International Business Machines Q3 2023 Earnings Call Transcript

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Provided by Quartr
October 25, 2023

There are 11 speakers on the call.

Operator

Welcome and thank you for standing by. Now I will turn the meeting over to Ms. Patricia Murphy, IBM's Vice President, Investor Relations. Ma'am, you may begin.

Speaker 1

Thank you. I'd like to welcome you to IBM's Q3 2023 earnings presentation. Objections. As the operator just mentioned, I'm Patricia Murphy, and I'm here today with Arvind Krishna, IBM's Chairman and Chief Executive Officer And Jim Kavanaugh, IBM's Senior Vice President and Chief Financial Officer. We'll post today's prepared remarks on the IBM Investor website Within a couple of hours and a replay will be available by this time tomorrow.

Speaker 1

To provide additional information to our investors, our presentation includes certain non GAAP measures. For example, all of our references to revenue and signings growth are at constant currency. We've provided reconciliation charts for these and other non GAAP financial measures objections 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.

Speaker 1

Additional information about these factors is included in the company's SEC filings. So with that, I'll turn the call over to Arvind.

Speaker 2

Thank you for joining us. Before we start, let me address the outbreak of war in Israel. We condemn all acts of terrorism. We are also saddened over the loss of innocent lives and joined the global community In the hope that peace and safety can be restored. Let me now turn to our business performance.

Speaker 2

In the Q3, we had solid growth Across revenue, profit and free cash flow, while delivering innovations and positioning our business to capture future opportunities. On the broader trends we are seeing in the market, technology continues to serve as a fundamental source of competitive advantage. Businesses and governments around the world are looking for opportunities to address demographic shifts, make the supply chains more resilient Higher for longer, add to the growing uncertainty. Technology helps organizations better deal with the many challenges they face. We see both tailwinds and headwinds to overall spending.

Speaker 2

Nearly every business we talk to wants to leverage technology to offer better services, We believe the tailwinds outweigh the headwinds and technology spend will continue to outpace GDP. In this past quarter, we saw good revenue growth in software and consulting. In infrastructure, More than a year into the product cycle, we continue to see good adoption of Z16. Our overall growth reflects our ability and seamlessly integrate hybrid cloud solutions. We also continue to position our business for the future, launching new products and offerings, Forging and expanding key partnerships, investing in talent and skills and focusing our portfolio.

Speaker 2

We have been taking concrete actions to deliver productivity in our own business. All of this results in an IBM Typically at this point, I talk about hybrid cloud and the progress we have made. Hybrid cloud remains vitally important to our clients and to our business. Given the inflection in AI And more specifically, generative AI, I want to spend more time today on AI and how we are approaching this opportunity. We believe that generative AI will be multi model with clients using a combination of IBM's models, Other companies' models, their own proprietary models and open source models.

Speaker 2

This hybrid approach to AI is similar to the hybrid approach to cloud. Let me give you an overview of the capabilities We have been building. Our generative AI software stack starts with Red Hat OpenShift, which serves as a foundation that allows clients to operate in a hybrid environment. These are services help make the data ready for AI. Watson X is a core platform that enables clients to train, tune, validate and deploy AI models.

Speaker 2

We We are providing models that address specific domains such as code, language and cybersecurity among others. Our AI assistants include the Watson X Code Assistant to augment developers, Watson X Assistant to augment customer service agents And Watsonx orchestrate to augment employees. This quarter, we introduced new AI capabilities for our clients and partners. We unveiled Granite, a multi billion parameter foundation model on Watsonx dotai, We also introduced the Watson X Code Assistant. This It's fueled by a 20,000,000,000 parameter model and can, as an example, swiftly translate COBOL to Java.

Speaker 2

There are 100 of billions of lines of code written in COBOL, so the opportunity is significant. Looking forward, We plan to launch what's the next dot governance before the end of the year that provides governance tools businesses need to mitigate risks And ensure compliance through the AI lifecycle. This is a key consideration for clients as they go beyond early proof of concept To bring our AI capabilities to life, we have more than 20,000 data and AI consultants, Including a center of excellence for generative AI. Our teams help clients navigate the AI landscape from crafting a strategy, Understanding how AI can be used and deploying AI responsibly. These consultants also provide valuable real time feedback to our product As in hybrid cloud, our ecosystem across GSIs, ISVs and hyperscalers plays a critical role in bringing generative AI to our clients.

Speaker 2

In the work we are doing, clear patterns are emerging objections, based on extensive feedback and trials to date, 3 have risen to the top: Code modernization, customer service and digital labor all have broad relevance and deliver tangible business benefits. We've also seen this internally as we apply our AI capabilities to areas such as client support, HR, IT Optimization and Source To Pay to automate a significant portion of tasks and improve the productivity of our people. Our book of business in the 3rd quarter specifically related to generative AI was in the low 100 of 1,000,000 of dollars. The interest is larger with thousands of hands on interactions with our clients. These are across our largest clients and smaller clients, which lays the groundwork for future Watson X opportunities.

Speaker 2

Let me close the discussion on AI By talking about a couple of client examples. Dun and Bradstreet is leveraging our consulting and software capabilities Fueled by Watson X to help their clients create proprietary generative AI solutions. IBM and Also just announced a new solution powered by Watsonx Orchestrate to enhance Our industry leading hybrid cloud platform, Red Hat OpenShift, which was recognized recently by both Gartner and Forrester as the leader in container management. We completed the acquisition of Aptio, which complements our IT automation capabilities. In Quantum, We're making good progress in building practical quantum computers that can solve hard problems in areas such as risk, finance and materials.

Speaker 2

In closing, we accomplished a lot this quarter. We launched our generative AI platform and have good momentum in helping our clients We continue to take portfolio actions to increase our focus on hybrid cloud and AI, And we are applying AI within our own business, improving execution speed and unlocking real value. All of this reinforces my confidence in our future. We're executing a strategy that closely resonates with our clients' needs And this is propelling our business forward. 3 quarters into the year, we are well positioned to deliver on 2023 expectations I'll hand it over to Jim.

Speaker 3

Thanks, Arvind. I'll get right into the financial highlights of the quarter. We delivered $14,800,000,000 of revenue, dollars 2,300,000,000 of operating pretax income We generated $5,100,000,000 of free cash flow. Reported revenue growth was 4.6%. This includes just over a point of growth from currency translation, which is significantly less than the currency rate suggested in July.

Speaker 3

In fact, currency movements over the last 90 days impacted our 3rd quarter revenue by about $250,000,000 At constant currency, our revenue was up 3.5%. As is typical, I'll focus the discussion on constant currency. Arvind talked about clients' priorities in today's environment, which are driving solid growth in our software and consulting offerings. I'll remind you, software and consulting are our 2 growth vectors and together make up about 3 quarters of our revenue base. Software revenue was up 6% as clients leverage their data for insights and automate their IT in a hybrid environment.

Speaker 3

We had good growth in both hybrid platform and solutions and transaction processing revenue. Our consulting business had another solid quarter with 5% revenue growth, strong signings performance As we help clients get value from hybrid cloud and AI and leverage our strategic partnerships. Our infrastructure revenue was down 3% with growth in Z Systems. More and more, we are seeing clients embrace IBM Z in their hybrid cloud environments, especially in regulated industries. This growth was offset by declines in distributed infrastructure and infrastructure support.

Speaker 3

IBM's revenue growth, together with a good portfolio mix and yield from our productivity initiatives, generated strong margin, profit and free cash flow performance. Operating gross margin expanded 160 basis points And operating pretax margin expanded 170 basis points. Within that PTI margin, We absorbed a year to year currency impact of over 150 basis points. Despite that headwind, Our margin expansion was broad based with improvements in every business segment. Driving Efficiency and productivity has always been part of our operating and financial models.

Speaker 3

These ongoing productivity initiatives Enable reinvestment in the business, increase financial flexibility and contribute to margin expansion. Our activities range from simplifying our application environment to digitally transforming our business processes We are ahead of pace to achieve our target of $2,000,000,000 in annual run rate savings The combination of our revenue and margin performance yielded strong profit growth. Operating pre tax profit Was up 17% to $2,300,000,000 We generated $1,700,000,000 of free cash flow in the quarter Free cash flow growth through the 1st three quarters was primarily driven by cash sourced from our operating profit performance. We also had working capital efficiencies driven by solid collections. These growth drivers were partially offset Year to date, we spent about $5,000,000,000 in acquisitions and returned $4,500,000,000 to shareholders through dividends.

Speaker 3

Our resulting cash balance at the end of September was $11,000,000,000 That's up over $2,000,000,000 from year end. But with the acquisition of Aptio in the 3rd quarter, cash is down over $5,000,000,000 from June. Our debt balance is now $55,000,000,000 also down from June. Putting this all together, Our business fundamentals are solid with sustainable revenue growth, margin expansion, solid cash generation and a strong balance sheet with financial flexibility to support our business into the future. Turning to the segments.

Speaker 3

Software revenue grew 6% with contribution from hybrid platform and solutions and transaction processing. This performance reflects growth in both our transactional revenue and our recurring revenue base, which is about 80% of our annual software revenue. As we execute our platform based approach to hybrid cloud and AI. Red Hat revenue was up 8%. We continue to deliver good growth in OpenShift and Ansible, both gaining share again this quarter.

Speaker 3

Clients are committing to our hybrid cloud approach with annual bookings up 14% in the quarter. This includes double digit growth across RHEL, OpenShift and Ansible, partially offset by headwinds and consumption based services. IT and business automation are top client priorities And we've been investing to capture the opportunity. This quarter, our automation revenue grew 13% We had strength in AIOps and Management, Driven by good performance in Instana, Terminomic and now Aptio as clients look to optimize business outcomes and boost productivity. Data and AI revenue was up 6%.

Speaker 3

Growth areas include data fabric and customer care As enterprise clients are both preparing for and adopting generative AI solutions, leveraging Watson X. We also grew in Asset and Supply Chain Management as we help enterprises run sustainable operations. Security revenue declined 3%. We delivered growth in security software driven by data security Looking across these businesses, our hybrid platform and solutions ARR has grown to $14,000,000,000 Up 7% since last year. In transaction processing, revenue was up 5%.

Speaker 3

Throughout this year, we've been talking about how the success of the last couple of Z Systems cycles is driving demand for this mission critical software. This together with price increases contributed to year to date growth in both recurring We expanded gross and pretax margins. Our pretax margin was up 120 basis points, Even while absorbing over 2 points of impact from currency, we continue to deliver operating leverage Driven by our revenue scale and mix this quarter. Our consulting revenue was up 5% With growth across all three lines of business and geographies. With another quarter of strong signings, As I said, our trailing 12 month book to bill ratio is now over 1.15.

Speaker 3

Clients continue to prioritize transformation projects that enable cost savings and productivity. These results are a proof point that we are well positioned to meet these needs in today's complex environment. IBM's focused hybrid cloud and AI strategy has become even more of a differentiator as clients' interest in generative AI Make better decisions with speed and improve customer experiences. We made a series of AI announcements over the last few months, Demonstrating continued advancement of our strategic partnerships. We're providing clients with the opportunity to accelerate The transformation and deploy Generate AI responsibly, whether that be leveraging AI capabilities of IBM, Our partners or a combination.

Speaker 3

Today, our strategic partnerships account for about 40% of consulting revenue and have continued to grow double digits across revenue and signings. In aggregate, our hyperscaler partnership revenue was up over 40% and signings essentially doubled year to year. Additionally, our Red Hat practice, Which helps clients optimize how they build, deploy and manage applications for a hybrid cloud environment Has continued to grow at a double digit rate with over $1,000,000,000 of signings in the quarter. Objections. All of what I just mentioned from market demand to how we're positioned in partnering to our investments to drive growth In Business Transformation, revenue grew 5%, again led by data and technology transformations, Including AI and analytics focused projects.

Speaker 3

Finance and supply chain transformations also contributed to growth. In Technology Consulting, revenue was up 1%. Growth in cloud based application development and modernization work Was partially offset by declines in on prem application focused projects. In application operations, Revenue grew 7%, driven by both cloud application management and platform engineering services. In platform engineering, we help clients design an application environment that runs securely and smoothly at scale.

Speaker 3

Moving to consulting profit, we expanded gross margin 150 basis points. Pretax margin expanded 40 basis points To just over 10%. Our year to year margin performance reflects productivity actions we've taken mitigated by increased labor costs and about a point of pretax margin impact from currency. Moving to the Infrastructure segment, revenue was down 3%. Hybrid Infrastructure revenue was flat, While infrastructure support declined 7%.

Speaker 3

Within hybrid infrastructure, Z Systems grew 9% in a seasonally smaller revenue quarter. Z16 revenue remains well ahead The program strength reflects both growing enterprise workload requirements and the economic value at scale of the platform in traditional processing and Linux consolidation. In fact, installed MIPS capacity for Linux on Z has grown more than fourfold over the last decade. Clients continue to value the security, resiliency and hybrid cloud capabilities of the Z Systems platform. Distributed infrastructure revenue was down 6% as compared to a strong growth in last year of 21%, Pre tax margin expanded 3.50 basis points, reflecting benefits from portfolio mix Now let me bring it back up to the IBM level to talk about our expectations before we go to Q and A.

Speaker 3

Just about 2 years ago, we introduced today's IBM, a more focused business with a platform based approach bring new products and innovation to market, expand our ecosystem and our talent base and drive productivity across our business. The result is a business that addresses today's client needs with a stronger financial profile. Our 3rd quarter performance reinforces this progress with 3.5% revenue growth, gross and pretax margin expansion 3% to 5% and free cash flow of about $10,500,000,000 that's up $1,200,000,000 over last year. We've had solid revenue performance all year in our growth vectors of software and consulting. We still expect software revenue growth at the high end of its mid single digit model and consulting revenue In the 6% to 8% range.

Speaker 3

Infrastructure revenue, of course, reflects product cycle dynamics. In total, with 1 quarter to go, it's prudent to assume the low end of IBM's 3% to 5% range. We are making great progress in our productivity initiatives. The work we are doing to digitally transform our business not only makes us more nimble By simplifying and streamlining our processes and operations, but it also frees up spend for reinvestment, provides financial flexibility and delivers operating leverage. This contributes to solid margin and free cash flow performance.

Speaker 3

We continue to expect about 0.5 point of operating pretax margin improvement and we see a mid teens tax rate for the year. Our free cash flow performance has been driven primarily from our profit performance. Through the first three quarters, we're up $1,000,000,000 year to year and we delivered nearly 50% Q4, we're on track to achieve about $10,500,000,000 for the year. As I look specifically at the 4th quarter With the recent currency movements, we now see currency to be neutral to a one point headwind to revenue growth. That's nearly $600,000,000 worse than 90 days ago.

Speaker 3

I'd expect constant currency revenue growth in the 4th quarter And the large Z16 transactional performance in infrastructure. This demonstrates continued momentum in our underlying business. Bring it all together, we've clearly got a higher growth, higher value business with strong cash generation, A business well positioned for the future. Arvind and I are now happy to take your questions. Patricia, let's get started.

Speaker 1

Thank you, Jim. Before we begin the Q and A, I'd like to mention a couple of items. First, supplemental information is provided at the end of this presentation. Operator, let's please open it up for questions.

Operator

Thank you. At this time, we'll begin the question and answer session of the Our first question comes from Amit Darianani

Speaker 4

Patricia, one last time, ask one question only, Ru. I guess, Arvind, there's a lot of macro concerns out there to say the least. I'm hoping you could spend a little bit of time just talking about when you talk to your customers and I'm sure you engage with a lot of the Fortune 500 companies, Given this macro environment, how are they shifting or prioritizing their IT budget dollars? And I fully understand, Ebony, you're talking about generative AI and Yes, how beneficial it's going to be, but given the macro environment, given the constrained IT budgets, I guess, where are they taking money away from to fund these investments? I'd love to just understand the customer feedback you're getting and how is the priority changing as we go forward?

Speaker 2

Hi, Amit. So thanks for the question. And it's actually wonderful to talk about this. So generative AI, just for me to very quickly reiterate the use cases we found And on, I'll call it, general digital workers, which is productivity in every enterprise function. So if you look at Code, To a person, every one of the clients said, we don't intend to get rid of any developers, but this allows us to take care of the tech debt that we've accumulated Amit, I'll kind of point out most enterprises are very quick to realize If you are more productive, that means you have a competitive advantage to your peers.

Speaker 2

And if they have a competitive advantage to their peers, they'll take share Without spending more on labor, that's an incredible long term competitive advantage. When you go to customer service, There is a cost takeout aspect, but it's not 100%, but there is probably a 20% to 30%. If you can have more calls, more chats Answered by AI, that means you can have much more volume with a smaller number of people. So there is both. Also, I'll point out to our audience, AI does not get It doesn't get angry.

Speaker 2

It doesn't get upset. So there is a NPS improvement you get along with it. And then on the third one on digital workers, There likely is a small productivity improvement, but I would call it more in the 4%, 5%, 10%, not 20%, 30%, 40%. So in the macro headwinds you're mentioning, higher interest rates, tougher to get skilled people, All of the issues around the geopolitical uncertainty that causes some of the concern or Might have caused a pause in some other environments. The AI side and to be candid, the hybrid cloud side offers them a way through that Without having to decrease their ambitions for next year.

Speaker 2

And I think we are seeing every one of them play to that. And I think that these are more fundamental, these are more core processes than some of the other areas that people were worrying about 2 or 3 years ago. 2 or 3 years ago, people were worrying a lot about what do I do to keep all our employees happy and can I add up all the tools for that? I think there's much less of a focus on that area.

Speaker 1

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

Operator

Next, we will hear from Wamsi Mohan with Bank of America. You may proceed.

Speaker 5

Yes. Thank you so much. I was wondering if you could comment a little further on the Red Hat deceleration in 3Q. Jim, it sounded like, it was driven partly by consumption based services that were somewhat weaker. Are you still expecting Red Hat growth in that 11% to 13% range for the year?

Speaker 5

And can you unpack some of the Software elements in the Q4 between Red Hat Transaction Processing and perhaps Aptio. Thank you so much.

Speaker 3

Yes. Thanks, Wamsi. I appreciate the question. Obviously, we're very pleased overall with our software segment performance growing 8%, Actual 6% at constant currency really led pretty pervasively with growth across the board. Automation led, Red Hat at 8% as you said, and I'll come to that in a second.

Speaker 3

But data and AI overall, really underpinning all that Like we said, starting the year, 1, a very strong solid recurring revenue base, High value 80 percent of that portfolio, by the way growing mid single digit growth. You see that play out in our transaction processing that we call the growth factor. And then also our Hybrid Platform and Solution business, dollars 14,000,000,000 ARR that's growing High single digit overall. Now within that, you see Red Hat. Red Hat, we talked about in the prepared remarks.

Speaker 3

1st of all, Arvind and I would acknowledge we came in a couple of points below our expectation. And I think that's an execution discussion overall. Embedded in that, where did it come from? It came from because I think this is very important. It came from the consumption based services And offering side of the equation, which by the way is about 20% of our portfolio shorter duration, overall.

Speaker 3

And it went from last quarter high single digit, which is about what the model is, to low single digit overall. If you look at that and compare that now, let's look at the other part of the portfolio, the remaining 80%. That is our subscription based business. That's our REL franchise industry market leader. That's Red Hat OpenShift and that's Ansible.

Speaker 3

We had a very strong annualized bookings in the quarter, which again subscription based business model, we talked about all year long, we were Be back end loaded on renewals. We grew that mid teens overall, including services by the way. If I extract out that 20% portfolio services and just look at the core subscription based businesses Of Red Hat, OpenShift and Ansible, we grew 19% overall, 110 plus percent NRR on that renewal Rate of that business and within that 19%, OpenShift and Ansible were north of 40% With REL growing double digits. So putting all that together, I think it's prudent right now. When we look at 4th quarter, We're only building into our model.

Speaker 3

Again, software at the high end of our segment model, We're only building in high single digit. We have to continue to monitor what happened to us in the Q3, get the team focused on execution. But I would tell you just given the signings growth that we posted in the Q3 and by the way another good pipeline In the Q4, we feel very confident in the long term posture of Red Hat growing double digits. We just got to get through and monitor what's happening to us on the services side. So thanks very much for the question.

Speaker 1

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

Operator

Our next question comes from Tony Sacconaghi with Bernstein. You may proceed.

Speaker 6

Yes. Thank you for Currency to be at the low end is somewhere around $17,300,000,000 which is Quite a bit below normal seasonality despite the fact that you have Aptio and you had strong services signings. So I'm wondering if you could Pull forward in mainframe from Q4 to Q3, this quarter, or are you expecting some Deceleration in transaction processing. Maybe you could kind of confirm the number for Q4 and then unpack it a little bit As to why it's below normal seasonality. Thank you.

Speaker 3

Great, Tony. Thanks very much for the question. I appreciate it. And I know Patricia really appreciate sticking to one question given it's her last call leading and piloting, And we thank her for all our efforts, but we'll have more time to celebrate in January. But as you stated, we remain confident And what our guidance is overall with regards to top line revenue growth 3% to 5%, albeit as we said Low end and that's just practically speaking given we have one more quarter to go.

Speaker 3

We said we expect similar performance 4th quarter As we just executed in Q3, constant currency revenue growth, right? Let me unpack that to your point. First of all, at the macro level, historically, we would generate quarter to quarter about $2,900,000,000 ish of revenue. Last year, by the way, we did $2,600,000,000 up quarter to quarter in revenue. That's 17.3 number in that ballpark, you're Not too far off, it's about equivalent to last year.

Speaker 3

It's about $2,600,000,000 But I would tell you one thing underneath that Tony We've seen a very different dramatic change in the currency FX U. S. Dollar strengthening. To tune about $300,000,000 if you go look at the math back into 2019, 2020, 2021. So underneath it, pretty consistent quarter to quarter performance as last year, which by the way, I would highlight We're going to match that even taking into account the FX headwinds overall that we called out going forward.

Speaker 3

One last thing that I'll put and then I'll get into the color is on a profit basis, although you didn't ask that. Historically profit, We generate somewhere, if I remember correctly studying over the weekend about $1,300,000,000 quarter to quarter. You look at our Operating pre tax margin, which we recommitted a 0.5 point for the year, that puts you in a profit range of, I don't know, dollars 1,700,000,000 $1,800,000,000 quarter to quarter. So you see the fundamental operating leverage of what's happening to our business. So you put all that together, we still believe we have a very confident year at that 3% to 5%, by the way, led by software delivering 3 points of that IBM growth, Consistent, I would say very good performance competitively in consulting, driving about 2 points of IBM's growth.

Speaker 3

Infrastructure, we're on the product cycle downside. We said beginning of the year and we're consistent. It's about a point hurt to IBM. And then you got the divestiture impact of about 0.5 point. You put all that together, I think that's a pretty good year overall and pretty much on top of our model.

Speaker 1

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

Operator

Next, we will hear from Matt Swanson with RBC Capital Markets. Your line

Speaker 7

Yes. Thank you for taking my questions. It was great to hear about some of the quantifiable success that you've seen in generative AI so far. But maybe flipping that a little bit, whether it's through early consulting engagements or customer conversations, where are you seeing some of the choke points That might hold up people from deploying as fast as they want. And whether it's through foundation models or some of your other tools Around the governance side, kind of how that's developing your R and D to develop solutions for those problems?

Speaker 2

Yes. Thanks. Let me try to address your question here. Look, I think the concerns that people have All coming around, are these models accurate? How accurate are they?

Speaker 2

Do they result in things that May cause long term liability. People are worried about the conversation because they hear and they read That whether it's artists, whether it's authors, whether it's code, writers are suing some of the Producers of Large Language Models. You alluded to governance that comes more around life cycle and how do you carry it out over the long term. Coupled with this are some people's concerns. If you add their own private data into a model, now what happens to the model?

Speaker 2

Where is it protected? Where does it stay? Do others learn from it? So if you begin to unpack all of that, We begin to say, all right. For models that are IBM produced, we will give you indemnification, Meaning, we are confident in our ability to stand by the data we have used to train, what is being used to be output And we'll stand behind the same indemnification as you provide for all enterprise software.

Speaker 2

As you would expect, that's hard for us to do For open source models. But we believe that that takes care and that is why we are so excited about code and customer service To start with, because that's where we believe that people can benefit from this indemnification. Talking about the governance and the lifecycle side, people are also worried about some of the long term deployment because an enterprise May well deploy a model for 5 or 10 years. So the governance tools that allow you to keep a lineage of the data used to train a model And then for those adding private data, we give them a commitment that data stays with them and the refinements of that model go nowhere else, I also want to point out there are many cases where people are not worried about some of these risks. If you're giving A quick website response, you could well use a model that may have some of these risks because the danger in using any of those other areas is small.

Speaker 2

So that is how it's playing out right now. I expect to see a lot of deployment in 2024 Going into full production across the world of whether you use the word large language models or foundation models or generative AI.

Speaker 1

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

Operator

Our next question comes from Ben Reitzes with Melius Research. Your line is open.

Speaker 8

Hey, thanks a lot. I appreciate it. My question is on consulting. I was very surprised to see 32% Bookings growth after 24% the prior quarter, 7% the prior quarter. It's really diverging From your perceived rival in consulting Accenture.

Speaker 8

And I was just wondering what the reasoning you would say is behind that? And then Jim, With regard to those bookings, what does that do for your revenue visibility for consulting, not only for the Q4, but for early next year? I would think The good book to bill might make you feel pretty confident about that 6% to 8% and continuing? Thanks a lot.

Speaker 3

Ben, thanks very much for the question. As I said earlier, pleased with the team overall in consulting, Not only on the signings and booking, but our revenue is well positioned for that 6% to 8%, which give us confidence to reiterate that, But also the fundamentals of that business, right? We talked a lot about this over the last handful of years. We're getting good operating leverage in that business, good cash So let me talk about kind of headwind, tailwind overall, because I think what you're trying to get at is the confidence level Arvind and I and the team have about this book of business going forward into Q4 and into 2024. We're still seeing very good demand overall in areas around digital transformation, application modernization And where there's real technology value, productivity, cost efficiency, quick payback.

Speaker 3

Is there pressure on discretionary based activity and that like? Absolutely. But you know what, we've seen that all year long. We haven't seen really any substantive change in the macro and the client buying behaviors overall. But that has enabled us to grow 30 plus percent.

Speaker 3

By the way, it's strongest bookings quarter we had quite a period of time and now we've got a trailing 12 month book to bill Of 1.16, I think the strongest in about 2.5 years overall. Now underneath that, what's going on? One, we've opened up IBM to strategic partnerships. We're seeing great ecosystem velocity and strategic partnership growth. Signings were about 50% year over year.

Speaker 3

Hyperscalers underneath that, 2x signings. Our hybrid cloud and application modernization, Red Hat, we signed north of $1,000,000,000 alone in the quarter. Now that's $10,000,000,000 inception to date. We got acquisitions that are now accretive and scaling nicely. So I think from that aspect, you look at the top end growth, we feel pretty confident about the 6% to 8% for this year This consulting company, there are macroeconomic challenges without a doubt, uncertainty, but we got to go out and compete every single day here.

Speaker 3

And duration, I would say not only we had great signings growth, we're monitoring our backlog realization. Our duration by the way this year has went up by a couple of months, But that revenue will play out over time. And all in all, if I sum it up, I think we're taking share. I'm pleased with the team.

Speaker 1

Thank you, Ben.

Operator

Open.

Speaker 9

Hey guys, thanks for taking my question. I'll stick to the one as well. And then maybe Jim, this Just for you. You didn't change your software consulting guidance ranges for the year. I think you had a minor benefit From Aptio closing earlier in early in 3Q, but you now expect the full year constant currency revenue growth to be at the low end of the 3% to 5% range.

Speaker 9

And so I'm just wondering, should we now think about software consulting to grow at the lower ends of those ranges that you provided earlier, Especially now kind of given some of your red hat comments, I'm just trying to understand what has changed underlying the different segments to get to the kind of that new view on total revenue Thank you.

Speaker 3

Yes. Thanks, Eric. I appreciate the question. So similar to I think Tony asked something similar to this overall. When you look at IBM 3% to 5%, just practically speaking, 1 quarter to go, we said It's better to say we're prudently at the low end of that range.

Speaker 3

Now let's talk about it by segment. Software, you dial back 90 days ago. We said that we were very excited about the announced acquisition of Aptio. We said that we expected that to close in early 4th quarter. Team did an outstanding job.

Speaker 3

We got through that regulatory approval. We closed it Mid August, but when we announced that acquisition in July, we actually given our first half performance, Both in our recurring revenue streams and the strength of that, but also in our transactional book of business, we actually took our Pull your guidance up to the high end of the range. Now we closed it and by the way, we said Apti will be about 0.5 point on the full year. Now we closed it what, a month, 1.5 months earlier. Okay.

Speaker 3

So that half a point of contribution in Aptio might be 70 basis points of contribution on a full year. We still feel very confident by the way through 3 quarters, we're up 6.5%. That's above our midterm model. Yes, we have the peak wrap on ELAs last year, but very interesting underneath Our Q3 year to year performance, we're growing transactional revenue, very different profile than what we started out in January, which I think prudently, we said we expected transactional revenue was going to be a headwind to us. What's happening?

Speaker 3

The new innovation we're bringing to market And we're also getting great clothing and NRR of 7 points versus history. So we think Like we just finished above our model in Q3 at constant currency on software, we said in the prepared remarks, we expect a pretty similar 4th quarter, at the high end overall, so we're maintaining software. If you look at consulting, we said 6% to 8% overall. By the way, year to date, we're up 6%, actually 6.4% to be exact. And we look at 4th quarter overall, We just talked about in Ben's question, our strong bookings, our book to bill at 1.16, The tailwinds on hybrid cloud around strategic partnerships, I think we feel pretty good about our overall guidance.

Speaker 1

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

Operator

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

Speaker 10

Thank you. Jim, you provided some good detail on free cash And the question really is, are there any early indications on what non operating items Could impact free cash flow next year, working capital, cash taxes, etcetera, as well as How restructuring actions this year may flow into earnings and cash flow as well over the next several months?

Speaker 3

Yes, David, thanks for the question overall. We'll spend a lot of time in January talking about 2024 free cash flow. But I'm glad you actually asked the question because we've been talking about free cash flow all year long. It's one of Arvind and IBM's 2 important metrics, revenue growth, free cash flow generation. We called out $10,500,000,000 by the way, Up $1,200,000,000 this year off of last year where we grew $2,800,000,000 year to year.

Speaker 3

And we said that's above our annualized model. Our annualized model is about $7.50 per year coming on off the I and E and the business fundamentals. Yes. You look through the Q3, we're up now $1,000,000,000 year to year. We're at $5,100,000,000 Very high quality by the way.

Speaker 3

Of that $1,000,000,000 $700,000,000 of it is cash sourced from Operating profit overall, so that's the improving fundamentals of our sustainable revenue growth and our operating leverage Productivity we're driving in this business. And as I said all year long, I was very transparent in January, repeated it in April, Said it again in July and now I'll say it again. When we look at that $1,200,000,000 free cash flow growth year to year, We're going to get most of it through cash source from profit, read that about $800,000,000 to $900,000,000 And we said That we would get working capital efficiency this year. Why? Because of our 4Q 2022 opportunity gap that we missed.

Speaker 3

We called it out transparently in January. We're seeing that play out. You do the puts and takes. Yes, we're going to get a little bit of a modest tailwind on structural actions this year that will offset cash tax headwinds. But you look at the underlying $1,200,000,000 free cash flow growth, It is a high quality fundamentally driven out of our revenue growth and operating leverage.

Speaker 3

Now you look to 2024, we'll spend a lot more time on cash tax. A lot of that is going to be predicated on where we actually finished Q4 overall. But we feel confident with the actions we've been Put it in place and we got to earn the credibility and discipline here closing out a free cash flow quarter by the way that's $5,400,000,000

Speaker 1

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

Operator

Our last question will come from Brian Essex with JP

Speaker 10

Circle back on this well worked topic of AI. Could you maybe just take a very high level approach at how How you're seeing customers evaluated adoption and how that might impact the nature of contracts within the consulting business and feed the Watson X platform, maybe adoption initial read on adoption rates and view into how consulting could be the tip

Speaker 4

of the spear there?

Speaker 10

Thank you.

Speaker 2

All right. Thanks, Brian, for the question. So consulting is going to be the tip of the spear, but it's not going to be the only, Because some clients do have enough expertise inside to do things on our own. As we approach clients, Trying to use, I'll call it, a big public chatbot to perhaps improve some service It's not where they look to us and we've been very clear that's not where we are going to go and we do not actually serve up any of those services. However, I'll take some maybe some quick examples as I go through.

Speaker 2

So with a large, I'll use the word financial services company. They want to use generative AI To dramatically improve the productivity of their developers. They actually use their own proprietary languages, not only The common languages that are available outside. They are then asking the question, who can I trust to augment their model? Give it to me.

Speaker 2

I don't really want to get into all the details of how I might use it, but I want them to provide the technology. In this case, Brian, we would work with them To augment the model using their language and their data and their code snippets, we would do it in a way that they are completely comfortable hitting 100% That leaks nowhere else. They will take back the model. It now becomes an as a service deployment in their private cloud infrastructure And we monetize it as is typical for as a service software. I'll take another example that we are building out With Dun and Bradstreet and I mentioned that briefly on the call.

Speaker 2

In that case, it is consulting led. They want to work with consulting Get greater insight, aka help DNB monetize their data better. So in that case, it is absolutely consulting led. I think without consulting, We would not have landed that deal. Let me go to others because there are also examples where our consulting team is using Both was available with Azure OpenAI, as an example, to go win deals because they have built up the expertise.

Speaker 2

They've also built up expertise on Amazon's Bracket platform and they are going forward with winning deals On those, in that case, they are coming in with the methodology, with knowledge, with the thousands of trained consultants who know how to work on those platforms And they're working with the clients to go do that. I think these are all examples of what's working. I think you're trying to also ask, Is it going to be consulting or is it going to be software? Look, we didn't say much on the call on this topic. We just characterized it as Low 100 of 1,000,000 of dollars of booking.

Speaker 2

But in the absence of anything else, think of that as maybe half and half between consulting and software, Which does tell you that a couple of points of growth for both those units came from the generative AI That we've been putting out. And I think that's the best way to think about it in terms of what's happening right now. And we are certainly expecting So let me now wrap up the call. This 3rd quarter performance reinforced our confidence in the strategy

Speaker 1

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

Operator

Thank you. Thank you for participating on today's call. The conference has now ended.

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Earnings Conference Call
International Business Machines Q3 2023
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