International Business Machines Corp (IBM) — Q2 2022 Earnings Call Transcript

Thank you for joining us today. In the second quarter, we drove solid results reflecting the investments and changes we have been making to execute our strategy. With this performance, we continue to deliver on our model of mid-single-digit revenue growth. Technology plays an important role in today's business environment. In fact, nearly every client I speak to believes that technology serves as a fundamental source of competitive advantage. It serves as both a deflationary force and a force multiplier and is especially critical as clients face challenges on multiple fronts from supply chain bottlenecks to demographic shifts. Given its ability to boost innovation, productivity, resilience and help organizations scale, IT has become a high priority in our company's budget. As such, there is every reason to believe technology spending in the B2B space will continue to surpass GDP growth. With this demand backdrop, we are executing our hybrid cloud and AI strategy. We have made changes to our portfolio and focused investments in our offerings, technical talent, our ecosystem and go-to-market model. Demand for our solutions remains strong. We continue to have double-digit performance in IBM Consulting, broad-based trend in software. And with the z16 platform launch, our infrastructure business had a good quarter. By integrating technology and expertise from IBM and our partners, our clients will continue to see our hybrid cloud and AI solutions as a crucial source of business opportunity and growth. Let me now delve a little bit deeper into the progress and the execution of our hybrid cloud and AI strategy. Hybrid cloud is about offering clients a platform that can straddle multiple public clouds, private clouds and on-premise properties, all the way to the edge. Our platform based on Red Hat allows our clients to consume powerful software capabilities driven by open source innovation. Our software has been optimized to run on that platform and includes advanced data and AI, automation and the security capabilities our clients need. Our global team of consultants offers deep business expertise and co-creates with clients to accelerate their digital transformation journeys. Our infrastructure allows clients to take full advantage of an extended hybrid cloud environment. As a testament to the success of our strategy, we continue to increase adoption of our platform with over 4,000 hybrid cloud platform clients, including more than 250 added in this past quarter alone. Apart from working with a greater number of clients, those who adopt our platform tend to consume more of our solutions across software, consulting, and infrastructure, expanding our footprint within those clients. Recently, clients such as P&C, Barclays, and Citi have chosen our hybrid cloud capabilities to unlock more business value and meet rapidly changing client demands. Organizations everywhere are also under intense pressure to fast track their digital transformation and harness the power of data. With the world now creating 2.5 quintillion bytes of data each day, artificial intelligence, or AI, is the only way to process this enormous amount of data from hybrid cloud environments all the way to the edge. That is why AI adoption is steadily on the rise. According to a new study released by IBM last quarter, 35% of companies are now using some form of AI in their business. Many of those companies are using AI and automation to address demographic shifts and move their employees to higher value work. This is one of the many reasons we are investing heavily in both AI and automation. These investments are paying off. In addition to the strong revenue performance in automation and data and AI software, we recently received two important recognitions. We were named as a leader in the latest Gartner Magic Quadrant for APM and Observability and in The Forrester Data Fabric Wave for our Cloud Pak for data. Over the last several quarters, I've highlighted the importance of the growing ecosystem of partners to our platform-centric strategy with leading firms like SAP, Salesforce, Adobe, Oracle, Microsoft, and AWS. This quarter, we continue to expand and extend our partnerships. I'll expand on just two. We announced a strategic collaboration agreement with AWS to offer a broad array of our software catalog on AWS. This includes capabilities that span Automation, Data & AI, Security, and Sustainability. Second, with Tech Mahindra, we launched synergy lounges to empower businesses with the innovation technologies and services for key industries such as telecommunications, manufacturing, banking, healthcare, energy, and utilities. The first synergy lounge was established in Bengaluru with a focus on edge, 5G, and software-defined networking solutions with hybrid cloud. This will be followed by the opening of three more centers in London, Seattle, and Melbourne. Clients aren't just simply buying software or hardware. They're entering a relationship with the company that's going to help them navigate the future of technology. This is why innovation and our ability to invent what's next remains so important. Quantum is a great example of our commitment to advance the future of technology. Building on our progress of a 127 qubit Quantum computer currently in our cloud, we have committed to demonstrate the first 400-plus qubit system before year-end. This will help us move forward toward our roadmap to deliver a 1,000-plus qubit system next year and a 4,000-plus qubit system in 2025. One of the implications of quantum computing will be the need to change how information is encrypted. We are proud that technology developed by IBM and our collaborators has been selected by NIST as the basis of the next generation of quantum-safe encryption protocols. In another example of innovation, our new z16 system became generally available in the second quarter. The z16 is designed for cloud-native development, server security resilience, quantum-safe encryption, and includes an on-chip accelerator, which allows clients to reduce fraud within real-time transactions. Given the importance of cybersecurity, in this past quarter, we also acquired Randori, a leading attack surface management and offensive cybersecurity provider. This builds on the recent acquisition of ReaQta and the launch of QRadar XDR. It's one of two acquisitions in the second quarter and over 25% in the last two years. Another major focus area across all stakeholders is ESG, which isn't just a regulatory requirement or about being a good corporate citizen. It's also a business opportunity. A poll conducted by the IBM Institute for Business Value shows that 50% of CEOs see sustainability as one of their highest priorities, and over 80% of CEOs believe their company's sustainability investments will improve business results and accelerate growth. To accomplish this, companies need to leverage AI and to turn the mountains of data they collect into sustainable action. SL Green Realty Corporation, Manhattan's largest office landlord, is a recent example. They are using Envizi, an IBM solution to manage their key indicators across their extensive real estate operations, including energy use, carbon emissions, and environmental and social responsibility metrics. Let me wrap up by saying that given the strength of our portfolio, the need for our technology and expertise with the benefits we're yielding from our actions, we remain confident in our ability to deliver revenue in 2022 at the high end of our mid-single-digit model.

Thanks, Arvind. I'll get right into the financial highlights. In the second quarter, we delivered $15.5 billion in revenue; $2.5 billion of operating pretax income, which is a margin of 16.2%; and operating earnings per share of $2.31. In the first half of the year, we generated $3.3 billion of free cash flow. Our revenue was up 16%. This includes nearly 5 points of incremental revenue from Kyndryl. As always, we discussed revenue growth at constant currency. But given the focus on the sharply strengthening dollar, I'll mention that currency translation impacted our reported revenue by over 6 points of growth or $900 million. That's over $200 million more than the spot rates would have suggested 90 days ago. Today's IBM has a higher growth profile driven by our growth vectors of software and consulting. More than half of our annual revenue is recurring, with about two-thirds of that in high-value software. Software revenue this past quarter was up 12%; and Consulting, up 18%. Infrastructure performance, which reflects a good start to our z16 product cycle, was up 25%. Software and infrastructure each include about 7 points of growth from the commercial relationship with Kyndryl. These results reflect the investments we've been making in innovation, our ecosystem, and talent, all aligned to our strategic areas of hybrid cloud and AI. We integrate consulting and technology to deliver these hybrid cloud and AI solutions. Our platform approach not only benefits our clients but also provides an attractive economic model for IBM and our partners with a multiple of software and consulting revenue generated for every dollar of platform revenue. Our hybrid cloud revenue from our full stack capabilities across software, consulting, and infrastructure was up 19% over the last year. It has grown to $21.7 billion or 36% of our total revenue. Looking at our P&L metrics, operating gross profit dollars were up driven by strong revenue performance in our high-value businesses. Our year-to-year gross margin decline reflects escalating labor and component costs. We're addressing this through pricing, though it takes some time to show up in our margin profile, especially in consulting. Our operating pretax income was up, and we expanded margin by 420 basis points. We had an operating tax rate of about 16.5%, which is up about 2 points versus last year, and our operating net income margin expanded 330 basis points. Let me comment on a few dynamics within our profit performance. Our pretax profit reflects the benefit from actions we've taken to streamline our operations and simplify our go-to-market model as well as profit contributions from incremental sales for the new commercial relationship post-separation. Our profit this quarter also reflects recent portfolio actions. At the end of June, we closed on the divestiture of our healthcare software assets, generating a pretax gain of about $230 million in the period. Mitigating that benefit to our overall profit results, we took charges to address stranded costs associated with the divestiture and absorbed operating losses related to the health business, together, over $75 million. We also announced the orderly wind down of our Russian operations, resulting in incremental charges in the quarter. Together with the year-to-year loss business due to the wind down, Russia impacted our profit results by another roughly $100 million. I also want to comment on the impact of currency. I mentioned that over the last 90 days, we've dealt with a sharply strengthening dollar. We execute hedge programs that cover the majority, but not all of the currency exposure. The combination of the rate and velocity of movement this quarter and the fact that we don't hedge 100% results in a currency impact to our profit and cash flow. Turning to free cash flow, we generated over $2 billion in the quarter and $3.3 billion for the first half with good working capital performance. This first half free cash flow is about 33% of our full year expected range, consistent with the average of the last few years. I'll remind you the $1 billion plus of proceeds from the health divestiture is reflected in cash from investing activities versus in our free cash flow. In terms of uses of cash for the first half, we invested nearly $1 billion in acquisitions with 5 closed this year, and we returned $3 billion to shareholders in the form of dividends. This results in a June cash position of nearly $8 billion, which is up slightly from year-end. And our debt of just over $50 billion is down about $1.5 billion over the same period. Turning to the segments, Software revenue grew 12%. This includes about 7 points from the Kyndryl software content. Growth was driven by our hybrid cloud and AI capabilities. Hybrid cloud revenue for the segment now represents $9 billion over the last year, up 23%. Software subscription and support renewal rates were up again this quarter. This contributes to our solid and growing recurring revenue base, which represents about 80% of software. From a revenue category perspective, our software growth vector of Hybrid Platform & Solutions grew 9%. This includes about 1.5 points benefit from the Kyndryl commercial relationship. We again drove pervasive growth across Red Hat, Automation, Data & AI, and Security. Red Hat revenue all in grew 17%. Revenue growth was fueled by new adoption and expansion of RHEL and OpenShift as both solutions continue to take share. These key offerings address hybrid cloud requirements in industries like financial services, public sector, and telecommunications, across environments and out to the edge. Automation revenue was up 8%. Solid performance in both AI ops and management and integration demonstrates the importance of automation in the IT journeys of our clients. We had strength in offerings like Turbonomic and Instana for observability; Cloud Pak for Watson AIOps; and our modern integration platform, Cloud Pak for Integration. Data & AI revenue grew 4%. This growth was led by demand for data fabric, data management and asset and supply chain management solutions. We also just expanded our Data Fabric portfolio with the acquisition of Databand.ai, which helps organizations with data observability. Security revenue was up 5% with growth in threat management and identity as enterprises continue to adopt a Zero Trust security strategy and implement additional identity controls. We're continuing to invest in our security capabilities, having completed 2 acquisitions in the threat management space over the last few quarters. Across the four Hybrid Platform & Solution business areas, our annual recurring revenue, or ARR, is nearly $12.9 billion, up 8%. Turning to our software value vector, transaction processing, revenue grew 19%, including 22 points from the Kyndryl content. We continue to have strong renewal rates for this mission-critical software and performed in line with our expectations this quarter. Looking at software profit, we delivered operating leverage given the solid revenue growth and new Kyndryl commercial relationship. Our pretax margin was up 4 points and keeps us on track for a full year software margin in the mid-20s. Moving on to Consulting, we again saw pervasive growth with double-digit revenue growth across all business lines and geographies. Revenue was up 18% compared to 8% growth a year ago. We maintained a solid book-to-bill ratio of 1.1 on a trailing 12-month basis as clients are choosing to co-create with IBM, trusting our deep industry expertise. The expansion of our skills, capabilities, and ecosystems are enabling us to capture demand as we drive adoption of our hybrid cloud platform and help clients with their digital transformations. Consulting's hybrid cloud revenue grew 32% over the last year to $8.6 billion. Momentum behind our Red Hat practice remains strong. We nearly doubled our Red Hat consulting revenue in the quarter and continued solid Red Hat bookings, which now exceed $6 billion inception to date. Our strategic partnerships also contributed to our performance in the quarter. Revenue from these partnerships continues to grow solid double digits, led by Azure, AWS, and SAP and Salesforce. Turning to our lines of business, Business transformation grew 16%. Its clients look to IBM to help them transform critical workflows at scale. Growth in business transformation was pervasive and led by our offerings focused on customer experience transformation, data transformation and our SAP practices. In technology consulting, where we architect and implement clients cloud platforms and strategies, revenue was up 23%. Cloud modernization and cloud application development led a significant portion of the growth, with on-prem modernization also contributing to the strong revenue performance in the quarter. Application operations revenue grew 17%. Growth was solid across our cloud offerings, mitigated by declines in the on-prem space. In this business, we are optimizing the management of applications and providing cloud platform services required to run our clients' hybrid cloud environments. Moving to consulting profit, our pretax margin expanded 1 point as we deliver operating leverage and benefit from IBM's more streamlined G&A and go-to-market structure. Our consulting margins reflect the significant investments we have been making to capture demand and fuel our revenue growth. Consulting, which makes up well over half of IBM's workforce, is most impacted by the inflationary labor market and increasing labor costs as we bring and increase capacity. We are starting to capture the reality of these higher costs in our pricing. But given the time from contract signing to revenue realization, it's taking some time to see it in our margins. Turning to the Infrastructure segment, revenue was up 25%, including about 7 points from the incremental Kyndryl content. Hybrid Infrastructure revenue grew 41%. And infrastructure support revenue grew 5%, including about 7 and 8 points of Kyndryl benefit, respectively. Within hybrid infrastructure, zSystems revenue was up 77%. This reflects solid execution around our z16 program, building on the momentum from z15. As Arvind mentioned, z16 brings the power of embedded AI at scale, cyber-resilient security and cloud-native development for hybrid cloud to our clients. We are seeing growth in new workloads like Linux and demand for AI capabilities like real-time fraud detection, leveraging the on-chip AI accelerator. Clients are investing in zSystems platform as an essential part of their hybrid cloud infrastructure. Distributed infrastructure revenue grew 17% this quarter. This growth was led by storage, driven by both high-end storage tied to the z16 cycle and distributed storage. We also had good performance in high-end Power10. Just last week, we announced the expansion of our Power10 server family as we deliver flexible and secure infrastructure for hybrid cloud environments. Looking at infrastructure profit, pretax margin was up 4 points year-over-year, reflecting mix benefits from the growth in zSystems, mitigated by the impact of increased component cost and supplier premiums. Now let me take it back up to the IBM level. We've taken actions and made investments over the last couple of years to execute a platform-centric hybrid cloud and AI strategy. IBM is now a more focused, faster-growing and higher value company. And while there is always more work to do, we are confident in our ability to deliver sustainable growth. Our first-half results were solid. We continue to see constant currency revenue growth at the high end of the mid-single-digit model for the full year. And on top of that, we expect about 3.5 points of growth from the Kyndryl sales spread over the first three quarters. I mentioned the impact of currency on our Q2 results. With the significant movement of the U.S. dollar as compared to nearly every currency, at mid-July spot rates, currency translation will now be about a 6-point headwind to revenue growth for the year. That's a degradation of about $1.5 billion from April's rates with most of that incremental impact still ahead of us in the second half. Currency is one unique issue we're dealing with. The other is the impact of exiting our Russia operation. Together, these are putting some pressure on our near-term results, and we now expect free cash flow of about $10 billion for the year. These are exogenous issues. Importantly, we feel good about the underlying fundamentals of our business. You see this in our segment expectations. Halfway through the year, there's no change to our full-year view of software. We continue to expect constant currency revenue growth in line with our mid-single-digit model range, plus 5 to 6 points from sales to Kyndryl. We also remain on track to a software pretax margin in the mid-20s range for 2022. Our IBM consulting revenue growth has been strong, and we continue to expect low double-digit revenue growth rate for the year, which is above our model. With continued investment in skills and a competitive labor environment, we now expect a consulting pretax margin of 9% to 10%, which is up over 1 point year-to-year. This reflects improving margin performance in the second half as we increase utilization of the resources we've added and price realization starts to flow to revenue. Our infrastructure revenue in any period reflects product cycle dynamics. We had a very strong launch of our z16 platform in the second quarter. This will drive infrastructure revenue performance above the model level for the year. On top of that, we're planning for about 5 to 6 points of revenue growth from the sales to Kyndryl in 2022. Despite some of the pressures from component cost increases and supplier premiums, we continue to see mid- to high-teens pretax margin for infrastructure for the full year. These segment revenue and margin dynamics yield about a 3.5 point year-to-year improvement in IBM's pretax margin for the full year. And we continue to expect a mid- to high-teens operating tax rate, which is a headwind to our profit growth. You'll recall that back in January, we expected a 40-60 first half/second half profit SKU. Now after a solid start to the year, our view hasn't changed, and we still see 60% of the full-year profit in the second half. Looking at the third quarter, we expect all-in constant currency revenue growth in the high single-digit range and about a 2-point year-to-year improvement in operating pretax margin. I want to mention two specific items on the third quarter. First, at current spot rates, currency translation has increased to about an 8-point headwind to revenue growth, impacting our reported revenue, profit, and cash. Second, we haven't had a zSystems product introduction in our large transactional second quarter in about 20 years. This unique timing, coupled with the strong start to the cycle, will result in a larger second to third quarter impact than typical seasonality. So to be clear, we expect a strong year-to-year growth in zSystems. In closing, these are interesting times, and we see technology as a way to help our enterprise clients capture today's opportunities and navigate challenges. We feel good about the strategy we are executing and the fundamentals of our business. Patricia, now let's go on to the Q&A.

Just one for me here. Obviously, we saw a bit of a deceleration in the Red Hat business. So would just love to hear what you're hearing from them and any impact that you could share with us on the deferred that's been a part of this business for a while? So that's it.

Thank you, Erik, for your question. We are very optimistic about the Red Hat business and continue to see strong demand. As we mentioned late last year, we expect growth in Red Hat to be in the upper teens, and we maintain that outlook. I think I heard you mention deferred revenue, which explains most of the difference in growth rates as we transition from last year to this year. I'll let Jim provide further details on that.

Yes, Erik, thanks. Just building on what Arvind said, 17% growth overall, taking share both in our core RHEL but also in our hybrid cloud platform-centric foundation, Red Hat OpenShift. By the way, Red Hat OpenShift, 4.5x now the revenue pre-acquisition. We had very strong bookings overall in Red Hat here in the quarter. Large deals were up 50%. Red Hat OpenShift bookings were up over 50%, which positions us very well with our backlog and a strong NRR. So we feel pretty good about our Red Hat portfolio overall. Arvind indicated, our model is high teens. We delivered on that in the quarter. And by the way, the deferred revenue, we talked about entering January this year that, that was going to lessen throughout the year. And we're pretty much through that. I mean there's some small round-up here in the third quarter, but that's pretty much behind us. And remember, we're three years into this acquisition right now. and we couldn't be more pleased as we move forward.

I have a question regarding the free cash flow guidance. The revenue appears to be performing better than expected compared to 90 days ago, especially at the beginning of the year. However, the free cash flow estimate is currently at $10 billion, down from an initial projection of $10 billion to $10.5 billion. Could you explain the factors affecting free cash flow? Additionally, you've mentioned the impact of foreign exchange headwinds on your revenue. Given the volatility in this area, there may also be implications for your earnings per share and free cash flow. Can you elaborate on how foreign exchange is influencing free cash flow in relation to the revenue? That would be helpful.

Yes, thank you very much. Let's take a moment to discuss this because it's crucial to look at our two key measures of success: revenue growth and free cash flow growth. We initially guided for free cash flow of $10 billion to $10.5 billion for the year, and now we've adjusted that down to the lower end at about $10 billion after the first half. Before addressing the details of your question, let's put this into perspective. That $10 billion of free cash flow represents a year-over-year increase of $3.5 billion, and it has even increased more than $2 billion compared to our 2021 post-separation baseline. We're transparent about the revenue growth from Kyndryl, and we've provided the pro forma baseline to all our investors. Overall, this reflects strong free cash flow growth. There are two key points I mentioned in my prepared remarks. Firstly, due to the unfortunate humanitarian crisis and the war in Russia, we made the correct decision to exit that business in the second quarter, which was very profitable for us and will result in a loss of around $100 million in free cash flow and profit for 2022. Secondly, we are not immune to the ongoing appreciation of the U.S. dollar. Regarding forward-looking free cash flow, we achieved $3.3 billion in the first half, which is slightly above our historical performance over the past five years. Looking ahead to the second half, we anticipate continued revenue growth and operating leverage from our business. Our working capital management has performed well in the first half. Given the volume dynamics and the positive start to our mainframe cycle, we expect to see leverage from that. Additionally, as I mentioned in January, we anticipate a modest cash tax benefit for the year. That summarizes the overall picture for free cash flow.

I was wondering if you could just comment on whether you still expect $35 billion in free cash through 2024 and what the bridge for that is? And then you mentioned that revenue sequentially would be a little lighter than usual in Q3 because of the mainframe. I think you're typically down about $850 million. The mainframe is like $500 million to $700 million a quarter. So maybe it's a $100 million headwind. So is that sort of the dimension that you're thinking about for Q3? Or are there other factors at work?

Toni, let me start by first addressing the $35 billion free cash flow question, and then I'll hand it to Jim. We are absolutely committed to our $35 billion total free cash flow cumulative over '22 through '24. And we still see very good signs, and we have confidence in delivering that number. And so with that, you said the bridge to that and then the 2Q to 3Q dynamics, I'll hand it to Jim for those.

Thanks, Toni. In my prepared remarks, I mentioned that we're looking at about $1 billion in sequential revenue. We've provided specific guidance for the third quarter, indicating that we expect to be in the high single digits at constant currency for the second quarter. To give context, we achieved mid-teens growth in the second quarter, which is the strongest constant currency growth we've experienced in 20 years, significantly surpassing our mid-single-digit model and accelerating from the previous quarter. Revenue growth, operating profit margin, and free cash flow have all accelerated. However, we're projecting a decrease in constant currency revenue from mid-teens in the second quarter to high single digits, roughly 9% to 10%. This represents a deceleration of about six points. Two of those points are due to our divestiture of a healthcare software asset, which contributed approximately $200 million a quarter. The remaining four points stem from the launch of a new mainframe cycle, which occurred in a highly seasonal second quarter. We performed exceptionally well, even increasing our revenue guidance for the second quarter by $200 million compared to usual seasonality, and we exceeded that expectation. Looking to the second half and into the third quarter, we believe it’s prudent to guide for a normal cycle, which will account for about four points of change from the second to third quarter due to the announcement in the second quarter. I also want to emphasize that we still anticipate a 40% to 60% improvement in our operating profit for the year, which has remained consistent since January. The dynamics now lie between the third and fourth quarters as we introduce the new Z cycle, which we are excited about for the second half.

Arvind, while I understand you have maintained your constant currency guidance for the year, could you provide some insights on what is performing better or worse than expected? Additionally, Jim, could you clarify the year-over-year change in PTI for the second half of the year? It appears that there was a notable improvement in PTI, with over 400 basis points in the second quarter, and you're projecting around 200 basis points for the third quarter. Does this suggest a potential catch-up for PTI in the fourth quarter, and how much of this is related to foreign exchange versus mainframe timing? You mentioned both factors when discussing the revenue impact.

Great. So Wamsi, let me address the first part of your question. We had very balanced performance in constant currency across geographies and actually across the different businesses. Now because of currency, the actual performance will be different in different geographies, but double-digit performance in the Americas, in Europe as well as in Asia Pacific. Jim laid out the numbers on the different business performances. He talked about at constant currency, 12% in software, 18% in consulting, 19% in infrastructure. Those are really strong performances, I believe. As we go forward, you should expect to see us maintain, and we said, we talked about we'll remain in the mid-single digits on software. We will get towards the low end of double digits in consulting, which is actually up from our previous high single-digit margin, and infrastructure will benefit from the Z cycle. So all in, that's very balanced across the portfolio and across the geographies, and that then contributes towards our confidence in the revenue profile for the rest of the year.

Yes, thanks for the question. Let me provide an overall perspective before discussing the third quarter. We are maintaining our guidance regarding high single-digit revenue growth before considering the additional Kyndryl contribution for the year. Recently, our expectations for the currency impact have changed to around 6 points, which is an increase from the 3 to 4 points we estimated 90 days ago, translating to about $1.5 billion. I have noticed some reports citing $3.5 billion, but the actual change is around $1.5 billion compared to what we discussed in April. With this revenue growth, we anticipate about $10 billion in free cash flow and a significant increase in operating profit margins, which are expected to rise by approximately 350 basis points year-over-year. In terms of segments, our software division remains stable, and we are confident that we will achieve mid-single-digit growth overall in software, with operating margins nearing the mid-20s. This indicates a 5 to 6 point increase in operating margin. For the infrastructure segment, we expect it to significantly surpass its model, with operating margins in the mid- to high teens, driven by product cycle dynamics. In consulting, we are experiencing strong demand and have revised our revenue growth model from 90 days ago to reflect low double digits. Additionally, we have adjusted our margin expectations to between $9 billion and $10 billion. This adjustment is due to the longer timeline for our price optimization to affect our margins. We still anticipate a year-over-year margin increase for the full year within that absolute range, and as we compare with easier benchmarks in the second half, we expect to see nice margin improvements in our consulting business during that period.

Jim, I appreciate your comments on the consulting side of the business. Could you provide more details on that? I'm interested in the pricing dynamics you mentioned. Additionally, could you share your insights on both the demand and supply sides? Specifically, do you see any changes in hiring, attrition, or wage inflation? On the demand side, it's encouraging to see the sequential improvement in constant currency growth, but it seems that the pace of business transformation has moderated even as technology consulting and application operations are improving. Could we explore the supply and demand dynamics to understand what is changing in that business and what is driving your confidence in the performance for the remainder of the year?

Thanks for the question, Brian. Let's take a moment to discuss this. We are seeing strong demand, which is reflected in our increased guidance and a consulting performance rise of 18%, compared to an 8% increase last year. This success is attributed to the sustainable competitive advantage technology provides, as clients across various industries accelerate their digital transformations and move to the cloud. Consulting plays a crucial role in our hybrid cloud strategy, and I’ve mentioned before that it helps drive the adoption of our platform and IBM’s technologies. If we think back to a year ago, we were dealing with a different situation coming out of the pandemic. We recognized the strong demand indicators that prompted us to strategically invest in skills, capabilities, ecosystem expansion, and acquisitions to meet this robust demand growth. We've been successfully capitalizing on this trend, maintaining consistent double-digit growth, and we've had another solid quarter with a book-to-bill ratio above 1.1 as we head into the second half of the year. However, while we are focused on supply, rising inflation has impacted our gross profit margins. We noted at the start of 2022 that we would take steps to optimize our pricing, though it would take time to reflect in our financials, which we expect to see in the second half. Overall, demand remains solid, and we've been working on optimizing the supply side through disciplined investments. Looking ahead to the second half, we anticipate easier comparisons, benefits from our acquisitions, increased utilization of our capacity, and continued price optimization, which should lead to improved profit margins. I hope that provides some insight.

So the strengthening dollar generally comes with a translation impact but also some demand destruction in nondollar-denominated markets. So are you able to size how much that demand-related impact might be, which would actually make your reiterated guidance for the high end of your mid-single-digit range for the full year for the core look even a bit better? Also connected to that, what is your sense if you have some perspective on how well international customers are positioned to be able to absorb the currency fluctuations?

Okay, Kyle. Thank you. I'll take this, Arvind. Let me spend a few minutes on currency since it seems to be a theme here across the questions and really how we manage it within our business and how it impacts our business model. So while we have a robust hedging program, as I indicated earlier, we're not immune over the long term, the currency impacts, especially when currencies move at the rate, breadth and magnitude that we've seen. Let me give you some stats as we've been going through here in the month of June and the early part of July. One, the U.S. dollar index is up 13% year-to-date, a 20-year high against the euro, 25-year high against the yen. The velocity of the strengthening is the sharpest that we've seen in over a decade. And it's been a broad-based dollar story, as you all know. All the currencies we hedge, over half of them are down double digits against the U.S. dollar this year. So it's kind of, I would say, unprecedented in what we've seen in the rate, the breadth of magnitude. Now to your question, Kyle. Our business profile, we operate in 170 countries around the world. That's in excess of over 100 currencies. The strong dollar definitely has an impact. And to your point, from an absolute revenue profile, I would agree with you completely. It even makes our constant currency revenue growth guidance even stronger in us capturing what's happening in the marketplace with regards to that acceleration of digitization and transformation and journey to cloud. But our robust hedging program, there's two important points I'd like to make. Number one, we don't hedge 100 currencies. One, it's not economically viable; and two, you can't hedge revenue per GAAP accounting. You can only hedge where you have cash proxies in countries. So we only hedge, give or take, about 35 currencies around the world out of the 100 plus that we're in. And also important, if not more important, we only hedge 12 months out. We don't do multiyear hedging in this business. We're not speculative. So when you look at the lasting relevance of a U.S. dollar appreciation, eventually, what hedging does is, it mitigates volatility in the near term. It does not eliminate currency. It allows you time to address your business model for price, for source, for labor pools, and for cost structures. Now also important, and this is where you see the dynamics playing out in our business model. Currency impacts a human capital-based business, very different than a product-based business, and I've talked about this many times over the years. In a human capital-based business, if you think about it, a large portion of your cost structure is a natural hedge because it's in local currency. Very different in a product-based business where a large portion of your cost structure is U.S. dollar-denominated. So as the dollar at rate and pace and magnitude appreciates, it has a disproportional impact on our high-value, product-based businesses, read that, software and infrastructure. And you saw that play on the second quarter at the gross margin level. Remember, our hedges end up in expense. Gross margin, you see the revenue and the margin implications. So we understand how to manage currency. We have a robust hedging program in place. We've taken the appropriate cost structure and the appropriate pricing as we deal with that going forward, and you see all that taken into account in our guidance.

Could you just remind us whether there are any expenses or stranded costs that remain in the 2022 P&L, that will diminish or go away in the next few years? You mentioned Russia had some losses. You mentioned the health care software divestiture. I don't know if there are any more. And perhaps beyond that, could you weave that dynamic into how it impacts free cash flow growth in the next year or two, given your 2024 target really implies a fairly meaningful increase in free cash conversion over the next two years?

Yes, David, thank you very much for the question. At its core, we actually took some conscious strategy back in the fourth quarter '20, if you remember. At the time, we announced the intent to spin off Kyndryl that we were going to try to get out in front of stranded costs. And as you see now, we've executed on additional portfolio actions with the divestiture and closure of our healthcare software assets across the board. If you look at 2022, there's about $500 million to $600 million, $700 million, give or take, in that range around structural action cash charges that will still impact us. And by the way, that's embedded in our about $10 billion overall. So now when you think to the core of your question about how that then plays out for '23 and '24, that actually turns into tailwinds in '23 and '24 because we're depressed in our free cash flow guidance. And again, I'll remind you, that's up $3.5 billion year-to-year and up over $2 billion against our post-separation baseline. That depresses 2022's free cash flow. And we get that return, not only on the cash charges that we won't have in 2023, but also on the incremental ROI of getting rid of that stranded cost as we move forward. So both pieces, it kind of gives you a double benefit as we move forward.

Arvind, I wanted to direct it to you, if I could. I wanted to see if you could look out over the horizon a little bit longer. Some of the software companies have talked about some of the pipelines in a deep sales cycle are starting to extend and I just wanted to see if you're seeing any economic impact. And then more specifically, I wanted to see if you could comment, historically, consulting has been highly correlated to economic cycles. And this is going back last 15, 20 years. And I just wanted to see as we're heading into late '22 and more importantly '23, how do you think the consulting business is prepared for some potential economic downturns? Or just more broadly, how do you think about the growth potential there? And Jim, if I could just sneak in one thing for you real quick, if you could just talk about what the M&A contribution is this year? You mentioned some recent deals. Just if you could provide an update, that would be great.

Okay. Keith, there's a lot to address in your question. Our pipelines are looking quite healthy right now. The second half appears to be consistent with the first half across various sectors including Red Hat, mainframe software, Automation, Data & AI, and Security, as well as geographically. This situation gives me a sense of optimism compared to many industry peers. Technology, as Jim has noted, is deflationary. In this inflationary climate, when clients adopt our technology and utilize our consulting services, it helps counterbalance the effects of inflation and labor challenges globally. Regarding consulting, it typically aligns with economic cycles, but we may see less correlation this time due to the nature of our consulting work. Much of what we provide involves implementing back-office applications, critical applications, and enhancing supply chain resilience, along with addressing cash conversion and cost optimization. These areas tend to receive increased attention, especially in slightly downturning economies. It's important to note that consulting relies heavily on labor. Jim outlined the demand and supply dynamics well. In a business that hires tens of thousands of people, we also experience significant turnover. This turnover can provide a way to adjust profit controls because if demand isn't present, we can slow down hiring. This can lead to a 10% to 20% impact that can be managed swiftly, usually within six months or so. On M&A, I can state that our model typically reflects a contribution of about 1 to 1.5 points each year through acquisitions. Last year demonstrated this consistency, and while this year's not finished, you should anticipate a similar range ahead. This encompasses both consulting and software acquisitions, and the valuations we've encountered align with that expectation. To conclude, we are pleased with our solid performance in the first half. As we move into the second half, our focus will be on executing our strategy to achieve sustained revenue and free cash flow growth. I look forward to our next interaction.