Q2 2022 International Business Machines Corp Earnings Call
Okay.
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.
Thank you this is Patricia Murphy and I'd like to welcome you to I B M second quarter 2022 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.
Proposed today's prepared remarks on the IBM investor website within a couple of hours.
A replay will be available by this time tomorrow.
To provide additional information to our investors our presentation includes non-GAAP measures for.
For example, all of our references to revenue and signings growth are at constant currency we.
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 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'll turn the call over to Arvind.
Thank you for joining us today in.
In the second quarter, we drove solid results, reflecting the investments and changes we have been making to execute our strategy.
With this performance we continue to deliver on our model of mid single digit revenue growth.
Technology plays an important role in today's business environment.
In fact, nearly every climbed or speak to believes that technology. So is a fundamental source of competitive advantage.
Serves as both a deflationary foods and a force multiplier.
And it's especially critical plants face challenges the multiple fronts from supply chain bottlenecks the demographic shifts.
Given its ability to boost innovation productivity resilience and help organizations scale.
It has become a high priority and our company's budget.
As such there is every reason to believe technology spending in the <unk> space will continue to surpass GDP growth.
This demand backdrop, we are executing our hybrid cloud and AI strategy.
We have made changes to our portfolio and focused investments in our offerings technical talent, our ecosystem and go to market model.
Demand for our solutions remained strong.
We've continued to have double digit performance in IBM consulting.
Broad based strength in software.
And with the <unk> platform launch our infrastructure business had a good quarter.
By integrating technology and expertise from IBM and our partners.
Our clients will continue to see our hybrid cloud and AI solutions as a crucial source of business opportunity and growth.
Let me now delve a little bit deeper into the progress and the execution of our hybrid cloud and AI strategy.
Hybrid cloud is about offering clients a platform that can straddle multiple public cloud private cloud and on premise properties all the way to the edge.
Our platform based on Red hat.
Allows our clients to consume powerful software capabilities driven by open source innovation.
All of the software has been optimized to run on that platform.
And includes advanced data and AI automation and the security capabilities our clients need.
Our global team of consultants offers deep business expertise and co create with clients to accelerate their digital transformation journeys.
Our infrastructure allows clients to take full advantage of an extended hybrid cloud environment.
As a testament to the success of our strategy, we continue to increase adoption of our platform with over 4000 hybrid cloud platform clients.
Including more than 250 added in this past quarter alone.
Apart from working with a greater number of clients those who adopt our platform tend to consume more of our solutions across software consulting and infrastructure.
Spending a footprint within those clients.
Recently clients, such as PNC Barclays and Citi have chosen a hybrid cloud capabilities to unlock more business value and meet rapidly changing client demands.
Organizations everywhere are also under intense pressure to fast track that digital transformation and harness the power of the data.
With the World now, creating two and a half quintillion bytes of data each day artificial intelligence or AI is the only way to process. This enormous amount of data.
From hybrid cloud environments, all the way to the edge.
That is why AI adoption is steadily on the rise.
According to a new study released by IBM last quarter.
35% of companies on all using some form of AI in their business.
Many of those companies are using AI and automation to address demographic shifts and move their employees to higher value work.
This is one of the many reasons, we're investing heavily in both AI and automation.
These investments are paying off.
In addition to the strong revenue performance in automation and data and AI software.
Recently received two important recognitions.
He was named as a leader in the latest Gartner magic quadrant for APM and absorb ability.
And in the Forrester data fabric wave for a cloud Pak for data.
Over the last several quarters I have highlighted the importance of the growing ecosystem of partners to our platform centric strategy with leading firms like S&P Salesforce, Adobe Oracle, Microsoft and AWS.
This quarter, we continued to expand and extend our partnerships all expanded just to.
We announced a strategic collaboration agreement with AWS to offer a broad array of our software catalog on AWS. This.
This includes capabilities that span automation data and AI security and sustainability second with Tech Mahindra, we launched synergy lounges to empower businesses that the innovation technologies and services for key industries, such as telecommunications manufacturing.
During banking health care energy and utilities.
The first synergy lounge was established in Bangalore roof, with a focus on edge <unk> and software defined networking solutions with hybrid cloud.
This will be followed by the opening of travel centers in London, Seattle and Melbourne.
Clients on just simply buying software or hardware that entering a relationship with a company that's going to help them navigate the future of technology.
This is why innovation and.
Our ability to invent what's next remains so important.
One of them is a great example of our commitment to advance the future of technology building on our progress of 127 qubit quantum computer currently in our cloud we have committed to demonstrate the first 400 plus cubic system before year end.
This will help us move forward towards a roadmap to deliver a thousand plus qubit system next year, and a 4000 plus qubit system in 2025.
What are the implications of quantum computing will be the need to change how information is encrypted.
We are proud of the technology developed by IBM and our collaborators has been selected by NIST as the basis of the next generation of want them safe encryption protocols.
And another example of innovation, our new <unk> system became generally available in the second quarter.
The <unk> is designed for cloud native development security resilience want them save encryption and includes an on chip accelerator, which allows clients to reduce fraud within real time transactions.
Given the importance of cyber security.
In this past quarter. We also acquired Red Dori are leading attack surface management and offensive cyber security provider.
This builds on the recent acquisition of reactor and the launch of new radar Xdr.
It's one of two acquisitions in the second quarter and over 25 in the last two years.
Another major focus area across all stakeholders is ESG.
Which isn't just a regulatory requirement or about being a good corporate citizen is also a business opportunity.
A poll conducted by the IBM Institute for business value shows that 50% of Ceos.
Sustainability is one of the highest priorities.
And over 80% of Ceos believe their company's sustainability investments will improve business results and accelerate growth.
To accomplish this company's need to leverage AI to turn the mountains of data they collect into sustainable action.
SL Green Realty Corp, Manhattan's largest office landlord is a recent example, they are using and busy and IBM solution to manage their easy indicators across their extensive real estate operations.
Including energy use carbon emissions and environmental and social responsibility metrics.
Let me wrap up by saying that given the strength of our portfolio the need for our technology and expertise.
With the benefits of a yielding from any actions we remain confident in our ability to deliver revenue in 2022 at the high end of our mid single digit model now.
Now, let me hand, it over to Jim who will give you more detail on our second quarter performance and add color on our expectations for the balance of the year.
Thanks, Arvind I'll get right into the financial highlights in the second quarter, we delivered $15 $5 billion in revenue tuna.
$2 $5 billion of operating pre tax income, which is a margin of 16, 2%.
And operating earnings per share of $2 31.
In the first half of the year, we generated $3 $3 billion of free cash flow.
Our revenue was up 16%.
This includes nearly five points of incremental revenue from kindred.
As always we discuss revenue growth at constant currency.
But given the focus on the sharply strengthening dollar I'll mentioned that currency translation impacted our reported revenue by over six points of growth our $900 million.
That's over 200 million more than the spot rates would have suggested 90 days ago.
Today's IBM is a higher growth profile driven by our growth factors of software and consulting.
More than half of our annual revenue is recurring with about two thirds of that and high value software.
Software revenue this past quarter was up 12% and consulting up 18%.
Infrastructure performance, which reflects a good start to our <unk> product cycle was up 25%.
Software and infrastructure each include about seven points of growth from the commercial relationship with kindred.
These results reflect the investments we've been making in innovation are ecosystem Intel it all aligned to our strategic areas of hybrid cloud and AI.
We integrate consulting and technology to deliver these hybrid cloud and AI solutions are.
Our platform approach not only benefits our clients, but also provides an attractive economic model for IBM and our partners.
With a multiple of software and consulting revenue generated for every dollar of platform revenue.
Our hybrid cloud revenue from our full stack capabilities across software consulting and infrastructure was up 19% over the last year.
It has grown to $21 $7 billion or 36% of our total revenue.
Looking at our P&L metrics operating gross profit dollars were up driven by strong revenue performance in our high value businesses, our year to year gross margin decline reflects escalating labor and component costs.
We're addressing this through pricing. So it takes some time to show up in our margin profile, especially in consulting.
Our operating pre tax income was up and we expanded margin by 420 basis points.
We had an operating tax rate of about 16, 5%, which is up about two points versus last year and our operating net income margin expanded 330 basis points.
Let me comment on a few dynamics within our profit performance.
Our pre tax profit reflects the benefit from actions, we've taken to streamline our operations and simplify our go to market model as well as profit contribution from incremental sales for the new commercial relationship post separation.
Our profit this quarter also reflects recent portfolio actions at.
At the end of June we closed on the divestiture of our healthcare software assets.
<unk> generated a pretax gain of about $230 million in the period.
Mitigating that benefit to our overall profit results, we took charges to address stranded costs associated with the divestiture and absorbed operating losses related to the health business together over $75 million.
We also announced the orderly wind down of our Russian operations, resulting in incremental charges in the quarter.
Together with the year to year loss business due to the wind down Russia impacted our profit results by another roughly $100 million.
I also want to comment on the impact of currency.
I mentioned that over the last 90 days, we dealt with a sharply strengthening dollar.
We execute hedge programs that cover the majority, but not all of the currency exposure.
The combination of the rate and velocity of movement this quarter and the fact that we don't hedge 100% results in a currency impact to our profit and cash flow.
Turning to free cash flow, we generated over $2 billion in the quarter and $3 $3 billion for the first half with good working capital performance.
This first half free cash flow is about 33% of our full year expected range consistent with the average of the last few years.
I'll remind you the $1 billion plus of proceeds from the health divestiture is reflected in cash from investing activities versus in our free cash flow.
In terms of uses of cash for the first half we invested nearly $1 billion in acquisitions with five closed this year.
And we returned $3 billion to shareholders in the form of dividends.
This results in a June cash position of nearly $8 billion, which is up slightly from year end.
And our debt of just over $50 billion is down about a 1 billion and a half over the same period.
Turning to the segments software revenue grew 12%. This includes about seven points from the Kindle software content.
Growth was driven by our hybrid cloud and AI capabilities.
Hybrid cloud revenue for this segment now represents $9 billion over the last year up 23%.
Software subscription and support renewal rates were up again this quarter.
This contributes to our solid and growing recurring revenue base, which represents about 80% of software.
From a revenue category perspective, our software growth factor of hybrid platform and solutions grew 9%.
This includes about a point and a half benefit from the kindred commercial relationship.
We again drove pervasive growth across red hat automation data and AI and security.
Red hat revenue all in grew 17%.
Revenue growth was fueled by new adoption and expansion of ROE and open shift.
As both solutions continued to take share.
These key offerings address hybrid cloud requirements in industries, like financial services public sector, and telecommunications across environments and out to the edge.
Automation revenue was up 8%.
Solid performance in both AI ops management and integration demonstrates the importance of automation in the journeys of our clients.
We had strengthened offerings like turbine AMIC, and then standup for observer ability.
Cloud Pak for Watson, AI ops, and our modern integration platform cloud Pak for integration.
Data and AI revenue grew 4%.
This growth was led by demand for data fabric data management and asset and supply chain management solutions.
We also just expanded our data fabric portfolio with the acquisition of data band that AI, which helps organizations with data observed ability.
Security revenue was up 5% with growth in threat management and identity as enterprises continue to adopt a zero trust security strategy and implement additional identity controls.
We're continuing to invest in our security capabilities, having completed two acquisitions in the threat management space over the last few quarters.
Across the four a hybrid platform and solution business areas, our annual recurring revenue or <unk> is nearly $12 $9 billion up 8%.
Turning to our software value vector transaction processing revenue grew 19%.
Including 22 points from the Kindle content.
We continue to have strong renewal rates for this mission critical software and performed in line with our expectations this quarter.
Looking at software profit, we delivered operating leverage given the solid revenue growth and new Kingdom commercial relationship.
Our pre tax margin was up four points and keeps us on track for our full year software margin in the mid twenties.
Moving on to consulting we again saw pervasive growth with double digit revenue growth across all business lines and geographies.
Revenue was up 18%.
<unk> to 8% growth a year ago.
We maintain a solid book to bill ratio of one one on a trailing 12 month basis as clients are choosing to co create with IBM trusting our deep industry expertise.
The expansion of our skills capabilities and ecosystems are enabling us to capture demand as we drive adoption of our hybrid cloud platform and help clients with their digital transformations.
Consulting is hybrid cloud revenue grew 32% over the last year to $8 $6 billion.
Momentum behind our Red hat practice remains strong.
We nearly doubled our red hat consulting revenue in the quarter and continued solid red hat bookings, which now exceeds $6 billion inception to date.
Our strategic partnerships also contributed to our performance in the quarter.
Revenue from these partnerships continue to grow solid double digits led by Azure AWS and SAP.
P and Salesforce.
Turning to our lines of business business transformation grew 16% it's.
Its clients look to IBM to help them transform critical workflows at scale.
Most of the business transformation was pervasive.
And led by our offerings focused on customer experience transformation.
Data transformation and our SAP practices.
In technology consulting, where we architect and implement clients cloud platforms and strategies revenue was up 23%.
Cloud modernization and cloud application development led a significant portion of the growth with on Prem modernization also contributing to the strong revenue performance in the quarter.
Application operations revenue grew 17%.
Growth was solid across our cloud offerings mitigated by declines in the on Prem space.
In this business, we are optimizing the management of applications and providing cloud platform services required to run our clients' hybrid cloud environments.
Moving to consulting profit our pre tax margin expanded a point as.
As we deliver operating leverage and benefit from Ibm's more streamlined G&A and go to market structure.
Our consulting margins reflect the significant investments, we have been making to capture demand and fuel our revenue growth.
We continue to invest in our partner ecosystem scale acquisitions and add skills.
And salting, which makes up well over half of Ibm's workforce is most impacted by the inflationary labor market and increasing labor cost as we bring them.
And increased capacity.
We are starting to capture the reality of these higher costs in our pricing.
But given the time from contract signing to revenue realization, it's taking some time to see it in our margins.
Turning to the infrastructure segment.
Revenue was up 25%.
<unk> about seven points from the incremental <unk> content.
Hybrid infrastructure revenue grew 41%.
And infrastructure support revenue grew 5%, including about seven and eight points of kindred benefit respectively.
Within hybrid infrastructure Z systems revenue was up 77%.
This reflects solid execution around our <unk> program.
Building on the momentum from <unk>.
As Arvind mentioned <unk> 16 brings the power of embedded AI at scale.
Labour resilient security and cloud native development for hybrid cloud to our clients.
We are seeing growth in new workloads, like Linux and demand for AI capabilities like real time fraud detection leveraging the on chip AI accelerator.
Clients are investing in Z systems platform as an essential part of their hybrid cloud infrastructure.
Distributed infrastructure revenue grew 17% this quarter.
This growth was led by storage driven by both high end storage tied to the <unk> 16 cycle and distributed storage.
We also had good performance in high end power Ted.
Just last week, we announced the expansion of our power <unk> server family as we deliver flexible and secure infrastructure for hybrid cloud environments.
Looking at infrastructure profit pre tax margin was up four points year to year, reflecting mixed benefits from the growth in Z systems mitigated by the impact of increased component costs and supplier premiums.
Now, let me take it back up to the IBM level.
We've taken actions and made investments over the last couple of years to execute a platform centric hybrid cloud and AI strategy.
IBM is now a more focused faster growing and higher value company.
And while there is always more work to do we are confident in our ability to deliver sustainable growth.
Our first half results were solid.
We continue to see constant currency revenue growth at the high end of the mid single digit model for the full year.
And on top of that we expect about three five points of growth from the Kindle sales spread over the first three quarters.
I mentioned the impact of currency to our <unk> results.
With the significant movement of the U S dollar as compared to nearly every currency.
At mid July spot rates currency translation will now be about a six point headwind to revenue growth for the year.
That's a degradation of about $1 billion $5 from aprils rates with.
With most of that incremental impact still ahead of us in the second half.
Currency is one unique issue we're dealing with the.
The other is the impact of exiting our Russia operation.
Together these are putting some pressure on our near term results and we now expect free cash flow of about $10 billion for the year.
These are <unk> issues.
Importantly, we feel good about the underlying fundamentals of our business you see this in our segment expectations.
Halfway through the year, there's no change to our full year view of software.
We continue to expect constant currency revenue growth in line with our mid single digit model range, plus 5% to six points from sales to kindred.
We also remain on track to a software a pre tax margin in the mid twenties range for 2022.
Our IBM consulting revenue growth has been strong.
And we continue to expect low double digit revenue growth rate for the year, which is above our model.
With continued investment in skills in a competitive labor environment. We now expect a consulting pretax margin of 9% to 10%, which is up over a point year to year.
This reflects improving margin performance in the second half.
As we increase utilization of the resources, we have added.
And price realization starts to Florida revenue.
Our infrastructure revenue in any period reflects product cycle dynamics.
We had a very strong launch of our <unk> platform in the second quarter.
This will drive infrastructure revenue performance above the model level for the year.
On top of that we're planning for about five to six points of revenue growth from the sales to Ken drove in 2022.
Despite some of the pressures from component cost increases and supplier premiums. We continue to see mid to high teens pretax margin for infrastructure for the full year.
These segment revenue and margin dynamics yield about three and a half point year to year improvement and Ibm's pre tax margin for the full year.
And we continue to expect a mid to high teens operating tax rate, which is a headwind to our profit growth.
You'll recall that back in January we expected a 40, 61st half second half profit skew.
Now after a solid start to the year, our view Hasnt changed and we still see 60% of the full year profit in the second half.
Looking at the third quarter, we expect all in constant currency revenue growth in the high single digit range.
And about a two point year to year improvement in operating pre tax margin.
I want to mention two specific items in the third quarter.
First at current spot rates currency translation has increased to about an eight point headwind to revenue growth.
Impacting our reported revenue profit and cash.
We haven't had a Z systems product introduction in our large transactional second quarter in about 20 years.
This unique timing coupled with a strong start to the cycle will result in a larger second to third quarter impact than typical seasonality.
So to be clear, we expect a strong year to year growth in Z systems.
In closing these are interesting times, and we see technology as a way to help our enterprise clients capture today's opportunities and navigate challenges.
We feel good about the strategy, we are executing and the fundamentals of our business.
Tricia now, let's go on 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 if you need to withdraw your question Press Star Q again to ask a question. Please press star one hour.
Our first question will come from Erik Woodring with Morgan Stanley . Your line is open.
Hey, good afternoon, guys. Thank you for taking my question just one for me here, obviously, we saw a bit of a deceleration in the Red hat business. So would just love to hear what your what youre hearing from them and any impact that you could share with us on the AR on the deferred.
That's been a part of this business for a while so that's it thanks.
Thank you Eric for the question let.
Let me start up by just.
We feel very good about the Red AD business, and we see very strong demand continuing.
That said, we had said late last year that we expect growth and read out to be in the upper teens, we continue to make that expectation.
Is what we are going to continue with.
Eric I think I heard you start to see differed revenue that accounts for the bulk of what has been the difference in the growth rates are coming down from last year to this year and I'll, let Jim add a bit of color onto that.
Yeah, Eric Thanks, just.
Just building on what urban said, 17% growth overall, taking share both in our core rail, but also in our hybrid cloud platform centric Foundation Red had open shipped by the way Red hat open ship four and a half times now the revenue pre acquisition, we had very strong bookings overall.
In Red hat here in the quarter large deals were up 50% Red had opened ship bookings were up over 50%, which positions us very well with our backlog and a strong NR. So we feel pretty good about our red had portfolio overall arvin indicated our model is high teens, we do.
Delivered on that in the quarter and by the way the deferred revenue we talked about entering January of this year that that was going to lessen throughout the year and we're pretty much through that I mean, theres. Some small round up here in the third quarter, but that's pretty much behind us and remember we're three years into this acquisition right now and we couldnt be more pleased.
We move forward.
Thank you Eric Let's go to the next question. Please.
Our next question will come from Amit <unk> with Evercore. Your line is open.
Yes.
Thanks of taking my question.
Yes.
Question really on the free cash flow guide and Neil one of the things that always comes up is I'll keep going.
Look at the numbers.
Revenue seems to be even better than what most folks pop. It was 90 days ago I think that the start of the year then.
The free cash flow number I think it is $10 billion disappointed with tend to tend to have initially.
Maybe just talk about what are the puts and takes on free cash flow.
That would be helpful to kind of understand and then maybe just related to that you've been very explicit on the FX headwinds on the top line.
I'm, assuming given how volatile this movement was there might be an impact to EPS and free cash flow. So maybe you could just flush out what's a decent free cash flow how does FX impact.
Below the top line that would be helpful. Thank you.
Yes, Amit. Thank you very much so let's take a moment to.
Go through this because I think it's very important when you look at our two key measures of success you talked about it revenue growth <unk> put in place to run this company and free cash flow growth. We started out the year guiding at 10 to $10 5 billion and now coming through the first half we have now moved it to the low end of that guidance.
At about $10 billion before I get into the puts and takes at the heart of your question, let's take a step back and put this into perspective that $10 billion of free cash flow is growing three $5 billion year to year.
And it's even growing north of $2 billion against our 2021 IBM post separation baseline that we gave to all of our investors remember, we're very transparent on the revenue growth of the <unk> contribution and we have given to each of you the pro forma baseline, but in either case.
<unk> that is very strong free cash flow growth overall.
Two pieces that I talked about in the summary of the prepared remarks number one given the unfortunate humanitarian crisis in the war in Russia, We made the right decision to exit that business here in the second quarter and that was a very highly profitable business for us and thats going to cost a couple.
$100 million worth of free cash flow and profit by the way in 2022. The second is what's been happening with the rate and pace of the U S dollar appreciation.
And that right now we are not immune to that as we move forward, but let me talk a little bit about.
The go forward free cash flow, we achieved $3 3 billion through the first half that is actually slightly above our historical attainment over the last five years.
And when we look at the second half we see continued revenue growth. We see continued operating leverage out of our business. We've had good performance out of working capital management here through the first half and given the volume dynamics and now our mainframe cycle, which should get off to a good start should provide leverage in.
And then as I talked about in January we do have a modest cash tax headwind or excuse me tailwind.
For the year, so that kind of wraps up free cash flow overall.
Thank you Amit let's go to the next question. Please.
Our next question will come from Toni <unk> with Bernstein. Your line is open.
Hi, yes. Thank you.
Was wondering if you could just comment on whether you still expect $35 billion in free cash through through 2024, and what the bridge for that is and then you mentioned that revenue sequentially would be a little lighter than usual.
In Q3, because of the mainframe I think I think you are typically down about $850 million, the mainframe like $5 to $700 million a quarter. So maybe it's $100 million headwind. So is that sort of the dimension that youre thinking about for Q3 or are there other factors at work. Thank you.
Alright, Tony let me start by first addressing the $35 billion of free cash flow question, and then I'll hand, it to Jim we.
We are absolutely committed to our $35 billion total free cash flow cumulative over 'twenty two through 'twenty four.
And we still are.
I see.
Very good signs and we have confidence in delivering that number.
So with that you said the bridge to that and then the <unk> dynamics I'll hand, it to Jim for those yes. Thanks, Tony If you. If you go back to what I said in the prepared remarks.
We typically I think the number is actually about $1 billion sequentially and revenue Tony overall, but we've actually given pretty explicit guidance on third quarter. We said that we were going to be all in high single digit at constant currency here in the second quarter. So let me address.
Your question from that dynamic because we gave we've given that explicit quarter to quarter and what's going to happen to constant currency total total revenue. So if you look at second quarter, we delivered mid teens by the way I would make the point that is the strongest constant currency growth.
We've had in 20 years in this company.
Well above our mid single digit model and an acceleration from second quarter by the way acceleration and revenue growth acceleration and operating profit margin up 420 basis points, an acceleration in free cash flow, but if you look at constant currency were gone from mid teens in second quarter.
So high single digit let me call that 9% to 10% that's about six points worth of what I'll call quote unquote deceleration two points right off the bat is coming from our health care software asset divestiture, we closed that at the end of June that's about $200 million a quarter.
<unk>, that's two points of the six the remaining four points is the dynamic of us for the first time in 20 years coming out with a new mainframe cycle and a highly seasonal transactional quarter of second quarter. We did extremely well remember 90 days ago, we took up our.
Second quarter revenue guidance by $200 million versus the normal seasonality, we actually beat that in the second quarter now when you look at second half and get into third quarter I think it's imprudent in this environment for US only the guide at what a normal cycle would be in <unk>.
Given the normal cycle, that's going to cost us about four points and a two Q3 Q given the announcement in second quarter and I'll wrap it up just saying that Tony I talked about upfront that we still see 40% to 60% SKU and our operating profit for the year that Hasnt changed since January .
This is really a dynamic between the third quarter and our fourth quarter now given how we announced.
The new Z cycle, which we're very excited about here in the second half.
Thank you Tony Sheila let's please go to the next question.
Our next question comes from <unk> Mohan with Bank of America. Your line is open.
Thank you.
And I know you you left your constant currency guide unchanged for the year, but it'd be helpful to get some color maybe on what is tracking a bit better or worse versus your expectations.
Jim can you help sort through the PTA change year over year in the second half of the year. It seems like you had significant improvement in PDI 400, plus basis points in the second quarter, you are guiding to about 200 basis points in the third quarter does it mean that there was a catch up of startup pte.
And in the fourth quarter or is this and how much of that is FX versus.
Mainframe timing related because you alluded to both of those.
When you were talking about the revenue impact thank you.
Great. So why don't you let me address the first part of your question, we had very balanced performance in constant currency across geographies and actually across the different businesses.
Now because of currency the actual performance will be different and in different geographies, but a double digit performance in the Americas and Europe as well as in Asia Pacific.
Jim laid out the numbers on the different business performances.
Talked about at constant currency of 12%.
Software, 18% in consulting 19% and infrastructure.
So really strong performances I believe.
As we go forward you should expect to see us maintain and we said we talked about will remain in the mid single digits on software, we will get towards the low end of double digits in consulting which is actually up from our previous high single digit margin and infrastructure will benefit from the <unk>.
Michael So all in that's a very balanced across the portfolio and across the geographies and that contributes towards our confidence in the revenue profile for the rest of the year.
Yeah <unk>. Thanks for the question let.
Let me give you.
Step back from an overall perspective, and then I'll come into the third quarter. We maintained the guidance to your question about high single digit.
Excuse me high end of our mid single digit revenue growth before the incremental <unk> contribution for the year Arvind just went through the portfolio dynamics of that by the way the currency change that now we expect about six points.
Impact beyond that constant currency strong performance that went up from about 3% to $4 90 days ago. So that's about 1 billion and a half I've seen some people quoting $3 5 billion, it's about 1 billion and a half overall a change from what we said here in April but with that revenue growth we expect.
About.
$10 billion of free cash flow and operating profit margins up a strong 350 basis points year over year. When you look at that by segment, we really haven't changed our software segment, we feel pretty comfortable comfortable and confident in our first quarter first half trajectory that we are still going on.
Grow mid single digit overall in software operating margins approaching mid Twenty's remember, that's five to six points of an operating margin infrastructure.
Infrastructure segment, we still think given the product cycle dynamics, it will be well in excess of its model and have operating margins around mid to high teens, and then consulting we see strong demand in consulting we took up our model on revenue growth 90 days ago.
And now Thats low double digit and our margin now we took down to nine to 10 Thats. The one change that's happening.
What we're seeing is it's taking longer for our price optimization of play through to our margin.
We still expect margin increase.
Increase year over year for the full year beats.
Between that 9%, 10% absolute PCI and that will actually be as we wrap on easier comparisons in the second half that will be some nice margin accretion here in our consulting business in the second half overall now third quarter.
Similar to how I answered Tony's question on revenue growth overall, our operating margins are typically flat quarter to quarter. When you look at the dynamics of mainframe coming out for the first time in 20 years and a highly seasonal transactional quarter and you look at that.
A prudent guidance and a third quarter that is about a four point margin impact.
By the way arts or third quarter, we guided to be up to <unk>.
So when you look at the dynamics, it's entirely even more so driven by the mainframe dynamics and to your question why AMC that comes back to US here in the fourth quarter. So we will just have a very different SKU given the the new introduction in the second in the second quarter.
Thank you once it let's go to the next question.
Our next question will come from Brian Essex with Goldman Sachs. Your line is open.
Hi, good afternoon, and thank you for taking my question. Jim I was wondering if you could I appreciate the comments on the consulting side of the business I was wondering if you could dig in a little bit there.
Appreciate you know kind of the pricing dynamics, you discussed, but I think if we if we look at this from.
Both the demand side and the supply side could you share any thoughts on what youre seeing if theres if anything is changing there so from on the supply side.
Hiring attrition wage inflation changing are stabilizing on the demand side I noticed that great to see the improvement in constant currency growth.
<unk> really nice.
Nice to see the acceleration, but it looks like business transformation moderated a little bit while we have improvement in technology consulting and application operation. So maybe if you could walk to supply dynamics and the demand dynamics.
What's changing within that business and what's driving your confidence in the performance for the rest of the year.
Sure Brian Thanks for the question Great question, So, let's take a minute here to go through this right. We continue I'm going to start with the demand side of the equation because in the human capital based business. The way. We manage this is our source of cost or value or ROI indicators, the human capital to go drive that demand and capture it.
So we continue to see a strong demand profile, we're capturing it by raising our guidance here and seeing the accelerated consulting performance in the quarter up 18% by the way on a plus 8% last year overall, so I think that's driven by what arvin has been talking about and that is.
The value of technology being a sustainable competitive advantage in this environment as clients in every industry are moving and accelerating their digital transformation journey to cloud consulting is also a very integral part to our hybrid cloud platform thesis I've talked every quarter about being the tip of the <unk>.
Spirit that drives the scale adoption of our hybrid cloud platform and pull through Ibms technology. Overall. So we saw this if you remember dial back a year ago, we were entering second half 'twenty one in a very different dynamic coming off of the pandemic.
And I think Arvind was very explicit about the demand indicators that we saw that we were going to take a conscious strategy to now I'm on your supply side to invest in skills and capabilities in.
Ecosystem expansion and in acquisitions, because we saw the robust demand growth that was going to be out there and I think we've been capitalizing on that growing consistent double digit and by the way another solid signings quarter with a trailing 12 month book to Bill North of one one.
We feel pretty good even as we enter the second half, but you take that conscious strategy of driving incremental skill capability capacity on the supply side and then you couple that with the highly inflationary environment that started to play out in the second half and you see that that's been impacting our gross.
Profit margins and we talked about as we came into 2022 that we were going to go take the appropriate actions around our price optimization, but that that would take time to get rolled through our P&L and that's what we kind of expect in the second half of this year. So when we look at all.
When demand still see solid the supply side of the equation, we've been optimized with a very disciplined strategic investment process and when we look at second half we are looking at one easier comps too.
To scale.
Scaling the acquisitive accretion of our acquisitions, where they actually we saw some good green shoots here in the second quarter three getting effective.
Increase in utilization of our capacity and for price optimization continue to play through so we saw nice improvement in our priced margins that will play out in the second half as we move forward. So hopefully that gives you a little perspective.
Thanks, Brian Let's go to the next question. Please.
Our next question will come from Kyle Mcnealy with Jefferies. Your line is open.
Hi, Thanks, very much for the question.
So the strengthening dollar generally comes with a translation impact, but also some demand destruction in non dollar dominated markets. So are you able to size how much that demand related impacts might be which would actually make your reiterated guidance for the high end of your mid single digit range for the full year for.
For the core look even a bit better.
Also connected to that what is your sense. If you have some perspective on how well international customers are positioned to be able to absorb the currency fluctuations.
Yeah.
Okay. Kyle Thank you I'll take this Arvind, let me spend a few minutes on currency since it seems to be a theme here.
Across the questions and really how we manage it within our business and how it impacts our business model. So while we have a robust hedging program as I indicated earlier, we're not immune over the long term the currency impacts, especially when currencies move at the right breadth and magnets.
<unk> that we've seen let you know.
Let me give you some stats as we've been going through here in the month of June in the early part of July one the U S. Dollar index is up 13% year to date.
<unk> year high against the Euro 25 year high against the yen.
<unk> of the strengthening its sharpest that we've seen in over a decade and it's been a broad based dollar story as you all know all the currencies, we hedge over half of them are down double digits against the U S. Dollar. This year. So it's kind of I would say quote unquote unprecedented what we've seen.
And the rate the breath of magnitude now are to your question Kyle our business profile, we operate in 170 countries around the world. That's in excess of over 100 currencies. The strong dollar definitely has an impact and to your point from an absolute revenue profile I would agree with you completely.
<unk> makes our constant currency revenue growth guidance, even stronger and us capturing.
What's happening in the marketplace with regards to that acceleration of Digitization and transformation journey of the cloud, but our robust hedging program. There's two important points I'd like to make number one we don't hedge 100 currencies, one it's not economically viable and two you can't hedge revenue per GAAP accounting you can only hedge.
You have cash proxies in country. So we only hedged give or take about 35 currencies around the world out of the 100 plus that we're in.
And also important if not more important we only hedged 12 months out we don't do multiyear hedging in this business we're not speculative.
So when you look at the lasting relevance of a U S dollar appreciation eventually.
What hedging does is it mitigates volatility in the near term it does not eliminate currency and allows you time to address to your business model for price for source for labor pools and four.
Our cost structures now also important and this is where you see the dynamics playing out in our business model currency impacts a human capital based business very different than a product based business and I've talked about this many times over the years in a human capital based business. If you think about it.
Large portion of your cost structure is a natural hedge because it's in local currency.
Very different in a product based business, where a large portion of your cost structure is U S. Dollar denominated so as the dollar at rate and pace and magnitude appreciates. It has a disproportional impact on our high value product based businesses.
Read that software and infrastructure and you saw that play on the second quarter at the gross margin level, because remember our hedges end up in expense gross margin you see the revenue and the margin implications. So we understand how to manage currency.
We have a robust hedging program in place we've taken the appropriate cost structure and the approach appropriate pricing as we deal with that going forward and you see all that taken into account in our guidance.
Let's see if we can squeeze in two more questions Sheila let's go to the next one.
Our next question will come from David Grossman with Stifel. Your line is open.
Thank you.
To remind us.
Was there any expenses are stranded costs that remain in the 2022 P&L that will diminish or go away over the next few years like you mentioned, Russia some losses.
The health care software divestiture I don't know if there any more in.
And perhaps beyond that could you read that dynamic into how it impacts free cash flow growth. The next year or two given your 2024 target implies a fairly meaningful increase in free cash conversion over the next two years. Thank you.
Yes, David Thank you very much for the question.
At its core we've got we actually took some conscious strategy back in fourth quarter 'twenty. If you remember at the time, we announced the.
Intent to spin off Ken drilled that we were going to try to get out in front of stranded cost and as you see now we've executed on additional portfolio actions with the divestiture and closure of our health care software assets across the board. If you look at 2022 Theres about five to 600 million.
$700 million give or take in that range around structural action cash charges that.
We will still impact us and by the way that's embedded in our about $10 billion. Overall. So now when you think to the core of your question about how that then plays out for 'twenty, three and 24 that actually turns into tail winds in 'twenty, three and 'twenty four because were depressed and our free cash flow.
Guidance and again I'll remind you that's up $3 $5 billion year to year and up over $2 billion against our post separation baseline that depresses 2020, two's free cash flow and we get that return not only on.
The cash.
Charges that we won't have in 2023, but also on the incremental ROI of getting rid of that stranded costs as we move forward. So both pieces that kind of gives you a double benefit as we move forward.
Thanks, David Sheila, let's take one last question. Please.
Our last question will come from Keith Bachman with BMO. Your line is open.
Hi, many thanks for taking the questions are going to wonder directed you if I could.
I wanted to see if you could look out over the horizon, a little bit longer.
Some of the software companies.
Talk about.
Some of the pipelines.
In a deep sales cycle or starting to extend and I just wanted to see if youre seeing any economic impact and then more specifically I wanted to see if you could comment historically consulting has been highly correlated to economic cycles.
And this is going back last 15, 20 years and I just wanted to see as we're heading into late 'twenty, two and more importantly, 23, how do you think the consulting business is prepared.
For some potential economic downturns or just more broadly.
Think about the growth potential there and Tim if I could just sneak in one thing for you real quick if you could just talk about what the M&A contribution is this year you mentioned some recent deals just if you could provide an update that would be great. Many thanks Keith.
Keith.
Lots to unpack in that question.
If I look at our pipelines our pipelines are remaining pretty healthy. So I would tell you that right now what we're seeing is that the second half at this point looks pretty consistent to the first half when we look at our pipelines whether its in right at our mainframe software automation data AI security and by geography.
So.
This is a little bit different which is why you heard me often say I'm a bit more optimistic that many of my peers, both within the industry and across the board because we see that technology and Jim has also said this as a vie is.
Deflationary.
In an inflationary environment with clients.
CAGR technology deployed leverage our consulting it acts as a counterbalance to all of the inflation in all of the labor demographics that people are facing all over the globe.
So that is the reason on software.
On consulting correlated to the economic cycle.
Maybe we see much less of that this time around because of the nature of our consulting if you look at it a lot of our consulting is around deploying back office applications critical applications supply chain Brazilians worrying about cash conversion worrying about optimization of our.
Of the cost within our clients those tend to get more attention actually in a I'll call. It at least a slight down cycle than.
And then not.
Good.
Consulting is very labor base, Jim talked a lot about the demand or the supply but to be completely clear in a business, where you do hire tens of thousands of people because of the scale of it you do churn in the neighborhood of tens of thousands each year that gives you an automatic way to hit a pause in some of the profit.
Trolls, because if you don't see the demand coming you're going to slow down your supply side and.
You get kind of a at least a 10% to 20% impact that you can pretty quickly control not in a given month, but certainly within a half year or thereabouts.
M&A actually I'll say it before Jim Boyle.
We have said that our model is about a point to point and a half each year based on M&A.
And if you look at last year that was pretty consistent if you look at this year, but for year is not over but you should expect it to stay in that range and it's a mix between consulting acquisitions and software acquisitions and the multiples that we've been getting them that still implied that range. So so I think we will give you.
That answer and we expect it to stay there.
So let me wrap up the call.
So let me just say we are very pleased with our solid first half performance.
As we look to the second half.
We're going to focus on the execution of our strategy delivering sustained revenue and free cash flow growth and I look forward to speaking with all of you again soon.
Let me 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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