International Business Machines Q4 2022 Earnings Call Transcript

Quartr
Provided by Quartr
January 25, 2023

There are 10 speakers on the call.

Operator

Now I will turn the meeting over to Ms. 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 Q4 2022 earnings presentation. I'm here today with Arvind Krishna, IBM's Chairman and Chief Executive Officer and Jim Kavanaugh, IBM's Senior Vice President and Chief Financial Officer. We'll post today's prepared remarks on the IBM Investor website within a couple of hours and a replay will be available by this time tomorrow. To provide additional information to our investors, our presentation includes certain non GAAP measures.

Speaker 1

For example, All of our references to revenue growth are at constant currency. We have provided reconciliation charts for these and other non GAAP measures at the end of the presentation, which is posted to our investor website. Finally, some 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. Additional information about these factors is included in the company's SEC filings.

Speaker 1

So with that, I'll turn the call over to Arvind.

Speaker 2

Thank you for joining us. Our 4th quarter and full year results demonstrate execution of our hybrid cloud and AI strategy. We delivered strong revenue growth in our business. The growth was broad based across our software, consulting and infrastructure segments as well as across geographies. Our clients recognize that technology continues to be a fundamental source of competitive advantage.

Speaker 2

Over the last several quarters, It has become clear that technology is playing a significant role in boosting productivity in the face of inflation, Demographic shifts, supply chain challenges and sustainability requirements. We entered 2022 To bolster our software portfolio, we invested in hybrid cloud and AI capabilities. We also delivered significant innovations in infrastructure with our Z16 and Power Platforms. All of this was brought to market with a more technical and experiential sales approach. Looking back on the year, we are pleased with the progress we made.

Speaker 2

We delivered revenue growth above our mid single digit model And we delivered solid free cash flow. But I'll acknowledge there is more to do. This year, we'll unlock more productivity, expand our strategic partnerships and put more investment in specific growth markets. For 2023, we see revenue growth in line with our mid single digit model range and about $10,500,000,000 of free cash flow. This keeps us on a path of sustainable growth.

Speaker 2

I will now provide some color on the progress we are making in the execution of our strategy. Our perspective is clear. Hybrid cloud and AI are the 2 most transformative technologies for business today. These technologies work together to drive business outcomes. Hybrid cloud is where the world is going.

Speaker 2

Containers are the preferred destination for applications. Hybrid cloud offers more value and relying on a singular public cloud. It enables organizations to drive business value across multiple clouds, seamless experiences and faster innovation cycles. Our platform built on Red Hat Structured Technologies have been optimized for this platform. Our consultants and others leverage their extensive technical and business To accelerate clients' digital transformation journeys.

Speaker 2

Clients are realizing real value from working with IBM's hybrid cloud platform approach. For example, we worked with the Canadian Imperial Bank of Commerce, CIBC to adopt a hybrid cloud approach. Using Red Hat technology, CIBC manages and scales its infrastructure with We delivered hundreds of new applications and reduced provisioning time by 95% and deployment time by 50%. We are helping Delta Airlines leverage hybrid cloud to modernize operations, automate operations and integrate security. IBM Consulting deployed Red Hat on Amazon Web Services and IBM Cloud PACS to provide a consistent platform.

Speaker 2

Delta now has more levers it can use to boost developer productivity, reduce time to market and improve employee satisfaction. CIBC and Delta are both great examples of the value hybrid cloud can provide. $15,000,000,000,000 to the global economy by 2,030, including a massive boost in productivity By infusing AI into every enterprise process, we have been co creating with many clients to deploy AI at scale. We automated the drive through experience for quick serve restaurants. We accelerated the rollout of COVID-nineteen vaccines by automating the processes that assist millions of customers with inquiries and appointments.

Speaker 2

By applying AI and automation, We have helped security analysts reduce the time to respond to threats from hours or days to minutes. Recently, the U. S. Patent and Trademark Office partnered with IBM to leverage a host of AI capabilities that make it easier for people to glean insights from their vast database of patents. The BBC is now using our AIOps software to automate the management of its IT infrastructure.

Speaker 2

For businesses, deploying AI can be challenging because it takes time to train each model. But by using large language models, companies can now create multiple models using the same data set. This means businesses can deploy AI with a fraction of the time and resources. That is why we are investing in large language All foundation models for our clients and have infused these capabilities across our AI portfolio. Our partner ecosystem plays a critical role in the execution of our strategy.

Speaker 2

In the 4th quarter, We made a series of new IBM software offerings available as a service in the AWS marketplace. Likewise, Red Hat continued the expansion of its offerings in hyperscaler marketplaces, making Ansible Automation Platform available on both Azure and AWS. Adobe and Salesforce are also leveraging open source innovation Based on Red Hat Technologies and their offerings, business with our strategic partners continues to grow with SAP, Microsoft and AWS All over $1,000,000,000 in revenue for the year. We've had great success with our strategic partners. And as we enter the New Year, We are expanding and better enabling our broader ecosystem.

Speaker 2

Recently launched Partner Plus, a new simplified program that increases our reach and scale through new and existing IBM partners. We remain focused on delivering new innovations that matter to our clients. The Q4, we introduced Red Hat Device Edge, A lightweight solution to flexibly deploy traditional or containerized workloads on small devices, such as robots, IoT gateways, to leverage the depth of our intellectual property on advanced semiconductors. We unveiled Osprey, a 433 Cubit Quantum processor that brings us closer to delivering our goal of building a 1,000 cubit system later this year. At the same time, we continue to acquire companies to complement our organic innovation.

Speaker 2

In the Q4, we acquired Okto, As sustainability becomes more of a priority, companies need digital technologies to analyze data, creating a baseline and improve the way they operate. Our software has helped IBM reduce its own carbon footprint. Across IBM's global real estate presence, We were able to reduce carbon emissions by over 61% when compared to 2010. Using IBM Sustainability Software, we have simplified and automated our sustainability reporting processes and reduced reporting costs by 30%. Let me wrap by saying, I'm pleased with the progress we have made with our portfolio, our go to market and our ecosystem.

Speaker 2

I'm confident in our ability to leverage hybrid cloud and AI to help clients turn business challenges into opportunities. Our strategy continues to strongly resonate with clients and partners, and this gives us a solid foundation to build upon in this year.

Speaker 3

Thanks, Arvind. I'll start with the financial highlights of the Q4. We delivered $16,700,000,000 in revenue, In our seasonally strongest quarter, we generated $5,200,000,000 of free cash flow. Our revenue for the quarter was up over 6 and we are now at a constant currency. While the dollar weakened a bit from 90 days ago, it still impacted our reported revenue by over $1,000,000,000 and 6.3 points of growth.

Speaker 3

As always, I'll focus my comments on constant currency. And I'll remind you that we wrapped on the separation of Kyndryl at the beginning of November. The 1 month contribution to our Q4 revenue growth was offset by the impact of our divested health business. Revenue growth this quarter and was again broad based. Software revenue was up 8% and consulting up 9%.

Speaker 3

These are our growth vectors and represent over 70% of our revenue. Infrastructure was up 7%. With mid single digit growth or better in Americas, EMEA and Asia Pacific. And for the year, we gained share overall. We had strong transactional growth in software and hardware to close the year.

Speaker 3

At the same time, Our recurring revenue, which provides a solid base of revenue and profit, also grew, led by software. I'll remind you that on an annual basis, about half of our revenue is recurring. Over the last year, As we land the platform, we get a multiplier effect across software, consulting and infrastructure. For the year, our hybrid cloud revenue was over $22,000,000,000 up 17% from 2021. This reflects a strong portfolio mix and improving software and consulting margins.

Speaker 3

The same dynamics drove a 60 basis point increase in operating gross margin. Our expense was down year to year, driven by currency dynamics. Within our base expense, the work we're doing to digitally transform our operations provides flexibility to continue to invest in innovation and in talent. Our operating tax rate was 14%, which is flat versus last year. And our operating earnings per share of $3.60 was up over 7%.

Speaker 3

Turning to free cash flow. We generated $5,200,000,000 in the quarter $9,300,000,000 for the year. Our full year free cash flow is up $2,800,000,000 from 2021. As we talked about all year, We have a few drivers of our free cash flow growth. First, I'll remind you, 20 21's cash flow results including Kyndryl related activity, including the impact of spin charges and CapEx.

Speaker 3

Despite strong collections, the combination of revenue performance above our model and the timing of the transactions in the quarter led to higher than expected working capital at the end of the year. This impacted our free cash flow performance versus expectations. Our year to year free cash flow growth Also includes a modest tailwind from cash tax payments and lower payments for structural action, We invested $2,300,000,000 to acquire 8 companies across software and consulting, mitigated by over $1,000,000,000 in proceeds from divested businesses, and we returned nearly $6,000,000,000 to shareholders in the form of dividends. From a balance sheet perspective, we ended the year in a strong liquidity position with cash of $8,800,000,000 This is up over $1,000,000,000 year to year, and our debt balance is down nearly $1,000,000,000 Our balance sheet remains strong, and I say the same for our retirement related plans. At year end, Our worldwide tax qualified plans are funded at 114%, with the U.

Speaker 3

S. At 125%. Both are up year to year. You'll recall back in September, we took another step to reduce the risk profile of our plans. Without changing the benefits payable to plan participants.

Speaker 3

This resulted in a significant non cash charge in our GAAP results in the Q3, and we'll see a benefit in our non operating charges going forward. Turning to the segments. Software revenue grew 8%, fueled by growth in both Hybrid Platform and Solutions and transaction processing. We concluded the year with seasonally strong transactional performance as well as a solid and growing recurring revenue base in software. In Hybrid Platform and Solutions, revenue was up 10% with pervasive growth across our business areas, Red Hat, automation, data and AI and security.

Speaker 3

Our platform based approach to hybrid cloud and AI is resonating with clients. As a proof point, OpenShift, our industry leading hybrid cloud platform, now has $1,000,000,000 in annual recurring revenue, and we modernize and optimize our software capabilities, including through cloud packs across automation, data and AI and security for that platform. Red Hat revenue grew 15% in the quarter, led by strength in OpenShift and Ansible, both growing double digits and gaining market share. Automation revenue was up 9%. Growth was led by business automation, application servers and integration as clients look to automate business workflows and improved applications.

Speaker 3

Data and AI revenue grew 8% with enterprise needs to organize, store and manage their data. This performance reflects demand in areas including data management, data fabric and asset and supply chain management. The annual recurring revenue or ARR for Hybrid Platform and Solutions is $13,300,000,000 And for all of software, hybrid cloud revenue is now more than $9,300,000,000 over the last year, up 16%. In transaction processing, revenue was up 3%. Demand for this mission critical software has followed increases in Z Systems' installed base capacity over the last couple of product cycles, And strong renewal rates continued this quarter.

Speaker 3

Both are evidence of the importance of this platform in a hybrid cloud environment. Moving to software profit. Our pretax margin was up 2 points this quarter, contributing to a full year margin of nearly 25%. Consulting revenue grew 9%. Clients are leveraging IBM's hybrid cloud leadership and deep industry expertise to navigate the complexity of their digital transformation journeys.

Speaker 3

Revenue growth was broad based Consulting delivered in the Q4 of 2021. Strong demand for our offerings led to signings growth of 17%. With this, 4th quarter had the best quarterly book to bill of the year, and we sequentially improved Our trailing 12 month book to bill ratio to 1.1. Clients are partnering with IBM Consulting as they decide what applications to modernize and how to migrate those applications across hybrid Multi cloud environments. Over the last 12 months, consulting delivered $9,000,000,000 in hybrid cloud revenue, Revenue from strategic partnerships also grew at a strong double digit rate.

Speaker 3

We continue to see momentum In aggregate, our strategic partnership bookings were up over 50% With Azure and AWS more than doubling. Turning to our lines of business, Business Transformation revenue grew 7%. Growth in Business Transformation was once again driven by data and client to transform critical workloads at scale. In technology consulting, where we architect and implement clients' Cloud Platforms and Strategies, revenue was up 10%. Growth was led by cloud application development practices.

Speaker 3

Red Hat engagements, along with our strategic hyperscaler partnerships, contributed to the growth. Application operations revenue grew 12%. We help clients to optimize their operations and reduce costs Applications are key differentiators. Moving to consulting profit. Our pretax margin was 11% for the quarter and nearly 9% for the year.

Speaker 3

The 4th quarter margin is up nearly 2 points year to year and over 1 point sequentially. We are starting to see the benefit from pricing actions and productivity, and our acquisitions have become more accretive. Turning to Infrastructure segment. Revenue grew 7%, driven by Hybrid Infrastructure, which was up 11%. Within hybrid infrastructure, Z Systems revenue grew 21% this quarter.

Speaker 3

Among the new C16 capabilities, clients are leveraging cyber resiliency to comply with business regulations and proactively avoid outages in their operation. And the new on chip AI accelerator, for example, has been helping mitigate risk and detect fraud in credit card application processes. Our distributed infrastructure revenue was up 5%. This performance was fueled by strength in power, following the extension of Power10 innovation throughout the product line. Infrastructure support performance was flat, including the impact from client adoption of new hardware with the latest Z16 product cycle.

Speaker 3

Moving to infrastructure profit, pretax margin was down less than a point in the quarter. And for the full year, our pre tax margin was nearly 15%. Now let me bring it back up to the IBM level to wrap up. At our investor briefing 15 months ago, We laid out our hybrid cloud and AI strategy and our priorities of revenue growth and free cash flow generation. Since then, We've been focused on our portfolio, our go to market model, our ecosystem and our capital allocation Our 2022 revenue was up nearly 12%, including nearly 4 points of incremental Kyndryl contribution.

Speaker 3

That's above our model of mid single digit growth. Over 70% of our revenue within our growth vectors of software and consulting and about half of our revenue is recurring. Margin by 2.5 points, and our free cash flow was $9,300,000,000 up $2,800,000,000 from the prior year. We invested organically and inorganically and returned significant value to shareholders through dividends. Now there were some external factors that we faced this past year that impacted our profit and cash.

Speaker 3

Putting it all together, we are pleased with the fundamentals of our business and the progress we have made in executing our strategy. Our 2022 performance demonstrates that we now have a higher growth, higher value company with higher return on invested capital and a strong and growing free cash flow. For 2023, We again expect solid growth in our 2 most important measures of success, revenue and free cash flow. Arvind talked about the important role technology plays in this environment and how our solutions are closely aligned to the needs of our clients. With this, we expect constant currency revenue growth for the year to be in line with our mid single digit model.

Speaker 3

As we enter this year, I think it's prudent to expect The low end of the mid single digit model. And for free cash flow, we'd expect to generate about $10,500,000,000 in 2023, which is up over $1,000,000,000 year to year. Let me spend a minute on our expectations for Constant currency revenue and pretax profit performance by segment. In software, With continued momentum in our recurring revenue stream in both Hybrid Platform and Solutions and Transaction Processing, We expect revenue growth in line with software's mid single digit model. This revenue growth generates operating leverage, and we'd expect software pretax margin to expand by about 2 points year to year.

Speaker 3

Consulting's model is to deliver high single digit revenue. We're coming off a strong year with revenue growth of 15% as we help clients with their digital transformations. This momentum and strong book to bill ratio support consulting revenue growth at the high end of its model despite the tough compare. We expect to expand consulting pretax margin by at least a point as we continue to realize more of the price increases and improved utilization. Infrastructure revenue is roughly flat over the mid term model horizon, with performance in any year reflecting product cycle dynamics.

Speaker 3

We're entering the year 3 quarters into the Z16 cycle and will also wrap on Power10. As a result, we expect 2023 infrastructure revenue below its model and pretax margin in the low teens. For perspective, Infrastructure should impact IBM's overall revenue growth by over a point. With these segment dynamics, We would expect IBM's operating pretax margin to expand by about 0.5 point. That's in line with our model.

Speaker 3

1st, as I said, currency was a significant headwind in 2022, impacting revenue by $3,500,000,000 With the movement of spot rates over the last 90 days, Currency translation would be fairly neutral to revenue in 2023, with a headwind in the first half Flipping to a tailwind in a second. But I'll remind you that we had over $650,000,000 and we are now in cash on a year to year basis. 2nd, as you know, we've taken a number of Significant portfolio actions over the last couple of years, which has resulted in some stranded costs in our business. We We expect to address these remaining stranded costs early in the year and anticipate a charge of about $300,000,000 in the first quarter. We would start to see benefits in the second half and payback by the end of the year.

Speaker 3

And then 3rd, We regularly review the useful lives of our assets. Due to advances in technology, we are making an accounting change to extend the useful life of our server and networking equipment effective the 1st January. Based on our year end asset base, we expect this change to benefit 2023 pretax profit by over $200,000,000 There's no benefit to cash. Looking at the Q1, our constant currency revenue growth should be fairly consistent at current spot rates. With operating leverage, we'd expect operating pretax margin to expand 50 to 100 basis points in the Q1, and that's before the charge I just mentioned for the remaining stranded costs.

Speaker 3

Given the timing of currency and stranded cost dynamics, we'd expect about 1 third of our net income in the first half and about 2 thirds in the second half. To sum it all up, We have made a lot of progress this past year. While there's always more work to do, we're confident in the fundamentals of our business

Speaker 1

Before we begin the Q and A, I'd like to mention a couple of items. First, supplemental information for the quarter and the year is provided at the end of the presentation.

Operator

Thank you. At this time, we'll begin the question and answer session of the conference.

Speaker 4

Thanks a lot for taking my question. I guess my question is always around the free cash flow numbers and perhaps you could spend a little bit of time You touched on kind of the 'twenty two levers a fair bit and how you got there. But as I think about calendar 'twenty three free cash flow of $10,500,000,000 or uplift of 1,200,000,000 What are

Speaker 2

the puts and takes?

Speaker 4

What are the bridges that get you there? And then maybe related to that, as I think about what you did in 2022 and 2023, It does imply to get to this $35,000,000,000 number over the over 3 years, dollars 24 would have to be $14,000,000,000 plus. So perhaps you can level set that because I do think from when you provided a $35,000,000,000 number, a fair bit has changed. So maybe a

Speaker 2

bridge for $23,000,000 and just an How are

Speaker 4

you thinking about that $35,000,000 number or 3 years as well? Thank you.

Speaker 3

Thanks, Amit. This is Jim. I appreciate Good question. So let's start there. We saw solid free cash flow generation in 2022, up $2,800,000,000 year over year.

Speaker 3

Now as you remember, we entered 2022. We talked about a very Strong free cash flow generation engine and we put in place a guidance for 2022 well in excess of our model of 7 1st, as we were very transparent, we were going to get at least about Half of that out of the Kyndryl related spin dynamics. That's the charges and CapEx. And we were going to get a little bit more than half of that out of our base operations overall. And I think when you look at 2022, what happened?

Speaker 3

We got impacted by 2 external factors. Number 1, the unfortunate humanitarian crisis with the war in Russia and Ukraine, and we exited that business, the right decision. 2nd Is unprecedented U. S. Dollar appreciation.

Speaker 3

I think last time I looked, the rate, the breadth, the magnitude of the change Is the most we've seen in multiple decades. We got hit with that. But we're able to overcome some of that with the fundamental underpinnings of our business overall and still delivered almost $3,000,000,000 of free cash flow year over year. By the way, Russia and currency By themselves is over $600,000,000 of profit and cash we had to absorb. So now to your question about 2020 3.

Speaker 3

We guided, as you heard in the prepared remarks, at $10,500,000,000 That's up $1,200,000,000 year over year. And again above our $750,000,000 year to year. The underpinnings of that though are going to be very different in 2023. Given the improving business fundamentals of our now sustainable revenue growth with a high value mix Contribution, we see then continued operating leverage. So our cash PTI Is going to deliver a substantial amount of that free cash flow generation year over year.

Speaker 3

We're still going to get working capital efficiency, so our realization will definitely be up over 100%, but that's really given the volume dynamics of what happened in the 4th quarter with a very strong And accelerated growth profiles we went through 4th quarter, we finished extremely strong on our transactional business in the month of December. So that now creates an opportunity for free cash flow generation in 2023, and that's in our guidance. And then there's some other puts and takes. Yes, we'll get modest structural actions tailwind, but they're going to be offset by a cash tax headwind So that kind of plays out 2022 and 2023. Now, how does that relate to a mid term model?

Speaker 3

First of all, we're 1 year into that mid term And as I talked about the dynamics in dealing with the decision to exit our Russia business and the significant U. S. Dollar appreciation, I quantified it for you over a $600,000,000 impact in profit and cash, but as you all know quite well, that's not a one time impact. That will continue over a multi period. And it definitely puts pressure on our midterm model.

Speaker 3

To the tune cumulatively about over $2,500,000,000 So we are entirely focused on how we execute this company on a sustainable revenue growth profile and generating that $10,500,000,000 of free cash flow. So it enables us with the right ample financial flexibility to continue to invest in our business and return value to our shareholders overall.

Speaker 1

Thank you, Amit. Sheila, let's go to the next question.

Operator

Our next question comes from Wamsi Mohan with Bank of America. Your line is open.

Speaker 5

Yes, thank you. Arvind, nice to see the Revenue guide here. I was wondering if you could share some thoughts around what's happening in software in particular. You've had A really strong performance in transaction processing over the past year. How are you thinking about the trajectory of Scott, I know historically we've kind of thought about this as a mid single digit or higher decliner and clearly we're Tracking very differently here.

Speaker 5

If you could share some thoughts around the trajectory of that in 2023 beyond that would be very helpful. Thank you.

Speaker 2

Yes. Thanks, Omzy for the question. So I'll address your transaction processing question first and then all our software right after that. So some of you have heard me talk about that transaction processing would be a mid single digit decliner in the past. And that's effectively, Wamsi, is what you asked, what's going to be different.

Speaker 2

As we look at our business there and we look both At the underlying MIPS growth as well as the criticality of that software as well as our ability to have some very modest Pricing uplifts, we would now look at that business as being a slight increaser as opposed to a modest decliner. So I think if you are looking at that one, Vamsee, low single digit increases Now that does help in overall software. So first, let's look at software and decompose it. Software, as Jim mentioned in his prepared remarks, Is almost 80% recurring revenue. We see that recurring revenue increasing consistent with our model That 'twenty two was a great ELA year, 'twenty three will be not as good as 'twenty two, but With the transactional piece of the business being less than 20%, that has a much smaller impact on the overall growth rate.

Speaker 2

As you put all that together, we see the mid single digits as being appropriate for the software

Speaker 1

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

Operator

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

Speaker 6

Yes, thank you. I was wondering if you could just comment on Operating profit more broadly, I think your target at the beginning of the year was for operating profit to improve 400 basis points And it came in at 270. I think your target for the Q4 was 250 basis point improvement in operating margin and came in at 170. And so and that's manifesting itself into a free cash flow number that was lower than you had expected This year and potentially for next year relative to your $35,000,000,000 target. So You have a dual mandate, Arvind.

Speaker 6

One is to try and grow mid single digits and the other is to deliver very strong cash flow, which is impacted by margins. The margin was not as strong this year, and I'm wondering if you can highlight what was different from your expectations And what were the challenges in forecasting that, and how investors should think about That and free cash flow realization going forward.

Speaker 2

Yes. Tony, thanks. So you're completely accurate that these numbers are slightly below our expectations from the beginning of the year. I will ask Jim to comment and give you a lot more color on it. So let me first comment on your statement of we have a double mandate of revenue growth and free cash flow So, but I want to also be clear.

Speaker 2

Revenue growth as which manifests itself And client satisfaction, higher NPS from our clients, better consumption of both software and consulting from our clients, which allows them to consume more and more over time is what we are focused on and it's an and We have to deliver the free cash flow growth. Jim mentioned in our response to the first question that we were not expecting The business in Russia was shut down. That impacted a little bit. We were not expecting the currency headwinds to be as severe as it turned out to be. That's certainly impacted.

Speaker 2

And I'll acknowledge that inflation, as in wage inflation, showed up and impacted our margins in consulting a lot more than we were expecting. Now an answer could have been to not hire people and to not give that, But that would have resulted then in lower capacity at the end of this year, which would not have allowed us the confidence into the growth both in consulting and in software that we are now committing for 2023. As we balance those, It becomes a business decision to say we are going to keep going on increasing capacity, which results in healthier revenue and it will result in improving margins, but that flows through into 2023 as opposed to giving it all to us in 2022. So Tony, that's kind of how we think about balancing the investments in the business versus a quarterly result. And I'll ask Jim to comment a bit more on some of the That's a fix of what you were asking.

Speaker 3

Yes. Just to put some numbers around this, Tony, you're exactly right. We entered the year, There are 2 points of external that both Arvind and I have both talked about Russia and currency. By the way, that was about and velocity and change in magnitude that we haven't seen in about 2 to 3 decades, but it impacts a human capital based consulting business very differently than a product technology based business. As we talk about human capital is all pretty much a natural hedge because Your cost is basically matched with your revenue outside of global delivery.

Speaker 3

But in a product based business, our costs like the industry is predominantly U. S. Dollar source, and that's why you've seen pressure on the gross profit margin line and the pretax profit margin line around our technology base of business. Now underlying that though, I think you're seeing a fundamental improvement and our margins as we go forward, so about 50 basis points of currency. The remaining 100 basis points was consulting.

Speaker 3

And we talked about that. That's been a rate and pace discussion. You dial back 15, 18 months ago, We called a very accelerated demand environment of our clients shifting the digital transformation and journey to cloud. And starting in the second half of twenty twenty one, we made the bet to make investments around skill capability, ecosystems, And we opened up the aperture to build extended capabilities inorganically. And we knew as we went through 2022 That we then were operating in a highly inflationary environment.

Speaker 3

And then it became a rate and pace discussion on how quick can you get price margin and optimization and realized through your backlog. And I think we've acknowledged that we were pretty slow throughout the year. Now with that said, we finished the year about 9 points of margin in consulting. We had Nice improvement. We exited 4th quarter at 11 point PTI model.

Speaker 3

That was up almost 200 basis points year over year. Our first half to second half, we saw an acceleration of 3 points of margin from about a 7 point Operating PTI model to well over 10 points of an operating PTI model. And most importantly, the green shoots are starting to play out in the 4th quarter. Our utilization of effective capacity, one of the three levers we've talked about all year, up 3 points in the 4th quarter. Our price margins, 3rd consecutive quarter, are up year to year, and you're seeing that play out in that operating profit performance.

Speaker 3

And finally, acquisitions. Now we're on a steady state and our acquisitions are back to accretion. So we see nice green shoots that lead to our guidance in 2023 at the high end of our high single digit model in consulting on revenue coming off of a very strong 15% growth in 2022 and guiding another 1 point plus in operating margins going forward.

Speaker 1

Thanks for the question, Toni. Let's go to the next question.

Operator

Our next question will come from Shannon Cross with Credit Suisse. Your line is open. Shannon, we're not able to hear you in conference. Please check the mute feature on your phone.

Speaker 7

Hi, can you hear me?

Operator

Yes, we can hear you now. You may go ahead.

Speaker 7

Okay. Interesting. Yes, Arvind, can you talk a bit about AI and how it runs through your business? There's obviously so much discussion right now about OpenAI and Microsoft making investments. And I guess I'm trying to think about how we should Think about IBM monetizing it, capitalizing on it, how you think about your competitive position relative to others.

Speaker 7

I don't know if there are examples you can give of where you're utilizing it. But I'm just I'm wondering as AI gets more and more of a becomes more and more of a discussion point apparently for 20 23, and you have such a long history with it. How we should think about where you are now and where you're going to take it? Thank you.

Speaker 2

Thanks, Shannon. So first, let me acknowledge, AI has become a big topic of conversation, this year. I was in Davos last week and it probably came up in almost every single discussion around technology, what's happening with AI, as well as what's happening with OpenAI. If I think about it over the last decade, I think there were 3 moments you can talk about and then I'll begin to translate those into a business impact. 1, When IBM won Jeopardy!

Speaker 2

With Watson, I think it was a big moment and AI came on to everyone's roadmap. 2nd, When DeepMind from Google or Alphabet started winning competitions around, for example, Go, And that became another big moment along with the protein folding that they did and now with OpenAI and Chat GPT. But if I step back just a moment, all of this latest version is based on what is called large language models is the underlying science. Universities do it, Google does it, IBM does it, as does OpenAI. To just get to why it's so exciting, For example, for us, it allows us to do 13 language models when we are looking at Understanding different natural languages in the same cost as originally one.

Speaker 2

That is what is so exciting about These technologies because if you can get an order of magnitude improvement in cost and speed and the resource consumed both in terms of hardware and people, That is incredibly exciting. Now let me translate this into how do we monetize this. So our monetization of AI It's very much focused on that $16,000,000,000,000 of productivity that I've talked about that we're going to get over the decade. The vast majority of that comes from enterprise automation. And when I say enterprise, I include governments into it.

Speaker 2

Some examples, if you can automate the drive through and order taking for quick serve restaurants, that's an example of what can happen. If we can get deflection rates of 40%, 50%, 60% at everyone's call centers, that's a massive operational efficiency for all of our clients. If we can help retirees get their pensions Through interacting with a Watson powered AI chatbot, that is an enterprise use case Where all of these technologies come into play. By the way, all my three examples are real clients, where we are resulting in anywhere from 100 to 1000 Of people, the efficiency for each of these clients, so that's how we get it. If I look inside IBM, how we do promotions, How we do people movement, how we begin to improve our quote to cash, how we improve our customer service and people ask complicated questions Around the triage of IT systems going down are all very real examples where we are improving client service

Operator

Our next question comes from Eric Woodring with Morgan Stanley. Your line is open.

Speaker 6

Hey Hey, guys. Good afternoon. Thanks for taking the question. I wanted to just touch on the consulting business. Signings were very strong in the December quarter, up 17 Your quarterly book to bill was an improvement from the September quarter.

Speaker 6

Can you maybe just again just step back and elaborate on the environment what we're in, what you On 4Q that potentially stood out to you, where strength in signings is coming from, changes to contract duration. Maybe just double clicking On the consulting business, just to help us understand what gives you confidence, to be kind of at the high end of your midterm model for 2023? Thanks.

Speaker 3

Thanks, Eric, for the question. I'll take this. When we entered the 4th quarter. We had a pretty solid pipeline and we talked about and reaffirmed mid teens Growth for consulting for the year, which as you know is well above our model. But again, as I talked about on the previous question, we had made the investments And bringing in skill capability, expanding ecosystems, strategic partnerships and acquisitions.

Speaker 3

But we saw that pipeline entering the quarter. We saw a very solid and pretty disciplined sales closure rate as we move through the year. Now How did the year end that positions us for 2023? And let me just put some stats Really bring it home. Number 1, ecosystem velocity, we saw continue to increase throughout the year of our strategic partnerships.

Speaker 3

I think we said in the prepared remarks, strategic partnerships, 1, grew revenue 25% In 2022 and was about 40% of our consulting base of business. That is up About 50% year over year. We have seen extensive acceleration. And by the way, in the Q4, our signings growth, which delivered a 1.3 Book to bill, our hyperscaler partnerships with Azure and with AWS, our signings were 2x. And our ISV portfolio, with the likes of SAP, Salesforce, Adobe, We were up over 50% in signings.

Speaker 3

So our book of business and the partnerships, We have tremendous strength that's fueling our backlog, point number 1. Point number 2, Red Hat. We continue to see acceleration Of consulting being the tip of the spear that's really driving the scale and adoption of our hybrid cloud platform. And by the way, Is also dragging IBM Technology and Software. Since inception, a little over 3 years, We signed $7,400,000,000 of business in Red Hat, tremendous strength and that again fuels our backlog for 2023.

Speaker 3

And then you look at full year, we grew both large transformational deals And we grew small deals double digit both sides. So it was pervasive across the board. So when we look at our backlog, We look at all of our indicators of our business on the realization of that model. We look on The acquisition portfolio and how it's scaling, we feel pretty confident about the high end of our high single digit model in 2023. By the way, to Tony's question, operating margins being accretive.

Speaker 1

Eric, thanks for the question. Let's go to the next one, please.

Operator

Our next question comes from Lisa Ellis with SVB MoffettNathanson. Your line is open.

Speaker 7

Hi, good afternoon. Thanks for taking my question. Maybe following on that, I had a broader question, Arvind, on The overall demand environment you're seeing, I think with earnings coming in from various enterprise tech players so far, we're seeing a pretty wide range of signals about how the demand environment is Shaping up for 2023. Can you just comment a bit on what you're seeing from your large clients, say, kind of relative to this past year? Thank you.

Speaker 2

Yes. Thanks, Lisa, for the question. Look, if I think about our overall client base, We were first really pleased that there wasn't much of a difference by geography. As I sort of go through it, Japan, India, Australia, the Middle East, Western Europe, the UK, North America, really pretty strong in demand across. So I think Lisa, if I break it down into the two portions around technology and consulting, What we are seeing is that most of our clients do believe that even if there are some, I'll call them, minor or Different headwinds in 2023.

Speaker 2

They are going to emerge stronger. As they want to emerge stronger, That means they're all deploying technology to help offset wage inflation, cyber issues, Supply chain challenges and all the demographic shifts, meaning there's just fewer skilled people to hire. Consequently, we're seeing them double down and that is why we are focused on certain areas and certain partners, both for consulting and in technology. So they all want to deploy automated ways to get from the front to the back. Maybe Salesforce and Adobe play a very strong role in that.

Speaker 2

They all want to leverage cloud technologies so they can scale technology up to better handle client demand. Our partnerships with the hyperscalers play into that. They all want to leverage far more technology than they have before to counteract the wage inflation and other inflationary aspects And what we do with Red Hat plays into that. So I kind of see, Lisa, that all of our clients play into that. Now you've mentioned a wide spectrum from the people you're seeing recently.

Speaker 2

I think the reason that we are remaining in this Optimistic frame of mind, we have no consumer business. I agree that our clients may have a consumer business, but we don't have that directly. And so I think consequently, we might be seeing a little bit different subset of the economy than those who might have a large direct exposure to a consumer business.

Speaker 1

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

Operator

Our next question comes from David Grossman with Stifel, your line is open.

Speaker 8

Thank you. So you had a very good transactional momentum in the software business in the 4th quarter. And you provided some good high level commentary in your prepared remarks about The business and the broad based growth, naval select, many of those changes that you've been talking about in the go to market strategy and sales changes. That said, Arvind, can you just talk specifically or identify any product specific changes in software that You think maybe driving that momentum and that may suggest your competitive positioning is shifting in any of those 3 non Red Hat segments? And then just one other thing, sorry about the 2 part question, but just for Jim, I just wanted to clarify whether that Working capital headwind in the Q4 that you talked about reverses in 2023.

Speaker 8

Thank you.

Speaker 2

Yes. Thanks, David. Let me talk a little bit about the product capabilities. And as you said outside Red Hat, it's all focused on automation, Data AI and Cyber. If I look at those, let's take automation.

Speaker 2

I'm really pleased with the progress we have made around an area I'll call AIOps. But if you think about we made a couple of small acquisitions, Instana and Turbonomic. We built our own AIOps And we are seeing tremendous pickup from that as our clients want to take out labor complexity, but also want to optimize their overall IT infrastructure, hardware and software. They also want to have uptime that is now they talk about Not just 2 nines and 3 nines, but up to 5 nines. And they also want to worry about how they make sure some go to always on.

Speaker 2

And so I think our AIOps portfolio there really advantages us and I believe we're in a unique position Because we help our clients in an environment across multiple public clouds and on premise and with their private clouds in that space. If I think about data and AI, our focus on data fabric and allowing our clients to leverage their data wherever it is, Not always moving it, but allowing them to catalog it, leveraging AI deep inside our products is another example And if we think about how we can leverage the inputs from all kinds of sources in these days and people are really worried About all of the threats coming whether from nation states or from just bad actors, then it allows them to leverage that portfolio better. Consequently, we're going to remain pretty focused on these areas. You should expect both organic and inorganic investment. And, David, I can't help but say, We are giving our clients the ability to deploy these capabilities on multiple public clouds as well as on premise.

Speaker 3

Yes. I would just build on that, Arvind. I mean, software book of business today, it's an Integral part of our hybrid cloud platform thesis. It is the foundation. We eclipsed $25,000,000,000 For the first time ever here, in 2022, it's over 40% of IBM's revenue and 2 thirds of our EBITDA.

Speaker 3

So when you look at it, we are a hybrid cloud AI platform centric company overall and software is right at that core. So Why that recurring revenue stream and the improvements we've been seeing throughout 2022? And as Arvind answered earlier, Getting that back to a growing contribution not only helps the competitiveness and market share of our top line, But I think all of you understand the marginal dollar of that book of business is in the 90 plus percent range So David, I think you also asked a question about clarification. Free cash flow growth, $10,500,000,000 about, up $1,200,000,000 year to year above our model of $750,000,000 That will be driven based on the Fundamental improvements of our underlying revenue growth and operating leverage and cash PTI, but there will also be, yes, A working capital efficiency contribution to our cash generation next year, really just the volume dynamics of what played out in the 4th quarter. We'll get that back.

Speaker 1

Thanks, David. We are past the top of the hour, but let's take one more question.

Operator

Our last question will come from Kyle Neely with Jefferies. Your line is open.

Speaker 9

Thanks very much for squeezing it in. This one is macro related as well, but it's pretty quick. It seems like some of the slowing macro is implied in your 2023 guidance, but I don't think you talked specifically about whether you're seeing anything Specifically slowing, it sounded generally positive for you guys even though there's a bit of slowdown in the guidance. Microsoft and F5 talked about a divergence Between new business and new applications seeing some growth versus renewal business, capacity expansions, cross selling and things like that, Are you seeing a similar thing in terms of new applications slowing a bit and some of the kind of recurring and cross selling capacity expansions holding up? How much of either of those is driving your lower end of mid single digit growth guidance for 2023?

Speaker 9

And kind of break it down if you can. Thanks.

Speaker 2

Okay. Look, I think that first and I'll address your point of new application versus existing pretty directly. The point about the lower end of the mid single digit is largely from the fact that infrastructure segment will be a Headwind going into 2023, whereas it was a tailwind in 2022. I wouldn't read anything more than that into our low end as opposed to Now from our perspective, if somebody is doing an expanded sales force deployment, I call that a new application. If somebody is doing a new application on Azure or if they are moving, well, they never really directly move.

Speaker 2

We always talk about refactoring, putting a new function, integrating with other applications they might have in their shop or that they buy a SaaS properties. We consider all that new development. And so for us, our consulting teams are largely doing that new development for our clients. And in that process, they tend to use OpenShift from Red Hat, they tend to use Red Hat Linux, they tend to use our AI automation. Our AI automation then surrounds all those things to make them much more resilient, much more robust, much more secure, And those are the capabilities we bring.

Speaker 2

So we are not really seeing that divergence. I will tell you straightforwardly, but There is likely a focus that in that new application, is it helping automate things more? Is it helping make things, I'll call it, straight through As opposed to with a lot of manual intervention, that is probably a bigger focus. Maybe we don't see it because we Got to call that play in late 2021 because we kind of saw those things coming and becoming more important and we decided to invest in them Patricia, with that being the last question, Let me now make a couple of very quick comments to wrap up the call. 2022 was an important year for us.

Speaker 2

As Jim said, It was the 1st full year of the new IBM. The results we delivered reinforce our confidence in our strategy and our model. While there is always more to do, we are pleased with our position as we enter 2023. And I look forward to continuing this dialogue as you move through the year.

Speaker 1

Thank you, Arvind. Sheila, let me turn it back to you to close out the call.

Powered by Quartr
Earnings Conference Call
International Business Machines Q4 2022
00:00 / 00:00