Q3 2022 International Business Machines Corp Earnings Call
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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 IBM third quarter 2022 earnings presentation.
I'm here with Arvind Krishna.
Chairman and Chief Executive Officer, and Jim Kavanaugh, Ibm's, Senior Vice President and Chief Financial Officer.
We'll post today's prepared remarks on the IBM investor website within a couple of hours and a replay will be available by this time tomorrow.
To provide additional information to our investors. Our presentation include certain non-GAAP measures for.
For example, all of our references to revenue growth are at constant currency.
<unk> provided reconciliation charts for these and other non-GAAP measures at the end of the presentation, which is posted to our investor website.
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.
With that I'll turn the call over to Arvind.
Thank you for joining us today.
The results, we delivered to the quarter.
Our continued focus on the execution of our strategy with over $14 billion of revenue and strong growth across the portfolio.
Technology remains a fundamental source of competitive advantage and we continue to see solid demand for our hybrid cloud and AI solutions.
Continued double digit revenue growth in IBM consulting.
Client demand for digital transformation.
Software revenue performance was also strong with growth across all categories.
And our infrastructure business had another high growth quarter in both Z systems.
Infrastructure.
Our revenue strength was broad based geographically as well.
When I talk with clients, it's clear, there's a real opportunity to help businesses leverage technology.
Clients are dealing with everything from inflation to demographic shifts.
Supply chain bottlenecks to sustainability efforts.
Deploying powerful hybrid cloud and AI technologies.
Helping businesses.
New opportunities will come to these challenges and emerge stronger.
We are building a stronger company that is closely aligned to the needs of our clients.
With our hybrid cloud and AI strategy, we have continued to focus our portfolio invested in our offerings technical talent in the ecosystem.
Streamline our go to market model.
With strong performance through the first three quarters, we're taking up our revenue expectations for the year and now expect 2022 revenue above our mid single digit model.
Let me now turn to the progress we are making in the execution of our strategy.
Point of view is clear.
Cloud and AI are the true.
Most transformational enterprise technologies, all part time.
Cloud is already becoming the dominant architecture for enterprise.
According to a recent survey by the hottest pool.
77% of businesses surveyed said they have adopted a hybrid cloud for their organizations.
Located across multiple cloud on premise or at the edge.
Hybrid cloud is about offering clients a platform that can drive value across these different environments.
Our platform based on Red hat allows our clients to consume software driven by open source innovation.
IBM software has been optimized to run on that platform.
<unk> advanced data and AI automation and security capabilities are.
Our consultants offer deep business expertise and co create with clients to accelerate their digital transformation journey.
And our infrastructure allows clients to take full advantage of our hybrid cloud environment.
Our platform centric strategy continues to have good momentum.
Adding a couple of hundred hybrid cloud platform clients in the third quarter.
We see more and more clients consuming across our portfolio of software consulting and infrastructure capabilities.
This quarter plants, such as bank of America, <unk> and Samsung electronics.
Chosen IBM realize the full potential of our hybrid cloud computing model.
Let me now say a few words about our AI capabilities.
As demographic shifts continue to add pressure to modern economies.
Coupled with wage inflation companies are eager to deploy AI and automation capabilities at scale to boost the levels of productivity.
That is what IBM is helping companies bring to bear.
Contracts for enterprise, you're seeing four main use cases emerge.
AI to interact and converse.
To automate it.
These.
Air to extract knowledge and insights.
And finally, AI to automate business workflows, such as HR supply chain and financial reporting.
We are working to bring these capabilities to clients across all industries.
For instance, this quarter IBM consulting parted with the U S Department of Veterans Affairs to automate business workflows related to the delivery of pension benefits.
This helps free up valuable time of BSF and speed up the processing of claims made by the veterans most in need.
Our partner ecosystem is a crucial element of our strategy.
Each quarter, we continue to expand the work, we do with partners to serve our clients.
For instance, we recently announced an expansion of our partnership with Vmware.
Help clients and regulated industries or easily move workloads to the cloud with IBM consulting now serving as a GSI partner for Vmware.
You announced that Red hat and Dell are launching a set of containerized solutions.
Aimed at simplifying the management of multi cloud environments on premise.
Doctor predicts that by 2026, 90% of organizations will use containers.
The actions represented another step in our efforts to seize this opportunity through ecosystem relationships and our technology offerings.
We are actively working to introduce new innovations and shape the technologies of the future.
Most recently unveiled the next generation of our Linux one silver bullet. It's in Kubernetes based platform designed to support thousands of workloads within the footprint of a single system.
As an example, Citibank is hosting Mongo DB on IBM Linux, one leveraging the platform security resiliency.
Elastic capacity and helping city lowered overall carbon footprint.
We also continued to make progress in quantum computing.
I mean on track towards our goal of building a thousand cubic system by 2023.
To advance the security of our communication networks.
Alongside Vodafone recently joined the GSM as quantum.
Quantum Telco network Task Force. This task force aims to introduce a framework for the telco industry to adopt new quantum safe approaches.
Complementing our organic innovation, we recently acquired dialects.
This brings our total number of acquisitions this year to seven adding new capabilities in areas like hybrid cloud services.
<unk>.
Absorbability.
Sustainability.
As the World takes on the challenge of sustainability and building a more circular economy.
Ibms in building a portfolio of solutions to help companies make progress on this journey.
This quarter, we received recognition highlighting our sustainability efforts.
Analyst firm Hff's research and Forbes, both recognized IBM for its capabilities in the area of sustainability.
<unk> and <unk> and our environmental intelligence suite software.
Let me conclude by it.
Reminding you that last October and.
And just prior to the separation of Kindred, we held our investor briefing.
Our priorities for our portfolio and growth.
Over the last four quarters, we have driven constant currency revenue growth at or above our mid single digit model.
Solid free cash flow.
And while there is always more to do we are pleased with our first years progress.
As we look forward, we remain confident in our strategy and execution and feel we are well positioned to address today's client needs.
Let me now turn it over to Jim who will provide more details on the quarter.
Our expectations for the balance of the year.
Thanks, Arvind I'll start with the financial highlights.
In the third quarter, we delivered $14 $1 billion in revenue.
$2 billion of operating pre tax income.
At a margin of nearly 14%.
Operating earnings per share of $1 81.
Through the first three quarters of the year, we generated over $4 billion of free cash flow.
Our revenue was up 15%.
Which includes about five points of contribution from sales to kindred.
Bob will discuss our results today at constant currency.
You mentioned that with the continuing strengthening of the U S. Dollar currency translation impacted our reported revenue growth by more than eight points or nearly $1 $1 billion.
As Arvind said, our revenue growth this quarter was pervasive.
Software revenue was up 14% and consulting up 16%.
These are growth vectors and represent over 70% of our revenue.
Infrastructure was up 23%, reflecting solid product cycle dynamics.
Software and infrastructure include about eight nine points of growth respectively from.
From the commercial relationship with kindred.
More than half of our revenue is recurring in this annuity content, which is driven by software continues to grow.
Performance was also broad based by geography.
Americas, EMEA and Asia Pacific revenue were all up double digits, and we gained share overall.
These revenue results reflect the execution of more focused hybrid cloud and AI strategy based on a platform centric approach and leveraging a broad ecosystem of partners.
Our full stack capabilities across software consulting and infrastructure delivered 20% growth in hybrid cloud revenue over the last year to over $22 billion.
Looking at our profit metrics operating pre tax income was up.
Margin expanded by 180 basis points year to year.
These prospects dynamics reflect our portfolio shift toward higher value led by software.
This mix shift is contributing to profit and margin.
Our pretax profit also includes the contribution from incremental sales to the kingdom.
Like our clients, we are focused on digitally transforming our own operations.
Buying AI and automation to drive productivity and efficiency and the spend base.
This provides flexibility to continue to invest in talent innovation and our ecosystem and in an inflationary environment.
90 days ago, we spent some time talking about currency dynamics.
Remind you of a few of the key points.
A stronger dollar impacts our revenue and gross profit dollars.
We execute our hedging program, which differs versus eliminates the impact of currency.
The gains from these hedging programs are reflected primarily in other income and expense.
But with the rate and magnitude of the movements and because we don't hedge all currencies, we do have a currency impact to our overall profit and cash flow.
Wrapping up the discussion on profit dynamics.
Currency impacts and a good amount of investments are in gross profit.
While the mitigating hedging benefits and operational productivity are reflected primarily in expense.
As a result pre tax income is a better indicator of our profit performance.
Our operating tax rate was about 16%.
Compared to last year tax is a significant year to year headwind to operating net income and operating EPS growth.
Which were both down modestly year to year.
Turning to free cash flow, we generated $4 $1 billion in the first three quarters.
That's up over $900 million year to year.
We're wrapping on payments related to the Kindle separation and the 2020 structural action.
And driving working capital efficiencies.
In terms of uses of cash in the first three quarters, we invested over $1 billion in acquisition.
Which was more than offset by proceeds from divested businesses.
And we returned nearly $4 $5 billion to shareholders in the form of dividends.
From a balance sheet perspective.
We issued debt in July to prudently get ahead of our 2023 maturities.
Our debt balance is up since June , but down nearly $1 billion since December .
We ended the quarter in a strong liquidity position with cash of $9 $7 billion.
This is up over $2 billion from year end and well in excess of the minimum cash required for our business.
Turning to the segments software revenue grew 14%.
This includes about eight points of Kindle contribution.
Most of our revenue categories hybrid platform and solutions and transaction processing grew this quarter.
This performance reflects our strong and growing recurring revenue base, which.
Which is about 80% of our annual software revenue.
And software is hybrid cloud revenue is now $9 $2 billion over the last year up 20%.
And the hybrid platform and solutions revenue was up 8%.
Including thing about a point and a half contribution from the kindred commercial relationship.
The growth was broad base.
Red hat revenue all in grew 18%.
As a leader in open source technologies for the enterprise Red Hat's performance was again fueled by market share gains across row opened shifts and ansible this quarter.
With our enterprise incumbency and global scale, we continue to see an increase in large deals as well as strong cross sell and up sell across Red hat solutions.
Automation revenue grew 3%.
This quarter's performance reflects continued adoption in areas like AI ops management and integration. While we're also wrapping a strong acquisition content from last year.
We're bringing innovation to our clients this quarter.
Such as new Instanter absorbability capabilities for Z systems in a hybrid cloud environment.
And data and AI revenue was up 4%.
Let me highlight just a few of the growth areas this quarter.
Data management fuels advanced analytics.
Data fabric helps clients discover and unlock the value of their data wherever it resides.
And information exchange enables the timely and secure flow of complex <unk> information.
And offerings like envisage, an environmental intelligence suite are resonating with clients as they prioritize sustainability efforts.
Security revenue was up 6% with growth in both data security and threat management.
And data security, we're seeing adoption of Guardian insights as we continued to deliver new product innovation.
Brent management growth was led by cloud Pak for security.
Which helps clients prevent and respond to modern threats across disparate security fees.
Across hybrid platform and solutions, the annual recurring revenue or <unk>.
<unk> is now a $13 billion and up 9%.
Transaction processing revenue was up 33%.
Putting about 26 points of Kingdom contribution.
The increase in Z systems installed capacity over the last couple of cycles and continued strong renewal rates a recognition of the importance of this platform in a hybrid cloud environment.
As a result, the transaction processing annuity base is now growing.
Looking at software profit, we delivered operating leverage given the solid revenue growth and new Kindjal commercial relationship.
Our pre tax margin was up more than four points over last year.
And salting revenue grew 16%.
This is the fifth consecutive quarter of double digit growth.
This strong performance was again broad based with revenue growing at double digit rates across all business lines and geographies.
Over the last year, our book to Bill ratio is one dot O five.
Clients Trust Ibm's deep industry expertise and co creation approach throughout their hybrid cloud and digital transformation journeys.
As IBM consulting designs and enables enterprise hybrid cloud strategies. This business delivered $8 $9 billion and hybrid cloud revenue over the last year.
It's up 28%.
Red hat consulting practice continues to be a meaningful contributor to revenue growth.
Growing strong double digits as we add new engagements.
Since IBM acquired Red hat, just over three years ago consulting has led nearly 1400 red had engagements with over $6 $5 billion in aggregate bookings.
Strategic partnerships also contributed to performance.
Continuing to grow revenue at a double digit rate.
Turning to our lines of business. This is transformation revenue grew 14% is.
As clients look to IBM to help them transform critical workflows at scale.
Growth in business transformation was pervasive.
Driven by supply chain finance data and client experience transformation.
Working with our partners like SAP Salesforce.
Salesforce and Adobe, we help our clients optimize their operations and improve the way they engage with their customers.
And technology consulting, where we architect and implement clients cloud platforms and strategies.
Revenue was up 17%.
Once again growth was led by cloud application development and cloud modernization.
<unk>, our red hat practice, which as I mentioned grew strong double digits.
Application operations revenue grew 17%.
IBM helps clients optimize their operations and reduce costs by taking over the management of clients' applications in hybrid and multi cloud environments.
We leverage AI to help predict problems before they happen and monitor our clients different environments with dashboards, enabling action to be taken quickly.
Moving to consulting profit our pre tax margin of about 10% is down year to year, so up nearly three points from the second quarter.
As we discussed in prior quarters insulting is most impacted by the labor cost inflation.
Dynamics continue to put pressure on the margin profile.
However, coming out of the third quarter, we are seeing signs of progress.
Our utilization rates are improving as we exited the quarter.
Our acquisitions are scaling and are on a path to margin accretion and.
And we've seen two quarters, a price margin improvement year over year.
That will benefit our margin profile going forward.
Moving to our infrastructure segment revenue grew 23% this.
This includes about nine points from the incremental Kindjal content.
Hybrid infrastructure revenue grew 41% and infrastructure support revenue grew 5%, including about 11 seven points of kindred benefit respectively.
Looking at hybrid infrastructure. These systems revenue nearly doubled driven.
Driven by continued adoption of our newest program <unk>.
This latest program combines embedded the AI at scale.
<unk> native development for hybrid cloud and cyber resilience security.
Back to <unk> 16 is the industry's first quantum safe system.
Delivering 25 billion encrypted transactions per day for clients.
And as Arvind mentioned, we just introduced our newest Linux one server.
A highly scalable Linux and Cooper <unk> based platform with capabilities to reduce clients energy consumption.
These systems remains an enduring platform.
Playing an important role in a hybrid cloud environment.
Distributed infrastructure revenue was up 21%.
Innovation across the portfolio enabled broad based growth within both storage and power.
These include the expansion of our power 10 server family earlier, this quarter and refreshes to the flash storage solutions throughout this year.
Looking at infrastructure profit pre tax margin was up one point year to year.
<unk> mixed benefits from the growth in Z systems.
Now, let me take it back up to the IBM level and I'll shift the focus to the full year in the fourth quarter.
Over the last year, we've continued to invest and make portfolio changes to advance our hybrid cloud and AI strategy.
Streamline our go to market and digitally transform our own operations.
Our more focused strategy and portfolio is aligned to client needs.
Our revenue performance so far this year demonstrates that.
And based on this revenue performance in the first three quarters as Arvind said, we now see constant currency revenue growth above our mid single digit model for the year.
On top of that into sales at about three five points of growth.
Primarily in the first three quarters of the year. So it is essentially behind us.
U S dollar continues to strengthen.
And at mid October spot rates currency translation will now be about a seven point headwind to growth for the year.
As I mentioned earlier, this impacts profit and free cash flow as well.
Looking at free cash flow our other key metrics, we continue to expect to generate about $10 billion for the year.
That's up over $3 billion from last year.
A large part of that growth comes from the wrap on the kindred spin related and structural payments.
But we're also driving working capital efficiency and improving operating profit profile.
We expect strong free cash flow performance in the fourth quarter, while we continue to face some external headwinds, including appreciation of the U S dollar and exit of our Russia operations.
In terms of segment performance for 2022 our.
Our view of software has been consistent all year.
We continue to expect revenue growth in line with our mid single digit model range.
Plus five to six points from sales to kindred.
And we still see software our pre tax margin in the mid twenties range for 2022.
Our IBM consulting revenue growth has been great.
And we're taking our view up to a mid teens revenue growth rate for the year.
While we are still operating in a competitive labor environment, we see some encouraging signs in our consulting margin profile exiting the third quarter.
We now expect a consulting pre tax margin for the year at the low end of our previous 9% to 10% range, which is up about a point year to year.
Our infrastructure revenue performance as always reflects product cycle dynamics.
With a strong launch of our <unk> earlier this year.
Infrastructure revenue performance will be above the model level for the year.
And that's before the five to six points from sales to kindred.
We expect infrastructure pretax margin in the mid teens.
Looking specifically at the fourth quarter, we expect all in constant currency revenue growth at the high end of the mid single digit range.
At current spot rates currency translation has increased to an eight to nine point headwind to revenue growth in the fourth quarter, that's up two to three points from 90 days ago.
And then I'll remind you in a couple of weeks, we will reach the anniversary of our separation of kindred.
While the external sales to kindred will remain in our revenue and profit base, we've essentially wrapped around a year to year contribution to our revenue and profit growth and margin expansion.
As we entered the fourth quarter, we look forward to closing out our first calendar year of today's IBM.
As always we will provide a view of 2023 during our fourth quarter earnings report in January .
Patricia 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.
Supplemental information is provided at the end of the presentation.
And 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 two.
Again to ask a question. Please press star one hour.
Our first question will come from Amit <unk>.
With Evercore your line is open.
Thanks for taking my question and a really impressive set of numbers, especially from a revenue perspective over here.
You know I guess arvin, maybe the question is for you, but there's a lot of anxiety I think among investors in the markets in terms of what the macro situation is and what it means for <unk> spending going forward.
I'd love to get your perspective, what are you hearing from your customers as they think about the I T budgets going forward.
How does that look in are they focusing on different things going forward versus what they've done historically from a ibm's portfolio perspective would love to just get a sense of what are you hearing from your customers in aggregate and then if you could be even.
How it is consulting shake up in a more challenging macro environment. It would be really helpful. Because the growth rate. So far there has been well above the long term trends. Thank you.
Okay. Thank you. Thank you both for the comment and those questions.
So let me answer the first part.
How do we feel about revenue and demand going forward.
If you just look at the data going backwards, we see pretty strong demand and we saw double digit growth in Europe double digit growth in Asia and double digit growth in the Americas.
But let me add some color on that as we look forward.
And it is with a couple of contextual elements as you said on your portfolio.
One.
<unk>, we have Oh.
Almost no <unk> business as if almost no like I said, none, but there is the weather business, which has got a little bit of elements.
CNN, but it's tiny.
So.
<unk> second we've done a lot of work over the last three years.
Our portfolio is largely in mission critical areas areas around automation area that are about leveraging AI for enterprise productivity and I think that that productivity team is going to play out over actually not just the remaining part of this year, but for the next half decade, maybe the flow decade.
Color in the Americas, I find a very robust business environment.
Find that most enterprises want to invest yes, leveraging technology to scale their business.
So if I go to Asia, it's very similar very little change from the past I think going into the next few months at least.
In Europe , I think we shouldn't put our head in the sand I think that with the mixture of energy and inflation you can sense that there is some caution creeping into the conversations.
Not in the data and not yet in <unk>.
What we are doing is business, there, but we'd be foolish not to prepare there could be a bit of a.
Downturn in Europe only.
But let me now put all of that back into context, So youre, saying Americas Asia Fine if I get to Europe , Western Europe ballpark, 20% of global GDP. So.
Even if you have a massive impact 5% to 10%, that's a 1% to 2% impact on a global level all in.
Technology is typically 3% to 4% ahead of GDP growth.
Is that still a robust technology environment in there.
Sure.
So I think that's the setup for two parts.
A few questions that are that we are addressing.
With that.
Thank you Amit let's go to the next question. Please Sheila.
Thank you. Our next question will come from Toni <unk> with Bernstein. Your line is open.
Yes. Thank you.
You saw really strong strength in mainframe, which I think was not.
Anticipated 90 days ago, and you also saw really commensurate Lees strong track.
<unk> processing quarter, and I'm wondering whether you SaaS.
Some strong elas in the quarter and maybe you could put that in context in terms of what percentage was in transaction processing.
And then separately Arvind given how strong the cycle is and given your comments about Europe are you still comfortable about.
Delivering mid single digit growth in 2023, thank you.
Okay. Tony This is Jim I'll take the first part of the question Arvind.
Wrap up about our portfolio and the confidence we have in positioning 2023, when you take a look at our third quarter performance. We're obviously very pleased with the entire IBM team of what we've been able to execute continue to instantiate the value of todays IBM, which is a very focus.
Hybrid cloud and AI platform company, but let's dial back 90 days ago 90 days ago. We said all in we were going to be at high single digit revenue growth.
And we were going to generate about.
200 basis points of operating leverage when you now play that picture of what played out in the third quarter. We are capitalizing on that focused ibm's hybrid cloud AI strategy and capitalizing on the accelerated demand from our clients that <unk> been talked about upfront and we're getting.
Revenue dollar contribution that is falling to the bottom line with regards to profit our profit is up 23%.
Now with that said when you look at the profile of the contribution it was very pervasive and broad based.
It was double digit growth across all three of our major segments and double digit growth across all of our markets around the world and within that software contributed about three points of growth ex Red hat IBM consulting delivered about five points of growth and infrastructure delivered about three points.
Growth to IBM and within infrastructure to your question on on mainframe mainframe basically came in about exactly what we guided to 90 days ago remember, we talked about at length.
First time in 20 years that we announced a mainframe new innovation and a second quarter and how it was going to change the seasonality of that business and we had a very strong second quarter, which by the way we took up revenue guidance in April for wheat.
We talked about 90 days ago, how third quarter was going to play out and fourth quarter and we pretty much executed to that so we feel pretty good about our book of business. So urban turn it over to you. Thanks, Jim attorney to sort of address the questions.
I'll talk to it.
You talked about that we are going to be at a mid single digit revenue growth model and that we will be increasing cash flow each year, and we had set out a target of 10 billion for this year and 35% over the period.
There is nothing that we see right now to alter off from what we had said at that time, so I'm going to say that those projections stay in place.
As Jim pointed out for 2020, do we are saying that we will be above our revenue model and that we believe will play out with the demand that you heard me talk about and then Jim just reinforced.
The middle part of the third quarter is not typically a big quarter. So we suggest rates kind of the normal seasonality Elas are really second and fourth March more than close to Todd.
So just to give you a little bit of color on what you are.
And what Jim said.
Mainframe hardware has had a strong start.
So you would expect the capacity increases.
The capacity increases you expect that to follow with a tiny lag sometimes a month, sometimes three months into our transaction processing portfolio.
Why are you kind of see the trends there.
Okay. Thank you Tony Let's go to the next question. Please.
Our next question comes from <unk> Mohan with Bank of America. Your line is open.
Yes, Thank you and congrats on the solid results.
Arvind can you talk about what youre seeing in the more transactional parts of the business in the context of particularly Q4, which is your largest transactional quarter any change in pipeline or conversion rates up that pipeline.
Any color there would be helpful.
If I could maybe Jim on the cumulative free cash flow that you guys just indoors.
How should we think about the step up in cash flow and what would be the key drivers of that outside of the top line growth conversion what are the other moving pieces that would help in bridging that gap. Thank you so much.
So obviously, let me start and then give it to Jim.
Multi going to reinforce a couple of points that Jim made in his prepared remarks.
On transactional business look I can't speak to the yield I can speak to the yield about 10 weeks from now.
So you deal with government over the next 10 weeks as opposed to right now.
If I look at our pipeline our pipeline indicates this trend that we're seeing that is what gave us confidence to say that we see revenue coming in above our mid single digit growth model.
We see the pipelines are strong across our software and hardware.
So the very strong hardware growth in the.
Third quarter that is captured in the infrastructure business I think that all reflects the demand that is there and across geographies. So not any particular.
As a single market being strong.
If I look at the software.
I expect that the overall growth will remain strong.
Some puts and takes in a couple of small countries as possible.
Is the advantage of having a business that goes across a 170 countries.
Tends to get absorbed into the overall right now I'll tell you what pipelines.
Based on the first nine months of the year, we expect yields to remain.
Good.
Even better than before and that's in this space.
And I'll, just make a comment I would like to.
Say as Jim pointed out in his prepared remarks.
That there is an impact on FX that is probably the biggest impact to what we're seeing right now.
Certainly I'll say hope that we are seeing the end of the dollar strengthening as opposed to another significant change yeah. So.
<unk> to that point as you know our two key measures of success since Arvin is taken over as chairman and CEO has been revenue growth profile converting this portfolio into a sustainable.
Growth orientation, and second free cash flow generation. So we can have the financial flexibility to continue investing in our business and on that we said maintaining guidance of about 10 billion I'll I'll remind everyone that $10 billion is up over $3 billion year to year first and it's up.
$2 billion from what we published as Ibm's post separation baseline when you normalize out all the Kindle related activity.
So as we spoke about in urban just kind of concluded before he turned over to me 90 days ago. This takes into account the external headwinds we've been talking about this year, one being the orderly wind down and the exit of our Russia business, which were already taken into account, we've been transforming our business and cost structure to take into account losing that.
High value prop.
Profit and cash and second is the continuous strengthening of the U S. Dollar now the ladder, let's be honest it definitely puts pressure on our mid term outlook, but we're three quarters into that mid term outlook right. Now we do have a robust hedging program because we are not immune I mean, we do business and all.
70 countries around the world over 100 currencies as we talked about 90 days ago, we do not hedge.
100% of our currencies and second we don't hedge out more than 12 months very important point. So currency has a real impact of profit and cash overall now we hedge to provide us.
Time to take the operational actions that price that sourcing strategies, that's cost structure and the productivity initiatives at urban and I have put within the business. So right now it's early in this midterm.
Outlook, we've got a headwind on the U S dollar until it stabilizes we are taking the appropriate actions, but let's be honest. We are all focused on completing 2022, we have a very big fourth quarter in front of US we've gotta do roughly $6 billion of free cash.
<unk> in the quarter, it's about 60% of our free cash flow by the way to put that in perspective from 2017 to 2020, we did at or better than $6 billion of free cash flow. So we've got the right portfolio. We've got the right set of operational actions and that's what we're focused on.
Where are we going to get that headwind tailwind one we completed our structural actions. So that's all behind us and we'll continue to get the Kindle tailwind for the next three months second we expect a very solid working capital quarter with regards to the mainframe cycle and the pure volume dynamics or what.
It's happening with our accelerated revenue growth profile and third we're going to continue driving a higher revenue profile get operating cash out of that by driving operating leverage in our business. So that's what our focus is on completing 2022 and we'll talk in January about where we're at and where the <unk>.
Okay.
Let's go to the next question.
Our next question will come from Erik Woodring with Morgan Stanley . Your line is open.
Hey, guys. Thanks for taking my call My question, Congrats on a really nice quarter here.
I wanted to talk about the consulting business.
I thought margins held up better than expected in the quarter. So can you maybe just elaborate on where you found success repricing contracts, where you've maybe had some challenges.
By end market or by geography.
Are those pricing increases keeping pace with dollar strength.
If you could just double click on some of the pricing actions and the success that you're having and where and why and how.
Yes, Eric Thank you very much I appreciate the question and I appreciate the compliment so I'm sure the entire IBM teams worked extremely hard.
With this quarter well lets talk about consulting.
We talked all year long remember you dial back to January we were talking about what we were seeing in the marketplace about an accelerating demand profile driven by our clients' digital transformations journeys to cloud and that we were going to invest upfront.
Get ahead of that demand profile.
Bolton skills capabilities ecosystems acquisitions, why because consulting plays an integral part to our hybrid cloud thesis is that tip of the spear. It drives the multiplier effect it drags the scale and adoption to our hybrid cloud platform and at polls are IBM technology.
Now with that said when you look at it.
We have an investment profile, coupled with a highly inflationary environment, we've seen pressure on our gross margin level throughout the year, but we've been making that up on an operating pre tax margin because consulting along with our infrastructure and software are yielding the benefits some of them much more.
Focused streamlined G&A structure now post separation of kindred and a much more effective and aligned streamlined go to market model, that's playing out but when you look at it <unk> year to date, our revenue profile is growing high teens, we're getting dollar contribution in <unk>.
We're seeing <unk> year to date about 30 basis points worth of margin now as I said in the prepared remarks, we talked about three core actions throughout the year.
Acquisitions utilization price and around those we saw green shoots exiting third quarter, our acquisitions right now run a steady state where they're going to be margin accretive in the fourth quarter.
Second we exited the quarter in a pretty challenging seasonal quarter of the third quarter with higher utilization. So that's a great sign.
And third for the second quarter ROE, we got price optimization and price margins at a rock that has led to our sequential improvement in margins from two Q3, Q by three points and by the way we expect that to continue in the fourth quarter margins up sequentially and year to year.
And that price optimization really as you would expect always translates back into the value proposition of your offerings, where we have value in application modernization red hat, our hyper scaler in strategic partnerships, we're seeing a nice margin.
And that's playing out and that's going to fuel the fourth quarter here and first half of 2023.
Thanks, Eric Let's go to the next question. Please.
Our next question comes from Shannon Cross with Credit Suisse. Your line is open.
Alright. Thank you very much for taking my question I'm curious just from an acquisition perspective, you talked about the small acquisitions you've made during the year.
How are you thinking about maybe a larger acquisition, it's been awhile since obviously did red hat.
And almost more importantly, I'm wondering as you think about your capital allocation and I know you've committed.
So what you you know the $10 billion for next year, but how do you how does the higher interest rate environment play into how youre thinking about what you might do and how you expect your balance sheet kind of longer term basis. Thank you.
Shannon, let me start by this thing.
First let me explain.
<unk> and our principles for acquisitions, because it's important to understand that it's not so much size.
Number one they've got to fit our strategy, our strategy being hybrid cloud and AI.
And in consulting doors, which add to our ecosystem.
Growth and autonomy.
So that limits the universe of what we would look at to assess.
Especially if it's going to be larger it's got to be accretive whether we talk about at the end of the first year are definitely in the second year, it's got to be accretive to cash flow.
There's got to be synergy with IBM.
Hi, Jim mentioned about $6 billion.
Since to date signings.
<unk> thousand 800 projects that consulting did with red hat that synergy, meaning that we would not have gotten that revenue and that book of business.
If we had not done that acquisition.
If I say that those are criteria those would be criteria that would open up if there is something that is larger with the correct valuation and the correct economic returns for the company.
Now to your point on.
On interest rates certainly interest rates have.
An impact, but we would also like to say that our multiple vehicles on how to raise cash.
Cash because the overall thin flex and we have talked about about $20 billion offense flex over the period, but there are other vehicles, we're also raising cash.
When we add an attractive.
August while the acquisition to come into.
Yeah, No I would just add to the last point on.
The interest rate environment.
As you saw during this year we've been.
Prudent I think in hindsight now, it's always better to be lucky.
And opportunistic because we went out to the market and basically have pre funded all of our requirements for the most part in 2023 already we issued $4 billion of debt in February and just recently in July we issued $3 billion to $5 billion worth of debt.
So we feel pretty good about our capital structure.
2023 is pretty much taken care of which is our largest maturity tower or do you think about $6 $4 billion and then it steps down from there in 2024 and 2025, so we feel pretty good about that.
Thanks, Shannon, let's go to the next question.
Our next question comes from Keith Bachman with BMO. Your line is open.
Hi, many thanks and echo the congratulations.
Strategic correction, Jim I, just wanted to see if you could provide a clarification what was the M&A contribution this quarter and if you could give any distinction on the M&A contribution to the software and then my broader question is.
As relates to going back to services, the signings was down about 2% in constant currency for the quarter.
How do you anticipate signing unfolding and what does that portend for.
Next year's growth, particularly as we look at.
Bumpier economy, particularly in Europe .
So Arvind you mentioned that you're affirming the mid single digit total revenue growth, but if you could just talk a little bit about.
The services business in particular, which I think is.
Perhaps has a bit more risk associated with some of the consulting activities.
In a tougher economic climate. Thank you.
Okay.
Hey, Keith I'll take the front end of this and then arpin can talk about the environment and our services portfolio overall.
Getting right to it.
<unk>.
Inorganic contribution in the quarter to IBM was about one point worth of growth overall.
When you take a look at that we grew six and a half at actual rates roughly 15% at constant currency five points of that being and drove year to year contribution. So read that about end points worth of growth. One point of that came out of acquisitions underneath that it's still about two points in <unk>.
Salting, which we're seeing nice scale of the consulting acquisitions and again as I said on the previous <unk>.
<unk>, we do see margin accretion as we kind of get to a stabilized level of our acquisition and to software.
Basically rounded to zero, it's all organic growth software had a very strong quarter, 14% growth at constant currency about eight points of that being Kendra that is all organic because we wrapped on our turbine imac acquisition, which by the way still has done extremely well.
The currency the or excuse me the inorganic component.
Is pretty much on a sustainable basis right now overall before I turn it over to Arvind, Let's just talk a little bit about what we see underneath signings first of all we.
We still have a we believe a solid book to bill on a trailing 12 months its $1 five and remember that's maintaining a book to bill in excess of one on very strong revenue contribution five consecutive.
Consecutive quarters of double digit growth and year to date, we're up in the high teens overall.
Where do we seeing underneath is I think as I've said many times before all signings are not alike and they all don't translate to revenue the same way when we look at our strong demand, it's driven by application modernization.
T J partnerships by the way the velocity of our strategic partnership signings are up trailing 12 months, almost 25%, 30% and it's about 40% of our business now we're capturing that.
Hat inception to date to $6 6 billion, but it's really the small deal momentum we're seeing the durations of our backlog come down a couple of months because our small deals that's the volume base business for six consecutive quarters in a row.
We've had double digit growth and what does that mean that has high revenue yielding contribution in period and that's what gives us the confidence when we look at that backlog realization and how it plays out for.
For fourth quarter for us to commit the low double digit revenue growth. Okay. Thanks, Jim.
So Keith let me just maybe use the opportunity.
Everybody of what we had talked about as our midterm model, which was sort of the three year model that we had laid out last October .
It said that we expect software to grow in mid single digits, So think 4% to 6%.
And we had said consulting to grow.
And high single digits and.
And we had said that infrastructure will be about flat. This year. It will be a good year, because the product cycle and then probably somewhere in late 'twenty three 'twenty four we will get the flip side of that.
Up from this year.
But then you get into consulting our long term model was not in the in the teens, which it has done this year it wasn't the high single digits.
So the book to bills combined with the shorter term signings gives us confidence that we will be able to maintain that model.
Look I think consulting to the point I think we're all trying to ask the nature of our consulting business is very different than some others.
The bulk of our consulting business is digital transformation, helping our clients move to cloud.
Our cloud Bot, AWS and Azure amongst it it's on properties that I think are fairly essential to our clients.
SAP.
CRM.
It'll be a great. Examples as you begin to wrap around help them move to cloud both public and hybrid.
Have them do digital transformation.
And take advantage of these massive productivity SaaS properties that I just named.
Even in the inflationary environment, even when the economy is not doing well these tend to be the projects that stay the course.
Maybe the signings come in smaller chunks and as long as we de lever well when people tend to sign up for more and more going forward and that sort of a bit of color on what we've seen play out already this year and we expect that to maybe increase next year.
Thank you Keith let's take one last question.
Our last question will come from David Grossman with Stifel. Your line is open.
Thank you. Thanks for squeezing me in I know, we've covered a lot of ground already.
Jim you've done a very good job of.
Summarizing how you get to that $10 billion of free cash flow for the year.
I was wondering if I could just follow up one thing up there the last quarter I think you talked about five to 700 million dollar of structural actions I think in the 2022 free cash flow guide if I'm over on the right, which should not reoccur and I think we need to add to that.
Exit from Russia, and FX. Okay. Thank you highlighted both however, any chance you could help dimension those last two items. So we could get just a.
Better baseline going into next year.
Yes, David Thank you and thanks for the complements really goes out to the entire <unk>.
B M team overall.
When you take a look at our free cash flow posture, one I think we have quantified back in.
Earlier this year in April about our Russia business orderly wind down right decision unfortunate humanitarian crisis that continues right now, but that was about a $300 million revenue profile in about a $200 million profit and cash profile overall as I said, yes, that's been an impact.
This year, which is one of the reasons why we went down to about $10 billion as we stated but again, we've been taking knowing that decision we've been taken the right operational actions to drive the productivity knowing that 'twenty three 'twenty four we won't have that.
So that's point number one point number two the structural actions, yes, north of $500 million, it's behind US. This year remember that becomes a tailwind in 2023 and 2024, that's why I've said multiple times before.
Free cash flow is not going to be linear when we look at 2022 2023 2024 one.
Have the wrap on that in 'twenty, three plus second the exit costs of getting rid of that stranded costs you get ROI on that activity overall.
The big wildcard.
Wildcard if you want to use it is what's going to happen to the U S dollar.
Now you see what's happened to us this year.
This year third quarter, let's put it in perspective as I said.
A little over eight point gap.
Between constant currency and actual rates as you've seen in our in our backup charts. It's about a $1 1 billion dollar revenue by the way that's about a 15 cent profit and EPS impact in the quarter that we've had to overcome operationally.
Now that again will continue to the extent the U S. Dollar doesn't devalue over time, we are taking the appropriate measures were running our scenario models or stress testing our business. We've got a long path into 23, and 24, but it's going to come from the action.
I talked about price.
Sourcing.
In cost structure each of those pieces are going to have to overcome that and the beauty of our hedging program is it buys us time to smooth out the volatility of earnings right. Now. So we are focused on that we'll talk a lot more about where we see the U S. Dollar 90 days ago from now and what that means for 2023 cash is.
Go forward now one last thing I wanted to I want to put in place that fourth quarter cash.
It's very important that $6 billion give or take in us delivering that about $10 billion that is going to come out predominantly out of our operational profit driven by one.
Revenue growth at high at the high end of our model all in by the way anniversary of Kindred, We got two more weeks and we anniversary that that is offset by basically Watson health. So all in high single digit model is a good representation of today's IBM second.
We expect two five points of operating margin in the fourth quarter.
Why is that important yes, it's going to deliver that free cash flow in the fourth quarter, but it also gives the investor perspective, now that we're basically anniversarying the year to year contribution of Kendra you see the healthy operating leverage at this portfolio now that we reposition can deliver.
That I will turn it back over to Patricia.
Yes.
Thanks, Jim and I think Jim gave you all a lot of color and these Q&A on cash flow the quarter and how we think of our business going forward. Let me just wrap up the call.
We have made really good progress since we laid out our strategy.
In our Investor Day last October .
We are well positioned to meet our client needs going into the end of the year.
And we look forward to taking you through our fourth quarter performance.
And our view of 2023 in January .
I look forward to speaking to all of you again soon.
Let's turn it back over to you to close out 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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