International Business Machines Corp

NYSE:IBM

Earnings Call Transcript 2020-Q3

[Operator]

Welcome, and thank you for standing by. At this time, all participants are in a listen-only mode. Today’s conference is being recorded. If you have any objections, you may disconnect at this time.

Now, I will turn the meeting over to Ms. Patricia Murphy with IBM. Ma’am, you may begin.

[Patricia Murphy, VP, IR]

Thank you. This is Patricia Murphy, and I want to welcome you to IBM’s Third Quarter 2020 Earnings Presentation. I am 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 that could cause our actual results to differ materially. Additional information about these factors is included in the Company’s SEC filings.

Our presentation also includes non-GAAP 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 wrapped 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-GAAP measures at the end of the presentation and in the 8-K submitted to the SEC.

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.

So, with that, I’ll turn the call over to Arvind.

[Arvind Krishna, Chief Executive Officer]

Thanks Patricia. I’m pleased to be speaking with you again just a week and a half after our strategic update on October 8th. Today, we’ll focus on our third quarter performance, which you’ll see is unchanged from the preliminary results we announced. But I want to start with a summary of our strategic discussion. We are redefining our future as a 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 trajectories.

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 investments 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.

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 is 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.

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 innovations we are bringing to market. We have great recent examples of clients making large-scale architectural commitments to our hybrid cloud platform.

Schlumberger 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 are also extending our relationship with Delta to transform their talent and modernize their IT environment using Red Hat, Cloud Paks, and leveraging GBS’ 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. As an example, Ernst & Young is now leveraging our open hybrid cloud platform and AI 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 the expansion of our 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 its 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 Kubernetes, which delivers the industry’s most robust multi-cluster, policy-based compliance and application management system. These capabilities are furthering our clients' abilities to "build once, deploy anywhere" with a hybrid cloud architecture.

In Quantum, we announced our roadmap to reach 1,000-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 have made good progress with clients, our ecosystem, and innovation.

Regarding today’s environment, clients continue to balance short-term challenges and opportunities for transformation. In the short-term they 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 in the continued momentum in Red Hat and in the large client engagements that enables a journey to cloud, leveraging both OpenShift and application modernization.

Now I’ll turn it over to Jim Kavanaugh, who is going to take you through the results, and then we’ll come back at the end for Q&A.

[Jim Kavanaugh]

Thanks Arvind. 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 cash flow, 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’ve previously discussed, our broad geographic footprint, and client and portfolio mix provide some stability to our revenue, profit and cash flow.

As Arvind 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.

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.

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 and large account incumbency.

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. 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 are 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 build outs 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.

This quarter, our portfolio mix with strong software contribution together with our focus on productivity, drove operating gross margin expansion of 160 basis points and operating pre-tax 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 remain strong fueled by our cash flow. We generated $1.1 billion of free cash flow 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 interest. These were offset by higher net capital expenditures and workforce rebalancing payments.

Over the last year, we generated $10.8 billion of free cash flow, which is 136% of GAAP 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 are in good shape to fund our upcoming maturities including $4 billion to $5 billion in the fourth quarter. We’ll end 2020 with debt down for the year.

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 on 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.

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 are 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 ago and added nearly 200 clients to our container platforms in the third quarter.

Cognitive Applications revenue trajectory improved to flat year-to-year led by strength in 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 are driving adoption of our CloudPak for Security and QRadar on 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.

Looking at the profit for this segment, we had strong profit and margin performance driven primarily by Red Hat contribution.

Turning to Global Business Services, revenue declined 6%, consistent with last quarter. As you’ll recall, prior to the pandemic, GBS was growing revenue and signings. Since March, our revenue has reflected the economic environment and a change 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 returned 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%.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 followed the pandemic curve by geography, but returned to growth overall for the quarter.

With the expertise and process knowledge gained through our application management incumbency, clients trust us to guide them through architectural decisions and facilitate their transformations with a 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. For example, about one-third of Cloud Pak revenue results from GBS engagements and, this quarter, we added another 60 Red Hat client engagements with such clients as Delta Airlines, which Arvind mentioned earlier, but also Royal Bank of Canada, IT Ergo, Florida Power and 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 1,500 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 to drive productivity, pace and quality.

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 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. They turn to GTS’ Managed Infrastructure Services business for its deep expertise in managing mission-critical infrastructures and its 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.

GTS’ 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. This has resulted in the backlog year-to-year trajectory improving by approximately two points from the beginning of the year.

Turning to GTS 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.

Turning to 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 dev ops offerings. 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 in client buying behaviors impacted our performance in the third quarter and will lengthen the adoption curve of this z15 cycle.

But by the end of this cycle, we have an opportunity to be fairly consistent with prior cycles. I’ll remind you, in the fourth quarter, we’ll be wrapping on 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 are 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 are accelerating IBM’s hybrid cloud platform strategy with increased focus and investments to drive future growth. We are 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 increased investments starting now, we expect to drive sustainable mid-single-digit growth after the separation of NewCo is complete.

In the near-term, the rate and 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.

Looking at our year-to-year dynamics at the end of 2020, we are 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 the detailed work to separate our Managed Infrastructure Services business. We are confident in the focus and direction of our business and what it means for our future.

Arvind, let me turn it back over to you.

[Arvind Krishna, Chief Executive Officer]

Thanks Jim. I am going to add just one final thought before the Q&A. We are managing for the long-term. 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, VP, IR]

Thank you, Arvind. 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’d ask you to refrain from multi-part questions.

So operator, let’s please open it up for questions.

Our first question comes from Matt Cabral with Credit Suisse. Your line is open.

[Matt Cabral, Credit Suisse]

Thank you very much. Arvind, 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 are seeing around the world and you mentioned delays you are seeing in a couple of areas within the portfolio. Just wondering when you think those deals will start coming through, particularly they are starting to think about the puts and takes heading into 2021.

[Arvind Krishna, Chief Executive Officer]

All right. So first, thanks for the question, Matt. So, a few comments on – because you ask about portfolio areas, you also ask about clients and you also ask 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.

While we are seeing very healthy growth in some parts of both software and systems, it’s kind of – it’s frantic, but we are also seeing people pause. Now maybe they are pausing because of their industry or because of geography or because they are 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 et cetera. So, that’s a one part. Now, we have also talked about that there is about a 70% of the industries that we are in, we are not seeing any pause as we see clients there are healthy. We see that their businesses are healthy. About 30% and that should not be a surprise to anybody in 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 out of the flavor under it. But then as I begin to look forward, Matt, because you are asking that question also, it’s really hard to predict the fourth quarter. That’s why Jim and I are pausing on giving guidance here.

However when we look at our people interested in these parts of the software portfolio, whether it’s supply chain and security as Jim mentioned, whether it’s cloud and data platform which is inclusive both of Red Hat and our cloud packs and all the technologies they find essential, we find that those will come back. We find our transaction processing platform or TPP yet somewhat aligned to the mainframe capacity increases as those go through you tend to see, I’ll call it an alignment. It’s not necessarily identical but there is some alignment therein.

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 there in other areas. So, I’ll sort of give you that color sort of across the client set, across the industries and across different parts of the portfolio, Matt.

[Patricia Murphy, VP, IR]

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

[Operator]

Absolutely. Our next question comes from Tien-tsin Huang with JP Morgan. Your line is open.

[Tien-tsin Huang, JP Morgan]

Hi. Thank you so much. It looks like services hirings did bounce back nicely little bit here. So, it sounds like some larger transactions coming back. What I am understanding, maybe if you don’t mind just this transition from going with the tighter integration of GBS and GTS to the separation now.

Can we see services results and bookings maybe weaken 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 given the changeover but that makes sense. Thank you.

[Jim Kavanaugh]

Yes, Tien-tsin, 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, $9.5 billion of signings, up 5%. We got a $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 Manage Infrastructure Services business which saw a very strong renewal rate that talks to the value of innovation that they bring to our client 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 while we grew 20%.

So we are pretty pleased there and that’s led to a two point backlog improvement in our GTS business since January. But what we really have seen a marked inflection of some signs of demand change is in GBS.

And you know 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 clients’ 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 of transformational deals here in the fourth quarter and again, given our announcement ten days ago, we are spending a lot of time with our clients to make sure we minimize disruption, ensure stability and provide that client value going forward.

[Patricia Murphy, VP, IR]

Thank you, Tien-tsin. Let’s go to the next question.

[Operator]

Our next question comes from Toni Sacconaghi with Bernstein. Your line is open.

[Toni Sacconaghi, Bernstein]

Yes, thank you. I know you are 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 is not really changing, why shouldn’t we assume normal seasonality and is that kind of the right number or framework? And then, Arvind, I am wondering if you could just comment on capital allocation going forward?

Your dividend is $6 billion a year. It’s basically been a 100% a year 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 long-term 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.

[Jim Kavanaugh]

Toni, this is Jim. Thanks for the question, multi-part. But let me take the first piece around, color around fourth quarter and then, Arvind can handle the capital allocation discussion around the strategy and I have to see if I can handle some of the numbers overall. But first, as we talked about in the prepared remarks, and you indicated the rate and pace of the recovery we still see is uncertain.

And there is 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 give guidance. But, let me give you some color.

First, we talked about at the onsite of COVID-19 that this has only accelerated our clients’ 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 in hybrid cloud, AI solutions, App modernization, Cloud Transformation Services within GBS, Red Hat actual backlog growth is accelerating, up 23% at $4.7 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 that we 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 and it’s going to be pretty similar to the first half.

And the second is our mainframe cycle coming off with a significant portion of the growth last year up 63%. So when you look at skew overall, in the fourth quarter, 3Q to 4Q, yes, I mean, there will be no reason not to expect a normal skew with regards to revenue. Some slight improvement in our software 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 of 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 liquidity position to make sure that we can continue to invest in our business.

We are 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 50 – mid-50s.

We should do maybe a little bit better than that, but I don’t think anything substantial about that. So, we see pretty similar dynamics. Arvind, over to you.

[Arvind Krishna, Chief Executive Officer]

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 have deleveraged 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 will get there by 2022. So that’s part one.

And so some of the cash you see in the balance sheet will be used towards that purpose because you said you are not paying down that, 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. Our dividend to our investors given that how much they depend upon that and how much you have 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 are asking. We will be allocating more cash to growth going forward. I think the simple answer to that is, yes, with no qualifications therein.

[Patricia Murphy, VP, IR]

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

[Operator]

Thank you. Our next question will come from Wamsi Mohan with Bank of America. Your line is open.

[Wamsi Mohan, Bank of America]

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.

[Jim Kavanaugh]

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 pretax level.

So, I think you are seeing that productivity and the fundamental change and the way we are 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 ten 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 is 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 of double-digit EBITDA growth profile. The second bucket or second third of that was, in any business when you separate out, you are going to create stranded cost and inefficiency and we are 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 is 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 inorganic place overall. So, I’ll take that one and then Arvind, do you want to take the second one?

[Arvind Krishna, Chief Executive Officer]

Yes. So, when you look at the different segments that we are in, Wamsi, so this is straightaway in the four areas that we had outlined. Number one, we are going to be increasing investments in GBS in order to get more skills in the areas that we are seeing demand. Second, we are going to be increasing investments in our ecosystem and ecosystems that 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 investments in how we work with those. But there are also hundreds of ISVs, not just the very large ones, it’s one 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 a second piece. I’ll put that in the ecosystem bucket.

Third, we are 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, in 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 looking the different cloud partners.

So when you think of those four buckets, it now goes pretty much across all of IBM’s segments, Wamsi, if you think about it, because we wanted 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 got to be driving in terms of organic R&D, in terms of working with certain areas where there is a lot of demand.

So you 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 will also add to added expenses eventually while the moment you complete an acquisition as expense in these different segments.

[Patricia Murphy, VP, IR]

Thank you, Wamsi. Let’s go to the next question please.

[Operator]

Next we will hear from Katy Huberty with Morgan Stanley. Your may proceed.

[Katy Huberty, Morgan Stanley]

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 pro forma basis with Red Hat it’s declining mid-single-digits. Would love your thoughts on why we are not seeing a stronger growth rate. Is it entirely macro-driven? And whether the steps and timeline for getting that software business back to pro forma growth given how important it is to hitting those mid-single-digit longer-term growth target?

[Arvind Krishna, Chief Executive Officer]

Thanks, Katy. And you got it correct. It is a critical part of us getting towards a 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 would tell you that some of it is indeed maximally the wrong word, but I think as there is 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 is driven more as I’ve said before in terms of the alignment to the mainframe capacity that’s in the ground. So we saw very good growth in the fourth quarter or 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, but 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 in 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 teens, and we expect that that should be able to continue and accelerate, then that in turn will give added growth to the whole portfolio more than enough to offset any weakness in TPP and then as you 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 do take multiple quarters to play out.

I wish it was quicker, but it is multiple quarters, but I would fully expect it at the same time as we complete the spin, we should be able to see those growth return in those parts of the portfolio and you got to fence of how we’ll do it across those various elements.

[Patricia Murphy, VP, IR]

Thank you, Katy. Sheila, can we take the next question please?

[Operator]

Absolutely. Our next question comes from Amit Daryanani with Evercore. Your line is open.

[Amit Daryanani, Evercore ISI]

Thanks for taking my question. I guess, Arvind, I would love to just hear the feedback you’ve gotten from your customers over the last ten days post the announcement of defense and it is pretty what I am kind of thinking about as the - pause in signing longer term deals so the spin is done and that could get perhaps that applies or spend growth. So, just any feedback over there would be helpful.

[Arvind Krishna, Chief Executive Officer]

Yes, great question, Amit. So, as you can imagine, this is something in which I think the only word I can use is, we are obsessive about this topic. We had our lists out. We knew exactly of 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 you give you a sense, we sort of internally, this is not something that we also tell the client, but based on the reaction, I mentioned that we already spoken to hundreds. So you can think that but now that we are ten days in, we have already spoken to at least between two and three hundred of the top clients where there is a strong intersection or where there is a very heavy SPINCO revenue base or deals that could be on the table.

And from there, we have gotten back over 80% our corridor 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 – we’ll do enough on both sides that they do have some concerns.

Both of those concerns are around, who is team that will be providing service. Who is the person whose going to be on the ground and we should be very clear that SPINCO is going to head out on day one with $19, the same management team on the ground who runs it from the client up is going to be team that does it.

Yes, it’s a corporate structure that we’ve 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 upturn that they provide, but also they bring very deep technical skills which is kind of gives them permission and the trust to play.

So, when I put all of that together, I think that there is a couple of dozen clients where we just have to make sure that we can tell them who is the team there is going to be servicing them and as they begin to get comfort on that, I can see the level of anxiety reduce. But as I said, over 80%, they understood what was happening and also many clients the majority on one or the other of naturally for them there is going to be less of a concern.

Now, to your point on why would they complete the deals. Look most of the larger deals are to our clients’ benefit. We 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 are going to defer your benefit for three to six months.

So, I think what drives things and luckily they have a month to sort of on both side, both our team as they find to sort of understand each other then there is still 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’ll be able to see most of the deals progress to a satisfactory conclusion.

[Patricia Murphy, VP, IR]

Thank you, Amit. Let’s go to the next question please.

[Operator]

Our next question comes from David Grossman with Stifel. Your line is open.

[David Grossman, Stifel Nicolaus]

Thank you. So, I know the end-markets have shifted quickly and I think I understand the challenges associated with reposition that Q2, that’s as I am having a harder time calibrating how you are thinking about the longer-term growth prospects for this business. Can you give us any insight into your analysis of the longer-term growth of the business? And what it really means to run it for cash flow? Does that simply mean that it continues to decline at a modest rate and generate cash or does that mean something totally different?

[Arvind Krishna, Chief Executive Officer]

Hi, David. Look, 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 has told us. A couple of things in there. Within that, if I find where is our portfolio and our clients today, is probably more heavily weighted and about 60% of that total as opposed to all of it. And we think that the ability to form many more partnerships as standalone is going to allow IX to much more fully participate in the complete market.

Two, we have waited pretty consistently that we are going to start them off with a investment-grade balance sheet. That should allow them to also make targeted acquisitions as appropriate. We can’t speak for that and we up to the management team post spin. But that is a place we are always in a market where it’s a scale game. That’s definitely a way that you can both grow and gain market share.

And so, two, 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 deals which we might not do, because the margin maybe dilutive to us, but it’s going to be accretive towards the new company, two possibly M&A 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.

[Patricia Murphy, VP, IR]

Great. Thank you, David. And let’s go to the next question please.

[Operator]

Our next question comes from Keith Bachman with Bank of Montreal. Your may proceed.

[Keith Bachman, Bank of Montreal]

Hi. Many thanks for taking the question and congratulations on the ongoing success of Red Hat. I actually wanted to ask a clarification question, Jim. Arvind, on a clarification, I wanted to come back to M&A, you seem to be talking more about M&A on this calls and in previous calls, and per previous question, I am just not sure the financial resources now that you have to be aggressive about M&A in that IBM typically generate between $12 billion and $13 billion of free cash flow and if you have $6 billion dividend payment, it just doesn’t leave a lot of room for M&A.

So is the message that you may look to get away from an investment-grade rating? I am just – I am not sure how to make the math work when you say impactful and then, I’ll just ask my question to Jim, if I could. Jim, you talked about GBS and how you are 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 have – where we before the pandemic hit and in fact – not had been growth challenges through 2019. And so, I just want to hear a little 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 it. Many thanks.

[Jim Kavanaugh]

Okay, Keith. Actually, Arvind, if you don’t mind, let me take both. As 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 got to recognize that there is always been seasonality in our free cash flow albeit we delivered $4.8 billion year-to-date in free cash flow 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, be a more large enterprise focus and its annuity content of both high value software, high value hardware platform and high value services piece provides a natural hedge in this environment the stability around revenue, profit and cash.

Now, yes, over the last couple of years we’ve been driving around $12 billion of free cash flow 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 are very confident in our portfolio, in fact even more confident given the decision that Arvind and the entire IBM team and our Board made on October 8th around repositioning two market-leading companies.

One within IBM and an accelerated growth profile with an already very strong EBITDA margin business that is going to generate significant cash and then two, a lead in the market-leading infrastructure services business that is 2x 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 cash flow to invest in our business organically and inorganically to delever 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 of 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. While 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 clients’ journey to cloud. That then drag listed our global process services where clients are now digitally reinventing themselves in how they run their companies around intelligent workflows.

So we are 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 runout 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 the three sub-segments.

[Patricia Murphy, VP, IR]

Thank you, Keith. Sheila, let’s take one last question please.

[Operator]

Thank you. Our last question will come from Jim Suva with Citigroup Investment Research. Your line is open.

[Jim Suva, Citigroup Investment Research]

Thank you very much. A pretty clear easy question here is, you’ve talked and highlighted IBM’s significant cash flow strengths 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 the focus mostly on dividend and M&A and we should think about stock buyback as being less of a feature compared to past history of IBM or 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 think that the stock buyback isn’t generating shareholder returns.

So they’d be shifting more towards M&A. Is that the way to kind of read the last half hour we heard through the Q&A?

[Jim Kavanaugh]

Yes, Jim. This is Jim. Let me take that and then I could wrap it up with Arvind overall. As you know quite well, our disciplined 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 the foundation we talked on October 8th.

We laid that foundation over the last couple of years, instantiated in the Red Had acquisition which was a bold move. We have been building and accelerating that growth. Now we want to capitalize on that $1 trillion 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 are going to return that back to shareholders.

That priority right now is our secure dividend and sustainable growth policy and as we get back to our targeted leverage ratios, at that point in time we’ll reevaluate share repurchase. But there is no need talking about that right now.

[Arvind Krishna, Chief Executive Officer]

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. But 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 transformation 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.

[Patricia Murphy, VP, IR]

Sheila, can we turn it back to you to close out the call please?

[Operator]

Absolutely. Thank you. Thank you for participating on today’s call. The conference has now ended. You may disconnect at this time.