Q4 2021 International Business Machines Corp Earnings Call

January 24, 2022

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Welcome and thank you for standing by.

Now I'd like to welcome you to IBM's fourth quarter.

Welcome and thank you for standing by. At this time all participants are in a listen-only mode. Today's conference is being recorded. If you have any objections, you may disconnect at this time. Now I will turn the meeting over to MS. Patricia Murphy with IBM. Ma'am, you may begin.

Yeah.

Thank you. This is Patricia Murphy and I'd like to welcome you to IBM's fourth-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.

I'll remind you the separation of our managed infrastructure services business Kyndryl was completed on November the third.

As a result, our income statement is presented on a continuing operations basis.

Our results also reflect the incremental revenue from the new commercial relationship with Kyndryl.

Because this provides a one-time lift to our growth, we will provide the contribution to our revenue growth for the next year.

In the spirit of providing additional information to investors. Our presentation also includes non-GAAP measures. For example, all of our references to revenue and signings growth are at constant currency. We have provided reconciliation charts for these and other non-GAAP measures at the end of the presentation and in the 8-K submitted to the SEC.

Finally, some comments made in this presentation may be considered forward-looking under the Private Securities Litigation Reform Act of 1995. These statements involve factors that could cause our actual results to differ materially.

Additional information about these factors is included in the company's SEC filings.

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

Thank you, Patricia, and thanks to all of you for joining us today.

Our fourth quarter results reinforce our confidence in our strategy and model.

Good morning.

With solid revenue growth, we are on track to the mid single digit tragically we had laid out in our investor briefing last October.

The trend we see is clear.

Across industries, [clients see] technology is a major source of competitive advantage.

<unk> technology is a major source of competitive advantage.

They realized that powerful technologies.

Embedded in the heart of the business and lead to seismic shifts in the way they create value.

This reality of technology being about a lot more than cost will persist.

And explains why clients are eager to leverage hybrid cloud and artificial intelligence to move the business forward.

Our fourth quarter results.

Illustrates a strong client demand we see in the marketplace for our technology and consulting.

IBM consulting again had double digit revenue growth.

As our ecosystem play continues to gain momentum.

Software revenue growth reflects strength in red hat and our automation offerings.

Infrastructure had a good quarter.

Especially with regards to IBM Z and storage.

Over the last year and a half we have taken a series of actions to execute our hybrid cloud and AI strategy and improve our revenue profile, optimizing our portfolio, increasing investments, expanding our ecosystem and simplifying our go to market.

As we start to yield benefits from these actions.

Our constant currency performance improved through 2021.

Our most significant portfolio action was the separation of Kyndryl.

You will remember we had initially expected the spin by the end of the year and we completed it in early November.

As we discuss our results, we will focus on the new basis and structure.

That encompasses today's IBM.

As we look to 2022.

We expect mid single digit revenue growth for Kyndryl and currency.

And 10 to $10.5 billion of free cash flow for the year.

Free cash flow for the year.

Both of these are consistent with our medium term model.

Let me now spend a few minutes on what we're seeing in the market, how we address it and the progress we are making.

We are seeing high demand for our capabilities in several areas.

Clients are eager to automate as many business [inaudible] as possible, especially given the new employee demographics.

This dynamic is likely to play out over the long term.

They're also using AI and predictive capabilities to mitigate friction in the supply chain.

Cyber security remains a major area of concern as the cost of cybercrime already in the billions of dollars rises each year.

As clients deal with these challenges and opportunities they are looking for a partner that can cross.

And who has a proven track record in bringing about strategic transformation projects.

This is why our strategy is focused on helping our clients leverage the power of hybrid cloud and AI.

Hybrid cloud is about providing a platform that can straddle multiple public cloud private cloud and as a service properties that our clients typically have.

Our approach is platform-centric and the platform via builders' open secure and flexible.

And it provides a solid base for the multiplier effect across software and services for IBM and our ecosystem partners.

It starts with Red Hat, which offers clients a unique software capabilities based on open source innovation.

Our software, which has been optimized for that platform helps our clients apply AI automation and security to transform and improve their business workflows.

Our consultants deliver deep business expertise.

The co-create with our clients to advance their digital transformation journeys.

Our infrastructure allows clients to take full advantage of an extended hybrid cloud environment.

This strategy along with the differentiated capabilities we bring to bear to our clients have led to an increase in platform adoption and new business opportunities across the stack.

We now have more than 3,800 hybrid cloud platform clients.

Which is up [1,000 clients] from this time last year.

Declines from this time last year.

IBM consulting continues to help drive platform adoption with about 700 Red Hat engagements for the year.

[inaudible] Bradstreet, National Grid.

ARB and Volkswagen have all recently chosen IBM's broad hybrid cloud and AI capabilities to transform their processes and move their business forward.

As I look back on the year, we had good success in broadening our ecosystem to drive platform adoption and to better respond to client needs.

During our Investor briefing, we talked about strategic partnerships that will yield billion-dollar businesses within IBM consulting.

As we move towards that we had more than 50% revenue growth this year and partnerships with AWS, Azure and Salesforce.

This adds to the strong strategic partnerships, we have with others, such as SAP Oracle and Adobe.

It's continuing to broaden our ecosystem reach.

In the fourth quarter, we announced an expansion of our strategic partnership with Salesforce to run.

Our new soft integration software on Red Hat OpenShift.

It also created a host of new consulting services with S&P to help clients accelerate their journey to S/4HANA.

Together with Deloitte, we announced [inaudible] and

AI enabled managed analytics solution.

And we have expanded our partnership with EY to help organizations leverage hybrid cloud AI and automation capabilities to transform HR operations.

We have also recently announced a host of new strategic partnerships with Cisco, Palo Alto networks and Deloitte.

All focused on the deployment of 5G edge and network automation capabilities.

During 2021, we have been making changes to increase our focus and agility.

And build a stronger client centric culture.

This includes putting experiential selling client engineering and co-creation at the heart of our client engagement model.

We have competed thousands of IBM garage of engagement.

And today, we have nearly 3,000 active engagements.

We've invested in hundreds of customer success managers to help clients capture more value from our solutions.

And we have upgraded our skills.

With fewer generalists and more technical specialists.

This is resonating well with our clients and it's starting to contribute to our performance.

The most important metric of course is revenue growth.

We're also pleased to see our cloud renewal rates, increasing and our recurring revenue base growing.

We are starting to see signs of sales productivity improvements with average productivity per technology seller, increasing from the first to the second half.

At the same time, innovations that matter to our clients remain a constant focus.

Innovations that matter to our clients remain a constant focus.

And the teams have worked hard to deliver a series of important innovations in the past quarter.

Starting with AI, we added new natural language processing enhancements to Watson discovery.

<unk> added new natural language processing enhancements to Watson discovery.

We're also combining and integrating products.

Such as [inaudible] and Watson AI ops.

To offer a complete set of AI powered automation software.

To address the significant demand. This quarter, Red Hat announced that the ansible automation platform is now available on Microsoft Azure, bringing more flexibility to fund and how they adopt automation.

This quarter <unk>.

<unk> announced that the ansible automation platform is now available on Microsoft Azure, bringing more flexibility to fund and how they adopt automation.

In partnership with Samsung Electronics.

IBM announced a breakthrough that reorient, our transistors are built upon the surface of a chip.

To enable tremendous increases in energy density.

And Quantom, we unveiled Eagle 102017, qubit quantum processor.

This is the first quantum shifts that breaks the 100 gigabit barrier.

And represents a key milestone.

Of our path towards building a thousand qubit processor in 2023.

Organic innovations that are important we continue to acquire companies that complement and strengthen our portfolio.

We made five acquisitions in the fourth quarter.

And a total of 15 acquisitions in 2021.

Two weeks ago, we announced the acquisition of Envizi.

Many consumers are willing to pay more for products that are made by companies that are more environmentally sustainable.

As the world continues to move towards a more circular economy.

Our clients need is the ability to manage and measure their progress.

Envizi's capabilities complement our own and help us respond to that client demand.

Sustainability is important across a number of stakeholder groups.

Including clients employees and investors.

We are continuing to make good progress.

And I'm particularly proud of our diversity and inclusion goals.

And our ability to attract and retain talent.

Our efforts were recently recognized by just capital for named IBM as one of America's most just companies.

Let me now close by emphasizing once again.

Our fourth quarter results strengthened our conviction that we have in our ability to deliver a model of mid single digit revenue growth.

Jim will take you through the fourth quarter.

And then provide more color on 2022, Jim, over to you.

Thanks, Arvind.

Let me start out with a few of the headline numbers, we delivered $16.7 billion in revenue.

58% operating gross margin, operating pre-tax income of $3.5 billion and operating EPS of $3.35.

For continuing operations.

Last January, we said we expected performance to improve over the course of 2021 as we start to benefit from the actions we've taken.

We have seen progress in our constant currency revenue growth rate every quarter and now again in the fourth.

This is the first view of IBM post separation.

We had solid revenue performance up nearly 9%.

I'll remind you. This includes the incremental revenue from the new commercial relationship with Kyndryl.

And we said we would be transparent on the contribution to our revenue growth for the first year.

This quarter our revenue growth includes about three-five points from the new relationship.

Excluding this, IBM's revenue was up 5%.

We have aligned our operating model and segment structure to our platform-centric approach.

In the fourth quarter software was up 10% and consulting was up 16%.

These are our two growth factors and together represent over 70% of our annual revenue.

Infrastructure more of a value vector.

Tends to follow product cycles and was up 2%.

The software and infrastructure growth each include nearly five points from the new Kyndryl relationship.

While there is no contribution to consulting growth.

Our platform centric model as attractive economics.

For every dollar of hybrid platform revenue, IBM and our ecosystem partners can generate three to $5 of software.

6 to $8 of services and 1 to $2 of infrastructure revenue.

This drives IBM's hybrid cloud revenue, which is up 19% for the year.

Post-separation revenue from our full-stack cloud capabilities from infrastructure up through consulting now represents $20 billion of revenue.

Or 35% of our total.

Looking at our P&L metrics, our operating gross profit was up 3%.

And the $3.5 billion of operating pre-tax profit was up over 100%.

Operating net income and earnings per share also grew.

Let me highlight a couple of items within our profit performance.

First, the year to year pretax profit reflects $1.5 billion charge to SG&A last year for structural actions to simplify and optimize our operating model and improve our go forward position, we're continuing to invest to drive growth.

Throughout the year, we have been aggressively hiring with about 60% of our hires and consulting.

We're scaling resources in garages, find engineering centers and customer success managers, all to better serve our clients.

We are increasing investments in R&D to deliver innovation and AI hybrid cloud in emerging areas like quantum.

We're ramping investment in our ecosystem.

And we acquired 15 companies in 2021 to provide skills and technologies aligned to our strategy, including capabilities to help win client architecture decisions.

Regarding tax, our fourth quarter operating tax rate was 14%.

This was up significantly from last year.

But roughly two to three points lower than what we estimated in October due to a number of factors, including the actual product and geographic mix of our income in the quarter.

Let me spend a minute on our free cash flow and balance sheet position.

Our full year consolidated cash from operations was $12.8 billion.

And free cash flow was $6.5 billion.

These are all in consolidated results and include 10 months of Kyndryl and the cash paid for the 2020 structural actions and spin charges.

IBM stand alone our baseline free cash flow for the year was $7.9 billion, which is aligned to our go-forward business.

This excludes kindle charges and pre-separation activity, but includes the IBM portion of the structural actions.

Payments for these IBM related structural actions and deferred cash tax paid in 2021 contributed to the year to year decline in the standalone results.

In terms of uses of cash for the year, we invested over $3 billion in acquisitions, we continue to delever with that down nearly $10 billion for the year and over $21 billion since closing the Red Hat acquisition.

And we returned nearly $6 billion to shareholders in the form of dividends.

This results in a year-end cash position of $7.6 billion, including marketable securities.

And debt of just under 52 billion.

Yes.

Our balance sheet remains strong and I'd say the same for our retirement-related plans.

You'll remember that over the last years, we've shifted our asset base to a lower risk profile.

In 2021, the combination of modest returns and higher discount rates improve the funded status of our plans.

In aggregate our worldwide tax qualified plans are funded at 107%.

With the US at 112%.

Now I'll turn to the details by segment and I'll remind you we have put in place a simplified management system and segment structure aligned to our platform-centric model.

And within the segments, we're now providing new revenue categories and metrics that will provide greater transparency into business trends and drivers.

IBM software delivered double-digit revenue growth in the quarter. This was driven by good revenue performance in both hybrid platform and solutions and transaction processing.

The latter benefiting significantly from the new Kyndryl content.

Software is important to our hybrid cloud strategy and our financial model.

Our hybrid cloud revenue and software is up 25% for the year to more than $8.5 billion.

Subscription and support renewal rates continue to grow again this quarter contributing to a $700 million increase in the software deferred income balance over the last year.

Hybrid platform and solutions revenue was up 9%.

This performance is an indication of the strength across the software growth areas focused on hybrid cloud and AI.

Worth mentioning this includes only a point of help from the new Kyndryl commercial relationship.

Let me highlight some of the trends by business area.

Red Hat revenue all in was up 21%.

Both infrastructure and App Dev and emerging tech grew double digits as ROE and open shift address enterprises critical hybrid cloud requirements.

With this performance, we're continuing to take share with our Red Hat offerings.

Automation delivered strong revenue growth up 15%.

As Arvind mentioned, there is strong market demand for automation.

We had good performance in the AI ops and management this quarter as we address resource management and observed ability.

Clients are realizing rapid time to value from [inaudible] and Turbonomic, two of our automation acquisitions.

And integration grew with continued traction in Cloud Pak for integration.

Data and AI revenue grew 3%.

We have particular strength in data fabric, which enables clients to connect siloed data distributed across the hybrid cloud landscape without moving it.

You'll recall we talked about the data fabric opportunity back in October.

We also had strong performance in business analytics and weather.

Within these solutions clients are leveraging our AI to ensure AI models are governed to operate in a fair and transparent manner.

Security revenue declined modestly in the quarter driven by lower performance in data security, while revenue grew 5% for the year as we called out in our recent Investor briefing security innovation is an integral part of our strategy.

In December we launched a new data security solution, Guardian insights with further plans to modernize the broader portfolio throughout the year.

This quarter, we also completed the acquisition of reactor.

Which leverages AI and machine learning to automatically identify and block threats at the endpoint.

Putting this all together, our annual recurring revenue or ARR is now over $13 billion, which is up 8% this quarter.

This demonstrates the momentum in our hybrid platform and AI strategy, including Red Hat and our suite of cloud packs.

Moving to transaction processing. Revenue was up 14%.

This is above our model driven by a few underlying dynamics.

First, all of the growth in transaction processing came from the new Kyndryl commercial relationship, which contributed more than 16 points of growth.

I'll remind you that we're wrapping on a very weak performance in the fourth quarter of last year, which was down 26%.

And lastly, we had some large perpetual license transactions given the good expansion in the IBM Z capacity, we've seen this cycle.

While the new capacity is important, what's just as important is the continued strong renewal rates this quarter.

These are both good proof points of our clients' commitment to our infrastructure platform and these high-value software offerings.

Looking at software profit, we expanded pre tax margin by 12 points.

Including nearly 10 points of improvement from last year's structural actions.

Turning to consulting. Revenue grew 16% with acceleration across all three revenue categories.

Complementing this strong revenue performance our book to Bill was 1.2.

Clients are accelerating their business transformations.

Powered by hybrid cloud and AI to drive innovation, increase agility and productivity and capture new growth opportunities.

Enterprises are turning to IBM consulting as their trusted partner on this journey.

They are choosing us for our deep client industry, and technical expertise, which drives adoption of our hybrid cloud platform impulse through key technologies.

Consulting's hybrid cloud revenue grew 34% in the quarter.

For the year cloud revenue is up 32% to $8 billion.

Offerings and application modernization, which are centered on Red Hat contributed to this growth.

The Red Hat related signings more than doubled this year and are now over $4 billion since inception.

This quarter, we added over 150 client engagements, bringing the total since inception to over 1000.

Our strategic partnerships also drove our performance.

Revenue from these partnerships accelerated as the year progressed and was up solid double digits in the fourth quarter led by Salesforce SAP.

AWS and Azure.

Turning to our business areas. Our consulting growth was led by business transformation, which was up 20% business transformation brings together technology and strategic consulting to transform critical workflows at scale.

To enable this, we leveraged skills and capabilities and IBM technologies and with strategic ecosystem partners such as SAP.

Salesforce and Adobe.

Our practices are centered on areas, such as finance and supply chain talent industry specific solutions and digital design.

This quarter, we had broad-based growth, reflecting strong demand for these solutions.

And technology consulting revenue was up 19%.

Technology consulting architects and implement cloud platforms and strategies.

We leverage hybrid cloud with Red Had opened shift and work with providers such as AWS and Azure in addition to IBM cloud.

This quarter, we continued to see good performance and application modernization offerings that build cloud-native applications and that modernize existing applications for the cloud.

Finally, application operations revenue grew 8%.

This business line focuses on application and cloud platform services required to operationalize and run in both cloud and on-premise environments.

Revenue growth was driven by offerings, which provide end to end management of custom applications in cloud environments.

Moving to consulting profit. Our pre-tax income margin expanded about eight points.

Including just over nine points from last year's structural actions.

We're in a competitive labor market and we continue to have increased pressure on labor costs due to higher acquisition retention and wages.

While we still expect to capture this value in our engagements, it will take a few quarters to appear and our profit profile.

So now turning to the new infrastructure segment. Revenue was up 2%.

The Kyndryl commercial relationship contributed about five points of growth, which is higher than we expected in October.

In this segment, we brought together hybrid infrastructure with infrastructure support which was formerly technology support services.

This allows us to better manage the lifecycle of our hardware platforms and to provide end to end value for our clients.

Hybrid infrastructure and infrastructure support revenue were up 2% and 1%, respectively with pretty consistent contribution from the new Kyndryl relationship.

Hybrid infrastructure includes IBM's Z and distributed infrastructure.

IBM Z revenue performance now inclusive of both hardware and operating system is down 4% this quarter.

This is the 10th quarter of Z 15 availability and the combination of security scalability and reliability continues to resonate with clients.

This program continues to outpace the strong Z 14 program.

And we ship more Mips and the Z 15 program than any program in our history. Our clients are leveraging IBM's Z as an essential part of their hybrid cloud infrastructure and then in distributed infrastructure revenue was up 7%.

Driven by pervasive strength across our storage portfolio.

Looking at infrastructure profit. The pre-tax margin was up over nine points, but essentially flat normalizing for last year's structural action.

Now I'll wrap up with a discussion of how our investments and actions position us for 2022 and the longer term.

We've been laser focused on our hybrid cloud and AI strategy.

Our portfolio, our capital allocation and the moves we've been making are all designed to create value through focus for our clients our partners our employees and our shareholders.

We took significant steps during 2021, the most impactful portfolio action was, of course, the separation of Kyndryl.

We've also been allocating capital to higher-growth areas, investing in skills in innovation and expanding our ecosystem, we've aligned our business to a more platform-centric business model.

And we're simplifying and redesigning our go to market to better meet client needs and execute on our growth agenda.

Bottom line, we're exiting 2021, a different company.

We have a higher growth, higher-value business mix with over 70% of our revenue in software and services and a significant recurring revenue base dominated by software.

This will result in improving revenue growth profile higher operating margin strong and growing free cash flow and lower capital intensity, leading to a higher return on invested capital business.

We also continue to have attractive shareholder returns through dividends.

In October we laid out a model for IBM's performance over the medium term defined as 2022 through 2024.

The model is focused on our two most important measures of success.

Revenue growth and free cash flow. As we enter the new year, I'll talk about our expectations for 2022 performance along those dimensions.

Starting with revenue.

We expect to grow revenue at mid-single-digit rate at constant currency.

That's consistent with the model.

On top of that, in 2022, the new commercial relationship with Kyndryl will contribute an additional three points of growth.

New commercial relationship with kindred will contribute an additional three points of growth.

Spread across the first three quarters.

Currency dynamics, unfortunately, will be a headwind. At current spot rates, currency is roughly at two-point headwind to reported revenue growth for the year.

And three points in the first quarter.

For free cash flow, we expect to generate 10 to $10.5 billion in 2022.

To be clear this is an all in free cash flow definition.

The adjusted free cash flow view we provided in 2021 was useful given the significant cash impact associated with the separation and structural actions.

Now in 2022, despite the fact that we still have nearly a half of $1 billion of impact from the charges, we're focusing on a traditional free cash flow definition.

The 10 to $10.5 billion reflects a year to year improvement driven by lower payments for the structural actions.

A modest tailwind from cash taxes.

Working capital improvements and profit growth, resulting from our higher growth and higher value business mix.

With this performance, we're on track to our model.

So now let me provide some color on our expectations for segment performance.

Because this is a new segment structure, I'm going to spend a little more time and provide perspective on constant currency revenue growth.

And pre tax margin in the context of our segment models.

In software, as we benefit from the investments in innovation and our go-to market changes, we're seeing progress in our software growth rate.

In 2022, we expect growth at the low end of the mid single digit model.

And then another five to six points of revenue growth from our external sales the Kyndryl.

We expect software our pre tax margin in the mid twenties range for the year.

We have solid momentum and IBM consulting revenue and expect this to continue into 2022 as we help clients with their digital transformations.

This momentum and our book to Bill ratio support revenue at the high end of our high single-digit model for the year.

With double digit growth in the first half.

We expect low double digit pre tax margin for the full year.

With improving performance through the year as we make progress on price realization.

Infrastructure revenue performance will vary with product cycle in 2022, with a new IBM Z introduction late in the first half we expect performance above the model and a slight contribution to IBM's overall growth.

On top of that, we're planning for about two to three points from the external sales to Kyndryl in 2022.

This supports a high teens pretax margin rate for the full year.

These segment revenue and margin dynamics, we yield about a four-point year to year improvement and IBM's pretax operating margin for the full year.

And two to three points in the first quarter.

In terms of tax, we expect a mid to high teens tax rate, which is a headwind to our profit growth.

Bringing this all together, we expect mid single-digit revenue growth before Kyndryl and currency.

And 10 to $10.5 billion of free cash flow for the year.

Both in line with our midterm model.

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

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

LT part questions Sheila.

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

Thank you. At this time, we'll begin the question and answer session of the conference. To ask a question, please press star one and record your name clearly.

To withdraw your question, press star Q. Again to ask a question, please press star one. Our first question comes from Amit [inaudible] with Evercore. Your line is open.

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

I wanted to go back to the $10 to $10 $5 billion free cash flow number for calendar '22.

I know there was a lot of moving parts here. So it's lower than what I think many had been modeling and if I think about the analytic framework we have talked about, it was supposed to be a $10 billion of free cash flow in '20, adding 750 million if I remember correctly annually. So that would put us somewhere in 11.5 I think is what I would have expected. So can you just talk about auto relative to that?

If you want.

What is the delta to free cash a lot of the puts and takes there that would be really helpful?

Sure, Amit. Thank you very much for the question first let's just ground everyone because I want to make sure we have absolute.

clarity.

As we're returning to reporting all in free cash flow to one aligned to our consistency of IBM's post-separation baseline to your point the $10 billion in 2020, and more importantly to align to our forward-looking guidance, which we talked at Investor day with a mid term model of

$35 billion cumulatively over 2022 to 2024. For 2022, specifically as you heard me say, we expect free cash flow to be between 10 and $10.5 billion all in.

And that puts us right on track for the 35 billion, mainly Amit because it includes still the remaining structural actions charges of about a half a billion dollars in 2022, and when you look at that because of structural actions you're not going to have linearity in that 35 billion.

Throughout 2022 to 2023 to 2024, so let me talk just a little bit so we get clarity around the drivers to your point at the heart of your question.

First, we do have about half a billion dollars remaining in the cash impacts from the structural charges.

As I stated earlier. That means year to year, it's about $1 billion give or take benefit. Second, we anticipate about a half a billion dollars of working capital efficiency just based on our AAR dynamics around volume and also we're entering a mainframe cycle late in the first half third.

Very minimal

Tailwind with regards to cash tax, which basically means the majority of this as to be delivered on our operational profit.

And invest less I should say investments in capital expenditures and that's going to come from revenue growth at our model mid-single-digit before we added Kyndryl operating leverage, which we talked about four points improvement for the year.

A mainframe cycle and us continuing to address the remaining stranded costs from the separation of Kyndryl as we move forward. So we feel very comfortable 110% to 10 and a half puts us on a position to that 35 billion and two more importantly that this cash provides us with ample.

Financial flexibility to continue to invest in our business, both organically and inorganically and return significant value to our shareholders what are committed dividend.

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

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

Yes. Thank you, Arvind, I couldn't agree more with your comments about the structural uplift in IT spending from technology diffusion across all sectors, but as you think about the stock market volatility over the last several weeks, is there any reason to believe that there could be some near term cyclical impact from that volatility?

And then maybe if you can also comment on whether the recent pullback in software valuations increases the likelihood that you might look at doing bigger M&A this year.

Thanks for the question.

Thank you for also noticing and acknowledging the robust spending environment.

Okay, I mean, if I react to every stock market.

Intraday volatility, that's a full-time occupation. I think today sure that they're actually these cycles are hard to predict.

And if I back up and look at our clients, I think they are not really reacting to these volatilities. We saw this in the middle of 2020 also not just in 2021 and 2022.

For the first time, despite a down business cycle in 2020, we saw people decide to keep up there.

IT spending now I'll acknowledge in 2020 that did.

Put a break on capital spending within IT.

But they all acknowledge that IT spending was critical to how they would come out and that showed up in 2021 spending. I suspect.

I suspect we.

But we are not as much expert on this as many of you on this call, but I would suspect that this volatility we have seen recently will not have much of an impact. Now, if it becomes into an overall bear market correction that that would be different but I don't think we had anywhere close to that.

I think in terms of near term cyclical impacts, I don't really see them. [All clients] tend to be people who are

Much more the, what we provide technology for as much more critical applications. People need them for doing online payments they need them for authorizations, reservations, retail banking.

Healthcare, Telecom.

Within the government for critical applications. So we don't tend to see much of a short term cyclical impact.

Now on your last question valuations look.

I'm always clear valuations, M&A it has to have an economic benefit.

For our company and our shareholders.

As valuations come.

Come down, certainly some targets may become more approachable that were not previously approachable.

And I have said before, look we have a little over $20 billion of flexibility over the next three years. So I'll just leave it at that. That's a total flexibility as prices come down certainly more things come within range.

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

Our next question comes from Toni [Sacconachi] with Bernstein. Your line is open.

Yes. Thank you. Really just some clarifications. You talked about the year over year improvement in PTI of about four points.

It looks like that the year over year Kyndryl contribution of $1.8 billion in revenue should come in at extremely high marginal contribution maybe 70%.

And then you're going to have a year over year contribution from

From fewer charges. So maybe you could dimension each of those and talk about whether you believe underlying PTI will improve and then similarly, if you could just clarify your expectation for the acquisition contribution to revenue in 2022.

And you didn't mention the divestiture of Watson health, how we should think about that.

Is that in addition to should we be factoring in on top of the guidance or does your guidance include the divestiture Watson health revenues? Thank you.

Okay, Tony, I'll take this. Thank you very much for the question.

A handful there to address overall, so if I got it correctly first of all yes, we talked about our guidance.

Coming off of a very solid fourth quarter gives us confidence in the foundation to really build on our midterm model and we said 2022 would be the next step.

We have we have progress more work to do mid single digit growth pre Kyndryl contribution operating margins up about four points and then free cash flow as I answered Amit at 10 to $10.5 billion. So when you look at that operating profit overall first of all yes.

We're very transparent in our two key measures of success. Number one, the contribution of revenue growth. And we said, we're going to be up mid-single-digit prior to adding the Kyndryl three points roughly for the year and the second key measure, which we've got our entire business.

Our operating model online too is free cash flow generation and we're very transparent in our free cash flow generation. That is all in with a baseline IBM.

Post-separation baseline of $7.9 billion, we reported in '21, go into 10% 10.5 billion on its way to delivering 35 billion cumulatively over time. Within that I gave you the breakout of the bridge on cash flow. No matter how you cut it we are going to invest more in capital expenditures this year.

But when you take out the working capital efficiency over half a billion.

Very modest cash tax tailwind.

And you take out the half of $1 billion of structural charges, you get substantial operating profit growth. And I would tell you, although we're not going to disclose based on commercial competitive reasons around the profitability of Kyndryl overall and I don't think you would expect us because we don't do that with any strategic partner.

They have a $1 billion of structural charges, you get substantial operating profit growth and I would tell you, although we're not going to disclose based on commercial competitive reasons around the profitability of kindred overall and I don't think you would expect us because we don't do that with any strategic partner.

Our client that that is a minimal component of the required operational profit improvement for 2022 overall, so we feel pretty good about the confidence in our guidance. It positions us on that midterm model and it gives us tremendous financial flexibility.

To continue to invest to extend our hybrid cloud leadership invest in innovation to bring on new technology and returned significant value back to our shareholders. Overall I think that was the first one the second one acquisition revenue contribution.

Obviously, we've got work to do to close this. This won't close until later in the second quarter and at that point in time, we will disclose information around Watson health and what the implications are to our guidance overall and we will update investors as we always do.

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

Our next question comes from [inaudible] Mohan with Bank of America. Your line is open.

Hi, yes. Thank you.

Arvind, as you think about the mid term model and layer in some of these puts and takes that you guys highlighted in 2022, you can have up to maybe a couple of points of benefit from M&A and up and maybe up to a point from mainframe as you look into 2023. Some of these elements will turn into headwinds, particularly maybe up to two points from infrastructure.

Sure.

What are the things that you are looking at that should grow better than 2022, and 2023 to offset some of this to get back to that mid single trajectory? And Jim, can you address 2022 seasonality for revenue growth and cash flow given the Kyndryl separation?

That should grow better than 2022, and 2023 to offset some of this to get back to that mid single trajectory and Jim can you address 2022 seasonality for revenue growth and cash flow given the <unk> separation.

Really very different timing on the Z cycle.

Yeah. Thanks. Let me address the first part of the question, the mid-single-digit growth in 2022 going to 2023.

Let me remind you. When we did our Investor day in early October, we talked about the mid-single digits growth comes from about two points of that for IBM comes from the consulting growth.

About between one and two points come from the Red Hat growth.

And then we will get some from infrastructure aka mainframe, but there's more than mainframe. There's storage in there and there is also powered product cycles.

And then organic software.

<unk> infrastructure organic software.

If you put that altogether, you will get more than mid mid single-digit in a given year.

But we begin to see cycles of that for example on mainframe, but we say it comes late in the first half, that means its really a second half '22 contribution. That carries on into the first half of '23 maybe till the third quarter, maybe longer depending on the cycle.

If I look at Red Hat, fully expect that to carry on. If I look at consulting, we expect that to carry on. So if I look at all of the underlying components and then as [inaudible] the acquisitions into software, those will begin to contribute a bit more in a bit more each year. You asked about the overall acquisitions I think that will give us about point each year.

Which is what we had said before but that is inside what I talked about the two points and the one to two points and appointed at the point.

And so that is the pieces here and by the way. So if you look at what I laid out '22 and '23 look remarkably similar not that different.

Pieces here and by the way. So if you look at what I laid out 'twenty two 'twenty three look remarkably similar not that different.

Jim, you want to yes, let seasonality question? Thank you very much very important question. When we think about 2022 just building on what Arvind just said right there. If you think about the revenue.

Growth profile and how it's going to play out in 2022, as we stated earlier, we expect the mainframe cycle this year and that will happen late in the first half. So read that minimal contribution in 2Q and then mostly in the second half, but second, really the big point I want to get out is you can quite expect.

Due to the separation of Kyndryl, which was a highly a newer ties based business, I think we're going to have a different business SKU.

Throughout 2022 on top of the product cycle that I just talked about earlier. I would expect somewhere in the neighborhood around profit.

To be about 40, 60, first half, second half, but I would tell you underneath that 40% in the first half is going to be skewed more towards second quarter, just given the new introduction of our mainframe cycle and also last year, we had a very strong first quarter mainframe, we grew over 20%

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

First half second half. Thanks.

Sheila, can we please go to the next question?

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

Next question will come from Jim Suva with Citigroup. Your line is open.

Thank you very much both Jim and all that you guys have done a tremendous amount of heavy lifting and work over the past couple of years, all the way from integration of Red Hat to spin out a kindle.

Looking ahead now just strategically my one question is are we looking at the core company is now it's really time to harvest everything or are there still some more transformational or pruning or spinning out going on? And I'm not referring to the Watson health. I'm talking about more bigger things are it seems like.

Now, it's time to start harvesting things, but maybe not hearing your comments correctly.

So Jim let me take that. This is Arvind.

Look I think that we have done a lot of the heavy lifting we need.

I fundamentally believe that we have the right portfolio and we have the right focus to be delivering on our midterm model.

Maybe I didn't quite understand the word harvest. I wouldn't say harvest.

We have the correct portfolio to be able to grow where our clients have got demand and where the market has demand.

We are now approximately 30% consulting company, a 70% technology company.

It's about a little bit under half is software.

If I look at software yes. There is a portion that is very much focused on transaction processing. We believe that model is going to be a

Mid-single-digit decline out over the very long term and if you look at some of the dynamics that Jim Gavin I talked about you kind of see that then if you go over the past.

Couple of years.

Then if I look at automation, security, data and AI, I think these plays very much into where there is a lot of demand in the market.

If I look at consulting, that's our clients are going to get their projects on digital transformation completed. And then if you look at hybrid infrastructure, we're quite focused and infrastructure on the areas that align to our high-value model and if I look at both storage and mainframe. They gave us a lot of benefits to also help drive the other parts of the portfolio. If I got it right, Jim.

Projects on digital transformation completed and then if you look at hybrid it infrastructure, we're quite focused and infrastructure on the areas that align to our high value model and if I look at both storage and mainframe. They gave US a lot of benefit to also help drive the other parts of the portfolio if I got it right Jim.

To your question. No, you should not expect any major strategic.

Divestitures like we just have talked about with Kyndryl. I think those are behind us. Now we have the portfolio that allows us to deliver on our medium-term model.

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

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

Alright, thank you.

This is a question for Jim. Jim, if we take your revenue growth.

Comments about '22 and the margin comments.

It would just seem to yield net income.

Below your free cash flow guidance, and obviously, I'm assuming the new model given the combination of software and professional services would yield free cash flow by 1X.

At a conclusion basis, So is that math right can you help reconcile the difference between the implied EPS guide to that 10 and $10.5 billion of free cash flow.

Yeah, well, David as we've talked since Arvind is has come on and taken over as chairman and CEO, we have aligned our portfolio, we've aligned our capital investment allocation structure, we've aligned the operating model in this company and I'm a very big believer in focus.

And that focus is around two measures revenue growth and free cash flow.

I am not going to talk about EPS guidance and by the way.

As you know quite well there are many ways of getting to an EPS number.

But I've given the breakout of the revenue growth overall, we've been very transparent mid-single-digit. We said we're going to get an operating leverage improvement about four points. When we broke that out by segment, we're going to get software, we expect up to mid-twenties on our

Path to approaching 30, and our midterm model, we said around consulting.

At the high end of our high single-digit revenue growth model, we're going to approach about 10% coming off of about a about 8.5 point margin business in 2021, and then infrastructure given we've got a product cycle. We expect above model on revenue as Arvind answered earlier, it will be a slight contribution.

to IBM, and we expect the operating margins and infrastructure to be in the high teens. When you take all those components of what I would I just brought out and then you do the free cash flow bridge, you get a quite healthy profit contribution to deliver that free cash flow and I think.

David, that is the focus that Arvind's got 250,000 IBMers mobilized on revenue growth that operating margin by segment to deliver the product mix and productivity and that free cash flow and that's what we're going to continue to guide on as we move forward.

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

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

Hi. Thanks very much for the question.

This one is about the trajectory of the infrastructure business given the moderation in growth that you saw last quarter in Q3, and then the better performance you saw this quarter do you got any AD added confidence now.

After the performance this quarter that we won't see another soft quarter like in Q3 before we get into the next IBM Z cycle in the second half of the year.

Carl, maybe I'll start there.

The third quarter I think we stated even when we finished the third quarter, but we saw a pause on some of the CAPEX purchases and infrastructure because people were digesting what to do around the Kyndryl separation.

That particular factor I do not believe is going to show up again.

Now that said.

As Jim said a bit earlier in answer to one of the other questions. This is the 11th quarter of mainframe.

When we look at that, we do expect softness on mainframe in the first quarter, but not in the remaining quarters.

I'd say that that's the only critical dynamic that could be different if we look at quarter to quarter, but that is expected and baked in and what we're talking about for the year and what we're talking about in terms of infrastructure performance, which for the year, we do expect it to be better.

In '22 but more of that in the second half as Jim pointed out earlier.

Thank you.

Sheila, let's take one last question.

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

Hi. Thank you, good afternoon, and thank you for taking the question maybe for Arvind.

It's been really nice business transformation technology consulting growth.

Business transformation technology consulting growth.

I'd love to hear your comments.

Or at least if you can reflect on customer conversations and what those have been like and how you might characterize some of that business activity, whether you feel as though we're in the early stages, maybe the middle innings of technology transformation efforts.

How would you frame that business and how much of that business is a leading indicator for Red Hat and automation growth?

Thank you, Brian for the question.

So to go to the middle part of your comment our color that we are in the early innings.

Not the middle or late innings of the growth

In consulting.

I wouldn't call it a very first inning, maybe the first inning was 2021 but early innings. So I think we have a long way to go on this.

Now I think that leads to the first part of yours, what are the anecdotes of what are the customer conversations that lead us there.

Everyone is looking for how do you deploy technologies be it Salesforce, Adobe, cloud technologies to improve their processes.

It's actually the compensation has changed from three years ago, it's not about cost savings, it's actually much more about how can you deploy these technologies to improve our process. Is it how do I do omnichannel and multi-channel, is it how do I do resilience and my supply chain, is it about how do I use every warehouse.

And store as a point of delivery not just for physical but for physical or online.

As you begin to look across these topics and then as we look at the added cyber threats that come in. These create a huge pull from clients on how do you improve the end to end customer experience how to improve the resilience of their supply chain, how do you improve the experience for employees.

How do you begin to use, I'd use the word bought because I'm a technologist. Others may use the word digital worker, that's probably a more correct word.

We use the word bought because I'm a technologist others may use the word digital worker, that's probably a more correct word.

Take care of all of our upcoming.

How to use of our demographics.

On the skill shortage that is endemic in technology now and that is sort of playing in although I don't believe that the skill shortages because of COVID-19 .

Do you believe Covid may have exacerbated or created a.

Paul in of those demographics, but those I think are going to last us for the decade.

Now.

I think that that is a leading indicator of automation red hat cyber security growth for sure.

It's not identical meaning you're not going to see the same percentage from one to the other.

Absolutely, we'll see correlation that is significant between those and when Jim talked about the number of Red hat.

Engagement and then we talk about the garage engagements from consulting those are then proof points of that correlation.

So Brian . Thank you for the question and that is by the way why we see a lot of the.

Of our confidence in the next few years of revenue growth.

First Bob and Jim. Thank you guys for answering your part of the questions. Let me now make a couple of comments to wrap up and I'm going to end, where I started the call.

We've been taking actions that position our business to address the attractive hybrid cloud and AI opportunity.

Our fourth quarter results and expectations for 2022, or a first glimpse of today's IBM and they reinforce our confidence in our strategy and our model.

Hope that all of you on our ASIC.

As excited about our future as I am.

And I look forward to speaking with all of you again soon.

Yeah look when we turn it back to you to wrap up the call.

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

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Q4 2021 International Business Machines Corp Earnings Call

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