International Business Machines Q3 2021 Earnings Call Transcript

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Provided by Quartr
October 19, 2021

Key Takeaways

  • IBM ex-Kyndryl revenue grew 2% in Q3, improving from 1% in Q2 and -1% in Q1 on a constant currency basis.
  • The company generated over $11 billion of adjusted free cash flow over the trailing 12 months, supporting investments and shareholder returns.
  • Software and Consulting drove growth, with software up 2% (Red Hat up 23% all-in) and IBM Consulting revenue accelerating 16%, representing over 70% of the post-separation mix.
  • Systems and Global Technology Services underperformed, with Systems revenue down 12% and GTS down 5% amid product cycle dynamics and pre-separation project pauses.
  • The Kyndryl separation remains on track for November 3, and IBM reaffirms its goal of sustainable mid single-digit revenue growth and strong free cash flow starting in 2022.
AI Generated. May Contain Errors.
Earnings Conference Call
International Business Machines Q3 2021
00:00 / 00:00

There are 11 speakers on the call.

Operator

Welcome and thank you for standing by. At this time, all participants are in a listen only mode. Today's conference is being recorded. If you have any objections, you may disconnect at this time. Now I will turn the meeting over to Ms.

Operator

Patricia Murphy with IBM. Ma'am, you may begin.

Speaker 1

Thank you. This is Patricia Murphy, and I'd like to welcome you to IBM's Q3 2021 earnings presentation. I'm here with Arvind Krishna, IBM's Chairman and Chief Financial Officer and Jim Kavanaugh, IBM's Senior Vice President and Chief Financial Officer. Please prepared remarks are on the IBM Investor website within a couple of hours and a replay will be available by this time tomorrow. I'll remind you the separation of Kyndryl is expected to be completed at the beginning of September.

Speaker 1

And as a result, our Q3 performance reflects IBM, Comments made in this presentation may be considered forward looking under the Private Securities Litigation Reform Act of 1995. These statements involve factors that could cause our actual results to differ materially. Information about these factors is included in the company's SEC filings. Presentation also includes non GAAP measures To provide additional information to investors, for example, we present revenue and signings growth at constant currency. In addition to provide a view consistent with our go forward business, we'll focus on constant currency growth, adjusting for the divested businesses for the impacted lines of total revenue, Cloud and our geographic performance.

Speaker 1

We will provide a reconciliation chart for these and other non GAAP measures at the end of the presentation 8 ks submitted to the SEC. With that, I'll turn the call over to Arvind.

Speaker 2

Thank you, Patricia, And thanks to all of you for joining us today to discuss our Q3 performance. At our recent investor briefing, laid out our hybrid cloud and AI strategy and our approach to delivering strong free cash flow And sustainable mid single digit revenue growth starting in 2022. For the last year and a half, we've been taking actions and investing to execute our strategy. This quarter, we reported modest revenue growth and delivered solid free cash flow, Generated over $11,000,000,000 of adjusted free cash flow over the last year. We also made tangible progress In our key growth areas of software and consulting.

Speaker 2

With that, I will acknowledge that in other areas of the business, We fell short of our expectations. Systems nearing the end of the ZYP cycle and Global Technology Services client Pausing ahead of the public filing of the Form 10 and separation of Kyndryl. We have made further progress in the Kyndryl separation in the last two weeks And announced the distribution date on November 3rd, which is ahead of our original schedule. We've done a lot to prepare Kyndryl for this moment. We took structural actions to improve the profit profile.

Speaker 2

The management team is in place. Employee transfers And the vast majority of client contract innovations are complete. We are now even more certain That separating this business creates value through focus. That said, the people of GTS have been a part of IBM for a long time. Hence, it is with mixed emotions that we are reporting on this segment for the last time.

Speaker 2

And just yesterday, you heard from Morton and his management team, Kinvol's strategy and value proposition. The separation is just one of the many actions we are taking to focus our business on hybrid cloud and AI and improve our financial profile. To give you some color on IBM's performance excluding Kyndryl, We delivered 2% revenue growth this quarter. That compares to 1% in the 2nd quarter and minus 1% in the 1st quarter. These results reflect the strong demand for technology products and services that help our clients advance their digital transformation.

Speaker 2

Our software revenue growth was led by Red Hat, Security, Automation and Cloud Paks across our software. Global Business Services, soon to be IBM Consulting, accelerated revenue growth to a double digit rate. Software and consulting are our 2 main drivers of growth and this was certainly true this quarter. I will now expand on the Progress we made in the Q3 toward our future. As I have described in the past, we have a platform centric approach, Time to meet clients wherever they are in their journey.

Speaker 2

The platform we have built is open, secure and flexible And continues to gain traction in the marketplace. Now I have more than 3,500 clients using our hybrid cloud platform. Not only fuels our Red Hat revenue performance, but also provides a solid base for the multiplier effect across software and services. IBM Consulting is helping to drive this platform adoption and this quarter had over 180 new Red Hat engagements. Our teams work alongside our clients to co create business products and solutions.

Speaker 2

So far, we have done more than 4,000 IBM In the last quarter, more clients are leveraging our platform capabilities and our expertise to unlock business value. Announced DISH is using IBM Software and Services To help automate their cloud native 5 gs network, Cloud Pak for Network Automation, which is infused with AI, automation And orchestration capabilities used by DISH to fine tune speed levels or coverage areas Depending on the needs of customer clients. Building on our partnership spanning half a century, We announced CreditMuchel is creating an IBM Technology and Skills Hub in France. The new hub will help CreditMuchel leverage AI, data, cloud and IBM Z. We also announced a new agreement with CaixaBank, one of the largest banks in Europe To boost its digital capabilities with IBM Cloud for Financial Services and the new IBM Cloud Malta Zone region in Spain, Caixa Bank will leverage IBM Consulting's industry expertise to move to a hybrid cloud approach for modernization.

Speaker 2

This quarter, we continue to leverage our ecosystem to drive what we described at our investor briefing as a flywheel of growth. That is The more we grow, the more our partners grow and vice versa. We're partnering with select GSIs to bring joint solutions to market. This quarter, Atos announced the setup of the FS Cloud Center of Excellence to help financial services customers With the digital transformation journey, also have continued momentum and revenue growth from our partnership with industry leading ISVs And hi, Pascada. This quarter, we are partnering with Adobe to help the British pharmacy chain Food, transform their e commerce platform and deliver new digital customer experiences.

Speaker 2

While we invest in partnerships, We also invest organically and inorganically to deliver innovation. We made 16 acquisitions since April 2020, Including Voxport and BlueTabs in the 3rd quarter. These will strengthen our hybrid cloud consulting capability. In the same manner, we are organically developing new innovations that matter to our clients. I'll mention a few new introductions, Sorry with our innovations in software.

Speaker 2

In the quarter, Red Hat introduced a new re architectured version of the Red Hat Ansible Automation Platform. Red Hat also launched a new version of its advanced cluster management for Kubernetes. These two products are now more tightly integrated, which helps drive hybrid cloud automation. In addition, the latest version of Red Hat OpenShift became generally available. IBM Cloud Pak run anywhere that OpenShift runs.

Speaker 2

They use common services such as logging, metering, monitoring and security and are infused with innovations and capabilities from IBM Research This will deliver much more value than containerized code. In this quarter, we launched Cloud Pak for security, SaaS, As well as new versions of Cloud Pak for Integration, Cloud Pak for Network Automation and the Maximo Application Suite. Also recently announced are Environmental Intelligence Software Suite. Product based on our Cloud Pak for data And leveraging our weather capabilities is designed to help companies measure, monitor and predict environmental outcomes, But also to help simplify ESG reporting, as you know, we made a commitment to be net 0 greenhouse gas emissions By 2,030, we will leverage this solution to inform management as we take action to reach this goal. In our systems business, we recently launched Power10.

Speaker 2

Power10 has unique hardware innovations, Including a processor specifically optimized for data intensive workloads such as SAP S4HANA. During the quarter, we also announced the Telen processor. This 7 nanometer microprocessor It's engineered to help clients gain insights from their data at the speed of the workload. At the same time, we've continued to see quantum Computing is a promising area of opportunity that will play out in the longer term. Our teams are hard at work to move this exciting field forward.

Speaker 2

Investors will have an opportunity to learn more about this within the next month. Let me quickly highlight one ESG announcement we made recently. To help protect the rights and privacy of cloud clients, we have joined other major companies in the tech industry, Amazon, Google, Microsoft, Salesforce and SAP to establish the trusted cloud principles. This initiative It's consistent with our long standing focus on trust and transparency. Before I transition to Jim, let Let me reiterate 3 messages we conveyed during our investor briefing.

Speaker 2

First, we are optimizing our portfolio to drive mid single digit revenue growth starting in 2022. 2nd, we are increasing our focus and agility To better serve clients. 3rd, we are generating strong free cash flow that enables our investment While providing attractive shareholder return. This quarter, we took another step towards this future. While much remains to be done, we are confident we can achieve our midterm objective.

Speaker 2

Tim, over to you.

Speaker 3

Thanks, Arvind. Over the last year, we have been very clear on the 2 most important measures of success: revenue growth And free cash flow generation. I'll start with these key metrics. In the 3rd quarter, our revenue of $17,600,000,000 Was up as reported and down modestly at constant currency. Excluding the content that will go to Kyndryl, IBM's revenue grew 2% With an improving trend over the last three quarters, our cash generation was up for the quarter, year to date and trailing 12 months.

Speaker 3

This excludes the cash charges associated with the separation of Kyndryl and the structural actions initiated at the end of last year. Looking at our revenue from a segment perspective, Global Business Services growth accelerated to 11%, And our software revenue was up 2%. Businesses will be our growth drivers into the future and together represent over 70% Of our post separation revenue profile, systems declined this quarter by 12%, reflecting product cycle dynamic. Across our segments, IBM's cloud revenue was up 11% over last year, and it's up 17%, excluding the cloud revenue going to Kyndryl. This is led by Global Business Services and Cloud and Cognitive Software, which are up 27% and 28 respectively over that period.

Speaker 3

Moving on to the profit dynamics. Pretax margin is up 10 basis points sequentially, but down 100 basis points year to year. Since we saw the demand environment improving in the Q4 of last year, We have been increasing investments in skills, innovation and our ecosystem organically and through acquisition. In the Q3, we continue to aggressively hire, bringing in technical talent in Red Hat and highly skilled expertise in consulting. We're scaling resources in our garages to provide a more experiential consulting and sales approach.

Speaker 3

We're adding client success managers to help clients get the most value out of their IBM solution, And we're increasing investments in R and D to deliver innovations in our hybrid cloud platform, AI and emerging technologies like Quantum. The structural actions we initiated at the end of last year are funding some of these investments. Roughly 2 thirds of the savings from these actions Address stranded costs from the separation and create financial flexibility to be reinvested for growth. The other one third addressed the Global Technology Services profit profile ahead of the separation, And we're seeing improvement in the GTS gross margin. Our 3rd quarter operating tax rate came in about 5%, which is lower than what we talked about last quarter.

Speaker 3

This was due to discrete tax benefits that occurred earlier than we previously expected As we prepare for the Kyndryl separation, it's important to note that our view of the full year operating tax rate has not changed since January.

Speaker 2

I'll comment on

Speaker 3

our free cash flow and balance sheet position. We generated $5,000,000,000 of adjusted free cash flow year to date And $11,100,000,000 over the last year. Both exclude cash impacts of about $1,800,000,000 For the structural actions initiated late last year and transaction charges associated with the separation of Kyndryl. Our adjusted free cash flow over the last year is up about $300,000,000 with growth in our underlying business performance Mitigated by a cash tax headwind. Our cash balance at the end of September was $8,400,000,000 up slightly from June, but down about $6,000,000,000 from year end.

Speaker 3

Over the same period, our debt is down $7,000,000,000 In addition to debt reduction, year to date, we've used $3,000,000,000 for acquisitions and over $4,000,000,000 for shareholder return through dividend. Our solid cash generation and disciplined financial management provides the fuel to invest in our business And pay an attractive dividend. Turning to the segments. Cloud and Cognitive Software revenue grew 2%. We have a strong recurring revenue base in software.

Speaker 3

Renewal rates for subscription and support were up again this quarter, Contributing to the increase in our software deferred income balance over the last year. By business area, Cloud and Data Platforms revenue was up 9%, while Cognitive Applications declined 1% and Transaction Processing Platforms Was down 9%. We recently shared plans to provide new software revenue categories starting in the 4th quarter. We will combine our 2 software growth vectors, cloud and data platforms and cognitive applications, and within that provide greater transparency into performance and trends by business area. Looking across these growth vectors, Red Hat, Security and automation fueled revenue growth this quarter.

Speaker 3

Red Hat revenue was up 17% on a historically normalized basis And 23% all in. Going forward, we will focus on this all in growth. Given these views, we'll converge over the next year As the impact of the deferred revenue impairment dissipates, Red Hat revenue growth was driven by double digit growth in both Infrastructure And application development and emerging technology, and we had more than 40% growth in OpenShift recurring revenue. Growth in automation was led by key solutions like Cloud Pak for Integration and Cloud Pak for Business Automation As well as a strong start to our recent Instana and Turbonomic acquisitions. Our data and AI revenue was down modestly.

Speaker 3

We had strength in Cloud Pak for Data, Weather and Maximo and declines in on premise data ops portfolio And supply chain as it wrapped on a strong Q3 last year. Security remains a key strategic focus area As we're helping clients adopt 0 trust architecture with Cloud Pak for Security and X Force Services. Growth in security revenue continued this quarter, led by Threat Management Software and Services as clients respond to the evolving Cybersecurity environment. In the spirit of transparency, I'll provide a couple additional metrics into our performance. Our annual recurring revenue, or ARR, across these software growth factors grew 7%.

Speaker 3

This is a good indication of the progress in our hybrid cloud and AI client adoption. And we now have over $8,000,000,000 in Software cloud revenue over the last year, which is up 28%. Turning to our software value vector, Transaction processing platforms, we provide flexibility to our clients in how they purchase this mission critical software. Over the last 18 months, we've seen a preference for OpEx over CapEx. This continues to pressure perpetual licenses In favor of more consumption like model.

Speaker 3

But importantly, we again had strong renewal rates in our transaction processing platform software. This is a solid indication that clients see long term value in these offerings. Looking at profit for the software segment, We expanded pretax margin sequentially, while we continue to invest in new innovation and our ecosystem. Moving to Global Business Services, revenue growth accelerated to 11%. Even with the strong revenue performance, Our book to bill ratio was greater than 1.

Speaker 3

Our GBS value proposition is aligned to our clients' priorities. We're helping our clients capture new growth opportunities and increase operational flexibility and productivity with hybrid cloud and AI. We leverage our incumbency, IBM Technology and strategic partnerships to modernize their applications And digitally transform their businesses at scale. GBS revenue growth is led by our cloud offering. GBS Cloud revenue now represents more than $7,000,000,000 of revenue over the last year and is up 27%.

Speaker 3

This performance reflects the continued investments we are making in our Red Hat, Microsoft and AWS practices. As Arvind said, we added over 180 Red Hat client engagements this quarter. This contributes The total Red Hat related signings of close to $3,500,000,000 since the acquisition. Within our 11% revenue growth, Consulting was up 16%. There's solid demand here.

Speaker 3

We're leveraging our skills and ecosystem partners to transform our clients' business processes and modernize applications based on OpenShift. Global Processing Services revenue was up 19%. Our offerings in Finance, Procurement And talent and transformation all grew at double digit rates. More and more, we're connecting consulting and BPO to transform client workflows using hybrid cloud and AI. Lastly, in application management, Revenue growth accelerated to 5% off a prior year that was impacted by the pandemic.

Speaker 3

Growth this quarter was driven By management of applications in a multi cloud environment. I'll shift to GBS profit profile, Where our strong revenue performance drove gross and pretax profit dollar growth. Our gross and pretax margins improved sequentially, But we're down year to year. With the market opportunity we see, we are making conscious decisions to invest ahead of revenue. We are investing in strategic partnerships, new offerings and practices and integrating and scaling out our acquisition.

Speaker 3

As I mentioned earlier, we are investing in skills for GBS. In the last several months, we have increased our go to market resources And scaled our practices built around our ecosystem partners and Red Hat. With a competitive labor market, This is putting some pressure on our labor costs, including higher acquisition and retention costs, which is not yet reflected in our current pricing. We expect to capture this value in future engagements, but it will take time to appear in our margin profile. So now turning to the Systems segment.

Speaker 3

Revenue performance was down 12%, driven by product cycles in IBM Z and Power, Mitigated by growth in storage. In IBM Z, revenue declined 33% in the 9th quarter of Z15 availability. While Z15 program to date continues to exceed the strong Z14 cycle, the magnitude of that overachievement Has come down a couple of points this quarter. IBM Z is an enduring platform. Given market needs for scalability, Reliability, security and more recently, cloud native development.

Speaker 3

These characteristics, Together with our newer flexible consumption offerings, further demonstrate the value of IBM Z platform within our hybrid cloud and AI strategy. Power revenue was down. Late in the quarter, we began the rollout of our next generation Power10, Starting with High End Systems. As always, new power technology is introduced over time And the mid range and low end power tent systems will be available during 2022. Storage delivered 11% revenue growth, driven by demand from hyperscalers for our tape products and growth in entry level all flash storage, following our product refresh earlier this year.

Speaker 3

Looking at profit in this segment, profit margin was down, reflecting where we are in the IBM Z and Power product cycles. So now let me turn to Global Technology Services. Revenue was down 5%, which is a 1 point deceleration from last quarter. The year to year trajectory of revenue generated from the backlog Has been improving over the last few quarters. In the first half of the year, we also had modest improvements in client based business volumes And project activity, which contributes to in period revenue.

Speaker 3

However, this quarter, clients paused on new project activity As the separation was imminent, resulting in the revenue deceleration. At the time we decided to separate Our Managed Infrastructure Services business, we undertook a series of actions to improve the margin, profit And cash generation profile of the business, including a substantial charge in the Q4 of 2020. The results of these actions can be seen in the margin improvement over the last several quarters. In this quarter, we again expanded gross margin, Up 120 basis points. Indra will take this improved profit profile into the separation.

Speaker 3

I'll wrap up with a view of our progress year to date and then talk about some of the 4th quarter dynamics. As we enter 2021, We laid out our expectations for the year for our 2 most important measures: revenue and free cash flow. We expected to grow revenue for IBM at actual rates, with underlying constant currency performance stronger in the second half than the first. We expected to grow revenue for IBM, excluding Kyndryl, at constant currency, and We expect it to generate $11,000,000,000 to $12,000,000,000 of adjusted free cash flow. That, of course, excludes the cash impacts of the Kyndryl transaction costs and the structural actions I mentioned earlier.

Speaker 3

Now we're 3 quarters into the year, And we just completed the last full quarter of IBM on a pre separation basis. It's a good time to take a snapshot against those objectives. Currency has been improving throughout the year. And excluding Kyndryl, our 3rd quarter revenue was up 2% year to year. And our adjusted free cash flow over the last 12 months is $11,100,000,000 Since the beginning of the year, We have streamlined our go to market.

Speaker 3

We have increased investments and closed 10 acquisitions. These actions and investments will help drive revenue growth, but it takes time to fully realize the benefit. Overall, our results over the 1st 3 quarters of 2021 reflect progress we've been making toward our midterm model. During the Q4, we will complete the separation of Kyndryl, which is on track for November 3. The Q4, therefore, is a major milestone as we transition to the future IBM.

Speaker 3

Now let me provide some color On three areas for the Q4. First, the revenue trajectory of the new segments 2nd, I'll comment on our tax rate and third, the impact of the separation of Kyndryl to IBM's consolidated results for November December on an operating basis. I'll start with the revenue trajectory of our segments as we'll report them in the 4th quarter. As always, I'll talk about it on a constant currency basis. But I'll remind you, the U.

Speaker 3

S. Dollar continues to strengthen And would be a 1 to 2 point headwind to growth based on current spot rates. To provide a better view of trends, I'll focus on the growth rates before the revenue from incremental sales to Kyndryl. We see continued momentum And our growth factors is software and consulting. We expect our software revenue growth rate to improve versus the 3rd quarter.

Speaker 3

And in IBM Consulting, we again expect double digit revenue growth. In Infrastructure, given product cycle dynamics, We expect fairly consistent performance with the Q3, which was a high single digit decline. 2nd, tax. I mentioned the timing of discrete tax benefits occurred earlier than we previously anticipated as we prepared for the Kyndro separation. We still expect our full year tax rate to be in the low teens range, in line with what we indicated back in January.

Speaker 3

That's our all in rate, including discrete tax items and applies a 4th quarter tax rate in the high teens. And then finally, IBM's 4th quarter consolidated results will reflect the Kyndryl separation. I'll frame the revenue and earnings per share implications based on the last couple of years. Kyndryl historically represented Just under $5,000,000,000 of revenue in the 4th quarter, with about $3,500,000,000 of that in November December. At the same time, we estimate we'll get about $350,000,000 from incremental sales in those 2 months From the new commercial relationship, the net impact to IBM consolidated results is a reduction of about $3,000,000,000 of revenue For November December due to the separation.

Speaker 3

And for those 2 months, we estimate an impact of $0.20 to $0.25 of earnings per share, including the new commercial relationship. At the time of separation, Kyndryl will be presented in discontinued operations with the balance of IBM in continuing operations. We will provide a historical restatement of continuing operations before the end of the year. We are on the threshold of the future IBM. We expect to exit the 4th quarter in a position to deliver our mid term model, A mid single digit revenue growth and cumulative free cash flow of $35,000,000,000 in 2022 to 2024.

Speaker 3

So with that, we'll be happy to take your questions. I'll turn it back to Patricia.

Speaker 1

Thank you, Jim. Before we begin the Q and A, I'd like to mention a few items. First, several references were made today to IBM's new Segment structure, which will be effective immediately prior to the Kyndryl separation. We provided information on the new segment scope and naming an article posted to our investor website at the beginning of this month. 2nd, supplemental information is provided at the end of the presentation.

Speaker 1

This concludes the schedule of the availability of recast financial information for IBM post separation. And finally, as always, I'd ask Operator, let's please open it up for questions.

Operator

Thank you. At this time, we will begin the question and answer session of the conference. Our first question comes from Wamsi Mohan with Bank of America. Sir, your line is open.

Speaker 4

Yes, thank you. Arvind, there seems to be a lot of concerns around the actual separation in terms of Potential disruptions, you noted on this call that you saw some hesitation or pause in spending. Do you feel given the changes that you have put in place also with sales comp, do you feel comfortable about the Trajectory of the business once you get past this threshold of near term disruption that you highlighted. And if I could, Jim, you noted about $2,500,000,000 onetime bump from Kyndryl In 2022, can you maybe calibrate that number for 2021 as well? That would be helpful.

Speaker 4

Thank you.

Speaker 2

Hey, Wamsi, thanks for the question. Look, I'd like to be very clear. I think that any and I would not use the word disruption, Wamsi. I would use the word that there may be a slight pause, which is the words that I used in my prepared remarks. I think there's a slight pause And it will be the end of Q3, maybe the beginning of Q4, and we see that pause mostly In hardware and in Kyndryl itself.

Speaker 3

By the way, just

Speaker 2

to add some color, why do you see that? There has been a lot of Hardware that actually does flow through Kyndryl. And many people, many of our clients think of that as being an alternate way that they have Procured infrastructure in the past. So it's not a surprise given the size of the relationship with Armando's clients that we see a pause in some of them. By the way, I think that that's the complete nature of it.

Speaker 2

When I look at our pipeline, I look at our sales compensation, I look at our executive compensation, I am completely confident that this will be well behind us by the beginning of 2022, meaning by January, well behind us. And as we also get into a new product cycle on some of the hardware in the first half of twenty twenty two, I think that will put it completely behind us. And so my view is that we hold firm to our 2022 and forward projections and this has actually got No long term or systemic issues that I see both in the numbers, in the pipelines and in the actual

Speaker 3

Thanks, Wamsi. To your second question, remember back on October 4th, at our Investor Day, we talked about the strong strategic relationship between IBM and Kyndryl going forward, of which I think at that time we shared About $2,500,000,000 of annualized business, predominantly structured around our high value, Mission critical recurring revenue of software and also some in our infrastructure segment around hardware purchases and around our infrastructure That was a full year annualized view. If you look at Q4, we're going to have 2 months' worth of that in 2021. And we estimate that that's about $350,000,000 to $400,000,000 So if you go back to what I said on October 4, the 2022 to compare to 2021, 12 months versus 2 months Is give or take about a little bit over $2,000,000,000 and that translates into the three points of incremental growth one time above our mid single digit model in midterm.

Speaker 1

Thanks, Wamsi. Let's go to the next question.

Operator

Our next question comes from Tony Sacconaghi, Bernstein. Your line is open.

Speaker 5

Yes, thank you. And I think Arvind, you touched on this in the first question, But perhaps let me ask it a little more directly. So this quarter, IBM grew at 1.9% for RemainCo Versus the comparison of constant currency at minus 3.5%. The comparisons get about 2 or 3 points More difficult looking into next year and you have to accelerate your growth rate to get to mid single digit growth By 2 or 3 points. So effectively adjusting for compares, the growth rate has to improve about 5 percentage points relative to what you did This quarter to hit that mid single digit target.

Speaker 5

Beyond a product cycle in Mainframe and the UNIX, Given you talked about sort of taking time for investments to pay off, what is going Seemingly pretty suddenly changed the growth profile adjusting for comps by potentially 4 or 5 or 6 points over The next few quarters. And how long do you continue to Expect to invest, I. E, have pressure on operating margins, particularly in software and GBS going forward? Thank you.

Speaker 2

Okay. Thanks, Tony. I'll take the first part of that and then I'll look at Jim for the second part of the question. Look, Tony, there's 3 parts of it. First, let me acknowledge, yes, our growth rates have to improve.

Speaker 2

So no question about it. We are not saying we are done. The three elements that will contribute to the growth rate, I think a lot of what you were pointing to was towards the software growth rate. I'll say it comes from 3 things. 1, We are seeing improvements in our organic, meaning the software we already have.

Speaker 2

We continue to see that. We expect that that will improve the software growth rates by a few points. I won't Actually, I'll say the upper bound because I don't expect that the three elements I mentioned all of them will all return at their upper bound. So let's say 1 or 2 points from the organic growth rate. 2, we will continue to make Acquisitions.

Speaker 2

So not only do the ones we have made keep contributing because they are growing well into double digit growth rates, For the new ones we make will also contribute to that. Think of that to be in the same range. The third one as we are making A lot of changes in our sales compensation as well as in the makeup of our sales teams. We talk about the garages, we talk about client Best managers leading to more experiential and more technical selling. We believe that will drive greater deployment and hence Quaker purchases in that segment and so all of those together will contribute towards a much improved growth rate In the software segment, up to the mid single digit, as I think you're pointing out in some of your math.

Speaker 2

I'm not going to debate is it 3%, 4% or 5%. Happy to do that when we have a bit more time. And I'll pass it over to Jim for the second part of

Speaker 3

the question. To that point, I can't resist but go into the numbers. So let's just Tony, great question. Thank you Let's talk about this quarter. Again, IBM X Kyndryl delivered about 2% growth.

Speaker 3

By the way, that's an accelerating trend, as we talked about in prepared remarks, from about flat through the first half to now growing 2%. Yes, often easier compare, we acknowledge that. But let's take a look at the revenue contribution analysis of What contributed to that two points? And now I'll tie it back to what we said on October 4th as our mid single digit Growth rate model. We said across our three segments.

Speaker 3

First, we have an improving growth profile as we shift to higher Which, by the way, also carries a higher value recurring revenue stream that those two segments will contribute all five points of IBM's growth. By the way, with improving operating margins, which I'll get into at the end, the Infrastructure segment, which is high value mission critical covering our mainframe, business and infrastructure support business It was projected to be flat over time as it follows innovation cycle. So as we bring out innovation next year, we Firmly believe and confident that we're going to grow there, but over a 3 year period, that's about flat, but a significant cash generator. So you got 2 growth factors, 1 value vector, 2 delivering growth, 1 delivering cash generation. Now let's look at how the 3rd quarter played out.

Speaker 3

Against that 70 plus percent of our 2 growth factors that targeted a 5 point contribution, we delivered 4.5 points Revenue growth to IBM. We fell about 0.5 point short, and that's in the software area because we overachieved In GBS, we have a strong book of business in GBS, now IBM Consulting, and we see that continuing to play out. We got work to do on software, but we're making underlying business performance because as you all know, you see the data, Our deferred revenue tailwind dissipates over time, and we lost about a point of growth in software Just due to the deferred revenue tailwind, which means that the underlying business of our pro form a IBM software Continues to improve. Why do we feel confident moving forward just adding to some of the points of Arvind? Number 1, We've been 5 quarters in a row now with strong renewal rates.

Speaker 3

80% of our software business Is recurring revenue, high value recurring revenue, and you see that in our deferred income and deferred revenue balance up $800,000,000 year over year. Number 2, we see nice acceleration in ARR and by the way NRR north of 100% again This is the 3rd consecutive quarter, and we're starting to see nice acceleration in Cloud Paks. And most importantly, as we talked about Three quarters ago, we are now starting to enter the early parts of our ELA cycle that will continue into 2022 In the first half of twenty twenty three, we feel pretty confident about the 2 growth factors. Where we missed It is based on being on the back end of a very successful mainframe cycle. The Infrastructure This segment took 2.5 points of growth away from IBM ex Kyndryl.

Speaker 3

So plus 4.5 points against the target of 5, We lost 2.5 points in infrastructure, and that will moderate out over time as we bring new innovation. And then finally, just wrapping up on your operating margin comment. We said entering this year, 2 most important measures, revenue growth, Free cash flow generation. We're achieving on both of those. We said that free cash flow generation was going to be important Because we needed to fuel investment in innovation and in IBM Consulting because we saw robust demand.

Speaker 3

We're playing that out consciously. We'll see that improve as we get into 2022, But we're still driving that cash, and I'll wrap up year to date through Q3, growing revenue, growing revenue ex Kyndryl, at constant currency, we're growing gross and pretax dollars, we're growing pretax margin, and we're growing Trailing 12 months free cash flow. So that's the model that we put in place, and we feel pretty confident as we enter 2022.

Speaker 1

Thank you, Toni. Victor, can we please take the next question?

Operator

Our next question comes from Katy Huberty with Morgan Stanley. Your line is open.

Speaker 6

Yes. Thank you. Arvind, you referenced the pauses in Kyndryl and hardware in the quarter, but software performance was also light of So can you talk about what drove the shortfall in cloud and cognitive software and where you see opportunities for better execution within that software business?

Speaker 2

Yes. Thanks, Katie. Yes, certainly, as actually even Jim acknowledged that we fell maybe a half point short of our own expectations and we Could have done better. Here is where I see it doing better. First, the one that performed exactly according to what we wanted was Red Hat.

Speaker 2

Red Hat gave us 17%, which is pretty much what we wanted and expected. If I now look at Our transaction processing platform, it was a little bit below what we would like because we have been saying that in a long term model that It'd be more mid single digit decliner, but this quarter it was a high single digit decliner. We think that as we get past because that is coupled, I wouldn't call it identical, but it is coupled to some of the infrastructure cycles. I expect that to come back starting in early 2022 or maybe late in 2021. Then on our category that is today called AI applications, We were minus 1%.

Speaker 2

There, I would expect us to get back to mid single digit growth. Now you sort of say, if I put it all together, Do we expect to see a tiny bit, I've got a tiny bit of pausing from people because of everything going on? Yes. Thank you. We are turning our incentive models.

Speaker 2

I spoke on it on the prior question very briefly. Our incentive models for our sales team I'm going to be very heavily tuned towards software going forward in 2022. That I believe Will result in better, much better performance because the only way that they will get anywhere near the target incentives is to make the software number. That is probably for the first time that that's been true in a long, long time at IBM. So Katie, that's sort of my view on what happened there

Operator

Our next question comes from Tien Tsin Huang with JPMorgan. Your line is open.

Speaker 7

Hey, thanks. It's good to I wanted to ask on the GBS side. So that did accelerate double digit revenue growth. It sounds like Q4 you expect that too, but it did come at a higher cost. So I'm just curious on the gross margin percentage front.

Speaker 7

So I'm curious on the confidence that you can reprice to offset the higher cost of delivery. Is there Risk that those costs could persist here, given all the demand side that you're seeing. Thank you.

Speaker 3

Yes. Tien Tsin, this is Jim. I'll take that as we move forward. As I stated earlier and Arvind commented in the prepared remarks, We do see a very robust demand environment out there. We called it as we were going through 4th quarter, We called a very conscious strategy, GBS, now IBM Consulting, again, plays a very integral role to our Hybrid Cloud Platform Centric Business Model.

Speaker 3

Why? Because it drives scale and adoption to our platform And it also fools IBM Technology, while taking advantage of the ecosystem and partnership in Skill and capabilities. So we started aggressively adding skill, capacity, expertise, Ecosystem partnerships and scaling acquisitions. I think we just announced today Our 8th CBS acquisition in the last 12 months overall. So it was a conscious strategy.

Speaker 3

And we believe that, that flywheel effect of GBS that turns into the multiplier Of driving our platform, pulling our software and driving a very robust Economic equation for our ecosystem partners is essential in our long term strategy. Now with that said, We saw margins down 3 10 basis points. We saw pretax margins down 110 basis Within that though, we grew gross profit dollars and we grew pretax dollars. We're about generating growth in top line and around generating cash contribution in GBS delivered debt I would also mention that GBS accelerated their margins quarter to quarter tremendously. Pre tax margins were up 5 points quarter to quarter, and they've been accelerating their gross margins sequentially every single quarter this year.

Speaker 3

So we delivered over 13 points of pretax margin in the 3rd quarter and our model as we said on October 4 was low teens. So we feel pretty comfortable. We see a very good book of business and we continue to see in Q4 IBM Consulting delivering double digit revenue growth and margin dollar and profit dollar and cash dollar contribution while pulling our software and hybrid cloud platform.

Speaker 1

Thanks, Tien Tsin. Let's go to the next question, please.

Operator

Our next question comes from Jim Suva with Citigroup. Your line is open.

Speaker 8

Thank you very much. My question Since a lot of them have been answered, there's just one of them and that is the impact of higher labor costs. No matter where you look, labor costs are going higher. And I do see that in your prepared slides that you did give that your signings were up 3%. So should we think about as time rolls forward, you'll implement more labor costs that escalate and go higher?

Speaker 8

Or Are they actually material enough so we should be modeling some adjustments into your cash flows? Or how should we kind of think about that as you work through the business because it's a pretty dynamic and fluid

Speaker 2

So Jim, great question. And by the way, I would tell you that I don't think that this year is unique. Maybe there's a touch more Issue is going on, but I don't think it's unique. I remember 2,001 really well. I remember 2,007 just before the financial crisis.

Speaker 2

This is a continuous movie in the technology industry. Now, you said the 3% signings growth. I wouldn't look at the 3%. I would look at our book to bill ratio, which is 1.1. And so book to bill gives a much better signal of what the demand is for our Forward looking revenue and demand in our IBM Consulting business.

Speaker 2

Now, look, labor has to be managed. We have a global labor model. We put people everywhere. And as Jim just mentioned in answers to the prior question Yes, when you do have inflation in your labor costs, there is an element of it that's going to price through For that side of the business. In all the rest of the business, actually I'm not so worried about labor cost.

Speaker 2

I'm worried about getting the right talent maybe, but that is always a worry that I have and I've been paranoid I bought that for 30 years. That's not unique. And I think it's similar to many of your businesses, Jim, like And not just yours, but all of your colleagues here on this call. The right talent is far more important. And while labor cost is important, In the end of the day, it's maybe 15%, 20% of the total cost and expense that is sort of critical towards the other businesses Because you can manage the rest.

Speaker 2

So net answer to you is, no, it's not something that needs to be modeled in. I don't believe so. But We always have to worry about it in terms of how do we price, how do we get the labor pools, where do we put the labor pools and all of those elements.

Speaker 1

Excellent. Thank you, Jim. Let's go to the next question please.

Operator

Our next question comes from Keith Bachman with Bank of Montreal, your line is open.

Speaker 9

Hi, many thanks for taking the question. I wanted to ask first on Cloud Paks. You seem to be suggesting that this is going to be a key or one of the many enablers to drive growth. And I was hoping you could explain a little bit why Cloud PEX, because it sounds Very similar to bundling, which IBM and many companies have been doing for years. So I want to try to understand a little bit why Cloud Paks It's different from the historic bundling that IBM has been doing.

Speaker 9

And then secondly, if I could just ask Jim, a question I've asked before is on Software maintenance, a good quarter on easy compares. And I just wanted to get your thoughts on the durability The software maintenance, not whether it's important, but is it in fact a growth category as we look out within GBS over the next 2 years, 3 years? Many thanks.

Speaker 2

Okay. So Keith, I'll take the first part of that question on Cloud Paks. So Cloud Paks are not just bundles and they're not just Containerizing software. I'll tell you right away, if all you do is bundle software, you'll actually get a price deflation. If all you do is containerize software, there'll be no plus or minus.

Speaker 2

It's just a different way of delivering it. So I'll take one of the cloud packs and maybe use it as a quick exemplar. If I take our cloud back for data, if I now turn around and tell you that whether we take some of our integration software or whether we take a database software like DB2, And that's all you provide through that? You're right. There's neither plus nor minus.

Speaker 2

I think it will stay where it is. However, It's not just putting those in as options. A lot of the Cloud Pak for Data is actually new innovation. It includes methods around data fabric. It includes methods around how do you federate data both from public clouds And from other repositories that are probably not IBM's inside the client's on premise environment.

Speaker 2

It contains the data catalog. It contains these ways to be able to do some competition without even moving the data. That new content Added to some of the existing content, we take advantage of our incumbency, but we get lift because there is more usage overall for these technologies As there was before, is why we are so excited about Cloud Paks and where it gives us both. Yes, some of it is just going to be a movement, but a lot of it is actually increased usage. And hopefully that sort of made the example clear on how we are driving innovation into the portfolio with that one example.

Speaker 2

So, Jim, I'll give it to you to address the I don't know whether to phrase maintenance as ARR or NRR.

Speaker 3

I think Keith and I'm interpreting your question given you applied it to GBS and we've had this discussion Many quarters appropriately so. And you're talking about Application Management Services, AMS. If I'm not answering the right question, please get back to Patricia and we can move forward from there. But AMS, As we've talked about for a handful of quarters, we got back to growth, up 5%, accelerated that growth, albeit, as we said in the prepared remarks, Offer much easier compared during the height of the pandemic last year in Q3. But it was up this quarter as we had growth in offerings, which modernized The clients' applications and as we move them to a hybrid cloud, we talked about our application management having a tremendous incumbency value In a hybrid cloud platform centric model, why?

Speaker 3

Because what we've seen and learned over the last 2 plus years After the acquisition of Red Hat is that, one, we've built up a $3,500,000,000 book of business around our Red Hat practice in GBS from a dead start during the acquisition. And we built that up of that $3,500,000,000 over a quarter the 3 quarters of that book of business Is in AMS accounts. 2nd, AMS or excuse me, GBS driving that flywheel effect I talked about earlier It actually delivers over 1 third of our cloud revenue Cloud Pak revenue growth each quarter. And within that, 80% are AMS accounts. So there is a causality and a correlation here between our strong incumbency base, us having industry business process knowledge And the technical expertise to be the clients' trusted partner to move them along their journey to cloud, AMS is a very integral part.

Speaker 3

So we saw good growth. And by the way, our penetration of AMS cloud activity, Remember, we talked about in the past this predominantly being an on prem enterprise application concentration issue. We continue to make progress. We're about close to 40% of our AMS business is now cloud, and we're capitalizing on Red Hat. We're capitalizing And we're capitalizing on very strong ecosystem partnerships with SAP S4HANA to name 1 as we move forward.

Speaker 1

Very good. Thank you, Keith. Victor, let's take one last question.

Operator

Certainly. Our final question comes from David Grossman with Stifel.

Speaker 10

Thank you and thanks for squeezing me in here. Just two really quick ones. First, How much, if any, of the revenue with Tyndryl is activity based, which may be dependent on their own execution? And then secondly, Jim, you mentioned the ELA cycle starting up, I think, early 2022. Perhaps you could share with us just how much of a headwind that it's been and Which segments it's impacted most?

Speaker 10

Thanks.

Speaker 3

David, thank you very much for the question. I think I'll take both and then Arvind can Wrap it up here. Overall, first around Kyndryl, if you go back to October 4 at the Investor Day, which we were pretty transparent And we said we're going to continue that transparency into 2022 around the external sales with A strong strategic relationship between IBM and Kyndryl. We set about on a full year basis $2,500,000,000 give or take. And in 2022, when you got 12 months versus 2 months in 2021, it'd be about $2,000,000,000 of incremental are about 3 points.

Speaker 3

Within that, David, the majority of that is in software And a majority of that is annuitized based, high value, mission critical based recurring revenue. So if you're thinking about do we have any deflationary impacts around that $2,000,000,000 plus on the software side, which The majority of it, no. The second component is we have about annualized about $500,000,000 With regards to our infrastructure support and hardware. On the infrastructure support, it's Again, annuitized based business overall. And with regards to hardware, in our strategic relationship, as we set Kyndryl up, We've given them a pretty aggressive and component of an aged inventory refresh program.

Speaker 3

So we have very little hardware purchases over probably the next 18 months to 2 years, Given we just went through a big asset refresh, so long answer to your question, but I don't think we have a lot Of impact moving forward against that. 2nd, around the ELA cycle, you know this quite well. It's typically a 3 plus year. The dynamics of client buying behaviors change over time, but we feel very confident. The good news is here is we have a lot of headroom.

Speaker 3

We're just starting the early part of that in Q4. That will predominantly play out in 2022 And then we'll also extend early into 2023 as we move forward. And if you look at our transactional related activity, we've been making Strong performance improvement in our annuitized base business with renewal rates and our on prem transactional business We struggled, especially during the pandemic. This will bolster that as we move forward. And most importantly, We feel confident in the investments in innovation and what we're bringing to market with our modernized and containerized Cloud Pak offerings Optimized on top of our hybrid cloud Red Hat platform that we're good.

Speaker 3

So with that, let me turn it over to Arvind.

Speaker 2

Thanks, Jim. Look, and first, I'd like to thank all of you for your questions. I thought they were really getting into the details, and hopefully, It helped our answers helped you understand our business a lot better. Let me just make a couple of comments to wrap it up. I hope you took away is that we continue to make this Progress this quarter in the key areas.

Speaker 2

Both myself and Jim highlighted them in our key areas of growth And in our value vectors as we go forward, especially looking into 2023. But we'll also acknowledge that we always have more to do. Importantly, we are on the threshold of the IBM of the future, and we expect to exit the year In a position that delivers on our midterm model starting in 2022, that is the Sustainable mid single digit revenue growth and the increasing free cash flow that fuels all the investments. So with that, I look forward to speaking to all of you again.

Speaker 1

Irvin, thanks. Victor, let me turn it back to you to close out the call.

Operator

Thank you for participating on today's call. The conference has now ended. You may disconnect at this time.

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