International Business Machines Corp (IBM) — Q2 2021 Earnings Call Transcript

Thank you. This is Patricia Murphy, and I'd like to welcome you to IBM's Second Quarter 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.

Hello, everyone. Thank you for joining us today. It's my pleasure to be speaking with all of you again. We continue to make progress this quarter. Our revenue growth improved to 3% as reported, led by Global Business Services and our Software business, and we grew adjusted free cash flow for the first half. Across every industry, enterprises are using technology to redesign business processes, whether it's automation in manufacturing, telemedicine in healthcare or omnichannel in retail. These digital transformations are enabled by a hybrid cloud environment. The technology and services we provide to our clients enable their business growth and productivity increases, and improve customer experiences. This is why our strategy is focused on hybrid cloud and AI. At the same time, the overall spending environment continues to improve. With the economy reopening in many parts of the world, many markets and industries are getting back on track. We see this in North America and in select industries. Jim will delve deeper into our performance across the different parts of our business. But I want to be clear upfront that with our results over the last two quarters, we remain on track to achieve our financial expectations for the year: revenue growth at actual rates and $11 billion to $12 billion of adjusted free cash flow. We continue to take decisive steps and make the investments required to execute on our strategy. This includes making acquisitions that strengthen our portfolio, offering new innovations and digital capabilities to our clients, expanding our partner ecosystem, accelerating changes to our go-to-market model, while also instilling more of a growth mindset among our teams and building a more client-centric culture. We are executing the separation of Kyndryl, which is still on track to be completed by the end of the year.

Thanks, Arvind. As always, I'll start with the financial highlights and then comment on our revenue performance, business model dynamics, and cash and liquidity position, before getting into the segments. In the second quarter, we grew revenue over 3% as reported to $18.7 billion. We expanded our operating gross profit margin and grew gross profit dollars by 4%. We reported operating earnings per share of $2.33. Our adjusted free cash flow was $3.8 billion through the first half, and we generated $11 billion over the last year. Our balance sheet and liquidity position remain strong. We continued to make progress in our revenue performance, led by 7% growth in Global Business Services and 2% growth in software, both at constant currency. As Arvind mentioned, the spending environment is improving. We see this in markets where reopening is progressing, like the US and Canada, and in several countries in Western Europe. From an industry standpoint, we saw a meaningful improvement in some areas that had been more impacted by the pandemic like travel and transportation, automotive, and industrial products. Globally, we are helping enterprises digitally transform, leveraging our platform approach. IBM's cloud revenue over the last year across software, services, and infrastructure is now $27 billion, which is up at a double-digit rate. This continues to be led by Global Business Services and Cloud and Cognitive Software, whose cloud revenue this quarter was up 30% and 25% respectively. As our revenue performance improves, the fundamentals of our business model remain solid. We expanded operating margins, with gross margin up 30 basis points and pre-tax margin up 70 basis points. We have taken actions to streamline and simplify our operating model. As I've said in the past, roughly one-third of the structural actions are to improve Global Technology Services' profit profile ahead of the separation of Kyndryl. We are realizing these savings, and our GTS gross and pre-tax margins are up this quarter. The other roughly two-thirds of the targeted actions address stranded costs from the separation and create financial flexibility which we are investing for future growth. We are ramping investments in skills, innovation, and in our ecosystem.

Thank you, Jim. Before we begin the Q&A, I'd like to mention a couple of items. First, we have included supplemental information at the end of the presentation. And finally, as always, I'd ask you to refrain from multi-part questions. So operator, let's please open it up for questions.

Thank you. Good afternoon. Question I guess for Jim, Cloud and Cognitive Software as well as GBS PTI margins are down year-on-year. I imagine a lot of that is coming from the investments that you walk through. But can you talk about any other factors like mix that are playing into the margin performance in those groups? And also are you seeing any impact from labor shortages and wage increases, particularly in the services business? Thanks.

Thank you for the question, Katy. Both GBS and Software are crucial growth areas for our business model. As we indicated at the start of the year, we provided guidance on both revenue and cash flow, and mentioned our commitment to significant investments in these growth areas. What you're observing in the second quarter is the ramping up of those investments from the first quarter. We are investing ahead of demand because we see a positive macro and demand outlook. This is evident in the notable growth in our software business quarter-over-quarter, as well as in GBS, which surpassed our expectations and returned to pre-pandemic revenue levels. To summarize: we are investing, our software business has high margins, and the dynamics between Red Hat and the decreasing deferred revenue as we progress through the year are apparent in our second-quarter results. We are confident in our software margins and will continue to invest in innovation, ecosystem, and skills, while feeling optimistic about our GBS business. Regarding labor pressures, we are facing a competitive landscape for talent, but we are making significant investments, bringing in thousands of GBS practitioners in the first half, and we are positive about the future of that business.

Thanks, Katy. Sheila, can we take the next question please?

Yes, thank you. It's nice to see the growth in gross profit dollars two quarters in a row. You had very strong consulting growth and GBS growth as Jim just alluded, but gross margins comprised 60 basis points year-on-year in GBS. It would be nice to see the full leverage in the model come through with both revenue growth and margin expansion to amplify the gross profit dollar growth. So my question is really, how much longer would you need to be in investment mode in GBS? And is it possible that we see in the coming quarters or years? When do we actually see both revenue growth and margin expansion come into the model in GBS? Thank you.

Wamsi, thanks for the question. So just building on Katy's question upfront. We are and will continue to invest in this business as GBS is an essential part of our hybrid cloud platform-centric strategy. It is both the tip of the spear, if you want to call it, in driving the demand from an architectural point of view to our platform that then creates that flywheel effect that we talked about for every dollar that we land on the platform, we get $3 to $5 in software and $6 to $8 of services revenue. So we're going to invest significantly. Now with that said, we rebounded off of the second quarter. Last year when the pandemic hit, we dropped 7 points quarter-to-quarter. We posted down 6 last year in GBS. We returned back to pre-pandemic revenue levels and exceeded growth expectations. But we're going to continue to invest in this part because of the importance GBS plays at hybrid cloud platform, and we'll get that profit dollar contribution and more importantly, you see it play out in our second key metric that we give guidance on, and that's our adjusted free cash flow. We feel very good about where our adjusted free cash flow is through the first half. It's up year-to-year really taking into account most of the cash tax headwind we talked about 90 days ago is pretty much behind us going forward. So our attainment wise on adjusted free cash flow, which is really going to be a reflection of both top line revenue acceleration and operating leverage and margin as we move forward.

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

Yes, thank you. I was wondering if I could ask you a little bit about acquisitions. I think over the last year, you spent $3.2 billion on acquisitions. And Arvind, you've said that you expect acquisitions on a sustained basis to contribute about 100 to 150 basis points of inorganic growth per year. So, is that what we should be thinking about, about $3 billion in acquisition spend, generating $600 million to $900 million, that's 100 to 150 basis points of RemainCo? Is that sort of the mental model framework we should think about? And then could you comment specifically on how much acquisitions impacted GBS' reported growth rate and Cognitive applications reported growth rate in the quarter? Or just give us a dollar figure for the inorganic acquisition contribution to each of those businesses please? Thank you.

Thank you, Toni. That's a great question. To start with, last year we generated $10.8 billion of free cash flow for 2020. This year, we expect to generate between $11 billion and $12 billion. Considering dividends, acquisitions, and capital expenditures, the expected figure of $3 billion to $3.5 billion seems reasonable. If we project an increase of $0.5 billion to $1 billion in free cash flow during the year, we anticipate that number for inorganic activities will rise year over year. The estimate for this year is fair and may increase as our cash flow grows. For next year, we now expect to generate between $12 billion and $13 billion, increasing from the previous estimate of $11 billion to $12 billion. Regarding your second question about GBS, we expect 100 to 150 basis points of growth from acquisitions, and GBS is likely at the top end of that range. In the second quarter, considering Cognitive applications—particularly in product Cognitive Software—the impact from acquisitions was minimal, contributing only very low numbers, perhaps a few tens of basis points. GBS acquisitions provide immediate returns that grow significantly, although they contribute less in comparison to software acquisitions. The deferred revenue from these software acquisitions begins generating revenue over 12 months, and they tend to grow rapidly, contributing to growth for several years, not just in one year. Thus, GBS has an immediate growth impact of about 150 basis points, while the software side contributes only a small part. However, all these contributions build up over time, providing a beneficial boost over the next two to three years.

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

Thanks for taking my question. Good afternoon, everyone. Arvind, I have a question on the hybrid cloud potential. You've talked a fair bit about it today and in the past and I think most investments really agree that hybrid cloud is the reality, but maybe you could touch on, a, why do you think IBM is better positioned to enable your customers to get there versus some of your peers? And then secondly, what does hybrid cloud mean for your profitability and free cash flow? Because I think to some extent there is a perception, perhaps misperception, that the shift from on-prem to hybrid is negative for IBM's margins.

Hi Amit, thanks. As you pointed out, I agree that hybrid cloud is the reality for our clients. Now, regarding why people would choose us for hybrid cloud, a large hyperscaler might implement hybrid using their own public cloud alongside some on-premises resources, with the aim of migrating workloads to the public cloud. Our strength lies in our ability to work across multiple public clouds, which is why I consistently refer to Microsoft and Amazon as our partners rather than just competitors. This has been a significant aspect of IBM's strategy for many years, integrating with the various environments our clients utilize. On a more technical note, the Red Hat acquisition primarily aimed to enhance our hybrid cloud capabilities. Red Hat provides both the platform and resources necessary to develop a hybrid cloud solution, as Linux is widely recognized as the standard operating system, with Red Hat Linux being the preferred choice in on-premises and private settings, and containers becoming the standard for future transitions. Our strong foundation in on-premises and private environments allows for a seamless transition to multiple public clouds, which we believe is an advantage. I also acknowledge that if hybrid cloud is indeed the reality, many will enter this space, but we believe our approach offers a competitive edge for the industries we cater to. While our clients may not exclusively rely on us, they will engage our services significantly. Regarding your question about profitability and cash flow, we project that over two-thirds of our revenue will originate from software. Given this, software typically comes with favorable margins. While there may be variations in revenue models from on-premises licensing to as-a-service or term licenses, these generally balance out over a two to three-year period, despite fluctuations in any given six months. Our focus is on driving revenue growth that will help us achieve gross margins in the 70s and 80s, which in turn will enhance profitability and cash flow. Additionally, our services are aimed at assisting our clients in this transition. As for GBS margin, we are committed to making investments slightly ahead of revenue growth, typically one or two quarters prior. This might affect percentages minimally, but it will positively impact absolute profit and cash flow in that segment of the business.

Yes, I would just add one thing to that, Arvind, to build on your point. When you look at the IBM company post-separation of Kyndryl, the IBM company is going to be roughly around 45% to 50% software as far as composition of mix. That carries with it a high EBITDA profile already today. And just as one example, when you look at our Red Hat base of business today as CFO, I love that. That subscription model has growth in ARR built into it overall. It's already running well north of the Rule of 40 today. So as we shift more and more to software-based contribution, that mix effect will help us bottom line in cash also.

Thank you, Amit. Sheila, let's take the next question.

Yes, thank you. Within Cloud and Cognitive, I was hoping to dig a little bit more into Cloud Paks, and wondering if you could talk about just more broadly the maturity of the Cloud Paks portfolio and where you are in the integration with OpenShift. Can you just talk about where you're seeing the impact in terms of customer adoption so far? And going forward, the contribution from Cloud Paks on the financial performance of the software segment from here?

Yes. Matt, thanks for the question. Let me answer the first part of your question on the, I'll call it the architectural elements and the use cases. And then I'll give it to Jim to answer it in terms of the financial listing. So, if you look at the maturity of Cloud Paks, I would tell you that every Cloud Pak we have been selling this year and deploying this year is on OpenShift. We made the move from other Kubernetes platforms onto OpenShift starting in October of '19. And so yes, of course, let's acknowledge that people might have purchased prior to 2019 would have bought other Kubernetes platforms. By last year, 2020, it was all going onto OpenShift. I think that maturity is complete. Now if some people have prior versions of the software deployed, we observe typically within three years from day one, they do move to the new versions. So I would expect by the end of this year, even the prior deployments would have fully transitioned, and that's done. If you look at customer adoption, Cloud Paks are a very strong contributor to the 3200 clients that we mentioned. Well over half of them come through Cloud Paks. And so what are the use cases? Look, the work we're doing with Palantir is a great example. Palantir runs on top of the Cloud Paks for data. That's a great example of what we're doing. When you hear us talk about Watson Assistant has in the CVS use case, which handled over 10 million calls in a quarter for COVID-19 vaccines that Watson Assistant runs on top of another Cloud Pak. So these are great examples of how mature the technology is. I would tell you the OpenShift maturity is complete and it really helps reinforce both adoption of OpenShift as well as then clients get very comfortable with deploying OpenShift for other use cases. It's a workload at the end of the day for OpenShift, and as clients get comfortable, we might deploy it for other purposes as well. In terms of the financials, I'll pass it to Jim.

Yes, just quickly Matt, thank you very much for the question. Taking a step back, first of all, we're very pleased with our overall progression within our software portfolio. More work to do, but we're making progress. And C&DP, which I'll remind everyone on the call and our investors is about 50% of our overall software portfolio and that's where the lion's share of our Cloud Paks sit. Now when you look at our C&DP performance, when we look at it on the way we manage the business on a historical normalized basis, we see acceleration. We returned back to growth in the first quarter, and we accelerated that growth to 4% here in the second quarter. And that is really attributed to the nice momentum we're seeing in Cloud Paks. We announced Cloud Paks 18 months ago, two years ago, given our ELA historical client base that takes time to churn through that client base. Last year was the trough of our ELA renewal cycle. We start to improve on that later in the second half, and really that ELA cycle plays out in 2022, but we actually had a very nice inflection here in the second quarter. Our Cloud Paks on NRR, net revenue renewal were north of 100%. So, we've said all along, Arvind and myself, that there is going to be a shift to Cloud Paks and there's going to be lift with Cloud Paks. And now we're starting to see a higher mix contribution of Cloud Paks and we're starting to see where we do have a shift: we're getting north of 100% on the NRR perspective and that's an encouraging trend.

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

Thank you, it's great to speak with everyone. Regarding the services side, consulting has shown strong double-digit growth, and signings have been quite robust. Do you believe that, in terms of backlog and pipeline, you are starting to see a shift that could lead to improved overall growth in the services unit, especially considering the investments you're making? Additionally, I apologize for the follow-up question, Patricia, but concerning transaction processing platforms, should we expect improved performance simply due to comparisons, or are there other factors we should monitor for better results? Is it just a matter of anticipating that transition? Thank you.

I'll take that, Arvind. Tien-Tsin, thank you very much for the question. In the quarter, we generated $9.2 billion in signings within our services business, reflecting significant growth. Our backlog has shown overall improvement, and there are different dynamics at play as mentioned in our prepared remarks. We are experiencing strong momentum in our GBS segment. Our signings performed well during the quarter, with a trailing 12-month book-to-bill ratio of 1.2. In the first half of the year, we saw approximately double-digit growth in signings across all three sub-segments, including solid performance in large deals and continued success in small deals. Additionally, our revenue, backlog, and revenue realization have all improved, giving us confidence moving forward. We anticipate a standard quarter-to-quarter seasonality overall. We expect GBS to accelerate growth a bit more compared to the second quarter. In GTS, we are witnessing good overall performance by leveraging our incumbency to drive strong renewals. We finally observed a positive trend in client-based business volumes and project-based services, with our incumbency accounts increasing by 20% in the second quarter. However, the acquisition of new logos remains challenging due to elongated sales cycles, despite a healthy pipeline. We continue to see nice acceleration in GBS, but for GTS, our focus is on the fundamentals, which emphasize margins, profit, and cash. In the second quarter, we made significant progress, with margins rising 110 basis points and pretax margins increasing 190 basis points, along with growth in gross profit and pretax profit dollars. Regarding TPP, as we’ve discussed frequently over the past year, we are witnessing a transition in this portfolio towards more consumption-based and annuity-based purchasing. This shift contrasts with the healthier macroeconomic conditions in 2018 and 2019 when clients opted for more perpetual licenses. The trend we saw then appears to be returning, and while we will continue to face headwinds from 2020 and 2021, we expect to see a return to normal market growth rates in 2022.

Thanks, Tien-Tsin. Let's go to the next question, Sheila.

Thank you. Actually most of my questions have been answered. I just have one follow-up question. I think Jim you mentioned, revenue retention of greater than 100% and I wasn't quite sure what the reference point was in software and whether you have any incremental data points you can share about revenue retention by business unit within the Cognitive segment?

Sure, David. Thank you very much. Cloud Paks are definitely an essential part as we've invested significantly to containerize our software and optimize it on top of OpenShift, our hybrid cloud platform overall. When we take a look at our Cloud Paks, we measure and manage, Arvind and I have a dashboard that we look at all of our large enterprise top clients overall, our deployment penetration within each of those clients, and we're able to see as we transition a client from a traditional middleware to a cloud-based containerized solution, not only can we track the deployment and how that progresses over time, but we can see the dollar of yesterday versus the dollar of today as they transition to Cloud Paks, and we measure the net revenue retention. Not only how much comes in whether we are able to upsell, cross-sell with multiple Cloud Paks as we move forward. And like I said, in the second quarter we're making progress; much more to do, but we're making progress on the mix composition of moving more and more to Cloud Paks, and we're also making progress on capturing more of our clients' wallet share dollar for that same dollar of traditional middleware overall. Hopefully, that helps David.

Jim, to make it into business terms or a use case, what that tells you is that when they renew, they are actually buying more volume, which means it's a beginning to become a larger part of their real estate, technology real estate at a client.

Very good. Thank you, David. You know, we're at the top of the hour, but let's take one more question, Sheila.

Hi, thank you, team. I have a question for Arvind regarding the growth assumptions or targets for Cognitive. This quarter, you achieved about 2% revenue growth, benefiting from comparisons in some Cognitive line items. While the growth is positive, there's still a way to go to meet our long-term target. What changes are needed to improve Cognitive? Additionally, considering Red Hat, we remain optimistic about its prospects in the coming years; however, there are ongoing challenges with long-term trends in Cognitive. As you've mentioned before, Db2 is likely in a declining market, and transaction processing platforms revenue is also expected to decline over time. Could you discuss how you plan to achieve your longer-term growth rates in Cognitive? Thank you.

Right. Thanks, Keith, important question, and important element of our pieces going forward. So we've been clear that our Cloud and Cognitive software will grow mid-single-digit going forward. And you are questioning, Keith, how is that going to be possible? So first and most important element, Red Hat today is sitting at about, in rough numbers, 25% of the business, growing at about 17% this quarter, let's call it 15% in the medium term. But as opposed to being 25%, it's going to go up and up to become 35% of the total and over a longer term even more. So 15% for one-third of the business, you kind of get the contribution from that, which is quite significant. Also, as we are both innovating organically, for example in Cloud Paks, and we are acquiring businesses that are going to turbocharge, a bit of a pun on Turbonomic, our business there on both management as well as on cybersecurity, we expect to see very high growth rates there. High-single digits that is well above the mid, maybe into the low double digits. Will we see declines in some parts of the portfolio? We have been very transparent. We expect DPP to be between mid and high single-digit decline in the mid to long term, but it becomes a smaller and smaller portion of the total. So it has a drag from there. Cognitive applications; we expect to be right in there, but it's the smallest part of the portfolio; it's not the biggest part of the portfolio. And so just a recap on that: number one, Red Hat growing in the mid-teens as it becomes a bigger contributor to the total. The rest of the cloud and data platform with a mixture of both organic innovation and inorganic acquisitions is going to then contribute to growth at or above the mid-single digits in the medium term. DPP mid-single-digit decline, probably right in line with the model. So hopefully Keith that gives you a breakdown into a lot of pieces. By the way, the DB2 that you mentioned declining is very much inside the DPP. So those are not really different questions. DB2, mainframe and DPP are one and the same. So, let me just make a couple of comments to wrap up the call. We again made progress in this quarter, but we acknowledge we still have more to do. As you move into the second half, we are continuing to invest and execute on our actions, which includes the separation of Kyndryl. All of this positions IBM to exit the year in a strong position on a path to sustainable growth, and I look forward to continuing the dialog with you.

Great. Sheila, can I turn it back to you to close out the call?