International Business Machines Corp (IBM) Q2 2020 Earnings Call Transcript

International Business Machines Corp  (NYSE: IBM) Q2 2020 earnings call dated July 20, 2020

Corporate Participants:

Patricia Murphy — Vice President, Investor Relations

Arvind Krishna — Chief Executive Officer

James M. Whitehurst — President

Analysts:

Matt Cabral — Credit Suisse — Analyst

Amit Daryanani — Evercore ISI — Analyst

Toni Sacconaghi — Bernstein — Analyst

Wamsi Mohan — Bank of America — Analyst

Katy Huberty — Morgan Stanley — Analyst

Tien-Tsin Huang — JP Morgan — Analyst

David Grossman — Stifel Nicolaus — Analyst

Keith Bachman — Bank of Montreal — Analyst

Presentation:

Operator

Welcome and thank you for standing by. [Operator Instructions] If you have any objections, you may disconnect at this time.

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

Patricia Murphy — Vice President, Investor Relations

Thank you. This is Patricia Murphy and I want to welcome you to IBM’s Second Quarter 2020 Earnings Presentation. I’m here with Arvind Krishna, IBM’s Chief Executive Officer and Jim Kavanaugh, IBM’s Senior Vice President and Chief Financial Officer. We’ll post today’s prepared remarks on the IBM Investor website within a couple of hours and a replay will be available by this time tomorrow.

Some comments made in this presentation may be considered forward-looking under the Private Securities Litigation Reform Act of 1995. These statements involve factors 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, provide additional information to investors. For example, we present revenue and signings growth at constant currency throughout the presentation. In addition to provide a view consistent with our go-forward business, we’ll focus on constant currency growth adjusting for the divested businesses for the impacted lines of total revenue, cloud and our geographic performance. We have provided reconciliation charts for these and other non-GAAP measures at the end of the presentation and in the 8-K submitted to the SEC.

Finally, consistent with our last few quarters, IBM’s 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.

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

Arvind Krishna — Chief Executive Officer

Hello, everyone. I’m pleased to be speaking with you again. In April’s call, I talked about the impact of the global public health crisis and I told you about the important work we are carrying out to help the shifting needs of our clients. I also told you about the confidence I have in our strategy and our portfolio, which is focused on hybrid cloud, as well as data and AI, all of this continues.

Today there are two topics I’d like to cover. First, I want to tell you about what we’re seeing in the market, and then I want to discuss our priorities and actions we have taken to move them forward. From a market perspective, while the current environment poses certain short-term challenges, it also presents long-term opportunities that IBM will see, as our clients accelerate their shift to hybrid cloud and AI. The essential work that we do in terms of running our clients mission critical processes continues. More profoundly, we see that the digital transformation of businesses is accelerating.

Our second quarter results demonstrate this with an increase of over 10 points in our cloud revenue growth over last quarter. The trend we see in the market is clear. Clients want to modernize apps, move more workloads to the cloud and automate IT task. They want to infuse AI into their workflows and secure their IT infrastructure to fend off growing cybersecurity threats. As a result, we are seeing an increased opportunity for large transformational projects. These are projects where IBM has a unique value proposition, but they are also projects that take time to shape and therefore to close.

At the same time, we are feeling the impact of austerity measures that businesses have put in place to preserve cash and capital. Our software and services results reflect this reality. Jim will take you through this in more detail. Taken altogether, this is the backdrop of our results for this quarter, they reflect the immediate challenges and long-term opportunities of this environment.

Now let me move on and discuss my priorities moving forward. As I touched upon in our last call, IBM is focused on helping our clients in the two major transformational journeys they’re on, hybrid cloud, as well as data and AI. Hybrid cloud is the dominant force driving change in our industry, but as far from universal adoption. Only 20% of the workloads have moved to the cloud. The other 80% are mission critical workloads that are far more difficult to move, as a massive opportunity in front of us to capture these workloads.

When I say hybrid cloud, I’m talking about an inter-operable IT environment across on-premise, private and publicly operated cloud environments, in most cases from multiple vendors. Why do we believe this is the future rather than a pit stop along the way? Clients find choosing a hybrid cloud approach is 2.5 times more valuable than relying on public cloud alone. This considers factors such as innovation, development time and portfolio optimization.

Let me spend a minute to describe our hybrid cloud platform. It starts with Linux, which is the De facto operating system standard. We have a tremendous advantage with Red Hat Linux, which is the market share leader. Linux along with Containers and Kubernetes provides the architectural foundation of our platform and OpenShift is our core product that captures all this and more. IBM has a vast software and middleware portfolio, which has now been containerized and runs on OpenShift and Red Hat Linux.

The family of cloud packs were introduced in the second half of last year, allows our middleware to run in a cloud native environment and bridge our clients from the past to the future. This means clients can now deploy our software anywhere OpenShift runs. It is infrastructure agnostic, across not just public and private clouds, but also our mainframes and power system platforms. OpenShift is also what makes it possible to develop and consume software in a new way. It’s what enables DevSecOps and all the subsequent boosts in productivity, security and speed of deployment.

Our hybrid cloud platform also includes a set of advanced technologies such as Watson, Analytics, Encryption, IoT and many other, what gives our hybrid cloud platform the fuel it needs to accelerate adoption and become pervasive is the large ecosystem of portals we are building. We have gone to great lengths to forge a global correlation of best of breed ISV. This includes recent additions like Adobe, Salesforce, SAP, Box and Slack, all are using our hybrid cloud platform to help clients modernize mission critical workloads. We have done the same with major system integrators, Ernst & Young, Infosys, Wipro, Tata Consultancy Services, Tech Mahindra, Persistent Systems, all are examples that are helping expand the reach of IBM’s hybrid cloud platform.

Finally, you’ll recall that nearly half the hybrid cloud opportunity lies in services. An important part of our platform’s value lies in the expertise we provide to help clients on their journey, whether that’s modernizing apps, building cloud native apps, migrating to the cloud or managing these applications on the public and private cloud infrastructures. We are currently helping on grades of major clients on these journeys.

I believe that our strategic vision is taking hold in the marketplace. I mentioned the acceleration in our cloud growth this quarter to over 30%. This hybrid cloud platform generated over $23 billion of revenue over the last 12 months. I just described the importance of Red Hat Linux and OpenShift to our platform and Red Hat continued its momentum in the [Technical Issues] combination of IBM and Red Hat driving strong revenue and bookings growth.

Across the board, we are seeing greater demand for Red Hat products. Clients are eager [Technical Issues] to open source innovation. They want the freedom to securely deploy, run and manage their data and applications on the cloud of their choice and retaining that choice is critical. Clients such as Bharti Airtel, American Express, Vodafone, Broadridge Financial Solutions, Banco Sabadell and CaixaBank all see the value in a hybrid cloud architecture built by IBM and Red Hat.

As part of our hybrid cloud strategy, a key focus is to help clients tackle a complex and highly regulated workloads. Last year, we launched the financial services ready public cloud with Bank of America and we recently created a new program for ISVs and SACK, software as a service provider. I’m happy to share that we now have 30 ISVs signed up, this happened with great speed and I’m confident that more will join soon.

So let me pause for a moment and remind you of the three priorities I shared with IBM is on my first day as CEO. One, help our clients on their journey to cloud and AI. Two, win the architectural battles in Cloud with Red Hat. Three, continually delight our clients. These priorities remain the same and you can see how we have made progress in all of them.

At the same time, we have continued to deliver a series of new innovations in the last quarter. We launched our new Edge and Telco network cloud solutions, built on Red Hat OpenStack and Red Hat OpenShift, that enable clients to run workloads anywhere from a data center to multiple clouds to the edge. We also launched our AI for IT offering to give every CIO the ability to automate their IT infrastructure that immediately reduces cost and becomes more resilient.

AI for IT runs across any cloud and works in collaboration with an ecosystem of partners that includes Slack and Box. On quantum computing, we added an additional four systems which expands our fleet to 22 quantum computing systems. That includes eight systems that have demonstrated a quantum volume of 32, a yardstick IBM has proposed to measure the relative power and usefulness of quantum computers.

I’ve talked previously about the importance of both organic and inorganic investment to drive innovation. We recently announced two acquisitions that will enhance our hybrid cloud and AI capabilities. In June, we acquired Spanugo to boost our compliance and cybersecurity capabilities for the hybrid cloud. And in early July, we agreed to acquire WDG Automation that advances AI infused automation capabilities into our Cloud Paks.

Needless to say, this is a unique and challenging time for our clients. To continue to be their most trusted partner, we are spending a lot of time and energy to drastically simplify how our teams go to market. We’re doing a lot of work on the back end to bring our portfolio together in a more cohesive fashion, so our teams can come at simpler and more relevant proposals. We are also focused on changing our culture and operating model, so we can make decisions more quickly and make our interaction with clients a lot more experiential. Jim will take you through a few of our more recent actions.

Moving forward we will continue to take actions that improve our operating model and accelerate our strategic priorities, so that we can emerge stronger. Before turning to Jim, let me end by saying a few words on our commitment to corporate social responsibility. This has always been important to IBM, but as you know with the current events in the United States, there has been a renewed focus to do more. As IBM CEO, I’m fully committed to ensuring that IBM will continue to lead in this area, but this is also about skills and creating opportunity.

Since 2011, IBM has helped to develop and expand a new public education model called vTech. vTech provides high school students from under served background with the skills and credentials they need for competitive jobs and stem. To that end, we recently made a commitment to hire 1,000 interns who come from vTech. To put this in context, we have between 5,000 [Phonetic] and 10,000 interns at IBM each year, so this represents more than 10% of our intern base. I’m always happy to expand later on this and other topics relating to our ESV efforts.

Now back to the quarter and the business, Jim is going to take you through our results. Jim, over to you.

James M. Whitehurst — President

Thanks, Arvind. During our first quarter earnings call, I talked about how we’re prepared for a wide range of outcomes, given the economic uncertainty. Our second quarter results were within that range. We delivered $18.1 billion of revenue, expanded gross margin, reported operating earnings per share of $2.18 and continued to generate solid free cash flow. Our balance sheet remained strong and we continue to have ample liquidity. The external dynamics we saw in March continued into the second quarter, with varied impacts by region and industry. As we discussed in April, we are not immune to the macroeconomic environment. But our client and our portfolio mix provide some stability in our revenue, profit and free cash flow, we saw that again this quarter.

Let me remind you of how our business mix provides this stability. From a client perspective, our business is more concentrated in large enterprises, which in total have been relatively more stable throughout the pandemic. Though as you would expect, we saw more weakness from smaller enterprises this quarter. About 70% of our revenue comes from industries that run the world’s most critical processes and those industries have been less impacted by the current economic and health crisis. We saw that in our results again this quarter and in fact grew revenue in financial markets, government and education.

From a geographic perspective, we have a global footprint of more than 170 countries. This provides a bit of a natural hedge, as we continue to see markets experience different impacts from the pandemic over time. And then finally, when you look at our portfolio, about 60% of our revenue comes from recurring revenue streams. While we’ve adapted quickly to conduct business virtually around the world, as expected we did have disruptions in transactional performance and volume reductions.

Many clients continued to delay projects, defer purchases and favor opex over capex spending in this environment. This pause in large purchases and discretionary spending was most evident in our perpetual software licenses and project-oriented services. While clients remained focus on near-term priorities running mission critical processes, operational stability and cash preservation. As Arvind mentioned, the last few months also highlighted the need for clients to accelerate their digital transformations, leveraging hybrid cloud and AI. Across IBM, our cloud revenue grew 34%, which is up from the 23% growth in the first quarter. IBM’s hybrid cloud platform generated more than $23 billion of revenue over the last 12 months.

With Red Hat, we are positioned to win the hybrid cloud architectural battle and have deployed the most secure, open hybrid cloud platform underpinned by OpenShift. We brought Red Hat and IBM technology together in our modernized Cloud Pak software solutions, providing the leading hybrid cloud platform. We now have over 2,400 clients using our container solutions and nearly 600 IBM services clients utilizing Red Hat technology. Red Hat delivered strong results in the period with normalized revenue growth of 18%, driven by the synergistic effect of IBM and Red Hat.

Last August we talked about how Red Hat would benefit from IBM’s incumbency and large accounts and leverage our global reach to expand into new markets. We’re seeing that where IBM and Red Hat come together, clients are making larger scale architectural commitments and longer-term and more strategic purchases. This quarter we had a significant increase in the number of Red Hat large deals and expanded Red Hat’s presence in under penetrated focus markets.

In the second quarter, we took additional steps to better position IBM in this environment and emerged stronger. We announced new offerings including AI for IT and 5G Edge and we recently added key capabilities in RPA and cloud security through two acquisitions. We are also working to fundamentally shift our operating model. We’re simplifying the geographic dimension of our go-to-market by consolidating our operations and moving to a streamlined structure for sales teams to be more flexible and responsive to our clients. We’ve enhanced our virtual selling capabilities including co-creation with clients on virtual platforms, addressing client needs and solutions with real-time data and shifting to contact list delivery even for the most complex, transformation projects.

We’ve created a virtual dynamic delivery model to effectively re-imagine services delivery, including improved access to expertise and enhance business resiliency and security. We’re transforming key business support functions to simplify our organizational structure and infuse AI into our workflows, to deliver faster, better insights and we’re expanding our developer and ISV centric ecosystem to drive workloads to our hybrid cloud platform.

The last dimension of our business model I want to spend a minute on is our liquidity and balance sheet profile. We further strengthened our cash in our balance sheet in the second quarter, fueled by solid free cash flow and we took additional measures to improve our liquidity position. We ended June with a cash balance of over $14 billion, up over $5 billion from the end of last year. We remained opportunistic in the capital markets, issuing $4 billion of debt across multiple tenders with very favorable economics. This provides us with additional liquidity in the short-term, while we remain committed to our longer-term deleveraging plans.

Our debt of just under $65 billion was consistent with March, as our bond issuance was offset by $4 billion in term debt and commercial paper reductions. Our debt includes $22 billion of Global Financing debt, which is primarily in support of IBM products and services and has a stable credit portfolio. Recently, we also successfully completed our annual renewal of IBM’s global credit facilities. We’re maintaining over $15 billion in undrawn credit, one of the largest corporate facilities in the S&P. Our high-value business model and strong balance sheet and cash flows gave us the confidence to increase our dividend in this environment, the 25th consecutive year with an increase.

Looking at the key highlights in the quarter, I mentioned our strong growth in cloud and our continued momentum in Red Hat. The combination of Red Hat, our focus on productivity and operational efficiencies and our cloud scale out drove significant operating gross margin expansion up 160 basis points. Our balance sheet strength was enhanced by $2.3 billion of free cash flow this quarter. We had strong working capital performance, driven by stable collections and good financing attach rates primarily on IBM Z. This was offset by a higher net capital expenditures and workforce rebalancing payments.

The capex increase was driven by the build out of our cloud infrastructure and lower proceeds from real estate sales, while de-emphasizing lower value services content. In the quarter, we also continued to have free cash flow contribution from Red Hat, net of interest expense. Overall, we generated $11.5 billion of free cash flow over the last year, which is about 145% of GAAP net income. These results show solid free cash flow performance and a strong financial profile.

Now I’ll turn to the segment performance beginning with Cloud & Cognitive Software, where revenue was up 5% driven by growth in cloud and data platforms. 90 days ago, we highlighted how software transactions stalled in March, as clients quickly shifted their focus to resiliency efforts. That focus on resiliency continued into the second quarter and impacted software performance especially in the first part of the quarter. Later in the quarter, demand improved for critical priority areas such as hybrid cloud solutions and some AI applications. We had a sequential improvement in software renewal rates as clients favored subscription models. Perpetual software licenses continue to be impacted particularly in some of the more troubled industries.

In cloud and data platforms, revenue was up 30%. This reflects the synergy of bringing IBM and Red Hat together, as we standardize on Red Hat OpenShift as our hybrid cloud platform and modernize our software portfolio to run on it. This quarter, we had good performance across Red Hat, including amplified bookings growth in the 30 under penetrated countries where IBM has helped Red Hat expand go-to-market efforts over the last year. And with further Cloud Pak traction this quarter, clients are embracing a hybrid cloud strategy and increasingly leveraging the OpenShift container platform. These actions all contributed the growth in the number of clients using our container platform to over 2,400.

Cognitive Applications revenue declined as clients in some of the more impacted industries deferred transformational or discretionary spending. We saw this play out in IoT engineering lifecycle management where demand from automotive, electronics and aerospace clients soften this quarter. These industries remained focused on core operations rather than transformational purchases. And our weather consumer business was impacted by general weakness in the advertising market. In transaction processing platforms, client focus on opex versus capex continued to impact transactions this quarter. 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.

Now turning to our Services segments. Global Business Services revenue declined 6%. As we entered the year, GBS had good momentum and we expected revenue to accelerate throughout the year, but as the pandemic intensified and the macroeconomic climate worsen, Clients quickly shifted their focus to operational stability and cash preservation. This resulted in a delay in both the existing projects and new commitments, especially in projects that are more discretionary over the longer time to value such as next-generation enterprise applications.

The delays impacted the revenue coming out of backlog, which is about 80% of the quarterly revenue, as well as the smaller in period signings, which yield revenue more quickly. While declines continued in these smaller signings from March through May, the trajectory improved and we returned to modest growth in June. For the quarter, GBS cloud signings grew at a double-digit rate as clients are prioritizing their digital transformations. Offerings such as cloud strategy consulting, application development and modernization continue to grow revenue in the second quarter. These offerings standardize on Red Hat’s OpenShift platform enable clients in their cloud journey’s. We are working with an additional 60 clients such as Bank of America, Medtronic, Loblaws, Bank of England, Credit Mutuel and Deutsche Telekom to utilize Red Hat technologies to transform their businesses.

Looking at profit, we expanded gross margin in GBS by 240 basis point. We managed the business well in this environment by leveraging our variable and global delivery resource model, improving price margin realization and optimizing utilization. We also had a currency benefit, which is fairly consistent with the last couple of quarters. At the same time, we’re continuing to invest, building skills and practices through education and hiring. Overall, while we’re dealing with some near-term macro challenges, GBS’ deep industry expertise combined with IBM’s and now Red Hat’s innovative technology play a critical role in the acceleration of clients digital transformations.

In Global Technology Services, revenue declined 5%, fairly consistent with the first quarter’s performance. We had signings growth in the quarter and strong growth in cloud revenue, but this was offset by continued declines in client business volumes. As we talked about in the past, about 90% of GTS’ quarterly revenue comes from contracts in our backlog. While this business has a high mix of recurring revenues, there is some variability in that revenue stream. We provide clients with flexibility in their capacity to deal with volume changes due to their business needs and macroeconomic environment.

As the pandemic intensified through the end of March and into the second quarter, we experienced lower client base business volumes reflecting challenges across industries. While performance in some of these industries like financial services was consistent quarter-to-quarter, other industries had a more significant decline. We saw this especially in retail, automotive, consumer goods and travel and transportation. This impacted the revenue coming out of our backlog in the second quarter. At the same time, clients are continuing their infrastructure transformations to hybrid multi cloud environments.

For example at Daimler, we have expanded our relationship to migrate their global after sales platform as the IBM Cloud and this quarter we announced Sabadell Mexico the first 100% mobile bank in Mexico will host its infrastructure on the IBM Cloud and use Red Hat Enterprise Linux to modernize its applications. They joined other financial institutions like Bank of America, BNP Paribas, Banco Santander, Latte card and Caixabank among others, as they move forward on their cloud journey.

These commitments contributed to the signings growth for GTS and in fact in the first half signings grew at a double-digit rate. This results in improved backlog trajectory from where we entered the year. Given the overall duration of the backlog, this will convert to revenue over a longer-term horizon. Looking at gross profit, GTS margin declined 30 basis points. This was driven by mix as the high value TSS business is impacted by the current product cycle. I’ll remind you, we have not yet realized the benefits from our first quarter’s structural actions.

Turning to Systems, revenue was up 6% this quarter and gross margin expanded over 400 basis points. We again had good growth in both IBM Z and storage. Clients value the new innovation of the z15 mainframe and high-end storage. Similar to the first quarter, the z15 offered enterprises valuable capabilities including remote management, security and importantly scalability. This quarter clients also increasingly look to IBM Z for resiliency and business continuity to keep mission critical workloads running smoothly.

We continue to offer additional hybrid cloud capabilities on z15. We released Red Hat Ansible certified content for IBM Z and launched a new cloud native development offering Wazi Workspaces which allows developers to use industry standard tools from IBM Z to multi-cloud platforms optimized on OpenShift. The growth in Z and storage was partially offset by weaker performance in power, reflective of where we are at in our product cycle, empowers client base of smaller enterprises which are impacted more during this pandemic.

Now let me bring it back up to the IBM level, I think Arvind summed it up well. The current environment presents some near-term challenges for our clients, but it also provides some longer term opportunities for us. We have a business profile and business model that provide some stability in the current environment. We have also recently taken a number of actions that strengthen our operating model for today and for the future. We built a robust hybrid cloud platform based on what we firmly believe is the winning architecture. This technology centric platform together with our deep industry expertise and ecosystem partners will enable us to accelerate client digital transformations and move more of our clients mission critical workloads to the cloud.

As we enter the second half, we have a compelling set of offerings and a strong pipeline across software, services and systems. How that pipeline yields to revenue will ultimately be tied to the rate and pace of the economic recovery and the result in client spending confidence. Given the uncertainty in the environment and consistent with our direction from last quarter, we’re not going to provide guidance for 2020, but I do want to remind you of a few specific dynamics. Systems performance reflects where we are at in our product cycle and we wrap on the IBM Z launch in September.

In Software, our transaction versus annuity mix varies by quarter. Historically, we have a lower mix of transactions in the third quarter and our largest transactional base is in the fourth quarter. And then for Red Hat, we anniversaried the acquisition in early July. We’re wrapping on a large part but not all of the impact of the deferred revenue adjustment and transaction charges. We also wrap on the divestitures completed in the second quarter of last year and the savings from our structural actions will start to yield in the second half, providing better cost competitiveness and margin performance especially in GTS. Finally, we remain confident that we have ample free cash flow and liquidity to invest in our business and return value to shareholders through dividends.

Arvind, any final comments?

Arvind Krishna — Chief Executive Officer

Jim, what’s most important to me and to IBM is that we emerge stronger from this environment, with a business positioned for growth. And I’m confident we can do that. My focus will be on investing and maintaining flexibility to take action not just to strengthen our operating model, but also to advance our strategic priorities.

Now over to Patricia for the Q&A.

Patricia Murphy — Vice President, Investor Relations

Thank you. Arvind. Before we begin the Q&A, I’d like to mention a couple of items. First, we’ve included supplemental information at the end of the presentation. And finally, as always, I’d ask you to refrain from multi-part questions.

Sheila, let’s please open it up for questions.

Questions and Answers:

 

Operator

Thank you. At this time, we’ll begin the question-and-answer session of the conference. [Operator Instructions] Our first question will come from Matt Cabral with Credit Suisse. Your line is open.

Matt Cabral — Credit Suisse — Analyst

Thank you very much. I understand you guys are not going to give formal full-year guidance at this point, but just wondering if you could spend a little bit more time about how we should think about moving into the third quarter versus seasonality where I think typically you’re down a little bit over $1 billion sequentially. And may be just take a little bit deeper into some of the biggest swing factors we should be thinking about by segment going from 2Q into 3Q?

Arvind Krishna — Chief Executive Officer

Thanks, Matt for the questions. Let me start and then I will give it to Jim for adding a bit more color on a bit more detail. So, as both of us said on the call, we’re seeing that there is — its two-sided. We see opportunity in hybrid cloud, we see opportunity in digital transformation, we see opportunity in people as they’re doing a return to the workplace and projects that all advance those things, some of those give them long-term benefit, some give them a short-term benefit. That said, we are seeing that there is a negative on things that require capex, things that have very long term payoffs and project-based businesses.

If we think about the difference between third and fourth quarter, third is a bit lighter on transactions, fourth is very heavy on transactions. If we also look at some of those project-based businesses, we’ll likely and this is where it’s tough to give guidance, but it’s likely that we see that the economic recovery is looking to be longer and more protracted than we might have hoped for back in March. And as we see that bouncing ball on the economic recovery, whether it’s in the United States and Brazil, in India, that has an impact on all of these elements. But the other thing that is important in some of the remarks that Jim made, we kind of have a two-third, one-third mix maybe a bit more than that in industries which are less impacted versus industries that are more impacted and that of course will play out in our results as well.

But let me give it to Jim to make some of those things more precise.

James M. Whitehurst — President

Yeah. Thanks, Arvind and thank you very much for the question overall. As we stated wrapping up the prepared remarks, we do have a very strong pipeline across our offering portfolio around systems, around software, around services. But as Arvind just indicated, the yield will be tied directly to the rate and pace of the recovery of the pandemic curves, which by the way very based on market around the world and industry which tied directly to client spending confidence overall. If you look at just macro level dynamics of our business profile, there is a couple of things that I think will play out as we look forward. One is we’re going to wrap on divestitures, that’s been a two point headwind to the IBM company for the last four quarters and we wrap as we enter second — the second half.

Number two, we’re dealing with actually a weaker dollar and you’ll see in the currency back up that is now flat to about 1 point of a headwind, where we were dealing with about a 2 point to 2.5 point headwind over the last few quarters. Three, the dynamics of client buying behavior is really shifting that acceleration of digital transformation and to cloud you see it play out in our results and we actually have a strong pipeline, Red Hat had another very good quarter, good pipeline set up, our hybrid cloud solution offerings around Cloud Paks with good momentum, we got a good annuity base of business that we’re going to continue to build on what renewal rates and we’ve got a systems business that we refresh with new innovation.

When you look at services to your point, we’ve got structural actions that are going to start yielding as we exit or excuse me as we enter the second half and we got a strong pipeline as Arvind stated on the call of large transformational deals. Now those are always binary as to when they close, but they will reposition the emerging stronger theme of our backlog in services overall, in the meantime we’re going to continue to deal with the economic impact around discretionary projects in particular around GBS.

Patricia Murphy — Vice President, Investor Relations

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

Operator

Yes. Next we will hear from Amit Daryanani with Evercore ISI. You may go ahead.

Amit Daryanani — Evercore ISI — Analyst

Thanks a lot. Good afternoon and thanks for taking my question, guys. I guess my question is really around the cloud revenue growth, which I think was about 34% this quarter was a really impressive acceleration from I think given what you guys said in the March quarter. Is there a way to think about just how sustainable do you think this growth is as we go forward. And then when I think of this number 34%, is it we’re going to see how much of this growth is from new logos and new wins on the customer side versus perhaps taking existing customers from a on-premise to a hybrid off-premise journey?

Arvind Krishna — Chief Executive Officer

Okay. Amit, let me start, this is Arvind and then we’ll ask Jim to add a lot more color. So Amit, so clearly, since this is the last quarter where Red Hat was I’ll call it inorganic that clearly had an impact on this. That said we’re still actually quite happy with the results despite that that had accelerated quite a bit from earlier and from both the first quarter and last year. So I’d just say it like that and, and leave it at that.

The second part you asked was, are we just moving out people from one side to the other or are we getting new wins? Amit, the vast majority of this, it is a big core of Red Hat as I describe our hybrid cloud platform, that’s not a left to right shift, that is actually net new. When we think about our wins in telecom, actually those are places we were never present, actually either of us not just one of us. If you think about modernizing peoples’ applications, that’s not a shift, that’s actually net new work for us.

You asked about new logos that may apply to a little bit of services, but for the company at large, look, we have a lot of clients, I mean like almost any enterprise of any size is already our client especially on the product side of the house. So talking about them being new logos would be unfair, but are we getting into areas within them that we previously did not have access to, I would say, we are absolutely doing that and that’s a big part why you see that 34% growth.

So with that, let me give it to Jim for adding to that.

James M. Whitehurst — President

Yeah. Just some color around how that 34% was actually delivered overall. Arvind talked about it from a client perspective in the value we bring around our hybrid cloud differentiated value proposition, but the 34%, Amit, as you indicated is up about 11 point sequentially quarter-to-quarter with regards to growth profile, that was driven pervasively across all four segments of our business. And in fact now a 11-point sequential year-to-year improvement or quarter-to-quarter improvement was entirely organic.

Red Hat contribute significantly to the 34% overall, but even on a pro forma organic perspective, we are growing right around 20%. We got a GTS business that has over a $9 billion book of business in our cloud portfolio, that grew 20% this quarter and accelerated from first quarter. Our GBS business which is about $5.5 billion on the trailing 12 months grew in the mid-teens. And our software business which is about $5.5 billion book of business, grew well in excess of 100%, but grew around 20% plus pro forma organically.

So I think we’re seeing broad base acceleration really driven by the client buying behavior shifts that are happening in the marketplace. And to Arvind’s prepared remarks overall, we feel pretty confident about the offering portfolio and the differentiated architecture on our hybrid cloud platform that positions us to continue to capitalize on that going forward.

Patricia Murphy — Vice President, Investor Relations

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

Operator

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

Toni Sacconaghi — Bernstein — Analyst

Yes. Thank you. I was wondering if you could comment on linearity in the quarter relative to sort of normal linear patterns, it sounded like software was a little worse in the first half of the quarter and then got a little bit better. I think there was one other business where you referenced things may be looking a little better as the quarter progressed. So, could you comment on whether that’s a fair observation and if it is, why shouldn’t we be thinking about modeling normal or better than normal seasonality from Q2 to Q3? And then separately, could you just comment on GBS signings, it sounds like they were down perhaps 20% year-over-year and what that might suggest for the GBS business trajectory over the next couple of quarters. Thank you.

Arvind Krishna — Chief Executive Officer

Hi, Toni. So you are very astute in your observations about linearity in second quarter. So let me just add a little bit of color to that. When we finished the first quarter, we were quite transparent in saying that March was a lot worse than we expected compared to what we see. I wouldn’t use the word linear because of the transactional side the last month of the quarter is a lot more, so I’ll just compare to normal maybe as opposed to linear. When we entered second quarter, the annuity side of the business yields pretty evenly other than the slight I’ll call it maybe 4% to 5% in volume that goes up and down. So that side is linear approximately and that didn’t change.

When we look at the transactional side of the business, I would tell you that the month of May was significantly worse than we would normally expect and we saw that begin to come back in June, but not really recover to normal levels. That’s why I pause on saying will 3Q be better because since May was worse than June, but June was still worse than we might have expected last year. So that’s also something about that. And then I’ll — let me give it to Jim to also comment on the impact of the signings, as well as more on the imports linearity question.

James M. Whitehurst — President

Yeah. So thanks, Arvind and thanks, Toni for the question. But as you indicated with the heart of your question overall, the dynamics in March that we saw generally played out as we entered the first part of second quarter. Clients are really continued focused on mission critical operational stability, cash preservation as any company as we were in the midst of the worst pandemic we’ve seen in quite a period of time. And then I could even tell you as CFO of the IBM company, we were maniacally focused on liquidity.

So that was not unexpected, but what we see play out as we move through the quarter is really the demand profile is really correlating to the curves of the pandemic and that plays out differently around markets around the world, around industries around the world and that’s why we try to give some color about our geographic diversification, which we believe provides a natural hedge in this environment as many markets are going through different curves and our industry concentration being 70% in the industries that are minimally or moderately impacted by the pandemic overall per Gartner and IDC.

But when you look at the rate and pace of that economic recovery as we said when we concluded prepared remarks is really going to follow that pandemic. But when you look at our performance in the second quarter and not to repeat Arvind, but just give a little color by unit, our GBS business really stalled in the month of March after starting very strong through two months, that continued through the first-two months of this quarter. And actually June, we saw our small transaction volume which has high yielding revenue content going forward actually come back to growth and it was led by Europe which stabilized with their pandemic curves and it was led by Asia-Pacific. Actually the Americas was the exact opposite, both Latin America and US.

We started out pretty strong as the US was getting the pandemic in curve underway and then when it started bouncing in June, we took a big step back. So that’s what happened in GBS. CNC software very strong conclusion where value and hybrid cloud solutions certain AI specific, Red Hat very strong closure the quarter, but I’ll tell you one we came off a very strong second quarter, large deal closure last year. So we had a very tough compare, but we didn’t grow in the month of June, we were just much better than March and April and May.

Systems finished pretty strong, which are a testament to our value prop and GTS — GTS was kind of a mixture, 90% plus of that business is annuitized. We are dependent on client base business volumes, that’s 70% of industry, we actually saw stability and for the first time and while some growth in like financial markets government, etc., but we are getting impacted in GTS by client base business volumes in particular around airline travel transportation and retail.

Patricia Murphy — Vice President, Investor Relations

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

Operator

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

Wamsi Mohan — Bank of America — Analyst

Yes. Thank you. Arvind, you noted that the hybrid cloud opportunity is half in services. Do you see for IBM a larger opportunity at GBS or GTS? And any additional color on the GTS, GBS mix of those large transformational deals you alluded to in your prepared remarks will be helpful. And if I could, Jim, could you maybe also talk about the seasonality relative to cash flows in second half versus first half this year given the Red Hat contribution in the first half? Thank you.

Arvind Krishna — Chief Executive Officer

All right. Thanks, Wamsi. So, look, so I mentioned explicitly that half the opportunity is services, when we look at the market that’s a $1.2 trillion market for hybrid cloud and about 550 billion [Phonetic] you could say maybe a touch more is a services opportunity. So that’s the almost half. Within that, the bulk of the opportunity is in application modernization and improving the end-to-end workflows of our clients’ processes. So when you look at those elements and then you look at both private and public cloud, the nature of those operations is much more automated and much more captured in code than traditional infrastructure. That’s my — I guess my technologist way of saying that the opportunity will be larger in GBS than GTS for those opportunities.

However, I’ll just put a caution, but that said the run component does remain important, it’s not that it goes away, but in terms of pure dollar opportunities it’s shifting more towards the GBS side for that side of the market as opposed to the traditional infrastructure. And we are seeing that play out in the mix of the opportunities because people need to get the work done first in terms of transforming their application. And that innovation is what is driving that interest and that’s why you see us keep using the word transformational because that is where people see the huge opportunity of these projects. And so with that, Jim, on —

James M. Whitehurst — President

Wamsi, thank you for the question overall around free cash flow and seasonality. Through the first half, we delivered $3.6 billion of free cash flow and $5.1 billion of cash from ops. Cash from ops is about flat year-over-year, our free cash flow is down about $400 million. That positions us on a trailing 12 month $11.5 billion I think in a very strong free cash flow realization.

Let me give you some of the underlying dynamics and then I’ll give you some color given we’re not given forward-looking guidance, we’re not going to give a free cash flow guidance here on the call, but to your question I’ll give you some color about seasonality and what were some of the headwinds tailwinds. As we stated when we entered January very similar, we talked about capital, we’re going to continue to invest in this business, capital through the first six months was a headwind of almost $0.5 billion. Our workforce rebalancing payments were a headwind predominantly in the first half, that will diminish as we get into second half and cash tax was a headwind through the first half already and that would — should be pretty consistent as we move forward.

Offsetting some of that here in the first half is we’ve had very strong working capital efficiency, very strong collection rates even in this environment, talking to the testament I think of the value and how essential we are to our clients in delivering mission-critical value and also we’re in a mainframe cycle. So our IGF attach rates are doing quite well and that is helping our free cash flow overall. So I assume as we move into the second half, we’ll have similar dynamics around the headwinds, we start now in the second half as we anniversaried Red Hat, the profitability of Red Hat will start accelerating as we get into the second half that should help us, we’ll start reducing the amount of tailwind on working capital efficiency as we get through our Z cycle overall. And I think with regards to cash taxes, I stated pretty similar.

Patricia Murphy — Vice President, Investor Relations

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

Operator

Next, we will hear from Katy Huberty with Morgan Stanley. You may go ahead.

Katy Huberty — Morgan Stanley — Analyst

Thank you. Good afternoon. A number of your peers Accenture, SAP, Oracle have recently provided guidance, is there something different about your business exposure or what you see in the market that is holding you back from providing guidance and what is it that you’re looking for in order to return to the prior framework of giving an annual outlook?

Arvind Krishna — Chief Executive Officer

Hi, Katy. Thanks for the question. I think is to deal — I can’t comment on is the business different or do we see a different, I can comment on what we see. We have a lot of uncertainty in the economic environment around the globe. And when we look at it by geography, by continent or by industry, there is just in so much variability that we can’t answer it. In April, when we said that we will have reevaluate it 90 days, maybe we were a little bit optimistic that we will get more stability on the health, which in turn leads to the economic conditions and that curves begin to flatten in three months to four months which was at that time a reasonable, but turned out to be a misplaced expectation.

And so we just can’t tell where those go. And because those have an impact not in a month or two were over six months to nine months, even on portions of the annuity business as Jim has been very clear, there is — clients do get the ability to dial volumes up and down in some range. So that creates for us the inability to really want to give guidance that we are confident about. And so it’s that mixture of confidence and uncertainty in the economics that makes us unwilling to provide guidance.

James M. Whitehurst — President

Yeah. The only thing I would add, Katy, is that, it’s not a statement of the confidence we have in our portfolio, our offerings, our strategy and our platform of what Arvind is trying to drive as the new CEO of the IBM company overall. We feel pretty confident in that and Arvind articulated that in his prepared remarks around our hybrid cloud strategy, our platform, our architecture and components of our business. As we see play out in the second quarter, this demand profile and the resulting client spending confidence is going to follow the pandemic curves around markets and around industries and we saw that play out in the second quarter and we’ll see how the world deals with the overall pandemic, the crisis and how we enable our clients and our employees and our communities to move forward.

So it is not prudent right now in this environment as we’re still dealing with it to tie down our flexibility move — to move forward. We’re going to continue to invest in our business and we have the right liquidity, strength of our balance sheet and investment in thin flex profile to take the right actions in this environment to advance our strategic priorities going forward.

Patricia Murphy — Vice President, Investor Relations

Thanks, Katy. Let’s go to the next question please.

Operator

Our next question will come from Tien-Tsin Huang with JP Morgan. Your line is open.

Tien-Tsin Huang — JP Morgan — Analyst

Hey. Thank you so much. Arvind, you mentioned you’re seeing large transformational projects in the pipeline, I think Jim you underlined that a couple of times. I was curious how meaningful could this be, I don’t know if you can compare it to past cycles, I recognize is going to hinch [Technical Issues] a little bit on the world healing, but just trying to get a perspective on the sizing here. And then also just as a second clarification, you talked about trading off the trade-off of opex versus capex, do you have pretty good line of sight at this point on your annuity business looks like transaction processing for example is pretty stable quarter-to-quarter in terms of year-on-year trends, I just wanted to make sure I didn’t miss anything there. Thank you.

Arvind Krishna — Chief Executive Officer

Thanks. Thanks, Tien-Tsin for the question. How meaningful can the large transformational projects be? So when we say large, these are typically projects that measure in the multiple hundreds of millions of dollars and contract value. But Tien-Tsin you do the P times, clearly say, pick a number is 300, 400, 500 million in total contract value and you do that and you say those typically will give their full yield over five years to seven years, that’s the kind of nature they take.

And then you say how many of those are we going to get done, we have a fairly large number of them in the pipeline. What we are hesitant to say is well to take three, six, nine or 12 months to get closed fully, though we’ve been added for a few months already and so I think it is quite meaningful if we begin to close them. We will absolutely see the needle move on our services business as those begin to close and yield.

Relative to past cycles, I think as we came out of past recessions or as we came out of different crisis, I’m not sure I can call the.com bust it was quite maybe it was a minor recession, but it was definitely impact on the tech industry for sure. And we saw the impact of those kinds of projects different nature now that about move into the cloud journey to cloud — hybrid cloud transformation then they were more about perhaps of a nature of outsourcing and beginning to create a lot of efficiency in infrastructure management. So the nature of these projects has changed.

And so let me — let Jim add color to it and also talk about the energy business.

James M. Whitehurst — President

Yeah. I would just, thanks Tien-Tsin for the question. I would just add to your last point, I think the nature and the rate and pace of those large transformational deals right now feel much quicker than when we were sitting back in 2008 moving through this. It was a very different recessionary time that impacted industries differently and markets differently. This is more so of a consumer-based, small medium market base industry specific base that is getting impacted at least immediately right now. But that time the value will shift over time as we move forward.

So I think, Tien-Tsin, when we went back and we’ve done many different stress test of our business model to ensure our balance sheet, our liquidity position scenarios, we looked at prior recessions, we don’t see anything different. The only difference is where that client behavior and now shifting from a managed services years ago to more of a hybrid cloud asset base differentiation.

The last thing on your annuity, we feel pretty confident about our annuity business, over 60% of our revenue today is pretty stable. TPP is a mixture of some annuity and most annuity I should say, some transactional I think from an annuity perspective we’re performing pretty consistent with the market overall and we see that continuing to play out here in the second half.

Patricia Murphy — Vice President, Investor Relations

Thanks, Tien-Tsin. Sheila, can we please go to the next question?

Operator

Yes. Our next question will come from David Grossman with Stifel Nicolaus. Your line is open.

David Grossman — Stifel Nicolaus — Analyst

Thank you. Good afternoon. The GTS business it appears to be all these different moving pieces — you’re significantly impacted by volumes, but looks like you had pretty good signings in the first half of the year, durations up in the backlog, etc. So, is there any way you could kind of shift through this for us, the cyclical impacts of it, we can get a better sense of how the transformation of that business is trending, particularly given the ongoing revenue challenges we’ve had over the last several quarters.

And perhaps you can reconcile those because I heard you made a comment seeing a shift to the applications where from GTS to GBS and maybe it’s more informative to look at it on a combined basis, I mean you’re managing and under one person now and you’re trying knot that together. So — so maybe you see more acceleration in GBS coming out of this and GTS maybe flattens out. So just trying to get a better sense of how to think about the health of that business now and how it’s trending.

Arvind Krishna — Chief Executive Officer

Okay. So David, let me maybe start and then I’ll ask Jim to add color. Look we should acknowledge that we are never happy when a business is declining even at mid-single digit. So let’s just — we acknowledge that and then say, but then what are the elements underwrite, which is what you’re asking about what are all the moving parts.

And given the large annuity nature of that business, that does reflect signings and commitments from the past not just within the quarter, so that is there and that means that you’re looking at the revenue impact that even if you have good signings, the revenue impact takes a long time to sort of make its way through the — through that business and also in terms of the backlogs that are in that business.

So when I look through the cyclical impacts there, I think that we want to be careful about trying to say that the trends change dramatically quarter-to-quarter. I think that those are places where it is going to take a while for the revenue trajectory in that business to change. And I’m not sure that looking at it combined. It is important to be able to leverage the parts of the business with each other and there are some elements that can be leveraged and that is why you refereed to Mark Foster’s role where he has both the services teams. However, they are very different businesses and they’re different business models. So I’m not sure that I would say that looking at them combined is a better indicator of how that trending. Jim?

James M. Whitehurst — President

Yeah, David. I would just add the last point you just made, they are fundamentally different business models, while were human capital base, one is a data center managed services based business model that is highly capital intensive. The other is a strategic capability industry lens project-based business, that is fundamentally human capital, not physical capital dependent. So they have different economic equations, different growth profiles, one is a growth engine, GBS, the other is a value-based platform in GTS overall.

Now with all that said, we’ve said all along that we’ve got a leverage at least from an offering a capability and to some extent at a client lens, some leverage between those two because clients are making architectural decisions that are application first and infrastructure second. But the GTS business model overall and I will echo Arvind’s point, we’ve been doing a ton of work around the portfolio looking at this backlog which by the way, any year David, as you know quite well, about 80 plus percent of a years out of that business is under contract.

Now we do have variability colors within that of about 30% of our clients today have that. But this is long annuitize based contracts that has a duration of probably five plus years, so you don’t turn that overnight. So when you take a look at that business, we’ve been looking at it by offering, by client, by industry, by contract type and we’ve been trying to determine how do we won, reposition and leverage the value of incumbency and then also to invest in new transformational services, which is where the growth is coming in managed services, building off of the back of the application side of GTS or GBS I should say.

And that is things like cybersecurity, managed services, data, managed services, compliance services and the like. So we’ve got our arms around this, but it’s going to take time to turn this business overall, especially in the pandemic.

Patricia Murphy — Vice President, Investor Relations

Thank you, David. We’re already at 10 minutes after the hour. So why don’t we take one more question.

Operator

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

Keith Bachman — Bank of Montreal — Analyst

Hi. Thank you very much. Jim, I’ll direct this to you, I wanted to see if you could talk about Cloud and Cognitive a little bit and my question is, how should we be thinking about, what I really want to dig into is, you’re going to anniversary Red Hat for the first time, albeit, you had some DR write-off. So it’s not a complete anniversary, you’re going to go ex mainframe cycle too. So I won’t — is there some impact on the transaction’s processing side or any other part of it. But all else equal the I would think the growth rate over the next couple of quarters is going to drop pretty meaningfully just given the anniversary of Red Hat, but perhaps combined with the mainframe cycle as well. But what are the puts and takes you want us to think about over the next couple of quarters in Cloud and Cognitive?

James M. Whitehurst — President

Yeah. Thank you very much for the question as we wrap up right now, so let’s take the cloud and cognitive business overall, right? I think first from a cloud and data platform perspective, we’re seeing very good growth overall. Yes, albeit very strong momentum on Red Hat and we couldn’t be more pleased with the synergistic value we’re bringing to our clients with regards to IBM and Red Hat better together. To your question, we –Keith, we actually anniversary that on July 9. So, we will now wrap around on the operational performance of Red Hat going forward. Still growing nicely at an 18% historically normalized basis here in the second quarter, so we’ll still get growth off of that.

But second to your other point, we’ve been dealing with this deferred revenue non-cash purchase accounting adjustment for the last four quarters. That now starts lessening over time. So when you look at Cloud and Cognitive Software with regards to Red Hat contribution in the first half of what we’ve seen to the second half of where we’re going forward, it’s about a point or give or take of a headwind compared, but still a positive contribution the Cloud and Cognitive Software overall. The other dynamic I’d bring up and I think Arvind talked about this earlier, you got to make sure that this business while 75% annuity 25% give or take in a year transactional, that transactional skew varies very differently between the third quarter and the fourth quarter.

Second quarter and fourth quarter are more like 25% to 35% of a transactional skew, first and third quarter are more like a 15%. So just based on that dynamic, when you look at 2Q to 3Q, we’ll get more of a tailwind and then when as we get into the fourth quarter if the pandemic curves do not lessen over time, then we’re still going to have to deal with this large perpetual license opex versus capex phenomenon overall.

So with that I will turn it back over to Arvind.

Arvind Krishna — Chief Executive Officer

Thanks, Jim. So let me make a couple of comments to wrap up this discussion. I hope that what you’ve taken away from this call is that while these are challenging times, we are excited about the opportunity that we have moving forward. I hope you got that from the remarks out both Jim and I made in the Q&A and in the prepared remarks.

We have aligned our offerings to the opportunity, the opportunity being that of hybrid cloud as well as AI. And I am certain we will continue to take the right steps to emerge stronger as a company and I look forward to continuing this dialog in the third quarter, in the meantime I hope all of you stay safe and productive. Thank you.

Patricia Murphy — Vice President, Investor Relations

Okay, Shelia. I’m going to turn it back to you to close out the call.

Operator

[Operator Closing Remarks]