Western Union Q3 2024 Earnings Call Transcript

Quartr
Provided by Quartr
October 23, 2024

There are 10 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 Olympia McNearney, IBM's Global Head of Investor Relations.

Operator

Olympia, you may begin.

Speaker 1

Thank you. I'd like to welcome you to IBM's Q3 2024 earnings presentation. I'm Olympia McNearney, and I'm here today with Arvind Krishna, IBM's Chairman, President and Chief Executive Officer and Jim Kavanaugh, IBM's Senior Vice President and Chief Financial Officer. We'll post today's prepared remarks on the IBM Investor website within a couple of hours, and a replay will be available by this time tomorrow. To provide additional information to our investors, our presentation includes certain non GAAP measures.

Speaker 1

For example, all of our references to revenue and signings growth are at constant currency. We provided reconciliation charts for these and other non GAAP financial measures at the end of the presentation, which is posted to our investor website. Finally, some comments made in this presentation may be considered forward looking under the Private Securities Litigation Reform Act of 1995. These statements involve factors that could cause our actual results to differ materially. Additional information about these factors is included in the company's SEC filings.

Speaker 1

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

Speaker 2

Thank you for joining us today. Let me start by discussing the quarter before I get into more detail on the execution of our strategy. We delivered double digit revenue growth in software with the reacceleration in Red Hat and continued strength in transaction processing. Infrastructure reflects product cycle dynamics with Z16 well ahead of prior cycles, highlighting customer adoption and continued reliance on the mainframe. In consulting, we continue to navigate an uncertain macro environment with results at the lower end of our expectations.

Speaker 2

We generated strong operating profitability and the highest levels of 1st 9 months cash generation in many years, while overall revenue performance was mixed. We continue to reposition our portfolio towards a higher growth, higher margin business that is well positioned to address client needs around hybrid cloud and artificial intelligence. I'll start with a few thoughts on the macroeconomic environment. Technology spending remains strong. Businesses view technology as a source of competitive advantage, allowing them to scale operations, improve productivity and drive growth.

Speaker 2

However, a pause in discretionary spending is impacting our consulting business. This is due to economic uncertainty, which stems from several temporary factors, including geopolitical issues, upcoming elections and the changing landscape of interest rates and inflation levels. The consulting market remains dynamic with significant opportunity as clients prepare for AI. Overall, we are confident in our business and our ability to capture these opportunities. Now turning to our performance.

Speaker 2

Software is nearly 45% of our total revenue, up from the high 20s in 2018, a testament to our focus on organic innovation and repositioning our portfolio. You can see this in our quarterly results as we delivered strong and accelerating software revenue growth of 10%, including Red Hat at 14%, 7 points of organic growth and strength across our key platforms. Software segment profit margin was about 30%. Our recurring revenue base, which is about 80% of annual software revenue, continues to deliver strong growth. ARR for hybrid platform and solutions now stands at $14,900,000,000 up 11% year over year.

Speaker 2

This quarter marks the 5 year anniversary of our acquisition of Red Hat, and I am proud of our accomplishments together. Since IBM announced the acquisition, Red Hat revenue has grown to approximately $6,500,000,000 doubling in size and delivering a mid teens CAGR. OpenShift scaled from about $100,000,000 in ARR to 1,300,000,000 dollars expanding more than 10 times. Red Hat has also continued to diversify its global footprint, expanding into many new countries since acquisition. We continue to drive innovation, announcing new capabilities, including Ansible 2.5, Rel AI and OpenShift AI.

Speaker 2

Red Hat was also named a leader for the 2nd consecutive year in the 2024 Gartner Magic Quadrant for container management. We continue to gain traction in enterprise AI. Our book of business related to generative AI is now over $3,000,000,000 inception to date, up more than $1,000,000,000 quarter over quarter. The mix is roughly 1 5th software and 4 5th consulting signings. This performance has placed us in an early leadership position, which is crucial at the onset of any technology shift.

Speaker 2

The AI portfolio we have built is designed to give clients a comprehensive set of tools to deploy AI within their enterprise. Relai and OpenShift AI allow clients to build a consistent AI foundation based on open source technology, while Watson X provides an AI middleware platform. Our assistants are designed to help clients becoming more productive using AI across a variety of business processes from code to HR, customer service and more. Consulting is helping clients design and execute AI strategies. We also continue to see our infrastructure segment play a larger role as clients bring AI to their data.

Speaker 2

Choosing the right AI model is top of mind for our clients. IBM's Granite family of AI models are fit for purpose. Earlier this year, we released code models with 8,000,000,000 to 34,000,000,000 parameters. This month, we updated Granite models, making them approximately 90% more cost efficient than larger models. These models can be trained in weeks instead of months and are easier to fine tune for specific tasks.

Speaker 2

Granite models are available in Watson X and Red Hat and are also integrated into offerings from partners like AWS, Salesforce, Qualcomm and SAP. Globally, clients are turning to IBM to transform their operations with technology. This quarter, we announced new collaborations with NatWest, Telefonica, Samsung SDS, Toyota Systems and many others. At the U. S.

Speaker 2

Open, IBM delivered AI generated match report summaries and we are collaborating with ESPN to enhance the sports coverage through advanced AI insights. We also continue to deepen our relationships with key technology partners, including Dell, Intel, Microsoft, Oracle, Salesforce, SAP and ServiceNow. We remain focused on delivering innovations to the market. For example, this quarter we announced Telum 2, IBM's next generation processor for Z and the Spire Accelerator, which will significantly enhance IBM Z's AI capabilities and processing power for enterprise scale applications. Investment in emerging technologies also remains the focus for IBM.

Speaker 2

Earlier this month, we opened Europe's 1st IBM Quantum Data Center. This is the 2nd IBM Quantum Data Center deployed globally, which will greatly advance our goal of expanding access to the world's most performant quantum computers. Before I conclude, let me touch on our outlook. The momentum in our software strategy can be seen in our year to date results. Our revenue guidance for the Q4 reflects this progress, balanced by macro dynamics in consulting and infrastructure product cycle dynamics.

Speaker 2

We remain confident in our free cash flow guidance, which we raised in July, driven by continued strength in our operating margin performance. Overall, our portfolio is well positioned to deliver an upward inflection in growth in 2025. I'm excited about the opportunities ahead of us and will share more details with you in January.

Speaker 3

I will now hand over to Jim to walk you through the details of the quarter. Jim, over to you. Thanks, Arvind. In the Q3, we delivered $15,000,000,000 in revenue, dollars 3,800,000,000 of adjusted EBITDA, dollars 2,500,000,000 of operating pretax income and $2.30 operating diluted earnings per share. And through the 1st 9 months, we generated $6,600,000,000 of free cash flow.

Speaker 3

We are pleased with the solid operating profitability and free cash flow generation of the business. Revenue growth combined with 100 basis points of operating pre tax margin expansion drove 8% operating pre tax profit growth and 5% operating diluted earnings per share growth. Our revenue growth for the quarter was up 2% at constant currency. Software growth accelerated to 10% with strength across our key platforms of Red Hat, automation, data and AI and transaction processing. Consulting was flat and continued to be impacted by a dynamic market environment as clients reprioritized spending and infrastructure was down 7%, reflecting product cycle dynamics.

Speaker 3

Our portfolio mix, operating leverage and yield from productivity initiatives generated strong gross margin, operating profit and free cash flow performance. These results represent our highest third quarter levels of gross margin and free cash flow in many years. We expanded operating gross margin by 2 10 basis points and operating pretax margin by 100 basis points over last year. Year to date, operating pre tax margin is up 150 basis points, well ahead of our guidance provided in July of over 50 basis points of improvement in 2024. In September, we closed on the Palo Alto QRadar transaction, generating a pre tax gain of about $350,000,000 in the quarter.

Speaker 3

As we previously discussed, this was substantially offset by the charges we took to address stranded costs and accelerate our productivity initiatives. These productivity initiatives allowed for continued investment to drive innovation, which you can see in our higher R and D expense, up 10% year to date. Year to date, we generate $6,600,000,000 of free cash flow, up $1,500,000,000 year over year. The largest driver of this year to date growth comes from adjusted EBITDA, up about $800,000,000 year over year. This quarter, we realized $500,000,000 in proceeds from the Palo Alto QRadar transaction.

Speaker 3

As I mentioned last quarter, for the full year, we expect only a modest contribution of free cash flow given payouts from structural actions we have taken and foregone profit from the QRadar business. Through the 1st 9 months of the year, excluding the impact of the QRadar transaction, we are several points ahead of our 2 year average attainment levels. In terms of cash uses, year to date, we returned $4,600,000,000 to shareholders in the form of dividends. From a balance sheet perspective, we have a strong liquidity position with cash of about $14,000,000,000 Our debt balance at the end of the Q3 was flat with year end 2023 at $56,600,000,000 including $10,400,000,000 from our financing business. Turning to the segments, software revenue growth accelerated to 10% with broad based growth across the portfolio.

Speaker 3

This reflects the repositioning of software around key growth platforms, hybrid cloud, automation, data and transaction processing, where we deliver a differentiated value proposition to address clients' most pressing needs. Growth this quarter was fueled by the same performance drivers we've highlighted throughout the year. Red Hat accelerated, contributing about 3.5 points of growth to software. The combination of innovation and recurring revenue contributed about 3.5 points to growth. And our focused M and A strategy contributed about 3 points of growth.

Speaker 3

Let me take you through some more details on each of these. Red Hat revenue growth accelerated to 14%, up 6 points sequentially. We gained market share across each of our key solutions with OpenShift and Ansible growing more than 20% and RHEL growing in the double digits. This strength reflects the demand for our hybrid cloud solutions as clients continue to prioritize application modernization on OpenShift containers and Ansible automation to optimize their IT spend and reduce operational complexity. We saw strong acceleration in Red Hat's subscription business, while the consumption based services business stabilized as we expected.

Speaker 3

Looking at our revenue under contract over the next 6 months, this metric continues to grow in the mid teens as our annual bookings grew double digits in the Q3. We are excited about the opportunities ahead of us, including generative AI, early client interest in our virtualization solution, and after the deal completion, potential synergies with HashiCorp. We delivered strong growth in our recurring revenue base and are seeing momentum from innovation across our software portfolio. Hybrid Platform and Solutions ARR was $14,900,000,000 up 11% year over year driven by strength across automation, data and AI and Red Hat. Transaction processing grew 9% in the quarter.

Speaker 3

Growing capacity, solid renewal rates and continued customer interest in our new generative AI product, Watson X Code Assistant for Z contributed to growth. We continue to invest in bringing innovation to market, launching new offerings like Rel AI, Ansible 2.5 and updated capabilities to our family of assistants, including the recently announced Watson X Code Assistant with advanced features for enterprise Java applications. Red Hat also announced a partnership with Dell that makes Rel AI the preferred platform for AI deployments on Dell PowerEdge servers. This innovation is driving organic growth acceleration with increasing contribution from our core WatsonX middleware in data and AI, WatsonX Orchestrate and IBM Concert in automation and our AI embed strategy across our software portfolio. Revenue performance this quarter also benefited from recent software acquisitions.

Speaker 3

August marked the 1 year anniversary of the Aptio acquisition And we're seeing strong synergies with our automation capabilities and broader software portfolio, driving continued acceleration in bookings and ARR growth since close. Additionally, the StreamSets and WebMethods assets are now part of the software business and we continue to expect the HashiCorp acquisition to close by the end of this year. Moving to software profit, we expanded gross margin and segment profit was up over 120 basis points from last year as we continue to deliver operating leverage driven by our revenue performance. Consulting revenue was flat, which was at the lower end of our expectations. As we discussed throughout this year, we are operating in a challenging macroeconomic environment and see no change in client buying behavior.

Speaker 3

At the same time, clients are reprioritizing their IT budgets to prepare for generative AI. While demand for large digital transformations remain solid, our overall signings declined for the 2nd consecutive quarter as we wrapped on record 3rd quarter signings from last year. Despite the weak current demand environment, we are well positioned to capture growth from generative AI. We continue to build a solid generative AI book of business with about $1,000,000,000 of new bookings in the quarter as we partner with our clients to design and scale AI solutions and develop new ways of working. This early momentum is important, engaging with clients as they architect their AI strategies is establishing IBM Consulting as a strategic partner of choice.

Speaker 3

In the Q3, our Red Hat practice, which helps clients optimize how they build, deploy and manage applications for a hybrid cloud environment continue to grow at a double digit rate, with this quarter being the largest single quarter of signings since the acquisition of Red Hat. Additionally, within our strategic partnerships, both our AWS and Azure practices continue to contribute robust revenue growth. Turning to our lines of business, business transformation revenue grew 2%, driven by strength in transformation projects for data, finance and supply chain. Both technology consulting and application operations declined in the quarter. While there was strength in cloud based application services across modernization, development and management, we continue to see clients reprioritizing spending away from on prem customized services.

Speaker 3

Looking at consulting profit, we expanded gross profit margin almost 1 point and delivered segment profit margin of 11%, a sequential improvement of 2 points, reflecting yield from our productivity actions. Moving to the Infrastructure segment, revenue was down 7%, reflecting product cycle dynamics. Hybrid Infrastructure was down 9% and Infrastructure Support declined 3%. Within hybrid infrastructure, IBM Z revenue declined 19% in what is now the 10th quarter of Z16 availability. The Z16 program continues to exceed prior cycles, delivering revenue growth in 8 of the last 10 quarters and program to date installed MIPS are up over 30%.

Speaker 3

Our clients continue to face increasing demands for workloads given rapid business expansion, complex regulatory environments and increasing cybersecurity threats and attacks. IBM Z remains uniquely positioned to address these demands with the technologies that our latest program offers embedded AI at scale, quantum safe security and cloud native development for hybrid cloud. Distributed infrastructure revenue was down 3% with product cycle dynamics impacting our power business, while we saw solid growth in storage, which continues to take share. For infrastructure profit, we expanded gross profit margin 120 basis points across the portfolio this quarter. At the same time, segment profit margin was down 110 basis points, driven by continued investments in innovation for our next generation of products.

Speaker 3

Now, let me bring it back to the IBM level to wrap up. Through the 1st 9 months of the year, we have grown revenue by 3%, expanded our operating pre tax margin by 150 basis points and grown free cash flow by $1,500,000,000 We have made solid progress in transitioning our portfolio to a higher growth, higher margin business that is well positioned as we head into next year. With 9 months of the year behind us, let me now focus on the Q4. We expect revenue growth in the 4th quarter to be consistent with the 3rd quarter levels. Software revenue growth has accelerated throughout the year and this should continue.

Speaker 3

We expect low double digit 4th quarter revenue growth for software led by Red Hat growth in the mid teens and continued strength in transaction processing. This now represents strong high single digit growth for the year. Consulting revenue is up 1% year to date, impacted by challenging macroeconomic environment. We expect 4th quarter revenue performance to be similar to the 3rd quarter. This represents the weaker end of our prior expectations of low single digit revenue growth for the year.

Speaker 3

And given we are at the end of a multi year product cycle, we now expect infrastructure to be about a one point impact to IBM for the full year. On currency, given the strengthening of the dollar, we now expect currency to be about a 0.5 point headwind to revenue growth in the quarter and about a point impact to revenue growth for the year. Now turning to profitability. For the full year, we are raising our expectation for operating pre tax margin expansion to about a point year to year, well above our model. The strength of this performance is driven by our revenue scale, portfolio mix and productivity initiatives, enabling operating leverage while providing investment flexibility.

Speaker 3

Actions taken in the Q3 help accelerate our productivity initiatives and we now believe we can achieve approximately $3,500,000,000 in annual run rate savings by the end of 2024, up from $3,000,000,000 Drilling down on segment margins, we expect software segment profit margin to expand by well over a point for the year. Consulting segment profit margin is now expected to be flat and we continue to see Infrastructure segment profit margin in the mid to high teens. Consistent with last year, we are maintaining our full year view of operating tax rate in the mid teens range. For free cash flow, given the strength of our performance year to date, we remain confident in delivering greater than $12,000,000,000 of free cash flow for the year, driven primarily by growth in adjusted EBITDA. We are on track to grow revenue, expand operating profit and grow free cash flow as we close out 2024.

Speaker 3

This positions us well as we look forward to 2025. We are confident in our portfolio and growth trajectory as we head into 2025, given the acceleration in software, the opportunities ahead of us in Red Hat, our new mainframe cycle and associated hardware and software stack, our generative AI positioning and contribution from acquisitions. Arvind and I are now happy to take your questions. Olympia, 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. And then second, as always, I'd ask you to refrain from multipart questions. Operator, let's please open it up for questions.

Operator

Thank you. Our first question comes from Amit Daryani with Evercore ISI. Please state your question.

Speaker 4

Good afternoon, everyone. Thanks for taking my question.

Speaker 5

I guess, you talked towards the end

Speaker 4

of your comments about And if I think about the segments, I think the infrastructure side is somewhat easier to see with the Z17 cycle, but I'd love to hear your thoughts on how does that inflection pan out on software and consulting, especially consulting after a few quarters of muted growth? Thank you.

Speaker 2

Thanks, Amit. First, thank you very much for picking up on that comment on upward inflection for 2025. That is something which we have worked really hard to achieve and that I'm really proud of what the whole team has gotten there. To be specific on the parts that you just touched on, what about the upward inflection on software and on consulting? So if you look at software first of all, with Red Hat having just delivered 14% us expecting similar performance for the next quarter and given that we get at least 6 months to 9 months worth of a look ahead based on the CRPO of Red Hat, We expect that to carry on into next year.

Speaker 2

That could easily, then provide a significant amount of lift to software, perhaps about 3 points of growth for software overall. 2, we've got very good traction both in our Gen AI products as well as in our automation suite and we can look at our pipelines and expect that those will be maintained. Given we've also seen a lot of mainframe deployment, the mix underlying capacity there will power ahead the mainframe or the TPS software. You put that together with already announced M and A of HashiCorp and then planned M and A that we will have over the year and that gives us a lot of confidence on software being at or likely above the model that we had laid out a few years ago. So I think that gives you the pieces in software.

Speaker 2

Now on consulting, I acknowledged in the call that there is some macro issues that will impact discretionary labor. So that is the piece that is there. But that is kind of baked in now to what we've been doing. But as we look forward, our book of our bill to book ratio at 1.14 tells us that there is a lot of pent up demand. As you see this Gen AI pipeline turn from signings into revenue, then we expect to see growth there.

Speaker 2

And we have a very healthy book of business with the hyperscalers and with our ISV partners as Jim had talked about. We put all of that together and we expect to see positive upticks on consulting. You'll note, I'm not trying to quantify that as deeply as I did in software, but it will be upwards. Put that together with what we'll see in infrastructure, where we expect to see significant upticks starting likely around the end of the first half and that gives us the confidence in 2025.

Speaker 1

Operator, let's take the next question.

Operator

Our next question comes from Toni Sacconaghi with Bernstein. Please state your question.

Speaker 5

Thank you for the question. I just wanted to follow-up largely along those lines, Arvind. IBM is a portfolio of many different things and some years things go really well like TPP this year and other things don't go very well like consulting this year. But if I look back at the last 4 years and maybe that's not the right time frame and correct me, growth this year will be 3% or less and growth has been 3% in 3 of the last 4 years. And so I understand that the setup for 2025 is good because of the mainframe cycle and acquisition.

Speaker 5

But why should that not be viewed as a one off, just like this year maybe as a one off and being below your 4% to 6% model of less than 3% growth? And specifically for next year, do you think consulting signings will inflect positively in Q4 because they've been negative the last two quarters. So if they don't start to pick up, then the leading indicator for consulting actually does not point to growth necessarily for 2025. So, if you can address those questions, that'd be great. Thank you.

Speaker 2

Tony, look, let me build on the comments I made in response to Amit's question and then address some of the points you made, Tony. So I'm not sure I would acknowledge the 3% of growth only, while that has been true in many of these years, 2022 was definitely far above that. But let me acknowledge that there were also perhaps a one off with the Kyndryl revenue now being recognized as intercompany as opposed to intracompany. Now despite that, we actually had higher revenue than that despite what we explicitly modeled out for the Kyndryl piece. So but let me acknowledge, at least in 2 of the last 4 years, it was around 3%.

Speaker 2

So what gives us confidence? So as I began to Amit's question, we've been really hard at work rebuilding our portfolio to be both sustainable and have a lot more value for our clients in terms of the innovation we are delivering them as well as our ability to manage the cost and complexity that they have as they're all leveraging technology to drive a much larger part of their own businesses. That's kind of the macro. Then under that, the fact that 7% of our software growth this year was organic in this last quarter, not at all acquisitive, gives us confidence about how well that software is being used. 80% of our software is actually now on a recurring revenue basis.

Speaker 2

That is up significantly over the last few years. Those all tell us real demand in that part of the portfolio. If I turn around and say it's 80% there and it generated 10%, that gives us confidence on the organic base of software even going into next year. And as far as we can see, the mainframe software will maintain perhaps mid single digit growth, not maybe high single digit growth going into next year. But that gives us really good tailwinds for what we're trying to do there.

Speaker 2

And while I called out HashiCorp, which has sort of already been announced, We do expect as we get through that deal to do a lot more M and A even going into next year. And since our cash flows have gone up from 4 years ago, that gives us more ability to do M and A without any other actions to speak of. On your consulting side, while the last year and if I go more than 4 years ago have been flat or negative. The confidence we're getting there is from the quality of the signings and from the yields that we expect. The overall signings this year have been lower than last year.

Speaker 2

But if those signings didn't yield then they don't mean very much. So it's the yields we worry about and the backlog that we get that we worry about and we are seeing those begin to turn. Note, I'm using the word begin to turn. I don't expect consulting to inflect like software and go into double digits, but I do expect it to turn into a tailwind for us in terms of being positive growth as we are going. And that's why I believe this may be a tale of 2 halves.

Speaker 2

Consulting may be very modest in the first half, but much better in the second half based on what we can see in terms of the signings, the offerings and as the Gen AI book of business turns into real revenue across all of our clients. I hope that that gives you a sense. And I know we don't talk in infrastructure and you acknowledge the mainframe cycle, but I also want to call out credit. Inside the infrastructure business, there is also a recurring revenue business, which is our hardware maintenance business. And that is also a piece that has gone from being a headwind to potentially close to flat next year.

Speaker 2

So just in year to year, that could well be a 4, 5 point tailwind on that part of the business.

Speaker 1

Operator, next question.

Operator

Thank you. Our next question comes from Wamsi Mohan with Bank of America. Please state your question.

Speaker 6

Yes. Thank you so much. Jim, in your comments, you noted no change in client buying behavior in consulting. But if we look at what happened with your AI book of business, which is up meaningfully a meaningful part of that and being in services, it would indicate that the underlying consulting business ex that kind of deteriorated. So I was wondering if you could reconcile that comment with what's happening in consulting?

Speaker 6

And secondarily, you noted year to date PTI margin performance of 150 bps improvement, but the fiscal year is guided to about 100 basis points, but you also noted sort of realizing $3,500,000,000 of annual run rate savings. So can you just talk about some of the profit dynamics in 4th quarter, how we should think about some of the puts and takes over there? Thank you so much.

Speaker 3

Sure, Wamsi. Thank you for the question overall. As Arvind and I said in the prepared remarks, we're obviously operating in a very dynamic uncertain macroeconomic environment around the entire consulting market overall. Yes, we posted flat revenue growth overall, by the way, up 1% year to date, so slight deterioration. Underpinning that, I think there is multiple dynamics that are playing out.

Speaker 3

And let me try to unpack some of these. First, to your question about the opportunity statement. And yes, Gen AI, albeit we're very early in the cycle right now, we are very focused on ensuring we get an enterprise lead position in establishing consulting as a strategic provider of choice and we're building that book. If you look at our book of business right now, we exited 90 days ago, IBM above $2,000,000,000 that was about 75% consulting. Now we're north of $3,000,000,000 and about 80% consulting.

Speaker 3

So underneath that, we are actually seeing the last two quarters of about $1,000,000,000 book of business each quarter being generated. Now within that, those are mid to long term digital transformation Gen AI based deals. By definition, higher duration, lower revenue yield and I think we spent time last quarter talking about it, about 3 to 4 points less yield than traditional book of business overall. But it's important because it's building that backlog growth that Arvind just answered Tony's question on overall because we believe albeit we're early, this is a long term growth vector with a multiplier effect across our platforms, our software, our infrastructure that is an integral part of the integrated value thesis with consulting here. Now mitigating some of that growth is the high yielding revenue short term discretionary projects.

Speaker 3

Those yields are about 4 to 5 points above what we're seeing in GenAI right now. So I think you're seeing the early cycle dynamics that will put pressure and has put pressure on our top line consulting revenue, but and that's why we guided 4th quarter consistent. But more importantly, I would look at the glass half full. We are becoming the strategic provider of choice. We're winning in the Gen AI space around consulting and that's going to fuel a growth factor around fueling 2025.

Speaker 3

Now with regards to profit equation, we're very pleased with our fundamentals of our business and the underpinnings of that. We drive operating leverage in this business 3 different ways. One, high value portfolio mix. That's why software is an integral part of our model, approaching 45% of revenue. That growing 10% is a strong profit contributor overall.

Speaker 3

2 is we get the high value leverage of a recurring revenue stream overall and productivity. And 3, we get that $3,500,000,000 that we are looking for coming out. We're well ahead of that year to date, as you said. I think we're being very prudent on how we're guiding Q4 right now. And we'll talk 90 days from now.

Speaker 3

We fully expect, by the way, that all drops to the quality and sustainability of free cash flow, are going to be up well over $1,000,000,000 with north of $12,000,000,000 this year and we'll be set up very nicely for 2025.

Speaker 1

Operator, let's take the next question.

Operator

Our next question comes from Ben Reitzes with Melius Research. Please state your question.

Speaker 7

Hey, thanks guys. Jim, we previously spoken about high single digit growth potential for free cash flow at this company. I was wondering, you've made a lot of comments about 2025. Do you think that's possible still in 2025 given the Hashi acquisition? And want to also see if you can address it.

Speaker 7

If consulting were to remain flat, does the mix shift still support that? Thanks a lot.

Speaker 3

Yes, Ben. Thanks very much for the question. A lot of interest as you know quite well from our investors on this particular question of our model. I'm not going to get into the specifics as you would probably not expect me to about actual quantification. I think Arvind and I have both said we feel very confident about our strategy, our portfolio and our growth opportunities heading forward into 2025.

Speaker 3

But let's take a step back, right? 3 years ago, when we laid out our midterm model, Arvind transitioned this company from a no growth company to a mid single digit company, a company that was roughly about 10 points of pretax margin to a company that's going to exit this year in the high teens growing 700 basis points to 800 basis points over 3 years and a company that was stagnant to declining free cash flow and will probably grow free cash flow, by the way, exiting 2024 pretty much on top of the absolute number we said in 2022. So I think we made a lot of progress. Now when you talk about going forward, we talk about upward growth inflection. All of you understand the portfolio mix composition in this business, the productivity mindset of what we drive in this company and the competitive business model positioning, which I would argue we still have a lot of headroom to continue to grow.

Speaker 3

Our model has always been to drive operating leverage that enables us to drive free cash flow faster than revenue. And I would fully expect that even with the Hashi dilution that we all acknowledge. We are very excited. We're hoping to close that still by the end of the year, but that transaction stands on its own. Strategic value, the attractive financial model and the synergistic value we get across our portfolio of software and consulting.

Speaker 3

And we've got that embedded in our model and we still feel very confident to grow free cash flow faster in revenue.

Speaker 1

Operator, let's take the next question.

Operator

Our next question comes from Jim Schneider with Goldman Sachs. Please state your question.

Speaker 7

Thanks for taking my question. I was wondering if you could maybe comment on the rate at which you're seeing consulting work and the consulting science you do have translate into revenue and the sort of the time to commencement. Is that what's giving you a bit of an increased confidence on the inflection in consulting or the slow improvement in consulting going to next year? And then maybe just kind of separately talk about, if you could, the types of M and A targets you're thinking about in software and how that might be different than what you've done in the past? Are you thinking of things that are in any way different from the sort of open source infrastructure and DevOps type of deals that you've done in the past and how that might be changing?

Speaker 7

Thank you.

Speaker 3

Great, Jim. Thank you. I'll take the first part of your question and Arvind can handle the second part about the targeted areas around M and A. As we stated, we feel very good about the strong start in our Gen AI book of business around consulting. Let's just put some numbers to it, right?

Speaker 3

IBM north of $3,000,000,000 growing over $1,000,000,000 quarter to quarter. The consulting book of business approaching $2,500,000,000 You put that in perspective against the last technological shift that we can see within our business that being hybrid cloud and Red Hat and we're about 2x that run rate because we did about $1,000,000,000 in the 1st 12 months. So we're seeing a very nice acceleration and we've talked enough about this being very early in the cycle. But that $2,500,000,000 book

Speaker 2

of business, that's up almost $1,000,000,000

Speaker 3

quarter to quarter and it's growing 35 plus percent. Now when you look at it, the underpinnings, as I said earlier, these are mid to long term strategic digital transformation Gen AI deals, higher duration. Durations are probably approaching high 40 months overall compared to a average duration in consulting that's in the low 20s, point number 1. Point number 2, I talked about revenue yield being lower, about 3 to 4 points lower. Revenue yields kind of hovering around mid to high single digit revenue yield.

Speaker 3

And again, that's about 3 to 4 points less than traditional. But I can't stress enough, I think these curves will inflect as we move into 2025 because as we start wrapping around the short term discretionary pullback that's impacting that traditional near term revenue, we're going to start seeing this long term growth vector pick up as we go forward, which then has multiplier effects of our software and our hardware going forward.

Speaker 2

Thanks, Jim. So Jim, let me address the second part of your question. I've been very clear about our M and A strategy. It has to fit our existing strategy. And in this case, for software, which you asked about, then the three areas would be what are we doing around hybrid cloud?

Speaker 2

I would say Hashi is a great example of something in there. What are we doing around automation? Aptio was probably a great example there, but so are some others like Turbonomic and Instana. And then what are we doing around data and AI, where I would tell you that portions of software AG fell into that camp. The reason that I want to stick to the lanes we are in is because we get a massive amount of go to market synergy and distribution synergy with IBM, which is the second element of the strategy.

Speaker 2

There has to be synergy with IBM that the target could not have realized on their own. Otherwise, there isn't an economic return for our investors. So those two pieces are essential right now. Now when we did Red Hat 5 years ago and I think that was implicit in your question, we did open up a new lane of a big open source play and we have stuck to that through the Red Hat discipline and with that brand name. But not everything needs to be open source.

Speaker 2

So let me be clear on that. Aptia was not open source. Turbonomic was not open source. When we do find an open source property that fits all our criteria, we would certainly look at it. But that is not our lens or our filter on looking at things.

Speaker 2

The filter and lens of looking at things were the 3 areas that I mentioned as being our strategic fit. Now Jim made a comment about 2 questions ago about there being headroom. We see a lot of headroom on these topics and helping people manage their infrastructure better, take cost out, reduce the labor complexity, leverage your data better, do AI at more cost efficient methods than everything that we see today. As we go through all of this, once we begin to run out of headroom, then we might add some areas, but I don't see that happening for some years at this point.

Speaker 1

Operator, let's take the next question.

Operator

Our next question comes from Brent Thill with Jefferies. Please state your question. Thanks. Jim, really good margin on software 30%, well above past Q3s. How sustainable is this 30% margin?

Operator

And any way to frame that going forward? Thanks.

Speaker 3

Yes, Brent. Thank you very much for the question. We're obviously very pleased with our software performance. It's core to our strategy overall, software being about 45% of IBM's revenue composition and 2 thirds of our profit. And most importantly, to Arvind's last question here that he just answered, integral to our hybrid cloud and AI platform centric model.

Speaker 3

It's all built around software overall. By the way, you probably noticed we did hit the rule of 40 here in the Q3. We feel confident that we continue to strategically reposition our business. And by the way, the margin inflection we've seen over the last 3 years in software has been both a combination of that revenue inflection of getting into more end markets with the strategic focus both organically and inorganically that Arvind talked about, hybrid cloud, automation, data and by the way, the inflection of transaction processing, which I'll remind all of you is a high margin, high profit contribution overall. So that coupled with the productivity initiatives are enabling us with the financial flexibility to continue to invest in innovation while still generating margin and operating leverage going forward.

Speaker 3

So we feel pretty confident about that continuing. Similar to how I answered the earlier question, we see a lot of headroom in front of us on operating margin continuing both for IBM and for software.

Speaker 1

Operator, let's take the next question.

Operator

Our next question comes from Eric Woodring with Morgan Stanley. Please state your question.

Speaker 8

Great. Thank you very much for taking my question. Jim, I wanted to maybe ask the consulting AI question maybe a different way, which was last quarter you had noted that consulting AI projects were largely cannibalizing other areas of consulting spend. And I'm just curious at what stage do you think these longer duration signings turn into recognized revenue in some materiality that that could really impact the trajectory of the consulting business? And then second, in what situation or environment would we see AI consulting projects turn from cannibal is it cannibalizing the traditional business to becoming incremental to traditional consulting?

Speaker 8

Thanks so much.

Speaker 3

Yes, great. And thanks, Eric, for the question overall. As we talked about, maturity of Gen AI, we're very early in the cycle. The key for us is to win this early leadership position to be the Gen AI strategic provider of choice. And I think we are carrying our own, to say the least, right now given the $2,500,000,000 book of business.

Speaker 3

Now with that, higher duration, lower revenue yield, there is revenue yield in the quarter. I don't want to leave anyone without the impression. It's just about 3 to 4 points below what our traditional are because of the longer duration. If I just do some of the mathematics around it very quick, first, we're going to start wrapping on the pullback when we started talking about the short term pause in discretionary spending as clients are looking at cost productivity to fuel investment into Gen AI projects that have longer duration. We'll start wrapping on that as we kind of get through the first half of next year.

Speaker 3

That's point number 1. Point number 2, that inflection curve, when we just look at what we experienced historically with the Red Hat generation, because in every technological shift, human capital and consulting based business, you're always going to see reprioritization. We've seen it with cloud technology shift, we've seen it with the Internet, we've seen it with globalization and we've seen it when we went through the hybrid cloud side on Red Hat. That kind of puts it in, as Arvind and I have been talking here, while we feel very confident in that upward growth inflection in 'twenty five, consulting is going to be more of a second half 'twenty five play as we move forward. And by the way, with that upward inflection, the key is backlog.

Speaker 3

We got to get the volume of demand here in the Q4 to Tony's question and we got to continue building that volume of demand in the first half because then that will build a multiplier effect that will be a nice healthy consulting growth orientation like we were at about a year ago.

Speaker 1

Great. Operator, let's take one last question.

Operator

Thank you. And the next question comes from Matt Swanson with RBC Capital. Please state your question.

Speaker 9

Yes. Thanks for taking my questions. Arvind, you talked about the latest addition of the Granite models being 90% more cost efficient, be trained in weeks. You've taken a really pragmatic kind of ROI focused approach to GenAI. Could you just talk a little bit about what you're hearing from enterprises and customers that are kind of supporting that direction of development?

Speaker 2

Certainly, Matt, and thank you for that question and for picking up on the credit models. Look, as I started talking to customers on this topic about a year and a half ago, there was a lot of excitement around GenAI deployment inside the enterprise, but you could see some people beginning to do the math and say, hang on, if I really use this at full scale for all of the transactions that happen inside our enterprise, then the bill could easily become tens of 1,000,000 a day, which very quickly becomes multiple 1,000,000,000 a year. And while that was advantageous to do it, they didn't see that kind of cost being affordable. So we sat back and said, how big do these models need to be because the size of the model determines or did determine previously performance as well as the cost. And so the question became, could we do a model that had tens of billions of parameters and was as good, but for a more constrained set of tasks.

Speaker 2

I kind of be a little facetious. Look, if you're running a big consumer model and you have no idea, is the person going to ask you to summarize a document or a piece of text, which they do, or they're going to ask you to write a poem or a haiku or translate Finnish to French. Okay. You got to have a model that does all those things. But if we need a model that can summarize a business document, but at much higher quality, that allows us to bring a model with about in this case to be precise, 8,000,000,000 to 30,000,000,000 parameters that is as good as the biggest models for those tasks, but doesn't do all those other things.

Speaker 2

But for the enterprise that does 100% of their use case and literally in this case could run with 97% more efficiency, then giving it to people with the indemnity, with the licensing that they can actually refine it and they don't owe the refinements or any improvements in the model back to us, we think is a winning hand as enterprises deploy more and more of generative AI. So with that, let me now wrap up the call. In the Q3 of 2024, we accelerated our software performance, including Red Hat. We are excited about the positioning of our portfolio and our growth prospects for 2025 and we look forward to sharing our progress with you as we close out the year. Thank you.

Speaker 1

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

Operator

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

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