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

Good morning. I'm Katy Huberty, Director of North America Research at Morgan Stanley. And I am absolutely pleased to welcome Tom Rosamilia, SVP of Software and Chairman of North America at IBM. I'm particularly looking forward to this discussion given Tom's tenure at the company and how important software is to the business. Tom has held a number of roles, more recently, SVP of Systems and now, as I said, Head of the software business. Before we begin, I just need to mention that important disclosures can be found at www.morganstanley.com/researchdisclosure. So Tom, thank you so much for being here today.

Thank you so much for having me, Katy. I really appreciate all of you coming, and I appreciate being in person, which is a treat for all of us, I think. It's so nice to see people again and so glad that you invited us to the conference. So...

Good. I couldn't agree more.

So just to kick off the discussion, talk a little bit more about your role and background and then some of the biggest changes that IBM is making around just strategic focus and culture.

So I've been with IBM forever. It's a long time, and I've been in mostly hardware and software roles. I spent a year running corporate strategy, and then I took over as the Head of Hardware or Systems, as we call it. And then as of July, it took over as the Head of Software. But most of my roles have been in software prior to the hardware job. I am very excited by the pivots that our current CEO, Arvind Krishna, has been making. I would say the largest acquisition we've seen in Red Hat have been very successful, and we'll talk about that. The courage and the execution to spin out GTS or our Global Technology Services has been a great thing for us for focus. The pivot to hybrid multicloud, and I'll stress the multi here, that we run on everybody's cloud, specifically, I'm partnering every day with AWS and with Azure for our software in addition to the IBM Cloud and in addition to on-prem. And also the moves Arvind's made around the ecosystem partners. You'll see us partnering with EY, with Deloitte, with Salesforce with, as I said, AWS and Azure. And so across consulting and across software providers and across hardware platforms and across cloud providers, it's great to see the pivot towards the ecosystem.

So I want to talk about how that strategy plays into the financial model, but I'd be remiss if I didn't ask about just the current environment with what's going on in Russia and Ukraine and how investors should think about just at a high level what the impact could be on the business.

So our first priority, as you've heard from others, is absolutely our people. We do have people in Ukraine. We've been working with them for over a month to get them out or get them safe. By the way, I also have employees in Russia, and I will tell you, after talking to several of them, they're not all for the invasion. They're not all for the war. So there's a humanitarian side for our employees in Russia as well. So first and foremost, it's about the people. And then secondly, for us, I would say the direct impact of Russia is not significant, but the indirect and the macro environment that it creates is TBD. We don't know what oil prices will do or supply lines will change or sentiment in Europe, all those various pieces. But direct, very small, trivial as I look at the numbers. Indirect, TBD.

So just to shift back to the long-term model. One of the, I think, most strategic things from an investor standpoint that Arvind did was to shift away from the focus on earnings towards sustainable revenue growth and free cash flow. And obviously, the software business is a big part of that goal to get to sustained mid-single-digit revenue growth. And so just walk through how you would plan to achieve that, and particularly how you achieve sustainable growth, even though there is some cyclicality in parts of the software business like TPP.

Yes, not as much cyclicality to the software business as you might think. It really does -- because the TPP business, our mainframe software business, really grows based on capacity. And so capacity can increase when we come out with a new model or it doesn't have to. So it can increase when we don't come out with a new model. So the TP part of it is really much more consistent and not as cyclical. But getting back to your point, we've promised and I promised with investors back in October that we get mid-single digits in the midterm, which is 22 to 24. That's really a combination of Red Hat. We've seen great success with Red Hat thus far, grew 21% all in, in the fourth quarter. That gives me about 4 points of tailwind to the software business. And then I get about 2 points from the rest of software. You say, well, what is that adds up to 6. But I do have the negative headwind of our TP software, which is predicted to decline in the mid- to high single digits. Didn't do that in the fourth quarter. We think that was a onetime event. It was certainly an easy compare. But the combination of 4 plus 2 minus 1 gets me to mid-single-digit growth in the midterm. The investments we're making around data and automation, I'm very excited about what we've seen with automation. We've had some excellent acquisitions in that space that have really helped us. And I think automation is going to be one of the hot topics of this year and sustainably based on skills. And I just think the more we can automate, the better off people will be. I saw the jobs report this morning, 11 million jobs open. So people are struggling, obviously, to hire. And so if we can automate more of the mundane tasks, the better off we'll be. So I'm very bullish on the automation portfolio. I think the security market in general gives us a great opportunity. It wasn't great for me in 4Q, was okay in 2021, full year was up 5%, but I think we'll get back to where we need to be with the security space. So I think the combination of all that gives us a great opportunity to deliver on what I promised back in October, and I'll promise again today.

You mentioned the Red Hat acquisition. You're a couple of years into the integration with the rest of IBM. Talk about some of the synergies you've seen with Red Hat and IBM Software and how you see that evolving and growing over time.

Very good. And I should just mention that all the numbers I gave you were without the benefit of Kyndryl. So that gave me another 5 points in the fourth quarter. So 5 plus 5 got us 10, but 5 points was without Kyndryl. So as I said, this was a hugely strategic acquisition for us. We spent $34 billion for the reason of acquiring OpenShift. So we could rebase our entire software portfolio based on OpenShift and move it to a container model and move it so that it could run everywhere. By rebasing our Cloud Paks, in this case, on OpenShift, we've now moved all of our middleware to an environment where I can deploy on an AWS, I can deploy it on Azure, I can deploy it on the IBM Cloud, and I can deploy it on-prem. And I should defend -- define for all of you. To me, hybrid multicloud means the combination of on-prem plus at least one cloud provider. And we see that data says that 3 years ago, people -- like almost 30% of people said, oh, I'm only going to have one cloud provider. Well, that number is down to 3 in the most recent survey. So people are saying, I'm going to choose multicloud because I want the best of all worlds, including what I have on-prem. And so our classic examples are combinations of those. But when I mentioned skills, I think the combination of having a consistent deployable software model that says if I'm doing Cloud Pak for data, I can do it on-prem or I could do it on AWS. If I'm doing Cloud Paks for business automation, I could do it on-prem or I could do it in the IBM Cloud. If I'm doing Cloud Pak for security, I could do it on-prem, I could do it with Azure. Having that consistent set of skills across the hybrid multicloud, I think, gives us a great advantage. And having the ability to run on-prem in either an x86 world or, in our case, a lot of Z franchise. So it gives us the ability to extend that value across the multicloud environment.

So that's a great segue into the broader discussion that I often hear from investors is that customers are moving to the cloud. IBM has a lot of big customers that run their most important applications with IBM. How -- in your conversations with the customers, how are they thinking about their cloud journey? How are they thinking about the part that IBM plays in that journey? And how do you go out and capture wallet share?

I think that's great. And I will tell you that 5 years ago, we were fighting an uphill battle talking about hybrid cloud as a destination. Everybody said it was a point along the way. Nowadays, we have 0 of those conversations. So everybody is accepting the fact that some of their workload is going to stay on-prem, and they need to modernize it. And I'm partnering with IBM Consulting to modernize their mainframe workloads. But it's the combination of that with what they're doing in a hybrid cloud that really gives the ability to sell. And so I think this days of everything is going public cloud or over, most people see it as I'm going to be -- the destination is going to be a hybrid multicloud environment where I want to take advantage of the best of all worlds. If I have economic reasons or I could have GDPR reasons, why I want the data to be in a certain location, working closely with a bank in Europe, ING, that has GDPR reasons, and I would say, cost reasons why they don't want to move big chunks of data. They want to move the result of queries, not the data to generate those queries or AI for, again, governance reasons, domain reasons and cost reasons. It's very expensive to move data to compute. It's actually easier to move compute or cheaper to move compute to the data. So I think that gives us a great leg up on the fact that people have realized, have woken to the fact that they're going to be in a hybrid cloud environment. So in that environment, I have the ability to secure a hybrid multicloud. I have the ability to federate data in a multicloud, not to put it all in one Data Lake, only to find out you missed one piece of data, and I got to go get that one. People are looking at 20-plus sources of data in order to do the work they want to do in AI. So they'd rather be able to federate that and have to move it all into one place. I want to automate that. I want to automate it from a network automation perspective, from a business automation perspective and from what we call AIOps or the operation of IT. And so I can get the most out of the systems that I'm buying, whether it's on-prem or in the cloud. And so the combination of all those things gives us the ability to help them understand this journey to a hybrid multicloud is best served with somebody you can trust so you don't have vendor lock in. You can run this everywhere you want to.

You mentioned earlier a big push into automation. And IBM, both organically and inorganically, has been investing in the opportunity. So talk a little bit more about how you see that evolving and the opportunity for IBM.

So I think with the skills gap that all of you see every day, the ability to do automation -- and maybe it's some of the simpler stuff we call BPM and RPA, just being able to automate more mundane processes, whether it's with humans or without, I still think it's a great opportunity. And we did 4 acquisitions in the automation space in the last 2 years. Then you get into the world of AI operations, and it's really difficult and hard to find the skills to get somebody that can really be an expert in all things in your system. So we did an acquisition of a company called Turbonomic. That's done very well for us, and it automates the process of IT. And not only does it give the users a better experience, their customers of our customers, but it also optimizes the spend that they have in different environments in a multicloud. So if you're spending too much on storage and not enough on processor, I'm limited by the number of JVMs I have or the size of my JVMs or my network is really the limiting factor, it means I'm overspending in all the other areas because I already ran out of capacity at some point. And everything above that, that I'm spending on storage or processor or whatever it is, a network is just wasted. And so the ability to do ARM and Turbonomic is the leading product in this area that we bought gives us a great ability to not only do the organic piece of AIOps, which we got from IBM Research, but also add to it combination of Instana around APM, which is the first container-native APM environment, and Turbonomic give us great ability. And then the last piece, which is much more nascent, is our ability to do network automation. And that's a new unit for me under a new GM we hired from outside. And we've had some great wins in combination with IBM Consulting around DISH and Telefonica and others. In fact, the team was just over in Barcelona at Mobile World Congress. Lots of interest in network automation. So I think automation is a hot area based on skills and based on the ability to have those same product skills be deployed across multiple environments.

And at the October Analyst Day, you profiled, in addition to automation, some other growth focus areas like data and security. Just talk about how those round out the strategy in software.

So I think you guys asked me back in October where we would -- where were I looking versus M&A activity -- for M&A activity. So I think data and security are 2 great topics, and they're both broad. I mean in the security space, you've got everything from identity to XDR, EDR to threat detection, all these data protection. All of these areas are of interest. We just did an acquisition in security following our conversation in October, something called ReaQta, which helps add to our EDR, XDR capability and QRadar. That really augments. It's a small acquisition but I think significant in the function that it provides. So security is certainly a topic of interest to me. It's a high-growth area, one that I think we'll continue to see growing. And the threats coming from Ukraine and Russia have gotten us to unprecedented levels of attacks. And so it's -- and the cost of a data breach now is the highest it's been in 17 years. It's more than $4 million per breach. So across our hardware and software, we're working with people to give them more resilient solutions. I just saw a note from a bank in France talking about the resilience of their on-prem solution with Z and the fact that they can do a level of cyber vault activity so that they can create copies of their data, gives them a real advantage in this kind of environment. And then around data, it's data science. It's analytics. It's AI. I should say that it's not just AI in the business of AI, but we're injecting AI everywhere. AI is in security. AI is in automation. And AI is in, obviously, the work we're doing around voice recognition and the NLP work that I'm doing. I'm very bullish on natural language processing and the work we've done with CVS around what we can do with automating their calls. They never could have hired enough people. And the domain is kind of narrow. People are asking, where can I get a vaccine? Where can I get a test? What kind of vaccine can I get? How do I make an appointment? We were able to do 80-plus percent handled with automation. And so the call center could be freed up to handle the much more challenging calls. Same thing with state of Rhode Island. They didn't have to hire a bunch of people that I never -- I don't think they would have found same kind of things. And then you may have noticed in the data area, we did do an acquisition in November of a company from McDonald's, McDonald's Tech, which actually was a company out here called Apprente when McDonald's bought them a couple of years ago. And it does automated order taking. So if you go to the drive-through, you can actually do the ordering from a voice reco system that can handle a lot. I mean I was there being, of course, a wise guy trying to order sushi just to see what it said or trying to order something from a competitor, and it handles it very well. And it times out after a certain amount of time, where if you curse at it, it will time out, then get a human on the line. But most orders can be handled, 80-plus percent. And franchise owners are going to love it because this is an employee that will show up every day.

Interesting. Just going back to security. You mentioned 5% growth last year. Fourth quarter was a bit weaker. What are you doing to invest in security to achieve the growth profile?

Yes. It was weaker in fourth quarter, but as you said, 5% on the year. I think the combination of product cycles -- we just came out with a new version of our data privacy software, Guardium, you may know it by. And we did the acquisition of ReaQta. So I'm looking at pipeline and looking at opportunity and looking at the growth in security in general. I'm confident we'll get back to the kind of 2021 average levels, if not better, as I look at '22 and the midterm. So I think it was really more of a blip based on a couple of factors and not a long-term problem. But we're hiring lots of security professionals every day. I've got the professional services part of security that goes out and works with everybody's software, including my own, to do -- to implement solutions. And we've got several centers. If you haven't been to a cyber range, I'd encourage you to go. We've got great examples of simulated attacks on your company and how do you handle it. Do you -- what do you do with ransomware? How do you handle the media? What do you tell your people? It's very exciting. And I will tell you, despite the fact that it's a simulation, your blood pressure and your heart rate go up like it was the real deal. We put microphones in your face until you address Morgan Stanley's on the phone. They want to know what it means to your investors. And -- or NBC's on the phone, they want to know what it means to the world. So it's very exciting to see the world of security, and I think we'll see good growth in that area.

Great. So we spent a lot of time on hybrid cloud. Arvind pitches the story and the transformation is hybrid cloud plus AI. You gave a few examples on this front. But just share a little bit more about how you see AI as part of the value that IBM brings to the market.

I think the combination of what we're doing with voice and injecting AI everywhere and the fact that if you look at the most recent IDC report, which just came out last week, they ranked us #1 in AI from a platform perspective. They called it a life cycle. I would call it a platform, the platform of AI, being able to do the data science, the analytics. We've got some great technology, I should mention, on the system side and the new z16, which is coming out this year, which is going to give us the ability to do accelerated analytics. I think it's great to be able to do in-transaction fraud prevention. And this whole move to doing this from a learning perspective -- the example I'll use is we were working with a bank in Japan that had a -- for fraud had a rules engine. So if you happen to trigger these rules, it would say, "Okay, this is logic. Probably fraud, likely fraud. Don't let this transaction through." Rules engines are a bit outdated. And so we work with them to work on one that really uses AI and ML to say there's patterns here that are not just a set of rules like if the transaction is more than this -- or easily written rules. It's -- this does not match Katy's buying pattern. This looks very anomalous. Or actually on the AI side of security, you're allowed to download files. But if you're doing like 4x the volume at 2:30 in the morning, maybe you're about to leave and take our data to competitors. So maybe I should stop that because it's an anomalous activity. So I think we're seeing the infusion of AI, whether it's AI-informed BPM, AI-informed security or any of these areas, really giving people much more insight into the what's normal look like, what's abnormal look like, what could be an opportunity and what could be a threat?

IBM has completed over 20 tuck-in acquisitions since the beginning of 2020, roughly half of which have been in software areas that we talked about, data and security and automation. Just at a high level, how important is M&A as a driver of growth as you go through the transformation? And what are some of the incremental areas of software that you're looking at?

So you mentioned the 20-plus, and half of those are software, which is great for me. And the other half are consulting, which I think is also great for IBM. We've been augmenting skills. We've been acquiring companies that give us additional skills around DevOps, acquiring companies that give us skills around Salesforce and around Azure. And I think my colleague over in IBM Consulting will continue to do that. I'm continuing to fill out the portfolio. And I mentioned data and security as good ones to look at. Network automation is another one. That's nascent for me. I think these are all really rich areas. And I've got my eyes on a lot. We're shopping every day. I know valuations aren't great for this room, but they're better for me. So as valuations fall, I can afford more. And other ROIs and IRRs close for me that might not close otherwise. And so we'll see how that goes, but we're shopping every day. We've got activity going all the time. I've got a couple in play right now. So it's not uncommon. But we're looking -- we probably look at 10 for every one we end up trying to buy. I love the addition of not only what comes out of IBM Research and my team in software development, but what we can add to it with companies like Instana, Turbo, myInvenio, ReaQta. We just did an acquisition and completed this year of a company called Envizi in the environmental intelligence area. So that -- in fact, we were using them. We were a customer of Envizi as IBM. We've committed to get to carbon neutrality by 2030 and reduce carbon by 75% by 2025. So having the carbon on a dashboard really can show us our impact on the environment. By the way, the combination of that with AIOps, if you think about the possibilities of saying if you ran that work here, your electricity would be much cleaner than if you ran your work there. I lived in China for a year. If your Tesla is fueled by electricity that's generated by coal, I'm not sure that, that's a positive move. So you really got to say, where does my electricity come from? Is it natural gas? Is it wind? Is it solar? Is it coal? Is it oil? Where is it coming from? So if I can -- and data centers are getting a lot of attention right now, and crypto is getting a lot of attention right now for its impact on the environment. So if I can give somebody a sense, hey, if you do that there, it's going to generate this much carbon. But if you do it here, it's going to generate a whole lot less. That could actually give people visibility to where to run workloads. So that might be another reason to run here or there, independent of data privacy and governance and GDPR and all of those things to give me an advantage. So we did this acquisition of a dashboard company. As I said, we were a customer. We started out thinking maybe OEM, and then we got enamored with it and said, let's just buy the company. So we completed that in January. And I'm very excited to add that to what's called the Environmental Intelligence Suite.

Interesting. One of the more underappreciated elements of the transformation is what you're doing internally around the go-to-market and investing in technical skills, rethinking how you compensate the salespeople, I imagine, to drive more hunting and to build a more open ecosystem. You mentioned a number of partners. Just give us a little more detail around those changes and how investors should think about the impact over time.

So thank you. We made a significant change in our go-to-market this year around how we put many more people on quota. So from a productivity standpoint, I'm very happy to have increased our capacity without increasing the price of all of this, but just having a lot more people focused. When we shed GTS -- when we spun out GTS, it gave us the ability to have technology-focused sellers and IBM Consulting-focused sellers. And so we no longer have the overlay of somebody who holds quota for both. Now it's you're either in technology, which means hardware and software, on-prem or anywhere, or IBM Consulting. And I would say, quite frankly, if you're in IBM Consulting, we're selling yourself. So it's not clear that I'm going to do a job saying -- good job saying, hey, let me sell you Katy services, like Katy can sell your services to the customer. So I think they get to go directly to the customer, and we get to do the same thing with technology. So it not only gave us the ability to focus without having the managed services, but also gave the ability to increase productivity, reduce the number of overlays and really increase the number of quota-carrying guys and gals that are out there selling technology and selling consulting. That combination has really given us -- by the way, they're all motivated to sell Red Hat. I should have mentioned that, that when you asked about the benefits, I think the go-to-market benefits of Red Hat have been fantastic and the reach that we've added in our go-to-market capabilities that Red Hat couldn't get there fast enough to get scale. And so that was another benefit to Red Hat. It's certainly -- we've changed our selling motion to be one of consumption and deployment. So we've now hired about 1,000 CSMs or customer success managers around the world because selling software is one piece of it, but getting it deployed is really what's important. And so getting all that -- all those Cloud Paks that we sold, getting the OpenShift software deployed is absolutely critical. And so now we pay people only on the consumption, only on the deployment of the software in their clients. And then we pay them to cross-sell and upsell, obviously. But getting the stuff we've already "sold" and getting it installed and up and running and in production is something we track religiously every 2 weeks. And these people are paid and incented on how much software they get deployed.

And a lot of those changes went into effect, I think, a year ago. So do you feel like IBM is past some of the risk point of making changes within the sales force?

I don't know that we want to make a lot of changes. I'm sure we'll do some refinement. But the most recent of these changes just went effect in January and putting more people on quota. So having technology sellers and IBM Consulting sellers, that's fairly -- that's only 2 months old, 2.5 months old. And so I think from a risk perspective, I think we've managed it really well. From an upside perspective, I think it's more to come. And we're obviously counting on the fact that this was a good change to make. But I don't think you want to keep changing and changing and changing, especially when it goes to in a sales motion. You want to -- the commitment to CSM, yes, happened 18 months ago. The commitment to a refined, I'll call it, go-to-market around consulting and technology is very recent.

And just to wrap up, we've talked about some disruptive technologies that are playing out in the market today around things like AI and security. But when you think about the business over the next 5 years, what opportunities will we be talking about? I know Arvind has spent a lot of time on, for instance, quantum computing.

And as did I up until about 8 months ago in the systems role. And I think quantum is going to fundamentally change the computer business. And I think we're on the leading edge of this based on the work that's been done with research and getting to an over 100-qubit system and getting to the point where quantum actually benefits because most -- up to this point, it's been what you could do on a quantum system, you could do on a classic computer. And so now we're at the point where you have quantum supremacy that things you couldn't accomplish otherwise. Think of quantum as really about mass optimization and about -- today, we model things because you can possibly represent all of them, whether it's at the atomic level or it's at the risk level for Monte Carlo Simulations. I think we're going to be able to -- you're going to be able to reprice risk on a transaction basis to say, well, what did that loan -- or what would that loan do to my risk portfolio if I go ahead and approve it? So being able to do that level of optimization, some of which we do -- I mean you saw this with -- we're going to see it more with oil, but you saw it with ships getting stuck in canals and people having to reroute things, things stuck off the coast south of here and waiting for goods to come in, scheduling which things should get there first. Where do I get paid a premium in order to get it quickly? Where do I pay a penalty? I'm going to get spoilage if this container ship doesn't come in. So there's a whole bunch of -- or crew scheduling for airlines or hospital scheduling for balancing staffing with quality of care, obviously, are all things, I think, we're going to see benefits from quantum computing. On the software side, I think it's going to be realizing a lot of what we've declared. I mean I will tell you that the pivots that Arvind has made in the last 2 years have been powerful and have me as a long time, which means old guy, in the business really excited about what I'm seeing. And so this move in this pivot to hybrid multicloud and our partnership and getting our software up and running on AWS and Azure in addition to the IBM Cloud and on-prem, building out the data portfolio, the security portfolio, like we've done with automation, I think, is very exciting. And I think the move to ESG is also very exciting. I think the partnerships around the ecosystem will do more of this. We've got to prove it to people who are serious about the EYs, the Deloittes, the Caps, the Indian providers. And I think we're building that, but we've got more work to do. So I think I'm good on pivots for now. I think we've got to go execute what plays the boss has already called and make sure that we can put the right meat on those bones of the strategy that he's put together. That doesn't mean we won't be paranoid and be watching and make sure that we're adjusting to events in the marketplace, but I don't think we're going to see new categories of software other than what I just defined in ESG and maybe what we're doing with network automation around SDN. But I think the categories are there. It's up to me now to go deliver.

Yes. No, that's a great place to end because it has been amazing to watch with the new leadership team, granted came from within, but a new reenergized leadership team that, as we talked about, changed the financial focus to the right metrics, made some big bets like with Red Hat, divested slower growth, less profitable business, investing in go-to-market, clearly a focus on M&A. There's a lot that's been done in a pretty short period of time, right, since April of 2020, and now it's really just about going and executing...

That's what I thought.

On sort of the hand you're holding. So that's great. Thank you so much for joining us.

Thank you so much, Katy. Very much appreciate it. Great to see you in person.

Same. Likewise.