International Business Machines Corporation

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. Now you may begin.

Thank you. This is Patricia Murphy, Vice President of Investor Relations for IBM, and I want to welcome you to our first quarter 2020 earnings presentation. I'm here with Arvind Krishna, IBM's Chief Executive Officer, and Jim Kavanagh, 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. I'm 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 FTC 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, we'll focus on constant currency growth adjusting for the divested businesses to 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 8K submitted to the SEC. I'd like to make two other comments regarding this quarter's presentation. First, consistent with our last two quarters, IBM's 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 non-cash. Second, our segment structure for 2020 remains consistent with 2019. So at the beginning of this year, we realigned a couple of offerings between segments, resulting in very modest adjustments. Our results reflect this realignment, and we're providing a view of first quarter 2019 on that recast basis in today's supplemental slides and two years of historical recast data on our website. So with that, I'll turn the call over to Arvin. Hello, everyone.

As you all know, we are in the midst of an unprecedented global public health crisis. I'd like to pause for a moment and say that my heart goes out to all those dealing with COVID-19. One of the first commitments I made was to be transparent and open, not just with our employees and our clients and partners, but with our investment community as well. In that spirit, I will participate not just today, but in earnings calls from now on. There are a few topics I'd like to cover with you today. First, I'll revisit areas I've talked about. Second, I'll tell you about what we've accomplished in the last two weeks. And finally, I'll tell you about areas I intend to focus on in the near future, and then I'll quickly touch upon our Q1 results. Let's start with the areas I've talked about. I have told our teams it is essential that we deepen our understanding of our clients' journey to hybrid cloud and AI, which will result in hybrid cloud as the fourth platform. We remain obsessed with continually delighting clients, and we further establish IBM as the gold standard for good tech. All these are underpinned by a culture that forces growth and an entrepreneurial mindset. I see these as our collective priorities. I'll move on to what's been done in the last few weeks. Despite the challenges we are facing as a result of the global crisis, we have remained steadfast in our commitment to employees, clients, and society at large. More than 95% of our 350,000 IBMers are working remotely now. In addition, about 8,000 of them remain at essential sites to carry out mission-critical work. As our clients adjust to this new normal, they need a partner they can trust. IBM is that partner. This isn't just about helping our clients navigate the crisis. It's about helping them to move forward, but to ensure that they emerge stronger and more resilient. To that end, we have taken concrete steps to bundle existing offerings to address the shifting needs of clients, such as leveraging hybrid cloud, using AI for automation, and enabling remote work. Another area we've been focusing on has been to mobilize IBM and IBMers to help with the global battle against COVID-19. Here are some examples. The computing power, over 360 petaflops that we have helped convene for researchers. The weather channels, COVID-19 -by-county map, which saw more than 40 million visits in the first week of launch. The AI assistance that can answer citizens' questions about COVID-19, 21 of them live today and nearly 90 being rolled out. And the educational resources available to anyone, anywhere. We are doing great work helping the city of New York and are delivering 300,000 tablets with educational software and free cellular data connections that can help students learn remotely. When we add this all up, we have done the math. In just a few weeks, we have already committed over $200 million in terms of contribution and volunteer time. I'm extremely proud of IBM's response to COVID-19. Now I want to tell you about some areas of focus for the near future. I want to be clear, the ultimate outcome that I am absolutely committed to is growth for our company as we emerge from the pandemic. A key area of focus is to ensure that IBM leads in the two major transformational journeys our clients are on, cloud and AI. IBM has already built three enduring platforms, mainframe, services, and middleware. The fourth one is hybrid cloud. Clients, however, need more than a platform. They need our deep industry expertise. This is why the services that clients rely on to build and manage the hybrid cloud platform is a massive opportunity for IBM. It's nearly half of the $1.2 trillion hybrid cloud opportunity. IBM, together with Red Hat, have unique sources of competitive advantage we can leverage to win the architectural battle for cloud. There's our open source and security leadership, our deep expertise and trust, but also the fact that we give clients the unique ability to build mission-critical applications once and run them anywhere. Together with Red Hat, we are establishing Linux, containers, and Kubernetes as the new standard. This is winning the architectural battle for hybrid cloud. Let's talk a little bit on how we take this to clients. I want IBMers to lead with a more technical approach. I want our teams to showcase the value of our solutions as early as possible. Likewise, there must be a relentless focus on quality. Our products must speak for themselves in terms of user experience, design, and ease of use. My approach is straightforward. I am going to focus on growing the value of the company. This includes better aligning our portfolio around hybrid cloud and AI to meet the evolving needs of the market. We will continue investing, including acquisitions. As you have seen, we have divested parts of software and services that did not align with our focus areas. This will continue. The past few weeks have catapulted us into the world of virtual selling and remote delivery. These entail new ways of working. This is a reminder we should always be asking ourselves, is there a better way to do this? If you don't question why you're doing things, you'll never evolve into something better. What's clear is our confidence in our strategy and our portfolio, which is focused on hybrid cloud and AI. Before turning to Jim, I want to comment on our results. In the first quarter, we had modest revenue growth. Tax net of currency and divestitures. We entered the quarter in a good position, with momentum from the end of last year. However, in the last few weeks, we faced a shift in client priorities towards the preservation of capital. This impacted software disproportionately, and Jim will comment more on this later. The other parts of our business maintained modest momentum. We're entering this challenging environment from a relative position of strength. Our clients are enterprises that run the most essential processes of the world. Our balance sheet is strong, and Jim is going to take you through that. I believe that what we are going through today, with the shift to remote work, automation, application modernization, will accelerate our client shift to hybrid cloud. This gives me immense confidence in our future. So I will turn it over to Jim to take you through the quarter, and then we'll come back at the end for Q&A.

Thank you, Arvin. I want to start out by expressing my sympathy to all those who have been impacted by this health crisis, and deep gratitude to the incredible people who have been helping IBM, our clients, and the world to deal with this crisis, especially those on the front line. Now, turning to our first quarter, we delivered $17.6 billion of revenue, with modest growth net of currency and divestitures. We had good gross margin expansion, operating earnings per share of $1.84, and continued solid free cash flow. Before I get into the specifics of the quarter, in light of the current environment, I want to take a step back and provide some perspective on a few areas. First, on our client base, our portfolio, and our financial profile, which you'll see provide some stability to our business. Second, what we saw at the end of the quarter, and then finally add on to Arvin's comments on what we're doing with our own business to address the current environment. IBM has always focused on the enterprise space, and within that, our business is more concentrated in large enterprises. For decades, we have run our clients' most critical processes, like core banking systems, supply chains, and claims processing. From an industry perspective, the majority of our revenue comes from clients in financial services, telecom, and the public sector, including government and healthcare. We have long-term relationships with these clients in the form of multi-year services contracts, recurring software streams, and financing arrangements. As a result, when you look at our business mix, about 60% of our annual revenue is in recurring businesses. While we're not immune in this environment to disruptions in the transactional content and volume reductions, our client profile and annuity base provide some level of stability, not only in our revenue, but also in profit and cash, as we manage through these challenging times. Looking at the first quarter, through February, we were tracking roughly in line with our expectations. As we got into March, the health situation and resulting social distancing became more widespread. As you would expect, we saw a noticeable change in client priorities. With that, there was effectively a pause, as clients understandably dealt with their most pressing needs. This was most pronounced in our software business, where the vast majority of transactions typically closed in the last two weeks of the quarter. For those clients that did engage at the end of the quarter, there was a noticeable change in priorities, where focus very quickly shifted to the stability of their operations and preservation of cash. They moved ahead with spending that addressed immediate and essential needs, including running mission-critical processes and securing a remote workforce. For example, we increased infrastructure capacity and services to meet unprecedented demands on critical banking functions for banks in countries ranging from Italy and Spain to the United States to Australia and Singapore. In Brazil, we developed a platform in a single week to connect patients to doctors via telemedicine. And at a major U.S. insurance company, we helped 40,000 employees to work remote, when they had absolutely no -at-home capabilities just two weeks earlier. At the same time, the last few weeks have only reinforced the need for clients to modernize their businesses for the new world, and cloud and AI are at the core of their digital reinventions. With our hybrid cloud and AI platforms, together with our expertise in running critical processes, we're ideally positioned to guide clients on their journeys. Anthem is a great example of a company accelerating their digital reinvention in today's COVID-19 environment. We're helping them to operate with more agility and provide greater quality of service by leveraging data and deep insights to enhance the experience of their 41 million members. We're doing this on a secure, open platform run on Red Hat and the IBM Cloud. Now, in parallel, we've taken actions within our own business to help IBM better operate in this environment and emerge stronger. For example, we're aligning investments to the key offering areas Arvin mentioned. We took structural actions to improve the competitiveness of our global technology services business and enable new ways of working across our operations. Our actions will deliver annualized gross savings of nearly $2 billion. We are accelerating our own digital transformation, from demand generation to further ramping up our digital sales capability. And in our supply chain, we are leveraging AI, blockchain, and IoT technologies to drive faster and smarter decisions with our suppliers. We also enhance health and safety measures at our sites to maintain our manufacturing operations at required capacity to meet our customers' needs. This caps off a lot of work over the last few years to make our supply chain more flexible and resilient. While we're supporting our clients in improving the flexibility and competitive position of our operations, we're also taking actions to enhance IBM's balance sheet strength and liquidity position. We accessed the debt market in early February with a $4 billion issuance, while reducing $4.5 billion of current and 2021 refinancing needs. In addition, while we do not rely on commercial paper for our funding needs, we thought it was prudent to take advantage of our access to the CP market. We ended the quarter with $2.5 billion of commercial paper, which increased both our debt and cash balances. As a result, we ended March with a cash balance of $12 billion, which is up $3 billion from year end. Our total debt of $64 billion includes $22 billion of global financing debt, which is in support of IBM product and services and has a stable credit portfolio. Finally, as we discussed in January, our pension plans were well funded at the end of 2019, with worldwide qualified plans funded at 102%. While we typically don't provide a status during the year, I can say that our overall pension funded status in March was fairly consistent with year end, and we do not see a change to our expected plan contributions in 2020. Bottom line, we have a strong cash position and ample credit available during these uncertain times to support and invest in the business. We will continue to be opportunistic in the capital markets, while remaining fully committed to our mid to high single A credit rating and our targeted leverage ratio. I'll remind you, we also have over $15 billion of unused credit facilities. And while we have no plans to draw on the facilities, they are available as backup liquidity, and our debt covenants are well within the required levels. And with our share repurchase program suspended since the Red Hat acquisition, our overall shareholder payout remains at a comfortable level, and we remain fully committed to our dividend. So with that as a backdrop, let me focus on a few highlights in the quarter before getting into the segments. We had strong cloud performance again this quarter, with cloud revenue up 23%. By bringing together our technology and expertise to help our clients accelerate their journeys to cloud, our cloud revenue has grown to $22 billion over the last 12 months. Arvin talked about winning the cloud architecture of Linux, containers, and Kubernetes, and the acquisition and integration of Red Hat bolsters our position in hybrid cloud. Red Hat momentum continued this quarter, with normalized revenue growth of 20%, and strong bookings and backlog growth. RHEL has proved to be mission critical for many customers, particularly in this environment, and infrastructure revenue was again up double digits. Application development and emerging technologies was up nearly 40% this quarter, driven by OpenShift and Ansible. The number of Red Hat large deals was up from the fourth quarter, and up about 50% over last year. Red Hat signed the two largest deals in its history, leveraging IBM's deep client relationships. This is a great proof point of the value of IBM and Red Hat together. We see it in the larger Red Hat deals, in the pipeline of IBM services engagements based on Red Hat's technologies, and in the number of clients now using Red Hat and IBM's container solutions. This has grown to over 2,200 as Red Hat and IBM have emerged as the leading container platform. The contribution of Red Hat, together with strong margin performance in our services businesses, contributed to our 150 basis points of operating gross margin expansion. Our pre-tax income reflects charges of nearly $900 million, primarily for the structural actions to improve our competitiveness in GTS and accelerate our shift to a cognitive enterprise. The charges for these actions were more than offset by non-cash discrete tax benefits. You'll recall I mentioned both the structural actions and the discrete tax benefits back on our call in January, and so these had been planned for some time. Our cash and balance sheet strength are fueled by healthy free cash flow. This quarter, we generated $2.1 billion of cash from operations and $1.4 billion of free cash flow, both excluding our financing receivables. There is a lot of seasonality in our free cash flow, and over the last year, we generated $11.6 billion, which is about 125% of GAAP net income. And a final comment on Red Hat's contribution to our free cash flow. When we closed Red Hat back in July, we expected Red Hat, net of interest expense, to be accretive to free cash flow by the end of the first year. With Red Hat's strong performance, after three quarters, we've now achieved that milestone. Now let me turn to the segment results, starting with cloud and cognitive software, which grew 7% this quarter. We had strong performance in Red Hat, IoT, and data and AI, and in our security services. This is I did for overall IBM. I'll start with a view of software dynamics as we move through the quarter. We entered the year with a robust offering portfolio and solid pipeline, and we had double-digit revenue growth through February. In March, our software transactions stalled nearly overnight, as our clients shifted their focus to resiliency efforts. We saw those dynamics play out most notably in cognitive applications, where many transformational deals were paused, especially in the retail industry. And in transaction processing platforms, given cash concerns, clients traded off capex or op-ex. These are typically large engagements, and in this environment, clients elected to defer purchases, impacting perpetual license sales late in the quarter. More than offsetting that, we continue to have good growth in cloud and data platforms, led by Red Hat and the synergies we're realizing by bringing together Red Hat and IBM software. Given the shifting software demands we've seen in some parts of the business, we are focused on a number of initiatives heading into the second quarter. We're doubling down on areas that facilitate the shift to cloud, including Red Hat and other cloud and data platform offerings, cloud packs for operational efficiency, and curator on cloud for security threats. Our -to-market teams are accelerating their shifts to digital channels, and we're now leveraging our partner ecosystem to expand our reach into critical industries and markets. To sum it up, our portfolio in cloud and cognitive software is aligned to the hybrid cloud and AI opportunity. We modernize our software to be cloud-native and optimized on OpenShift, which provides a compelling hybrid cloud platform for clients on their digital journeys to cloud. While we expect near-term pressure on transactions, we continue to invest in new development and innovation for our hybrid cloud and AI strategy. Turning to global business services, we entered the year with a good momentum in revenue, gross profit, and signings, and our backlog returned to growth. This growing backlog and the revenue we expected to yield from it gave us confidence that GBS revenue performance would accelerate as the year progressed. We had solid performance in GBS in the first quarter, with revenue growth of 1% and gross profit margin expansion of 100 basis points. Our consulting revenue grew 5%, led by offerings that help clients with their digital reinventions, such as cloud advisory and application modernization, and offerings that leverage AI to inject intelligence into business processes. These offerings enable clients to re-engineer their business processes and IT environments for speed, flexibility, and efficiency to better serve their end users. We have standardized our cloud application modernization offerings on OpenShift and built the world's largest Red Hat consulting practice. We are now working with over 100 clients on Red Hat technologies, such as Anthem, Procter & Gamble, USAA, Santander, and Horizon Healthcare, just to name a few. In the first quarter, we also had good growth in many of the transformational offerings, like next-generation enterprise applications. But as the impact of COVID-19 intensified in March, clients began to deprioritize some of these projects. In this environment, we are aligning our -to-market and delivery resources to the near-term opportunity, addressing challenges like engaging customers virtually, modernizing and migrating applications to the cloud, empowering a remote workforce, and cybersecurity and IT resiliency. Internally, we have shifted from a predominantly -to-face engagement model to a virtual one, now with almost 100% of our GBS delivery resources not only working remotely, but productively working to support our clients. Over the last few weeks, we've gotten questions from investors on our ability to support clients, given the shutdown in some countries. I can tell you that in India, we had over 98% of our practitioners working remotely within 48 hours of lockdown. As we look forward, we have a solid base of business and a growing backlog. Though in the near term, we expect customers to continue to delay and replan some projects. We are going to continue to prudently manage the business by leveraging our variable and global delivery resource model to ensure utilization is balanced with the rate and pace of backlog consumption and new deals. And we're going to continue to build skills and practices so that as the demand returns to more normal levels, we're ready to address it. Turning to global technology services, our revenue decline of 4% was fairly consistent with last quarter's performance, and we expanded gross profit margin by 30 basis points. As I said in the past, we are managing this business for margin and cash contribution. Last quarter, I talked about the actions to accelerate the shift to higher value segments of the market and improve our cost competitiveness. So let me start with a quick update on our progress. A significant portion of the first quarter structural actions address GTS. This improves our position for the future but impacted our PTI in the first quarter. In this dynamic environment, we're going to continue to evaluate the cost competitiveness of this portfolio, and we'll take further actions as required. We also advanced our joint offerings and -to-market capabilities with GBS. As clients shift their mission-critical workloads to the cloud, they are looking for integration across the application and infrastructure stack. By more tightly integrating GBS and GTS, we're providing a differentiated solution. While we are in the initial stages of this work, we see some early indications of progress in our signings this quarter. Both total signings and our cloud signings grew at a double-digit rate. This includes significant engagement at Keisha Bank and Anthem. Strong signings contributed to an improved total services backlog, which is now roughly flat -to-year. Within that, cloud now represents over 40% of our outsourcing backlog. This fuels our GTS cloud revenue, which was up 12% this quarter. In the current environment, enterprises are focused on infrastructure solutions which enhance IT resiliency and business continuity, address new cybersecurity risks, and reconfigure their IT environments for cost efficiency and business agility. We are prioritizing our resources and our management system to these opportunities, focusing on offerings like unified communications, business continuity and resiliency, workplace virtualization, and enabling remote working. At the same time, we are adopting alternative delivery models as we continue to support mission-critical workloads without service interruption. In fact, almost 100% of our employees in our GTS global delivery centers are now working remotely. While in this environment we expect to have some impact due to lower business volumes, this will ultimately lead to an acceleration in the shift of mission-critical workloads to the cloud. And as I've said, this will be a hybrid, multi-cloud environment built on open standards. IBM services will leverage our incumbency, our industry, regulatory and business process expertise, and of course Red Hat to capture this opportunity. And so now looking at systems, revenue was up 4% this quarter, and gross margin expanded over 400 basis points. In an environment where client behavior shifted at the end of the quarter, our hardware portfolio held up well. This reflects the importance of IBM Z and high-end storage for mission-critical operations, as well as product cycle dynamics. These are high-end systems, and client value in this segment is driven by new innovation. We see that in the Z15 mainframe, and we see it in storage, with the high-end DS8900 introduced at the end of 2019. And more recently, a new and simplified distributed storage portfolio, which supports hybrid multi-cloud deployment. In the second full quarter of availability, the Z15 proved to be a crucial backbone of enterprise operations, providing a stable, secure and scalable platform. Our financial services clients were able to scale up their capacity to meet the significant demands from unprecedented spikes in market volatility, without touching their physical infrastructure. And in high-end storage, which is tightly integrated with the mainframe, we had a good quarter, especially in support of mission-critical banking workloads. The growth in Z and storage was partially offset by a decline in power. This reflects where we're in our product cycle, as well as the fact that power is more skewed to smaller enterprises, which were more impacted by the dynamics in March. We're continuing to adapt our operations to meet the needs of clients most effectively, especially in this changing environment. We're expanding the digital sales channel for both the storage and power business, and we're leveraging technology to proactively manage our globally diversified supply chain. Now, after going through the segments, I want to bring it back up to the IBM level and talk about what this means going forward. First and foremost, we have confidence in our strategy and our portfolio, which is focused on hybrid cloud and AI. Nothing we've seen over the last two months causes us to waver from these priorities. In fact, as Arvin said up front, we believe the challenges clients are facing today will speed their transitions to digital. That bodes well for us. But there is obviously some dislocation in the near term. In this environment, we've taken quick and prudent actions to manage our costs and expense, further improve our liquidity position, and focus on opportunities to emerge stronger. Since the crisis began, we've been stress testing our model and running a number of scenarios based on various assumptions. Given the level of uncertainty around the duration of the health crisis and the rate and pace of economic recovery, there's a wide range of outcomes for the year, which we are prepared for. But to assign probabilities to the assumptions during these unprecedented times just isn't valuable. As a result, it is prudent to withdraw our expectations for full year 2020, and we will reassess at the end of the second quarter. So to be clear, under the various scenarios we ran, we have ample free cash flow and liquidity to support our business and secure our dividends. Before turning back to Arvin, I want to provide some perspective on how we're entering the second quarter. Over the last few years, our software transactional content in the second quarter is about 20 to 25% of our software revenue. We have a solid pipeline of deals, but in the end, our software performance will depend on how we yield against that pipeline. If we continue to see the same client buying behavior, it's reasonable to expect the second quarter will be more challenging. Systems hardware is essentially all transactional. Here, too, we have a good pipeline in IBM Z and storage. While the current environment is expected to impact closure rates, I would expect less of an impact to Z and storage, given the essential nature of the purchases and the additional capacity requirements, especially in certain industries. In services, we've made real progress in the backlog, and for the first time in a while, we ended the quarter with services backlog essentially flat versus last year. That's with GBS up and GTS down modestly. About 80% of the GBS revenue and 90% of the GTS revenue in a quarter has historically come from the opening backlog, though our contracts adjust for flexible volumes in our clients' businesses. As mentioned earlier, close to 100% of our people in our service delivery centers are working remotely. Looking at our costs and expense, we're closely managing our spending and capitalizing on new and efficient ways of operating. The savings from structural actions will start to yield in the second half. We are likely to take additional actions in the second quarter. I'll remind you that we are well positioned from a liquidity perspective and remain focused on driving our free cash flow, including robust working capital management. For years, we've been talking about our high-value portfolio and business model, and in times like these, that really matters. This is why our liquidity position is naturally strong, and our pension plan is well funded coming into this environment. So we're prepared for this environment, have a strong financial position and compelling value propositions for clients. But our near-term performance will ultimately be influenced by client buying patterns in this economic environment. Arvind, I'll turn it back over to you.

Thank you, Jim. We have taken the importance of transparency seriously, and so it was a tough decision to withdraw guidance. But these are unprecedented times, and this quarter is not the time to declare that we have clarity. That does not benefit us, and it does not benefit you as investors and analysts. With better clarity on the economic recovery, we will provide an update at the end of the second quarter. But please note there's a difference between the ability to accurately predict a near-term revenue or earnings per share number and confidence in our business over the longer term. And I have confidence in our business. Under different scenarios, we have ample free cash flow and liquidity to support the business and secure our dividend. We are entering this environment from a position of strength. So over to Patricia for the Q&A.

Thank you, Arvind. Before we begin the Q&A, I'd like to mention a couple of items. First, you'll notice we updated our chart format to streamline the information presented during the webcast. The content no longer presented in the mainline charts is now included in our supplemental information, which is at the end of the slide deck. And finally, as always, I'd ask you to refrain from multi-part questions. So, operator, let's please open it up for questions.

Thank you. At this time, we'll begin the question and answer session of the conference. To ask a question, please press star 1 and record your name clearly. If you need to withdraw your question, press star 2. Again, to ask a question, please press star 1. Our first question will come from Hamid Sarayanani with Evercore. You may go ahead.

Thanks, guys, for the opportunity. And Arvind, congrats on the spot and nice having you in the Q&A session. Arvind, you spent a fair amount of time kind of talking about the areas where you want to focus on as you go forward and maybe to put aside the COVID discussion. How do you think about the investments the company needs to do? And how do you go about that organic versus inorganic? I just want to understand when you think of investments, which way are you going to skew as you go forward? And maybe on the flip side of the coin, are there things that you want to focus less on? Are there things and opportunities to divest to further potentially help your balance sheet?

Okay. Thanks, Hamid. And let me start with talking about the portfolio and your questions on investment. So, look, obviously the portfolio is something I evaluate deeply. We do it all the time and continuously. But I do want to caution that in the immediate period, which is right now, we've got to focus and put our priority on supporting our employees and clients. Now, investment to us encompasses both. It encompasses both organic investments and inorganic or acquisitions. We've been clear that we will acquire when we find properties that are both attractive but that fit our strategy. And hybrid cloud and AI are the focus of our business moving forward. But when we talk about hybrid cloud, it is an all-in. And I'll just give a quick reflection on Red Hat. We had Linux as the core. We had open shifts around it. We put all of our middleware on open shift. We have hundreds of GBS projects already leveraging both the Cloudpacks and open shift to make application modernization. And then eventually, we'll find services also running those modernized applications for our clients. You'll find there are many, many properties in my broader definition of hybrid cloud that will fit that. And data on AI, AI should be looked upon as the way to get the value out of the data that people collect, both their internal data and external data. Now, I don't want to also comment on big or small. Size is not a strategy. It's about being thoughtful and strategic. And so you should expect that over time, over time meaning just let it get past the next few months, we will get back to an acquisitive strategy.

Jim? Yeah. The only thing I would add, Darwin, is our capital allocation strategy obviously is there to support the business design and the business and portfolio strategy that we have chosen. To your point around hybrid cloud, data AI, we've got enough firepower with regards to a strong balance sheet, solid free cash flow generation, solid investment grade, a good access to market, which we talked about in the prepared remarks, that gives us ample free cash flow and flexibility to invest in our business while also returning value to our shareholder in securing that dividend that we talked about up front. And that acquisition component is a very big important part of our capital allocation strategy, and that hasn't changed.

Okay. Thanks. Sheila, can we go to the next question,

please? Yes. Our next question will come from Wamsi Mohan with Bank of America. Your line is open.

Hi. Thank you, Arvind. Congrats on the new role as well. You mentioned some changes in GoToMarket and your prepared remarks leading perhaps with a more technical bent. I wonder if you can elaborate there a bit. And Jim, I appreciate you're not providing explicit guidance at this point, but maybe can you address the levers the company has in responding to the pandemic in the context of preserving cash flows? You alluded to a few things in your prepared comments as well, but last call you had mentioned several puts and takes to the cash flows as tailwinds and headwinds, and just wondering if you could maybe recast those again.

Hey, Wamsi. Good to hear from you. With respect to a more technical approach to selling, it's a journey we have been on, but actually the current crisis in effect catapulted us or accelerated what we are doing. And I'll touch on sort of three elements. We have always wanted to have our product teams do a lot of demonstrations and proof of concepts, but we are now going to do them virtually where we stand the properties up on our public cloud and then allow the clients to sort of play around with them. And so you take away the weeks of doing it in a more traditional manner. Second, in our services teams, they're doing a lot of what they call virtual garages. So a garage used to be that we would have our consultants and our implementers sit side by side with a client and go do those. But when you do have social distancing, and it's not just us, our clients don't really want us on premise either, we have now become virtual garages. But there's an advantage there, by the way. A bigger advantage is it allows you to actually get access to skills that are around the globe, not just those that may be physically co-resident at a client. And that is, again, a much more technical approach. And then third, with a lot of remote delivery happening in the GTS part of the business, they are also bringing a much more technical solution to bear through this. So those are the elements that I mentioned, but you can expect us to do more and more of this as we go along. And Jim, I'll give it to you for the second part.

Yes. Hello, Wamsi. Thanks for the question. I mean, because this is important. As you can imagine, given the unfortunate and unprecedented situation everyone around the world is dealing with right here with COVID-19, we've been spending a lot of time on our business profile, our business model, stress testing it, running multiple scenarios, as I said in the prepared remarks. But when you look at it, it's always been done around one, the long-term sustainability of the IBM company to deliver value for our clients and for our investors. And that means you've got to have a strong balance sheet. You've got to have ample liquidity to give you flexibility to continue to invest so that we emerge stronger as we get through this pandemic when we move forward. And that really, you know, simplistically, if you take a step back, is two levers. One is on the top line in revenue and the other is on the fundamentals of your operating leverage in the business. Both of those deliver that free cash flow and that cash. And in that latter part, I would put in there optimization of your balance sheet. And we've looked at our revenue portfolio as we talked about in prepared remarks. We believe we are differentiated, although we're not immune from what's happening in the marketplace. We do have some level of stability in our revenue, our profit, our cash, and that's driven by all of the work that we've done over time to transform this company, transform and optimize our portfolio. We went from in 2008 at the last recession, we were only about 45, 47 percent annuity. We are now north of 60 percent. We have always been focused on large enterprise versus consumer SMB, and that is playing out well. Our industry concentration, as I said in the prepared remarks, over 70 percent of our revenue sits in industries based on IDC and Gartner that are going to be either moderately or minimally impacted by COVID-19. So we are diversified along geographic dimensions, market dimensions, industry dimensions, client dimensions that gives us that strong annuity content to move forward. And then on the margin of balance sheet, we're going to optimize as we've always done the portfolio shift in the higher value, the structural actions we just got done here in the first quarter, 900 million that impacted our PTI in the first quarter. That, by the way, will give us a annualized return of over 2X. And we'll keep watching our credit portfolio and the quality, our deferred revenue, and also our DPO and DSO, which is in very good shape. So net of that is we feel confident around ample financial flexibility, ample liquidity to continue to invest in our business as we move forward and secure that dividend.

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

Our next question will come from Tony Sackeneggy with Bernstein. You may go ahead.

Yes, thank you. Arvind, welcome and great to have you on the call. I was wondering if you could maybe define or articulate on a scale of one to ten how different do you think IBM's portfolio businesses will be two years from now? I recognize change is not going to happen imminently, but one to ten with ten being extremely different, where would you place that? And then, Jim, if you could just very quickly, you talked a lot about the stability of IBM's portfolio, but it looks like year over year pre-tax income went from over 2.2 billion to under 1.6 billion if I back out the restructuring in charge. So even though revenues weren't impacted, PTI adjusted for the restructuring was down nearly 30 percent, and this is your lowest transactional quarter. Is that how we should be thinking about changes to profit going forward, or was there something unique about this quarter where we saw more negative leverage? Thank you both.

Thanks, Tony. Look, Tony, if you look at our industry, it's a fast-moving industry with a lot of change that goes on all the time. If I look at where we were five years ago, and if I fast-forward to today, Red Hat was not there, Cloud Pax was not there, our cloud backlog inside services was a tiny fraction of what it is today, and I would look at all of that and say it looks like in aggregate likely about half our business has changed in the last five to seven years. That, I think, is the hallmark of a successful company, where you begin to change it. It takes advantage of the relationship, the value, the incumbency we have with our clients, but it also takes advantage of the fast-moving nature of technology. Now, the question you didn't ask, what I thought I'd put in there, is the question of the focus. I think the focus is going to be much more around what we've been talking about. It's going to be around, in the near term, it's going to be around hybrid cloud and AI. It's likely quantum coming down the road, which I do believe has a half-trillion dollars' worth of value to give back to our clients, since you give me the five-year horizon, not just the one- or two-year horizon. So let me sort of begin with that and say that, and it's hard to put that on a scale of one to ten, because you didn't tell me how much of a change is in ten, but I gave you the sense that probably half the things changed.

Jim? Yes. And Tony, thank you very much for the question, because operating leverage is obviously one of the core fundamental pillars of our -value-based thesis and -value-based business model overall. Well, let me just cut to the chase with regards to your question overall. You asked about it from a pre-tax income. I'll take it down to an EPS level, which was similar to net income. We were down 18 percent overall. That EPS was down 41 cents -to-year. Yes, it includes the $900 million worth of restructuring, and the structural charges also includes, as we guided back in January, a discrete tax event. But the thing that you're missing in that equation is all of the Red Hat integration and -cash-related purchase accounting implications that are in our EPS and in our profit number. Now, as we close that transaction, by the way, less than three quarters ago, and we feel very confident about the health and the profile of our Red Hat business overall, we took a substantial write-down with regards to that deferred revenue, $2.2 billion overall, and we talked about Red Hat being free cash for accretive year one and being operating EPS accretive at the end of year two. We already hit the milestone on the first metric, and we're well on our way delivering the progress on the second metric. And just to bring this all home, the EPS of $1.84, down 41 cents -over-year, about 35 to 38 cents of that 41 is the Red Hat non-cash deferred revenue and integration. Why do I bring that up? Because as we said, that will diminish over time. And as we continue to replenish the backlog, which we are and we'll talk about, and we wrap around those expenses, that's where you're going to get even more substantial operating leverage going forward in the future.

Thanks, Tony. Let's go to the next question.

Our next question will come from Matt Cabral with Credit Suisse. Your line has opened.

Yeah, thank you very much, and welcome to the call, Arvind. I appreciate the commentary and the prepared remarks about what you guys saw during the month of March. I wonder if you could extend that a little bit and just talk about what you've seen so far across the first few weeks of April across the segments and just the extent to which, if any, you've had customers asking for pricing sessions, new concerns, new terms, even on the more recurring pieces of your

business. Okay. Thanks, Matt. Let me start with that because, look, April tends to be a month where, as Jim pointed out, it's not just in the first quarter. In every quarter, larger transactions do tend to get one stop near the end of the quarter. I'd say that probably is more June than April. And he also asked a question on the Enviti side of the business or what I would call subscription. We haven't seen, at least so far, any big change in the subscription side coming into April. Now, that is no doubt because, as both of us have pointed out, we do tend to run our clients' mission-critical workload. It's not the workload that will be the first to turn off. If anything, it will be amongst the last to get impacted. And so the subscription side we feel quite good about. Now, on the transaction side, so far things are holding up, but it's too early to tell. That's one of the reasons you heard what Jim and I talk about, the drawing guidance, because a little bit of progress is not enough to give us a full view into what will happen this quarter. Jim?

Yeah, Matt, thank you very much for the question. So Arvind kind of gave a perspective of what we're seeing here for the first couple weeks. And as he stated, just given the one transactional versus annuity nature, second quarter, like fourth quarter, is our highest transactional quarter, particularly in our software base of business

overall.

But let me give you a little perspective around the month of March versus February quarter of May, because I think it's important for our investors to understand the value of our -value-based business model and integrated business model, because the unfortunate COVID-19 situation that's impacting economies around the world has a very different profile across our business, whether it's hardware, software, and services. And as we've seen coming through February, the IBM company was growing revenue through February, led by strong double-digit growth in software overall. In the month of March, as I said in the preparatory remarks, as the health crisis intensified, that's where we saw the fundamental shift in client-buying behavior, appropriately so, by the way, as we've done in IBM, where first and foremost you wanted to focus on the operational stability. And business continuity of your enterprise, and second, around the preservation of cash. But when you look at it, it was more pronounced in our software and our GBS business. We actually substantially grew in the month of March in our hardware portfolio, but I would align that more around bringing new innovation to market. We're in the cycle of mainframe, and we did very well with the attach of storage overall. And our GTS business, remember, is a strong annuity base, and it's running mission-critical work. And our outsourcing IS business actually got better by a point quarter to quarter. So that's pretty stable, but within GBS and software, interesting around software, our cloud and data platform, 34% growth. Yes, driven by Red Hat, but even on a normalized, organic basis, we grew over 3%. And that's really the instantiation of our hybrid cloud thesis with Red Hat overall. So that part of the portfolio is still executing well, and I think that's part of what Arvind said. Clients are now even faster, more accelerating their journeys to cloud, and it plays right to that. Now where we got hit was in cognitive applications and in transaction processing platform. Two different phenomenons across that portfolio are Cog Apps is much more centered around industry-related content, where industries that are getting more impacted disproportionately, like retail, like industrial, like automotive. And in TPP, that was a function of just the preservation of cash shifting away from capex and opex. And just concluding, GBS, although we're very pleased, remember, 90 days ago, we talked about accelerating momentum in GBS. We turned that business back to backlog growth. We actually delivered growth in the quarter, strong growth in consulting, strong signings in consulting, but we did see a pullback in the latter part of March, particularly in many European countries, around project-based, transformational-based activity in next-generation applications like S4HANA, Oracle, Workday, and other people are delaying. And we expect that to continue here in the second quarter.

Thanks, Matt. Sheila, can we go to the next question, please? Yes.

Our next question will come from Katie Huberti with Morgan Stanley. You may go ahead.

Thank you, Arvind. I'll add my welcome. It's great to have you on the call. I wonder if you could start out by just commenting on what the one or two metrics are that you would like us to measure you and your team on over the next couple of years. And then I wanted to follow up and ask, either you or Jim can comment. You talked about scenario, a range of scenarios for this year. Obviously, the most bearish would be social distancing through the remainder of the calendar year, and the most optimistic would be reopening economies over the next year. What does that translate to in terms of sort of the bearish scenario on EPS and free cash flow and, you know, more optimistic scenarios, just any color as to how wide that range may look like? Thank you.

Thanks, Katie. So, let me start. You said what KPIs or what metrics should you use? Look, I think I've been clear. We should look at growth as the metric, albeit once we begin to emerge from the pandemic. And it's impossible for me to predict how long this is going to be. You mentioned two scenarios, but I listened to all of you and your peers. I don't have any particular crystal ball on this. The estimates are all over the place in both the depth and the length of the impact. Now, the other one that I think you should hold us to in metric other than revenue or a pure financial metric is the number of clients on which we are engaged on hybrid cloud engagements. We talk about it from a product perspective. We talk about 2200 clients to date. But as you begin to wrap those also with services engagements, I think that's the second metric that is then effectively a leading indicator towards the overall revenue metric, because that's the preconditioner for that. And that's where we're driving the entire company to. That's what I'm focused on. I run a wall room on that every week. And that's what our sales forces are incented to go get done. So, Jim, I don't know whether you want to add something. No, those are

the two that align to our business model. But to your second question, Katie, I'm not going to talk the specificity around there. As I said in the prepared remarks, we have done a tremendous amount of work on stress testing, running these scenarios. There's a wide range of outcomes. The key here for investors, I think, are two questions. One, in any of those scenarios, do you still have the strength of your cash, your liquidity position to ensure that you can, one, invest in your business to make sure as you come out of this you can emerge stronger? And two, can you maintain your capital allocation and your commitment to our investors with regards to the dividend? And both of those, emphatically yes. The second question is, around each of these scenarios, how are we actually managing our businesses across the board? And I would tell you, if you break this into a product-based business and a services-based business, start with services. It is the safety around having an annuitized-based model. GBS entering a quarter is about 80%. GTS is about 95% plus. That does come down as quarters N plus one, N plus two, N plus three go out. But it provides us a very solid base to work with as far as stability that drives that profit, that cash, and that flexibility. But what are we looking at and how we're managing a services business right now is what Arvind and I are looking at daily is, one, what's happening to the rate and consumption of our backlog? What are clients doing around projects, around offerings? What's happening to our utilization, our chargeable billable rates, our price realization? Each of those are fundamental KPIs that we're looking at in this environment right now to the health of the indicator around a services-based business. Around a product-based business, much more transactional. As Arvind said, software is about 20 to 25% transactional here in the second quarter. It has a strong annuity base. By the way, Red Hat's subscription-based model, strong annuity base. But the dynamics of how we're managing that are looking at our pipeline, our volume, our deal sizes, our yields, our progression, our renewal rates, our demand capacity for our hardware products and where they're at within their cycle. So we are driving the operational discipline you would expect in this company as we move forward. But at the end, we have enough of that financial flexibility and cash and liquidity, which I think is the most important message for the investor.

Thanks, Katie. Can we please go to the next question?

Our next question will come from Tin Jin Wong with JPMorgan. You may go ahead.

Thanks so much. Good to have you on the call, Arvind. Hope you guys are all safe and healthy. I wanted to ask just a quick one, acquisitions for you, Arvind. Just looking beyond the pandemic, I know that's hard to do, but criteria, size, thinking on accretion, dilution you're willing to accept there as you want to move quicker to hybrid cloud and AI. Can you share your thoughts on that? Thank you.

Good to hear from you. You asked about criteria, size, accretion and this thing. Look, I think on all three, one that is easiest, size. Size is not a criteria. So I'm just going to put that to the side. As Jim said a couple of times, you have enough influx to do a fair number of things. And most things that we might, I think are possible for us to be able to get done. So I'll put size aside and say that's not really an issue. You asked about accretion and decrease. Jim and I are clear. We manage the business for the long term. So if it becomes accretive after a year or two, as we described about Red Hat, that's more than sufficient for us. It doesn't have to be accretive on month one or day one. As long as it's a healthy business, provides us the correct growth profile and provides us the ability to get sufficient synergy, both for IBM and for the property itself. Both have to be winners. It cannot just be one of us. Otherwise, it's not that attractive. And then he said about criteria. The criteria is those things that make our clients value us even higher. And the areas we have chosen to be their trusted partner on is hybrid cloud and AI. So that's part of the criteria. But please take a wide stance on hybrid cloud. Hybrid cloud encompasses how we connect private and public. It includes how we might secure them. It might include the data that is inside those properties, provides more visibility. And as we shift that out over time, that will widen even more. Because the definition of what is the cloud market also tends to change over time. So hopefully that answered your question. But it's something we give a lot of thought to.

Thanks, Tingen. Let's go to the next question, please, Yos.

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

Thanks, Arvind. Congratulations. Nice to have you on the call. This is, I guess, for both of you. Are there any components of the business that are in transition, whether that's GPS or certain legacy software segments where the current pandemic creates an opportunity to accelerate that transformation? And perhaps you can tie that into the comments, I think, in your prepared remarks that telegraph that there may be some additional rebalancing actions in the June quarter.

I think, David, we're always looking at this and always looking at portfolio optimization. I would not say because of the pandemic or COVID-19 would we look at this. As you saw last year, we divested in the software portfolio quite a few things that weren't core to hybrid cloud. They were around marketing properties and -a-service properties around many of our retail clients. It didn't really necessarily fit or pull along or have synergy with the core hybrid cloud portfolio, so it made sense to divest them. I think we're done with that round, just to be upfront. Now, as we always look and say, does this or does this not bring value? Is there a reason for a client to have both the core hybrid cloud portfolio and something? We're going to re-evaluate that all the time, but I don't have something to name for you that we are trying to do right now. As the quarters go along, as the months go along, we will do it. But I also want to be clear that for the next few months, we have to be focused on the stability of the business and we have to be focused on making sure that we preserve our liquidity and our balance sheet. So that's what we kind of focused on for the very near term.

Okay. Thanks, David. Sheila, let's take one more question.

Thank you. Our last question will come from Keith Bachman with BMO. Your line is open.

Hi. Thank you very much, Arvin. Congratulations on your promotion as well as Jim Whitehurst. Congratulations on your promotion as well. I wanted to ask a little higher level question. As I think about IBM, there's many constituents, but probably three broad ones, shareholders, employees, and then customers. And as you think about the stock performance over the last, I don't know, five to seven years, I think shareholders would conclude that they've been disappointed with IBM's performance. And even from a customer perspective, if you look at IBM's revenues relative to growth of the many markets you participate in, probably some disappointment there. So as you think about your new leadership and perhaps focusing, excuse me, on the investor side, what do you think you really need to do differently for IBM and its shareholders versus what's happened over the last five to seven years? Thank you.

Maybe I'll start, Keith, and begin to do it. Look, I think that, I think we had acknowledged that the market's value of growth above other things. So while we have always selected on high value, and to your point on clients, we measure our Net Promoter Score or NPS, which I think is widely regarded as being one of the best metrics of how clients value what they're getting from you. And that has actually improved substantially, I think over ten points, if I remember, over the last two years. So given that the NPS is improving, our clients are much more delighted with what they get from us. And that said, the overall portfolio has to be able to grow to return, to make investors happier. And that's why we are clear. You noticed me announce a lot of our management team at the beginning. I think this is a team that's going to be able to deliver growth back to the market. So Jim Kavanaugh, of course, and you heard him talk about capital allocation and how he's going to use that friend flex to enable both organic and in organic investment. Jim Whitehurst, who many of you know well, who has dealt really well, both with crises when he was at Delta and at growth when he was at Red Hat. Bridget Van Kralingen, who has a strong record of understanding client needs and is going to drive some of the -to-market changes we mentioned. Howard Goebel that we're bringing in, who was at Bank of America, who has a deep empathy and understanding for some of our largest clients, but also who drove a lot of efficiency when he was at the bank, and he can bring those attributes to the clients as well. And Mark Foster, who has services and who has a real tension for growth and for making sure that he brings value to our clients and services. We put all that together and I think it is a team that can go deliver growth. But let's also be clear. We can talk about which is important. Is it growth or is it only EPS or is it only liquidity? So liquidity is essential. Without that, no company is going to survive through the next period. And I don't know how long that period is going to be. So I think our obsession with that is going to serve us well in this period. But what you're hearing me say is that growth has to be an equal obsession to other metrics that are there. We are going to go do that. So it may not be a completely full answer, Keith, but we'll probably get there as the months go on and we get more clarity. So I think that was the last question, if I remember. So let me make a few comments to wrap up the call. These are truly unprecedented times. Over the coming weeks and months, we are going to continue to focus on our employees, our clients, and how we can help broader society. As difficult as this crisis is, it presents an opportunity for IBM as a technology leader and as a trusted partner. Personally, it's an interesting and exciting time to be taking on this role. I look forward to continuing this dialogue with all of you, and we'll update you at the end of the second quarter. Thank you.

Great. Thanks, Arvin. Thanks, Jen. Thanks for all of your questions, Sheila. Let me turn it back to you to wrap up the call.

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