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

All right. So it's 3:20, so let's get started here. Again, welcome, everyone, to day 1 of the TMT Conference. My name is Erik Woodring. I lead the U.S. technology hardware research based out in New York. Before we get started, I need to mention that important disclosures can be found at Morgan Stanley research disclosure website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. I'm delighted to be joined by Jim Kavanaugh, CFO of IBM. Jim has been around IBM for almost 3 decades, held a number of different roles, but obviously, importance here as CFO. So Jim, obviously, thank you for another year here at the TMT Conference.

Absolutely. Thank you for having us, Erik.

So I think maybe to start, it's important to look back, and that is you just capped 3 years since divesting Kyndryl, wrapping your first midterm model. A lot has changed for IBM in the last 3 years. So maybe for all of us, can you just walk through, one, the most important changes you, Arvind and the team have kind of implemented over this 3-year period, where you think you've outperformed and then maybe some areas where you felt short that you need to, I don't know, refocus or double down, and we'll go from there.

Great. Great place to start, and good afternoon. Really appreciate you having us here today. Today's IBM, as you position it, we are a fundamentally radically different company than what we were just a handful of years ago, really focused on the 2 most transformative technological shifts we believe that are occurring in the marketplace today, one being hybrid cloud and the second being Gen AI. And Arvind, since he's come on board, has really led a bold strategic pivot of our company. And that is around aligning of portfolio around a platform-centric model, playing to our hardware, software and services with a very attractive economic multiplier overall. And that's been a great strategic pivot that's played extremely well over the last 5 years. But to your point, aligning that strategy, we had to do a lot of fundamental work around the business and operating model within our company. And let me just highlight a few of them to the heart of your question. Number one, it started with portfolio optimization, shifting our portfolio to higher-end growth markets, shifting our portfolio to a software-led platform-centric business. We've taken software from mid-20s pre-Red Hat acquisition to now exiting around 45% of our composition. So a fundamentally different company. Second, we reinvigorated investments in our organic innovation, and that has ignited organic revenue growth into our company. We've also been building out capabilities around opening up IBM to strategic partnerships. We've been investing in M&A around a set of growth plays that have been bringing significant synergies. And we've been driving a very reinvigorated culture change across IBM around speed, around risk tolerance and around talent acquisition and productivity mindset. This has played significant value and return to IBM over the last 3 years, to your question. If you take a look at it, let me put it in perspective. Prior to our midterm model, we had a business profile that was dilutive on revenue growth, incrementally dilutive on profit margin annually and a stagnant free cash flow. Over the last 3 years, we have strategically repositioned this business that now over the 3 years, we have exceeded or met all of our midterm financial measures around revenue growth, profitability and free cash flow. We are now a durable, sustainable grower. We've improved our operating pretax margins by 800 basis points over 3 years, and we basically doubled our free cash flow generation exiting 2024 with the highest free cash flow margin in the history of IBM. So I think this financial performance, the strategically repositioning the company around a focused platform-centric strategy has unlocked significant shareholder value as we have consistently outperformed both the S&P 500 and the S&P Tech over the last 3 years. And it plays to our investment thesis: higher revenue growth company, higher operating margin company, strong free cash flow and an attractive return to shareholder program.

Perfect. So it's a perfect segue into what you announced a few weeks ago at your Analyst Day. Again, starting big picture, we'll get into some of the segments. But you just talked about investments in organic growth, strategic partnerships, cultural change. What are the priorities now that you look forward after those 3 years? So you've reinvigorated the business. Now what is your goal? What is Arvind's goal? What are you working on to drive the next leg of growth over the next 3 years?

Yes. It's a great next step coming off of a very successful last 3 years of a really repositioned today's IBM. If you take a look at it a month ago, we were up on stage with our investors. We did a Capital Markets/Investor Day, which we talked about the next leg of our journey. And if you look at it, we laid out a long-term strategic value creation framework, our IBM financial model. And what that model is predicated on is taking the next step in a revenue growth acceleration, really driven by driving a more durable, more sustainable, higher inflected revenue growth profile in the IBM company to 5% plus annualized growth, led by software growing double digits overall. We said that, that accelerated revenue growth profile was going to be driven by a shift of portfolio mix to higher growth end markets, capitalizing on a very attractive economic multiplier with an integrated value proposition around software, consulting and infrastructure and about investing aggressively in bringing new innovation to market to ignite our organic revenue growth. If you take a look at that revenue growth profile, we said then that scale, that portfolio mix around higher growth software, higher margin, coupled with, I think, credible productivity that we've been able to execute, we said we would generate a higher profitability company in the IBM business going forward. And we committed to expect to grow operating pretax margins by roughly 1 point per year over the strategic horizon and to grow free cash flow 2 to 3 points faster than revenue growing high single digits overall. That free cash flow engine is going to create significant financial flexibility to invest back into our business and extending our strategic platforms and also providing a very attractive return to shareholder program with some optionality in the future while maintaining a very strong investment-grade balance sheet. But the heart of your question about priorities, we laid out at Investor Day that the integrated strategy around IBM drives that shareholder value creation framework. And we laid something out called the flywheel of growth. Those are the priorities that we're setting our company on. And let me take just a minute or 2 talking about that flywheel. First, as always, it starts with clients. Our incumbency position is hard-earned to generate trust. 80% of our client base today buys across the integrated solution portfolio of software, consulting and infrastructure today, great economic flywheel multiplier overall. Second, very focused strategy, Erik, we talked about upfront. We are the de facto hybrid cloud platform, and we have an early leadership position in Gen AI. 93% of our clients in the Fortune 500 utilize our hybrid cloud solutions today. And we exited 2024 with over a $5 billion book of business inception to date on Gen AI, so an early strategic leadership. Third, IBM has always been committed to being a high-value enterprise innovation provider. And we execute that through a disciplined capital allocation process. We invested $20 billion of R&D on an accelerated revenue growth profile overall to generate that software, that new innovation of infrastructure, emerging technologies like quantum computing, Gen AI integrated solution portfolio. So that investment and innovation critical component. Fourth, we are the only IT company that brings a differentiated value proposition around a generative AI technology stack and a consulting business at scale to drive scale and adoption overall. And then finally, around any platform-centric company, we've invested building out numerous strategic partnerships. And over the last 3 years, we've created 3-plus strategic partnerships well north of $1 billion, and we believe we've got a lot of headroom to go. So those are our priorities around that financial model.

Okay. You touched on the $5 billion book of business, cumulative book of business you've gotten in Gen AI so far, split between software and consulting. Can you maybe just go into a little more detail for all of us, one, the strategy, the differentiation that you're talking about? And then two, really where within that ecosystem you are seeing traction with clients?

Excellent. Gen AI. We have a very differentiated integrated open innovation Gen AI portfolio that's been resonating well, albeit very early in the cycle right now, Erik. We exited 2024 with about over a $5 billion book of business. About 25% of that is software, north of $1 billion book of business, and about 75% of that is consulting, north of $4 billion book of business overall. And we spent time at Investor Day talking about our enterprise client pain points around what's the inhibitors around scale and adoption. And the reason I start there is because it infuses the strategy around how we're developing our Gen AI technology strategy overall. But we talked about 3 areas of pain points: One, cost, higher technical and operational costs as enterprise clients are looking for a more efficient way of driving Gen AI solutions in their business; two, complexity, and it's beyond models. It's now into data and applications and how they're running in a hybrid cloud environment with a priority around security; and three, expertise. How do they infuse Gen AI technology, application and workloads into their business work streams, HR, finance, procurement, supply chain, how you run a company. And that requires deep domain expertise and knowledge and technical expertise overall. That is infused intelligence in how we've created our strategy. And we said our strategy was focused on a set of competitive advantage, 4 areas. Number one, we are an open innovation Gen AI technology provider. Why? Because we believe in the power of a developer community that drives rapid innovation value. Two, cost efficiency. We have always believed in smaller fit-for-purpose models that today, our Granite LLM models are 90% more cost efficient today with better performance running on the most economic AI platform overall. Three, hybrid. To the heart of being a hybrid cloud and AI company, IBM is the only company that can build, deploy and manage software in a hybrid cloud and AI world. And then finally, 4 domain expertise, as I talked about. We are the only company that brings that Gen AI tech stack along with a consulting business at scale. And we've developed a portfolio of full stack offerings, everything from the AI platform, which is built on an open innovation, RHEL AI, OpenAI -- a Red Hat Open AI strategy to our AI data services, to our AI middleware, to our AI assistants and solutions, to embedded strategic partners like Salesforce, Red Hat -- or excuse me, SAP, Adobe, EY to name many. And we have a consulting business at scale. So the reason I talk about that full stack is we have many ways to monetize the value of that. We monetize value across platforms, across middleware, across agents and solutions and across consulting. And we talked about at Investor Day early in the cycle for every dollar we land on our watsonx platform of Gen AI, we are getting a multiplier of $5 to $6 across our software and our consulting business overall. And our model going forward over the next medium and long term, we expect out of that 5-plus percent growth, we'll get a few points out of Gen AI. So we feel pretty good about it.

Okay. Perfect. Let's shift to your segments. So let's start with software. Obviously, biggest, most important, highest margin, increasingly kind of become the ballast of the company. You are guiding to, let's call it, 10% annual constant currency software growth for the next 3 years. That's an acceleration from your last model. Can you help us all kind of understand the building blocks of how you get to that low double-digit growth between M&A, core, Red Hat, et cetera, and where you believe your competitive advantages really lie to get to that 10% growth?

Absolutely. IBM at its core, software-led integrated platform-centric company. Software today, as I said, we exited 2024 approaching 45% of IBM. You dial that back pre-Red Hat, we were in the mid-20s. We now have a target with an expectation to get to north of 50% overall. It also has a high-value recurring revenue stream. 80% of our software is high-value recurring revenue overall. It drives a high marginal profit dollar, and it's a significant contributor to how we have now exceeded the Rule of 40 across our software portfolio and that delivers about 2/3 of our profit and cash overall of IBM. And it capitalizes on a very attractive economic multiplier around those platforms we talked about earlier, right now, generating around $3 to $5 of software for every dollar of platform overall. But we operate a very synergistic software portfolio that provides end-to-end capability around hybrid cloud and AI, around 4 areas: one, hybrid cloud. That is our Red Hat portfolio, that's Linux, that's containers, that's virtualization, that's Open AI innovation, that's automation. The target there is mid-teens growth overall. By the way, pretty consistent with the 5-year CGR of Red Hat. Second is our automation portfolio. We have an industry-leading automation portfolio around IT ops, application ops, around FinOps built around Instana, Turbonomic, Apptio, webMethods. And by the way, just last week, we closed HashiCorp overall, which we're extremely excited about. That model is to grow low double digits over time. Third is our data. This is around our next-generation open warehouse, around our Lakehouse, our data fabric and all of our AI models in middleware and our agents and solutions. That model is to grow mid-single digit to high single digit overall. And finally, the fourth category, transaction processing. Very important. It drives the mission-critical workloads around our systems infrastructure, and that's targeted to grow mid-single digits. If you bring all that together, the strength of our portfolio of software, the investments in innovation, our strategic M&A growth engines and synergies, we believe with conviction that we can consistently grow that 10% software over the strategic horizon overall. And if you think about it differently, how do we get that 10 points of growth? Number one, Red Hat growing mid-teens, that should generate 3 to 4 points of that 10 point of growth. Two, that 80% high-value recurring revenue base with an incredible incumbency moat and strong renewals, that generates another 2 points of that growth. Three, our new innovation in Gen AI, we're going to get 2 to 3 points out of our platforms, middleware, agents and assistants. And then finally, four, our M&A, very disciplined strategy, we'll get another 2 to 3 points. So that's how we build up that growth overall. So I think we feel pretty good. You bring it all together. We showed at Investor Day our flywheel of growth for software. What differentiates us? One, I talked about, we're the only company that can build, deploy, manage hybrid cloud and AI for software overall. Two, we have an incredible incumbency moat. 93% of our clients use our hybrid cloud solutions and 80% of our clients buy across all 4 of those categories. High flywheel, high NRR overall, and we get that capitalized economic multiplier on our platform. So we feel pretty good about that.

Great. Very compelling. Let's turn to consulting. The outlook for the consulting market is more mixed. You're guiding to low single digits in 2025. You do expect to grow in excess of the market, but there is still some uncertainty about how the services market might grow over the next 3 years. So maybe, one, why is there more uncertainty there? And maybe just digging into maybe cyclical versus secular factors. And what are you doing to make sure that you're growing in excess of that market?

Yes. Great area to talk about right now from a consulting. First of all, consulting, integral part of our hybrid cloud AI platform-centric model, right? One, capitalizes on an attractive economic multiplier. Every dollar we land on a platform, we get $6 to $8 of an economic multiplier on services overall. That's hybrid cloud, that's AI, that's our mainframe platform overall. Two, it provides a tip of the spear that drives scale and adoption. So a very essential strategic component of having consulting within our model overall. And three, it pulls our IBM technology and the synergies overall. Now to the heart of your question, from a market perspective overall, we've been obviously operating in a very dynamic macroeconomic environment. And we've been talking over the last 3 to 4 quarters about clients are dynamically reprioritizing their spending focused on cost and productivity. And why are they doing that, Erik? They're doing that because they're trying to create investment flexibility to reposition their businesses for sustainable competitive advantage around how do they exploit digital transformation, hybrid cloud services, generative AI to reposition their business models. And that doesn't surprise us overall. The IT services market, when you look at human capital services over a long period of time, it always experiences cyclicality with new technological innovations over time. But over the long period of time, the IT services market has been growing, what, 4% to 7% over a long period of time. And most importantly, what we're excited about is the differentiation and growth on high-growth vectors, that being hybrid cloud services, AI services that we see growing double digits over the next 3 to 5 years. So to your question, what differentiates us? What's our growth engine around IBM Consulting and our competitive advantage? Well, one, we've done a lot of hard work, as Arvind has come on over the last 4 or 5 years, to reposition our operating model and our portfolio composition around consulting. Today, 85% of our consulting book of business centers around hybrid cloud, AI, application modernization and around automation overall. High growth vectors, very little composition around discretionary-based businesses overall, which positions us well moving forward. Two, we talked a lot about at Investor Day, how we have been aggressively moving forward to leverage human capital and digital labor together, bringing a first-of-a-kind AI-based platform with our IBM Consulting Advantage to market with our clients. We're getting great receptivity. It enables us to differentiate our value proposition, but also leverage technology arbitrage. So we talk about how we're going to convert services as software now through an AI standardized platform, which is getting great receptivity in the marketplace. So that's another key competitive advantage. Third, we're able to drive strategic partnerships. A few years ago, we sat on stage here talking about how IBM and Arvind, in particular, has opened up IBM being a platform-centric company. At that point in time, we had one strategic partner that had a book of business north of $1 billion. Over the last 2 to 3 years, we now have 3: SAP, Microsoft, AWS, and we're well on our way to building out more capability. And then four, I would tell you is we've been opening up with a very disciplined strategy around our M&A growth and synergistic play. And that is around IBM platforms, around hyperscalers, around key ISPs. So overall, we feel pretty good. And then I'll wrap it up on Gen AI. A lot of discussion in this conference around Gen AI, around disruption or disruptor around consulting. We feel pretty good in the long-term secular growth opportunity around Gen AI for consulting. And what I've been talking about is when you look at what did cloud do, cloud enabled digital transformation a decade ago with consulting. People were worried about the disruption. It ended up being a bigger TAM and a higher growth vector for consulting. We think Gen AI is now going to ignite digital transformation 2.0. We got our early leadership position as a strategic provider of choice, north of $4 billion book of business, and we're looking forward to capitalize on that as we move forward. So we feel pretty good about it.

Okay. Okay. Perfect. And then maybe if we end the kind of segment conversation on infrastructure. I thought it was interesting at your Analyst Day, Ric Lewis called infrastructure a secular growth business, which is a change in tone from IBM. You also highlighted 1% to 3% growth for your model, which is also an uptick. My question is really -- they both end up going back to mainframe. I realize you do more than mainframe, but both of the questions are on mainframe, which is, one, how do we think about the strength of the z17 cycle after such a strong z16 cycle? And then two, a concern we hear is about refactoring workloads off of the mainframe. Is this behavior you're seeing? Where would you push back on that thesis?

Yes. First of all, thank you for asking an infrastructure question. Really appreciate it. And Ric and team have done a phenomenal job of repositioning the infrastructure portfolio. Putting it in perspective, we've been moving this business from what used to be historically a cyclical base business to now, as you stated, a secular grower. Over the last 3 years of our last midterm model, we have shifted to a secular growth business, growing 2% over time from being down mid-single digit for a long period of time. We've also been able to expand our operating pretax margins by 300 basis points, and we've been growing our profit dollars 20% on a compounded basis. And when you look at that, to the heart of your question, it is a statement of the criticality of what's been happening with our mainframe business overall. But let me put it in perspective. Mainframe is the industry leader in running mission-critical transaction processing across many industries. 45 of the top 50 banks, 10 of the top 10 insurers, 9 of the top retailers, 4 of the 5 top airlines, we run 70% to 80% of all mission-critical transaction processing across every industry. Why is that? Because I think we deliver a differentiated value proposition that's playing the client needs today. What are all the critical factors facing clients today? One, a lot of capacity requirements coming out of COVID around digital transformation; two, cybersecurity; three, resiliency; four, AI workloads; five, energy efficiency. I go on and on and on, changing regulatory environment, sovereignty needs. So the mainframe is playing to that market overall. z16, one of our most successful programs overall, 11 quarters in, by the way, grown 8 of those 11 quarters, talking about a secular grower now, not cyclical. We're generating about 120-plus percent of the prior program. And here's some interesting stats. One, our installed MIPS capacity over the last few mainframe cycles are up 3x. And that's not tens of thousands of installed MIPS out there. That's millions of MIPS that are out there. We are up 3x. Two, 70% of our clients are growing workloads on mainframe overall. And that is a very important point because we generate stack economics of our software portfolio, our storage attach, our maintenance, our financing overall. So we've had a very good cycle on mainframe, reinvigorating through investing in innovation because we bring to it now cloud-native apps. By the way, our Telum AI chip, we invested in AI on the mainframe years ago before ChatGPT. Cybersecurity, quantum-safe encryption, all of this differentiated value proposition is driving that. And by the way, of those 70% of clients growing new workloads, 30% of that is total new workload growth overall. We were never able to say that in the past. So now you fast forward, we're coming out with our z17 technology here at the end of the first half. We feel very excited about the next generation. Why we're bringing the Telum II AI chip to market on that, along with the sphere inferencing that is going to generate AI workloads at scale overall. And second, we have made a strategic decision, Erik, and you'll remember this, we've extended the longevity of our mainframe cycles now to 3 years. That extension drives a very sweet spot from an economic lease penetration perspective with our clients. So we feel pretty good about that overall. Finally, around Gen AI, to your point, we've been taking an offensive approach on this, I will tell you. One, we invested in that Telum chip years ago. And we're seeing -- right now, we've got over 250 use cases with clients already in production on using Gen AI on mainframe for fraud, AML, compliance, risk management, security, on and on and on. Second, we've actually, with an integrated portfolio of consulting, with a huge application modernization practice, we are going out aggressively to our clients to help them with one Gen AI technology to drive watsonx Code Assistant for Z about enabling transitioning code modernization of COBOL to Java and also extending the investments for our clients on their platform in this enduring portfolio overall. So I feel pretty good, and we're excited about next generation coming out in a very soon period of time.

Very cool. Given the time, I want to make sure we talk about something that came to light in your Analyst Day that maybe wasn't as well understood. And that is a bit of the juxtaposition of SG&A spend versus R&D. So you alluded to 100 basis points of PTI margin expansion each year. Underlying that, you're really leaning into R&D spending, but actually, the model kind of calls for SG&A efficiency and kind of being able to cut back there despite growing your top line. So -- and M&A. Can you just walk us through, one, where you're investing, what your R&D priorities are? And then two, just provide us some examples of how you are able to drive those efficiencies in SG&A over multiple years as you're growing, as you're acquiring companies?

Yes. Great question overall. But you know what, let me start with the second part of that question first because I think it will provide context in the first part as to where we're investing overall. When we talked about upfront, Arvind has brought so much to our company to reinvigorate not only the portfolio, the innovation, the growth mindset, he has brought a cultural transformation back around a productivity mindset in the company. How do you generate speed, velocity, efficiency, value? Oh, by the way, we spent time talking about enabling IBM as what we call client zero. How do we take our technology and deploy it inside to reinvent how we run our company. All of that is contributing significant productivity value overall. But if you look at it, operating leverage has always been an instrumental element of our business operating and financial model of IBM overall. Within our management system, we generate operating leverage, which we talked about, the model is 1 point per year for the sustainable future. If you look at it, we generated 3 ways: One, portfolio mix, [indiscernible] software, high-growth, high-margin content, high recurring revenue, strong scale efficiency on marginal profit; two, productivity, getting ROI out of our innovation investment, our go-to-market investment, our delivery of services, our ecosystem; and three, around scale efficiencies. That's driving our G&A to competitive benchmarks overall. We believe we started out, the last midterm model, we said we had a pretty audacious target of generating $2 billion of productivity exit run rate by the end of '24. We just finished '24 over our last midterm model, generating $3.5 billion of productivity. And you saw that play out in our margin explosion of 2024. Our margins were up, what, 130 basis points in gross, 120 basis points in pretax margins overall. But we believe we got still a lot of headroom to go with multiple levers. How are we going to do that? One, leverage technology and digitization to drive scale. Two, embed AI into our workflows. We're only about 60% penetrated in AI overall. Three, streamline our supply chain, drive procurement value creation, drive structure, talent utilization. We got many different levers. And we talked about it's important in our financial model because why? 1/3 of that is for profit enablement, 2/3 of that is for a flywheel to reinvest back in our business, to the first part of your question. Where is that investment going to go? It's going to go back into R&D innovation, around hybrid cloud with our software portfolio, around AI with our open innovation portfolio, around critical infrastructure, so we bring out that next generation of infrastructure innovation. And four, which we spent time on at Investor Day, emerging technology, that being around quantum computing that we have an early leadership position overall. So those are both important from that flywheel effect overall.

Jim, we've hit limit. So I just want to thank you. Appreciate it. We'll see you next year.

Appreciate it. Thank you so much.

Thank you, Jim.

Thank you.