International Business Machines Corporation (IBM) Earnings Call Transcript & Summary

Thanks, everyone, for joining. We have the IBM session up next here. My name is Tien-Tsin Huang. I cover the payments and IT services sector at JPMorgan and super excited to have Jim Kavanaugh back with us from IBM. Jim is the CFO of the company. We're going to go through a fireside chat. I'm going to ask him some questions that we've gathered from the investment community and go through that over the next 35 minutes or so. [Operator Instructions] But I think we'll hopefully cover a lot of the important topics here in this session. So Jim, great to see you. Thanks for joining us.

Great. Well, thank you very much, Tien-Tsin. Appreciate being here.

No, it means a lot to me to have you here. So let's just get right into it. There's been a lot of talk about macro and reopenings, and I think IBM has got a great view on enterprise spending. Maybe if you wouldn't mind, just catching everybody up, walk us around the globe. I know I think Americas was relatively flat last quarter and the rest of the world was down. How has the pandemic impacted your business?

Yes. Great place to start. And again, thanks again for taking the time here and giving us a platform to discuss with our investors. But I'd tell you, as you know me quite well, Tien-Tsin, I don't pretend to be an economist. So I'll give you a perspective from the lens of our business overall. We've been talking about, over the last 18 months or so, the dynamics from a macroeconomic perspective and also from a client buying perspective overall. And what we've seen throughout this pandemic is really an acceleration of clients' digital transformations and journeys to cloud. And if you look at it, we've actually been capitalizing on that. And our first quarter is a clear indication that we see a nice rebound in enterprise-based spending and in particular, around the key strategic areas of our hybrid cloud around Red Hat and even consulting coming back to growth here in the first quarter. So we're encouraged by this. But I'll tell you, when you look at it, unfortunately, depending on where you're at, geographic market or industry, there is some correlation to the pandemic curves around each market and the client buying behaviors and confidence levels overall. And you touched on some of that earlier. When you look at the composition of IBM -- and allow me to just break it down by geo and then by industry, because I think they give a pretty interesting perspective overall. From a geography perspective, we're pretty balanced. And by the way, we operate in 175 countries, so we are a pretty good barometer of enterprise spend overall. But when we look at it based on the pandemic curves, we're actually seeing some nice rebound in enterprise-based spending. Our Americas got back to growth in the first quarter, led by the United States returning to growth, a nice sequential improvement off the fourth quarter. Canada returned to growth. So North America, overall, is doing quite well and enterprise spending is accelerating. Latin America is going through some challenges around the balance of the curve, in particular, around Brazil, which has highly been publicized overall, and our Latin America results reflect that in the first quarter. When you look at Europe, Middle East, Africa and you look at Asia Pac, both saw very nice sequential improvement overall from the fourth quarter, and is really led by Western Europe overall. The U.K., Italy, France, Germany, all very nice sequential improvement, including Japan from an Asia Pac perspective. So I would tell you, we're cautiously optimistic, we see enterprise spending increase moving forward. And we believe we're well positioned, which led to us reiterating our growth profile for 2021 and post-separation, our mid-single-digit growth profile in 2022.

All right. No, that's great to hear. At the macro, I don't want to spend so much time on the macro, but I know IBM is doing a lot of heavy lifting to change the sales motion and get to this growth culture. So I wanted to ask, Jim, just back in January, if you look back, IBM announced some big changes to its go-to-market model, right? So can you elaborate on what those changes are exactly? And is it moving the needle already? What should we expect?

Sure. I mean, when you take a look at it, as I've told many of our investors after our earnings, we've been doing an engagement, the go-to-market is the heart and lungs of an organization. We don't change go-to-market often here in IBM, as you know quite well, Tien-Tsin. We -- last time I think we changed our go-to-market was in the mid-2000s, when we moved to our integrated account model, as we move forward. But I think it's important to understand why we made this go-to-market change and why now. And I'll tell you, Arvind and I are very big believer in creating value through focus. Arvind, since he's come in, has solidified and centered our strategy around being all-in hybrid cloud and AI to capitalize on a $1 trillion TAM market opportunity. We have aligned a financial investment thesis to sustainable growth and free cash flow generation. And what brings these two together is the operating model on how you execute moving forward. And one of the critical components of the operating model, to your question, is go-to-market. And I would tell you the go-to-market changes that we announced early in '21, were really grounded in a handful of pillars. And let me talk about each of them. First, your go-to-market always has to align to a focused strategy around hybrid cloud and AI. What has this done? Learning and getting feedback from our clients, we are encouraging a tighter connection between IBM and Red Hat to enable us to lead in a hybrid cloud platform-centric based business. It also is driving a tight integration about where Arvind's taken the company from a culture perspective to the components of your question. And that is around a growth mindset, entrepreneurial mindset and around being open to risk taking. So the first thing is aligning to a simplified and a focused strategy. The second was addressing what's happening with the fundamental shifts in client behavior and feedback. Clients want to engage IBM in a consistent way. And arguably, over time, we became very complex in each of our lanes, in each of our pillars. Although we were driving an integrated thesis, we had a go-to-market model that wasn't aligned to an integrated thesis. Now we have segmented our client base; we have aligned and integrated thesis overall; and we've aligned in our incentive systems around really providing a differentiated go-to-market model based on, one, technical, and two, experiential. Think about what we've been doing learning from our GBS IBM Garage methodology, we're investing significantly in experiential-based selling, which is what is our -- what our clients are talking about today. And finally, third is we've changed the go-to-market model to elevate the role of ecosystems, a very essential element in capitalizing on the network effect for us to drive scale, value and adoption of our hybrid cloud overall. So when you think about it, those go-to-market changes, now as you know quite well, Tien-Tsin, those take time to yield the ROI. But we are starting to see some green shoots. Our overall cloud book of business, nice acceleration around that hybrid cloud, $26 billion over the last 12 months; our number of client running our containerized software and hybrid cloud is now over 3,000, which is a nice early indicator; and the third point is our GBS Red Hat engagements, which is another early indicator of how we drive that integrated value of our go-to-market. So we're pretty pleased. The return and value, we think will start in '21, but not get to full scale until 2022 and 2023, as you would expect.

Got it. Yes, you're lining it up, obviously to get there, which makes a lot of sense. And I know cloud, you've mentioned it several times, so I'll ask it again, just to zoom in on it with hybrid, multicloud. I think cloud was up, I wrote down here, 18% in the first quarter. How do you view cloud? How is IBM positioned to win here when you're thinking about benchmarking and where you want to be, especially as you realign your sales as you just discussed?

Great question. Thank you very much for asking it, because it's at the top of mind for our clients and it's at the top of mind for all of our investors out there. And when you get to it, it gets right at the heart of what Arvind is trying to do with the IBM company, which is a focused hybrid cloud and AI company overall. Now a few years back, you'll remember this, we saw a big arc shift that was happening in the industry with the advent of cloud and the tighter integration of data and AI to cloud. And that has led the clients accelerating now their digital reinventions and their journey to clouds overall. And we have a very distinctive point of view, Tien-Tsin, around hybrid and it's predicated on where our clients are at and what they're telling us, but more importantly, where they're going. And we have a point of view that the world will be multicloud and the world will be multi-environment, everything from public to private, to on-prem all the way to the edge. So if you believe in a world of multicloud -- and by the way, I could tell you even in IBM, we're running about 6 or 7 different clouds within IBM when you talk about Salesforce -- excuse me, Workday and many others. But when you think about that, that led to the strategic rationale of the Red Hat acquisition. Because what did it give us? It gave us the industry's first horizontal hybrid cloud platform architecture built on a foundation of Linux, Kubernetes and containers that allowed us to operate and create value for clients in a multicloud and multi-environment overall. So what does our point of view around cloud, around hybrid mean with regards to a value proposition? Well, an open hybrid cloud architecture provides 2.5x estimated the value versus a traditional, singular, proprietary hyperscale public cloud provider. Why? Because clients can tap into value drivers or vectors around compliance and security, around digital transformation, around strategic optionality, around cost efficiency, DevOps efficiency as you move forward. In addition, the market is only about 25% into this entire cloud journey, as we all know, from a workload perspective. And we've been saying that for 2 to 3 years now when we acquired Red Hat. Now what a hybrid cloud environment does is it's going to start breaking down those barriers to scale that 25% even faster. What barriers am I talking about? Data sovereignty, latency, and security and regulatory requirements. And we built the industry's first hybrid cloud platform with all of those value components to enable clients to realize that value. So we have a pretty distinctive point of view on cloud being hybrid, and we've aligned our portfolio around this $1 trillion hybrid cloud TAM market opportunity, everything from infrastructure to the hybrid cloud platform, to the software architecture on the platform, to our cloud transformational services. And we've also created and committed an investment of $1 billion to build out an ecosystem. Why? To capitalize on the network effect of that hybrid cloud differentiated strategy, which then drives an economic multiplier that we've talked about, Tien-Tsin. For every $1 we land on a hybrid cloud platform, we see $3 to $5 of software drag and $6 to $8 of services drag overall. So it's a pretty compelling thesis about, one, where we believe the market is going to go and we have a distinctive point of view on hybrid; and two, a pretty good, strong economic thesis around the value of how we can get our hybrid cloud to be a leadership position overall.

Yes. And I think those multiplier effects are definitely underappreciated. So -- and you mentioned ecosystem, if you want to get into that, that's helpful to hear. But just thinking about, culturally, I know Red Hat is very important. This entire journey, you mentioned in the beginning, your tighter integration between IBM and Red Hat, I'm curious with the shift of multicloud and hybrid, just the culture side of what did Red Hat bring? Do you feel the changes there, Jim, with what's going on [indiscernible] standpoint, including Cloud Paks, of course. And from a selling perspective, like tell us about what's changed and what more can we expect as a result of this -- the Red Hat synergy?

Yes. Yes. And again, thank you for the question. I mean we're 7 quarters in, right? We're into our 8th quarter right now of the Red Hat acquisition. And we couldn't be more pleased with what we believe in the instantiation of the value of IBM plus Red Hat better together overall. But if I had to cut it down to a one-line statement around culture and Red Hat, Red Hat has transformed IBM into an open hybrid cloud platform company today, period. No hand -- no bars about it. But when you look at it, what have we done? We've learned a tremendous amount from the cultural aspect of Red Hat -- remember, wasn't too long ago when we announced this acquisition and many were questioning how are you going to take two very distinct cultures and how are you going to make this work. In fact, that was the argument against the valuation of the acquisition, whether you can ever recoup the control premium that we had to pay, which I would argue now, just given 7 quarters in, what we've been able to produce, the price is actually looking very attractive to us right now compared to where we were at the time of announcement. But Red Hat has transformed IBM into being a platform-centric, open hybrid cloud company. What has it done? Think about our technology architecture, what we've done with our software portfolio, how we've containerized, modernized and optimized our software to be cloud-native, run on top of OpenShift as a key architectural decision around this acquisition. Because remember, when we acquired Red Hat, we kept these two separate, it's not an integration. Our go-to-market is separate, our developer ecosystem around open architecture is separate. And we've done a pretty good job of figuring out the synergistic effects of technology architecture and around as we're learning more about a client ecosystem developer perspective overall, but very pleased. And just to put some numbers behind it, Tien-Tsin, as you know, I can't get away from the numbers, because the numbers, at the end of the day, are the proof points in the instantiation. I mean 7 quarters in, compounded growth were high teens, 18-plus percent growth compared to preacquisition were low teens. Two, we built a book of business that's north of $5 billion backlog today and we've rebuilt a deferred income balance. Remember, we had to take a $2.2 billion impairment charge at the time of the acquisition. We just exited first quarter with almost $3.2 billion of deferred revenue in the balance sheet, very strong renewal rates, instantiation of the subscription-based model and the value of our portfolio overall. And most importantly, we've been scaling the Red Hat OpenShift hybrid cloud platform. Now 3,000 customers on that platform at the end of first quarter and we've actually taken our Red Hat OpenShift, and tripled the revenue in 7 quarters. Think about that from a subscription-based business model, tripling that revenue at 3 quarters, that's led to the significant acceleration of our backlog in that business overall. But when we talked about the Red Hat acquisition, Tien-Tsin, remember, we not only talked about Red Hat and what it was going to do to IBM around selling more Red Hat, because the value to IBM, the Red Hat was our global scale and enterprise incumbency. And I think we've been able to leverage an acceleration of their business. But we also talked about sell more blue, sell more software, sell more GBS services. And I think around each of those, our software book of business, we exited first quarter with a cloud software portfolio, $7.5 billion on a trailing 12 months, up 2x since the time we announced the Red Hat acquisition. Great acceleration, 3,000 clients on our hybrid cloud and our containerized platform, and strong momentum in Cloud Paks overall. GBS, just to wrap it up, GBS is loaded out of the park with regards to our revenue synergy case overall. Since the time of acquisition, 7 quarters in, we just eclipsed $2 billion worth of signings on our Red Hat practice. We have the largest Red Hat practice overall. We've been adding hundreds of new Red Hat engagements every single quarter. And the beauty about that GBS business, being a flywheel or tip of the spear, is that GBS also drags cloud-based business and also drags Red Hat OpenShift. So we couldn't be more pleased with it.

Great. Those are good stats to refresh us on. So just thinking about the halo effect of Red Hat and bringing it to software and your book of business around software overall, you did return to growth, right, in the first quarter. I get a lot of questions around the transaction processing platforms piece to being a drag. I think you've called out adverse client consumption for a while here. But when can we expect that to ease and recover, so we can start to see the broader software piece improve?

Yes. So I mean, made progress in first quarter on software. As you stated, return back to growth, really led by cloud and data platforms were up double digit, with nice continued momentum in Red Hat and also in Cloud Paks to the previous discussion. But we also returned Cognitive Applications to growth up 2%, led by strong security performance overall. Now we said that we expect that to continue, for us around cloud and cognitive software to continue momentum throughout 2021 and expect growth across our portfolio. Why do we say that? One, We're seeing nice adoption acceleration to the previous question around our cloud book of business and software, $7.5 billion, was up 34% in the first quarter, which led to the overall IBM growth up 18%, Red Hat, Cloud Pak momentum, our strong renewal rates, our annuity overall and our strong acceleration in ARR. So we see overall software growth for 2021. We see acceleration as we move through '21. Now to the heart of your question overall, software is a very integral part of that cloud economic multiple that we talked about, right, $3 to $5 a software for every $1 of platform. When you look at our software portfolio, we really have 2 growth vectors, that being cloud and data platform and cognitive applications, that, by the way, Tien-Tsin, makes up 85% of our software portfolio. The remaining 15% is transaction processing systems overall. And when you look at our platforms overall, when you look at that part of the portfolio, it's about 15% of our portfolio, and it's really a value vector. That market is down mid-single digits typically overall, but it produces tremendous profit and cash that we use to fuel investments into our growth vectors of cloud and data platform, Red Hat Cog Apps. Now we've been going through a transition. right, that we've talked about in 2020, and we expect that to continue in 2021. But let me take a step back and explain what's really been going on. When you look at our TPP portfolio, it's always been predicated on when and how clients commit to choose -- to commit to the long term overall. And we've always offered flexibility in consumption-based models, whether they want to buy it in perpetual licenses or they want to bet it -- buy it in annuitized or subscription-based models. And historically, Tien-Tsin, as you follow this, you know quite well, that portfolio was predominantly pre-'18, predominantly consumption-based, annuitized-based portfolio. About 90% annuitized, 10% transactional. What happened in 2018 and 2019, now in retrospect, is that clients actually shifted their buying behaviors much more to perpetual-based licenses. Why? We were operating in a very robust market; clients' CFOs, like myself, wanted to lock in certainty based on their business demands, they bought licenses upfront, which gave them that certainty. But that changed the portfolio composition mix much more to perpetual licenses monetizing value upfront, and it moved that 90-10 model to about 70-30. Now fast forward to 2020. In the advent of the pandemic, unfortunately, the tremendous uncertainty and disruption that impacted the marketplaces, clients reverted back to more consumption base. So we saw about a 2-year shift in that portfolio from annuitized to more perpetual. Now what we're seeing is clients shifting back to more of a OpEx versus CapEx, more consumption base versus perpetual licenses, and we expect that to continue. It started in '20, we think it's going to continue in '21. And then we'll be back and revert back to that 90-10. So when we get into 2022, we'll be at kind of that normalized down mid-single digit. And again, 15% of our software portfolio, we'll be able to absorb that and deliver some nice sustainable software growth going forward.

Great. Thanks for walking through that. That's really good for us to have out there. I want to be mindful of time. We got 10 minutes left. Arvind's been emphasizing IBM's expansion, if you want to call that, into ecosystems. You mentioned some investments there on the ecosystem front. Can you just elaborate on what that means for growth? I know you've mentioned Schlumberger and Siemens and Palantir and a lot of great names, but can you just help us understand what that means for the P&L?

Sure, sure. Very different IBM. I mean we are changing, everything from the portfolio, what we've done, the work, with the announcement of the Kyndryl separation, to our go-to-market operating model changes you asked about, to our culture, to ecosystems overall, all centered around a focused strategy about enabling a platform-centric hyper cloud and AI company. Well, to enable a platform-centric company, ecosystems are essential to capitalize on that network effect overall to scale not only our platform, but also to scale our software and our services' integrated value overall. And capitalizing on that network effect, why is it advantageous for clients? Now that we've opened IBM up, it's a very different IBM with regards to an ecosystem strategy. One, we have a platform now given the acquisition of Red Hat; and two, there's a strong economic multiplier. That economic multiplier I talked about and you referenced of $3 to $5 a software and $6 to $8 of services, that same economic multiplier is very attractive to GSIs, ISVs, industry-specific plays overall. So we have recognized the value of a network effect. We feel we have a strong value proposition in the economic multiplier. We've committed to $1 billion investment in building out our ecosystem over time. And just so you brought it up, let me bring it to life with one example, if you don't mind, Schlumberger, since you brought it up. Schlumberger, many of you may know or maybe you don't know, has a pretty sizable book of business of a software suite with their DELFI environment overall that addresses the needs of industry vertical of oil and gas overall. DELFI was scaling, doing their DevOp model, creating applications around enabling a transformative services value around the DELFI environment. And what they came to find out, which goes back to our differentiated point of view about cloud, right, that I talked about, they figured out, this world is moving to multicloud, and it's moving to multi-environment, on-prem, private, public, all the way to the edge. And for me, as Schlumberger to have the DevOps support costs to port our applications to each hyperscaler and not have the flexibility of writing once and running it anywhere, was not a economically viable model. So they came to IBM. And we went all in. Schlumberger, with their vertical ISV software application optimized with an exclusive relationship on top of IBM's Red Hat OpenShift, they are now able to address the barriers that they were faced with around security and compliance, around data sovereignty, around latency. The same articulation of the value proposition components we talked about in the cloud answer was exactly around Schlumberger. Now what does it provide to IBM? Well, one, it definitely scales our Red Hat OpenShift platform overall. Each instantiation of their software suite on DELFI environment drags a platform of OpenShift. Two, I think last week, which we talked about earlier, I think last week, we announced a whole new Cloud Pak for data management on Red Hat OpenShift that now Schlumberger is going to take advantage of. So when you look at the ecosystem play, the ecosystem play, attractive value proposition for them, but for IBM, it's going to drive that multiplier effect of driving the platform and pulling our hardware and our software business and also our cloud transformational services business. There are many countries that Schlumberger is going to want our GBS consulting practices to go do the implementation of their suite. So I think you'll start seeing that revenue contribute over time into our cloud and cognitive software and into our GBS business. And to put it in perspective, you take a Schlumberger or a Siemens, that's a couple of hundred million dollars, we think, minimum over a 3- to 5-year period. When you start scaling that in the 10s, it becomes a big composition of IBM's growth profile.

Yes. No, it's a change for the company, which is why I asked, and it fits the common theme, right around pull through and surrounds and this multiplier effect. So that's why I want to make sure I ask the question, because it is a change in the services side with ecosystem. So I have to ask you a services question and then we'll wrap it up. I wouldn't be doing my job if I didn't ask at least one services question. So I'll call it consulting because you mentioned it, consulting being positive. We usually think of consulting as the tip of the spear, how it pulls through a lot more work as you've been talking about in other businesses. Is that -- do you think this is the case here? What can we learn from the success using GBS and specifically within consulting?

Yes, absolutely. And I didn't expect that I would get out without a services question from you, Tien-Tsin, overall. But services, and in particular, GBS and Consulting are integral part of our overall hybrid cloud platform thesis in portfolio overall. But the short answer is consulting, we definitely believe is a leading indicator of how clients are accelerating their digital reinventions and journeys to cloud. And we intend, and we are capitalizing on that, as clients redesign their business models, for long-term sustainable advantage. Clients are deeply ingraining and redesigning their business processes. And we're going to capitalize on GPS business process, digital transformation and on enabling that business process transformation through a hybrid cloud overall. And you see that in our cloud book of business that really has been led by consulting overall. Our GBS cloud book of business is north of $6 billion on a trailing 12 months. It was up 28% in the first quarter, up double digits across all 3 subsegments with the -- with strong growth led by consulting. But why is consulting so integral to a hybrid cloud platform thesis? Well, when we look at it, and we've talked about this before on earnings. If you look at the lifespan or life cycle of journey to cloud, we look at it in 4 major categories: advise, build, move and manage. And when you look at it, that inevitably starts with the consulting base of business around the advisory and around the front end of the build and the architecture. From consulting then goes into software, into applications, all the way through to business processes at the end of the day, which will then lend itself to our AMS business around applications, to our GPS business, around business process transformation, all the way through to our software book of business overall. So GBS being an integral part of that hybrid cloud platform-centric thesis, having one, the digital transformation skills with deep industry knowledge; and two, the applications incumbency, enables us to provide that economic multiplier equation of the $6 to $8 of services for every $1 of platform landed, but it also, to your point, provides a tip of the spear and pulls kind of a flywheel effect over -- Tien-Tsin, since we created our Cloud Paks and optimized our software portfolio, over 1/3 of our Cloud Pak revenue is through GBS engagements. And I think what may surprise many people, 95% of our new Red Hat OpenShift single-year bookings and transactions are GBS engagements, in particular, AMS incumbency engagements. So GBS plays an integral role of that hybrid cloud platform thesis. It push and pulls both the aspects of that value equation.

Okay. No, that's great. That's great to hear. Look, there's a lot going on. I know you're really busy. We covered a lot of ground. I wish we had a little bit more time. I'll get you out of here on one last question, right, there's a lot of change going on at IBM, Arvind has gone -- has really initiated a lot of change here. What do you think is still underappreciated by the market?

Well, I'd tell you, there's always a lot going on, right? We're always busy overall. I couldn't be more excited, though, about where we're at as a company, about where the industry is at overall and the opportunity set that is in front of us. In particular, around two things I would call out, most underappreciated. One is our distinctive point of view around cloud. And hopefully, I gave the investors a little bit of perspective around our differentiated point of view that the world will be hybrid. It is going to be multicloud, multi-environment, and we've got a portfolio and an economic multiplier equation, led by an ecosystem network effect that is going to be able to position us as a leadership position to address a $1 trillion TAM opportunity. But I think the second thing, Tien-Tsin, and I know we didn't get to any questions around our strategic announcement of the separation of Kyndryl. Without going through all the specifics as to why we did that, et cetera, which we covered with investors last October, I think the most important thing from a financial perspective that is underappreciated is what is the business model composition post separation. And if you look at the IBM company, again, we've got a lot of work to do, which, by the way, we remain on track to execute the separation by the end of the year. The most underappreciated pieces, post separation, the IBM company is going to be roughly 50% revenue and about 2/3 EBITDA profile, a software-based business, which goes right to the heart of our hybrid cloud thesis overall. And when you look at IBM today, we're trading at a multiple that's analogous to a hardware infrastructure and services provider. So we think we've got tremendous opportunity to unlock value through the announcement of the Kyndryl separation and really hone in on this hybrid cloud platform-centric company overall.

Jim, this was great. Thank you so much for the time. I think we covered a lot of ground. I wish we had more time, like I said. But we'll catch you again on the next go around. Thanks so much for spending a few minutes of time with us today.

Really appreciate it. Thank you very much for having me. I wish you best of luck.

Thanks, Jim. Great to see you.

You too.