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

Hello, and good morning, everyone. Thank you for joining us again on our Bottom Line Matters CFO Call Series, where similar to our CEO Call Series, we invite CFOs to discuss financial strategy, the financial model, capital return and financial priorities. Before we get started, I need to mention that conflict disclosure as related to the individual companies or securities discussed on the call today can be found on the call invitation. We're going to keep this call to about 50 minutes. With that, I'm super excited to welcome Jim Kavanaugh, who you all know. Jim was appointed CFO of IBM in January of 2018. And prior to this role, Jim was SVP of Transformation and Ops from 2015 to 2018. So he does have a really rich operational background and has done a lot of the work behind what you see in what has happened with the transformation of the company from a financial perspective and a lot of the decisions that have supported the strategic changes that the company has undertaken. Previously, he was also IBM's Controller from May of 2008 to 2015 and has held various finance leadership positions that have included responsibility for IBM sales and distribution worldwide, IBM Americas Group and just a broad swath of experience here. So Jim, welcome. We're really honored to have you here today, and thank you so much for taking the time.

Thank you very much, Wamsi, for having me, and thanks for the kind opening remarks. We'll hopefully try to live up to that here. So thank you.

Well, you guys as CFOs have been navigating a lot of different crosscurrents over the last few years. So this is just -- it's a nice little break from all the work that you do, hopefully.

So well, maybe a good place to start would be just the overall macro environment. And how are you thinking about the sustainability of enterprise demand in 2023? And how are you, in particular, looking at IBM position for a potential downturn?

Yes. As you say, a great place to start. It's an understatement to say the last few years had been interesting, especially as a CFO and trying to deal with many different dynamics overall. But I think when you look at enterprise demand in the macroeconomic environment right now, I think every company is challenging traditional forms of competitive advantage to try to understand how to emerge stronger. And if you think about it, internally in IBM and many of my peers that I talk to, the macroeconomic environment is posing many different challenges and opportunities for clients, whether it's demographic shifts, labor shortages we're all still dealing with, inflation, some supply chain dislocations, cybersecurity challenges all the way through to increased sustainability requirements. But underneath it, we have a firm belief that technology is the source of competitive advantage. And really, it aligns to our 4 strategic convictions that we are building this company on. First, technology, we believe, is the only deflationary force. That's why it is so important and why you see technology always outstripping GDP by 3 to 4 points. It's the #2 driver of GDP overall behind health care. Second, AI is the vehicle for productivity. Everyone is jumping in and moving from experimentation to scaling. Three, right at the core of IBM now is digital reinventions are all requiring a heterogeneous and hybrid environment, and we play to that. And four, and you go back to what we did with the Red Hat acquisition, open source is now becoming the new innovation model for all companies. So when you look at that, the dynamics, the challenges, the opportunities facing many clients around the world, we feel pretty comfortable that technology will continue to outstrip GDP in 2023 because of that deflationary force and productivity impact overall. Now to IBM overall, as you started, as a CFO, our job is to always run multiple scenarios and looking at all facets of both exogenous impacts and internal execution. And underneath it, when you look at challenging economic situations, IBM has fared relatively well. And I think that's a result of the macroeconomic model that we have built around, one, geographic diversification. We operate in 170 countries around the world. It pretty much provides us a natural hedge because every market goes through different curves. Second, we participate in 17 different industries. We're pretty broad-based penetration. Third, probably most importantly, is our client segmentation focus on enterprise. We're not consumer. And we serve over 95% of the Fortune 500 companies. And fourth, kind of wrapping up here, is our business model. That transformation you talked about upfront of how we changed our portfolio and our business model, we now have a high-value recurring revenue stream here in IBM that represents over 50% of our portfolio, and that buffers us and provides us some stability in revenue, profit and cash over time. So we feel pretty good about the environment we're in and how we could capitalize on that.

Thanks, Jim. That's a really fantastic backdrop to start the discussion here. So IBM, you guys just reported really strong revenue growth in 2022, and you've guided for 2023 revenue at the low end of your midterm model. Can you dissect the growth by segment and what the underlying drivers are for each? We get a lot of questions around this.

Yes. Great, again, place to start overall. When you look at it, we're pleased with 2022's performance. It's behind us now. We're entirely focused on '23. But I think there are some important components underneath '22 that really position us for 2023 and that confidence in our guidance overall. First, it was our first full year of what we call today's IBM. And that is a much more focused, streamlined, hybrid cloud platform-centric company with a compelling integrated multiplier effect across our software, our hardware and our consulting businesses overall. And you see how that played out in 2022. We delivered, I think, what, $60.5 billion of revenue, up 6% at actual rates, up 12% at constant currency, and that included about 4 points of the incremental Kyndryl contribution. So even without the Kyndryl contribution, we're up 8% above our mid-single-digit model. But underneath it is what makes us most exciting about the work that we've done to change this company to a sustainable growth level. When you look at it, we've had good global demand throughout 2022 that was pervasive across our segments and across our geographic markets, representing the value of our hybrid cloud and AI offerings. Second, our growth vectors, that being Software and Consulting. A big part of that portfolio transition, that is now over 70% of our business portfolio, and we had very nice growth, up 6% in Software last year and up 15% in Consulting overall. And third, that recurring revenue, which is not only a high-value annuitized-based stream, is we saw a nice acceleration of that growth throughout the year, and we finished last year growing 8% in our recurring revenue stream. And it's very important, I'm sure we'll get back to it a little bit later, of the marginal profit dollar and multiple that, that gives us. So all of those facets give us the confidence in our guidance in 2023, as we talked about a few weeks ago, that we expect to be on our mid-single-digit model. Although I did say as CFO, prudent in the month of January entering the year to be on the low end of that model. By the way, to your point, that was a take-up from the average street analyst by about over $2 billion of revenue. So you get underneath it, you asked about segments. Let's talk about our 3 major segments real quick, and we can go into deeper detail if you want later. But around -- let's start with Software. Software, over 40% of IBM's revenue. We guided to our model of mid-single digit. That will generate 3 points of IBM's mid-single-digit growth. And that's really going to come out of the culmination of that strong accelerating recurring revenue stream and also a very healthy ARR book of business, $13.3 billion exiting the year, with a nice NRR well over 100% that we've been able to capture. So we got some good momentum there that gives us confidence. Second, Consulting. Consulting, we guided to be at our high end of our high single-digit model, again coming off of a mid-teens growth in 2022. We still see very good demand in the marketplace around digital reinventions, around application modernizations. And we've got, exiting the year, over a $9 billion book of business in hybrid cloud. That's up 23%. Strong growth driven by application modernization. But we also have accelerating trends in our strategic partnerships with our ecosystem velocity; in our scaling of acquisitions, which are doing extremely well in Consulting right now; and our Red Hat practice, which continues to accelerate. I think inception to date, we signed a book of business of $7.4 billion over 3 years. And we exit the year with a pretty strong book-to-bill. So I think that gives us confidence. And then third, our Infrastructure segment. As we always said, innovation drives growth. And we had some very nice receptivity to our new innovation around our mainframe platform in 2022 and around our power architecture in 2022. We'll wrap on that in '23. So we acknowledge that, and that's going to probably cost us about 1 point of IBM growth. So when you look at that mid-single-digit growth, 3 points out of Software, 3 points out of Consulting and about 1 point headwind around our Infrastructure as we wrap on the cycle.

Okay. No, that's great. Maybe just to focus, Jim, on Software. Maybe one of the ways to think about it might be to think about Red Hat, where there is a lot of investor focus about Transaction Processing, where there seems to be a change in trajectory and then the rest of the business. So if we were to sort of segment it in that way, maybe starting with Red Hat, how do investors -- how should investors think about the confidence of this asset driving mid-teens growth?

Yes. I mean, let me start with Software overall because I think it's very important for our investors to understand the portfolio and the composition. Software definitely is the foundation of our hybrid cloud platform-centric business. $25 billion worth of revenue, last year growing 6% overall, good strong performance. I talked about that ARR book of business, $13.3 billion, of which Red Hat is a big piece of that and a strong accelerating NRR component built off of our modernized and optimized Cloud Pak technology. But let me dissect Software, and we'll get into TP, Transaction Processing, Red Hat and the rest of our IBM Software business overall. But at a backdrop, our Software business overall is about 80% high-value recurring revenue and about 20% transactional business. We offer many different modernization models on the transaction business from perpetual license sales to subscription businesses to SaaS-based businesses, et cetera. But that Software book of business, high value, 80% of it is recurring revenue. And when you look at 2022, that recurring revenue, as I stated, nice acceleration throughout the year. Exiting the year, growing about 8% overall. But we also, as expected, had a very solid and strong transactional year because we entered 2022 at the beginning of our ELA cycle. And when you look at that growth of Software in 2022, growing a little bit north of 6% above our model, by the way, it was driven by about 4 points out of recurring revenue and about 2 points out of our transactional business. Kind of as expected, team executed well. Now when you get to '23, our '23 guidance is to be on model, mid-single digit. But the underlying revenue contribution mix is going to shift. That nice accelerating recurring revenue which, by the way, drives high, like 90 points of marginal profit dollars, that is going to contribute 5 to 6 points of our overall Software growth. Why? When you look underneath it, about half of that is going to come from Red Hat, a very compelling subscription-based model that's the foundation of our hybrid cloud platform, with Linux at its core, with RHEL, with our Red Hat OpenShift and with great receptivity in our Ansible automation platform that's growing very nicely. And I think in January, I talked about Red Hat OpenShift for the first time exceeded $1 billion of ARR. Red Hat grew 17% in 2022, and we guided to mid-teens. Now that 5 to 6 points of recurring revenue, about half of that is going to come out of Red Hat at mid-teens. But I would tell you, I expect Red Hat to actually accelerate throughout the year. We're probably going to start the first half a little bit below the mid-teens. Why? Because in 2022, we were on the down cycle of our renewal year. We now enter an up cycle on all of our renewals on subscriptions in 2023. So we'll see a nice acceleration in Red Hat deliver that mid-teens growth. The remaining half of that 5 to 6 points of recurring revenue is going to come from us capitalizing on that accelerating trend in 2022 off of a strong renewal year and capitalizing on the successful mainframe platform cycles that we've had over the last handful of years. Our installed MIPS capacity are up around 40% year-over-year, and we're seeing nice acceleration and attach rate to that overall. And then third, this is the area we have pricing power, and '23 will be a pricing optimization discussion that we built into our guidance. So 5 to 6 points of that Software growth is that high-value recurring revenue, and it's that Red Hat, Transaction Processing and our pricing leverage. The remaining 1 point of a headwind is we acknowledge that we're coming off that strong ELA cycle overall. Now ELAs don't peak 1 year and come down the next year and then normalize. They build up over the year, and we saw the beginning in 2022, and will start coming down gradually in '23 and then '24 and then build back up. But we've got all that embedded into our model overall.

Okay. No, that's a lot to think about. So maybe just, Jim, can we just talk a little bit about the ELA comment that you made so -- at the end? So when you think about the headwind to growth as investors think about maybe '23 and '24 from an ELA perspective, how much of a headwind would that create? Or how much is kind of currently being baked into the model?

Yes. Like I said, when you look at the composition of our Software business, again, 80% high-value recurring stream-based business. That's our subscription models, that's our Transaction Processing business, our SaaS-based business. 20% is that transactional business. And of that transactional business, I would say, give or take, Wamsi, about 50% to 60% of that is ELA-driven. Roughly, the remaining half is your normal volume-based perpetual license sales, again, across our high-value components of automation, data, AI, security parts of our portfolio overall. So when you look at it in 2022, we probably penetrated about 60% of our ELA cycle. The remaining 40% will be in '23 and in '24, '24 being the tail end of it. So when you think about those optics, 20% overall of IBM, we're about 60% through our ELA cycle, another 40% to go in the next 2 years. That's how we get to our 1 point headwind that we're planning on right now. Obviously, our job is to execute and over-deliver on that, but I think that's prudent as you enter the year overall.

Okay. No, thanks for that color, Jim. And then just on the other comment you made around pricing, right? So typically, you always are able to capture the pricing given the value that the assets are generating. But as you think about '23, is there something different about pricing? Is this an incremental increase in pricing? And was any of that realized in '22?

Yes. When you take a look at the first question we talked about, every company, every CFO is dealing with dynamics around inflationary cost to their business, right? We saw that play out. We talked a lot last year about our Consulting business, which is a human capital-based business by definition, right? And I think we were pretty honest that rate and pace was the discussion of Consulting in 2022. But we saw some very nice green shoots around our pricing optics in Consulting, which is where we started. In the second half of the year, third quarter and in fourth quarter, our price margins were up nicely, and we expect that to continue into '23. When you look at our technology business overall, we've taken into account -- we took very little inflationary base price optimization decisions in '22 consciously. One, we needed to get back the incumbency position coming off of this very successful last couple of cycles of our mainframe. But when you get into '23, just given the economics of what we're all dealing with in this inflationary environment, we've taken up our normal price actions by about 3 to 4 points overall. It's in areas where we do assess price elasticity curves. I always say that pricing follows the differentiated competitive advantage that you have in your technology. If you don't have that differentiated competitive advantage, we all know what happens to price elasticity curves. But in areas like our Transaction Processing software, our mainframe-based software overall, we do have incumbency, strong value propositions, and we'll see that pricing power play out throughout 2023 and probably more so in the second half of '23 overall. Hopefully, that helps answer some of your questions.

Yes. No, absolutely. That's very clear. And then, Jim, just to go back to Transaction Processing, there is a change in trajectory over here. Might be helpful to -- for investors to understand, what's actually driving that change in trajectory? Outside of pricing, is there something else that's going on that you can share with us?

Yes, sure. I mean, Transaction Processing is a critical component to our model overall. Why? One, it's a value vector. It's about 30% of Software's overall business, right? And we went through some very different dynamic changes over the last 3 or 4 years as clients change their buying behaviors, more upfront perpetual license versus more annuity stream over time. And that was really due to certainty and visibility of the macroeconomic environment, we truly believe, overall. But there was a very important inflection point as we went through 2022. One, it is that value vector. It's important to us because it is a high-profit, high-cash generation engine that provides us financial flexibility to reinvest back into our growth vectors of our hybrid platform and solution offerings around Red Hat, automation, security, data and AI. In the last few years, we've been dealing with, what, down mid-single digits in that arena. That has been quite a pressure on not only the top line software portfolio but on our bottom line profit and cash. That changed in 2022. We got back to -- now, let's put it in perspective. We got back to flat, much better than the trajectory of down mid- to high single digit over the last few years. But what makes us confident in '23 is the underpinnings of what we've been seeing underneath that. One, our renewal rates over the last 18 months have been the strongest in the last 5 years. And I think that's a testament to the value of innovation that we brought to that software part of our portfolio. And second, it is a reflection of the great success we've had over the last 2 mainframe cycles, which have been well above our historical performance. So we have about 40% more installed MIPS space capacity, read that as an opportunity pool, and we have a very strong moat incumbency position that provides us a tremendous leverage-ability of driving that multiplier effect on getting that attach rate, renewal rate up in that demand capacity. So you take those inflection points and now you point them to '23, and we actually guided, because we feel pretty confident, that we see Transaction Processing returning to growth at low single digits in '23. Big statement to our overall top line Software revenue position and also a very big statement because it carries about 90 points of marginal profit dollar for each revenue dollar overall. So thanks for bringing that up. Very good question.

And so, Jim, just to wrap on that one point. So is that something that you see as sustainable on a go-forward basis where this is just a change in trajectory for the business, such that investors should now think of Transaction Processing as accretive to aggregate IBM and Software growth? Because that would really be a big difference from mid- to high single-digit decline over the last several years and maybe what investors are underwriting for the aggregate growth of that piece of the portfolio.

Yes, definitely. We feel very confident in that multiplier effect of Transaction Processing that's built on our mainframe platform stack overall, the innovation that we've been building into that portfolio, now our transformed go-to-market model. By the way, our sellers, we've aligned up and down to revenue growth to annuitize stream-based business. We understand that carries different multiples. And to your question, we do see sustainable growth going forward. We started out at low single digit. Let's get to that growth profile first. It does drive -- over time, I think it's about 1 point of IBM top line revenue growth on a $60-plus billion base, and this could be up to maybe 200 basis points of profit contribution to the overall IBM model. So it has a very big investment thesis to that point.

Yes, absolutely. And I don't think that's well appreciated. Jim, maybe just to go back to one more of your comments around the renewals dynamic that you spoke about around Red Hat. As we -- what actually is causing the renewal dynamic to be such where you saw the sort of shape of renewals to be maybe deceleration in '22 and then an acceleration in '23?

Yes. Well, let's put Red Hat in perspective overall, right? We've got a book of business that over a 3-year period is over 2x the revenue contribution from pre-acquisition. By the way, 3-plus years in, we just had our Board meeting last week, we are on our business case 3-plus years on a $34 billion acquisition. And cumulatively over 3 years, we're growing high teens, and we just finished last year at, what, 17.5% revenue growth. So we feel very confident that the instantiation of this hybrid cloud platform-centric model is really playing out. And more importantly, it's not only the Red Hat portfolio and the contribution that it's been driving in of itself. Look what it's done to our overall Software portfolio, a portfolio pre-Red Hat that we were struggling to grow low single digit. And now as we've invested to modernize and optimize our software on top of that Red Hat platform, which was the investment thesis overall, you've seen a nice acceleration in our overall Software portfolio. So when we look at 2022, it shouldn't surprise you, given the culture and the dynamics of IBM around our software ELA cycle, 3-year type cycles, we embed part of that value thesis, right? We went to the market back in 2018 when we announced the acquisition. It's the global breadth and scale and distribution of the IBM go-to-market model for that Red Hat technology. And yes, we capitalized on that over time. So we kind of expected that to play out because that cycle quickly flipped to a cycle analogous to an IBM. So there's good and bad to that, and we'll have to deal with that. But the underlying fundamentals of what happened, 2022 was a down year. Our bookings were low teens overall on a total bookings level last year, which is about what we expected. But by the way, even on that total booking, our NRR was close to 120% overall. Why is that important? Now you get into '23 and we're on an uptick of a strong renewal cycle, by the way, kind of opposite of the ELA, so it kind of gives us a natural hedge to the IBM Blue software. As you get to that up cycle in '23 with that strong NRR, that positions '23 and also '24's revenue, just given the subscription-based model, in a highly annuitized-based model. Hopefully, that answers your question.

That's -- yes, absolutely. And that's a lot of color. I really appreciate that. Maybe switching to Consulting. You guided to the high end of your Consulting model in terms of revenue growth for '23. What sort of demand environment are you seeing in Consulting? And I know you shared a little bit of color around that. And what's giving you the confidence about continued strong revenue performance in Consulting? When the context -- maybe the broader context, Jim, there is just that a lot of consulting companies are talking about significant deceleration in their own projections.

Yes. Well, first of all, very pleased with our performance top line. More work to do, rate and pace on the operating margin, and we know that. But again, as I talked earlier, nice green shoots, and we guided to operating margin acceleration in 2023. But to your question on top line, I think this goes back to our first question, and we talked about what are the fundamental drivers that clients are looking at today in light of the challenges and opportunities in the marketplace around demographic shifts, labor shortages, high inflation, cybersecurity? Every company is trying to reinvent themselves for sustainable competitive advantage. And that gets to digital transformation, that gets to application modernization, that gets to journey to cloud. And we have -- you started upfront about all the work prior to me stepping in the CFO role. I had the chance to step out of a core finance role after being a Controller. I think I was the longest-standing Controller in the IBM history for 8 years. But I had a chance to step out and really lead the next evolution of IBM, and Consulting was an integral part of that because we had to do a lot of work to transform the offerings, our growth platforms, our delivery models. And now when you look at Consulting, it's a fundamentally different business profile overall. And what do I mean by that, which gives us confidence in '23? Number one, about a $9 billion book of business built around hybrid cloud. That's application modernization, that's capitalizing -- opening IBM up to strategic partnerships or hyperscalers. That's our Red Hat book of business. I talked about $7.4 billion over 3 years that we've signed overall. That's acquisitions, right? I still remember taking over the CFO role in 2018, having drawn out debates with our heads of Consulting about acquisitions spent in Consulting. It was 0 because I was not going to put a dollar of capital allocation until we fundamentally reposition that business model, so we can ensure that we get the financial return. As we got through that, we opened up the aperture, what, 18 months ago, 2 years ago, and we're seeing tremendous success and acceleration built around those strategic partnerships, ISV capabilities, hyperscaler capabilities. So I think all of those pieces, coupled with where did we finish the year? It's a sign-in book-and-bill type business, as we all know. We finished the year with a very strong book-to-bill off of a 15% revenue growth. Our book-to-bill ended up at over 1.1. Fourth quarter, our strongest in most recent history of 1.3 book-to-bill. We grew our signings for the year, both large deals, double digits; small deals, double digits. I think it's a testament to that differentiated offering capability. And we entered the year looking at our backlog. And our backlog right now, yes, in a Consulting business, that's about 60% to 2/3 of your full year under contract. Yes, we need to look at the backlog realization, the churn rates, the new sell and bill. But all of that points to us being at the high end of our high single-digit model overall. So we feel pretty good about that. But definitely, we all know, in any challenging macroeconomic environment, these are areas that on a discretionary perspective get cut first. So we are looking at all the KPI indicators. But as of right now, we still see pretty good growth overall.