Q1 2022 International Business Machines Corp Earnings Call (Preliminary)
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.
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.
Thank you this is Patricia Murphy and I'd like to welcome you to Ibm's first quarter 2020 earnings presentation.
I'm here with Arvind Krishna.
I am Chairman and Chief Executive Officer, and Jim Kavanaugh, Ibm's, Senior Vice President and Chief Financial Officer.
Post today's prepared remarks on the IBM investor website within a couple of hours and a replay will be available.
Tomorrow.
To provide additional information to our investors. Our presentation includes non-GAAP measures for example, all of our references to revenue and signings growth at constant currency.
We've 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 $19 95.
These statements involve factors that could cause our actual results to differ materially.
Information about these factors is included in the company's SEC filings.
So with that I'll turn the call over to Arvind.
Thank you Patricia and thanks to all of you for joining us today.
Our first quarter results.
The changes we have made to position our business for the future.
Solid start to the year.
Reinforces our confidence in our strategy.
We now see revenue growth for 2022 at the high end of our mid single digit model.
What we're hearing from clients is clear.
Acknowledging has become a fundamental source of competitive advantage.
It is at the very center of Hot businesses scale.
And there is no longer perceived primarily as a way to cut costs.
This is especially true in our current environment.
Harnessing the power of technologies, such as hybrid cloud and AI.
Essentials as our clients face a number of strategic challenges and opportunities whether it is competing for talent supply chain issues inflation cyber security or geopolitical instability.
We continue to see a strong demand environment for both technology and consulting.
Help our clients respond to these issues.
Over the last two years, we have been optimizing our portfolio.
Spanning our ecosystem and simplifying our go to market to capture this demand.
This quarter.
Again had double digit revenue growth in consulting.
And software growth reflects solid performance across the portfolio.
Our infrastructure business as always reflects product cycle dynamics.
Our revenue performance. This quarter is a strong indication that our focus our investments and our actions are paying off.
Before we go Florida, Let me say a few words about the war in Ukraine.
We are first and foremost focused on the safety and security of our employees.
IBM is providing health, including relocation assistance and financial support to <unk>.
IBM is in the region and matching donations from our employees around the world to nonprofits.
In terms of the business impact from Russia, Jim quantify but also the impact of the measurable but not large.
Let me now turn to the progress we are making when it comes to our hybrid cloud and AI strategy.
Hybrid cloud is all about providing a platform that can straddle multiple public cloud private cloud and on premise properties that our clients typically have.
The platform, we have built is open secure and flexible.
At its core it is based on Red hat, which gives clients powerful software capabilities based on open source innovation.
Our software has been optimized for that platform and helps our clients apply AI automation and security to make their business work better.
Our global team of consultants offers deep business expertise.
To do this by co, creating with clients and finding ways to harness the power of technology to accelerate their digital transformation journey.
Our infrastructure allows clients to take full advantage of an extended hybrid cloud environment.
Platform centric strategy is producing solid results.
We have more than 4000 hybrid cloud platform clients.
During 200 added in the first quarter.
This gives us two avenues of growth from.
From the incremental number of clients.
More importantly, it allows us to expand our software consulting and infrastructure footprint at these clients.
Clients are Charles Schwab discover financial and the U S Department of education.
All recently chosen Ibm's hybrid cloud capabilities to digitally transform and build new and differentiated experiences and services.
Clients also turn to Ibm's AI capabilities to move their employees to higher value tasks and improve their customer experiences.
<unk>.
IBM is now working with Mcdonalds to pilot and automated drive through experience with Watson order.
In addition, TD securities is using Ibm's AI powered virtual assistant.
In support of their precious metals digital store.
We were recently recognized in this area as a leader in a Gartner magic quadrant.
These highlight our ability to drive innovation and natural language processing and bring these new capabilities to clients.
An important element of our platform strategy is a Puerto Rico system, where we continue to gain momentum.
We see this in IBM consulting where signings with our ecosystem partners were up more than 50% to $2 billion this quarter.
In the first quarter, we continued to broaden our ecosystem.
We announced an expansion of our strategic partnership with S&P.
Moving as S&P's rise premium partner to help clients move workloads to the cloud.
Adobe announced a significant expansion of our partnership around the use of AI powered weather data on the Adobe experience platform.
Collaborating with Wally and ABB to build a digitally enabled solution that will help energy companies build and operate green hydrogen facilities.
Efficiently and at scale.
We also signed an agreement to join the Uae's network of industrial product or champion are.
A major public private partnership designed to accelerate the digital transformation of the country's industrial sector.
Within IBM, we're making significant changes to the way we work to build a client centric culture based on technical excellence.
New client engagement model based on experiential selling client engineering and co creation is strongly resonating among clients.
Over the last few quarters.
Sales productivity is rising renewal rates are increasing and recurring revenue is growing.
While we are focused on meeting the needs of clients today, we continue to shape the technologies of tomorrow.
Most recently, we announced the IBM Z <unk> platform in early April .
<unk> is designed for cloud native development Cyber security resilience and includes an on chip AI accelerator.
This allows clients to reduce fraud with a real time transaction.
<unk> exemplifies our ability to drive critical innovations to our platform that remains essential to the world economy.
At the same time, we are bullish on the immense potential that automation represents we firmly believe that our AI ops capabilities are poised to seize the significant opportunity in the last quarter, we announced a new AI ops solution in collaboration with Flex era that is designed to automate software license compliance.
One of them is another example of our commitment to advance the fundamental signs of computing by deploying the world's first 127 qubit processor.
Are the only company to have an actual operational computer that is available on our cloud.
Companies and governments around the world are taking steps to prepare for quanta.
As an example, we have recently forged new partnerships with HSBC and the government of Quebec.
Delivering organic innovation remains an important and constant focus at the same time, we continue to make acquisitions to strengthen our portfolio and add value to our clients.
In line with this thinking we completed three acquisitions in the first quarter and VZ new desk, hence the docker.
Clients partners employees and investors are placing a premium on ESG.
As the world moves towards a more circular and sustainable economy clients need help on their journey.
That is why we recently launched the IBM sustainability accelerator, a social impact program that applies IBM technology and consulting to help populations that are vulnerable to environmental threats.
This is just one of the many efforts we have made around ESG, which you can see in IBM impact our first integrated ESG report that we released last week.
I will wrap up I'd say that.
You're seeing this quarter.
Direct reflection of our ability to execute against our strategy.
Each quarter, we have continued to strengthen our portfolio expand our Puerto Rico system.
And drive productivity and simplification through the business.
IBM is now a very different company.
Have in effect changed our company's trajectory.
And while much remains to be done we are beginning to reap the rewards of our hard earned effort and we are confident in our trajectory for the year.
Now, let me hand, it over to Jim who will share the details of the quarter and our expectations with you.
Thanks, Arvind, let me start out with a few of the headline numbers, we delivered $14 $2 billion in revenue.
$1 $5 billion of operating pre tax income.
Operating earnings per share of $1 40.
And $1 $2 billion of free cash flow.
90 days ago, I talked about the first quarter and the full year in the context of our medium term model, which is to deliver mid single digit revenue growth.
And about $35 billion of free cash flow from 2022 through 2024.
These first quarter results are a solid step towards delivering on the year and that model.
Our revenue was up 11%.
This includes over five points of incremental revenue from the commercial relationship established with Kendall last November .
Our business entering 2022 reflects our higher growth higher value mix.
It is also a business with more recurring revenue dominated by software.
This quarter software revenue was up 15% and consulting was up 17%.
As we've discussed in the past these are our two growth factors and together represent over 70% of our annual revenue.
Infrastructure performance, which is influenced by product cycles was flat as compared to last year.
The software and infrastructure performance each include over eight points from the commercial kendrew relationship.
As a reminder, there is no incremental contribution to IBM consulting is growth.
Our strategy as Arvind said is based on a platform centric approach to hybrid cloud and AI.
Not only do we benefit from the platform itself, but IBM and our partners also generate a multiple of software and consulting revenue on that platform.
It's an attractive economic model.
You can see our success in capturing that value in our hybrid cloud revenue.
Which was up 17% in the first quarter and over the last 12 months.
Revenue from our full stack cloud capabilities from infrastructure up through consulting represents $28 billion of revenue over the last 12 months or 36% of our total.
Looking at our P&L metrics, we grew operating gross profit dollars so margin was down.
With improvement in software margin offset by consulting investments and infrastructure mix due to product cycles.
For operating pre tax income, we grew profit dollars and expanded margin by 280 basis points.
This profit performance reflects that we're capturing demand in high value areas like software.
And profit contribution from incremental sales for the new commercial relationship.
We have taken actions to streamline our operations and simplify our go to market model.
Consistent with our more focused platform centric business.
With a more streamlined business, we're getting operating leverage from strong revenue performance.
Our profit dynamics also reflect increasing investments in innovation, our ecosystem and talent.
We are increasing investments in R&D to deliver innovation and AI hybrid cloud and emerging areas like quantum.
We're investing in our ecosystem organically and Inorganically.
For example, one of the three acquisitions Arvind mentioned was new testing, which adds key hyperscale capabilities to address hybrid multi cloud demand.
And as we've discussed over the last several quarters, we have been aggressively hiring.
We're adding capabilities and skills to support our garages and client engineering centers client success managers to help clients get the most of their ibm's solutions and technical talent across our business.
Now we are operating in an inflationary environment and cost, especially the cost to attract and retain talent are escalating.
We're addressing this through pricing, which will help over time.
The other item I'll mention is the impact of a strengthening dollar.
We execute hedging programs.
With the majority of our hedging gains reported in other income and expense.
These gains mitigate the currency impact in revenue and gross profit.
And then looking at net income we expanded operating net income margin by 130 basis points.
This reflects an operating tax rate of 16%, which was up significantly from last year.
Turning to free cash flow, we generated $1 $2 billion in the quarter.
I'll remind you we've gone back to our traditional all in free cash flow definition.
Which includes payments for the structural actions initiated at the end of 2020.
The $1 $2 billion is about 12% of our full year expected range.
Consistent with history.
The anomaly from that historic attainment was last year with.
With 23% of our full year free cash flow realized in the first quarter due to the unique dynamics of the kindred separation.
In terms of uses of cash for the quarter.
We invested about $700 million in acquisitions, and we returned $1 $5 billion to shareholders in the form of dividends.
We also issued $4 billion of debt in early February which supports maturities later in the year.
This results in a march cash position of $10 8 billion and debt of over $54 billion.
Turning to the segments software delivered strong revenue growth up 15%. This includes over eight points from the recurring kindred software revenue in line with our expectations.
Software performance was driven by good growth in both hybrid platform it solutions and transaction processing.
The latter benefiting significantly from the Kindle content.
Our software is central to our hybrid cloud value proposition.
Within this segment hybrid cloud revenue was up 25%.
Now representing $8 $8 billion over the last year.
And subscription and support renewal rates grew again this quarter contributing to a software deferred income balance of over $11 billion.
Hybrid platform and solutions revenue grew 10% this quarter include.
Inclusive of about a point and a half contribution from the kindred commercial relationship.
We've driven focus within this portfolio around the most strategic hybrid cloud and AI needs of our clients.
Red hat data and AI automation and security.
Growth was pervasive across all business areas this quarter.
Red hat revenue all in was up 21%.
Revenue growth continues to be fueled by good performance across the Red hat portfolio.
And we again gained share across both ROE and open ships are foundational hybrid cloud offerings.
Red Hat's hybrid cloud offerings continue to transform enterprise.
And deliver new innovations.
For example, this quarter, we announced a new partnership with Nvidia to accelerate AI applications.
Automation delivered 5% revenue growth this quarter.
Growth was led by AI ops and management.
And the integration.
We've invested in AI powered approach to automation.
And our solutions are resonating with clients as they address growing complexity digital shifts and skill shortages across their businesses.
We extended this AI powered automation strategy this quarter with the joined Flex Cirrus solution Arvind mentioned earlier.
Data and AI revenue grew 4%.
These offerings help our clients accelerate data driven agenda is by connecting and governing all of their data and infusing AI to enhance decision making.
Performance this quarter reflects client demand across the portfolio.
Including continued adoption of data fabric.
<unk> of our data management footprint.
A focus on sustainable operations with asset and supply chain management and.
And needs for reliable data sharing with information exchange.
We had growth in solutions like cloud Pak for data <unk> and Maximo application suite just to name a few.
Security revenue grew 8% building on strong performance in the first quarter of last year, when we were up 14%.
With the evolving cyber security environment, we delivered growth this quarter in threat management and data security.
We continue to see good client demand for cloud Pak for security and.
An integrated and open security platform that advances clients Zero Trust strategy, while leaving data where it is.
And we've been investing in security innovation, including a new <unk> endpoint solution following the reactor acquisition.
Looking across the performance of our hybrid platform and solutions, our annual recurring revenue or <unk> is up 9% year to year.
Transaction processing deliberate 31% revenue growth this quarter, including 28 points from the kindred content.
The overall dynamics are much like last quarter.
We wrapped on weak performance in the first quarter of last year, which was down 15%.
And we continue to see strong renewals of these critical software offerings.
Building on the expanded Z systems capacity and traction we have gotten through the strong Z 15 program.
Looking at software profit, we delivered operating leverage given the strong and broad based revenue performance this quarter.
Our pre tax margin was up seven points and puts us on track for our full year software margin in the mid twenties.
Just as in software consulting is capitalizing on strong demand profile.
Both revenue and signings at double digit rates across all business lines and geographies.
Revenue growth accelerated to 17%, while bookings were up over 40%.
Our book to Bill remains solid at $1, one for the quarter and over the last year.
Clients Trust IBM to execute their complex business transformation.
Leveraging our deep industry expertise and the investments, we've been making and skills capabilities, our ecosystem and in scaling our acquisitions.
We are positioned to capture demand and drive adoption of our hybrid cloud platform.
Consulting is hybrid cloud revenue grew 32% on trailing 12 month basis to $8 $3 billion, which makes up 45% of the consulting business.
We continue to see strong demand and momentum in our red hat related engagements this quarter.
Nearly doubling red hat related signings year to year.
Our strategic partnerships also contributed to our performance in the quarter.
Revenue from these partnerships grew solid double digits led by Salesforce AWS.
AWS and Azure.
And now turning to our lines of business.
Business transformation revenue grew 19%, bringing together technology and strategic consulting to transform critical workflows at scale.
The growth was broad based.
With particularly strong growth in our practices centered around customer experience.
<unk> and data transformations, as well as supply chain and finance applications.
And technology consulting.
Where we architect and implement clients cloud platform and strategies revenue was up 19%.
Growth was pervasive led by our engagements around developing and modernizing applications for cloud deployments.
Finally application operations revenue grew 14%.
This business slide focuses on the management of applications and cloud platform services required to run a hybrid cloud environments.
Growth was broad based in this space as well led by cloud application management.
Moving to consulting profit our pre tax margin expanded about one point <unk>.
Delivering operating leverage and benefiting from Ibm's more streamlined G&A and go to market structure.
Our consulting gross margin reflects the significant investments we have made over the last year.
Fueling our revenue growth.
We are investing in our partner ecosystem expanding our reach.
We continue to scale. The 12 acquisitions, we made in the last 18 months, including two which closed in the first quarter.
And we're investing in talent across our workforce upskilling existing resources, adding certifications and bringing in technical skills in areas of hybrid cloud and AI.
Consulting is where we are most impacted by the competitive and inflationary labor market, which puts pressure on profitability.
We expect to capture value through price and our engagements and recognize it will take a few quarters to appear and our margin profile.
Turning to infrastructure segment revenue performance was flat versus last year.
Hybrid infrastructure revenue declined 2% <unk>.
<unk> offset by growth of 4% and infrastructure support.
The Kindle content contributed over eight points to infrastructure.
With consistent benefit across the two business areas.
Within hybrid infrastructure Z systems revenue was down 18%.
We're now in the 11th quarter of Z <unk> availability.
<unk> has been a very strong program.
Both in revenue performance and capacity in.
In fact, we shipped more <unk> mips than in any other program.
Building on that momentum, we just announced our newest solution IBM Z 16.
<unk> commented on the three differentiated capabilities of <unk> 16.
Embedded AI at scale.
Cyber resilience security and cloud native development for hybrid cloud.
Distributed infrastructure delivered 8% revenue growth this quarter.
Client demand for S for Hana data intensive workloads on our newest power 10 high end systems fueled this performance.
Looking at infrastructure profit pre tax margin was down three points, reflecting where we are in our IBM Z product cycle.
Now, let me take it back up to the IBM level.
We focused our business on our platform centric hybrid cloud and AI strategy.
Over the last couple of years, we've been taking steps to optimize our portfolio.
Streamlining our operations and allocate capital.
To execute that strategy and improve our financial profile.
Our first quarter results reflect these very significant changes and put us on track to our full year expectations for our two key measures of revenue growth and free cash flow.
90 days ago, we expect it to grow revenue at mid single digit rate at constant currency.
Before the incremental <unk> sales.
With the strong start to the year, we now see revenue growth at the high end of that mid single digit range.
On top of that we expect about three five points of growth for the year from the commercial relationship with Kendall.
Fred over the first three quarters.
And then looking at currency with the strengthening U S. Dollar at mid April spot rates currency will now be a three to four point headwind to revenue growth for the year.
For free cash flow, we continue to expect 10 to $10 $5 billion in 2022.
As I said earlier this is an all in free cash flow definition and includes the cash impact associated with our 2020 structural actions.
Before getting into the segments and color on the second quarter.
I'll comment on the business impact of our Russian operations.
Our business in Russia is not large.
But its concentrated in high end infrastructure and software.
Last year business in the country contributed about $300 million of revenue.
And about $200 million of profit and cash.
For this year, we expect no contribution from Russia.
Which puts us closer to the low end of our free cash flow range.
Now let me provide some color on our expectations for segment performance for the year.
In software, we got off to a good start and we haven't changed our view of constant currency revenue growth or the contribution from the external sales to Kendra.
We also remain on track to our software our pre tax margin in the mid twenties range for the year.
And IBM consulting with our first quarter revenue and signings performance, we're taking up our view of consulting revenue to a low double digit growth rate for the year.
With continued investment in talent and a competitive labor environment, we now expect a pre tax margin approaching 10%.
Which is up a couple of points year to year.
This reflects improving performance in the second half as we realized price increases in our contracts.
Our infrastructure revenue performance as always reflects product cycle dynamics.
This year, we would expect performance above the model given the launch of our <unk> late in the second quarter.
This will contribute to second quarter performance and ramp further in the second half.
On top of that we're planning for about four to five points from the external sales to kindred <unk> in 2022.
We see a mid to high teens pre tax margin for the full year.
These segment revenue and margin dynamics would yield about a four point year to year improvement and Ibm's pretax margin for the full year.
In terms of tax we continue to expect a mid to high teens operating tax rate.
Which is a headwind to our profit growth.
Let me comment on a couple of items specific to the second quarter.
At current spot rates currency would be a five point headwind to revenue growth.
We expect to close the sale of the healthcare software assets.
With a gain utilized to address stranded costs.
And we expect a four to five point year to year improvement in operating pre tax margin and a tax rate in the high teens.
Based on our solid first quarter performance and view of the year. We are on track to our mid term model.
And now 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 and then second as always I'd ask you to refrain from multi part questions.
Operator, 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 two.
Again to ask a question please press star one.
Our first question comes from <unk> Mohan with Bank of America. Your line is open.
Yes. Thank you great to see the solid revenue performance and the organic growth guide uptick here.
Arvind.
And a lot of investor conversations now are focused around concerns.
The economy steering itself into a recession, given the tightening that we're seeing from the fed can.
Can you maybe characterize how IBM, which is a pretty defensive portfolio could fare in a recessionary environment given that there have been structural portfolio changes and a quick one for Jim Youre, maintaining your free cash flow guide despite the incremental headwinds from FX and some of the other macro elements you pointed to the including Russia and Ukraine.
Can you maybe just help us think through how you are offsetting free cash flow impact from FX. Thank you.
Always good to hear from you, but just a comment on <unk>.
To me in I'll call it demand.
We are seeing very strong demand as I said in my prepared remarks, I think technology has shifted from being just one aspect of our business to being the source of competitive advantage.
When that happens, we think and we believe in the past couple of quarters of bond. This out that demand for technology is going to say that 4% to five points above GDP.
Even though GDP falls to flat part of there is a quick recession or if it's a very slight recession, we see demand staying strong.
And continuing now I'll acknowledge if you have something much more catastrophic that's different but for all of the scenarios that we do outline and we do look at we see that demand is going to continue growth.
Both phase.
For the foreseeable future.
Jim Yes.
Well thanks for the question just at this.
The point here.
The composition of our portfolio.
Today's new idea.
Opposition being much more skewed towards growth vectors software consulting.
And our solid recurring revenue base.
<unk> offers us any economic shock.
I think that's what you were referencing.
<unk>.
If you look at past.
Economic shocks overall, but to your question about free cash flow, let me spend a minute on free cash flow and just give you a perspective and unpack it a little.
We are maintaining our guidance at $10 $10 5 billion for 2022 again I'll remind everyone. That's an all in free cash flow consistent with Ibm's post separation baseline and consistent with our mid term model of accumulative about 35 billion.
Over the next three years.
That basically is growing north of $2 billion of free cash flow in 2022, we started out the first quarter, we delivered $1. Two 4 billion in free cash flow, that's about 12% obtained and by the way that's pretty consistent with where we've been arguably prior to <unk>.
Last three or four years, we were in the high single digits. So we're off to a pretty good start now I spent time last quarter talking about headwinds in tailwind.
On the tailwind side, we talked about.
Hey, John we're doing some technical difficulties here. Thank you very much hopefully that that is better and you can hear me I've gone through the headwinds and tailwind on free cash flow overall, when you look at free cash flow, we talked 90 days ago, We've got tailwind on.
Remaining about a half a billion dollars of structural actions in 2022, we've got about a half a billion dollars of working capital efficiency, given our mainframe cycle and volume dynamics and we've got a couple hundred million with regards to modest cash tax.
<unk> <unk> overall, the rest of that two plus billion dollars.
Free cash flow generation has to come from operating profit now when you look at the first quarter. Many of those <unk> are all in front of US our operating profit that's the acceleration in revenue and operating margin by segments that will continue as we move forward and as part of our guidance.
Our working capital actually was a use of cash in the first quarter as we prudently.
<unk> built up our inventory position just given the supply chain disruption going on in the marketplace. We secured our supply for the anticipated <unk> 16, and we also got most of our structural actions behind us. So we've got a lot of tailwind going forward that gives us confidence in that 10 to $10.
At $1 billion, and the only headwind, which we called out in the prepared remarks is the unfortunate situation with regards to the war in Ukraine, and we quite overall.
Okay. Thank you want to see can we please go to the next question.
Our next question comes from Amit.
Hey, Mark.
Okay.
Okay.
Thanks, a lot for taking my question congrats on the strong top line.
I guess my question is really around.
Topline guidance from mid single.
And in the mid single digit range.
Could you just talk about what is driving mostly organic or is it really the deals that you've done that give you better conviction in the growth trajectory.
The uplift in guide organic versus inorganic.
I understand that.
Maybe related to that there's a lot of product going around what's happening in Europe , very specifically and.
Any spillover potentially from Russia.
What you're seeing in Europe into city spinoff progression. Thank you.
Hi, Amit let me begin by answering the question on both pieces. So if you look at it we have always said our model for.
Acquisition contribution is typically between a point to point and a half for the year.
And so that remains.
Steady in that in that range, we don't really look at that as a coming up yet.
Certainly if it gets above that but but that is not the case.
We are seeing right now is strong demand for what you would call the organic part of the portfolio.
Can see that in the software portfolio, we can see that the strong <unk> growth.
Consulting is largely by the way organic growth that is driving it because we've been to 13% at actual 17 at constant currency and only a few points of that was.
<unk> was acquired growth so I would say much more organic than acquired acquired is in the range that we have.
Called out before.
So when you talk about Europe , Jim quantified certainly Russia is direct.
Intifada its impact indirect.
That $300 million, we don't really expect to see this year at all.
Now when we look at.
Overall growth in Europe , we still see and it is likely because we are a much more I'll call. It mission critical applications. We are much more in fundamental transformations at our clients.
And with the focus on file.
Financial volumes on critical systems on Telecom utilities healthcare government, we tend to see that right now the demand profile in Europe is staying strong.
And so we are not seeing at least at this point that demand profile coming down.
As things go on that could evolve as I've said before.
Our jobs to be concerned about all of these things that we've been watching them very carefully but with our book to bill ratios and consulting which is kind of a leading edge. We see right now the demand profile is continuing and it is not.
<unk> slowed down at this point.
Okay, Amit Thanks for the question, let's go to the next one please.
Our next question comes from Toni <unk> with Bernstein. Your line is open.
Yes. Thank you.
I wanted to just discuss a little bit the <unk>.
<unk> side of the equation.
So you.
Relative to expectations on revenue.
But not on EPS.
This year, our full year guidance for revenue, but not on free cash flow.
So.
Just wanted to explore the dynamics there are you seeing incremental pressure testing consulting.
And are there other areas and then I was hoping you could answer two very specific clarifications one is your.
Your operating margin expansion was 280 basis points year over year, but obviously you had very high margin Kendra contributions. So we X out the <unk> contribution what was the change in operating profit Pgi percentage year over year, and then secondly, how much is the healthcare asset sale.
Gain.
And it sounds like that will be included in free cash flow could.
Could you confirm that as well thank you.
Okay, Tony I'll turn it I'll handle each one of those maybe I'll start with that.
The last one first and then go backwards if it's okay with you.
Thanks for the question so healthcare yes.
As we talked about 90 days ago, we still expect to close on the Watson health.
Divestiture late in the second quarter.
It is embedded in our forward looking guidance as you know it is now consistent with what we've been doing with all divestitures. It does now in our other segment by the way history has been restated so our software segment and our other segment of our apples to apples year to year with.
<unk> to this we do expect.
The loss profit in the second half.
And the lost revenue, but we do expect a modest gain in the second quarter and we will utilize that gain to address stranded costs. So it's embedded in our guidance.
No impact to the second quarter, but obviously, we are dealing with the loss revenue topline in the second half and in light of that we still took up our guidance to the <unk>.
High mid single digit overall.
It is.
And our free cash flow, there's no impact to that overall either so.
On operating margins you asked about 280 basis points, Yes, we are very pleased with our performance.
I would start to the year.
Progress more to do as Arvind and I have always said this is a journey we've given our mid term model you all understand our midterm model, but let me put the profit margin contribution in perspective, because yes, as we've been transparent both in revenue.
And by the way and free cash flow because our free cash flow as a post IBM separation baseline we've got to grow two plus billion dollars of free cash flow both of those normalize out Kindle.
But let's talk about the <unk> contribution because youre right to pre tax income and pre tax margin Theres a benefit from the kimco sales.
And.
There is also.
Yes.
Hopefully, we can take care of the technical difficulties Echo sounds like it went away.
Yes.
But when you take a look at the topline revenue growth we grow IBM overall.
11% at constant currency.
All in we said within that constant currency about a little over five points is due to the Kindle external sales so call that about 50% of our contribution of growth came from Kendall and about 50% of our contribution came from our broader client set.
<unk> overall IBM grew revenue in the first quarter.
$1 billion externally from last year, so about $500 million of Kindjal contribution give or take round numbers and about 500 from our broader set of clients you apply standard margins because.
As you can all appreciate for competitive commercial reasons, we're not going to give exact profitability of any client overall, but if you apply standard margins against that Youll get against our $500 million of profit contribution you get about two thirds of it coming from kindred sales and about one third.
Vic coming from IBM and I'll remind you we're on the back end of a very successful mainframe cycle and that back and we went down a couple of hundred million dollars in infrastructure profit so growing IBM, both with incremental sales of Kendra.
And with our broader client base on the backend of a mainframe product cycle, we're pretty pleased with the operating leverage we see in our business and that gives us the confidence in that free cash flow guidance and 10 to $10 5 billion.
Okay. Thanks, Tony Let's go to the next question.
Our next question comes from Erik Woodring with Morgan Stanley . Your line is open.
Great. Thank you very much for taking the call.
Really nice performance on Red hat and security with growth in both either holding up relative to <unk> or accelerating.
Partially offset by a slowdown in automation of it but maybe if you could just take us a level deeper and help us understand really the puts and takes for each of the software businesses. What surprised you in the quarter what was more challenge.
Then lastly, just what was the growth contribution from acquisitions and software in the quarter.
So Eric this is Robin let me start with addressing some of these.
And gimbal help with some of the precise quantification. So if you look at this overall contribution that you are going through all of these let me first address the kindred base because that maybe in some of your.
Behind some of your questions. The kindred contribution was largely in our mainframe software segment and the TPP segment. So I'll put it there and there were you pointed it out I think 28 of the 31% comes from.
From kindred following as an absolute amount, we expect that to stay going into next year, but obviously it won't contribute to growth.
Going forward after after this October .
Now as we look at some of the others a lot of it comes down to the focus of nimbleness in which we are now operating the company, where we have a technology segment and the consulting segment I.
I believe that that is what contributed suddenly there was demand in the market for security because you asked that question, but the nimbleness and the focus of our teams now allows us to go fulfill that demand and that is why you saw that growth rate come up by 7% to 8% between the fourth quarter, just looking at quarter to quarter dynamics.
Then when you look at Red hat I think execution was very good but right now it has been in the upper teens and that is where we expect it to keep performing for the rest of this year and that speaks to both the quality of the portfolio and the demand. That's in the market of course, we always have to keep executing against that demand. So I think no real puts and takes in.
They're in these three now when we come to the data and AI and automation I do believe that with some of the acquisitions, we did last year and being able to fulfill the demand against those that led to the second half of last year, having a accelerated growth.
Right and automation and we do expect it to remain.
Within our model our model calls for mid single digit growth in both automation and data and AI.
That said, let me just tell you that.
My instinct from listening to our clients from seeing what they want to do and from looking at all the shifts happening in demographics, meaning tech skills are very hard to get I anticipate that for the market at large there will be more and more demand and both in automation and in AI now the execution is on us to go.
Fulfill against that demand.
I would just add urban.
Eric Thank you very much for the question software is obviously, an integral part to our hybrid cloud platform centric thesis overall arvin went through the portfolio and the dynamics, but let me add some of the kpis to that so it gives you some of the fundamentals underneath the pervasive growth across red hat at 21% auto.
<unk> had five data and AI growing four in security with a nice rebound delivering return on the new innovation, we brought to market, but when you look underneath that are hybrid platform and solution our growth factor, which is about 75% of our software segment nice growth double digits overall underneath them.
We've got an IRR now is subscription book of business about $13 billion. That's now accelerating growing 9% overall from an IRR perspective, we see nice acceleration and cloud Pak portfolio underneath that with a flywheel effect, we're getting <unk> that are new.
North of a 100% I think this quarter is about 105%. So we've had now three or four consecutive quarters of that flywheel effect.
And we're seeing strong renewals across the early parts of our Elas cycle, which is just beginning and that strong renewal renewal is leading to a record deferred income balance north of $11 billion right now and growing nicely. So we feel pretty good about it.
Software portfolio, a lot of execution in front of us.
Eric Sheila let's go to the next question. Please.
Our next question will come from Kyle Mcnealy with Jefferies. Your line is open.
Hi, Thanks, so much for the question I would like to see if we could put a bit of a finer point on the timing when do you think the benefit from new pricing and the changes youre, making and consulting will offset some of the cost inflation, you're seeing I believe earlier in the call you said that it would take a few quarters to get the benefit. But then you mentioned that second half 'twenty two consulting margins will improve.
Based on the pricing coming in so should we expect better pricing helps Q3 and is there any way you can quantify how many points of margin you might get back by the end of the year.
Thanks, Scott and I'll take this one overall.
Great question I mean, we're obviously operating in an environment of accelerated demand in the consulting space and I think you see we are capitalizing on that and we've been talking about this since the second half when we were looking at all of our indicators across the portfolio and our enterprise clients.
We saw a pretty robust demand environment, and we made a conscious strategy to invest in building out skills capabilities ecosystem partnerships and we started if you remember beginning of 2021 investing significantly in acquisitions to build out scale.
<unk> for our hybrid cloud adoption overall now you couple that with the highly inflationary environment right now that we started to see them play out in the latter half of 2021, and we said at that point in time that when you couple the investments we've been making which is conscious to build.
That capability because consulting as I've always said is the tip of the spear that provides tremendous value and polling IBM technology and driving scale and adoption of our hybrid cloud platform that you couple that with the inflationary environment, you're seeing the pressure on our gross margins.
Now I will tell you, let me try to quantify a little bit of this when you look at our gross margins, we were down about 350 basis points and consulting arguably after toughest compare that we'll face in 2022. The compares get easier so well acknowledged that right off the bat number two when you look at the.
Nationair environment, we've been seeing within that 350 basis points about 150 basis points is due to the accelerating cost of talent acquisition.
The remaining two points or so is about a point of acquisition.
Which as you know as you get ramp and scale those become very quick accretive we expect that to be accretive as we get into latter half of second quarter and into third quarter and then we've been investing when we saw that robust demand environment, we invested a significant amount of capable.
Building capacity in the early innings of that you have underutilization.
We knew that that's why we had to get after our G&A structure to optimize and streamline by the way reinventing IBM through automation Digitization everything our clients are doing we have been doing inside IBM. That's been mitigating the profit impact overall, so I think you'll start to see.
Seeing improvement.
As we get into third quarter, but will make sequential improvement here in the second quarter overall, but I will tell you again gross margin improvement will turn accretive in third quarter in the second half.
And our pretax operating margin, we've guided to approaching 10% that's up a couple of points, we will see that improvement throughout the year.
Thanks, Kyle let's go to the next question. Please.
Our next question comes from Brian Essex with Goldman Sachs. Your line is open.
Great. Thank you good afternoon, and thank you for taking the question great to see the stability on the software side, particularly red hat growth, but I guess on the consulting side are then.
Maybe I'd love your perspective, or perhaps you can share some of what you've heard from conversations regarding the sustainability of durability of the digital transformation consulting spend and maybe you don't need a pivot on <unk> question earlier.
We all know consulting tends to be discretionary in nature, but with.
Would love your view on your portfolio of consulting business and how that might fare in a more difficult.
The difficult macro environment, where.
Customers may kind of sharpen the pencils on their budget is it different than say system integration and application engineering.
Consulting spend.
Yes, so Bryan and thank you for the question and it is one that we think a lot about and we talk a lot to our clients about to understand where they are so if you look at the makeup of our consulting portfolio.
And that is.
We have very little of what I would call the.
The infrastructure services. So those all went with kindred.
So what we have left is helping clients and Jim talked about a very high growth rates with some of our ecosystem partner that is consulting around topics like salesforce and Adobe and public clouds.
Even in difficult environments, we believe that the adoption of those platforms is going to continue with all of our clients.
Second as we look at Digitization. So digitization is not just taking something I'll call them coloring, it and making it digital but if we look at it as being one of the primary ways to address the labor demographics issue, meaning the shortage of high skilled labor that is there pretty.
Pretty much globally.
We believe that that actually continues even in a difficult environment because it gives our clients a way to go address that I mean, if I take for example airline scheduling.
You take rebooking.
Uh huh passengers, if I take quote to cash where you cut across all of the silos, if I take much more real time.
Impact of revenue and Omnichannel. These are all examples of Arkansas.
All consulting projects, which we see carrying on even through a difficult environment.
When I look at that that tells me, there's a sustainability and durability.
I don't see the number of trained people and experts coming up suddenly and so consequently, I think that because of that because there is a shortage of technical talent in the world. It will continue to go well even in a constrained economic but Brian that we acknowledged when I say constrained I mean if.
If we enter a what I'll call a mild recession or a quick recession, if you get something deep and sustained.
My comment a little bit to the side.
And we'll have to then go look at that again.
But I think that because.
Because of the makeup of our portfolio I think it actually fared quite well.
Thanks, Brian Sheila let's go to the next question.
Our next question comes from David Grossman with Stifel. Your line is open.
Hi, Thank you I wanted to just follow up on earlier question on the consulting gross margins.
Historically GBS says.
Operator has a lower gross margin than its peers with a difference somewhere around about four to 500 basis point range and I. Appreciate all the commentary about GBS margins, including the cyclical items and the investments that are impacting margins. Currently however, looking beyond that are there structural differences that explain.
That dynamic.
With many of the strategic changes and investments in the business that are underway.
Peer group margin achievable and if you think it is what timeframe do you think you can achieve that.
Yeah, why don't I address it. Thank you David for the question overall.
When you take a look at the consulting margin, let's just.
Take a step back in market into your point.
Competitive benchmark right now I would say, it's probably low to mid teens.
We're not going to be a pure play industry consult excuse me, India consulting based company that has a very different value proposition, but if you look at some of the peers that we benchmark you are in the low to mid teens.
We've talked about our mid term model.
Now that mid term model as we put out.
Aligned to an integrated ibm's thesis of hybrid cloud.
Hey platform centric business built on a foundation of Red hat GBS or excuse me consulting has an integral role of not only being a pure play competitor, but they play a very essential role in driving this scale and adoption of our software portfolio and also.
So pulling through our technology and by the way we've talked many times about how well they are doing and building up a red hat practice I think inception to date about a $4 $5 billion book of business on top of our hybrid cloud platform centric thesis and they drive about depending on any quarter.
20 to 30% to 40% of our cloud packs, but we talked about our mid term model that we would get in the low double digit margin range that has a three year picture. So I think we've already given that at high single digit.
Revenue growth the investments, we're going to make the integrated value. It delivers to IBM, we take that high single digit revenue growth you take low double digit approach into the low teens, where in a competitive playing people playing field and it's an integral part of IBM that dredge that software portfolio and net profit so.
We feel pretty comfortable that that mid term model answers your question.
Thanks, David Sheila, let's take one last question.
Thank you our last question will come from Jim Suva with Citigroup. Your line is open.
Thank you.
Saving the best.
First question for the last I guess.
A long time it has already been spent talking about the various segments, except really not your mainframe segment. So maybe I'll take a shot.
A question on that is you laid out three really nice enhancement. The mainframe is that enough do you think to make mainframe be growing over past cycles or competitive with past cycles, because people have been calling for the death of the mainframe for a decade and that deck has been greatly exact.
I'm just kind of thinking about these enhancements can it actually be more and then on the profit side a mainframe.
Companies like Citigroup, why work reorder mainframes well in advance with the components.
Change with pricing is there anything we should be conscious effort for the <unk>.
Profitability is the new Z mainframe.
Thank you.
So Jim let me start with answering your question on the capabilities of mainframe driving growth in mainframe and then ask him to address the profitability side.
If I look at the demand side on mainframe.
A lot of our clients are seeing additional volumes because of the mainframe.
Really well as a system of record is that transactional engine that helps drive our clients business.
If there is volatility in the markets. If there is 10 20, 30%.
<unk> increases.
Which we are sensing many of our clients see that is the.
Primary driver of growth in.
And the second driver of growth, where we talked about resiliency is everybody is not wanting to be 24 by seven and because of all of the issues around not just the resiliency due to physical issues or software errors, but also because of cyber people are much more concerned that that drives additional capacity.
But people want to make sure that there is a.
Working copy of that application and data set available at some other place and that is why you heard us talk about that.
Then as the volumes go up we know that there is always an indication of fraud that can go up and because of the fraud, we embedded AI into the processor. So you can now make your fraud decision in line with the transaction decision and you can imagine whether it's processing credit cards, whether it's moving money.
All of those capabilities are going to drive that so if I back all of that and then unpack it Jim I would tell you that we saw over the last three years more growth and better adoption of mainframe and we have seen in prior cycles.
We expect from early signals have you're going to see that continue over the next couple of years, but that said, we got to go out and execute we got to make sure that our clients actually are able to quickly deploy these obligations of the us.
That will allow us to grow the mainframe or this coming cycle as well.
Yeah, and I'll just wrap it up Jim. Thank you very much for the question mainframe, obviously in a central element.
Of our innovation and.
<unk> value strategy overall, we operate the mainframe as a platform centric model. So on top of that mainframe. We are mission critical software as you know quite well, we have storage high and attach we had maintenance that goes to it when you look at the Z 15 cycle.
We actually it's the first time in a few cycles our profitability of that staff is actually increase really due to where arvin ended which is the most successful shipped mips cycle that we've ever had from a program.
Our installed Mips capacity now is up over 45% from the prior programs. We got roughly about 80 million Mips that are out there today, that's our opportunity set to deliver tremendous value to our clients, but also monetize that value in many different ways.
But you touched on some and I just want to wrap up because I wanted to talk a little bit about how mainframe plays into second quarter and then the summary in the prepared remarks, you talked about the high level of second quarter, but when you look at second quarter from a top line revenue perspective mainframe is going to have a major.
Contribution in the historical quarter to quarter, if I look at it from a history of the last three years, we typically do about $900 million of revenue quarter to quarter one <unk>.
All in and by the way.
That excludes the Kindle component of this but when you take a look at this year, we expect <unk> to be a couple of hundred million dollars above that historical.
Quarter to quarter of 900 million so call. It about 1 billion won a little bit more underneath that mainframe is going to be a substantial contributor to that albeit ship late in second quarter.
And also that underlying fundamental business performance is offsetting as I said in prepared remarks. The continued dollar strengthening so currency versus history will be heard against that so it will more than offset that currency and the dollar strengthening with with a better than <unk>.
Oracle <unk> revenue compare in mainframe is going to be a very big piece of it. So Arvind let me turn it back over to you then alright. Thanks, Jim Let me just make a couple of comments to wrap up the call.
Our performance this quarter reflects the actions we have been taking.
We have strengthened our portfolio.
Leveraging our ecosystem.
<unk> our business.
While I acknowledge there is always more to do we are pleased with the start to the year and I look forward to speaking with all of you again soon.
Thanks, Sheila let me turn it back to you to wrap up the call.
Thank you for participating on today's call. The conference has now ended you may disconnect at this time.
[music].
[music].
[music].