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

So I think we're going to get started. We have about half an hour here, so I want to make sure we utilize all the time. Just as a quick -- sorry about that, as a quick introduction, my name is Erik Woodring. I'm head of the hardware research team here at Morgan Stanley. Before I introduce our guests, let me just quickly read research disclosure. For important disclosures, please see the Morgan Stanley research disclosure website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to a Morgan Stanley sales representative. So I am delighted to be joined this morning by Jim Kavanaugh, CFO at IBM. Jim has been at IBM for almost 3 decades now, a huge football fan that I just learned about -- but had a number of different roles, but really, really happy that you're joining us this morning.

Thank you very much, Erik. Appreciate you having us here.

So let's start big picture. IBM has been through a number of changes over the last few years. Can you kind of tease out for us, elaborate what has been -- what have been the most significant changes that IBM has gone through? Why is the company better positioned today to meet the needs of your clients. And how is that translating into financial performance? We can probably spend half an hour on that, but let's start with that and go from there.

Most definitely, but a great place to start, right, because we've been through a lot, the handful of years that you talked about. Today's IBM is a fundamentally different company. When you think about the strategic shifts that we've made over the last few years, I'm talking portfolio, operating model, business model, culture, client segmentation, you name it, all centered around driving a sustainable growth profile for our company. So when I think about those strategic shifts, I'll just talk about a couple of them: one, portfolio; two, go-to-market; three, ecosystem. Around portfolio, we've been very acquisitive over the last 3 years. Since Arvind Krishna has taken over as Chairman and CEO, we've made 30-plus acquisitions. We've repositioned our portfolio, 17 different divestitures or spin-offs really centered around creating a very focused hybrid cloud and AI company. We have now a hybrid-cloud, platform-centric business model that has a compelling value proposition around an economic multiplier of Software, Consulting and Infrastructure. We have repositioned our portfolio. Now our growth vectors, that being Software and Consulting is now over 70% of our revenue profile, driving nice sustainable growth. And we've got a high-value recurring revenue book of business that's over 50% of IBM's revenue that's growing nicely. So a lot of work around the portfolio to get streamlined, focused on where we can win and how we can win. Second, go-to-market. We embarked on a major go-to-market transformation a couple of years ago, probably the first time in a decade, aligned to our repositioning of the strategic thrust around being hybrid cloud and AI. And the team has done an outstanding job, really repositioning go-to-market around, one, being much more technical; and two, being much more experiential on how clients are buying today. That is investing in Client Engineering to do application migration, application modernization, technology architecture but also around client success managers. So we drive adoption, scale, consumption and deployment of our software. So a lot of great work there. And I would tell you, exiting 2022, that go-to-market shift, we've seen one of the highest NPS client segmentation or sentiment analysis in the history of IBM. So we're off to a good start. And finally, I think the most underappreciated piece of what Arvind has brought to the company is opening up IBM to an ecosystem partnership coopetition strategy. Driving our hybrid-cloud platform, we have now partnered with many ISVs, GSIs, hyperscalers, and we've generated probably 4 to 5 different partnerships that are north of $1 billion from a standstill. So great transformation, strategic pivots overall, all of that center around driving the investment thesis of IBM, today's IBM, to your point, higher revenue growth company, higher operating margin company, stronger free cash flow yield, lower capital intensity and higher return on invested capital. So it's a good place to start around. Thank you.

So let's just talk about a topic at the conference this year. Just kind of the strength of enterprise spending, the different crosscurrents that we're all seeing in the market, how are you thinking about the sustainability of enterprise technology demand? What are you hearing from your customers? And kind of how are you positioned, again, you kind of just spoke about this, but to capitalize during this environment?

Yes. I would tell you as CFO, this industry and market we're operating in can be defined by one word, change, right? I think today's market environment is forcing every company to rethink traditional forms of competitive advantage to emerge stronger. If you think about it, every company is facing challenges from a macroeconomic perspective: one being demographic shifts; two labor shortages; continued supply chain dislocations; high inflationary costs, we just saw Chairman Powell this morning talk about more longer extended and higher rate environment potentially; and then finally, increasing sustainability standards. All of those are exogenous impacts that are impacting every industry. But we really believe that technology is a source of competitive advantage. It's why technology continuously outstrips GDP and demand by 3 to 4 points overall. And I think it aligns very well to our 4 convictions around IBM: one, technology is the only deflationary force; two, and I know we'll talk about this later, it's a buzz here today, and that is AI is the vehicle of productivity, productivity being front and center for every enterprise today; three, now you go back to why we bought Red Hat, we believe digital reinventions repair a heterogeneous, hybrid environment; and four, open source is really now the source of innovation. Those 4 convictions, I think, lead us to believe that enterprise demand overall in '23 is still going to outstrip GDP overall, because of that deflationary force and the ability to generate productivity. But I would tell you internally, like every CFO, we are running multiple scenarios on how to manage in this uncertain environment, no company is immune. But you've reported on us many times that our macro business profile actually positions us relatively better than many others, given our geographic diversity, industry diversity, our client segmentation being enterprise-focused and our recurring revenue to point to your point. So very, very uncertain environment, but we believe we've got the right portfolio and right alignment to compete.

Cool. So I have the CFO, time to get into some numbers, right? A little over a year ago, Arvind set out the plan to grow revenue mid-single digits in constant currency. 2022, you exceeded this, you grew about 8% year-over-year in constant currency. This year, you're guiding to the lower end of that mid-single-digit model. So maybe just walk us through the different segment-level drivers of this guide in 2023. And as we sit here today, early March, what gives you confidence in providing that guide?

Yes, 2022 was the first year of what we define as today's IBM post separation at Kyndryl. And we're pleased with that performance in 2022 that instantiates the value of that hybrid-cloud platform thesis of a compelling value prop, software, consulting, hardware overall. Did $60.5 billion of revenue, up 8%, to your point, overall. We saw good pervasive growth across our hybrid cloud and AI offerings. We saw good growth in our growth factors, Software and Consulting, growing 6% and 15%, respectively. And we have a high-value recurring revenue stream that we just talked about that accelerated throughout the year. Now all of that gives us confidence in that mid-single-digit growth guidance that we just gave in January this year. But if you look at the underlying drivers of that mid-single digit, very simplistically, one, across our 3 major segments, Software. Software growing mid-single digit will generate 3 points of IBM revenue contribution overall. Consulting, we guided to grow high single digit, that will generate another 3 points of growth overall. And finally, Infrastructure. Infrastructure revenue growth always follows, Erik, as you know, innovation cycles. And we're going to be on the back end of our innovation cycle in '23. So it will be about a 1 point headwind to IBM overall. So that mid-single digit 3 points from Software, 3 points from Consulting and 1 point headwind from Infrastructure.

Right. Okay. Perfect. So let's get into the different segments. So let's start with Software, the largest segment. Again, maybe help us, give us a sense of the revenue growth drivers for this portfolio this year. How do we think about, for example, some of the pricing increases that you've put through? How is -- is that a tailwind for 2023? How did -- or how will ELAs impact 2023? Help us kind of take 1 level deeper on the Software side.

Great place to start with regards to Software in our portfolio. Software is the foundation of our hybrid-cloud, platform-centric strategy, right? $25 billion of revenue, over 40% of IBM's revenue, the largest segment in IBM and represents 2/3 of our EBITDA and about 3/4 of our free cash flow generation in the company. We've built up a nice book of business overall around Red Hat, around automation, around data AI, around security. That has about a $13.3 billion ARR business, growing nicely and high single digit, and with an accelerating NRR well north of 100% overall. But when you take a look at Software, let me break it out and take a step back and put it in perspective. That $25 billion of revenue, about 80% of that business is high-value recurring revenue, about 20% of that business is transactional. By the way, we offer clients many different monetization models across our software, both perpetual licenses, subscription models, SaaS-based models overall. But if you look at 2022 and that we grew above our model above 6%, we saw a nice acceleration in that high-value recurring revenue, and we also had the tailwind of entering our ELA cycle. And that 6-plus points of growth, about 4 points came out of our high-value recurring revenue and about 2 points came out of the transactional business as we capitalized on that ELA cycle. Now in 2023, we guided to Software to be at mid-single digit. But the revenue mix contribution is going to shift in '23. That high-value recurring revenue, given the nice acceleration we saw in 2022, it gives us confidence that we're going to get 5 to 6 points of revenue growth in our Software book of business around that high-value recurring revenue. Underneath that, about half of that comes from Red Hat, growing nicely, mid-teens for the full year. And about half of that comes out of our IBM high-value recurring revenue coming off of a very successful last couple mainframe cycles and around high-value recurring revenue and pricing leverage that you asked about in your question. That will then be offset or mitigated somewhat by ramping off the ELA cycle, which will be about a 1-point headwind to us overall.

Okay. Perfect. So we get a lot of questions on your Software portfolio, rightfully so. Again, we've talked about it being the biggest segment. The questions mostly center on Red Hat and TPP transaction processing. So how do we think about Red Hat's competitive positioning today? How do we think about the sustainability of double-digit growth for Red Hat? And then separate to that, you guys made -- you made some comments on the earnings call about being more bullish around transaction processing. Why should we be more bullish about transaction processing going forward?

Yes. Let me start with the second part of your question first because I think this is a very important inflection point for IBM. As you know, our transaction processing software, by the way, runs our mainframe -- runs on our mainframe architecture that supports over 90% of the transactions in many different industries, financial services, retail, airline industry, et cetera. That is a very important value vector for IBM, about 30% of our Software book of business. It carries a very high profit and cash generation that provides financial flexibility for us to reinvent -- reinvest. And also, one of the probably important findings out of the Red Hat acquisition is it provides a tremendous moat for us to leverage an incumbency position to then capitalize on a flywheel effect of getting our software, our hybrid-cloud platform, our automation into those clients. Historically, Erik, as you know, that typically follow the mainframe cycle pattern that was down about mid-single digit to high single digit historically. Well, we saw an inflection shift in '22. And it was really we saw acceleration throughout '22 about flat year-over-year for the full year, ex Kyndryl sales, but we saw that change really being driven by what's been happening with the last couple mainframe cycles. And we've seen from the z14 mainframe cycle, z15 and now most recently z16, is that we've been generating significant accretive value versus prior cycles. What does that mean? That means we have much more installed MIPS capacity out in the marketplace compared to what history would be. That is an opportunity set with a high contribution from renewal rates that's actually been generating much more opportunity in our transaction processing system that has now given us the confidence to say that inflection point, that we are going to grow low single digits in our transaction processing. To wrap that up, why is that important? One, it carries very high marginal profit dollars, about $0.80 to $0.90 on every dollar of growth; two, that inflection shift from being down in our portfolio, mid- to high single digit to now be an accretive and growing low single, that has about a 100 basis point impact to our top line and about 200 basis point impact to our bottom line; and then three, as a CFO, we love that high-value multiple that comes out of that piece. So that's transaction process, very important inflection shift. On Red Hat. We couldn't be more pleased with the Red Hat acquisition, 3-plus years in, growing mid-teens to high teens consistently, really instantiating the strategic thrust behind the acquisition. And that was an acquisition at the time back in 2019 that we had a distinctive point of view in the marketplace about, one, hybrid cloud; and, two, AI. We believed that the world was going to move to multi-cloud, which I think now has proven right. And we also believed that the world was going to move to multi-environment. Workloads were not 100% going to move to public cloud. There was going to be an environment and architecture for on-prem, public, private and now reality, all the way to the edge. And three, there was going to be a tighter linkage. Red Hat is the foundation of the hybrid-cloud, platform-centric model, and it carries a great economic multiplier effect. Every dollar of Red Hat we land, we get $3 to $5 of Software, $6 to $8 of Consulting, which we've been able to generate overall. And as you know, Red Hat is the world's leader of enterprise open source IT solutions, growth vector in IBM around, one, our hybrid-cloud platform being Red Hat OpenShift, which -- by the way, in the fourth quarter, just eclipsed $1 billion ARR from pre-acquisition, it was less than $50 million overall. So we saw explosive growth in that hybrid thesis. And second, Ansible, which is our automation platform, consistently growing in the high 20s and taking share. So we feel pretty good about Red Hat. '23, we guided to mid-teens growth. I would tell you, we're probably going to be a little bit short of that in the first half and see accelerating growth throughout the year because we're into a renewal year in '23 and those renewals will start coming in midyear in second half that would generate that accelerating growth.

Okay. Super detailed. That's great. Let's move to Consulting. We've heard from some of your peers, more cautious commentary. You had a very strong 4Q. You guided to high single-digit revenue growth for Consulting in 2023. What are you hearing from your customers? What kind of visibility do you have into this year taking into account things like contract length? How much pricing -- how much does pricing help in 2023? Help us distill that high single-digit growth guide that you gave.

I'll tell you, Erik, you'll remember when you came out with your thesis on IBM, I mean, we saw a very different client buying behavior environment, second half of '21, and we invested significantly around what is known now as digital transformation journeys to cloud. We've been able to capitalize, delivered 15% revenue growth last year. But we have repositioned our Consulting business around leveraging a hybrid-cloud, platform-centric strategy, $9 billion book of business, up mid-20% and. We've been opening up our Consulting business to new partnerships, that being strategic partnerships with hyperscalers. That now represents 40% of our Consulting book of business overall, growing mid-20s. And we've been generating significant acceleration in our Red Hat practice. What, 3 years in since we acquired Red Hat, we signed $7.4 billion worth their book of business in Red Hat overall. And finally, we've been scaling and investing in acquisitions to build out new capabilities around cloud, around AI, around security and around now sustainability overall. So I would say when you look at '23, we guided to high single digit, which is our model. Our focus is around, one, digital transformation, but I would tell you it's a little bit different. 18 months to 2 years ago, when you talked about digital transformation, it was all a public cloud story, and it was all around application migrations, lift and shift. Now the tough work of application modernization is really at the sweet spot of where we drive our value contribution. So we still see now a shift more from just a migration to how we rationalize or how clients are rationalizing their application architecture, and it's more of a modernization, by the way, higher value for us. And second, to the core of our earlier discussion, it's all around productivity, quick payback, data, AI, automation, business process reengineering, and that's how we're repositioning the book of business overall.

Okay. All right. Perfect. So you touched on this in your response, but you've made 30-ish, let's call them, tuck-in acquisitions. Since 2020, over half of them have been in Software, again, you mentioned automation, security. What is your willingness -- and you've talked about this, but what's IBM's willingness to do something bigger? Is that still the case? What are some of the characteristics that you look for when you think about something that could be not tuck-in, but something that could be something more transformational?

Yes. Well, I would tell you, I'd be foolish to sit up here and say size was a determinant in trying to figure out your capital allocation strategy. But with that said, I think it's a very fair question overall. First, this company generates significant financial flexibility through our capital structure overall. It's important because we have to compete, both investing organically and inorganically and also continue with a very attractive return to shareholder program with our dividend policy. But when you think about our capital allocation inorganically around M&A, we operate a very disciplined capital allocation strategy, really centered around how do we leverage extended value to our leadership in hybrid cloud and AI to acquire capabilities, assets, skills, IP to drive a very differentiated point of view of that multiplier effect that I talked about earlier. But when you think about criteria, criteria is always centered around strategic fit, hybrid cloud and AI, synergistic value to that multiplier effect. So as we invest $1 in an inorganic acquisition, it has to pull through Consulting, Software Infrastructure, so we get that multiplier effect. And third, sound financials overall. So I would tell you, just given what we've seen, we're operating in a very different environment over the last 12 months to 18 months. Many more companies are becoming much more attractive to us. They're popping up on our market scan. And as I've talked about in many of the breakouts earlier before we came up on stage, I think there's really a barbell effect happening right now. On one aspect, you've got many very attractive private companies, technology-based asset IP that are becoming very attractive, and we'll see funding rounds and what's going to happen there. And there's a lot of reach outs coming to us around there. It could be a very attractive play for IBM. On the other hand, you've got a set of public companies that are going through a rationalization of valuations overall as they move forward and they're becoming very attractive to us. So I would tell you, are we busy? Very busy, but I'll leave it at that.

Perfect. No, that's great. So you mentioned this at the top of the session. I want to give you the stage here. Obviously, AI is a big theme of this conference. You have a long history of being on the forefront of AI. We can go back decades. Where are you now when it comes to AI? Where do you see the opportunity from the perspective of IBM?

Yes. Well, as we talked about walking up here on stage, we're obviously very excited about the explosion and technological shift of AI now being front and center. I was talking with a group of investors earlier, it's interesting, with our Consulting business, we do business value studies each year like many consulting-based businesses. And I would tell you, you go back as little as 18 months, 2 years ago, and the studies showed that about 95% of business enterprises were experimenting with AI. Less than 10% were actually scaling AI within their enterprise. We think right now, we are at an inflection point with what's happening with both traditional and generative AI applications that is going to provide the next, you pick it, 1, 3, 5, 10 years' worth of explosive growth. Now to your question, IBM has it been investing in AI for over a decade, right? And we've taken an approach that really, at the time, many people used to always ask me at every conference, how big is Watson? Well, reality is we don't run Watson as a thing. We've always taken the approach to embed AI across everything we do. All the software we sell, we embedded it into security, into automation, into our data, into Red Hat now. We embed it into our Consulting engagements, and we even embedded into our Infrastructure overall in z16 having AI-embedded chip on the Telum chip overall. But if you look at it, we see 4 primary use cases right now exploding. One is AI to interact and converse, read that customer care. That's what we're doing, partnering with McDonald's right now, which is scaling nicely around the world in their drive-throughs, using AI to attract labor, which is the second use case around business process reengineering. To address what we talked about earlier, every company challenging with demographics and labor shortages. The third, very interesting, is AI for IT automation. Read that as AI for code. We've embedded -- partnering with research in Red Hat on our automation platform of Ansible, we've embedded AI onto our platform that's now doing tremendous things around code overall. And finally, we've had a history over the last 4 or 5 years, embedding AI to safeguard enterprises with cybersecurity. So we see those as some of the use cases overall.

I remember the IBM -- IBM Think doing the McDonald's drive-through. You tried to trick them and say, I want to order this. And it would tell you, no, you're not allowed to order this, that doesn't exist. So I think it's super fascinating. So we just have a couple of minutes here. I kind of want to give you this stage. And we've talked about a lot kind of revenue down through margins, through capital allocation, through key business functions. What is -- in your perspective, what is most underappreciated about the IBM story today? Kind of for this audience, what do you want to leave them with as we wrap up here?

Yes. I think it's a great place to end because I want to revert back to where we started, right, which is we're a fundamentally different company today than what we were 3, 5 years ago. Arvind has come in, we've done a lot of strategic pivots. I talked about portfolio, operating model, business model, our financial model, our culture, which has been huge, our employee sentiment, our client sentiment. All that has led to us, and it's a beauty being a CFO here now, to be a very focused company around hybrid cloud and AI. Knowing where we can win, how we can win, how we deploy capital and investment to go capture that. And that led us to this hybrid-cloud, platform-centric model with that very compelling economic value proposition of the $3 to $5 of Software, $6 to $8 of services. But also opening up on what we learned, reverse integration from the Red Hat acquisition. The power of open source right now, being that new innovation powerhouse overall. And then finally, ecosystems. We're a very different company now and building that up and scaling. And I think that all leads us to where we started, which is the investment thesis around IBM today is a higher revenue growth profile company, higher operating margin profile company, strong free cash flow yield and a higher return on invested capital. And we're focused on delivering that each and every day for our clients, our employees and our investors overall.

That's a perfect place to stop. Jim, thank you very much for spending your time. Thank you guys all for attending.

Thank you, Erik. Appreciate it.

Thank you.

Thank you.