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

All right. Good morning, everyone. My name is Brian Essex. I'm JPMorgan's software analyst. And with me today, I have Rob Thomas, Senior Vice President of Software and Chief Commercial Officer from IBM. So Rob, thank you so much for joining us.

Great to be with you, Brian.

Maybe a great place to start. Maybe we can start a little bit with your background. I think you've been with IBM for quite a while, but would love to get a quick take on your experience with IBM and maybe then step into the broader enterprise technology landscape and what kind of shifts you've seen over the recent years, how you see it evolving in the future based on like the tenure that you've had at the company?

I've worked in every part of IBM. I started in consulting, did that for a number of years and then microelectronics -- spent a couple of years living in Japan, leading microelectronics across Asia and then joined software, I think it was around 2007, 2008. And I've really been in software since then, ran engineering and software, M&A, ran go-to-market. So most of my roles since then have all been focused on software. And I think that's probably maybe the biggest pivot, if you look at the last 5 years for the company is becoming more product-centric, still a very important consulting business. That's a key part of what we do. But I would say more product-centric. And at this point, software is nearly 45% of IBM's revenue, which is a dramatic change if you think about -- you go back 20 years in terms of what IBM is. And I think that represents what today's IBM is, and I'm actually very optimistic on that.

And maybe if you could reference back to your experience 5-plus years ago. What was the focus of the business then? And how is it really different now? It seems like Arvind is more of a technologist and he's leading you kind of in that direction, but how does that substantially differ from the way the company used to be run?

I would say a few things. Arvind is definitely a technologist. And so you even see it in the culture and the management system, meaning once a month, we'll sit down with all the product and technology leaders in the company. And Arvind will really dive deep on topics. And I think that sets the right tone on urgency and expectation of depth and really becoming a technology-focused company. So I think culturally, that's had a great impact. If you think about the software business itself, if you go back about 5 years, the story is really about focus. I think we knew what we were good at, and there was a point in time where we drifted from that a little bit. We kind of moved into health care applications, things like weather. Our view is that's really not what we're great at. And so as we've kind of reworked the portfolio, those pieces are no longer part of IBM, but that's enabled us to focus on what I think we're really good at, which is infrastructure software. We want to solve hard problems for clients on resiliency, availability, automation, these data, like these are the kind of things that we understand very well. It's kind of who we are as an engineering team. And so I think just putting that kind of focus has enabled us to really, I'd say, change the trajectory of the business. I mean, go back 5 years, I think software was growing 2%-ish. Last year, we did 9%. We've talked about how our ambition is moving towards double digits. I mean it's a pretty dramatic change in just a few years.

And maybe take a step back and reflect on a number of years ago, IBM acquired Red Hat. It was a transformational acquisition for the software business. How does that play into the way the business is developed today?

Maybe let's start with the basics on Red Hat because I think People see it as part of our hybrid strategy, which obviously it is, but I think there's a little more depth to the role that Red Hat plays in the world. First, it starts with security. The biggest exposure for any company in security tends to be the operating system. And the brand promise of Red Hat is we will deliver the most secure, the most stable operating system in the world, and that still matters a lot, especially if you think about hybrid cloud expanding to public, private, edge. So the role that Red Hat plays in securing the operating system, providing updates, application compatibility, this is like really fundamental for enterprise technology. Next is OpenShift. And I think many people will talk about OpenShift as a vehicle to run applications across multiple clouds, which is true. But I think the story there is a little deeper, which is if you look back, I'd say, early 2000s, the wave that we wrote in IBM and software was around J2EE and WebSphere. And that was -- our view at the time was this is probably a 20-year tailwind for the application architecture that will play out in companies. And we view containers and OpenShift is the container product container management platform as similar. I mean we think this is a 20-plus year wave in application architecture. And I think we're still very early in that. So while we've done incredibly well with OpenShift, nearly $1.5 billion, growing 40%, like we're just at the start of what we think is a long-term tailwind in application architectures. Next for Red Hat is AI. And the reason you see us doing things in AI, it kind of ties back to those first 2. It's making models available as part of Red Hat Enterprise Linux AI, making models available in OpenShift. So by design, we're kind of connecting the AI strategy for Red Hat into those first 2 trends, which we think, again, have multiple years behind them. And I'd say then maybe the unexpected surprise is the tailwind in virtualization. In the last year, the world has really come our way, looking for alternatives on virtualization. And for clients, that's a decision of, do I just want to change exactly what I have in which case they can use Red Hat virtualization -- or do I want to think about modernizing my applications, which moves them down the path with OpenShift. And I'd say we're kind of indifferent on that decision. We want to meet them where they are and help them through that. But all of those factors together, that's really what Red Hat is. And this is why you can see some of the momentum in the business, high teens booking growth in Q1, we did mid-teens revenue, and we're pretty optimistic.

Yes. That leads me to jump ahead a couple of points because you mentioned virtualization. Can you talk about what you're seeing from your clients that are currently on VMware or potential clients that are currently on VMware, that kind of migration opportunity. What are those conversations like? And why would they choose to go the OpenShift route versus other solutions in the market like a Nutanix?

Not every client, but some clients are looking for alternatives. And so we think that can be a catalyst for us. And the decision on an alternative, it really comes back to your applications, which is where do I want to run applications in the future? And do I want to just take what I have sitting in one place and duplicate that? Or do I want to think about my overall application strategy. So when we go in and do an assessment for a client, which tends to be pretty quick. In 2 weeks, we can give them a pretty good view. Here's your application estate, here's what you should modernize in place versus here's what you should move to containers. In 2 weeks, we can tell them pretty quickly what is the right direction. And sometimes it ends up as just Red Hat virtualization. Sometimes it goes down the container path. But it is effort to do. As I tell every client, this is not trivial. And so if you think you're up against a deadline, you kind of need to get moving now. And I think this is why we've seen some good momentum in bookings on this topic over the last year, meaning hundreds of millions of dollars in bookings because people -- they see a level of urgency here if they're going to do something. And I think this is where maybe it's the combination of IBM and Red Hat. Clients trust IBM. And they know that they can rely on us in any conditions, ups and downs. And so I think kind of that brand promise, coupled to what we can deliver with technology and Red Hat, it makes for a really good option for clients.

Do you have any visibility into what clients have decided with VMware? I mean, you had the acquisition happened a short while ago. You had a choice to renew for a short period of time. But with regard to customers that might migrate on to an alternative solution, whether it be IBM or another vendor, you mentioned deadlines. Do you have a lot of visibility into when those deadlines are approaching when they're actually going to have to take action as opposed to getting caught off guard and what those horizons might look like over the next few years?

I don't think there's one answer for that. Many are kind of looking at this as a multiyear view to think about their application strategy. That's every discussion that I'm in because even if you want to do something instantly, that's not very practical. And so this is about -- you do need to get started, though. If you want to do something, you need to get started, and I think we'll see how that plays out over time.

Got it. And then maybe taking a step back real quick on the overall macro environment. I have to ask a macro question. Can you comment on buyer behavior today? What are you seeing from a macro perspective? And how has that changed, if at all, over the past few months in your view?

If you go back to January, we hosted a dinner with CEOs in Davos. I'd say a ton of optimism at that point, really based on the belief there would be less regulation, which is obviously pro-growth. And I think that part has played out. I think since then, yes, obviously, a little more uncertainty, which is never great. But as we look at it for our business, our geographic diversity is very good. I mean we're 50% Americas, 31% Europe, 19% Asia Pacific. So we've got good geographic diversity. You look at the software business, 80% is recurring revenue. So IBM tends to do well in times where there's a level of uncertainty because we have good diversity and clients know that they can rely on us. As you think about the bigger picture, I always try to think about -- what is not going to change. Even if there's a lot of things changing, what is not going to change. And there's kind of an old equation in macro that says GDP growth comes from productivity growth plus population growth plus debt growth. You look around the world, I don't think there's going to be really population growth. There's a few places, but in aggregate, there's not going to be, okay? So that won't be a driver of GDP growth. Debt growth, maybe, but I would say it's probably unlikely. And so then the only answer for GDP growth becomes productivity. So I don't think regardless of any ups and downs in the short-term and medium term, there's going to be a huge focus on productivity. And if anything, since the start of the year, this has been a catalyst for clients coming to us to saying, what more can we be doing to drive productivity in our business? How can we leverage AI? How can we leverage technology? So in terms of things that don't change, focus on productivity is not going to change, focus on resiliency is not going to change. I'll call it flexibility kind of coming back to our focus on hybrid cloud. Now every company, every government is realizing they need a level of optionality in how they deploy technology. There's a lot of discussions on sovereign clouds. And if you're thinking about building a sovereign cloud, I think the only answer is actually leveraging Red Hat for that. That's kind of the promise of open source. And so kind of focus on the things that don't change because then we can keep running the business.

Got it. Super helpful. And then maybe just to kind of bring that back to the performance of the software business. You delivered 9% growth in the first quarter, and Jim guided to software revenue approaching double-digit growth this year. Maybe if you can bring it back to the positioning of the software business and the overall portfolio for software today and the key drivers of where that confidence comes from in getting it to that like approaching double-digit level.

Sure. Let me start with kind of the basics. When we looked at the software business a few years ago, I spent a lot of time kind of studying why do large companies struggle to innovate. And kind of 2 things stuck out to me. One is -- over time, as companies get big, you get more managers and process coordinators than builders, engineers. And so we focused heavily, if you go back to 2020 on building engineering capacity and software. And this takes many years to play out, but it's actually -- it's going quite well for us. So one big focus is just on do we have the raw capacity and talent to innovate. The second part of innovation, and I think this is the other place large companies struggle is innovating requires a tremendous amount of patience. And most large companies do not have that. When we want to release a product and if it's like, hey, if this product is not $1 billion within a year, we're going to give up. And I think we've really changed that mentality in IBM that we're going to be really patient about iterating on new products. And I think probably the 2 best examples for today are things like watsonx Orchestrate and Concert. These are both like overnight successes in 4 years into it. So like we've been at this for 4 years. It's been 2 steps forward, 1 step back, which I think is the whole process of iteration when you're building. And we're starting to hit something. Like I think for orchestrate, the first product was literally 4 years ago. It was an internal implementation that we did. It didn't work very well. But now we've kind of found our way to -- I think we're right at the center of what's happening in agents because we're able to deliver all the orchestration for agents. And in the past, maybe we would have given up after a year, but now we're 4 years into it. And I'd say similar with something like Concert, where we announced Concert at Think last year. And then this year, we had the CIO from Deutsche Telekom on stage talking about how what used to take hours in terms of patching vulnerabilities, they can now do this with AI using Concert in minutes. Like that was a really gratifying story to me because we stuck with Concert for 4 years when we weren't getting a lot of customer traction. So I think the story here is about iteration to become great at innovating. And I think we've lost that muscle for a while, but it's coming back. How do you see that in the software business? Today, we've got, I think, a great business in automation did 15% growth last quarter. And this is a business we weren't even really in 5 years ago. And now I'd say it's one of the major areas of growth in software, everything for how you automate technology, operations, networking, FinOps. So that's been a really good catalyst for us. Data, which has been -- as I mentioned at Investor Day, data has been a little bit slower for us, but I'd say we've developed a thesis around what we think is the most ignored part of data, which is unstructured data. That led to our announcing the intent to acquire DataStax. And I think I'm encouraged by what we can build around unstructured data, which I think is probably an ignored part of the market. Last area would be transaction processing. And I always get a lot of questions on transaction processing. This is our mainframe software. And I think the story here is twofold. One is there are consumption dynamics and volatility is actually good for us because clients need more capacity. They're doing more transactions. I think that can be good. I think there's also an innovation story, though. We had not built a lot of new products for Z software if you look at the 2010 to 2020 period. And you look at since 2020, we built a lot of new products. Code Assistant for Z, watsonx Assistant for Z IntelliMagic, which is AIOps for Z. And when you bring new products onto this platform, I mean, we know exactly who the clients are. They'll definitely take our calls. And so if we can demonstrate value with new products, they will adopt new products. And so I'm encouraged about the progress we're making there, too.

Yes. I wanted to touch on transaction processing because you mentioned it. I know a lot of investors struggle with that a little bit. I struggle with it a little bit. Just in terms of like how should we think about the visibility that you have into the growth of that business? It's been surprisingly strong relative to what it's seen in the past. Is that just MIPS volume? Or is it that you've had new products that drive better volume on the platform? And I know from a vertical perspective, you've got retail, financial services, travel that all kind of like support that. But how do we think about the health of that business and the key drivers as we try to assess the growth potential of that transaction processing business?

I think there's 3 main factors. One is there's consumption. So why do people use mainframe in the first place? It is the best platform and the most economical platform for transactionally intensive workloads. Now there are things on mainframe that probably don't belong there. So we work with clients on mainframe modernization. If they're doing mobile apps or something like that, that probably doesn't make sense on mainframe. So if we help them move those off, that could take MIPS down. But we try to focus on what are the things that uniquely run best and most economical on mainframe. That's transactionally intensive workloads. And we see when we help clients optimize and have the right strategy on mainframe, they will use more because it is the most economical place to do that. So there's an element around consumption. There's an element around pricing, and we have proven that as we take price actions, we can sustain that and people will stay on the platform because they get so much value on the platform. And then third comes back to new products. And I think if you think about what's really different than the last few years, it's probably that third piece, which is delivering new products and new innovation on the platform. And kind of back to my comments on innovation, I'd say we're just getting started there. I mentioned 3. We've had other things we've tried that don't work as well. So we'll continue to iterate, but I think we can deliver more and more product here.

Great. You made a comment on talent a little bit ago. And I think whenever someone thinks about talent in IBM and they think about the consulting business. What about the software business? How have you seen your ability to attract and retain talent on the software side of the business to help you innovate and iterate on that platform? And where are you sourcing talent from?

We are able to, I'd say, almost recruit anybody that we want. The gap, if you will, is, as I said at the start, IBM is nearly 50% software. Most people don't know that yet. So that's like a well-hidden secret even though it's right in the numbers. And so there is normally a process with some people to kind of explain what is IBM today because I think IBM for so long was a hardware company and then for so long was a services company that great software engineers, they're like, "Oh, I'm not sure I want to do that" -- but once they understand who we are, it actually becomes pretty easy. We're able to recruit around the world. We have kind of focused our global innovation centers. We do a lot in the U.S., a bit in Canada. We've gotten much bigger in India. We opened a lab in Saudi Arabia last year. We still have sites in U.K. and Germany. So we have good geographical diversity, and we find we can recruit senior talent from other technology companies who want to do that. We can easily recruit from universities. We do that in a really targeted way. So I feel really optimistic about, I'd say, the progress we've built in terms of building a leadership team here and then scaling that out.

Got it. And then you -- you previously mentioned orchestrate, so we'll tie back to that. And I thought it was really interesting at the recent Think conference, it was showcased the AI automation, how it's used to drive better productivity. Can you highlight how you use AI and automation on the software side of the business? And how does that tie into recent announcements like Orchestrate?

So maybe I'll start with just what's the AI strategy and products, and I'll come back around to your question. When we look at AI, I would view it almost as a stack, and I would simplify it to 3 layers. One is you have models. And we've made significant investment in Granite models that we open sourced. I think our place in the world with models is what I'll call small language models. Focused on specific domains tuned to client data, we think there's a really good spot in the market for that. We've then partnered with Meta for Llama. We've partnered with Mistral so that we have open alternatives for larger parameter models, which often serve different type of use cases. So the strategy is really multi-model, and we have a good feeling for where we can differentiate our own models. Like one of the pleasant surprises was we open sourced a time series model on that's out on Hugging Face, and it's the most downloaded time series model in the world. So there is certain domains where we know we can lead. So that's kind of the bottom of the stack, which is models. Next part is what I would call the AI middleware or orchestration. This is where I would put watsonx orchestrate. This is how do you get multiple models to act together at the same time. So if you have an application and you want -- instead of the user deciding which model to use, you want the application to choose the best model based on performance or cost. That's what I mean by middleware. It provides governance around models if you want that. So we've made a significant investment kind of in that middle layer of middleware. And then at the application layer, we have things like watsonx Assistant, which does very well for customer service, employee service, planning analytics, which is really the #1 product in the world for financial planning and budgeting. So that's kind of the stack. It's like what we can deliver on applications for middleware then for models. We partner at all layers of that stack. And one of the announcements last week was EY has built a tax application using our AI stack. And last year, we announced Dun & Bradstreet built an Ask Procurement application, their data using watsonx as the stack. And so I think really pleased with the product strategy here and how that's playing out. Back to your question, what does this mean in terms of how we run the business? Well, we use a lot of AI to make our own engineers more productive. So we deploy watsonx Code Assistant, and we're generating 20%, 30% of our code right now using AI. And I know there's a lot of claims that engineers are going to go away. I actually don't believe that at all. I actually think the sweet spot is, I don't know, 20%, 30%, 40%, 50%. I think engineers still have a long run in this world, but it can be a great complement to your engineering team. So that's one example. Another example I'd give is just even automating our processes for how we release products. This used to be a very long process. Releasing a new product would take 6 to 9 months. And that 6 to 9 months has now become a week. And to give you evidence of that, when we closed the acquisition of HashiCorp, normally, we would close an acquisition and then the product would be generally available under IBM terms typically in 6 to 9 months. And we made the HashiCorp products generally available 8 days after the acquisition closed. And that's an example of AI, automating what was a bunch of manual processes around security checks, certifications, that type of thing. So I'm encouraged by the speed that this has put into our business.

Got it. You mentioned HashiCorp, so I'll jump to a different topic kind of related, but with that acquisition came a meaningful amount of dilution. How have you supported management confidence in covering that dilution based on the operations of the software side of the business?

Well, we look at the full picture and M&A is always in our model. And so it's obviously conscious in the back of our head. What we saw with HashiCorp was a very unique asset that we thought could really accelerate everything that we're doing in hybrid cloud. The vision of that team was we want HashiCorp running in every data center. And the core of their value proposition was clients are going to be running in one place, typically on-premise. And if we could automate how they move to cloud and how they move to multi-cloud, then that would be a winning position. Actually, Hashi actually means Bridge in Japanese, which is the whole idea was the bridge between a single implementation to multi-cloud implementation. So to us, it was the perfect asset at the perfect moment for what we're doing. And in terms of synergy, I would say 3 main areas. You've got Terraform plus Red Hat Ansible, which is how do you automate getting started on day 1 and then all of your day 2 operations. I think that's a great lever. Second would be Vault and OpenShift. So anybody using OpenShift is trying to manage all of their API keys and their secrets and Vault with an integration makes that very easy to do. And then thirdly, and I think this surprised some people, but we did release Vault on mainframe because many clients actually start with mainframe as where they manage some of their security permissions. And so by putting Vault on mainframe, in our view, this opens up a whole new market for that product. And so we looked at the opportunity, we looked at the synergies, and we thought this was too good to pass up.

Got it. With that, I just want to take a test of the audience and see if there are any questions in the audience. No, okay. We'll move on. But if there are, just raise your hand, we'll try to get to you. I think we have a few minutes left. I think one of the things I wanted to mention now on HashiCorp, you mentioned DataStax. You've had a meaningful amount of growth come from M&A. And I think the management has kind of like indicated that a substantial amount of future growth will come from M&A. As you're focused on building out the software business, what would you say the top 3 to 4 areas of interest are from an M&A pipeline perspective and there's gaps you're looking to fill in your platform?

It would all come back to kind of the areas we talked about. We're obviously looking for how do we accelerate our lead in hybrid cloud. One example was we bought Neural Magic, which is the company behind the LLM, which is think of that a way to inference across different chip architectures that became part of what we're doing in Red Hat. So anything that would accelerate what we're doing in hybrid cloud, that is of a big interest. Second would be in automation. Like I said, I think we've built a lead where for anybody that wants to do automation of technology and operations, IBM is going to be the partner of choice. So anything that accelerates that. Like to give you an example, we've done a decent bit in software-defined networking. We acquired NS1, we acquired Pliant, we acquired SevOne. And that was our view of this is an adjacent market to what we know well. This would give us really good TAM expansion. And we built some products, but we also thought we could accelerate what we were doing through M&A. So that's an example in automation. For data, I kind of talked about the opportunity in unstructured data, but I think the opportunity in data is broad from data integration to data cataloging to analytics, there's still a lot happening in data. And so that will be an area. And then I'd say we're opportunistic around mainframe software or TPS. We've done a few smaller ones here or there. But if that can, I'd say, accelerate road maps for how we're thinking about innovation, we would do that.

Got it. And I want to circle back -- sorry, I'm jumping around a little bit, but I want to circle back to Red Hat for one minute because I do get a lot of questions from investors on this. Still growing very nicely. This quarter, it was a little bit slower growth than it was in the fourth quarter of the year. I know historically, Jim has called out that there's a consumption piece of that business. Can you help me understand how meaningful is the consumption piece? And how meaningful of a role did that play on performance this quarter for the software business?

I don't think I'd draw the line that directly. When we talk about a consumption business, a lot of this is software running on hyperscalers. So there's an OpenShift managed service on AWS and there's one on Azure. Clients can obviously tune that up or down based on what's happening in their business. But I'm not sure I would point to that. On Red Hat, I kind of come back to -- we've made really good progress over the last, I guess, 6 quarters now where we've shown really sustained higher bookings growth. And if you kind of come back to the tailwinds I talked about, new version of RHEL, momentum there, OpenShift, I think we're still in very early days of containers. And if you believe my comments that this is a 20-year trend on applications, say, very optimistic there. AI is still very early. And that's, I'd say, all upside. And then, again, we kind of got this tailwind with virtualization that I'm not sure we even expected a couple of years ago, and that's been a pretty good catalyst for us.

Got it. And then I wanted to hit on partnerships real quick. What role do ecosystem partnerships play in your business? And can you share some examples of successful collaborations that have contributed to the growth of the software business?

I think the most obvious one when you think about TAM expansion is what we've done with hyperscalers. In 2020, we had 0 IBM software products in AWS marketplace or an Azure marketplace. And we made a conscious decision that it was a part of the market that we were missing out on. Now we have nearly 100 products on AWS, about half that on Azure. It just opens up a whole new distribution channel, the way that clients can leverage their committed spend to acquire software. And so that's, I'd say, one dimension of partnerships that I think it was just a part of the market we are missing, and that's been all upside for us, which has been good. I think the second piece was working with systems integrators. So yes, we have a consulting business. And our consulting business is a great catalyst for what we're doing with watsonx and generative AI. But we can't afford to ignore the rest of the systems integration market. We put a pretty big explicit focus on we're going to partner with Deloitte. I mentioned EY. We're going to partner with Accenture, LTIMindtree, many of the Indian SIs. And that's created a lot of opportunity that we were just missing out on because we can't just be a captive to our own consulting business. So that was expansion. We've done a lot working with ISVs on what we would call embedded AI. So ISVs that aren't going to invest $1 billion of R&D to go after AI, they can use our AI to make their products better. Box talked about this at LlamaCon last week, how they're using watsonx -- that's one example. We've done it with Adobe with Salesforce. Qualtrics, I mean, hundreds at this point. And so these are all different ways, I'd say, alternative routes of distribution, whether it's hyperscaler marketplaces, working with SIs, ISVs that are embedding our technology. I think it was really important to diversify our distribution and how we attack revenue growth.

Got it. Maybe last one for me. You made a lot of really exciting announcements recently. What gets you most excited about the future of IBM?

I think IBM is one of the most important companies in the world. And clients for a while were questioning the relevance of IBM. And I think that's completely gone away. People are now leaning in. I think they think we nailed it on the strategy around hybrid cloud and AI. So the client sentiment has changed dramatically. So I'm very optimistic about that. I'd say secondly is I think everything we've talked about here, we're actually just at the start of, whether it's go-to-market transformation or innovation and products, these things do take a while to play out. And we got some quick -- relatively quick near-term successes in the last 4 years, but we are just at the beginning, and that's probably what excites me the most.

Excellent. With that, we're out of time. Rob, thank you very much for joining us, and thank you all as well.

Good to be with you.

All right. Great.