenging transactional environment, this benefited us. Our cloud and data platforms delivered 19% revenue growth. This was led by Red Hat’s strong performance, with double digit growth across both infrastructure software, and application development, and emerging technologies.
Jim Kavanaugh: (16:20)
A couple of weeks ago, Red Hat was recognized as the leader in multi-cloud container development platforms in Forrester’s latest Wave Report. Leveraging this OpenShift container platform, our AI-powered Cloud Paks provide clients with ease of use and the ability to scale and secure operations across a variety of environments. We’re expanding and leveraging the IBM and Red Hat ecosystems, with over 180 partners now selling IBM Cloud Paks. We’re seeing good penetration in our large accounts. We’ve now more than tripled the number of clients adopting Cloud Paks versus a year-
Jim Kavanaugh: (17:03)
The number of clients adopting cloud packs versus a year ago, it added nearly 200 clients to our container platforms in the third quarter. Cognitive applications’ revenue trajectory improved the flat year to year, led by strengthened security and supply chain. In security, we had good demand for our threat management software and services as clients transform and manage their security operations. We’re driving adoption of our cloud pack for security and QRadar on the cloud and identity and trust services also had good performance as we’re helping clients with their secure digital transformations. Forrester and IDC, just named our managed security services as an industry leader, based on our integrated product and services capabilities. We also had good performance in our supply chain software, supply chain order management enables the shift to more flexible and scalable digital channels, which is a great value prop to our clients during the pandemic.
Jim Kavanaugh: (18:14)
Looking at the profit for this segment, we had strong profit and margin performance driven primarily by Red Hat contribution. Turning the global business services revenue declined 6%, consistent with last quarter. As you’ll recall, prior to the pandemic, GBS was going revenue and signings. That’s March, our revenue has reflected the economic environment and it changed in client priorities, leading to project delays and less demand for more discretionary offerings. But as we pivot our offerings and delivery to address these client needs, GBS posted double digit signings growth in the third quarter and return its backlog to growth. This was driven by cloud strategy, application development and modernization and offerings that use data and AI to transform workflows. As I mentioned earlier, our GBS cloud signings were up over 25%.
Jim Kavanaugh: (19:22)
We signed a number of large transformational contracts with a total value greater than $100 million, which will yield revenue over time. Our small deal performance generally filed the pandemic curve by geography what returned to growth overall for the quarter. With the expertise in process knowledge gain through our application management and competency clients trust us to guide them through architectural decisions and facilitate their transformations. With their particular expertise in application modernization at scale across all on-prem, private and public cloud environments, GBS drives adoption of IBM’s hybrid cloud platform and is a gateway to bring the wider set of IBM capabilities to enable a client’s digital journey.
Jim Kavanaugh: (20:17)
For example, about one third of cloud pack revenue results from GBS engagements. And this quarter, we added another 60 Red Hat client engagements, which such clients is Delta Airlines, which Arvin mentioned earlier. But also World Bank of Canada, IT Ergo, Florida Power & Light and Telefonica Espana. As our clients are transforming, we are also investing in our GBS business to position for growth in the future. We are continuing to invest in skills, resources, offerings and ecosystems. We have implemented a virtual sales engagement model and are delivering nearly all of our more than 1500 active paid garage engagements virtually. And we are taking the learnings from our initial shift to remote delivery to establish a new delivery model. Dynamic delivery integrates technical foundations with virtualized methods and practices enhanced with AI and automation that drive productivity, pace and quality.
Jim Kavanaugh: (21:32)
As we apply the dynamic delivery principles across our client base, in the third quarter, we delivered more than 90% of our services remotely while maintaining stable quality and increasing net promoter score. Looking at the profit dynamics with our focus on high value offerings, productivity and strong operational discipline, we’ve expanded GBS gross margin by 190 basis points. In global technology services, revenue was down 4%. Fairly consistent with last quarter. Infrastructure services continues to experience lower client-based business volumes in the more economically sensitive industries. And TSS performance reflects hardware product cycles and continuing volume impacts due to the pandemic. But many clients are taking a longer term view and are looking to modernize their infrastructure to create agility and operational efficiency.
Jim Kavanaugh: (22:38)
They turn to GBS as managed infrastructure services business for its deep expertise in managing mission critical infrastructures. And it’s next generation service delivery capabilities infused with AI and automation. Coca-Cola European partners is a great example. We recently signed a multi-year agreement to accelerate their modernization journey. We’ll help them to reduce operational expenses, increase IT resiliency and leverage AI to bring enhanced insights and deliver greater service to their customers. DTS signings were down 1% this quarter, but up 12% year to date with 19 deals over $100 million, including eight this quarter. In addition to new work, clients continue to make long-term commitments with significant contract renewals as we deliver new value.
Jim Kavanaugh: (23:42)
This has resulted in the backlog year to year trajectory improving by approximately two points from the beginning of the year. Turning the GBS profit gross margin declined by roughly 80 basis points. This was driven by the investments we are making in public cloud and the volume impacts, which come at a high margin. Earning the systems revenue was down 16% driven primarily by product cycle dynamics. IBM Z revenue was down 20%. We launched the z15 toward the end of the third quarter last year. We’ve had widespread adoption of both z15 and LinuxONE across many industries and countries in support of clients hybrid cloud journeys. IBM Z is seeing record setting volumes on Linux as clients leverage Red Hat, OpenShift, Ansible and our cloud native DevOps offerings.
Jim Kavanaugh: (24:47)
At the same time, this pandemic has impacted our historical IBM Z cycle dynamics, which is playing out differently by industry. This platform has proved invaluable to our clients in areas like banking and financial markets, helping them rapidly and remotely scale up capacity and respond to unprecedented market volatility. As a result, these clients accelerated their adoption of z15 within the cycle. That said, in many other industries, clients remain focused on cash preservation during this pandemic. This dichotomy and client buying behaviors impacted our performance in the third quarter and will lengthen the adoption curve of the z15 cycle. But by the end of this cycle, we have an opportunity to be fairly consistent with prior cycles.
Jim Kavanaugh: (25:47)
I’ll remind you in the fourth quarter, we’ll be wrapping on a very strong performance from last year when we were up 63%. These cycle dynamics impacted our storage revenue as well, with performance driven by declines in high-end storage. Now, as always before the Q&A I’ll bring it back up to the IBM level. We’re seeing tremendous opportunity to help our clients become digital businesses. Our technology centric hybrid cloud platform, deep industry expertise and growing ecosystem are enabling us to accelerate these transformations. The value we provide clients is evident this quarter in our cloud revenue growth, in our continued momentum in Red Hat and in our strong GBS signings driven by cloud and application modernization offerings. And now we’re accelerating IBM’s hybrid cloud platform strategy with increased focus and investments to drive future growth.
Jim Kavanaugh: (26:56)
We’re taking structural actions to simplify and streamline our business. And as we discussed earlier this month, we expect a fourth quarter charge to our operating results of about $2.3 billion. The savings from these actions will be reinvested in areas like hybrid cloud, data and AI, security and emerging technologies. With our focused hybrid cloud platform strategy and the increase investments starting now, we expect to drive sustainable mid single digit growth after the separation of NewCo is complete. In the near term, the pace of recovery remains uncertain. And as a consequence, we have not seen a fundamental shift in overall demand levels. Given this uncertainty and consistent with our direction for most of this year, we are not going to provide guidance. But I will remind you from an historical perspective, the fourth quarter seasonally is our strongest quarter in terms of revenue and operating earnings per share, due to our high value software and hardware transactions.
Jim Kavanaugh: (28:11)
Looking at our year to year dynamics at the end of 2020, we’re wrapping on a strong fourth quarter of 2019 when we had a very strong software performance. Our first full quarter of z15 availability and our first full quarter of Red Hat contribution. So going into this fourth quarter as always, we have a lot of work to do. It’s our largest transactional quarter. We’ll be focusing our investments in hybrid cloud and AI. And of course we’re starting to detail work to separate our managed infrastructure services business. We’re confident in the focus and direction of our business and what it means for our future. Arvin, let me turn it back over to you.
Thanks, Jim. I’m going to add just one final thought before the Q&A. We are managing for the longterm. We are making strategic decisions, taking actions and increasing investments today to better position our business and accelerate our top line growth on a sustainable basis. Patricia, let’s go to the Q&A.
Patricia Murphy: (29:25)
Thank you Arvin. Before we begin the Q&A, I’d like to mention a couple of items. First, we’ve included supplemental information at the end of the presentation. And finally, as always, I’ll ask you to refrain from multi-part questions. Operator, let’s please open it up for questions.
Thank you. At this time, we’ll begin the question and answer session of the conference. To ask a question, please press star one and record your name clearly. If you need to withdraw your question, press star two. Again, to ask a question, please press star one. Our first question comes from Matt Kabral with Credit Suisse. Your line is open.
Matt Kabral: (30:04)
Thank you very much. Arvin, you touched on this briefly during your prepared remarks. I was wondering if you could expand a little bit more on the health of the wider IT spending landscape you’re seeing around the world. And you mentioned delays you’re seeing in a couple of areas within the portfolio. Just wondering when you think those deals will start coming through, particularly as we’re starting to think about the puts and takes heading into 2021.
Hi, first, thanks for the question, Matt. So a few comments on… Because you asked about portfolio areas, you also asked about clients and you also asked about geographies. And it all varies, but we are seeing first from large client deals as well as services projects. Let me just reiterate, but add a little bit of color to what Jim and I said, in our prepared remarks. Why we are seeing very healthy growth in some parts of both software and systems? It’s kind of schizophrenic, but we’d also seen people pause. Maybe they’re pausing because of the industry or because of geography or because they’re into a cash conservation mode. We think it’s a pause. We don’t believe it’s a decline forever. We do believe that some of those deals come back and we tend to see that.
We saw that from the first to the second, second to the third quarter, etc. So that’s a one-pot. Now we have also talked about that there is about 70% of the industries that we are in. We are not seeing any pauses. We see funds that are healthy. We see that their businesses are healthy. About 30%, and that should not be a surprise to anybody on this call we do tend to see some temporary softness and maybe think about brick and mortar retail. You think about airlines. You think about hospitality. I think it’s not a surprise that some of those. Now we also tend to be with larger clients. So we don’t believe that they have a sustainability issue by and large. It will tend to come back.
So that’s sort of the flavor under it, but then as I begin to look forward, Matt, because you’re asking that question also. It’s really hard to predict the fourth quarter. That’s why Jim and I are pausing and giving guidance here. However, when we look at are people interested in these parts of the software portfolio, whether it’s supply chain and security. And Jim mentioned it, whether it’s cloud and data platform, which is inclusive, both of Red Hat and our cloud packs and other technologies, they find essential. We find that those will come back. We find our transaction processing platform, our TPP get somewhat aligned to the mainframe capacity increases. So as those go through, you tend to see… I’ll call it an alignment. It’s not necessarily identical, but there’s some alignment there in.
And then let’s not forget that as a global business services and other SIs do transformation projects, they also tend to pull through software more in cloud and data platform than in other areas. So I’ll give you that color sort of across the mindset, across the industries and across different parts of the portfolio.
Patricia Murphy: (33:22)
Thank you, Matt. Can we please go to the next question?
Absolutely. Our next question comes from [inaudible 00:33:28] Wan with JP Morgan. Your line is open.
Speaker 2: (33:32)
Hi, thank you so much. For collective services signings did bounce back nicely a little bit here. So it sounds like some larger transactions coming back. What I want to understand, maybe if you don’t mind, just this transition from going with a tighter integration of GBS and GTS to the separation now. Could we see services, results and bookings maybe weekend in the short term before taken up again? I know the signings were good here, but just trying to think about this fourth quarter and first quarter transition.
Speaker 2: (34:03)
… here, but just trying to think about this fourth quarter and first quarter transition given the change over, if that makes sense. Thank you.
[inaudible 00:34:10] this is Jim. I’ll take that one. Let’s talk a little bit about the quarter in what we just finished with regards to services signings. We’re pretty pleased given the overall macroeconomic environment and the rate and pace and the continued uncertainty. The teams executed very well. Nine and a half billion dollars of signings up 5%. We’ve got $108 billion backlog right now that’s flat at actual rates, down 1% at constant currency. And to your point, we saw, actually, very good progress in large transformational deals. I think 11 in the quarter in excess of $100 million and eight of those in our GTS managed infrastructure services business, which saw a very strong renewal rate that talks to the value of innovation that they bring to our clients set overall.
And that has led to year to date. I think we said in the prepared remarks, GTS up 12% signings. And I’ll remind you, that was off of a third quarter last year, where we grew 20%. So we’re pretty pleased there. And that’s led to a two point backlog improvement in our GTS business since January. But where we really have seen a marked inflection of some signs of demand change is in GBS. And while the revenue kind of played out consistent with 2Q, our signings were up double digits. I think it was our third largest signings quarter almost in history and our both large and small deals overall. And that was really a testament to our GBS capability around application modernization and being our client’s provider of choice for digital transformation and journey to cloud. So we feel pretty good about that. It’s good early trends. We got a very nice pipeline, transformational deals here in the fourth quarter. And again, given our announcement 10 days ago, we’re spending a lot of time with our clients to make sure we minimize disruption, ensure stability and provide that client value going forward.
Speaker 3: (36:21)
Thank you [inaudible 00:02:22]. Let’s go to the next question.
Our next question comes from Toni Sacconaghi with Bernstein. Your line is open.
Toni Sacconaghi: (36:31)
Yes. Thank you. I know you’re not commenting on Q4 guidance, but maybe you can tell us how to think about it. Typical seasonality might be for revenue up about $3 billion if demand’s not really changing. Why shouldn’t we assume normal seasonality and is that kind of the right number or framework? And then Arvind, I’m wondering if you could just comment on capital allocation going forward. Your dividend is $ 6 billion a year. It’s basically been 100% of your free cash flow year to date in the last… you haven’t paid down any debt, you haven’t done any deals without taking on incremental debt this year. So if you really are managing the business for the longterm and growth is a priority, are you considering lowering or suspending the dividend or is the dividend safe? And if it is, why wouldn’t you be more aggressive in allocating more cash to growth going forward? Thank you.
Toni, this is Jim. Thanks for the question, multi-part. But let me take the first piece around color or around fourth quarter and then Arvind can handle the capital allocation discussion around the strategy. And I obviously can handle some of the numbers overall. But first, as we talked about prepared remarks and you indicated, the rate and pace of the recovery, we still see as uncertain. And there’s no real fundamental change in client buying priorities around cash preservation, around operational stability. And consistent with prior quarters, that has led us to not get guidance. But let me give you some color. First, we talked about at the on-site of COVID-19 that this has only accelerated our client’s digital transformation and journey to the cloud. And you see that playing out in our results over the last few quarters with continued very good momentum in our cloud business and in our Red Hat business.
And when we look at fourth quarter, we see very healthy pipelines and hybrid cloud AI solutions at modernization, cloud transformation services within GBS, Red Hat. Actual backlog growth is accelerating, up 23% at 44.7 billion. And we see pretty healthy pipelines in our cloud and data platform and in our cognitive apps business led by Cloud Paks and security. The two things that we called out though in our prepared remarks, we’ve talked about the last few quarters, and those are headwinds. And first, in particular around TPP, our clients committed to that platform. We had a very strong 2019 and given the environment and the focus on cash preservation, we don’t see that coming back in the fourth quarter. It’s going to be pretty similar to the first half. And the second is our mainframe cycle coming off of the significant portion of the growth last year, up 63%. Then when you look at skew overall in the fourth quarter, 3Q to 4Q, I mean, there would be no reason not to expect a normal skew with regards to revenue.
Some slight improvement in our portfolio offset by TPP and we’ll wrap on the hardware piece. Now, in terms of EPS, you saw the very strong fundamentals in third quarter coming off a strong 2Q, operating gross margins up 160 basis points, operating pretax margin up 140 basis points. We feel very confident in the strength of our balance sheet, our cash and the liquidity position to make sure that we can continue to invest in our business. We’re starting that immediately here in fourth quarter, around technology, around innovation, around skills, around capabilities. And you’ll see that play out in addition to the $2.3 billion structural charge. So when you look at EPS, you all know the numbers as well as I do, over the last X number of years our 3Q to 4Q pre the $2.3 billion charge has been a nice growth of about mid 50s. We should do maybe a little bit better than that, but I don’t think anything substantial above that. So we see pretty similar dynamics. Arvind, over to you.
Thanks. Thanks, Jim. And Toni, thank you for asking the capital allocation question, a really important piece of our growth strategy going forward. So a couple of points there for context; one, when we acquired and closed on Red Hat, we did commit to pausing share repurchase until we had the leverage and gotten back to our target ratios of debt-to-EBITDA. So we are on track to do that. We fully intend to do that. And we had said that we’ll got there by 2022. So that’s part one. And so some of the cash you see on the balance sheet will be used towards that purpose because as you said, you’re not paying down debt, but you’ll see us begin to pay that down to get towards those ratios. Part one. Part two, we are committed to a stable and growing dividend. Given our investors, given that how much they depend upon that and how much we’ve heard about that and feedback, we intend to keep a stable and growing dividend.
That means everything else is up for what is prudent for managing for the long term. And so when we talk about increased investments and on October 8th I was clear, we are going to both increase expenses organically in order to be able to grow in both software and in GBS. But we are also going to be quite acquisitive in the areas that we have called out. We will be acquisitive in GBS and we will also be acquisitive in the software areas around hybrid cloud, data AI, security, and in emerging technologies such as quantum. So when you see us do that, I think we are going to be doing exactly what you’re asking. Will we be more cash to growth going forward? I think the simple answer to that is yes. With no qualifications therein.
Speaker 3: (43:03)
Thank you, Toni. Can we go to the next question please, sheila?
Thank you. Our next question will come from Wamsi Mohan with Bank of America. Your line is open.
Wamsi Mohan: (43:14)
Yes. Thank you. The second half was going to deliver some strong margin uplift from the productivity actions and we saw some of that come through in the third quarter. Can you help us with how much more productivity benefit is yet to come in the fourth quarter? And as you talk about the reinvestment of the savings associated with the actions you just announced last week, can you give us a segment view on that reinvestment please? Thank you.
Yes. So Wamsi, thank you very much for the question overall. If you look at the structural actions we took as we entered 2020, remember we talked a lot about this in January pre COVID on how we were going to reposition our businesses as we move forward. You see that actually playing out in our results. I mean, our margins in the second quarter were up roughly 150 basis points at gross margin level. And in third quarter we just came off margins that are up 160 basis points at the gross level and operating margins that are up 140 basis points at the pre-tax level. So I think you’re seeing that productivity and the fundamental change in the way we’re actually driving and running the business now adapting given the onset of COVID-19 and the implications to the economic environment. If you take a look at the fourth quarter actions overall, we talked about, 10 days ago, the strategic action around separating out and creating two market-leading companies and creating an independent, publicly traded company around our managed infrastructure services business.
That was going to be about a $2.3 billion charge. And if you remember what I said at the time, and you can kind of think of this in one third buckets. The first is about a third of that is going to go to help improve the EBITDA growth profile in our NewCo business to be on a trajectory to achieve post-separation, a double digit EBITDA growth profile. The second bucket, or second third of that was, in any business when you separate out you’re going to create stranded costs and inefficiency. And we’re committed to addressing that in 2021 with this charge. And then the third piece is we are making significant investments to capitalize on the $1 trillion hybrid cloud market opportunity. And the third bucket’s going to be used for additional fin flex. That is going to be centered around technology, innovation, people, skills, capability, ecosystems, and also, as Arvind just answered, around the inorganic plays overall. So I’ll take that one and then Arvind, you want to take the second one?
Yes. So when you look at the different segments that we’re in, Wamsi, so this is straight away in the four areas that we had outlined. Number one, we are going to be increasing investments in GBS in order to get more skilled in the areas where we are seeing demand. Second, we are going to be increasing investments in our ecosystem. And by ecosystem there are large partners, we just announced ServiceNow last week, but we announced Adobe a couple of months before that. You’ve seen us with Salesforce. You’ve seen us with others. So we are going to be increasing our investment and how we work with those. But there are also hundreds of ISVs, not just the very large ones with whom we are also working to get them on our hybrid cloud platform, on our cloud properties. And so how do we invest in that in order to drive growth down the road is the second piece. I’ll put that in the ecosystem bucket. Third, we’re going to be increasing investments in our core software areas in terms of the hybrid cloud platform itself.
And you saw that in some of my prepared remarks on the innovations we are driving into the Red Hat technologies. But in addition to that, in terms of data and AI and security and others, we are going to drive innovation in there. And as you put all those areas together, let’s not also forget, NewCo is also going to be seeing increased investments around automation, around infrastructure modernization, against working with different cloud partners. When you think of those four buckets, it now it goes pretty much across all of IBM segments, Wamsi, if you think about it, because we want it to be, I’ll call it balance. It’s not identical growth, but we want all of the segments to be contributing to growth and so we’re going to be driving in terms of organic R&D, in terms of working with certain areas where there’s a lot of demand. So you’ve got to get skills in there. And of course, as we add M&A, that’s not quite directly from these buckets of money, but the M&A would also add to added expenses. Eventually, the moment you complete an acquisition it’s expense in these different segments.
Speaker 3: (48:31)
Thank you Wamsi. Let’s go to the next question, please.
Next we’ll hear from Katy Huberty with Morgan Stanley. You may proceed.
Katy Huberty: (48:41)
Thank you. Arvind, just looking at the cloud and cognitive software business before you closed on the Red Hat acquisition, that was a growing business. Today on a proforma basis with Red Hat, it’s declining mid single digits. Would love your thoughts on why we’re not seeing a stronger growth rate. Is it entirely macro driven? And what are the steps in timeline for getting that software business back to proforma growth given how important it is to hitting the mid single digit longer-term growth target.
Thanks, Katy. And you got it correct. It is a critical part of us getting towards our mid single digit growth target. So that is essential. So as we begin to go under it, and you look at it for the last few months, I will tell you that some of it is indeed… macro maybe the wrong word, but I think there’s two elements in there. People are pausing certain large software license transactions, and that is perhaps the macro environment. And then there is the TPP piece which is inside of the software segment, which has driven more, as I’ve said before, in terms of the alignment to the main frame capacity that’s in the ground. And we saw very good growth in the fourth quarter of last year, we saw that tied to that. And as you begin to see that slowdown in the third quarter of this year, we do expect to, I think, see that continue for some time.
But within that, when I look at our cognitive applications and we look at cloud and data platform, we do see healthy growth there that I expect to see continue. As we invest more into that and as we invest more into Red Hat, I would expect that as we get through the next year, we are going to see that that should be able to more than offset anything that happens inside TPP. And just to give a sense of that, Katy, when you begin to look at Red Hat by itself, and we see the growth there in the mid to high [inaudible 00:00:50:51], and we expect that that should be able to continue and accelerate, and that in turn will give added growth to the whole portfolio more than enough to offset any weakness in TPP. And then-
… More than enough to offset any weakness in TPP. And then as we are increasing our investment in our ecosystem, as well as in internal R&D, as well as in acquisitions? While I’ll acknowledge that those layers do take multiple quarters to play out, I wish it was quicker but it is multiple quarters. But I would fully expect that at the same time as you complete the spin, we should be able to see those growths return in those parts of the portfolio, and you’ve got a sense of how we’ll do it across those various elements.
Speaker 4: (51:32)
Thank you, K.D. Sheila, can we take the next question, please?
Absolutely. Our next question comes from Amit Daryanani with Evercore. Your line is open.
Amit Daryanani: (51:44)
Thanks for taking my question. I guess I would love to just hear the feedback you’ve gotten from your customers over the last 10 days, post the announcement of the spin. And I guess really what I want to think about is [inaudible 00:51:56] pause, declining along with the VO so the spin is done. [inaudible 00:01:03]. Any feedback over those would be helpful.
Great question Amit. So as you can imagine, this is something which I think the only word I can use is… We are obsessive about this topic. We had our lists out, we knew exactly what clients might be concerned about. And I wouldn’t say that we are 100% perfect, but I think we feel very, very good that we were correct in our estimations of the level of concerns. To give you a sense, we internally… This is not something that we often tell the client, but based on their reaction, I mentioned that we have already spoken to hundreds. You could think that about 10 days in, we’ve already spoken to at least between two and 300 of the top clients, but there is a strong intersection of whether it is a very heavy spin core revenue base, or deals that could be on the table. And from there, we have gotten back over 80% I would call it, out in the great to good, to not really concerned. And I’ll come back and give some color on why we believe that’s true.
Then there are some who do enough on both sides that they do have some concerns. Most of those concerns that around who is the team that will be providing service? Who is the person who is going to be on the ground? And we should be very clear that Spinco is going to head out on day one with $19 billion, the same management team on the ground who runs it from the client up is going to be the team that does it. Yes, there’s a corporate structure to be put in place, but that’s not the team on the ground just to be clear. They have very high satisfaction with the majority of their clients, and that is because they bring both service excellence in terms of the service and the uptime that they provide, but also they bring very technical skills, which gives them permission and the trust to play.
So when I put all of that together, I think that there’s a couple of dozen clients where we just have to make sure that we can tell them who the team that’s going to be servicing them. And as they begin to get comfort on that, I can see the level of anxiety reduced. But as I said, for what, 80%? They understood what was happening. And also, many clients are majority on one or the other. Naturally for them, there’s going to be less of a concern.
Now, to your point though, why would they then complete the deal? Look, most of the larger deals are to a client’s benefit. Clients don’t do something unless they are going to get a business benefit from that. And in this environment, if you want to go pause that for three or six months? You’re going to defer your benefit for three to six months. So I think what drives things… And luckily they have a month on both sides, both our teams and the client’s to understand each other and to spend enough time in the quarter to go get those deals done.
So the quarter will tell us whether we are right or not. But based on everything I can see, I am confident that actually we will be able to see most of the deals progress to a satisfactory conclusion.
Speaker 4: (55:24)
Thank you Amit. Let’s go to the next question, please.
Our next question comes from David Grossman with Steeple. Your line is open.
David Grossman: (55:33)
Thank you. So I know the end markets has shifted quickly, and think I understand the challenges associated with repositioning GTS. That said, I’m having a harder time calibrating how you’re thinking about the longer term growth prospects for this business. Can you give us any insight into your analysis of the longer term growth to the business, and what it really means to run it for cashflow? Does that simply mean that it continues to decline at a modest rate and generate cash, or does that mean something totally different?
Hi, David. The market is a $500 billion market from what we can see, from what IDC shows us, as well as what many other third party consultants have told us. A couple of things in there. Within that, if I find… Whereas our portfolio and our clients today is probably more heavily weighted in about 60% of that total as opposed to all of it. And we think that the ability to form many more partnerships as a standalone is going to allow, IF to much more fully participate in the complete market.
Two, we have stated pretty consistently that we are going to start them off with an investment grade balance sheet. That should allow them to also make targeted acquisitions as appropriate? We can’t speak for that, it’ll be up to the management team post spin. But that is a place. We’re always in a market where it’s a scale game, that’s definitely a way that you can both grow and gain market share.
Three, Jim mentioned that a third of the restructuring charge is for also improving the EBITDA profile of the spin company. That is going to allow them to also invest in new offerings in areas such as cloud modernization, as well as added offerings in aspects of compliance and security and resilience. And also in much more automation, which is going to allow them to deliver even higher service delivery excellence to their clients. So when I look across all those, the opportunity is certainly there, and freeing them up to do deals, which we might not do because the margin may be diluted to us but it’s going to be accretive towards the new company, to possibly MNA down the road, but that’s not for some time. And three, in terms of leveraging new offerings and partnerships with other companies who might be doing it, but maybe not as wholeheartedly as they would do it with an independent company.
Speaker 4: (58:26)
Great. Thank you David, and let’s go to the next question please.
Our next question comes from Keith Bachman with Bank of Montreal. You may proceed.
Keith Bachman: (58:35)
Hi, many thanks for taking the question and congratulations on the ongoing success of Red Hat. I actually wanted to ask a clarification question to Jim. Arvin, on a clarification, I wanted to come back to MNA. You seem to be talking more about MNA on this call than in previous calls. And per a previous question, I’m just not sure of the financial resources now that you have to be aggressive about MNA, in that IBMs typically generate between 12 and 13 billion of free cash flow, and if you have six billion of dividend payment, it just doesn’t leave a lot of room for MNA. So is the message that you may look to get a way from an investment grade rating? I’m not sure how to make the math work when you say impactful, And then I’ll just ask my question of Jim if I could.
Keith Bachman: (59:24)
Jim, you’ve talked about GBS and how you’re confident of growth there. I certainly think consulting business can improve, particularly next year as we get into presumably better economic cycles. Yet application management and global process were weak before the pandemic hit. In fact, there had been growth challenges throughout ’19. And so I just wanted to hear a little bit about those two businesses. What are your expectations on an organic basis, when you think about GBS for roughly half the revenues that frankly were pretty growth challenged before the pandemic that’s hit many things?
Okay Keith. Actually, Arvin If you don’t mind, let me take both. Because I think part of the first question, you’ve already answered from a strategic capital allocation perspective on what we want to do with regards to our investment profile, both organically and inorganically. But Keith, the heart of your question gets to a mathematical equation. And I think one, first you’ve got to recognize that there’s always been seasonality in our free cashflow. Albeit, we delivered $4.8 billion year to date in free cashflow overall. As you all know quite well, well over 50% of our free cash flow in this business comes in the fourth quarter. That coupled with… We talked about two quarters ago at the onset of COVID-19, how the business model composition of IBM. With its geographic diversification, its industry composition, its client segmentation. Being more large enterprise focused, and it’s annuity content of both high value software, high value hardware platform and high value services piece provides a natural hedge in this environment to stability around revenue, profit and cash.
Now yes, over the last couple of years, we’ve been driving around $ 12 billion of free cashflow. In light of the economic challenges due to COVID-19, that number just trajectory wise will be less this year. We’ll see how fourth quarter plays out, but we’re very confident in our portfolio. In fact, even more confident given the decision that Arvin and the entire IBM team and our board made on October 8th around repositioning two market leading companies. One with an IBM on an accelerated growth profile with an already very strong EBITDA margin business that is going to generate significant cash. And then two, the market-leading infrastructure services business that is two X the next competitor. And in that business as you all understand quite well is a scale economics business.
So from that aspect, I think when you look at our fin flex? Our fin flex only gets better. And with our disciplined financial capital allocation policy that this company operates on, we feel very comfortable that we got ample free cashflow to invest in our business organically and inorganically to deliver and hit those targeted leverage ratios, and also to maintain our return to shareholder program with a secure dividend and sustainable dividend growth policy overall. So that’s the first question.
Second question, when you look at GBS? As I talked about, we did see signs that demand improvement here in the third quarter. And if you remember 90 days ago, we talked about the first half of second quarter and the second half of second quarter in the month of June, and we saw some nice growth in June. Well, that continued into the third quarter, where double digit signings growth overall. And by the way Keith, that was pretty pervasive. That was good growth in consulting, but it was led by large transformational deals around application services in this environment to capitalize on our client’s journey to cloud. That then dragged with it our global process services, where clients are now digitally reinventing themselves and how they run their companies around intelligent workflows.
So we’re seeing that demand inflection move. Now to your question, that revenue is more long-term as we play out. But when we look at our current backlog and our current backlog run out for our GBS business? In 2021, we see GBS getting back to pre-COVID growth rates by mid-year, and a big chunk of that is improvement across all of the three sub-segments.
Speaker 4: (01:04:26)
Thank you Keith. Sheila, let’s take one last question please.
Thank you. Our last question will come from Tim Suba with Citigroup Investment Research. Your line is open.
Tim Suba: (01:04:37)
Thank you very much. A pretty clear or easy question here is, you’ve talked and highlighted IBM’s significant cashflow strength, and I believe it’s the high priorities of paying down debt to get closer to investment grade, and then the spin out of the company and get it well positioned. Post all that, is a focus mostly on dividends and MNA, and we should think about stock buyback as being less of a feature compared to past history of IBM, where a lot of EPS growth has been driven by stock buyback? But it seems like perhaps maybe the view is that the management and the board thinks that the stock buyback isn’t generating shareholder return, so maybe shifting more towards MNA? Is that the way to read the last half hour week we heard through the Q&A?
Yeah Jim. This is Jim, let me take that and then I could wrap it up with Arvin overall. As you know quite well, our discipline capital allocation process first and foremost focuses on how we reinvest back in our business, both organically and inorganically. And we are focused now with the strategic move that we announced, we laid foundation we talked on October 8th, we laid that foundation over the last couple of years, instantiated in the Red Hat acquisition which was a bold move. We have been building and accelerating that growth, now we want to capitalize on that one trillion dollar hybrid cloud opportunity.
Now with that said, just given our investor mix. Outside of allocating capital and investment to our own business, when we have excess cash, we’re going to return that back to shareholders. That priority right now is our secure dividend and sustainable dividend growth policy. And as we get back to our targeted leverage ratios? At that point in time, we’ll reevaluate share repurchase, but there’s no need talking about that right now.
Okay, thanks Jim. Look, just to reiterate, we have talked about growth, we have talked about a maniacal obsession on hybrid cloud and AI as the engines of growth for the company. Let me just make a couple of comments to wrap up the discussion. We are certain on our direction even in these uncertain times, and we are laser focused on helping our clients with their digital transformations. Leveraging our hybrid cloud technology platform, our incumbency and our expertise. And the actions we are taking starting now in the fourth quarter will enhance our focus and accelerate our future growth. And I look forward to continuing this dialogue with you.
Speaker 4: (01:07:24)
Sheila, can we turn it back to you to close out the call please?
Absolutely, thank you. Thank you for participating on today’s call, the conference has now ended. You may disconnect at this time.