Q3 2019 Earnings Call
Welcome and thank you for standing by at this time all participants are in 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 Mr., Patricia Murphy with IB Ma'am you may begin.
Thank you. This is Patricia Murphy, Vice President of Investor Relations Friday, and I want to welcome you to our third quarter 2019 earnings presentation.
I'm here, Jim Cavanaugh, IDN, Senior Vice President and Chief Financial Officer.
Well post today's prepared remarks on the IB I'm investor website within a couple of hours and the replay will be available by this time tomorrow.
Some comments made in this presentation, maybe 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 growth at constant currency throughout the presentation.
In addition to provide a view consistent with our go forward business will focus on constant currency growth adjusting for our recently divested businesses for the impacted lines of total revenue cloud and our geographic performance.
Provided reconciliation charts for these and other non-GAAP measures at the end of the presentation and in the 8-K submitted to the FCC.
I also want to remind you that are the EMS revenue profit and earnings per share reflect the impact of purchase accounting and other transaction related adjustments associated with the acquisition of Red hat.
These adjustments and charges are primarily noncash.
So with that I'll turn the call over to Jim.
Thanks, Patricia and things so all of you for joining us in the fourth quarter, we delivered $18 billion of revenue.
<unk> point $4 billion of operating net income in $2.68 of operating earnings per share.
We continued our strong cash generation with $12.3 billion, a free cash flow over the last year, which is 126% normalized free cash flow realization.
And we reduced our debt balance by nearly $7 billion since the end of June maintaining a strong balance sheet.
This quarter, we continue to see good performance in the key high value areas of data and they are high security cloud and digital.
We continue to bring new innovations to the market.
Watching or Z 15, mainframe and container I think our software and of course, we closed the acquisition of Red hat, where we've had a good first quarter with red hat revenue growth accelerating to 20% on a normalized basis.
Let me give you a little more color by segment.
Cloud and cognitive software was up 8% this quarter led by growth in cognitive applications and cloud and data platforms, including the contribution from Red hat.
Global business services revenue was up over 2%.
And we expanded gross margins.
Once again, we had solid performance in consulting driven by next generation application offerings and an application modernization for the cloud.
And global Technology services revenue was down 4%.
We continue to have good growth in the services that help our clients to move and managed cloud workloads and our cloud revenue in the segment was up 10%.
But our GTS performance fell short of our expectations due to lower in period revenue from client business volumes in certain markets.
While the volume impact was near term revenue and profit implications.
We had good long term signings and a solid pipeline of deals that deliver productivity to clients in this environment.
Our systems revenue was down 14%, primarily reflecting the backend of our Z 14 mainframe product cycle.
We continue your best to bring new innovation to our platforms and we announced our next generation of IB M. Z, which started to ship the last week of the quarter.
Our news the 15 has a strong value proposition and we had a solid start to the cycle inline what our expectations.
And so I'd be UBS performance continues to be led by areas that helps our clients with their digital transformations and journeys the cloud.
Across our segments, our cloud revenue growth accelerated to 14% and I'd be EMS cloud revenue over the last year is now over $20 billion.
We're entering the next chapter of cloud, which will be driven by mission critical workloads enterprise clients will need to securely deployed run and manage these workloads across on Prem private and public cloud environments.
These hybrid multi cloud environments will be based on a foundation of Linux would containers and kubernetes.
Red hat is at the center of this with a number one Linux operating system ROE and the leading hybrid cloud platform Openshift.
When we bring these together would I be UBS enterprise incumbency scale and expertise, where ideally position to lead in the significant hybrid cloud opportunity.
We've invested to bring new innovations to market leveraging the technology architecture of Linux containers and kubernetes, we have standardized on red hat Openshift as our hybrid cloud platform.
And Weve modernize our software portfolio. So that it can run on all private and public clouds, we've announced openshift on IBCM cloud and on IB M. Zee.
And we've introduced consulting and technology services for Red hat to capitalize on our expertise in digital Reinventions and our leadership position in managing mission critical workloads.
And now at the end of the third quarter, we're off to a great start as I said Red hat revenue in the quarter was up 20%.
That's normalize to provide a better comparability to red Hat's historical performance, but remember IB UBS reported results also include the deferred revenue purchase accounting adjustment, which by the way was within 30 million of the third quarter estimate we provided in early August .
The 20% growth is an acceleration from Red Hat's performance before we announced the transaction.
This quarter Red Hat's infrastructure business, which is predominantly ROE had double digit growth and continue to take share.
This is a great proof point of the continued importance of Linux as the foundation for enterprise workloads, and a hybrid cloud environment and momentum continued in application development and emerging technologies, driven by both Openshift and ansible.
We're adding new openshift clients that expanding red hat adoption in existing clients. For example in the third quarter I B M held red hat expand its footprint at visa and supported the clients strategy of accelerating technology platform innovation using open source solutions and so.
And its retail or El Corte dei inlays selected Red hat Openshift as the foundational technology together, what I'd be EMS migration and implementation services for its hybrid cloud strategy.
The expansion of the client base and the revenue trajectory are good indications of our clients confidence and the value of red hat and I'd be m. together.
And in terms of confidence of the workforce over the last several months Red hat hired about a thousand new associates to address the growing demand for the red hat portfolio and hybrid cloud value proposition, while employee attrition has been stable year to year.
So let me turn to IB EMS key financial metrics, which of course include Red hat.
As we discussed in the past I'd be EMS revenue profit and operating earnings per share reflect the impact of the noncash deferred revenue purchase accounting adjustments along with other transaction related activity. Our operating gross margin was flat so up 30 basis points when you exclude.
The impact from the divested businesses.
You'll recall, we took a workforce rebalancing charge in the second quarter to address the foregone profit of these businesses and some stranded costs will start to see more of the savings in the fourth quarter.
Our pretax income also reflects growth in expense. This operating expense increase was driven by the addition of Red hat, both operational spending and transaction related costs for equity retention and higher interest expense.
At the same time, our based spending reflects investments to bring our software and systems innovations to the market and we had a lower level of IP income.
Our operating tax rate in the quarter was a few points less than we estimated in early August .
Due to the timing of discrete tax items.
We continue to expect the full year all in operating tax rate of 9% to 10%, which includes red hat and and the estimate of discrete tax items for the year.
And so the year to year decline in operating net income and operating earnings per share was driven predominantly by the noncash purchase accounting adjustments.
But more importantly, our cash metrics are not affected by these adjustments, we generated $1.8 billion of free cash flow in the quarter and nearly 6 billion year to date.
Because our cash generation is so heavily skewed to the fourth quarter as always the trailing 12 months is the best way to look at our free cash flow performance on that basis, we generated $12.3 billion, which results in 126% normalized FFO.
Recast full realization.
Our strong cash generation and focused on capital allocation resulted in a stronger balance sheet.
Ending the quarter with a cash balance of about $11 billion and significantly lower debt levels versus 90 days ago.
So let me comment on how we've improved our debt profile. This quarter as you know we took on additional debt to fund the Red hat transaction and at the end of June we had $73 billion in debt.
This includes what I'll call core debt of $48 billion and $25 billion for our financing business, which is fully supported by our financing receivables.
Looking at our global financing debt, we're winding down our OEM commercial financing operations by the end of this year.
This reduces our financing debt and approves the overall credit quality of our receivables.
To accelerate reduction of our core debt, we suspended our share repurchase program.
We did this in early July when we closed the Red hat transaction.
The result of these actions is the reduction in IB EMS total debt from $73 billion to $66 billion during the quarter, that's nearly $7 billion and so I'd say our deleveraging plan is on track.
As we look forward our debt repayment profile provides good opportunity to continue the de leverage.
And as we said we're committed to achieving a leverage ratio consistent with a mid to high single a rating within a couple of years.
So now I'll get into the segment results, starting with cloud and cognitive software, which was up 8% this quarter.
We had strong growth at both cloud and data platforms now inclusive of Red hat and cognitive applications, while transaction processing platforms revenue was down.
Cloud revenue in this segment was up over 60% this quarter, reflecting the investments and steps we've taken to capture the hybrid cloud opportunity.
In cloud and data platforms, we delivered double digit growth as we begin to execute on the combined IBCM and red hat hybrid cloud strategy.
I mentioned earlier, the importance of Linux containers and kubernetes as the platform for hybrid cloud standardizing on Red hat Openshift.
We have containerized, our software and introduce cloud Pecs containerized software solutions that incorporate openshift and ROE.
We're re architecting and optimizing our offerings, including integrating technologies from IBM cloud private into our cloud packs and into Openshift.
And now just about 90 days following the closing of the acquisition Red hat demonstrated strong and broad based revenue growth this quarter.
And although early we're seeing green shoots and our newly launched cloud packs were working with over 18 Hunter clients with access to our container solutions, including Openshift and cloud packs. For example, Cvs health has selected multiple cloud pack offerings income.
Loading the cloud pack for integration in support of their hybrid cloud initiatives for agile data services and improved consumer experiences.
These offerings will combine the power of IP M. software with Openshift and rail.
Cognitive applications revenue growth of 6% was led by security software and services and industry verticals like Aiotv.
In security, we were just recognize again by Gartner as the number one enterprise security vendor.
We continue to see strong performance in our threat management software and services offerings like Q radar and ex force threat management.
We recently announced the project working with the city of Los Angeles, and the L.A. Cyber lab to provide threat intelligence to local businesses to proactively fight cybercrime, leveraging ex force incident response and intelligence services.
And as clients are increasingly looking to migrate secure operations to the cloud we're seeing traction with the combination of Q radar on the cloud and ex force threat management for managed threat monitoring services on the cloud.
And I O T. We had traction across the portfolio, including in our maximal and try Riga offerings.
We continue to invest in new offerings, and our industry specific solutions like Maximo for transportation maximal for oil and gas and Maximo for aviation had been resonating with clients.
And then in our transaction processing platforms, which includes software that runs of mission critical workloads on our hardware platforms revenue decline this quarter, while much of this revenue as annuity base in any quarter. The performance reflects the timing of larger transactions.
That are tied to client buying cycles.
Looking at the profit for this segment the decline in pre tax margin was primarily driven by the purchase accounting impacts from the Red hat acquisition.
Moving to global business services revenue was up over 2%.
And gross margin expanded by 110 basis points.
Consulting revenue grew 5% driven by offerings that address cognitive technology application modernization and next generation enterprise applications, such as S. Four Hannah and Salesforce.
Application management was flat.
We had growth in our strategic areas of application modernization, such as cloud application management and application development on emerging platforms offset by declines in traditional enterprise application management.
GBS brings together deep industry expertise and technology to provide clients, what a holistic approach to de risk and orchestrate their digital transformation journeys.
Our cloud application offerings help clients, the implement cloud centric architectures to modernize and automate their application portfolio.
This is where we're seeing some early progress in synergies with Red hat as we standardized and Openshift as our preferred development platform. This quarter, we signed over 20 deals across industries, ranging from telecommunications that banking and financial services to travel and try.
Exportation to retail, which utilize red hat capabilities to modernize their application portfolio.
GBS also works what enterprises to leverage cognitive technologies to drive insight and process improvements as they evolve from isolated use cases, the deploying AI at scale.
We have good traction here with double digit growth this quarter in our process reengineering and business decision support practices.
Turning to gross profit GBS gross margin was 31%.
The 110 basis point margin expansion was driven by continued mix shift to higher value offerings yield on our delivery improvement productivity in utilization initiatives and currency benefit from leveraging our global delivery resource footprint.
And global Technology services total revenue declined 4%.
Last quarter I mentioned that based on the backlog run out we saw an inflection point in the year to year revenue in the second half.
This was based on an improving trajectory in the run out projections over the subsequent quarters.
Revenue from backlog represents about 90% of next quarter's revenue and 85% two quarters out.
So it is typically a good indicator of the total revenue performance.
In the third quarter the in quarter revenue did not come in as expected.
We had lower customer business volumes in certain markets and some multinational clients versus our expectations and this impacted the growth rate by an additional point.
Because this work leverages existing resources it has a higher margin profile and so these lower volumes impacted our gross margin, which was down about a point from the prior year. We have a supplemental chart that describes the revenue dynamics in more detail.
But now taking a broader perspective.
We had good overall signings.
Our GTS signings were up 20% this quarter and signings are also up over the last 12 months.
This results in a one point sequential improvement in the GTS year to year backlog performance.
The signings growth is driven by cloud our cloud signings were up over 60% and cloud now comprises over 40% of the GTS outsourcing backlog.
This is up from just over 25% as we exited 2017.
Enterprises are in the early phases of their journeys to modernize their infrastructures to deliver savings productivity and innovation.
We are ideally position to move our clients to the cloud and de risk the journey for them.
We've been shifting our portfolio to capture this opportunity.
Investing in our cloud capabilities, while de emphasizing and exiting certain lower value content.
We have realigned our offerings across our clients cloud lifecycle journey of advise move build and manage.
We've been infusing our offerings would IP and now leveraging red hat's capabilities.
M. services is taken in integrated approach to application modernization for the hybrid cloud.
At the same time, we have continued to expand our cloud availability zones and data centers.
And in the coming weeks, you'll hear more from us on how companies from across some of the most highly regulated industries are turning to IB EMS public cloud as their preferred destination for mission critical workloads.
The IB I'm cloud offers these clients the highest level of security, leading data protection and the best infrastructure to run Red hat, Openshift and enterprise grade workloads and so we're going to continue to deliver solid growth in cloud and this will drive performance over the long.
Longer term, but.
But in the short term given the dynamics around the lower client consumption, we're going to manage for margin profit and cash.
We're continuing to deemphasize low margin offerings and contracts will get more benefit from the workforce actions, we took in the second quarter.
We're scaling our agile services delivery model and accelerating our use of AI and automation in our delivery operations and finally in the near term, we're going to aggressively manage our variable spending while of course continuing to invest in cloud capabilities.
So now turning to systems revenue was down this quarter, reflecting the backend of our product cycles.
Let me walk through the dynamics across the portfolio.
In the third quarter IBCM Z revenue was down 20%.
This is compared to good growth, we had in the third quarter of last year.
The mainframe isn't a during platform.
And in September we announced our newest and most advance mainframe Z 15.
As I said, we had a solid start to the cycle based on shipments in the last week of the quarter.
Building on the momentum from the advanced security of the 14, the Newsy 15 capabilities extend the platforms differentiation.
Encryption everywhere is the industry's first commercial data privacy and security enforcement solution.
Including data privacy passports, which allow for remote access management.
The 15 also supports private and public clouds via Linux Kubernetes in industry standard tools.
With the introduction of Red hat Openshift support this new mainframe most support cloud native development within enterprises.
And instead recovery significantly reduces the impact of planned and unplanned downtime.
Enabling enterprises to get back to work more quickly.
Putting all this together, we're offering clients improved productivity security and efficiency would see 15.
Power revenue was down 27% this quarter I'll remind you in the third quarter of last year, we had the best power performance in some time.
Due to the introduction of mid range and high end power nine and the rollout of our supercomputers for the U.S. Department of energy labs in the second half of 2018.
Power continues to offer clients the performance resiliency and security capabilities, a power nine to optimize enterprise workflows.
In storage revenue was down 4%.
This is an improvement in the year to year performance compared to recent quarters, driven by our high end and growth in all flash array.
We're focused on continued innovation in storage and we announced the next generation high end system DS 8900, together with the mainframe in mid September .
Looking at systems profit pre tax profit margin was down reflecting mix headwinds and the investments, we're making to bring new hardware innovation to market.
Turning to cash flow and balance sheet as I said, we've now generated $12.3 billion of free cash flow over the last 12 months in the third quarter, we generated $2.5 billion of cash from operations, excluding our financing receivables and 1.8 Bill.
In our free cash flow.
That brings our year to date free cash flow, the $5.9 billion, which is up about $500 million year to year.
These results reflect our operational performance effective capital management in some of the expected headwinds we mentioned at the beginning of the year.
On capital expenditures, our strategy to deemphasize lower value content across our services and financing portfolios contributed to our Capex decline year to date Capex also reflects the benefit from real estate sales in the second quarter.
You will recall at the beginning of the year, we said, we expected a headwind on cash taxes.
We saw some of that materialize in the third quarter and expect an additional headwind in the fourth as well.
Also reflected in our performance is the impact from a software and services divestitures I'll remind you that the proceeds from the divestitures are considered and investing activity. So are not included in our free cash flow.
Finally, red hat had strong operational free cash flow performance, which was offset by incremental interest expense in some retention payments.
As we have said, we expect red hat to be free cash flow accretive within 12 months of closing.
Looking at the uses of cash over the last three quarters, we've returned $5.6 billion to our shareholders, including $4.3 billion in dividends and $1.4 billion of gross share repurchases as we previously disclosed we suspended our share repurchase.
Just program when we closed the red hat transaction.
And then recapping the balance sheet highlights we ended the quarter with $11 billion in cash which is down from $46 billion in the second quarter.
With approximately $34 billion used to close the red hat transaction.
As I mentioned earlier total debt was down nearly $7 billion from the previous quarter.
So to sum up the cash and balance sheet dynamics, we continue to generate strong free cash flow and together with the portfolio actions, we've taken and the suspension of share repurchases were positioned to return to our targeted leverage ratios within a couple of years.
In the meantime, our balance sheet is strong with the flexibility to support our business.
So I'll make a few summary comments on the quarter end the year before we move on to Q and eight.
During our Investor webcast back in August we shared our strategy and differentiation to address the hybrid cloud opportunity.
We had been building a strong foundation and now with Red hat, where even better position to win in chapter two of our clients digital Reinventions.
In the third quarter, you saw IB M. and Red hat are off to a great start and across IBCM, our cloud revenue growth accelerated.
From a segment perspective, we had good growth in cloud and cognitive software and and global business services.
In systems, we had a solid start to our Z 15, which shipped at the ended the quarter and we announced a new high end storage.
Global Technology services also had strong cloud results, but overall performance was weaker I described the dynamics and in the short term, we're going to manage this business for margin and cash.
Outside of the impact from the divested businesses, our gross margin expanded reflecting operating leverage which is an important element of our model.
And our expense reflects a higher level of investment as we continue to bring new innovations to market.
And so as we move into the fourth quarter. This is seasonally our biggest transaction quarter.
It will be the first full quarter of availability for our Z 15, and we're expecting a normal IBM Z cycle.
And we're assuming we have solid software transactional execution and of course, we're still facing a strengthening dollar.
With all of this and a steady economic environment, we continue to expect to deliver at least $12. An 80 cents of operating earnings per share and free cash flow of 12 billion for the year.
This is consistent with the view we provided on August 2nd when we updated our view of the full year for the acquisition or Red hat.
And with that we'll take your questions.
Thank you Jim before we begin the queuing <unk> I'd like to mentioned a few items.
First I'll remind you of the year to year growth rates for providing today for red hat our normalized.
To provide comparability to red hats historical performance.
Second we have supplemental charts at the end of the slide deck that provide additional information on the quarter.
This includes the GTS revenue dynamics chart, Jim mentioned, a few minutes ago.
And finally as always I'd ask you to refrain from multi part questions.
So operator lets please open it up for questions.
Thank you at this time will begin the question answer session at the constraints to ask a question. Please press star one entry quite your name clearly if you need to withdraw your question Prestart Q I can't you asked the question. Please press Star line.
Our first question comes from Wamsi Mohan with Bank of America. Your line is helping.
Hi, yes. Thank you Jim Thanks for the incremental color on the other drivers of the GTS shortfall in the Supplementals. What do you think is the root cause of the lower volumes in the quarter or do you think it's a macro pause and if you fast forward to 2020 to the backlog run off support slots.
GDS revenue or are the exiting two week in 2019 to also that right now and if I could on the GTS margin front, how much else Dennis I think you alluded to the lower volumes being.
Mainly the issue, but most pricing also an issue in the quarter on GTS margins. Thank you.
Okay. Thanks, Wamsi I appreciate the the question. So let me start with the last part of that multiple part question.
Because as I stated in the prepared remarks.
When you look at a GTS business profile as you know high value hi, annuity content business and when we're looking in quarter about 90 plus percent of our revenue in quarter comes out of that backlog. Now you also have a labor based structure, that's relatively fixed in a short period of time and 90.
Days and what you saw happened in the hopefully.
You have taken a look at the supplemental chart again for enhanced transparency for all of you. So you can understand the dynamics, what's happened to our business when that in period revenue that remaining 10% falls away. It has tremendous de operating impacts from a leverage perspective overall.
So that is high value high profit and when it hurts you at the latter part of a of the month a it definitely falls to the bottom line. So you know I'm sure we'll get into it we're taking a lot of action structurally we got out ahead of that in the second quarter, and we're well positioned to report turn back to margins in GTS.
As I stated in the fourth quarter, but lets go back to the first part of your question, which is you know that that in period, 10%.
Activity that really comes from two aspects one is based on our client business volumes that are embedded in our backlog and two new Selwyn bill signings that happen within a quarter. The latter began a minor part the former being the major part.
And when you take a look at what happened to us in the quarter.
We did get impacted by lower.
Lower client business base volumes that came out of predominately to markets in Europe that being the United Kingdom and in Germany, but I would tell you you know Europe overall, Europe was flat and pretty consistent with second quarter. Overall, so we still had good performance and our other.
Her based platforms a hardware software, we fell short, though in a client base business volumes and GTS.
So I wouldn't say its per se macro, but we obviously saw less activity, but you know we got to improve our execution period.
Thanks, Wamsi seemed like clean please go to the next question.
Our next question comes from Amit Daryanani with Evercore Your line is something.
Oh, Thanks, a lot good afternoon guys out.
Yes, just on the Red hat side, you, it's nice to see the robust 20% growth do you guys had this quarter with Red Hot I think the notable uptick then we're somewhat red hat freezing standalone at least what do you think is a longer term trend line that we should think about red hat's revenue growth as we go for forward on niobium, both maybe on the subscription and services side and you Jeff.
To kinda levels up this the 14% pretax margin drop off what happens drop in the cognitive segment, which is not as just transaction related worse as other factors. Thank you.
Okay. Thank you very much I. Appreciate you are you asking the question upfront here on Red hat, because obviously, we're very pleased and I think this is in instantiation and validation of the power of bringing IB EM and Red hat together and how it is better for our clients and for our shareholders overall.
We definitely made some significant innovation announcements.
Early August we talked about our business profile at Investor Day, and I think 90 days into this we're very pleased 20% growth overall at a normalized basis to give you a normalized historical comparison. So we're very pleased but let me talk a little bit.
About the progress and what we're seeing you know within that 20% growth and to your point I would definitely reference for our investors pre the announcement and October of 2018 Red hat was growing mid teens.
Just you know three four quarters later at the time of closing and our first 90 days you see the instantiation of that value <unk>, given we accelerated its a 20%, but let's talk about some of the other milestones and and and a key indicators one you talked about.
Sure we had strong growth in the infrastructure led by rail and that that returned to double digit growth of 12% if I'm not mistaken and it's it's been a long time since ROE actually it was growing 12% the application development emerging technology, including Openshift is growing mid Thirtys are open.
And ship and now our newly announced containerized software modernization of our software and cloud facts, we have now over an 1800 install base client.
<unk> embedded with that our backlog on a normalized basis up 19% and within the first 90 days, we talked a lot about at the Investor day, the deferred revenue write down that we had to take a 2.2 billion, we talked about over time the value of Red Hat's platform and tech.
Allergy and the high renewal rates well within the first 90 days, we actually replenished almost a half a billion dollars of deferred revenue because we had very strong bookings and those bookings were led by subscription we actually had 11 deals over $10 million, which was up threefold. So.
We're very pleased with Red hat overall, and I guess I will conclude most importantly, the confidence in the workforce and IBCM in Red hat attrition stable and we hired over 1000 people and lastly to your point about operating margin the entire operating margin impact was due to.
Transactional related cost okay. Thanks, Amit Clinton has got to the next question.
Our next question comes from tinge anyone with JP Morgan Your line is helping.
Hi, Thanks, so much maybe to build on that with Red hat doing a little bit better still going to cloud and cognitive overall that was weighed by.
Ah softer transaction processing platform as when you. So should we expect Jim this dynamic to can you continue Im just looking for clues here now legacy I'd be m. software might perform as you execute on Red hat.
Yeah, I mean, if you take a look at our Ah our third quarter performance, our cloud and cognitive software, we posted 8% growth. We're very pleased with that now obviously that that normalize red hat growth at 20% does not get consolidated Ensign IB EMS books as you all quite well know given the deferred revenue.
Adjustment in fact as you saw in a supplementals again for transparency as I committed to all of you since the beginning of the year Red hat delivered $371 million revenue little bit better than a round the threefifty that we talked about and within that.
Just to the to call it outright off the bat. This <unk> the 70 cents dilution that we expected in the third quarter. As we stated then repair remarks, we did about 30 million better on a on the deferred revenue write down by the way that's a skew vert threeq you versus fourth quarter, we still expect about $1 billion.
So in the second half of 19, so we're very pleased with that 8% overall by the way we grew organically to now to your point, we had very good growth in cloud and data platform led by our cloud packs great off to a nice start we grew in d. be too in our core offerings. We.
Grew when our organic base cognitive act applications portfolio with very strong growth in security and in some of our industry verticals like maximum and try Riga, but we actually did fall short and our transaction processing platform and as you know as I've said, many times, that's high value to us and.
It's high value to our clients because we run the mission critical workloads and applications on our systems portfolio and that's always tied to climb buying cycles now when you take a look to Europe to your question what do we see going forward into fourth quarter, we see pretty consistent performance high single digit in this segment.
You know a couple things I would call out number one we have a much tougher compare number two the difference between the amount of transactional activity, you're doing a fourth quarter versus third quarter is obviously a.
A big Hill to climb, but we've got a nice pipeline and it's all about execution I would not expect our TPP to come back here in the fourth quarter. We grew I think six 7% fourth quarter last year.
So we will not grow in TPP into fourth quarter, but we will have strong growth in cloud and data platform and in cognitive apps.
Thanks Tinge and can you got to the next question. Please.
Our next question comes from Katy Huberty with Morgan Stanley Your line is helping.
Yes. Thank you Jim just given all the moving pieces, but divestiture Ben.
Thanks.
How would you like that's bad.
Fourth quarter.
<unk>.
Sequentially.
Okay.
Great. Thanks, Katy I appreciate I think I got the the hard to your question you were breaking up there a little at least a in the room here on my speaker.
You know as you heard in their prepared remarks, we did reaffirm guidance at least 12 80 and about 12 billion a of free cash flow as we look into the fourth quarter, we expect revenue to sequentially increase about three and a half the 3.7 in that range quarter to quarter and as I just stated.
Nonetheless question, it's typically our biggest transactional quarter will ever excuse me.
Within a year now a couple points due to what you brought up so it's a little bit higher than what you had had asked one it's higher sequentially than 2018, and it's more representative of a normal mainframe cycle, which if you go back to 2017, we were right within that now to your point, there's a few things.
I want to call out and give a little color what's underneath that number one we continue to face a stronger and stronger dollar every quarter I if it feels like a each quarter I get up and I talk about that whereas 90 days ago. We were saying is it basically no headwind we were looking right now about a piece.
Just a point in half headwind in the fourth quarter based on where rates are at today second to your question. We still have a two point headwind give or take on the divesting of our software and mortgage processing base business, which was 2 billion annually or here in the fourth quarter. So those two are kind of headwinds now when you.
Take a look at our portfolio our mainframe we're very pleased with the initial start we announced it very late in the third quarter. We in essence have one weeks' worth the shipment it met our expectation and most importantly, the value proposition to strong value proper proposition around data for.
Privacy encryption everywhere.
Cloud native apps and in putting red hat Openshift on our mainframe and instant recovery are resonating well and we got a very good pipeline and we expect the normal normal cycle here in the fourth quarter and I would attach that to the high end DS 8000 that we also announced so systems, we feel pretty good.
About the innovation in about a striving to fourth quarter software I just talked about we see consistent performance services GBS.
GBS continues to have great momentum, we had a good signings quarter high single digit signings. We continue to have good backlog run out, but again GBS grew 7% last year, we had a strong quarter. We closed on a lot of milestone billings, but we still see growth here in GBS, albeit probably very low single.
Digits and continuing that momentum by the way GBS their backlog run out is actually improving right now as we move through 2020, So we see consistency and a GTS based on what I said in his prepared remarks, and you could see in the supplemental chart. It's prudent right now not the plan on anything better we are taking.
Actions to aggressively.
A change and adapt our portfolio our offerings, we're seeing very good green shoots in our cloud base of business in that segment and we're going to continue to adapt and change that overall, so we're going to manage this business from margin profit and cash and we're going after the rights structural actions going forward. So hopefully that gives you a little.
Color about the 3.5 through seven.
Thanks, Katy she'd like me place take nice next question.
Our next question comes from Toni Sacconaghi with Bernstein. Your line is something.
Yes. Thank you.
Jim you talked about a little bit of a different strategy focusing on cash and profitability up for GTS given that that's about 35% of your revenues and you're looking at maybe a more muted growth rate are you still comfortable in talking about four to five points.
Of growth and mid single digit growth for 2020, and then just related to that maybe you can just talk about the dynamics of of sort of what happened over the course of the quarter you provided a.
Some guidance on the early April call you fell a little short of that and it sounds like it was mainly GTS, but at that point did you not have a good read on what was happening.
With your your workloads during the quarter and I guess the question I'm asking did it did they continue to decelerate from there and what does that either say about the value proposition of GTS today for existing clients or more just about the the health of your of your clients. So.
Sorry, I snuck two in there, but one just how we think of revenue growth next year in light of GTS being lower and then to what sort of changed from August fit that Don Thank you.
As always Tony Thank you very much.
At least it was only two and not three like last quarter, but.
Who's counting anyways, let me try to take this in a couple different components. So we can unpack. This so you can understand fundamentally what's happening to us in GTS what happened throughout the quarter and then to your first part of your question what do we see overall for I.B.M. and 2020, which by the.
They will spend a lot more time on in January because given the amount of transactional business both on hardware and software, but also on services signing so we got to get done here in the fourth quarter, we got a very robust pipeline over the next couple of quarters and that will dictate you know more importantly, how 2020 will play out.
If you take a look at you know within the quarter. So let me talk a little bit about I'm not going to repeat what's on the supplemental chart. The net message of supplemental chart is 90 days ago, we printed down for as you all know in our GTS and technology services revenue.
That was basically all out of backlog in our in period Selim Bill activity and volumes from our clients was roughly muted. It was flat that was been consistent for quite a while we saw at that time, a backlog that ran out and third quarter, but roughly down three and then for.
This quarter was down one to two that was the driver behind calling the inflection point now how did the quarter play out quarter actually played out through August quarter to date, our GTS business was improving off of that down 4% that we exited second quarter, we were hover and about down three give or take.
This all happened late in the quarter and by the way to the earlier question. That's why you see it flow through our fixed structural cost that impacted our margins overall. So when you look at it you know it one it was tied to volume base businesses in a couple different markets around the world and.
Too it was tied to some part of our execution I'm not going to back off that from a credibility perspective, we've got to execute better there we've been focusing this business some margin profit and cash it is a high fixed costs high capital intensive business and we got to deliver that right return to our investors.
Given that we've chosen our capital allocation strategy with the acquisition, a red hat and the what we've done to our balance sheet to lever up which by the way we made a great down payment on with the $7 billion a debt we paid down but it happened late in the quarter.
We are taking action around that now I'll conclude entering into 2020, we continue to see very strong performance as we continue to adapt our portfolio and our offerings and GTS argued to capture what we believe is that chapter two of hybrid cloud.
One our cloud base of business.
With regard to our backlog RG test backlog $80 billion.
Over 40% of that backlog is cloud.
By the way and I know you've done a ton of analysis on this over the last five years, our GTS backlog ex currency is flat.
And within that we went from low single digit cloud content, the 40% cloud content overall, and now with the acquisition or Red hat and building out differentiated offering and capabilities, we expect that to accelerate as we go forward, we delivered 60% signings growth in a fourth quarter, 40%.
Of our backlog now is cloud and we got a book of business on trailing 12 months in excess of $8 billion on cloud. So when we looked at 2020, we talked about on August 2nd four to five points to your point, we talked about moving I've, yet to a sustainable revenue path and what I see.
In play out in third quarter, while we got a headwind right in front of us on GTS and fourth quarter nothing would change my mind with regards to 2020 on driving sustainable revenue growth overall, great. Thanks can you. Please go to the next question.
Our next question comes from that coupled with credit Suisse. Your line is helping.
Yeah. Thank you Jim you called out some headwinds you're seeing in Germany in the UK and GTS, but I'm wondering if you talk a little bit more broadly about the enterprise spending environment by geography, and just if you're starting to see any impacts from a more volatile macro that's a across your business.
Sure Matt. Thank you very much I mean, obviously, we operate in 170 countries around the world. So if we are always monitoring and analyzing the market and most importantly to the heart of your question client buying behaviors. You know when you look at ice the industry IC industry has always been predicated on effective balance.
The leveraging technology for growth and leveraging technology for productivity and overtime that balance might shift and we are seeing a shift than we have seen a shift by the way. It's not just right in front of US here in the month to September that clients from a buying perspective are shifting more and more to productivity to quick pace.
Back to ROI and also predictability is spend which by the way plays to the breath and value of our portfolio overall and you see how that played out in our GBS base of business continue momentum and on our salt cloud and cognitive software business driving the value because clients.
There are still spending their spending in those key high value areas around cloud around digital around data AI and around security why because they want to create a competitive advantage to win in the marketplace. So there we still see spending in those areas and when we look around the world and I can only.
Give yeah the lens of five yeah. When you look around the world, we had strong growth in many markets around the world Japan.
Canada, Brazil, Mexico, Italy, Spain, amongst many that grow that grew very nicely. We did fall short and a couple other areas around the world that I called out in GTS, specifically, a UK and Germany, but I'll tell you overall, our Europe business was flat.
So I would not say per say this is a macro related thing and by the way, we're selling hardware software based platforms all over the world, So where acknowledging shifts and buying behavior. We're adapting our value propositions clients are still spending in those key high value areas and that's where we're placing.
I mean as CFO I could tell you, we're we're placing all of our investment and capital allocation in our business.
Thanks, Matt Sheehan like can we please go to the next question.
Our next question comes from Jim Schneider with Goldman Sachs. Your line is open.
Good afternoon. Thanks for taking my question, Jim I would question on on a the services business the signings rebounded nicely in the quarter up 15%.
Do you maybe talk a little bit about the composition of those signings are particularly what that means about the sustainability of growth in GBS, a and to what extent those signings were kind of overweighted toward GTS do help replenished the backlog. Thank you.
Sure.
So the question Jim I appreciate it so let me unpack this a little on signings backlog in backlog realization, we've been talking a lot about this [laughter] I think over the last six quarters, we had great signings signings over $9 billion up 15%, we had growth in GTS north of 20% growth in GBS hi.
Single digits, if I'm not mistaken about 9% growth within that the composition as we all know signings are not all the same they're not equal and how they impact backlog how the impact realization.
But we had great signings growth above 100 million large deals up 45% overall, and we had small midsized deals up high single digits. Overall, so when you take a look at our signings that then translated into an improvement in our overall backlog position, our backlog improved one point quarter to quarter.
And let me break it out that between GTS in GBS and again for enhanced transparency you saw the supplemental chart on GTS GTS backlog 80 billion.
That backlog is down 2% that improved about point point, a half quarter to quarter, we've seen relatively stable duration and GTS. This backlog for a long period of time, even the as we continue to mix more and more to cloud and now that cloud is over 40% of that backlog.
GBS grew signings, 9% GPS backlogs down for and that improved almost a couple of points quarter quarter. It's this phenomenon of signings to backlog to revenue realization has really played out dramatically fertile land.
Two plus years in GBS, the we talked about hallmark and the team have done a great job remix in the portfolio and offerings to capture we're value and were spend are going that is moving more and more to a consulting basis and that cloud app.
Application modernization base area, that's shorter duration, our duration in our GBS backlog has reduced over 20% to 25% over the last couple of years and that's why you've been able to see an overall backlog that's been down mid to high single digits.
And we're delivering consistent revenue growth anywhere from one to 3% to 4% in that GBS base of business. So that is where you're seeing a big change.
Okay. Thanks, Jim can we please go to the next question.
Our next question will come pension schemes that with Citigroup. Your line is outstanding.
Thanks, very much you know I'm definitely not the smartest person on this call, but can you just spend maybe a brief minute going over on slide 18. When you talk about the GTS service revenue dynamics, you you've mentioned in period business volumes, but then it looks like it continues on into Q4 in one or more.
Interested in his duties in period things continue on into Q1 in 2020, or maybe help a person who doesn't fully comprehend everything better understand it. Thank you.
Sure as you have no problem and hopefully appreciate the enhanced transparency and in the chart overall, obviously, Patricia and the team and spent a lot more time on on this tonight, but as I stated earlier than that messages in ace in a GTS outsourcing base business.
You have roughly in you have as you enter a quarter you have about 90 plus percent of that revenue that's under backlog.
Hi, annuity content based businesses under contract you have a remaining 10% that is in period selling bill activity and also tied to that the client business volumes that run off that backlog and when you look at second quarter. It pretty much played out as we expected down four.
Percent, that's what the backlog said and during the quarter are in period activity of selling bill and transactional components, where basically muted.
As we got into third quarter, you. So you see the way the charges laid out that backlog run out said.
Inflection point down for goes the down three goes down the down one to two assuming that we consistently execute both in a in an IBCM manner and the market overall and when you look at the third quarter. The third quarter are in period.
That 10% was down mid teens.
Due to a less client business volume and also execution on our small deals predominantly in Europe . As I stated that then has they flow through because now we're starting October one looking at fourth quarter, whereas we thought we were going to be down one to two in backlog now were down two to three.
And to the extent, we can go back and execute.
To to that that 10% that has a muted effect, we would we would end up the quarter at that level. If it plays out like third quarter, we're going to be down 3% to 4%. That's why stated we're going to focus all of our energies on continuing to transform the offerings and portfolio and capture where span.
And in growth is coming from and getting that third the structural cost to drive the margin expansion.
Okay at Sheila, let's take one last question.
And my last question comes from Keith Bachman with Bank of Montreal. Your line is open.
Hi, Thanks, very much team for sitting in Jim I wanted to pick up on the duration can comment you made does duration normalize in 20 in other words do you think you can begin to grow grow rather services backlog or do you still feel like a there's compression associated with the services signing on duration.
And then I'll ask my second question too the consulting business in GBS also had a good quarter 5%.
Gross accentures had some some weak bookings frankly on consulting and I'm, just wondering how you're thinking about that business and the economic sensitivity associated with it as we seem to be facing some more headwinds here do you think that consulting business that you see today continue to crows low to mid single digits over the next.
Couple of quarters and that's it for me thanks very much.
Okay. Thanks.
Good good way to wrap up on a on a part of our portfolio that is delivered consistent operational execution and as I stated earlier the team really should be commending because we are capturing and we are becoming the clients provider in service provider of choice as they embark on.
Their digital reinvention journeys and journeys to cloud, but let me take your second part of your question first if I remember correctly and that is comparison accenture, but more importantly, I'm not going to talk about them I'm going to talk about our business our consulting business continues.
To execute very well, we delivered 5% growth here by the way off of a tougher and tougher compare as we move throughout 20.
18, we improved our consulting performance in GBS, we delivered from 5% growth great growth in application modernization consulting and also in our next generation a enterprise applications I guess for Hannah and in ER, and Salesforce and by the way I talked about GBS signings.
Up high single digits, we were up significant double digits in consulting signings. So we had a great quarter overall on on signings and that kind of leads me to your first question.
You know when you look at our backlog our duration is come down like I said, 20% to 25% over the last handful of years I don't see that changing right now as this world moves more and more to cloud we are moving more and more to shorter duration higher consumption base Act.
Tivity, that's going to play to the hand, and the portfolio that we've put in place overall. So I think you know the reason I gave enhanced disclosure between GE chessen GBS on duration and overall backlog I think you're seeing a fundamental differences between the two and the GBS will continue to.
The impact when you just look at the printed number of I'd be but you know you I would focus more on a GTS overall as far as looking at the total backlog.
Going forward.
So with that again want to thank you for joining our call here today, a few comments just to wrap up as I've stated, we've been investing and taking bold actions to position our business to win in chapter two of hybrid cloud the acceleration in Red hat, our early support for our cloud packs and.
Modernizing our software portfolio and growth in our digital and application modernization services are all validation. The actions. We've taken are resonating with our clients in driving that key high value growth areas in the industry at the same time, we're continuing our disciplined finance.
Sure management, which should serve us well as we head into fourth quarter and 2020, So again I'd like to thank you for joining us today and we look forward to the continued dialogue, okay shale I'm going to put it back to you to close out the call. Please.
Thank you. Thank you just participating in today's call. The conference has now ended you may disconnect at this time.