International Business Machines Q2 2023 Earnings Call Transcript

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Provided by Quartr
July 19, 2023

There are 12 speakers on the call.

Operator

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

Operator

Patricia Murphy, IBM's Vice President, Investor Relations. Ma'am, you may begin.

Speaker 1

Thank you. I'd like to welcome you to IBM's Q2 2023 earnings 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. For example, all of our references to revenue and signings growth or at constant currency.

Speaker 1

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

Speaker 2

Thank you for being here. Our second quarter results reflect continued solid execution of our hybrid cloud and AI strategy. We again had strength in our growth vectors of software and consulting and solid cash generation consistent with our financial model. Clients and partners continue to view technology as a source of competitive advantage. Clients turn to us to speed up their transformation journeys, modernize applications and optimize their business workflows.

Speaker 2

At the same time, they continue to prioritize projects that focus on productivity and deliver quick time to value. To seize this opportunity, we are bringing new innovations to market, Expanding strategic partnerships and making investments in targeted growth markets, while unlocking value through our productivity initiatives. All of this gives us confidence in our ability to achieve our full year expectations for revenue and free cash flow, which remain our 2 primary areas of focus. We've made progress in our strategy around hybrid cloud and AI, the 2 key drivers of business innovation. Hybrid cloud is the most widespread form of IT architecture.

Speaker 2

Red Hat OpenShift, our leading container platform Based on open source innovations, plays a crucial role in making this possible along with IBM Software and Infrastructure. Our consultants use their technical and business knowledge to speed up clients' digital transformation journeys and help drive adoption of our technology platforms. Our broad ecosystem of partners amplifies our reach and ability to meet client demand. Let me highlight a few collaborations from this past quarter that take advantage of our platform centric approach. We are helping Air Canada improve its digital footprint, including their website, mobile application and loyalty program, using a hybrid cloud approach Helps Air Canada better connect and tap into their commercial, operational and financial data.

Speaker 2

With Diageo, IBM Consulting embarked on a large global digital transformation to improve customer satisfaction, optimize business workflows and enhance its financial performance reporting capabilities. We also forged a strategic partnership with Nokia, Where Red Hat OpenShift becomes the preferred platform provider to Nokia's core network applications business. This past quarter, we made strategic moves to bolster our hybrid cloud and AI capabilities with the announcement of our plans to acquire Aptio, which offers a virtual command center for CEOs, CFOs and CIOs to manage their technology investments. Aptio's offerings combined with IBM's IT Automation Software and our AI capabilities will give clients the most comprehensive approach to optimize their IT environments. AI is a transformative technology that has the potential to unlock tremendous business value.

Speaker 2

According to a recent McKinsey study, AI could add up to $4,400,000,000,000 annually to the global economy. Our focus is on enterprise AI designed to address these opportunities and solve business problems. The list of use cases is long and includes IT operations, code generation, improved automation, Customer Service, augmenting HR, predictive maintenance, financial forecasting, fraud detection, Compliance monitoring, security, sales, risk management and supply chain amongst others. AI is being infused into our software products. We are already building products that address specific enterprise use cases Such as digital labor with Watson Orchestrate, customer service with Watson Assistant and code generation with Watson Code Assistant.

Speaker 2

At our Think Conference in May, we announced What's the Next, our enterprise ready AI and data platform to help Clients and partners capitalize on the AI opportunity. WatsonX delivers the value of foundation models to the enterprise, enabling them to be more productive. We began to roll out Watson X a little over a week ago, and we are excited by the client response. To date, the platform has been shaped by more than 150 businesses across industries from telco to banking. Businesses around the world are excited about tapping foundation models and machine learning in one place with their own data To accelerate generative AI workloads.

Speaker 2

For example, Samsung is exploring generative AI to deliver unprecedented innovation for clients. Citi is pursuing the potential use of large language models For connecting controls to internal processes, NatWest is embedding WatsonX into its chatbot to improve customer experience and SAP is integrating IBM Watson AI into their solutions. IBM is also working with an expanding ecosystem of partners to co create and innovate across industries and use cases from space to sports, including work with NASA To build the 1st foundation model for analyzing geospatial data and Wimbledon, where Watson X was used to produce tennis commentary. Large language models are a step change in the evolution of AI with more than 80% of enterprises exploring their use. We believe the opportunity for large language models for enterprises is immense given the existing amount of business data.

Speaker 2

This includes Sensor data, chemistry data, materials data, geospatial data, code and of course speech. Because enterprise AI draws from both public and private data, it is more effectively trained when companies adopt a hybrid cloud approach. Enterprise AI can also be based on multiple models, including public, private and open source. Our Watson X platform takes into account this reality and is differentiated in a few important ways. For instance, Instead of relying on a single model, Watson X enables companies to leverage the best models to meet their needs, Whether they are open source technologies, IBM's models or those co created with us, another fundamental aspect of Watson X is trust, In addition, beyond offering companies the capability to tap into existing AI models, IBM empowers them to create their own.

Speaker 2

To help clients on this journey, we have over 20,000 data and AI consultants and recently launched our new center of excellence for generative AI, already staffed with more than 1,000 consultants with specialized generative AI expertise. The investments we are making in products and skills will help us to seize the AI opportunity. Our path is clear. In the same way we built a consulting practice around Red Hat's hybrid cloud platform that is now measured in the 1,000,000,000 of dollars, we will do the same with AI. And just like OpenShift is the technology platform at the heart of our hybrid cloud capabilities, Watson X will be the core technology platform for our AI capabilities.

Speaker 2

WatsonX is just one of many new technology innovations. Shortly after previewing Watson X at our Think conference, at the Red Hat Summit, we introduced OpenShift AI, which is a unified solution to train, serve, monitor and manage the lifecycle of AI models and applications. We also unveiled IBM Hybrid Cloud Mesh, a SaaS solution that streamlines application centric connectivity For edge, hybrid and multi cloud environments. To help clients with their sustainability agendas, we launched our AI powered cloud based tool That helps clients track the greenhouse gas emissions for cloud workloads. And as an example of how we continue to push the boundaries of innovation, IBM recently demonstrated using error mitigating techniques, Quantum Computers can produce results at a scale of 100 plus cubits.

Speaker 2

This is a significant breakthrough that firmly puts us on a path towards building practical quantum computers that can solve hard problems in areas such as risk, finance and materials. Let me conclude by reiterating our confidence in our strategy and execution. It is clear that the work we have done to better align IBM to the needs of our clients is paying off. The momentum in our business and continued focus on productivity position us to achieve our full year expectations and deliver sustainable revenue and free cash flow growth. With that, I would like to hand it over to Jim, who will delve deeper into our performance and expectations.

Speaker 3

Thanks, Arvind. As always, I'll start with the key financial highlights of the Q2. We delivered $15,500,000,000 in revenue, dollars 2,400,000,000 of operating pretax income, Free cash flow. In the Q2, we had modest revenue growth at constant currency, and that includes over a point of impact from the businesses we divested last year. Currency rates continue to be a headwind to growth, with dollar strengthening over the last 90 days.

Speaker 3

Currency impacted our reported revenue growth by about 80 basis points, which is about 0.5 point worse than what Spot rates suggested in April. As is typical, I'll focus my comments on constant currency. Revenue performance was again led by software and consulting. These are growth vectors That together represent about 3 quarters of IBM's revenue and contribute to a solid base of recurring revenue and profit. Software revenue was up 8% with good growth across both Hybrid Platform and Solutions, led by Red Hat and Data and AI and Transaction Processing.

Speaker 3

IBM Consulting revenue growth of 6% was also broad based, With growth across all three lines of business and geographies. Our infrastructure revenue in any quarter Reflects Product Cycle Dynamics. Infrastructure revenue was down 14%. This, as expected, Had a disproportional impact to IBM's overall revenue growth this quarter, given the very successful launch of Z16 in the Q2 last year. Looking at the 2 year compounded growth rate, infrastructure revenue was up.

Speaker 3

Turning to our profit metrics. Operating gross margin expanded 140 basis points, driven by our portfolio mix and productivity. We had good performance this quarter with gross margin improvements in every reportable segment. Our operating pretax margin was down 70 basis points. Last year, we had a gain of about $230,000,000 from the sale of our healthcare software assets.

Speaker 3

Without the year to year impact of the divestiture gains, our operating pretax margin was up 70 basis points. This is a better indication of our ongoing operational performance. Let me comment on a couple of items within our As we discussed in the last couple of earnings calls, We address the remaining stranded costs from our portfolio actions, resulting in a higher level A workforce rebalancing activity this year, about $115,000,000 in the quarter. Workforce rebalancing impacted our year to year pretax margin expansion by another 60 basis points. And the currency remained a year to year headwind, not only to revenue, but also to our expense and pretax profit.

Speaker 3

The combination of translation and hedging impacted operating pretax profit growth by about $150,000,000 and operating PTI margin by about 80 basis points year to year. As I've discussed in the past, this disproportionately impacts our product based businesses. We have good momentum in our underlying operational profit performance. I mentioned a strong business mix, But we're also making progress on our productivity initiatives. We're digitally transforming IBM as client 0, Simplifying workflows and deploying AI across our processes from IT operations to HR, to Source To Pay.

Speaker 3

The productivity benefits free up spend for reinvestment and contribute to margin expansion. Turning to free cash flow. We generated $2,100,000,000 in the quarter and nearly $3,500,000,000 in the first half. This first half performance is up over $100,000,000 year to year and keeps us on track to our full year expectation. Growth is driven by the cash from our profit performance, Working capital efficiencies and lower payments for structural actions.

Speaker 3

This was mitigated by higher performance based In terms of cash usage, through the first half, we returned $3,000,000,000 to shareholders in the form of dividends and spend about $350,000,000 to acquire 6 companies. Later this year, we expect to close the acquisition of Aptio, which complements and advances our IT Automation capabilities. From a balance sheet perspective, we continue to have very strong liquidity position with over $16,000,000,000 of cash. That's down over $1,000,000,000 since March and up $7,500,000,000 since December. Our debt balance at the end of the second quarter was over $57,000,000,000 which is up $6,500,000,000 from year end.

Speaker 3

You'll recall earlier in the year, we were opportunistic in as well as capital allocation priorities. Turning to the segments. Software revenue growth accelerated to 8% this quarter. Both hybrid platform and solutions and transaction processing grew as clients leverage our hybrid cloud and AI platform capabilities. This performance again reflects growth across both our recurring revenue base, which is about 80% of annual software revenue as well as transactional revenue.

Speaker 3

In Hybrid Platform and Solutions, revenue was up 7%, fueled by growth in Red Hat, Data and AI and Automation. Our hybrid platform and solutions ARR is now over $13,600,000,000 and up 7%, reflecting the importance of our strategic offerings with our clients. Red Hat revenue grew 11%. OpenShift, our leading hybrid cloud platform, grew more than 30% in the quarter and now has $1,100,000,000 in annual recurring revenue. Ansible also delivered double digit growth and gained market share this quarter.

Speaker 3

In automation, revenue was up 2%, reflecting growth across integration, Application Servers and Business Automation as clients drive enhanced business value through productivity And performance optimization. Data and AI revenue was up 11%. The broad based growth included areas like data management and business analytics, giving enterprise needs for data visualization, organization, analysis and insights as the underpinnings for AI workloads. Security revenue declined 1%. We delivered growth in security software driven by data security with Guardian Insights.

Speaker 3

This was more than offset by declines in Security Services this quarter. In Transaction Processing, Revenue grew 10% off of an easier compare last year. The increase in Z Systems installed capacity over the last Couple of cycles and strong software renewal rates reflect the importance of Zsystem platform in a hybrid cloud environment. These dynamics contributed to both recurring and transactional software revenue opportunity again this quarter. Putting this together with price increases, we had strong performance in Transaction Processing.

Speaker 3

Moving to profit for software segment, our pretax margin was up 0.5 point, while absorbing over a point of impact from currency. We delivered operating leverage given both the revenue scale and mix this quarter. Consulting revenue was up 6%. In April, we discussed that we were seeing sustained demand for larger transformations that delivered meaningful ROI. At the same time, other projects considered to be more discretionary were being delayed, predominantly in the United States.

Speaker 3

The 2nd quarter client buying behavior played out much in the same way. Our signings were solid, up over 20%, with double digit growth in both large and small engagements. This takes our book to bill ratio up to 1.1 over the last 12 months. We address continued demand for technology driven transformations as clients prioritize projects that drive cost savings and increase productivity. Turning to our lines of business and consulting, growth across our service offerings was broad based.

Speaker 3

Business Transformation grew 5% driven by data and technology transformations, including AI and analytics focused projects. Digital transformations continue to be underpinned by clients Embracing a Hybrid Cloud Strategy. Technology Consulting grew 5% and application operations grew 8% as we again saw strength in cloud based application services across development, modernization and management. Contributing to growth across the business, our strategic partnerships grew signings and revenue double digits. With solid performance from partnerships with AWS and Azure.

Speaker 3

Our Red Hat practice also grew signings and revenue double digits. We have an annualized revenue run rate in excess of $2,000,000,000 Moving to consulting profit, we expanded both gross and pretax margins 180 basis points. Our margin expansion is a reflection of the pricing and productivity actions we've taken, more than offsetting the increased labor costs and investments. Turning to the Infrastructure segment, Revenue was down 14%, reflecting product cycle dynamics. This impacted both Hybrid Infrastructure and Infrastructure Support.

Speaker 3

Within Hybrid Infrastructure, Z Systems revenue declined 30%. We've wrapped on strong revenue performance last year, up 77% when Z16 launched in the seasonally strong quarter. Through the 1st 5 quarters of availability, revenue is well ahead of prior cycles. Z16 brings the power of embedded AI at scale, cyber resilience security and cloud native development for hybrid cloud to our clients. For example, clients are adopting IBM Z16 and the TELUM Processor as the foundation for real time AI insights across significant volumes of data.

Speaker 3

Distributed infrastructure revenue was down 6%. Let me remind you, we're ramping on strong growth last year, Up 17%, driven by strength in storage and Power10 high end systems. Moving to infrastructure profit, we expanded gross margins 200 basis points, while pretax margin was down 40 basis points, including about a point of impact from currency. Now that I've gone through the segment results, Let me bring it back up to the IBM level to wrap up. We feel good about our first half performance.

Speaker 3

With momentum in our growth vectors of software and consulting and a solid recurring revenue base driven by our high value software. We're delivering strong gross margin performance with growth across our segments driven by portfolio mix and productivity. Our overall year to year profit dynamics, as expected, reflect the impact of last year's divestiture. As we look to the full year of 2023, we're holding our view of the year on our 2 primary metrics, Revenue growth and free cash flow. We see constant currency revenue growth of 3% to 5%, And we expect free cash flow of about $10,500,000,000 which I'll remind you Is up over $1,000,000,000 year to year.

Speaker 3

Let me comment on a few items within these full year expectations. We expect IBM's operating pretax margin to expand by about 0.5. Year to year, driven by a combination of product mix and progress on our productivity initiatives. That's consistent with our view 90 days ago and in line with our model. We're also maintaining our view of our tax rate for the year, which is in the mid to high teens range.

Speaker 3

And then finally, while there has been some volatility in currency rates over the last couple of weeks. At current spot rates, currency translation is still expected to be fairly neutral to our revenue growth for the year. I'll remind you that our profit and cash dynamics this year Are impacted by the wrap on last year's hedging gains, which is about a point of headwind to our pretax margin expansion. In terms of segment dynamics, in software, we had a good first half and now expect revenue growth at the high end of software's mid single digit model. This is all in, including acquisitions.

Speaker 3

Our revenue growth drives operating leverage with software pretax margin expected to expand 1.5 to 2 points year to year. In consulting, we've repositioned our business to address today's clients' needs. What we saw in the Q2 didn't change our view of the year. We continue to expect consulting revenue growth in the range of 6 to 8% and to expand consulting pretax margin by at least a point. And then for infrastructure, As I described in the past, revenue is roughly flat over the midterm model horizon, with performance in any year reflecting product cycle dynamics.

Speaker 3

In the Q2, we wrapped on the Z16 introduction in a seasonally strong quarter. For the year, as you expect, 2023 infrastructure revenue will decline, impacting IBM's overall revenue growth by over 1 point. We continue to expect pretax margin in the low teens. Our expectations for 2023 reflect a higher growth, higher value business with strong cash generation, what we have referred to as today's IBM. The analyst estimates also reflect these dynamics.

Speaker 3

And as we look at the Q3, the average of analysts' estimates look reasonable. In closing, we are pleased with our first half performance and it keeps us on track to deliver revenue growth, Expand margin and grow free cash flow for the year. I'm happy to provide more color on the quarter and our expectations in the Q and A. 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, supplemental information is provided at the end of the presentation. Operator, let's please open it up for questions.

Operator

Thank you. At this time, we will begin the question and answer session of the conference. Our first question is from Wamsi Mohan with Bank of America. You may go ahead.

Speaker 4

Yes. Thank you so much. Arvind, you noted some initial traction Around AI and I was wondering, you guys have made a lot of major announcements around AI. Wondering if you can share some thoughts on AI monetization in the short to medium term and any quantification if possible either in terms of dollars or growth rates over And if I could, Jim, you saw very strong transaction processing growth. You noted a few different items I was wondering if you could talk about how much of that is structural versus cyclical?

Speaker 4

And if transaction processing is growing this fast, Does that drive upside to software revenue for the year or are there other areas that are offsetting? And if you could Just reiterate if Red Hat, you still expect that to grow 11% to 13%. Thank you so much.

Speaker 2

Wamsi, so thank you for the question. And as you noted, I am very excited by our progress on AI and what it's going to do for our clients most importantly and then return of course for us as we monetize it. Our monetization is largely going to be through consulting and software and I'll explain that. Infrastructure will benefit, but I would not call that a direct monetization route. So let me start with consulting.

Speaker 2

If you noticed, I talked about and Jim talked about what we have done with hybrid cloud, AKA OpenShift in consulting. When we began with this journey in 2019, our book of business was to be precise and to round it out, 0. In the 1st year, we signed about $1,000,000,000 of business. And at this point, we have inception to date signed $9,000,000,000 with an annual run rate of $2,000,000,000 in consulting. I would tell you and expect that we'll play out AI In a similar way, I hesitate to call it anything else until we get 6 months or so down the road, in which case then we'll have more knowledge.

Speaker 2

Now on the software side, we are very, very excited by the initial reaction to the Watson X platform. The number of projects we have going on, the client interest, it really is something which we are very, very pleased by. So what's the model to think of it on? As I think about how OpenShift, which was a Red Hat product came in, in 2019, It grew literally doubled each year for the 1st 4 years. And at this point, the revenue is About 10 times of what it was when it came in.

Speaker 2

And right now, we have quantified it at $1,100,000,000 on our Annualized run rate basis. So that gives you a sense of the excitement we have around these projects, these technologies and what it could do for us as we begin to go forward. Now 3rd and most important, but I don't want to quantify it, To the fact that AI will infuse in models every single product we have, whether it's sustainability, Whether it's our database products, whether it's our consulting projects, whether it's inside the mainframe of the Tellium, But I'm not including those in those first two categories. So with that, let me give it to Jim for the TPS question.

Speaker 3

Thanks, Arvind, and thanks, Wamsi, for the question. We're obviously very pleased with our overall software performance here in the 2nd quarter accelerating to 8% At constant currency, it was pretty pervasive, both acceleration in the hybrid platform and solution and to your question, transaction processing. But you Get underneath the performance double digit in Red Hat, double digit in data and AI and double digit in our high value Transaction Processing business overall, which by the way gives us the confidence exiting first half to raise our guidance on Software overall to the high end of our mid single digit model. Now to your question about transaction processing, we constantly talk About on these calls, the value of TP in our business model. It's a value vector, 30% of software, The tremendous source of profit and cash that gives us financial flexibility to reinvest for growth overall.

Speaker 3

It also provides a tremendous incumbency position for IBM Multiplier effect. We entered the year, Arvind and I talked about, we saw the inflection shift in TP in 2023 and that was predicated on the successful mainframe Programs that we've had over the last 2. By the way, the last program were up 2x on installed MIPS capacity. So we have a much more extended opportunity base to go get those strong renewal rates overall. But we said from a model perspective, We saw the inflection shift versus being down mid single digit, which was a tremendous drain on us.

Speaker 3

We saw low single digit growth. Now on top of that, just given the highly inflationary environment, we talked about we were going to get disproportional price in 2023. Call that, I don't know, 2, 3, 4 points somewhere in that ballpark. So when you look at our first half performance, our first half were up 8%. By the way, our first half last year Was relatively flat.

Speaker 3

It's our easier compare. So we have to acknowledge it's easier compare. We're going to enter a different more difficult compare in the second But that 8 points of growth overall, I would say once you normalize for the easier compare, we can grow low single digit on a sustainable basis. This year, just given the differentiated price position, we said we'd grow mid single digit. We feel very confident exiting First half.

Speaker 1

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

Operator

Thank you. Next question is from Amit Darianni with Evercore. You may go

Speaker 5

ahead. Yes. Thanks for taking my question. I guess I was hoping you would spend

Speaker 3

a bit of time

Speaker 5

on the consulting Brian, your growth did decelerate there a little bit from 8% in Q1 to 6%. I'd love to understand how did that 6% growth in consulting in Q2 Stack up versus your internal expectations. And then given the deceleration in June, maybe just talk about what gives you confidence that the growth rate holds up in that 6% to 8% range for the back half of the year when some of your peers have actually talked about that market decelerating a bit. Thank you.

Speaker 3

Thanks, Amit. I'll take this one. We're actually pleased with our consulting performance. Remember, you dial back 90 days ago And we saw a real change in buying behavior, particularly in the United States around discretionary project based activity That slowed down in the month of March and that impacted our backlog realization in the quarter. But we We actually posted relatively strong growth 8% in the Q1.

Speaker 3

We had mid teens, if I remember correctly, signings growth. When we look at Q2, we have not seen any substantive change in client buying behavior at all. So I think that's actually a positive indicator. We didn't see it Permeate across other markets around the world. Clients like us, internally, I'm focused every single day on getting Productivity cost, quick payback ROI and our clients are looking at that.

Speaker 3

But on top of that 6% growth here in the 2nd quarter, I think it should be noted, we delivered very strong signings growth that was pervasive, both large deals, small deal. So we see continued momentum where client demand is there, where there's a value to clients overall and how we've differentiated ourselves. And I would argue we're gaining share. We grew 24% in signings in the 2nd quarter. And that was driven by areas that you would quite expect around Digital transformation, application modernization, data and technology, AI, By the way, grew 50% signings in the Q1, so to Arvind's opening Volley about AI and how we're going to monetize.

Speaker 3

This is early green shoots on some of these things. So we exited the quarter with about 1.1 book to bill. By By the way, that's the strongest book to bill we've had in quite some time. Now that positions us well for the second half. We got very good Strategic partnership velocity, we got very good Red Hat book of business growing strong double digit, but we're going to continue to monitor This client buying behavior on backlog realization, that's the critical piece.

Speaker 3

And by the way, our erosion, we have not seen any change or inflection shift in erosion. So we're positioned well for the second half and that gave us confidence in our 6% to 8% maintaining guidance for the year.

Speaker 1

Thanks, Amit. Sue, let's take the next question, please.

Operator

Thank you. Next is Tony Sacconaghi with Bernstein. You may go ahead.

Speaker 6

Yes, thank you. I just wanted to clarify when you talked about feeling comfortable with Q3 estimates was that both the revenue and an EPS statement. And then my question is on software, I think you were looking for 200 basis point margin improvement For the year and now you're saying 150 to 200. Can you speak to that? And also when we look at The improved software revenue growth, is that just improvement in transaction processing because you were way above your forecast in Aptio?

Speaker 6

Or is there something beyond that? And related to that, are you modeling any substantive revenue from AI in consulting or in Talk through this year and why would that not impact your outlook if you were? Thank you.

Speaker 3

Hey, Tony, thank you. I'll take The first 2 or 3 or 4 of your questions and then I think Arvind can talk about the AI piece overall. But when you look at Our software margin overall. First of all, we're taking our full year guidance up on revenue to the high end of our model. So that's about a point raise year over year.

Speaker 3

And by the way, that's all in, as we stated in prepared remarks, including How we're very excited about the Aptio acquisition overall. But that raising guidance, I think is a reflection Of the pervasive performance we've seen in the first half that we feel pretty confident in. We entered let's dial back. We entered the year. We said mid single digit.

Speaker 3

We were coming off of peak ELA. We said we get 5 points to 6 points of growth out of annuity and we would have about a 1 point headwind on transactional. We had a pretty solid first quarter Delivering above our model, we continued and accelerated that in the second quarter. And by the way, it's both transaction processing, High growth company, high recurring revenue and a highly profitable company. And we expect it just given normal customary Regulations of closing probably assume sometime early Q4.

Speaker 3

So that's about a half a point in that raise. The remaining half a point is going to be solid mid single digit growth on TP to my answer to Amit. And then third is, We actually exited our first half with very solid transactional growth, albeit we do understand we're going to wrap in 4th quarter on a very Strong ELA cycle, but the first half we're seeing very strong clothing upsell that's in the mid-twenty percent year over year on those expiring ELAs through the first half. So I think it's all three pieces overall. I think I covered both the revenue piece.

Speaker 3

On the margin, Tony, that is really just the dilution effect in the Q1 of Aptio. So We called about 200 basis points for the year. Now we're putting Aptio in. We're somewhere between 150 basis points and 200 basis points, but I'll remind you, we expect a very quick accretive business as we go forward just given They're profitable overall.

Speaker 2

So I'll

Speaker 3

turn it over to Arvind on the AI.

Speaker 2

Yes. Thanks, Jim. So Tony, I'll comment quickly on the color on revenue from AI, both in software and consulting. So as I said, in consulting, we are expecting a number of projects to get signed. By the way, as Jim mentioned, some of that is getting baked in and you're seeing that in the strong signings that we have in consulting in the 2nd quarter With the over 20% growth in signings and a lot of that was indeed data and AI consulting projects.

Speaker 2

Ditto and software, I'll just note that we had double digit growth in the data and AI sub segment of software and no doubt Some of that is colored by clients doing more around AI with us than they have historically. So we expect to see it. Well, I do want us to be sort of all in. All in with 2023, Including the AI color, we see software at the high end of our model and we see consulting as in the range that Jim just laid out. So while we are very excited about it and we see a lot of traction on AI, it is included in the estimates that we just gave.

Speaker 1

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

Operator

Thank you. Next question is from Shannon Cross with Credit Suisse. You may go ahead. Thank you very much. Arvind, I'm wondering, can

Speaker 7

you talk and I know you haven't launched it globally, but I'm sure everybody's having conversations right now. What is the interest level and understanding of AI by geography? And how do you think that sort of plays out and rolls through? And then just as a follow-up to the commentary on Acxiom, I wondered if you could talk a bit more about what were sort of the key drivers of That acquisition, what KPIs we should watch for? And then I'm also curious as to how the $450,000,000,000 of Anonymized data that you're gaining with that, how do you think you'll leverage that within your foundational model?

Speaker 7

Thank you.

Speaker 2

Thanks. Sharon, great questions. So when I look at AI by geography, at one sort of simple level, I would tell you that Over the last 6 months, the interest in AI spans across all markets, all industries. So it is an International phenomena not confined to the U. S.

Speaker 2

Now we got to dig under it. Then if I look at the maturity of clients to Actually have their enterprise ready to embrace AI, to be able to interact with their clients, their employees, That does vary. I have to acknowledge it. The North American market is probably the most Further ahead on this, I think Western Europe comes second, likely together with some of the more advanced and developed markets in South America. Following that then is Asia and all of what would be called the Global South.

Speaker 2

Japan has a strong interest, but they tend to be cautious on adopting technology, not necessarily in experimenting. In experimenting, they'll be pretty quick. And then it will go into South Asia, where always, I think technology adoption tends to lag by a year or 2 behind the West. So that gives you some sense of that. But that said, every government, every enterprise, every CEO, every CIO that I talk to Wants to talk about AI, what it can do to their company, what should it be in their country and all of the questions around sovereignty of models and data And privacy and not depending only on a few international players comes into the conversation.

Speaker 2

And that's why we talk a lot about private models And models that can be left behind with the client because that is coming up more and more. And so that I hope gives you some color on how this is going to play out. Coming to the next part of your question on Aptio. Look, the key drivers of this acquisition are pretty straightforward. When we look at and talk to CIOs, CFOs, CEOs, they're all getting worried about their spend across the hybrid landscape.

Speaker 2

What do I spend on my first public What is it on my second? What is it on a SaaS property? What am I spending on my own data centers? So to give people a virtual cockpit That really lets them span across this, not just in terms of the 3rd party spend, but also the people and the process spend It's something that all deeply, deeply interested in and more than a few CEOs I've talked to said it really gives them a handle on what's going on and where the money is being spent. That I think is going to play in right away.

Speaker 2

And you went right to the second value prop. With that spend data coming in across enterprises, the aggregate anonymized across the asset is the 450,000,000,000 Now helping people benchmark who does this better than you, who does this process better, who can do this with fewer Our total spend on a public or a private resource is interesting to people because benchmarks is a great way to guide oneself To better performance, we expect that over time we'll be able to monetize that Into a large language or a foundation model and be able to give people even better predictors Or where they can take their spend to. That's why we are so excited about it. And I think the last part of your question was KPIs. Look, As we look to get Aptio much more international, while our footprint I'll call it maybe 2 thirds, 1 third outside the U.

Speaker 2

S. And in the U. S, they're almost the inverse. So as we can put it into our distribution channel, That will be one big expansion as we go over the next year or so. The second one is, we believe we have a great chance to also increase the penetration In our larger clients.

Speaker 2

So those are 2 big metrics, while we continue the success and the growth rate they've had using their own channels.

Speaker 1

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

Operator

Thank you. Next is Eric Woodring with Morgan Stanley. You may go ahead.

Speaker 8

Good Good afternoon, guys. Thanks for taking my question. Arvind, I'd love to dig into how you guys are thinking about M and A today. Obviously, you announced the Appio deal a few weeks ago. That largely probably takes transformational M and A off the table.

Speaker 8

But you obviously still have some additional dry powder to make other acquisitions. So maybe if you could talk about what your For you, maybe said differently, just what's your message on M and A today post Aptio? Thanks so much.

Speaker 2

Eric, so I might sound somewhat repetitive to those of you who heard me over the past 2 years on this topic. So if I just sort of maybe just step back and say, Taking unusual actions off the table for a moment, we had talked about a total FinFlex, Let's call it circa $20,000,000,000 over a 3 year period. That includes the ability to raise additional debt If we so desired. We've been spending circa about $3,000,000,000 a year for the last couple. So that tells you what's the capability and the flexibility that we have.

Speaker 2

You asked about valuations And I hope my answer there tells you that we are always on the lookout and I'll get to which categories because you asked that also. On valuations, I wouldn't call it so much that today's is restrictive. What I could say is that while some Of at least the reports I was reading were talking about valuations perhaps coming down in multiples over this year. It doesn't seem So that's the case. They've not gone up in any kind of tremendous way, but they have not come down.

Speaker 2

But the market is what the market is. So we find properties That meet our criteria, my criteria are pretty straightforward. Does it align with our strategy and I'll call those areas out in a moment? Does it actually give us synergy, meaning can we, the combined entity, grow faster than the individuals could before, I just put it in very financial terms. And if it is larger, it has to be accretive.

Speaker 2

And by larger, I mean, it's not a tuck in, It's not a few 100,000,000, it's larger than that. Then it's got to get accretive, let's say, within 2 years at the latest. So if it meets those criteria, it's certainly an attractive proposition. The areas we are in, We don't want to open up more strategic lanes, so to speak. Our areas are hybrid cloud, data and AI, Automation, cyber and those consulting properties which in turn help these.

Speaker 2

So that's kind of the lanes we're in. And if I look at the latest one, Aptio, I'd say it kind of hits 3 out of my 4. It hits hybrid cloud because it helps you deploy those. It is a big data and AI property because that's what they use and it is automation because it takes out human labor cost from any of those processes. So it was actually a very, very good fit.

Speaker 2

And if any of you have suggestions for similar things, we are all ears and you can certainly write to me.

Speaker 1

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

Operator

Thank you. Next is David Grossman with Stifel. You may go ahead.

Speaker 9

Thank you. Arvind, you spoke extensively about the favorable impact of pricing on the transaction processing portfolio. What have you learned from repricing that portfolio? What other segments of your business could potentially benefit from similar actions? And Sorry to violate that one question rule, but Jim, I just want a clarification.

Speaker 9

My recollection is that you had about $500,000,000 A working capital tailwind factored into the free cash flow guide. Just want to make sure I got that right and that's the same. Thanks.

Speaker 2

So David, let me address the first part of your question on pricing. Look, I'd like to be careful. TP certainly benefited this year, But the biggest part of the benefit has been the mainframe cycle and the capacity and value that our clients see. Yes. Was there a price increase?

Speaker 2

Given the labor inflation of 2022 and some ongoing in 2023, Given the strong dollar, effectively there was pricing increase because of those factors and that got Taken well by the market because of the value they see on that. Would I expect to see similar pricing on TP and then I'll come to other parts of both consulting and software? I doubt, David, that it will be on the same range because definitely I think we would all agree, 2022 had a high inflation and because our costs Go together with the labor and the dollar. I don't think it will be as strong as that, but I would expect maybe moderate Increases based on just the pricing in TP. Now consulting has also got both labor and inflation built in.

Speaker 2

And when we are seeing 6%, 8%, 10% increases in labor costs, it is I think appropriate to be able to pass some of that on, Albeit with a lag and you heard Jim talk in his prepared remarks about that, that is somewhat what is coming through in consulting. If there remains underlying labor inflation, I fully expect to be able to pass it on, again with a bit of a lag to clients in consulting because Otherwise, that's not a healthy business to go around. I think on the rest of software, except TP, I would expect that as labor inflation is there, those elements do come in effectively on pricing, renewal rates and so on. But I'd also say it's a competitive market and you have to remain competitively priced to where the others are. So I would say it's in those 2, TP Consulting and then in other elements of the portfolio that pricing can play a role.

Speaker 2

By the way, our renewal rates are a very strong indication that these are portfolios that provide tremendous value to our clients, But we remain competitive on price.

Speaker 3

Yes. I mean, our strategy overall has always been around pricing for value, right? But David, just to put it in perspective, Last year, we all dealt with a very and we're still dealing with a very highly inflationary environment that was somewhere anywhere, what, 3, 4, 5 points above history overall. That's kind of what we've been talking about is a disproportional price in 2023. You're not going to get that every single year to Arvind's point.

Speaker 3

But I've always said pricing optimization is a direct correlation To the value and differentiation you offer to clients, you got to bring value to clients or they're not going to accept the pricing and we've been seeing good Take up with our mission critical transaction processing. Arvind talked about the human capital based business, the consulting, etcetera. But just quickly to wrap on your second question, David. We said entering the year, remember, we came off of December where we had A shortfall leaving much more on the balance sheet than collected in working capital. Working capital for the year is probably somewhere around $400,000,000 to $500,000,000 like you said, And that's a tailwind coming off of last year.

Speaker 3

The remaining piece of the $1,200,000,000 of free cash flow growth year over year Is the fundamental improvement in the operating discipline of our revenue and operating margin and cash from profit.

Speaker 1

Thanks, David. Let's see if we can squeeze 2 more in. Let's go to the next question.

Operator

Thank you. The next question is from Keith Bachman with BMO. You may go ahead.

Speaker 10

Hi, many thanks for the question. Arvind, I wanted to direct this to you, if I could. You've talked About the success you've had even at these early stages of signing new AI offerings in the consulting side of the business, How are you thinking about the supply side of the business? And what I mean by that is, as you look out over time, The software development process, as you talked about down in Orlando, is going to become much more efficient. And so if your consulting business It is really a seat based model that drives revenue.

Speaker 10

And if those developers are increasing productivity by, I don't know, 30%, forty Because it's in AI, presumably clients will want that back. So how do you think about the disinflationary forces Associated with JNai on delivery side of the model, which is I think separate and distinct from the opportunities associated with new Demand sources. And if I could just sneak one in to you 2. If you could talk about the total mix Growth not just the cycle growth, but the total mix growth that you've recently experienced. And as we look at it over the next couple of years, just trying to understand What the pricing increase, how that may how you may be able to use pricing on TP to leverage that mix for it?

Speaker 10

That's it for me. Many thanks.

Speaker 2

So Keith, let me address the first part of your question. So if I look at it in the short term, Let's just walk through what does the consulting team actually do. They spend a lot of time upfront with the business side going through business Please worrying about how to optimize business processes, cutting across silos, coming up with data architectures, which could help the business, All of that to be candid holds even in a world of Gen AI, Now let's get to the next level. A lot of what our teams do and it is perhaps unique to us, We tend to work on much more mission critical systems. We tend to work much more on things which are fundamental to the business around financials, Supply chain, cyber resilience and so on.

Speaker 2

Will Gen AI and large language models have an impact? Absolutely. I would tell you that if I look over a 5 to 10 year horizon, I would agree with you That for that second part of consulting, not the first, I would agree and expect to see a 30% productivity. Now, I would tell you that in that time frame, I would believe that for IBM, that's an advantage, not a disadvantage. Why?

Speaker 2

Absolutely is disinflationary, but if we share that with the client, that means we can win more work and the total labor pool we need To drive an amount of revenue is lower because there is obviously value in the technology that we are using, be it for test automation or code writing. And maybe I could be a little bit boastful. I'll use that word, Keith, and talk about one example that we have. So we wrote a code assistant for Ansible and it is part of our What's the Next family. That code assistant for Ansible can help Our Ansible developers, which is used as a I think it's the most widely adopted language for IT deployment, Get up to 60% more productive.

Speaker 2

Now that's one piece of it. IT deployment overall, I would then say, Yes, probably somewhere between 10% 30% overall productivity. So that's why I think that 30% number is a good one So keep in mind, but to go across all the environments, COBOL, Java, Python, AI models, that's going to take a few years before our clients get the full confidence around that topic.

Speaker 3

Keith, thanks for the question. On Mainframe overall, pretty pleased given where we're at GA Plus 4 quarters in, so we wrapped on last year. Remember, we talked a lot last year. We came out with unlike the prior programs, We came out with a second quarter launch in a highly seasonal transactional quarter and we grew 77% last year Overall, we wrapped on that this year. I think we printed down 30% here in the Q2, but to your CGR, so far, 5 quarters in, It's the most successful program, a mainframe that we've had.

Speaker 3

Now why is it important? Yes, definitely the value we deliver to clients, whether it's embedded AI at scale, Cyber Resilient Security, Cloud Native Development, but it's important internally to us because it's a platform That drives a multiplier effect to your question around transaction processing. And we've been talking about this 2x installed MIPS capacity over the last program, that was actually the Z15 program over Z14, Because we're only 5 quarters into Z16, but if you fast forward right now into Z16 5 quarters in, We're 120% to 130% up on a installed MIPS capacity already. And you know the tail of that usually happens in the outer path of the next 3 or 4 quarters before we come out with the new one. So we feel pretty good and that's Why we had the confidence entering this year, Arvind and I, to take up the transaction processing Model to actually low single digit growth from being down mid single.

Speaker 3

So, we see that continuing. Thanks for your question.

Speaker 1

Okay. We're at the top of the hour, but let's squeeze in one more question, please.

Operator

Thank you. Our final question comes from Ben Reitzes with Melius Serge, you may go ahead.

Speaker 11

Hey, thanks a lot. Thanks for sneaking me in there. I wanted to ask you, Arvind, In layman's terms with regard to AI, I find a lot of investors want to understand IBM's And in terms of AI, where you have your consulting and then hand it off to software, are you finding that IBM It is well positioned to help people pick the right models to train, to lower their costs. What is it about IBM With the consulting and software that has your unique place set for growth and some of the optimism that you sound like you have heading into next year.

Speaker 2

Ben, thank you for the question. And I deeply appreciate you're asking it in that form. Look, When we look at let me start with our extreme advantage. When clients have data That they'd like to train models on and they absolutely want to preserve the intellectual property in that data. They do not want The learnings, I mean, I can go through 3 forms.

Speaker 2

Almost everyone will say, look, we're not going to take your data and give it to anybody in direct form. Okay. Next, How about learnings in the model itself from the data? Do you use that implicitly or explicitly or not at all? 3, The very fact that you're asking a certain kind of question can in turn reveal information, I'll use the word from my College training of side channel information.

Speaker 2

I'm sure that all of you also understand what that word could imply. So for people who are worried about all that, Which we estimate to be at least 30% of the overall AI opportunity. Think about a bank dealing with regulatory compliance. Think about a pharma company dealing with reports to the FDA. Think about a healthcare company worried about some kind of side effect on something.

Speaker 2

Think about a chemicals company worrying about their proprietary formulations, not just what's in the literature. So as you go through all of these, there are lots and lots of examples where people want to train models. Maybe it's a Finement of a larger known model, so to your point on other models, and I'll come to that. So we find that there's a lot of opportunity and those are the questions that Then next, a number of people are correctly, they have great models. They're great for big public consumption.

Speaker 2

They're great because everybody kind of has Same need for productivity, but there is also a word right now from the partners we work with, there's already over a 100,000 open source models. In addition to the models that we IBM provide, how do you pick from those models? Which one is appropriate? And we have taken a conscious strategy that we are not going to constrain the model that our clients want. So on our consulting teams, we will work with all the models, our own, open source and others' models, so we can help our clients Look, 30 years of being here has shown us that trying to help the clients navigate through The extreme complexity of this world is helpful to us and we can become much better advisors and gain revenue In the process.

Speaker 2

So hopefully that gives you a sense of how we are going to win here and get our fair share of this market. So given that we just passed the top of the hour, let me wrap up the call. We are in a really good position as we enter the second half of the year. Solutions meet today's client needs, new innovation we are bringing to market and there is momentum and productivity in our underlying operations.

Speaker 1

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

Operator

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

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Earnings Conference Call
International Business Machines Q2 2023
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