International Business Machines Q1 2023 Earnings Call Transcript

Quartr
Provided by Quartr
April 19, 2023

There are 11 speakers on the call.

Operator

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 IDM's Q1 2023 earnings have any questions, please press star. I'm here today with Arvind Krishna, IBM's Chairman and Chief Executive Officer and Jim Cavanagh, exclude certain non GAAP measures. For example, all of our references to revenue growth are at constant currency. We have provided look at the reconciliation charts for these and other non GAAP measures at the end of the presentation posted to our investor website.

Speaker 1

Finally, some comments made in this presentation may be considered forward looking under the Private Securities Litigation Reform Act could, please press star and press star and press star and press star and press star and press star and press star and press star and press star and

Speaker 2

press star and press star and press star and press star and press star and press star and press star and press star and press star and press star and press star and press star and press star and press star and press star and press star and press star and press star and press star and press star and press star and press star and press star and press star and press star and press star and press star and press star and

Speaker 3

star and press star. Thank you for joining us. Our first quarter results demonstrate that clients continue to turn to IBM to help them address As clients continue to accelerate their digital transformations, modernize their applications, automate their workflows And create flexible and secure hybrid cloud environments. More recently, clients are prioritizing digital transformation projects That focus on cost takeout, productivity and quick returns. While demand for our offerings that support these priorities remain solid, Technology helps them scale and enhance productivity, which is especially important in the face of inflation, demographic shifts, Cybersecurity, supply chain issues and sustainability goals.

Speaker 3

All of this supports our revenue growth expectations for the year. Our focus remains on revenue growth and free cash flow. 90 days ago, I shared that in 2023, we'll continue to unlock more productivity, expand our strategic partnerships and put more investment in specific growth markets. Productivity has always been an important part of our business model. It frees up spending and increases financial flexibility to enable investments.

Speaker 3

We have started to see some of this payback in our results, Let me spend a few minutes on the progress we have made in the execution of our strategy. Our focus is on hybrid cloud and artificial intelligence, the 2 most influential technologies for business. In tandem, These technologies drive both business outcomes and innovation. Hybrid cloud is now the most prominent form of IT architecture And our approach is platform centric. Red Hat OpenShift is the leading container platform, Enabling clients to leverage the latest innovations in open source software.

Speaker 3

IBM Software and Infrastructure have been tailored for this platform. Our consultants use their technical and business knowledge to speed up clients' digital transformation processes. The Q1, we co created with more clients to unlock business value from a hybrid cloud approach. We are working with Virgin Money to migrate their credit card service to the IBM Cloud for Financial Services. They will also leverage IBM's consulting capabilities to create new digital customer experiences.

Speaker 3

For the Boston Red Sox, We are collaborating with Wasabi Technologies, leveraging hybrid cloud technologies to analyze key data sources That improves the club's operations. The second element of our strategy is top of mind for a lot of clients, artificial intelligence. AI is projected to add $16,000,000,000,000 to the global economy by 2,030. Keep in mind that AI for business is different than AI for consumers given their need have a question and answer session, please press star and answer session. AI techniques such as foundation models, Large language models and generative AI give businesses the ability to create 100 AI models From a single data set, early client engagements experience a 70% faster time to value.

Speaker 3

That is why we are seeing a lot more interest from business in using AI to boost productivity and reduce costs. Productivity gains will come from enterprises turning their workflows into simpler automated processes with AI. To achieve this, we are collaborating with companies like Citi to enhance their internal audit and compliance processes through AI. JB Hunt Transport used our Turbonomic AI powered resourcing and automation engine This is a great example of the work we're doing in IT operations. In other areas such as customer care, We are automating hundreds of thousands of call center responses with AI with more than 90% accuracy and greater levels of Customer satisfaction.

Speaker 3

In cybersecurity, our elite defense teams are deploying AI to defend against criminals in real time. In digital labor, we are helping finance, accounting and HR teams save thousands of hours Automating what used to be labor intensive data entry task. To bring our hybrid cloud and AI strategy to market, Our partner ecosystem continues to play a critical role. We expanded our partnership with Adobe To help marketing and creative organizations make the production of content easier, IBM and announce a collaboration using IBM Software in Iwai's sustainability consulting practice to help companies operationalize decarbonization action have any questions. Juniper Networks and Nokia also recently expanded their collaboration around IBM's Network Intelligence on delivering new innovations that matter to our clients.

Speaker 3

A good example of this is the Cleveland Clinic, IBM Discovery Accelerator, where multiple projects are underway that leverage the latest in quantum computing, Artificial intelligence and hybrid cloud to help expedite discoveries in biomedical research. To complement our own innovations, in the Q1, we acquired 3 companies that extend our capabilities in hybrid cloud For example, in the area of manufacturing, Siemens and IBM are announcing a new software solution that integrates software from both companies to enable sustainable product development. Sustainability is a focus area for all business. And just last week, we released our annual report on IBM's efforts in this area, IBM Impact. I'd encourage you to read about our progress in areas ranging from energy savings and carbon emissions reduction I'll conclude by saying that we are are confident in the changes we have made to our business over the last 3 years, aligning our strategy, priorities and portfolio to the needs of our clients.

Speaker 3

This work together with our continued focus on productivity are enabling us to deliver sustainable revenue and free cash flow growth. I'll now hand it over to Jim, will offer more insight into our performance and expectations.

Speaker 4

Thanks, Arvind. I'll start with the financial highlights of the Q1. We delivered $14,300,000,000 in revenue, $1,400,000,000 of operating pretax income, dollars 1.36 of operating earnings per share And $1,300,000,000 of free cash flow. Our revenue for the quarter was up about 4.5% at constant currency. That includes over a point of impact from the businesses we divested.

Speaker 4

Currency rates impacted our reported revenue growth As always, I'll focus my comments on constant currency. Revenue growth this quarter These are our growth vectors and now represent about 3 quarters of our annual revenue. Our infrastructure revenue was flat With continued strength in Z Systems. All three of our geographies grew with high single digit growth in both EMEA led by high value software, which is growing at mid single digit rate. Looking at our profit metrics for the quarter, Operating gross margin expanded 80 basis points.

Speaker 4

We expanded gross margin in all segments with a strong portfolio mix Overall, operating pretax income, excluding the impact of workforce rebalancing, was up 12% recall, back in January, I mentioned we were planning to address Remaining stranded costs from our portfolio actions and we anticipated a charge of about $300,000,000 As we executed our plan, we took a charge of $260,000,000 in the Q1, and we expect to complete this action in the 2nd quarter. This workforce rebalancing charge primarily addresses indirect support functions. We are no longer including workforce rebalancing charges in our measure of segment profit. To provide a view of our segment results consistent with our ongoing operational profile. At the IBM level, Including the workforce rebalancing activity, operating pretax income was down 4% and margin was down 50 basis Within our margin performance, we absorbed a significant currency headwind.

Speaker 4

The combination of translation Mitigating that, the change in useful lives of our server and networking equipment provides a 50 basis point year to year We've been digitally transforming IBM. Much in the same way, we're helping our clients with their transformation Using both IBM and 3rd party capabilities, think of IBM as client 0. We are driving G and A efficiencies by reimagining and transforming the way we work. Let me give you a few examples. Across IBM's IT environment, we're realizing the value of hybrid cloud.

Speaker 4

We reduced the average cost of running an application by 90% by moving from a legacy data center environment to a hybrid cloud environment running on Red Hat OpenShift. We've been simplifying our application environment By standardizing global processes and applying AIOps, we are reducing our application portfolio avoiding hundreds of thousands of manual tests and eliminating the risk of human error. And we're deploying AI at And end to end processes like Quote2 Cash and Source To Pay. For example, in HR, we now handle 94% of our company wide by up to 75%. These productivity initiatives free up spending for reinvestment And contribute to margin expansion.

Speaker 4

Turning to free cash flow, we generated $1,300,000,000 in the quarter. This is up $100,000,000 year to year and puts us on track to our full year expectation. Growth is driven by our profit performance and working capital efficiencies as well as lower payments for structural action. This was mitigated by an increase in capital expenditures and higher performance based compensation payments Given last year's strong results. In terms of cash uses, we returned $1,500,000,000 to shareholders with cash over $17,000,000,000 which is up nearly $9,000,000,000 from December.

Speaker 4

We have been opportunistic in accessing the debt market and issued debt early in the year to prudently get ahead of 20232024 maturities. Our debt balance at the end of the first quarter was over $58,000,000,000 up nearly $8,000,000,000 from year end. Turning to the segments. Software revenue grew nearly 6%, in line with software's mid single digit model. We had growth in both hybrid platform and solutions and transaction processing.

Speaker 4

This performance captures the benefits of our growing recurring revenue stream, Which is about 80% of annual software revenue, with continued strong renewal rates. We continue to see client demand for broad capabilities across Red Hat, automation, Data and AI and Security. Red Hat revenue grew 11% with growth across all major offerings. We have particular strength in our hybrid cloud platform, OpenShift and Ansible, our IT automation solution. Both offerings also continue to take market share this quarter.

Speaker 4

Automation revenue was up 2%, Driven by integration and application servers, given client demand for improved IT performance and costs. In data and AI, revenue grew 3%, reflecting growth across data management, business analytics and Asset and Supply Chain Management. Many of these offerings, like DB2, serve as the underpinnings for modern AI And mission critical workloads. Security revenue was up 2% with growth across Security for hybrid cloud, which includes both identity and threat management and security for data. Bringing this all together, our hybrid platform and solutions ARR is now at $13,500,000,000 In transaction processing, revenue grew 6.5%.

Speaker 4

This software remains core to our clients' hybrid cloud strategies. The strong performance of the last couple of Z system cycles drove significant capacity growth. In fact, installed MIPS growth during our Z15 cycle was 2 times that of Z14. This translates to software opportunity and contributed to growth in both recurring Moving to profit for the software segment. Gross margin was up and pretax margin was flat this quarter, With the latter absorbing nearly a point of impact from currency.

Speaker 4

Consulting revenue was up 8%, And I'll remind you, we had a strong growth in the Q1 of last year. Our book to bill ratio over the last 12 months was 1.07. Signings in the quarter grew 7% with similar performance across both larger And smaller engagements. We continue to see broad demand for projects that deliver technology driven transformations, Leveraging a hybrid cloud environment. Within the quarter, demand was solid for cloud modernization offerings, From digital transformations in areas such as talent, finance and supply chain transformation.

Speaker 4

In terms of revenue, while we had solid growth overall, we have seen some clients in the U. S. Pull back Bringing it back up to the global level, business transformation grew 6%, technology consulting grew 4% And application operations grew 13%. Revenue growth was led by data and customer experience transformation project, in addition to cloud application development and management. Have any questions, please press star.

Speaker 4

Thank you. Red Hat Consulting revenue, now over $2,000,000,000 annually, continue to grow at a double digit rate. And our strategic partnerships continued strong growth, making up over 35% of our revenue in this segment over the last 12 months. Moving to consulting profit, We expanded both gross and pretax margins. Our pretax margin of about 8% in the quarter was up 50 basis Revenue was flat.

Speaker 4

Hybrid Infrastructure revenue was up 4% and Infrastructure Support revenue was down 4 Within hybrid infrastructure, D Systems revenue was up 11%. This was the Q4 of Z16 availability and the solid program performance has outpaced that of prior cycles. In addition to capabilities around embedded AI at scale, cloud native development for hybrid cloud In Cyber Resilience Security, clients are also leveraging z16 for its energy efficiency. For example, Consolidating Linux workloads on a single Z16 system can reduce energy consumption by up to 75%. We continue to see strong growth in shipped MIPs for new Linux workloads on Z16.

Speaker 4

Distributed infrastructure revenue was flat. Growth in storage was offset by declines in power As we have wrapped on the launch of the POWER10 high end systems. Moving to infrastructure profit, We expanded both gross and pretax margins. The 80 basis point improvement in pretax margin reflects benefits Now let me bring it back up to the IBM level to wrap it up. When we first introduced today's IBM back in October of 2021, we provided a mid term model for revenue growth, margin expansion and free cash flow growth.

Speaker 4

We delivered on that model could, we will now have a good start to 2023. In the Q1, we delivered constant currency revenue growth in line with our mid single digit model, expanded gross margin, drove productivity in our underlying business and grew our free cash flow. Looking at full year 2023, as always, I'll start with our 2 primary metrics, revenue growth and free cash flow. On the top line, we expect constant currency revenue growth of 3% to 5%, And we continue to expect free cash flow of about $10,500,000,000 which is up over $1,000,000,000 year to year. Inherent in our mid term model is margin expansion, driven by improving business mix, efficiency initiatives and productivity enhancements.

Speaker 4

Driving efficiency and productivity has always been a part of our operating and financial models. I mentioned some of the initiatives we have underway, and we continue to evaluate additional actions. Altogether, the current initiatives are expected to deliver $2,000,000,000 in annual run rate savings By the end of 2024. These initiatives provide additional flexibility, enabling reinvestment in the business Let me spend a minute on our expectations for constant currency revenue and pretax profit performance by segment. In software, we continue to expect revenue growth in line with software's mid single digit model.

Speaker 4

This revenue growth drives operating leverage, and we still expect software pretax margin to expand by about 2 points year to year. In consulting, we continue to see strong demand for digital transformations and application modernization. We now see consulting revenue growth in the range of 6% to 8% and continue to expect To expand consulting pre tax margin by at least a point as we capitalize on the yield of our productivity actions. Infrastructure revenue is roughly flat over the mid term model horizon, with performance in any year Reflecting product cycle dynamics. We're about to wrap on the Z16 introduction.

Speaker 4

As a result, We expect 2023 infrastructure revenue to decline with pretax margin in the low teens. To provide some perspective, infrastructure should impact IBM's overall revenue growth by over 1 point. With these segment dynamics, we would expect IBM's operating pretax margin to expand by about 0.5. Year to year. That's in line with our model, and we continue to expect our tax rate to be in the mid to high teens range.

Speaker 4

As I mentioned earlier, the dollar has strengthened over the last 90 days. We now expect currency translation I'll remind you that our profit and cash dynamics this year are impacted by the unwinding of last year's hedging gains, Which is about a point of headwind to our pretax margin expansion. Looking at the second quarter, We expect 1st to second quarter revenue seasonality to be fairly consistent with last year. That's up about $1,300,000,000 So the underlying dynamics are different due primarily to Z Systems' product cycle and currency. I'll remind you, we had a successful launch of our Z16 in the Q2 of last year, And that creates a year to year headwind to growth of about 3 points.

Speaker 4

In terms of profit, We now expect a little over 1 third of our operating net income in the first half and just under 2 thirds in the second half. This reflects the first half headwind from currency and workforce rebalancing dynamics, both of which flipped Between the 1st and second quarter, the charge should be in the range of $300,000,000 maybe a little more. We still expect this action to pay back by the end of the year. In closing, We entered the year as a more focused business with solid fundamentals. We had a good start to 2023 I'm happy to provide more color on the quarter and our expectations in the Q and A.

Speaker 4

Patricia, let's get started.

Speaker 1

Thank you, Jim. Before we begin the Q and A, I'd like to mention a couple of items. First, have any questions, please open it up for questions.

Operator

Thank you. At this Our first question will come from Shannon Cross with Credit Suisse. Your line is open.

Speaker 5

Thank you very much. Arvind, there's a significant amount of uncertainty with regard to end demand at the market So I'm wondering, as you speak to customers, can you talk to demand trends you're seeing both on a vertical and a geographic basis? Just give us some more color on what you're hearing because I mean after CDW, I know it's a different market, but there's a lot of questions out there in terms of What people are spending money on, why they want to spend and if it's going to continue in the second half?

Speaker 2

Thank

Speaker 3

you. Shannon, thank you for the question. And as you can imagine, We spent a lot of time both digesting and making our own estimates based on what our clients are saying. So you said geography, verticals and then within technology segments. So let me try to unpack it a little.

Speaker 3

So on a geography level, A lot of the uncertainty that is in the media here certainly in North America is not there in Asia at all. If I look across Japan, India, the Middle East, which kind of covers a broad swath of Asia, with the exception of China, we don't see any of that playing out. The geopolitics around China is a slightly different piece, but I think everyone is subject to that right now. Then if I come to Europe, it's actually been stronger than I would have predicted 6 months ago, but that is because of my point on Technology is a deflationary force. When we look at the mixture of interest rates, inflation, wage inflation, demographic, Meaning labor shortages, supply chain resiliency, cyber, technology is actually the only answer companies have against all that.

Speaker 3

Now that does apply to the larger enterprises who are our primary customers. When I come to the United States, We did see some slowing down in consulting projects as I said, but that is because consulting is somewhat discretionary. However, we are not seeing people cancel projects. What they are doing is slowing them down, meaning pushing to the right, which is why we took the numbers down for consulting, Believing that, that may spread in some sense to other parts of the globe as well. Software, we are seeing demand remain very steady.

Speaker 3

We are not seeing any signs of weakness in software. Admittedly, we are in B2B Software. We are not in any B2C segment. And in infrastructure, I think it's less of a It's much more, in our case, a product cycle issue that is playing through. I hope that gave you some color On why we have confidence in the demand, weakness in one particular area, which we think will likely play through.

Speaker 3

But I want to caution that weaknesses are shrinking. It just says that double digit rates went down into the 6% to 8%, which is still healthy.

Speaker 1

Very good. Thank you for the question, Shannon. Let's go to the next one, please.

Operator

Our next question comes from Amit Darianni with Evercore. You may proceed.

Speaker 6

Good afternoon. Thanks for taking my question. I guess I was hoping you could talk a bit More on the software side, I think growth across both hybrid and transaction seems to be fairly good in the quarter. But Arvind, as you think about some of these consulting softness that's happening, you talked about that in North America. How do you think about the risk of that potentially Spread in some of the software side as well.

Speaker 6

So I'd love to understand, are you seeing any sense, any of that push out happening in the software side as well? And then As you think about this mid single digit growth in software for the year, how do you think that stacks up between hybrid versus transaction processing? Thank you.

Speaker 3

Samit, let me just take the first part of your question on the linkage between consulting and software, and then I'll hand it to Jim for the other parts of the question. So I think that if I look at the consulting, it's not going to spread to software in our belief. Remember, our consulting is comprised, if you just want to break it down into sort of 3 parts. We work with a lot of other partners, including on the Public clouds, including with large software providers, and we tend to do these projects for our clients. I keep cautioning, It's slowing down, but still in the 6% to 8%, not in a rate lower than that.

Speaker 3

Yes, there is a linkage to software, but a lot of our software Running critical systems for our clients and we don't see those very subject to what we see in the current macroeconomic environment. And so that's what gives us confidence on those. Also, I think the movement towards hybrid clouds And the ability to take advantage of AI for enterprise productivity is perhaps going to be a tailwind As we enter the second half of the year, because I do think that clients are going to do a lot of automation and a lot of cost cutting, Which will likely benefit elements of our software portfolio. Jim?

Speaker 4

Yes. So, Amit, thank you very much for the question. I mean, as Building on what Arvind just said, we are very pleased overall with our start to the year with regard The software here in the Q1, nearly 6% growth at the high end of our model overall. By the way, the fundamentals of that business Doing extremely well, growing gross margins, 60 basis points, growing pretax income. But software is an integral part Not only our hybrid cloud platform thesis, but also an integral part of that economic multiplier equation.

Speaker 4

Dollars 25,000,000,000 of revenue, Over 40% of IBM's revenue composition, over 2 thirds of IBM's profit, Solid ARR of $13,500,000,000 growing 7% and a flywheel effect of NRR going well north of 100%. And I think linking back to Shannon's question and part of your question, Arvind has been very clear that we believe that technology Now let's take a step back as you asked the question about revenue contribution and then the mix of hybrid platform and solution versus transactional. Let's Talk first about the revenue contribution. Going back 90 days ago, we laid out the year. We said we were confident in our software portfolio growing On model, we started off the Q1 with putting a dot on the board and contributing to that level actually near the high end.

Speaker 4

Well, we said entering the year that we've got about 80% of our portfolio is high value recurring revenue annuitized revenue. And we thought that, that is going to contribute a little over 5 points of that mid term model growth, mid single digit model growth. And underneath that five points, about half of it's going to come out of Red Hat, by the way, growing 11% to 13% for the year And about half of that out of our recurring revenue stream from IBM, capitalizing on a very strong Install MIPS capacity and renewal rates along with some price optimization. And by the way, Q1 played out that way. Now transaction, the remaining 20%, we said we definitely acknowledge we're heading into The down cycle on ELAs.

Speaker 4

And by the way, ELAs don't go up 100% 1 year and down. Over a 3 year period, You typically get 60% in the 1st year and then it whittles down over the next couple of years. And we said we expect about a 0 to 1 point headwind. And in the Q1, we actually did quite well. The transactional volume actually contributed over a point of software's growth.

Speaker 4

So that's kind of a Build up of the contribution between our two businesses. Now around the lines of business, hybrid platform and solution, our model Is anywhere from mid to high single digit. We delivered 5% in the Q1 and what we see for the full year is right along that model. Red Hat improving given the performance of a renewal cycle. We've got an ARR at $13,500,000,000 growing 7%.

Speaker 4

And by the way, that's a leading indicator, which is positive for us. Our Cloud Pak growth continues to be very strong, And we got new innovation that we continue to bring to market. And then transaction processing, very pleased overall Q1, 6.5% growth. We believe full year is going to be somewhere in the low to mid single digit. And again, that is capitalizing on that 2x growth in installed MIPS And those strong renewal and price.

Speaker 4

So that kind of hopefully sums up the software portfolio for your question.

Speaker 1

Okay. Sheila, let's go to the next question, please.

Operator

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

Speaker 7

Yes, thank you. I was just wondering if you could comment a little bit about Red Hat. I think I recall your guidance was for mid teens growth for the year. And in the Q1, it was 11% at constant currency, but ex deferred revenue accounting was probably 7% or 8%. So how do we get confident that the back half of the year where there's little to no deferred revenue accounting contribution can be fundamentally like 17%, 18%, so an acceleration from 7% or 8% to 17% or 18%.

Speaker 7

And then secondly, can you comment just on the impact of software pricing? Are you only seeing that in transaction processing? Or you're seeing it other parts of the software business and how should we be thinking about sort of the magnitude of the impact of price increases? Thank you very much.

Speaker 3

Tony, great questions. Let me start and then I'm going to give it to Jim for a lot more detail. So first of all on Red Hat, As I think Jim answered in one of the prior questions and in some of the prepared remarks as well, We are now expecting 11% to 13% for the year. That's kind of where we expect RadHard to be. And that's an all in number for the year that's inclusive of Q1.

Speaker 3

So Q1 was at the bottom end of that range. We are seeing more demand coming up as we go through the year. We know our cycles of renewals on Red Hat. If you think that much like other software businesses, it's about a 3 year cycle. If you go all the way back to 2020, which was a boom year, Those are coming up in 2023.

Speaker 3

And so we believe that will give us a point or 2 for the tailwind behind the Q1 numbers. As we sort of go through that, that gives us confidence based on the demand profile, the renewals, as well as the uptick Of the faster growing areas like both OpenShift and likely Ancillary coming down the road that we'll see numbers in that range. So with that sort of color on that, let me give it to Jim to add a lot more color on to both Red Hat and the other part on your pricing question.

Speaker 4

Yes. Thanks, Arvind. Thanks, Tony, for the question. So we can get some clarity out here because I know this has been a hot topic of All of my discussion with investors over the Q1, especially in light of the macroeconomic environment. First of all, as Arvind indicated, we're Pretty pleased with the performance overall of our Red Hat portfolio.

Speaker 4

11% growth Here in the Q1 off of by the way the toughest compare last year at 21% growth overall. And by the way just to put this to rest, The operational growth compared to the GAAP growth is very similar in the Q1. So The combination of deferred revenue, which by the way is de minimis, it's like in a single $1,000,000 and the intercompany To get a bridge from operational to GAAP is a rounding error in the Q1. And by the way, we continue to expect that As we go forward. So the number that we report, by the way, we're what, 4 years into this acquisition now, And we continue to talk about deferred revenue.

Speaker 4

Well, let's put that aside. Underneath the performance of 11%, Red Hat OpenShift strong performance here in the quarter, growing north of 40%. We talked about 90 days ago, we put the number out there now We've got to a $1,000,000,000 ARR business. We're seeing very good momentum And OpenShift as the leading hybrid cloud platform overall. And our Ansible portfolio, to Arvind's We called the year now at 11 to 13.

Speaker 4

I think being prudently cautious. We have a Strong renewal available base that will start kicking in, in the second half. So I think that's really the core to the answer about the renewal base on the subscription, but just wrapping up Red Hat and the discussion I have with investors, taking a big step back, We're pleased overall. We're 4 years into this acquisition. We have quadrupled the Red At revenue from pre acquisition in 3.5 years.

Speaker 4

And around the multiplier effect, We've accelerated our software portfolio and we've accelerated our consulting portfolio to a high mid to high single digit growth business overall. So we're very pleased overall.

Speaker 1

Okay. Thanks for that. Sheila, can we please go to the next question?

Operator

Yes. Our next question will come

Speaker 8

Arvind, you're now incorporating the possibility for slightly lower revenue growth, it sounds like both around consulting, some areas like Red Hat, And some of this is clearly macro. But at the same time, profitability is even more back end loaded now. So what is giving you the confidence that these PTI improvements that you're targeting by segment, 100 bps in consulting and 200 bps in software is really going to come through in the second half of the year and Free cash flow guide remains unchanged despite sort of the revenue outlook having potential deterioration. Love to get some color on that. Thank you.

Speaker 3

Sure, Vamsi. Look, I'll answer it in terms of what I'm seeing on the business and I'll let Jim then put some precise numbers on it. We actually when we spoke to all of you in January, we were saying about a third in the first half and 2 thirds in the second half. Now we are seeing actually a little bit more than a third in the first half and the remaining in the second half. So actually we are actually bringing it up a little bit Despite taking on the restructuring charges and some of the Kyndryl associated charges that we're absorbing in those numbers.

Speaker 3

So what gives me confidence is when we look at the underlying performance in the Q1, not All of our actions and productivity play out right in the quarter. But we are seeing enough green shoots in all of them to be able to predict those increases of the point in consulting, the two points in software, etcetera, as you play through the year. And that allows us to have confidence in both the PTI and the cash flow despite the revenue numbers that we are projecting going forward. And I think actually Q1 is a good down payment towards that, Wamsi. Despite the restructuring charge, We increased free cash flow by $100,000,000 And so that actually all goes together towards our number.

Speaker 3

Jim, anything you'd like to add to that?

Speaker 4

Yes. I would just say, I mean, you nailed it, Arvind. Wamsi, thank you very much for the question. Again, another Important topic for investors overall. The real two issues that are driving this distortion Of seasonality of our profit and our cash, to Arvind's point is currency and the workforce rebalancing charge.

Speaker 4

We said on the latter That it would pay back in the year, maybe a little bit more, but that is a big distortion of a $300 plus 1,000,000 charge in the first half And a significant return in the second half. And by the way, that will benefit all of our segments. As you know, we fully allocate all of our indirect Support cost to all of our segments, so they'll get margin leverage off of that. But the only point I'd make on currency, currency is a very look at the different picture, half to half. Revenue neutral for the year, a headwind, by the way, it was a bigger headwind in the Q1.

Speaker 4

It was The high end of 400 basis points. 2nd quarter, we say it's about 100 basis points headwind. That turns into a nice tailwind in the second half. And as we talked about many times in the past, currency impacts our business differently between our human capital based Consulting business, which by the way, as you all understand, is a natural hedge because cost is sourced the same way as revenue. But our product based businesses have a distortion in predominantly U.

Speaker 4

S. Dollar cost and revenue in local currency. So when currency flips To a translation benefit in the second half, it has substantial margin leverage ability coupled with that Software growing at mid single digit. In a high value annuitized TP world, That carries very high marginal dollar profitability. So all else equal, currency and Workforce rebalancing aside, it's a pretty typical year.

Speaker 4

And we, on top of that, have put out the $2,000,000,000 productivity number that we're going to continue Aggressively going after.

Speaker 1

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

Operator

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

Speaker 5

Good afternoon. Thanks for taking my question. I wanted to ask about the impact of the recent banking mini We've had over the last 6 weeks or so. What impact are you seeing on your business, given how much work IBM does with financial Like are you seeing any disruption or maybe on the flip side of that, any acceleration in demand for products and services, say, in like the risk management area? Could, thank you.

Speaker 3

Lisa, great question. I'll begin by saying that what we have seen, which is so far mostly United States and a little bit in Europe is going to be a second order impact on us, not a first order impact. Let me unpack that and say what I mean. The bulk of the uncertainty is around the smaller banks. They're being labeled regional banks, but let me acknowledge some of these regional banks are really national banks.

Speaker 3

But that said, now as they get forced into tightening some of their lending standards, That is largely going to have an impact on SMB, small and medium business clients who are not our direct clients. Now Let me acknowledge, they are clients though of other larger companies who are our clients, but it gets muted as in the impact on us. When we're looking at our large banking clients, whether you think of the top 5 or 10 in the United States, you think of the top 20 In Europe, we are seeing pretty consistent demand right now because that is largely driven by payments, by retail accounts, by capital markets. And as you think about all of those, as long as you have reasonable employment and reasonable GDPs, We expect that, that demand is going to continue for our first order of clients. The second order will no doubt have a muted, but it's a very tiny impact and that is kind of what is baked into our current growth

Speaker 1

Very good. Let's go to the next question please.

Operator

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

Speaker 9

Hey, good evening guys. Thank you so much for taking the question. I guess, Arvind, maybe if you can just give us an update on how you're think about M and A, just given the broader macro environment, some of the comments you made about The consulting business, interest rates, your cash balance, if you just bring it all together, maybe just provide an update today and if anything has changed relative to 90 days ago. Could

Speaker 3

Thanks, Eric. Great question. So I actually believe I'll begin by saying, I believe that as Asset prices adjust, this could be quite an opportunistic time. Now, is it going to be opportunistic in a month or in 3 months or in 12 months? I can't really predict.

Speaker 3

I'll be candid to say most of you probably determine that far more than we do. Now, What are we doing to prepare and in what areas are we interested? If you notice, we carry a fair amount of cash on our balance sheet. As we have pointed out, we have a fair amount of FinFlex at the IBM level. Even accounting for the dividend, because if you look at it over 3 year period that leaves circa $20,000,000,000 of total FinFlex over 3 years.

Speaker 3

We're going to be judicious. We're going to wait for the right time And it is going to be in the areas that we want. Those areas are going to be in our higher value software and in areas where consulting can accelerate. We expect to remain 60%, maybe 75% of our total spend will be in software, the remaining will be in consulting. In software, we're going to stick to our areas, hybrid cloud, automation intelligence and data, cyber automation, The areas we have talked about.

Speaker 3

So those are the areas, that is the amount we have and we're going to wait for the appropriate time To elaborate, but Eric to answer, M and A is a very definite part of our model and it is part of what is baked into both our mid and long term A model for growth.

Speaker 1

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

Operator

Our next question will come from David

Speaker 8

could talk a little bit more about The pricing dynamic in the marketplace and the pricing environment given the shifting macro that we face. And Perhaps you can help us better understand.

Speaker 10

Whether you're doing anything different with your business now versus the past few years. Do you have any new standalone AI products that you're launching that you could could use to help reaccelerate in data and AI. I know the products go across the whole business, but some reacceleration in data and AI software products would be great. In what areas of the business do you see the most near term opportunity, whether it's end to end applications or foundational models or Infrastructure like the VeloCloud native supercomputer you just announced? Thanks.

Speaker 3

Kyle, great question. I'm not sure we have an hour, so I'll try to get my answer into 2 or 3 minutes. So we see a lot of opportunity. You used the word foundational models. So I think that look just for everybody else, AI has gone through sort of 4 generations very quickly, from expert systems in the 80s 90s to Machine learning through about 2010, deep learning for the last decade and now this era of large language models and generative AI.

Speaker 3

We believe it has a tremendous application to the B2B side of AI inside enterprises. I kind of Capturator's AI for business as opposed to AI for consumers. A lot of the excitement out there is on AI for consumers and I think it's going to It'll be a home run for those companies that are going down that path. But there's a lot of industries where people still worry about the data. They're careful about what's used to train the data.

Speaker 3

They cannot have an answer that occasionally inserts some friction into the answer. They need an answer that is from Reliable sources only. Then the second part is a lot of these techniques, what people don't realize is It takes down the cost of deploying AI. What we are seeing is that a large language model can be trained and then do a 100 tasks So, it's very minor additional training. So, yes, the first training is a lot more expensive, maybe 4, 5 times.

Speaker 3

But then if you can do 100 tasks For almost no additional cost, you can see that the overall is a 4 to 5 times benefit in terms of time to value and productivity. So what are some examples? We did a preview of AI for ITOps around a product called Ansible. We'll be calling it Project Wisdom is our internal code name, but it shows that you can get 60% to 80% of the code That a IT operations person might write, gets written by the AI, well, that's a 3 to 4 times productivity for that individual. That's one example.

Speaker 3

Another example that we use and you can see that play through in our customer care examples, which are multitudinous, whether it's Order taking at McDonald's or CVS Health or Bradesco Bank, where we can now do 10 We've seen 20 languages as in Spanish, French, English, German for the cost of effectively one language from the past. So that shows through in the speed Of deployment that we can do there. The areas that we are focused on to go drive all this is customer care, IT operations, Digital labor and an example of that is what Jim talked about in our internal service centers and in cybersecurity. You'll see it come through sometimes directly like I talked about in Wisdom, sometimes embedded with 1 of our software partners and sometimes as a piece One of our products, be it our data lake products or our cybersecurity products. So in all those three flavors, So let me now wrap up the call.

Speaker 3

I hope what we took away from this discussion over the last hour is we feel very good I'm confident about our ability to meet client needs in this environment and our ability to deliver value to shareholders. I look forward to continuing the dialogue as we move through the year.

Speaker 1

Sheila, I'll turn it over to you to wrap up the call.

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Earnings Conference Call
International Business Machines Q1 2023
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