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

Good afternoon, everybody. Welcome to the Goldman Sachs Communacopia Technology Conference. My name is Jim Schneider. I'm the semiconductor and IT services analyst here at Goldman Sachs, and it's my pleasure to welcome IBM and CFO, Jim Kavanaugh, on the stage today. Welcome, Jim. Thanks for being here.

Great. Thank you for having us. Looking forward to talking about our business here today.

Excellent. Jim, back in second quarter, you negatively preannounced that quarter. And I think one of the central investor debates following the earnings call has been was the spending shift you mentioned was mainly a timing issue or perhaps evidence of a more durable headwind in sort of the customer IT spending priorities that you're seeing. You talked about a late quarter shift in which some clients prioritize purchases of server, storage and memory ahead of price increases and delaying certain IBM purchases. Maybe should investors be thinking about the duration of the dynamic as a very short-term thing or clients now moving past that period of infrastructure catch-up? Or should we expect that prioritization to sort of remain a headwind in the back half of the year?

Jim, great place to start. So let me unpack our second quarter because I think that will put this all in perspective about what are we seeing right now in terms of client buying behavior and demand. But more importantly, what does that mean for our strategy, our portfolio and our second half guidance overall, which I think is at the heart of your question. When you look at second quarter, I'm not going to recap that. We spent a tremendous amount of detail in July, but we fell short to our expectations. We were very transparent in that. And that was really driven by a performance gap in our mainframe performance and associated software that's attached to that platform overall. And that was driven by a reprioritization of CapEx spending, to your point, given the secure supply-constrained environment and infrastructure demand and associated price increases. Let me put that in perspective. That mainframe platform and associated software, that impacted IBM's growth by over 5 points of growth in the quarter on only about 15% of the composition of our portfolio. The remaining 85% of IBM actually did extremely well at or well above our expectation. Red Hat accelerated one point to 11% growth, leveraging the demand that's in the marketplace around hybrid cloud modernization, virtualization, AI, automation, Red Hat OpenShift growing 29% in the second quarter, really the industry leader hybrid cloud platform, now a $2.2 billion ARR. Second, our acquisitions doing extremely well, both HashiCorp, which we anniversaried 1 year, and albeit very early, Confluent off to an excellent start. Third, our high-value recurring revenue, 80% of our software business doing extremely well. It's approaching a $25 billion ARR book of business, growing high single digit. That includes everything from our GenAI portfolio to parts of our automation portfolio, our data portfolio and our Red Hat portfolio. And then finally, our distributed infrastructure, doing extremely well, record quarter, 37% growth. We exited the first half with about $500 million worth of backlog. So we're capitalizing on that explosive demand that's in the marketplace. And consulting, delivering durable growth actually with very healthy signings unlike many of the other competitors in the industry, and that's really leveraging GenAI. Now to the heart of your question, we spent a lot of time, and I think we were very clear and confident on the call that we see nothing that changes the absolute conviction we have in our strategy and our portfolio in this marketplace. And we mobilized IBM around a core set of actions, go-to-market actions, new offerings and innovation, new monetization models to really capture the durable growth that we see in the market. In terms of timing versus demand destruction, I'll use that word. We think this is absolutely timing overall. All the indicators, demand profile, pipeline, propensity to buy models, renewal rates that we're seeing in the third quarter, we're not seeing any demand destruction. And when you look at it, probably the most powerful point, over 40% of our slip deals coming out of the second quarter, we've already closed. put that in perspective, we typically only close about 75% over multiple quarters of sub deals. We're already at 40%. So that gives us confidence in what we guided for the year. We guided IBM now 4% to 5% revenue growth. At the high end, basically at where we were in April. At the low end, I think, prudently to protect our profit and cash. Our operating margins, we took up for the year, our earnings we took up for the year, $5.5 billion of productivity and free cash flow, a critical enabler. We maintain that at about $1 billion of growth year-over-year. So...

Very good. So on the software side, let's pivot here. So on the software side, I think that's very central to the thesis of many people on IBM in terms of long-term growth narrative. Q2 highlighted sort of the difference between the roughly 80% of your portfolio, which is recurring and the more transactional CapEx-sensitive portions. Maybe explain why that mix gives you the confidence in the underlying health of software despite last quarter's growth rate.

Yes. So software is an integral part of IBM's hybrid cloud and AI thesis, right? It's the core foundation. Why? 45% of IBM's revenue composition software, high-value recurring revenue, that 80% high marginal profit, high cash contributor. And it's a business that's operating right now at about a rule of the mid-40s over time. And most importantly, three, it capitalizes on a very attractive economic multiplier for every dollar of platform we land on hybrid cloud and AI and now soon to be quantum, we get a multiplier of software $3 to $5 and a higher NRR. But let's dissect and I guess, unpack the software algorithm growth profile. Why do we feel so confident? One, we have absolute conviction in the strength and durability and diversity of our business model in taking a business, it wasn't too long ago that we were plus or minus 0 software growth to building a business that was growing low single digit to building a business that was growing mid-single digit to building a business exiting last year growing high single digit, and we guided this year to growing 10% overall. What are the underpinnings? Number one, you talked about that 80% software. That's high-value recurring revenue. That's made up of our subscription businesses, our consumption businesses, our GenAI portfolio, our Red Hat portfolio. That's accelerating in growth. That's right now at high single digits here exiting the first half, and we see that continuing momentum. Second, we've spent a lot of time reinventing our portfolio. And both organically in investing and inorganically from an M&A perspective, we changed the portfolio dynamics to a much more higher growth end market portfolio, addressing high TAM, high-growth vectors, Re.AI, hybrid cloud, virtualization, automation, data, security. Those are areas that we invest and we're focused on, and we continue to improve the portfolio mix. Third, this is all about IP investment, new innovation we bring to market. We're coming out this year already with a whole new control plane from an orchestration layer, watsonx Orchestrate. We just came out with IBM Bob to address the software development life cycle model. We came out rapidly with Lightwell, the security play with regards to open source security vulnerability, Concert to address security overall, HashiCorp from a Vault perspective, Confluent and go on and on and on. Next, M&A. The synergistic value is still all in front of us. We're just a year wrap through on HashiCorp. By the way, record performance on HashiCorp through the first year. We've added net new $200 million of net new ARR through the first year of that performance. And Confluent off to a great start. And then finally, we're dealing with -- to your first question, we're dealing with a near-term client buying behavior dynamic in TP software. That's the mission-critical software that runs on our mainframe that impacted our software growth in the second quarter by 3 points. We have confidence in the long-term growth vector of this. Why? Because it's directly correlated to the mainframe performance of our stack. How do you monetize value? The more capacity you ship in the market, the more capacity that's utilized, installed and driving workloads on mainframe platform, the more monetization opportunity you have, the more price opportunity you have and the more value creation opportunity you have. And when you look at it, our z17, 5 quarters in, the most successful program in the history of IBM on decades and decades of mainframe cycles overall. We've shipped over 100% new MIPS in the marketplace over 5 quarters, program to program. We're at 129% from a revenue attainment. That's about $1 billion more revenue. And our installed MIPS are up almost 20%. Why do I bring that up? Because that instantiates a very encouraging future monetization opportunity with regard to TP. So when you look at it, that's the growth algorithm. We're going to grow this company. The aspiration is to get this to a sustainable double-digit level. We've got it there in hybrid cloud. We've got it there in data. We got a little bit more progress to do in automation. In TP, that's just a future monetization opportunity.

Yes. So on the revised software outlook, 6% to 8% for the year, what are the variables to kind of drive that to the high or low end of the range?

Yes. Coming out of second quarter, we did a very deep analysis with regards to -- our demand profile, propensity to buy models, pipeline -- by the way, our pipeline exiting -- entering the second half is extremely strong. We built a model that said on the high end 8%, on the low end, 6%. High end, 8%, let me break it down in the composition of how you were asking the question earlier. 80% high-value recurring revenue, subscription business models, consumption business models. We see that accelerating to double digit in the second half. So a nice acceleration trend, and we're on our path to go do that, just given the bookings in Hashi, strong start in Confluent, the momentum we have in Red Hat, et cetera. On the 20% transactional business, remember, we offer clients flexibility in how they want to purchase. That transactional business [ Re. ] is our perpetual license models, our ELA models. We said out of those slipped deals that happened in the second quarter, we would close on our historical level of about 75% of those deals, right? Second, we then took the strength of our pipeline and we said, let's apply a historical discount to that, and we come up with a prudent level at the high end of 8%. The low end, just very simplistically, says we get a moderate acceleration in that 80% of that high-value recurring revenue, just given the dynamics of what we see in the ARR playing out. But then on the transactional business, we basically assume second quarter performance continues, which is about where we're already at on slip deals, about 40% and it's about a pipeline yield that is about half of what we historically have set up. We did that why? To protect profit and cash and drive the right productivity levels so we can ensure we deliver on earnings and we can ensure we deliver on free cash flow. And if we end up at the high end, that is upside to our year.

Got it. You talked about M&A before. That's been part of your software expansion growth strategy. Has there been any kind of change in terms of your appetite for software M&A in terms of the types of assets you're looking at, the size of assets you're looking at and sort of how aggressive would we expect you to be at this point on the -- on the M&A front over the next few quarters?

Yes. I could tell you, one, we're extremely busy, but extremely focused. I think we've earned the right over the last handful of years under Arvind's leadership about being disciplined capital allocators, about running our M&A playbook built off of the Red Hat acquisition, one of the most successful acquisitions, I think, that will go down in history overall. And that is basically centered around a set of criteria: one, being absolutely strategically focused on where we can win, how we can win around our platforms. Hybrid cloud, AI and quantum. You saw we just announced an acquisition with HRL in Quantum. Two, driving and capitalizing on the synergistic value across our portfolio of software, consulting and infrastructure overall. And three, we're always looking to drive an attractive financial return profile for our shareholders overall. And I would argue we have done a pretty good job on the M&A front in building out that capability. You see what it's done to the acceleration of our software portfolio and for that matter, the acceleration of IBM's revenue growth profile in addition to our free cash flow profile. So when you look at it, what is our strategy? We target and we see category technology leaders in structurally growing markets where we can add distinctive value, integrate and drive the synergistic value moving forward. Without getting into some competitive dynamics, extremely busy. And I think Arvind has proven we will be bold, but we will be focused and disciplined around driving it.

Very good. GenAI. As a company, I think, Jim, you've been very clear that your strategy isn't about going after frontier model building or creation, but instead data layer orchestration, governance, hybrid deployment and sort of smaller scale models. Can you talk about some specific use cases where clients are moving past pilots, improving those at the enterprise level? And were those kind of capabilities or your traction actually greater than you thought?

Yes. Let's bring it up a level because I think it's important to understand, to your point, we've been very focused on our AI strategy. How do we win, where can we win? And more importantly, how do we build a set of portfolio capabilities and invest in those areas around building out an integrated full suite of offerings. Remember, across IBM, when you think about our AI portfolio, we are not a highly capital-intensive business. We're not a frontier model provider. We believe that the monetization value is going to move up the stack, and we want to have control points and capabilities around where we think the future revenue, profit pools in enterprise are going to be at the end of the day. So what have we done? We've built out an open infrastructure AI platform with data connectors, which I'll come back to, with AI middleware, with agents and assistants and capabilities, with an orchestration control plane, with an AI infrastructure level capability around server, storage, mainframe, even having AI on the chip and a consulting business at scale that drives domain industry knowledge that can help clients go scale and drive value realization. So we provide that entire integrated suite. What is our differentiated value proposition and what we go to market with? One, open innovation around AI platform, open-weight, open source models. Two, we firmly believe the core competency of IBM's strategy is around hybrid, multi-model, sovereignty overall; three, orchestration control plane. Four, data, security, governance, life cycle management. That's where we think the value is going to get created at the end of the day. And when you take a look at it, I speak to a lot of my peers around the industry. And to your point, clients are moving right now from experimentation to scale. I would tell you, we're still very early innings coming up on baseball playoff season, we're probably in the third inning. Not in the first inning anymore. We're in the third inning. Best-in-class companies might be in the fifth or sixth. But on average, we're in the third inning. Every company, every CFO is focused on understanding the life cycle of AI from a value investment and realization point of view. I always say, one, I need to understand total AI economics, two, govern AI consumption; three, optimize continuously across my company; four, plan dynamically; and five, deliver value realization. And I think all of that plays to the core competencies we have today. Think about IBM and what do we provide? One, from an AI perspective, we own the enterprise foundation software layer, Linux containerization. The explosion of AI is going to generate billions of new applications. Where are those applications going to run? On containers, plays sweetly through Red Hat OpenShift. Two, it increases AI, increases the importance of data, data connected in a secure, hybrid multi-cloud way. That was the essence behind the strategic thesis of Confluent to be the cross-platform data connector. Three, the orchestration layer is where the value is going to be, not just on model optimization, cost optimization, but it's fundamentally on how you're going to run your businesses, your supply chains, your financial management systems, your HR systems, et cetera. So you take our control plane of watsonx Orchestrate, coupled with Red Hat that allows you to do inferencing on any architecture. We're the only company that can provide that. You add to that IBM Bob addressing the developer community, IBM Concert, addressing the security, the governance, the compliance and a very powerful Apptio capability, which gets at the core and the heart of the love of the CFO, understanding transparency of all your AI investments, and the value realization around that. So that's where we're going to play. Today, we've built out billions of dollars of pipeline opportunity. And I think those are spanning everything from code modernization to digital labor and reinvent workflows to customer service, all of those areas are moving to scale.