International Business Machines Q4 2021 Earnings Call Transcript

Quartr
Provided by Quartr
January 24, 2022

There are 12 speakers on the call.

Operator

I'd like to welcome you to IBM's 4th quarter.

Speaker 1

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.

Speaker 1

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

Operator

Thank you. This is Patricia Murphy and I'd like to welcome you to IBM's Q4 2021 earnings presentation. I'm here 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. I'll remind you the separation of our managed infrastructure services business, Kyndryl, was completed on November 3.

Operator

As a result, our income statement is presented on a continuing operations basis. Our results also reflect the incremental revenue from the new commercial relationship with Kyndryl. Because this provides a one time lift to our growth, we will provide the contribution to our revenue growth for the next year. In the spirit of providing additional information to investors, our presentation also includes non GAAP measures. For example, all of our references to revenue and signings growth are at constant currency.

Operator

We have provided reconciliation charts for these and other non GAAP measures at the end of the presentation and in the 8 ks submitted to the SEC. 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, Patricia, and thanks to all of you for joining us today. Our 4th quarter results reinforce our confidence in our strategy and model. With solid revenue growth, we are on track to the mid single digit trajectory we had laid out in our investor briefing last October. The trend we see is clear. Across industries, clients see technology as a major source of competitive advantage.

Speaker 2

They realize that powerful technologies embedded at the heart of their business can lead to seismic shifts in the way they create value. This reality of technology being about a lot more than cost will persist and explains why clients are eager to leverage hybrid cloud and artificial intelligence to move the business forward. Our 4th quarter results illustrate the strong client demand we in the marketplace for our technology and consulting. IBM Consulting again had double digit revenue growth as our ecosystem play continues to gain momentum. Software revenue growth reflects strength in Red Hat and our automation offerings.

Speaker 2

Infrastructure had a good quarter, especially with regards to IBM Z and storage. Over the last year and a half, we have taken a series of actions to execute our hybrid cloud and AI strategy and improve our revenue profile, optimizing our portfolio, increasing investments, expanding our ecosystem and simplifying our go to market. As we start to yield benefits from these actions, our constant currency performance improved through 2021. Our most significant portfolio action was the separation of Kyndryl. You'll remember we had initially expected the spin by the end of the year and we completed it in early November.

Speaker 2

As we discuss our results, we'll focus on the new basis and structure that encompasses today's IBM. As we look to 2022, we expect mid single digit revenue growth 4 kindrel and currency and $10,000,000,000 to $10,500,000,000 of free cash flow for the year. Both of these are consistent with our medium term model. Let me now spend a few minutes on what we are seeing in the market, how we address it and the progress we are making. We are seeing high demand for our capabilities in several areas.

Speaker 2

Clients are eager to automate as many business tasks as possible, especially given the new employee demographics. This dynamic is likely to play out over the long term. They are also using AI and predictive capabilities to mitigate friction in their supply chains. Cybersecurity remains a major area of concern as the cost of cybercrime Already in the 1,000,000,000 of dollars rises each year. As clients deal with these challenges and opportunities, they are looking for a partner they can trust and who has a proven track record in bringing about strategic transformation projects.

Speaker 2

This is why our strategy is focused on helping our clients Leverage the power of hybrid cloud and AI. Hybrid cloud is about providing a platform that can straddle multiple public clouds, private cloud and as a service properties that our clients typically have. Our approach is platform centric And the platform we have built is open, secure and flexible. And it provides a solid base for the multiplier effect across software and services for IBM and our ecosystem partners. It starts with Red Hat, which offers clients unique software capabilities based on open source innovation.

Speaker 2

Our software, which has been optimized for that platform, helps our clients supply AI, automation and security to transform and improve their business workflows. Our consultants deliver deep business expertise and they co create with our clients to advance their digital transformation journeys. And our infrastructure allows clients to take full advantage of an extended hybrid cloud environment. This strategy along with the differentiated capabilities we bring to bear to our clients have led to an increase in platform adoption and new business opportunities across the stack. We now have more than 3,800 hybrid cloud platform clients, which is up 8,000 clients from this time last year.

Speaker 2

IBM Consulting continues to help drive platform adoption with about 700 Red Hat engagements for the year. Clients like Dun and Bradstreet, National Grid, AIB and Volkswagen have all recently chosen IBM's broad hybrid cloud and AI capabilities to transform their processes and move their business forward. As I look back on the year, we had good success in broadening our ecosystem to drive platform adoption and to better respond to client needs. During our investor briefing, we talked about strategic partnerships that will yield $1,000,000,000 businesses within IBM Consulting. As we move towards that, we had more than 50% revenue growth this year in partnerships with AWS, Azure and Salesforce.

Speaker 2

This adds to the strong strategic partnerships we have with others such as SAP, Oracle and Adobe. We're continuing to broaden our ecosystem reach. In the Q4, we announced an expansion of our strategic partnership with Salesforce To run MuleSoft integration software on Red Hat OpenShift, we also created a host of new consulting services with SAP To help clients accelerate their journey to S4HANA, together with Deloitte, we announced Dapper, an AI enabled Managed Analytics Solution and we have expanded our partnership with to help organizations leverage hybrid cloud, AI and automation capabilities to transform HR operations. We have also recently announced A host of new strategic partnerships with Cisco, Palo Alto Networks and Teris, all focused on the deployment of 5 gs, edge and network automation capabilities. During 2021, We have been making changes to increase our focus and agility and build a stronger client centric culture.

Speaker 2

This includes putting experiential selling, client engineering and co creation at the heart of our client engagement model. We have completed thousands of IBM Garage engagements and today We have nearly 3,000 active engagements. We've invested in hundreds of customer success managers to help clients capture more value from our solutions. And we have upgraded our skills with fewer generalists and more technical specialists. This is resonating well with our clients and is starting to contribute to our performance.

Speaker 2

The most important metric of course is revenue growth, But we are also pleased to see our client renewal rates increasing and our recurring revenue base growing. Are starting to see signs of sales productivity improvements with average productivity per technology seller increasing from the first to the second half. At the same time, innovations that matter to our clients remain a constant focus and our teams have worked hard to deliver a series of important innovations in the past quarter. Starting with AI, we added new natural language processing enhancements to Watson Discovery. We're also combining and integrating products such as Turbonomic, Instana and Watson AI Ops To offer a complete set of AI powered automation software to address the significant demand, this quarter Red Hat announced that the Ansible Automation Platform is now available on Microsoft Azure, bringing more flexibility to clients and how they adopt automation.

Speaker 2

In partnership with Samsung Electronics, IBM announced a breakthrough that reorients how transistors are built upon the surface of a chip to enable tremendous increases in energy density. In Quantum, we unveiled Eagle, 127 Cubit Quantum Processor. This is the 1st quantum chip that breaks the 100 cubit barrier and represents a key milestone on our path towards building a 1,000 cubit processor in 2023. While organic innovations are important, We continue to acquire companies that complement and strengthen our portfolio. We made 5 acquisitions in the 4th quarter and a total of 15 acquisitions In 2021, 2 weeks ago, we announced the acquisition of Envisi.

Speaker 2

Many consumers are willing to pay more for products that are made by companies that are more environmentally sustainable. As the world continues to move towards a more circular economy, our clients' need is the ability to manage and measure their progress. Envisi's capabilities complement our own and help us respond to that client demand. Sustainability is important across a number of stakeholder groups, including clients, employees and investors. We are continuing to make good progress and are particularly proud of our diversity and inclusion scores and our ability to attract and retain talent.

Speaker 2

Our efforts were recently recognized by Just Capital, who named IBM as one of America's most just companies. Let me now close by emphasizing once again our 4th quarter results strengthen the conviction that we have in our ability to deliver our model of mid single digit revenue growth. Jim will take you through the Q4 and then provide more color on 2022. Jim,

Speaker 3

over to you. Thanks, Arvind. Let me start out with a few of the headline numbers. We delivered $16,700,000,000 in revenue, 58 percent operating gross margin, operating pretax income of $3,500,000,000 and operating EPS of $3.35 for continuing operations. Last January, we said we expect the performance to improve over the course of 2021 as we start to benefit from the actions we've taken.

Speaker 3

We have seen progress in our constant currency revenue growth rate every quarter and now again in 4th. This is the first view of IBM post separation. We had solid revenue performance, up nearly 9%. I'll remind you this includes the incremental revenue from the new commercial relationship with Kyndryl and we said we would be transparent on the contribution to our revenue growth for the 1st year. This quarter, our revenue growth includes about 3.5 points from the new relationship.

Speaker 3

Excluding this, IBM's revenue was up 5%. We have aligned our operating model and segment structure to our platform centric approach. In the 4th quarter, software was up 10% and consulting was up 16%. These are our 2 growth vectors and together represent over 70% of our annual revenue. Infrastructure, more of a value vector, tends to follow product cycles and was up 2%.

Speaker 3

The software and infrastructure growth each include nearly 5 points from the new Kyndryl relationship. While there is no contribution to consulting's growth. Our platform centric model has attractive economics. For every dollar of hybrid platform revenue, IBM and our ecosystem partners can generate $3 to $5 of software, $6 to $8 of services and $1 to $2 of infrastructure revenue. This drives IBM's hybrid cloud revenue, which is up 19% for the year.

Speaker 3

Post separation, revenue from our full stack cloud capabilities from infrastructure up Consulting now represents $20,000,000,000 of revenue or 35% of our total. Looking at our P and L metrics, our operating gross profit was up 3% and the $3,500,000,000 of operating pretax Profit was up over 100%. Operating net income and earnings per share also grew. Let me highlight a couple of items within our profit performance. 1st, the year to year pre tax profit reflects $1,500,000,000 charge to SG and A last year for structural actions to simplify and optimize our operating model and improve our go forward position.

Speaker 3

We're continuing to invest to drive growth. Throughout the year, we have been aggressively hiring With about 60% of our hires in consulting, we're scaling resources in garages, fine engineering centers and customer success managers, all to better serve our clients. We're increasing investments in R and D to deliver innovation in AI, hybrid cloud and emerging areas like quantum. We're ramping investment in our ecosystem And we acquired 15 companies in 2021 to provide skills and technologies aligned to our strategy, including capabilities to help win client architecture decisions. Regarding tax, Our 4th quarter operating tax rate was 14%.

Speaker 3

This was up significantly from last year, but roughly 2 to 3 points lower than what we estimated in October due to a number of factors, including the actual product and geographic mix of our income in the quarter. Let me spend a minute On our free cash flow and balance sheet position. Our full year consolidated cash from operations was $12,800,000,000 and free cash flow was $6,500,000,000 These are all in consolidated results and include 10 months of Kyndryl and the cash paid for the 2020 structural actions and spin charges. IBM standalone or baseline free cash flow for the year was $7,900,000,000 which is aligned to our go forward business. This excludes Kyndryl charges and pre separation activity, but includes the IBM portion of the structural actions.

Speaker 3

Payments for these IBM related structural actions and deferred cash tax paid in 2021 contributed to the year to year decline in the standalone results. In terms of uses of cash for the year, we invested over $3,000,000,000 in acquisitions. We continue to delever with debt down nearly $10,000,000,000 for the year and over $21,000,000,000 since closing the Red Hat acquisition. And we returned nearly $6,000,000,000 to shareholders in the form of dividends. This results in a year end cash position of $7,600,000,000 including marketable securities and debt of just under $52,000,000,000 Our balance sheet remains strong and I'd say the same for our retirement related plans.

Speaker 3

You'll remember that over the last years, We've shifted our asset base to a lower risk profile. In 2021, the combination of modest returns And higher discount rates improved the funded status of our plans. In aggregate, our worldwide tax Qualified plans are funded at 107% with the U. S. At 112%.

Speaker 3

Now I'll turn to the details by segment and I'll remind you we have put in place a simplified management system and segment structure aligned to our platform centric model. And within the segments, we're now providing new revenue categories and metrics that will provide greater transparency into business trends and drivers. IBM Software delivered double digit revenue growth in the quarter. This was driven by good revenue performance in both hybrid platform and solutions and transaction processing, the latter benefiting significantly from the new Kyndryl content. Software is important to our hybrid cloud strategy and our financial model.

Speaker 3

Our hybrid cloud revenue and software is up 25% for the year to more than $8,500,000,000 And subscription and support renewal rates continue to grow again this quarter, contributing to a $700,000,000 increase in the software deferred income balance over the last year. Hybrid Platform and Solutions revenue was up 9%. This performance is an indication of the strength across the software growth areas focused on hybrid cloud and AI. It's worth mentioning. This includes only a point of help from the new Kyndryl commercial relationship.

Speaker 3

Let me highlight some of the trends by business area. Red Hat revenue all in was up 21%. Both infrastructure and app dev and emerging tech grew double digits as RHEL and OpenShift address enterprise's critical hybrid cloud requirements. With this performance, We're continuing to take share with our Red Hat offerings. Automation delivered strong revenue growth, up 15%.

Speaker 3

As Arvind mentioned, there is strong market demand for automation. We had good performance in AI ops and management this quarter as we address resource management and observability. Clients are realizing rapid time to value from Instana and Turbonomic, 2 of our automation acquisitions and integration grew With continued traction in Cloud Pak for integration, data and AI revenue grew 3%. We have particular strength in data fabric, which enables clients to connect silo data, distribute it across the hybrid cloud landscape without moving it. You'll recall we talked about the data fabric opportunity back in October.

Speaker 3

We also had strong performance in business analytics and weather. Within these solutions, clients are leveraging our AI to ensure AI models are governed to operate in a fair and transparent manner. Security revenue declined modestly in the quarter, driven by lower performance in data security, while revenue grew 5% for the year. As we called out in our recent investor briefing, Security innovation is an integral part of our strategy. In December, we launched a new data security solution, Guardium Insights, with further plans to modernize the broader portfolio throughout the year.

Speaker 3

This quarter, we also completed the acquisition of Reacta, which leverages AI and machine learning to automatically identify and block threats at the endpoint. Putting this all together, our annual recurring revenue or ARR is now over $13,000,000,000 which is up 8% this quarter. This demonstrates the momentum in our hybrid platform and AI strategy, including Red Hat and our suite of cloud packs. Moving to transaction processing, revenue was up 14%. This is above our model, driven by a few underlying dynamics.

Speaker 3

1st, all of the growth came from the new Kyndryl commercial relationship, which contributed more than 16 points of growth. 2nd, I'll remind you that we're wrapping on a very weak performance in the Q4 of last year, which was down 26%. And lastly, we had some large perpetual license transactions given the good expansion In the IBM Z capacity, we've seen this cycle. While the new capacity is important, What's just as important is the continued strong renewal rates this quarter. These are both good proof points of our clients' commitment to our infrastructure platform and these high value software offerings.

Speaker 3

Looking at software profit, We expanded pre tax margin by 12 points, including nearly 10 points of improvement from last year's structural actions. Turning to consulting, revenue grew 16% with acceleration across all three revenue categories. Complementing the strong revenue performance, our book to bill was 1.2. Clients are accelerating their business transformations, powered by hybrid cloud and AI to drive innovation, increase agility and productivity and capture new growth opportunities. Enterprises are turning to IBM Consulting as their trusted partner on this journey.

Speaker 3

They are choosing us for our deep client, Industry and technical expertise, which drives adoption of our hybrid cloud platform and pulls through key technologies. Consulting's hybrid cloud revenue grew 34% in the quarter. For the year, cloud revenue is up 32% to $8,000,000,000 Offerings and application modernization, which are centered on Red Hat, contributed to this growth. The Red Hat related signings more than doubled this year and are now over $4,000,000,000 since inception. This quarter, we added over 150 client engagements, bringing the total since inception to over 1,000.

Speaker 3

Our strategic partnerships also drove our performance. Revenue from these partnerships accelerated as the year progressed and was up solid double digits in the 4th quarter, led by Salesforce, SAP, AWS and Azure. Turning to our business areas, our consulting's growth was led by business transformation, which was up 20%. Business Transformation brings together technology and strategic consulting to transform critical workflows at scale. To enable this, we leveraged skills and capabilities in IBM Technologies and with strategic ecosystem partners such as SAP, Salesforce and Adobe.

Speaker 3

Our practices are centered on areas such as finance and supply chain, talent, industry specific solutions and digital design. This quarter, we had broad based growth reflecting strong demand for these solutions. In technology consulting, revenue was up 19%. Technology consulting architects and implements cloud platforms and strategies. We leverage hybrid cloud with Red Hat OpenShift and work with providers such as AWS and Azure in addition to IBM Cloud.

Speaker 3

This quarter, we continue to see good performance in application modernization offerings that build cloud native applications and that modernize existing applications for the cloud. Finally, application operations revenue grew 8%. This business line focuses on application and cloud platform services required to operationalize and run-in both cloud and on premise environments. Revenue growth was driven by offerings which provide end to end management of custom applications in cloud environments. Moving to consulting profit.

Speaker 3

Our pretax income margin expanded about 8 points, including just over 9 points from last year's structural actions. We're in a competitive labor market And we continue to have increased pressure on labor costs due to higher acquisition, retention and wages. While we still expect to capture this value in our engagements, it will take a few quarters to appear in our profit profile. So now turning to the new infrastructure segment, revenue was up 2%. The Kinjol commercial relationship contributed about 5 points of growth, which is higher than we expected in October.

Speaker 3

In this segment, we brought together hybrid infrastructure with infrastructure support, which was formerly technology support services. This allows us to better manage the lifecycle of our hardware platforms and to provide end to end value for our clients. Hybrid Infrastructure and Infrastructure Support revenue were up 2% and 1%, respectively, with pretty consistent contribution from the new Kyndryl relationship. Hybrid infrastructure includes IBM Z and distributed infrastructure. IBM Z revenue performance now inclusive of both hardware and operating system is down 4% this quarter.

Speaker 3

This is the 10th quarter of Z15 availability and the combination of security, Scalability and reliability continues to resonate with clients. This program continues to outpace the strong Z14 program And we shipped more MIPS in the Z15 program than any program in our history. Our clients are leveraging IBM Z as an essential part of their hybrid cloud infrastructure. And then in distributed infrastructure, revenue was up 7%, driven by pervasive strength across our storage portfolio. Looking at infrastructure profit, the pre tax margin was up over 9 points, but essentially flat normalizing for last year's structural action.

Speaker 3

Now I'll wrap up with a discussion of how our investments and actions position us for 2022 and the longer term. We've been laser focused on our hybrid cloud and AI strategy. Our portfolio, our capital allocation and the moves we've been making are all designed to create value through focus for our clients, our partners, our employees and our shareholders. We took significant steps during 2021. The most impactful portfolio action was, of course, the separation of Kyndryl.

Speaker 3

We've also been allocating capital to higher growth areas, investing in skills and innovation and expanding our ecosystem. We've aligned our business to a more platform centric business model, And we're simplifying and redesigning our go to market to better meet client needs and execute on our growth agenda. Bottom line, we're exiting 2021 a different company. We have a higher growth, higher value business mix. With over 70% of our revenue in software and services and a significant recurring revenue base dominated by software.

Speaker 3

This will result in improving revenue growth profile, higher operating margin, strong and growing free cash flow and lower capital intensity, leading to a higher return on invested capital business. We also continue to have attractive shareholder returns through dividends. In October, we laid out a model for IBM's performance over the medium term, defined as 2022 through 2024. The model is focused on Our two most important measures of success, revenue growth and free cash flow. As we enter the new year, I'll talk about our expectations for 2022 performance along those dimensions, starting with revenue.

Speaker 3

We expect to grow revenue at mid single digit rate at constant currency. That's consistent with the model. On top of that, in 2022, the new commercial relationship with Kyndryl will contribute an additional three points of growth spread across the 1st 3 quarters. Currency dynamics unfortunately will be a headwind. At current spot rates, Currency is roughly a 2 point headwind to reported revenue growth for the year and 3 points in the Q1.

Speaker 3

For free cash flow, we expect to generate $10,000,000,000 to $10,500,000,000 in 2022. To be clear, this is an all in free cash flow definition. The adjusted free cash flow view we provided in 20 21 was useful, given the significant cash impact associated with the separation and structural actions. Now in 2022, despite the fact we still have nearly $500,000,000 of impact from the charges, We're focusing on a traditional free cash flow definition. The $10,000,000,000 to $10,500,000,000 reflects a year to year improvement driven by lower payments for the structural actions, a modest tailwind from cash taxes, working capital improvements and profit growth resulting from a higher growth and higher value business mix.

Speaker 3

With this performance, we're on track to our model. So now let me provide some color on our expectations for segment performance. Because this is a new segment structure, I'm going to spend a little more time and provide perspective on constant currency revenue growth and pre tax margin in the context of our segment models. In software, as we benefit from the investments in innovation and our go to market changes, we're seeing progress in our software growth rate. In 2022, We expect growth at the low end of the mid single digit model and then another 5 to 6 points of revenue growth from our external sales to Kyndryl.

Speaker 3

We expect software pretax margin in the mid-20s range for the year. We have solid momentum in IBM Consulting revenue and expect this to continue into 2022 as we help clients with their digital transformations. This momentum and our book to bill ratio support revenue at the high end of our high single digit model for the year with double digit growth in the first half. We expect low double digit pre tax margin for the full year with improving performance through the year as we make progress on price realization. Infrastructure revenue performance will vary with product cycle.

Speaker 3

In 2022, with the new IBM Z introduction late in the first half, we expect performance above the model and a slight contribution to IBM's overall growth. On top of that, we're planning for about 2 to 3 points from the external sales to Kyndryl in 2022. This supports a high teens pretax margin rate For the full year, these segment revenue and margin dynamics will yield about a 4 point year to year improvement in IBM's pretax operating margin for the full year and 2 to 3 points in the Q1. In terms of tax, we expect a mid to high teens tax rate, which is a headwind to our profit growth. Bringing this all together, we expect mid single digit revenue growth before Kyndryl and currency and $10,000,000,000 to $10,500,000,000 of free cash flow for the year, both in line with our midterm model.

Speaker 3

Patricia, let's go to the Q and A.

Operator

Thank you, Jim. Before we begin the Q and A, I'd like to mention a couple of items. 1st, Supplemental information is provided at the end of the presentation. In addition to our regular materials, we've included a summary of our new segments for your reference and historical data on segment pre tax income. And then second, as always, I'd ask you to refrain from multipart questions.

Operator

Sheila, let's please open it up for questions.

Speaker 1

Thank you. At this time, we'll begin the question and answer session of the conference. Our first question comes from Amit Daryanani with Evercore. Your line is open.

Speaker 4

Thanks a lot for taking my question and thanks for the clarity.

Speaker 2

Jim, I want to go back

Speaker 4

to the $10,000,000,000 to $10,500,000,000 free cash Number for calendar 2022. In other words, a lot of moving parts here. So it's more than what I think many had been modeling. And if I think about the Analyst Day framework we have about it was supposed to be a $10,000,000 free cash flow in 2020 adding $750,000,000 if I remember correctly annually. I would put this somewhere in the $11,500,000,000 range, I think is what I would have expected.

Speaker 4

So can you just talk about either relative to that, if you want, what is the delta to free cash flow? What are the puts and takes there? That would be really helpful.

Speaker 3

Sure. Amit, thank you very much for the question. First, let's just ground everyone, because I want to make sure we have absolute clarity as we're returning to reporting all in free cash flow to 1, align to our consistency of IBM's post separation baseline to your point to 10,000,000,000 in 2020 and more importantly to align to our forward looking guidance, which we talked at Investor Day with a midterm model of $35,000,000,000 cumulatively over 2022 to 2024. For 2022 specifically, as you heard me say, we expect free cash flow to be between $10,000,000,000 $10,500,000,000 all in. And that puts us right on track for the $35,000,000,000 mainly, Amit, because it includes still the remaining structural actions charges of about $500,000,000 in 2022.

Speaker 3

And when you look at that, because of structural actions, you're not going to have linearity in that $35,000,000,000 throughout 2022 to 2023 to 2024. So let me talk just a little bit so we get around the drivers to your point at the heart of your question. First, we do have about $500,000,000 remaining in the cash impacts for the structural charges, as I stated earlier. That means year to year, it's about $1,000,000,000 give or take benefit. 2nd, we anticipate about $500,000,000 of working capital efficiency, just based on our AR dynamics around volume and also We're entering a mainframe cycle late in the first half.

Speaker 3

3rd, very minimal tailwind with regards to cash tax, which basically means the majority of this has to be delivered on an operational profit and invest less, I should say, investments in capital expenditures. And that's going to come from revenue growth at our model mid single digit before we add on Kyndryl operating leverage, which we talked about 4 points improvement for the year, a mainframe cycle and us continuing to address the remaining stranded costs from the separation of Kyndryl as we move forward. So we feel very comfortable. 1, dollars 10,000,000 to $10,500,000,000 puts us on position to that $35,000,000,000 And 2, more importantly, that this cash provides us with ample financial flexibility to continue to invest our business both organically and inorganically and return significant value to our shareholders with our committed dividend.

Operator

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

Speaker 1

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

Speaker 5

Yes. Thank you. Arvind, I couldn't agree more with your comments about the structural uplift in IT spending from technology diffusion across all sectors. But as you think about the stock market volatility over the last several weeks, is there any reason to believe that there could be some near term cyclical impact From that volatility? And then maybe if you can also comment on whether the recent pullback in software valuations increases the likelihood that you might look at doing bigger M and A this year?

Speaker 5

Thanks.

Speaker 2

Thanks, Katie, for the question. And thank you for also noticing and acknowledging the robust IT spending environment. Look, Carey, I mean, like if I react to every stock market, Intraday volatility, that's a full time occupation. I think today showed that they're actually These cycles are hard to predict. And if I back up and look at our clients, I think they are not really reacting to these volatilities.

Speaker 2

We saw this in the middle of 2020 also, not just in 2021 2022. For the first time, Despite a down business cycle in 2020, we saw people actually decide to keep up their IT spending. Now I'll acknowledge in 2020, they did put a break on capital spending within IT, but they all acknowledged that IT spending was critical to how they would come out and that showed up in 2021 spending, okay? So I suspect look, we are not as much expert on this as many of you on this call, but I would suspect that This volatility we are seeing recently will not have much of an impact. Now if it becomes into an overall bear market correction That would be different, but I don't think we're anywhere close to that.

Speaker 2

I think in terms of near term cyclical impacts, I don't really see them. Our clients tend to be people who are in much more what we provide technology for is much more in the critical applications. People need them for doing online payments. They need them for authorizations, reservations, retail banking, healthcare, telecom within the government for critical applications. So we don't tend to see much of a short term cyclical impact.

Speaker 2

Now on your last question valuations, look, I'm always clear, valuations M and A has to have an economic benefit for our company and our shareholders. As valuations come down. Thirdly, some targets may become more approachable that were not previously approachable. And I've said before, look, we have a little over $20,000,000,000 of flexibility over the next 3 years. I'll just leave it at that.

Speaker 2

That's our total flexibility. As prices come down, certainly more things come within range.

Operator

Thank you, Katy. Can we go to the next question, please?

Speaker 1

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

Speaker 6

Yes, thank you. Really just Some clarifications. You talked about the year over year improvement in PTI of about 4 points. It looks like that The year over year kindle contribution of $1,800,000,000 in revenue should come in at extremely high marginal contribution, maybe 70%. And then you're going to have a year over year contribution from fewer charges.

Speaker 6

So maybe you could dimension each of those and talk about Whether you believe underlying PTI will improve? And then similarly, if you could just clarify your expectation for The acquisition contribution to revenue in 2022 and you didn't mention the divestiture of Watson Health, How we should think about that? Is that in addition to should we be factoring in on top of the guidance or does your guidance include the divestiture Watson Health revenues? Thank you.

Speaker 3

Hey, Tony, I'll take this. Thank you very much for the question. A handful there to address overall. So if I got it correctly, 1st of all, yes, we talked about our guidance coming off of a very solid Q4 gives us confidence in the foundation to really build on our midterm model. And we said 2022 would be the next step.

Speaker 3

We have progress, more work to do, mid single digit growth, Pre the Kyndryl contribution, operating margins up about 4 points and then free cash flow, as I answered Amit, at $10,000,000,000 to $10,500,000,000 So when you look at that operating profit overall, first of all, yes, we're very transparent in our 2 key measures of success. Number 1, the contribution of revenue growth. And we said We're going to be up mid single digit prior to adding the Kyndryl 3 points roughly for the year. And the second key measure, which we've got our entire business, our operating model aligned to is free cash flow generation. And we're very transparent in our free cash flow generation that, that is all in.

Speaker 3

With a baseline IBM Post separation baseline of $7,900,000,000 we reported in 2021 going to $10,000,000,000 $10,500,000,000 on its way to delivering $35,000,000,000 cumulatively over time. Within that, I gave you the breakout of the bridge on cash flow. No matter how you cut it, we are going to invest more in capital expenditures this year. But when you take out the working capital efficiency of a 500,000,000 a very modest cash tax tailwind and you take out the $500,000,000 of structural charges, you get substantial operating profit growth. And I would tell you, although we're not going to disclose based on commercial competitive reasons around the profitability of Kyndryl overall.

Speaker 3

And I don't think you would expect this because we don't do that with any strategic partner or client that, that is a minimal component of the required operational profit improvement for 2022 overall. So we feel pretty good about the confidence in our guidance. It positions us on that midterm model And it gives us tremendous financial flexibility and to continue to invest to extend our hybrid cloud leadership, invest in innovation to bring on new technology and return significant value back to our shareholders overall. I think that was the first one. The second one, Acquisition revenue contribution, obviously, we've got work to do to close this.

Speaker 3

This won't close until Later in the Q2 and at that point in time, we will disclose information around Watson Health and what the implications are to our guidance overall and we'll update investors as we always do.

Operator

Okay. Thank you, Tony. Can we please go to the next question?

Speaker 1

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

Speaker 7

Yes. Thank you. Arvind, as you think about the midterm model and layer in some of these puts and takes that you guys highlighted in 2022,

Speaker 2

you could

Speaker 7

have up to maybe a couple of points of benefit from M and A and maybe up to a point from mainframe. As you look into 2023, some of these elements will turn into headwinds, particularly maybe up to 2 points from infrastructure. What are the things that you're looking at That should grow better than 20222023 to offset some of this to get back to that mid single trajectory. And Jim, can you address 2022 seasonality for revenue growth and cash flow given the Kyndryl separation and really very different timing on the Z cycle?

Speaker 2

Yes. So, Vamji, thanks. Let me address the first part of the question, the mid single digit growth in 2022 going to 2023. Let me remind you, when we did our Investor Day in early October, we talked about that the mid single digit growth comes from About two points of that for IBM comes from the consulting growth, about between 12 points comes from the Red Hat growth And then we would get some from infrastructure, AKA mainframe, but there's more than mainframe. There's storage in there and there's also power product cycles and then organic software.

Speaker 2

If you put that all together, you would get more than mid, mid single digit in a given year. But we begin to see cycles of that. For example, our mainframe, When we say it comes late in the first half, that means it's really a second half twenty twenty two contribution. That carries on then into the first half of twenty twenty three, maybe till the Q3, maybe longer depending on the cycle. If I look at Red Hat, fully expect that to carry on.

Speaker 2

If I look at consulting, We expect that to carry on. So if I look at all the underlying components and then as I bake in the acquisitions into software, those will begin to contribute a bit more and a bit more each year. You asked about the overall acquisitions. I think that will give us about a point each Which is what we had said before, but that is inside what I talked about the 2 points and the 1 to 2 points and the point and the point. And so that is the thesis here.

Speaker 2

And by the way, so if you look at what I laid out, 2022 and 2023 look remarkably similar, not that different. Jim, you want to seasonality question? Yes. Wamsi, thank

Speaker 3

you very much. Very important question when we think about 2022, just building on what Arvind just said right there. If you think about the revenue growth profile and how it's going to play out in 2022. As we stated earlier, we expect the mainframe cycle this year and that will happen late in the first half. So read that minimal contribution in 2Q and then mostly in the second half.

Speaker 3

But second, really the big point I want to get out is you can quite expect Due to the separation of Kyndryl, which was a highly annuitized based business, I think we're going to have a different business SKU throughout 2022 on top of the product cycle that I just talked about earlier. I would expect somewhere in the neighborhood around profit, to be about forty-sixty first half, second half. But I would tell you underneath that 40% in the first half, It's going to be skewed more towards Q2 just given the new introduction of our mainframe cycle. And also last year, we had a very strong Q1 mainframe. We grew over 20%.

Speaker 3

So we're wrapping on a GA plus 11 quarter at the end of its cycle on the most successful mainframe program we've had program to date, we're very late in that cycle. So I would expect more of that profit to be in second quarter and again, 40 to 60 First half, second half.

Operator

Thanks, Wamsi. Sheila, can we please go to the next question?

Speaker 1

Absolutely. Our next question will come from Jim Suva with Citigroup. Your line is open.

Speaker 8

Thank you very much. Both Jim and Arvind, you guys done a tremendous amount of heavy lifting and work over the past couple of years, all the way from integration of Red Hat to spin out of Kyndryl. Looking ahead now, just strategically, my one question is, are we looking at the core company is now it's really time to harvest everything or there's still some more transformational or pruning or spinning out going on? And I'm not referring to the Watson Health, I'm talking about more bigger things or it seems like now it's time to start harvesting things, but maybe I'm not hearing your comments correctly.

Speaker 2

Jim, let me take that. This is Arvind. Look, I think that we have done a lot of the heavy lifting we need. I fundamentally believe that we have the right portfolio and we have the right focus to be delivering on our midterm model. Maybe I didn't quite understand the word harvest.

Speaker 2

I wouldn't say harvest. We have the correct portfolio to be able to grow where our clients have got demand and where the market has demand. We are now approximately a 30% consulting company, a percent technology company. It's about a little bit under half is software. If I look in software, Yes, there is a portion that is very much focused on transaction processing.

Speaker 2

We believe that model is going to be a mid single digit decline over the very long term. And if you look at some of the dynamics that Jim Kavanaugh talked about, you kind of see that then if you go over the past couple of years. Then if I look at automation, security, data and AI, I think these very much into where there is a lot of demand in the market. If I look at consulting, that's how clients are going to go get their projects on digital transformation completed. And then if you look at hybrid infrastructure, we are quite focused in infrastructure On the areas that align to our high value model, if I look at both storage and mainframe, they give us a lot of benefit to also help drive the other part of the portfolio.

Speaker 2

If I got it right, Jim, to your question, no, you should not expect any major strategic, divestitures like we just have talked about with Kyndryl, I think those are behind us. Now we have the portfolio that allows us to deliver on our medium term model.

Operator

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

Speaker 1

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

Speaker 9

Thank you. This is a question for Jim. Jim, if we take your revenue growth comments about 22% in the margin comments. It would just seem to yield net income below your free cash flow guide. And obviously, I'm assuming The new model given the combination of software and professional services would yield free cash flow by 1x on a conversion basis.

Speaker 9

So if that math is right, you help reconcile the difference between the implied EPS guide to that $10,000,000,000 $10,500,000,000 of free cash flow?

Speaker 3

Yes. Well, David, as we've talked since Arvind has come on and taken over as Chairman and CEO, we have aligned our portfolio, we've aligned our capital investment allocation structure, we've aligned the operating model in this company And I'm a very big believer in focus. And that focus is around 2 measures, revenue growth and free cash flow. So I am not going to talk about EPS guidance. And by the way, EPS, as you know quite well, there are many ways of to an EPS number.

Speaker 3

But I've given the breakout of the revenue growth overall. We've been very transparent mid single digit. We said we're going to get an operating leverage improvement of about 4 points, and we broke that out by segment. We're going to get software, we expect up to mid-20s on our path to approaching 30 In our midterm model, we said around consulting at the high end of our high single digit revenue growth model, We're going to approach about 10% coming off of about 8.5 point margin business in 2021. And then infrastructure, given we've got a product cycle, we expect above model on revenue, as Arvind answered earlier.

Speaker 3

It will be a slight contribution to IBM and we expect the operating margins in Infrastructure to be in the high teens. When you take all those components of what I just brought out and then you do the free cash flow bridge, you get a quite healthy profit contribution to deliver that free cash flow. And I think, David, that is the focus that Arvind's got 250,000 IBMers mobilized on revenue growth, that operating margin by segment to deliver the product mix and productivity and net free cash flow. And that's what we're going to continue to guide on as we move forward.

Operator

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

Speaker 1

Our next question comes from Kyle McNealy with Jefferies. Your line is open.

Speaker 10

Hi, thanks very much for the question. This one's about the trajectory of the infrastructure business, given the moderation in growth that you saw last quarter in Q3 and then The better performance you saw this quarter, do you got any added confidence now after the performance this quarter that we won't see another soft quarter Like in Q3 before we get into the next, IBMZ cycle in the second half of the year?

Speaker 2

Kyle, maybe I'll start there. The Q3, I think we stated even when we finished the Q3 that we saw a pause on some of the CapEx purchases and infrastructure because people were digesting what to do around the Kyndryl separation. That particular factor I do not believe is going to show up again. Now that said, as Jim said a bit earlier in answer to one of the other questions, this is the 11th quarter of mainframe. When we look at that, we do expect softness on mainframe in the Q1, but not in the remaining quarters.

Speaker 2

I'd say that that's the only critical dynamic that could be different if we look at quarter to quarter. But that is expected and baked And what we're talking about for the year and what we're talking about in terms of infrastructure performance, which for the year we do expect it to be better in 2022, but more of that in the second half as Jim pointed out earlier.

Operator

Very good. Thank you, Kyle. Sheila, let's take one last question.

Speaker 1

Thank you. Our last question will come from Brian Essex with Goldman Sachs. Your line is open.

Speaker 11

Hi, thank you. Good afternoon and thank you for taking the question. Maybe for Arvind, some really nice Business Transformation Technology Consulting Growth. And I'd love to hear your comments of or at least if you can on customer conversations and what those have been like and how you might characterize some of that business activity, whether you feel as though we're in the early stages, Maybe the middle innings of technology transformation efforts, how would you frame that business? And How much of that business is a leading indicator for Red Hat and Automation Growth?

Speaker 2

Thank you, Brian for the question. So to go to the middle part of your comment, I would call it that we are in the early innings, not the middle or late innings of growth in consulting. I wouldn't call it the very first inning, maybe the first inning was 2021, but early innings. So I think we have a long way to go on this. Now I think that leads to the first part of yours, What are the anecdotes or what are the customer conversations that lead us there?

Speaker 2

Everyone is looking for how do you deploy technologies, be it Salesforce, Adobe, Cloud Technologies to go improve their processes. It's actually the conversation has changed from 3 years ago. It's not about cost savings. It's actually much more about how can you deploy these technologies to improve a process. Is it how do I do omnichannel and multichannel?

Speaker 2

Is it how do I do resilience in my supply chain? Is it about how do I use every warehouse and store as a point of delivery, not just for physical, but for physical or online commerce. As you begin to look across these topics and then as we look at the added cyber threats that come in, these do create a huge pull from clients on how do you improve the end to end customer experience, how to improve the resilience of their supply chain, how do you improve the experience for employees, How do you begin to use I'll use the word bot because I'm a technologist. Others may use the word digital worker, that's probably a more correct word, to take care of all the upcoming, I'll use the word demographics on the skill shortage that is endemic in technology now and that is sort of playing in. By the way, I don't believe that the skill shortage is because of COVID.

Speaker 2

I do believe COVID may have exacerbated or created a pull in of those demographics, but those I think are going to last us for the decade. Now I think that that is a leading indicator of automation, Red Hat, cybersecurity growth for sure. I would call it it's not identical, meaning you're not going to see the same percentage from one to the other, but you absolutely will see correlation that is significant between those. And when Jim talked about the number of Red Hat engagements and then we talk about the garage engagements from consulting, Those are then proof points of that correlation. So Brian, thank you for the question.

Speaker 2

And that is by the way why We see a lot of the of our confidence in the next few years of revenue growth. So, first, Pat and Jim, thank you guys for answering your part of the questions. Let me now make a couple of comments to wrap up. And I'm going to end where I started the call. We've been taking actions that position our business to address the attractive hybrid cloud and AI opportunity.

Speaker 2

Our 4th quarter results and expectations for 2022 are a first glimpse of today's IBM and they reinforce our confidence in our strategy and our model. I hope that all of you are as excited about our future as I am. And I look forward to speaking with all of you again soon.

Operator

Sheila, can we turn it back to you to wrap up the call?

Speaker 1

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

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Earnings Conference Call
International Business Machines Q4 2021
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