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

Everyone, thanks for joining us. My name is Dan Knauff, I'm a member of the IT hardware team here at Credit Suisse. And today, I have the pleasure to be joined by Jim Kavanaugh, Senior Vice President and CFO of IBM. Jim, thanks so much for coming today.

Thank you very much for having me.

And it's an exciting time to have you here with us with the business just completing the managed infrastructure services spin-off. To start, I was hoping maybe you could just touch briefly on IBM's new simplified reporting structure and the strategic focus of the company post spin.

Yes. It's a great place to start. So a very different IBM as we move forward given the separation of our managed infrastructure services business. But I'll take you a step back. Last couple of years, we've been on an accelerated transformation of the company, really led by the strategic acquisition of Red Hat and the strong adoption we've seen to really position IBM for success and what we believe are the 2 most transformative technology shifts, that being hybrid cloud and AI. Now a few years ago, we saw this big arc shift happening, and we have a very pointed view around this, and that we believe the world, number one, is going to be multicloud, which I think you see playing out right now. Two, the world was going to be workloads are going to have to operate in multiple environments, everything from public cloud to private cloud to on-prem, all the way now to the edge being reality. And three, which is really the gist of how we got back to our strategy is that there's going to be a tighter integration of hybrid cloud and data and AI and security. That's what the IBM company is about. We spun off our managed infrastructure services business to create 2 market-leading companies, but the IBM company, we've realigned our strategy, our portfolio, our operating model and our capital allocation model around this hybrid cloud-centric strategy. And let me just give you a clear depiction of what that is. At its core, Red Hat OpenShift as our industry-leading hybrid cloud platform. On top of that hybrid cloud platform, we have all of our IBM software that's modernized, containerized and optimized on top of Red Hat OpenShift. And then we have IBM Consulting on top of that hybrid cloud platform. And that Consulting is really there to go drive scale adoption of our hybrid cloud and to pull through IBM's technology. And all of that then is supported by IBM infrastructure. And that is mission-critical and regulated workloads to support our enterprise client base. So when you look at it, a very different IBM right now, an IBM that has an improving growth profile, stronger operating margins, a strong free cash flow yield, lower capital intensity and a higher return on invested capital overall. So to your question about the segment structure, the strategy I just outlined, we've aligned now our external reporting structure around that hybrid cloud platform-centric model. We have 4 major segments, IBM Consulting, IBM Software, IBM infrastructure and financing. All of them are designed to optimize our business model around offerings, around investments, around innovation, around financial returns. And we've done that to give our investors a better perspective of one, transparency; two, visibility and sustainability into our growth vectors and our value vectors overall. So that's a little bit about the strategy and about the segment structure and how it aligns to it.

And you've also outlined a target for mid-single-digit revenue growth, excluding the MIS business starting in 2022, which is up from low single digits the last couple of quarters. And I was hoping you can maybe talk about some of the key drivers you expect to contribute to accelerating growth ahead.

Yes. Great question. I mean the whole shift in the separation of Kyndryl was around unlocking value through focus for IBM, and that is a growth orientation now across IBM. But when you look at those 4 segments I just talked about in the last question, it's really a different company post separation not only in terms of business mix, growth profile, operating margin and cash generation. But when you look at it -- we had our Investor Day conference here in early October that I know you participated in. And we laid out our midterm financial model from 2022 to 2024. And we said that, that model was targeted to grow mid-single-digit top line revenue growth, and with that growth profile with an improving business mix shifted much more to software and consulting and a high-value recurring revenue base. Over 50% of IBM's revenue is recurring right now, dominated by software. That would create natural operating leverage and operating margin. And that will then drive high single-digit free cash flow generation. So how do we get -- to your question, how do we get that revenue growth profile? So mid-single digits is what we're targeting overall. Coming off of the last couple of years post -- excuse me, with the -- excluding Kyndryl, we were hovering anywhere 1%, 2%, somewhere in that ballpark. Well, number one, let me go through the individual segments. IBM Consulting now represents about 30% of IBM post separation. It's targeted to grow high single digit. That will contribute 2 points of revenue growth to IBM overall. Red Hat, which we're very pleased with right now, we're entering our third year of that acquisition. Red Hat is targeted to grow high teens. That is another 2 points of that mid-single-digit revenue growth. And by the way, that's very consistent with the inception of their performance. We've been growing high teens for the last 2.5 years overall since the acquisition. So the remaining point of that mid-single-digit revenue growth has to come from our hybrid cloud and AI IBM Software portfolio. And we expect to get that based on what we've been doing to invest in new innovation around Cloud Paks to new offerings coming out to expanding ecosystems. We've redesigned our entire go-to market this year and our incentive-based system. And we're also going to continue to leverage the financial flexibility we have within our company around M&A. In each of those pieces, we'll generate that point of revenue growth. And then finally, very important value vector in our business, IBM infrastructure, we said we projected that to be flat over the midterm horizon because growth always follows innovation cycles. But it's a substantial cash generator in our portfolio that enables us to reinvest into our growth vectors overall. So 2 points out of Consulting, 2 points out of Red Hat, both of them we've got instantiation points on. One point has to come out of software. We got to prove that we can go execute to that. And then with our innovation out of infrastructure, we should be flat over time with strong cash generation.

And digging into the segments that you just touched on, maybe starting with software. You've noted Red Hat revenue growth has been strong. And recent data points on whether it's customer adoption of OpenShift, Red Hat-related GBS engagements, all of those kind of point to pretty solid traction, bringing clients on to that hybrid platform. When you look forward, what gives you confidence that the OpenShift adoption plus the introduction of Cloud Paks is going to provide a more meaningful boost to the rest of the core software portfolio as clients begin to leverage the platform to modernize and migrate their applications?

Excellent question because software is an integral part of that hybrid cloud thesis overall, right? Just to put in perspective, about 40% plus of IBM's revenue post separation, software margins approaching 30% overall and about 75% of our free cash flow generation. But let me start -- since you started the question, let me start with Red Hat. As I stated, very pleased with the performance. We're 3 years in now, growing 17%, instantiating the value, the strategic narrative of IBM and Red Hat better together in driving this hybrid cloud thesis. But some stats behind that. One, we've got about 3,500-plus clients on our hybrid cloud platform today, Red Hat OpenShift. That's up from just under 800 pre acquisition. And we continue to take share with Red Hat OpenShift as we move forward. Our Red Hat OpenShift revenue is up 3.5x since acquisition. And we're getting very strong renewal rates in that subscription-based business model with cross leverage and a healthy deferred income balance overall. So that strong platform adoption of landing that hybrid cloud Red Hat OpenShift platform creates a solid foundation for this economic multiplier flywheel effect that I talk about. And that is for every $1 we land a platform, we get $3 to $5 of software and we get $6 to $8 of services. So let's start with the services piece, around Consulting. First of all, Consulting, inception to date, we built in less than 3 years a $3.5 billion book of business around cloud migration, application modernization with Red Hat overall. Second, our cloud book of business in Consulting is now north of $7 billion on a trailing 12-month basis, growing 30% in the third quarter. And 1/3 of that cloud growth is coming from those Red Hat engagements. And we've taken, what, third quarter, we had about 180 new engagements with Red Hat and inception to date, over 900. And as I stated earlier, Consulting also has an important responsibility not only to scale the adoption of the platform, but also to pull through our technology. And it pulls through now roughly 1/3 of the Cloud Pak revenue overall. So strong economic flywheel effect that happens. As you land the platform, you get the tip of the spear, scaling adoption with our services. Now that leads you then to software. Software, we're seeing nice growth in our Cloud Paks overall. They're resonating with clients. I think it's a testament of the power of OpenShift and RHEL with our strategic enterprise software incumbency overall. But a few points around software. 80% of our software portfolio is high-value recurring revenue. That's growing with strong renewal rates. It has an ARR that's high single digit overall, and it has now a cloud book of business over $8 billion. But to your question around Cloud Paks overall. Cloud Paks, we're in a -- Dan, in the very early innings right now. We're only about 20% of the way penetrated through Cloud Paks, and we feel very confident given the investment we made around modernizing and optimizing this on top of Red Hat that we're actually going to see now in 2022 with our ELA cycle, we're going to see a nice acceleration in that going forward. So we're doing a very good job landing the platform, winning that architecture war. We're getting great pull and scale of our services business and consulting. And now we're going to start seeing that software acceleration as we move forward.

Maybe honing in on Cloud Paks a little bit more. I know one of the things you talked about in the past was the net revenue retention rate among clients adopting Cloud Paks being over 100%. Can you help the audience maybe understand how Cloud Paks are accretive to core IBM revenue versus cannibalizing existing traditional on-prem deployments?

Yes. So let's first start with trying to articulate what Cloud Paks are and then the value proposition of enterprise clients overall. Cloud Paks are much more than just containerized software that run cloud native. If it was just repackaging of our legacy software base of business, it would be all shift overall, but in reality -- or worst of all, deflationary to our business. But Cloud Paks are AI-powered software products that are designed to enable clients to have modularity, customization, ease of deployment, management and integration. And it enables a client to write once and run anywhere, on-prem, public, private, all the way to the edge. And we're also investing new innovation overall around that. And you see that come out in key strategic software areas around Cloud Paks that we've invested in security, automation, which we talked about earlier. We firmly believe this is a net new area for us with Watson AIOps, with business automation, with network automation and also data in AI where we've invested in modernizing containerized software. But you've also seen inorganic investments, specifically around Instana and Turbonomic, which are off to a great start, that are leveraging APM and ARM capabilities on top of our hybrid cloud platform. But to your question about cannibalization or growth. When you look at software, we've got 2 major subsegments, as you know quite well, hybrid platform and solutions and transaction processing. Our hybrid cloud platform and solutions actually is the growth vector of our software business. It's about 75% of our software business. That's where Cloud Paks resonate. In the third quarter, we grew 6% overall. So very nice acceleration from the beginning of the year, and that's contributed about 4.5 points of software growth overall to the segment, led by Red Hat, automation, security executing well. But Cloud Paks are instrumental part of that growth profile overall. To your point, our NRR, which we started disclosing, is north of 100%. So it is accretive to software overall. And our ARR across our entire recurring revenue stream is now accelerating, and it's in high single digits here in the fourth quarter. So we feel good about the investment, but I'll reiterate, we're very early in the cycle and we've got a lot of headroom in front of us right now.

Great. Maybe switching over to Consulting. You've seen pretty good momentum in the last couple of quarters and also noted a strong order book that's given you confidence that this is kind of sustainable at least over the next quarter or 2. Can you talk about what -- some of the areas where you're seeing the strongest booking activity and also how we should think about translating some of the book-to-bill numbers you provide into the growth potential for the business overall?

Yes. Well, we're very pleased with the rapid recovery of our IBM Consulting business overall. We just finished third quarter growing double digits, 11%, I think, at constant currency and with a book-to-bill well north of 1.1x over the trailing 12 months. The thing we're most proud about is it's pervasive across all of our lines of business and software. Our Consulting business was up 16% overall. Our Global Processing Services business, GPS, was up 19%, and we returned our AMS business back to growth, up 5% overall. Underneath that, what's driving it? I think one, application modernization. Clients are accelerating their digital reinventions and journeys to cloud. So we're seeing nice acceleration in application modernization. We're seeing good growth in our business transformation services, and we've got some very accelerated growth in Red Hat overall. That leads to that cloud book of business north of $8 billion. But if you look at it underneath it to certain practices and where the growth is at, around business transformation services, we're seeing -- where we're now leveraging Consulting in what used to be our BPO business and leveraging and transforming workflows with AI and hybrid cloud, we're seeing nice growth in finance practice. We're seeing nice growth in talent and transformation and in customer care overall. But we're also now, as you know, we've been talking about investing significantly and expanding IBM with ecosystem strategic partnerships. We are seeing tremendous velocity growth in the consulting part around things like Adobe practices, Salesforce practice, SAP and ServiceNow over now. So that's kind of business transformation. We're also seeing some nice acceleration in technology consulting, that driven by the application modernization, not only with our Red Hat, which now we have a $3.5 billion book of business, but also we've been investing both organically and inorganically around AWS practice and around Azure. So we're seeing nice growth in that business transformation services and consulting and around technology consulting or hybrid cloud consulting overall. So that gives us confidence, as we talked about in our earnings, that we see this growth momentum continuing in the fourth quarter. Why? Number one, we have a very strong backlog overall. Our backlog is in a very strong position. Our near-term backlog realization runout points to that continued double-digit growth here for the next couple of quarters. Two, we've got a very good momentum in our small deal engine, which is off to a great start in 2021. Why is that important? Because it's near term revenue realization overall. Three, we're scaling these ecosystems with tremendous velocity. Four, the investments we made inorganically, we're seeing nice returns immediately, some of them which are accretive already, which is well in excess of what our business case was. And finally, we've been plowing a tremendous amount of investment in skill, expertise, talent and capacity into our GBS business. And we're starting to see now some of that investment productivity yield play out. So we feel very confident about our IBM Consulting business as we move forward.

It sounds like, obviously, a lot of opportunity there and demand is pretty good. But some of your peers throughout the industry have also noted some challenges with IT talent shortages and wage inflation. Can you talk about some of the steps you guys are taking to kind of mitigate the potential risk that, that could pose to the growth potential and margin profile for Consulting?

Yes. I'd tell you, it's a hot topic right now in any human capital-based business right now, supply chain in general. But now we're talking about IT talent overall. I would tell you, we fare very well so far through this pandemic right now in attracting and retaining talent to capture that demand. That's why we've been seeing the nice acceleration on our revenue profile. In fact, just this last week, we went through our human capital-based reviews, we've had over 2x the number of applicants this year come into IBM, and we're on track to have 5 million applicants across IBM in 2021. So we are attracting talent overall. Now that's great because we see a very robust consulting-based market. And we believe we have a distinctive competitive advantage around the value proposition around scaling our hybrid cloud strategy and around transforming intelligent workflows with AI and hybrid cloud that plays out very well. Now within Consulting, we said with our financial model, we expect high single-digit revenue growth. We expect margins approaching low teens and that would generate strong free cash flow generation. But in a human capital-based business, it all starts, to your question, around ensuring you got the right talent, you got the right skill, you got the right capability and got the right capacity. We've been investing ahead of demand, and we've been talking about this throughout 2021. Why? Because we see that robust demand environment out there. Where we've been investing: cloud enablement skills, Red Hat skills, and we've been investing significantly in building out these ecosystem strategic partnership capacity. Now the operating leverage around this human capital-based business, it's really going to come from a mixture of a handful of things: one, continued shift to higher value offering mix content; two, price optimization; three, delivery optimization; and four, embedding AI into our human capital management process, which arguably, we've done a very nice job, which leads to that attracting and retaining numbers overall. Now we are operating in an environment, as we talked about in our earnings, that is an escalating labor-based environment. And we feel very confident that the value proposition we bring to our clients that we're going to continue to adjust our pricing models going forward, and we'll extract that value in future engagements. So we feel pretty comfortable about the growth profile and about our ability to hit our midterm model.

And I guess the final segment that we haven't touched on in in-depth is infrastructure. And you're at the tail end of what's been a pretty successful z15 mainframe cycle. Wondering if you can talk a little bit about the durability of demand for the Z platform, even as we've seen kind of public cloud adoption accelerate, and how the mainframe and maybe hardware more broadly integrates with IBM's hybrid-centric approach going forward.

Yes. Great question. Mainframe, I'll tell you, it's one of the most enduring platforms, I think, in all of the IT industry overall. We continuously invest in bringing out new innovation, and we're very pleased with the performance overall, which I'll get into in a second here. But let's just talk a little bit about why, to your point about public cloud because we get asked this question a lot. What is the mainframe in a public cloud world? Well, reality to where I started upfront where we see this big arc shift, we think the world is going to be multicloud. We think the world is going to be multiarchitecture environment, on-prem, private, public, et cetera. And mainframe applies to all of that. But why has mainframe been able to be an enduring platform? It's because the innovation we continue to bring into it. So if you think about z15, we've got enterprise-grade cybersecurity at the core of every enterprise client today, every board today. What does that mean? We have encryption everywhere and 100% data privacy that's very essential to our enterprise-based clients. Second, we now enable cloud-native capabilities and workloads on top of mainframe. By the way, not only does RHEL run on mainframe, Red Hat OpenShift runs on mainframe, Ansible runs on mainframe, Wazi runs on mainframe, Linux, et cetera, I'd go on and on and on. And much of our workloads that are -- been driving had been these specialty workloads around cloud native capability. Three, we've offered and continued to adjust the way we do our pricing. We've offered tailor-fit pricing, which basically enables cloud-based pricing for mainframe, consumption-based over time, and it's resonated very well with our clients. And four, we've embedded AI accelerators in the mainframe. What does that mean? It enables the most trusted, secure, reliable transaction processing system in the world to have real-time unlocked value of insights around transaction workloads. But when you think about mainframe, you talked about, it's been our most successful program to date for decades, well in excess of 100% of the prior program. And to put it in perspective, we had record number of shipped MIP in 2021. And over the last decade, our installed MIPS capacity is up 3.5x, which if you understand the mainframe, it's ran as a platform, that has stack level drag or network effect of our storage, of our software, of our maintenance, of our financing. It drives $3 to $4 more as we go forward around that platform economic multiplier.

Great. And I think the other major component from a higher level, besides the revenue growth targets that you laid out, was around free cash flow. And the vast majority of IBM's free cash flow generation was retained in the business post spin. And you've guided to about -- you expect about $40 billion of cumulative free cash flow generation and some excess balance sheet capacity to be able to deploy over the next 3 years. Can you talk about how you're prioritizing your allocation options? And also what's an appropriate level of leverage for the business longer term?

Sure. Great question. With the separation of Kyndryl, our managed infrastructure services business, the whole thesis around that was unlocking value through focus. And it's unlocking value through focus not only on our strategy and our portfolio and our offering. It's all around capital investment prioritization as we move forward. With the divestiture of Kyndryl, for those of you, it's about 25% of our revenue profile, but it was only about 6% of our free cash flow profile. So to your point, the lion's share of that free cash flow generation sits within IBM going forward. And that's been the strength of the IBM financial model over time. Historically, we've been a value-based sector and a value-based stock overall because of the strong free cash flow generation. And we've stated in our midterm model that we will generate $35 billion worth of free cash flow cumulatively. And with that $35 billion of free cash flow generation, you will have additional debt capacity. So overall, about $40 billion of financial flexibility. So how are we going to use that? We're going to continue to remain very disciplined in our capital prioritization. Number one, always focused on reinvesting back in our business, both organically and inorganically to really accelerate this hybrid cloud platform thesis. Also, advance new technologies. As you've probably seen last week, we announced a whole new 127-qubit quantum machine overall, as one example of advancing emerging technologies. And three, we're going to continue to invest in building out our ecosystem. So that's our prioritization about investing for the business. But we're also going to prioritize on maintaining a very attractive shareholder return policy through our dividend. Those are 2 primary overall. And to the core at the end of your question, we feel very comfortable where we're at operating at a A level. And by the end of the year, we'll be at a leverage ratio that we feel very comfortable on. Why? Because, one, our business, with the high recurring revenue-based stream of software, our substantial liquidity pools and the strength of our balance sheet, we're positioned quite well to where we need to be overall. So unlike where we've been in the last 3 years where we've been delevering the company, given the acquisition of Red Hat, now we've got that $40 billion of firepower that's really going to be geared towards investing for growth and maintaining and prioritizing a very attractive shareholder return.

I think we've talked a lot about hybrid today and that being a key component of IBM strategy, but I think Arvind has also phrased it as a hybrid and AI strategy. And I was wondering if you could maybe expand a little bit more on AI and how it contributes to maybe the business and some of the growth targets that you've laid out here.

Yes. So first of all, like we talked about with Cloud Paks, AI, we are still in the very early innings of enterprise-based AI, overall adoption and scale. I mean depending on the reports you pick up and you read, anywhere from as high as 20% to as low as 5%. So we're very early in it. We've always said, overall, it's a hybrid cloud and AI strategy because of that big arc shift that I talked about earlier. We think the value moving forward is the tighter integration of hybrid cloud and AI. That's public, that's private, that's on-prem workloads, and that's all the way to the edge. So we've taken approach to embed AI across our portfolio. What do I mean by that? What are our Cloud Paks? They're AI-powered software products that offer that modularity, that customization, integration, management, all embedded into it, whether it's automation software, whether it's security software, whether it's data and AI, et cetera. Two, we've embedded AI into our consulting base of business because how you attract, retain talent and do human capital-based management is all based on embedded AI capabilities of how we run our dynamic delivery model overall. But where we're going forward, I can speak to this as being CFO but also owning all the operations for IBM. How are we looking at AI inside IBM? First, everything -- I've talked about 3 pillars. Everything starts with data architecture, standards, governance; second, business process optimization, how do you run your business, HR, finance, supply chain, et cetera; and third then is how you apply technology and digitization and AI to transform that way. And what's happening right now is that plays to our Consulting business overall. So we see the tip of the spear being Consulting driving AI. It's going to pull through the scale of our platform and our software technology, which has AI embedded into it, as we move forward. So we're very excited as we move forward on the potential of what AI means to our enterprise client base and our shareholders.

Terrific. I think we're going to have to leave it there. Jim, thanks again so much for coming. It's a pleasure.

Great. Thank you. Appreciate it, Dan. Thank you.