Q2 2024 International Business Machines Corp Earnings Call
Welcome and thank you for standing by.
Operator: At this time, all participants are in a listen-only mode. Today's conference is being recorded, have any objections, you may disconnect at the, Now I will turn the meeting over to Olympia McNerney, IBM's Global Head of Investor Relations. Olympia, you may begin. Thank you.
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 Olympia McNerney, IBM's Global Head of Investor Relations. Olympia, you may begin.
Olympia Mcnerney: I'd like to welcome you to IBM's second quarter 2024 earnings presentation. I'm Olympia McNerney, and I'm here today with Arvind Krishna, IBM's Chairman and Chief Executive Officer, and Jim Kavanaugh, IBM's Senior Vice President and Chief Financial Officer. We'll post today's prepared remarks on the IBM Investor website within a couple of hours, and a replay will be available by this time tomorrow. To provide additional information to our investors, our presentation includes certain non-GAAP measures.
Thank you. I'd like to welcome you to IBM's second quarter 2024 earnings presentation. I'm Olympia McNerney, and I'm here today with Arvind Krishna, IBM's Chairman and Chief Executive Officer, and Jim Kavanaugh, IBM's Senior Vice President and Chief Financial Officer.
Olympia Mcnerney: For example, all of our references to revenue and signings growth are at constant current rates. We provided reconciliation charts for these and other non-GAAP financial 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 filing. So with that, I'll turn the call over to Arvind.
Speaker Change: 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.
Speaker Change: To provide additional information to our investors, our presentation includes certain non-GAAP measures. For example, all of our references to revenue and signings growth are at constant currency.
Speaker Change: We provided reconciliation charts for these and other non-GAAP financial measures at the end of the presentation, which is posted to our investor website.
Speaker Change: Finally, some comments made in this presentation may be considered forward-looking under the Private Securities Litigation Reform Act of 1995.
Speaker Change: 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.
Arvind Krishna: Thank you for joining us today to discuss IBM's second quarter earnings. We delivered a strong quarter, exceeding our expectations, driven by solid revenue growth, profitability, and cash flow generation. We had strong performance in software and infrastructure above our model, as investment in innovation is yielding organic growth, while consulting remained below our model. Our results underscore the continued success of our hybrid cloud and AI strategy and the strength of our diversified business. Let me start with a few comments on the macroeconomic environment.
Arvind Krishna: Thank you for joining us today to discuss IBM's second quarter earnings. We delivered a strong quarter, exceeding our expectations, driven by solid revenue growth, profitability, and cash flow generation.
Arvind Krishna: We had strong performance in software and infrastructure above our model, as investment in innovation is yielding organic growth, while consulting remained below model.
Arvind Krishna: Our results underscore the continued success of our hybrid cloud and AI strategy and the strength of our diversified business.
Arvind Krishna: Technology spending remains robust as it continues to serve as a key comparative advantage, allowing businesses to scale, drive efficiencies, and fuel growth. However, as we stated last quarter, factors such as interest rates and inflation impacted the timing of decision-making and discretionary spend on consulting.
Speaker Change: Let me start with a few comments on the macroeconomic environment. Technology spending remains robust, as it continues to serve as a key comparative advantage allowing businesses to scale, drive efficiencies, and fuel growth.
Speaker Change: As we stated last quarter, factors such as interest rates and inflation impacted timing of decision making and discretionary spend in consulting.
Arvind Krishna: Overall, we remain confident in the positive macro outlook for technology spending but acknowledge this impact. It has been a year since we introduced Watson X and our generative AI strategy to the market. We have infused AI across the business, for the tools clients use to manage and optimize their hybrid cloud environment, to our platform products across dot AI, dot data, and dot gov, to infrastructure and consulting. You can find AI innovation in all of our segments.
Speaker Change: Overall, we remain confident in the positive macro outlook for technology spending, but acknowledge this impact.
Speaker Change: It has been a year since we introduced Watson X and our generative AI strategy to the market.
Speaker Change: We have infused AI across the business, from the tools clients use to manage and optimize their hybrid cloud environments, to our platform products across .ai, .data, and .gov, to infrastructure and consulting, you can find AI innovation in all of our segments.
Arvind Krishna: For example, in software, a broad suite of automation products like Aptio and Watson X Orchestrate are leveraging AI, and we expect to do the same with HashiCorp once the acquisition is complete. Red Hat is bringing AI to OpenShift AI and RHEL.AI. In Transaction Processing, we are seeing early momentum in Watson X Code Assistant for Z. In infrastructure, IBM Z is equipped with real-time AI inferencing capability, and consulting experts are helping clients design and implement AI strategies.
Speaker Change: For example, in software, a broad suite of automation products like Aptio and Watson X Orchestrate are leveraging AI, and we expect to do the same with HashiCorp once the acquisition is complete.
Speaker Change: Red Hat is bringing AI to OpenShift AI and REL.AI.
Speaker Change: In Transaction Processing, we are seeing early momentum in Watson X Code Assistant for Z.
Speaker Change: In infrastructure, IBM Z is equipped with real-time AI inferencing capabilities. In consulting, our experts are helping clients design and implement AI strategies.
Arvind Krishna: Our enterprise AI strategy is responding as we evolve to meet client needs. Let me start by discussing IBM models. Choosing the right AI model is crucial for success in scaling AI. While large general purpose models are great for starting on AI use cases, clients are finding that smaller models are essential for a cost-effective AI strategy. Smaller models are also much easier to customize and tune.
Speaker Change: Our enterprise AI strategy is resonating as we evolve to meet client needs. Let me start by discussing IBM models.
Speaker Change: Choosing the right AI model is crucial for success in scaling AI. While large general-purpose models are great for starting on AI use cases, clients are finding that smaller models are essential for cost-effective AI strategies.
Speaker Change: Smaller models are also much easier to customize and tune.
Arvind Krishna: IBM's Granite models, ranging from 3 billion to 34 billion parameters and trained on 116 programming languages, consistently achieve top performance for a variety of coding tasks. To put cost in perspective, these fit-for-purpose models can be approximately 90% less expensive than large models. Hybrid cloud remains the top priority for clients as the flexibility of deployment of AI models across multiple environments and data sovereignty remain a key focus. We believe in the power of open innovation, and recently announced at IBM Think that we open sourced IBM's Granite family of models, now available under Apache 2.0 licenses on both Hugging Face and GitHub.
Speaker Change: IBM's Granite models, ranging from 3 billion to 34 billion parameters, and trained on 116 programming languages, consistently achieve top performance for a variety of coding tasks.
Speaker Change: To put cost in perspective, these fit-for-purpose models can be approximately 90% less expensive than large models.
Speaker Change: Hybrid cloud remains a top priority for clients as flexibility of deployment of AI models across multiple environments and data sovereignty remain a key focus.
Speaker Change: We believe in the power of open innovation, and recently announced at IBM Think that we open-sourced IBM's Granite family of models, now available under Apache 2.0 licenses on both Hugging Face and GitHub.
Arvind Krishna: We see Parallels to Linux becoming dominant in the enterprise server space, thanks to the speed and innovation offered by open source. We are confident that the same dynamics will play out with AI as we benefit from developer mindshare and community innovation. We also recently launched InstructLab, a tool for more rapid model tuning through synthetic data generation, allowing our clients to more efficiently customize models using their own data and expertise.
Speaker Change: We see Parallels to Linux becoming dominant in the enterprise server space, thanks to the speed and innovation offered by open source.
Speaker Change: We are confident that the same dynamics will play out with AI as we benefit from developer mindshare and community innovation.
Speaker Change: We also recently launched InstructLab, a tool for more rapid model tuning through synthetic data generation, allowing our clients to more efficiently customize models using their own data and expertise.
Arvind Krishna: The last 12 months of AI pilots have made it clear that sustained value from AI requires truly leveraging enterprise data. In summary, our AI strategy is a comprehensive platform play. Rail.ai and OpenShift AI are the foundation of our enterprise AI platform. They combine open source IBM Granite LLMs and InstructLab model alignment tools with full stack optimization, enterprise-grade security, and support, and Moral Indemnification.
Speaker Change: The last 12 months of AI pilots has made it clear that sustained value from AI requires truly leveraging enterprise data.
Speaker Change: In summary, our AI strategy is a comprehensive platform play.
Speaker Change: RHEL.AI and OpenShift AI are the foundation of our enterprise AI platform.
Speaker Change: They combine open-source IBM Granite LLMs and InstructLab model alignment tools with full-stack optimization, enterprise-grade security and support, and model indemnification.
Arvind Krishna: On top of that, we have an enterprise AI middleware platform with Watson X, and an embed strategy with our AI assistance infused through our software portfolio and those of our ecosystem partners. In addition, our consulting services are critical in helping clients build their AI strategies from the ground up. We also continue to see our infrastructure segment play a larger role as clients leverage their hardware investments in their AI strategy. Our book of business related to generative AI now stands at greater than $2 billion from inception to date. The mix is roughly one-quarter software and three-quarters consulting services.
Speaker Change: On top of that, we have an enterprise AI middleware platform with Watson X and an embed strategy with our AI assistance infused through our software portfolio and those of our ecosystem partners.
Speaker Change: In addition, our consulting services are critical in helping clients build their AI strategies from the ground up. We also continue to see our infrastructure segment play a larger role as clients leverage their hardware investments in their AI strategies.
Speaker Change: Our book of business related to generative AI now stands at greater than two billion dollars inception to date. The mix is roughly one quarter software and three quarters consulting signings.
Arvind Krishna: We believe these strong results highlight our momentum and traction with clients. Our early leadership positions us for long-term success with this transformational technology, which is still in the initial stages of adoption. As clients build out AI strategies, the IT landscape is becoming increasingly complex. Labor demographic shifts further emphasize the importance of optimizing IT spend and automating business processes.
Speaker Change: We believe these strong results highlight our momentum and traction with clients. Our early leadership positions us for long-term success and this transformational technology which is still in the initial stages of adoption.
Speaker Change: As clients build out AI strategies, the IT landscape is becoming increasingly complex.
Speaker Change: Labor demographic shifts further emphasize the importance of optimizing IT spend and automating business processes.
Arvind Krishna: We continue to innovate and invest and have created a leading automation portfolio to capture this opportunity, which you can see in our results. This includes aptitude for cost management, capabilities for observability and resource management, and, with the announced acquisition of HashiCorp, the automation of cloud infrastructure. The powerful combination of Red Hat Ansible and Terraform will simplify provisioning and configuration of applications across hybrid cloud environments.
Speaker Change: We continue to innovate and invest, and have created a leading automation portfolio to capture this opportunity, which you can see in our results.
Speaker Change: This includes Aptio for cost management, Capabilities for observability and resource management, and with the announced acquisition of HashiCorp, the automation of cloud infrastructure.
Speaker Change: The powerful combination of Red Hat's Ansible and Terraform will simplify provisioning and configuration of applications across hybrid cloud environments.
Arvind Krishna: The latest addition to this portfolio is IBM Concert, also announced I think, a Gen AI power tool that helps clients get end-to-end visibility across business applications. We also recently completed the acquisition of the StreamSets and WebMethod assets from Software AG. This acquisition brings together leading capabilities in integration, API management, and data ingestion. Let me now spend a minute on the continued strength we are seeing in infrastructure. IBM Z, our mainframe solution, is an integral part of our client's hybrid cloud environments, driving their most secure and mission-critical workloads.
Speaker Change: The latest addition to this portfolio is IBM Concert, also announced at Think, a Gen AI-powered tool which helps clients get end-to-end visibility across business applications.
Speaker Change: We also recently completed the acquisition of the StreamSets and WebMethods assets from SoftwareAG. This acquisition brings together leading capabilities in integration, API management, and data ingestion.
Speaker Change: Let me now spend a minute on the continued strength we are seeing in infrastructure. IBM Z, our mainframe solution, is an integral part of our clients' hybrid cloud environments, driving their most secure and mission-critical workloads.
Arvind Krishna: Our latest cycle Z16 is uniquely tailored to offer client security, Scalability, and Resilience, which help clients address both cybersecurity threats and complex regulatory requirements. The Z16 Stellum processor is a unique differentiator, driving real-time, inline AI inferencing at unprecedented speed and scale for applications like real-time fraud detection.
Speaker Change: Our latest cycle, Z16, is uniquely tailored to offer clients security, scalability, and resilience, which help clients address both cybersecurity threats and complex regulatory requirements.
Speaker Change: Z16 Stellum processor is a unique differentiator, driving real-time, inline AI inferencing at unprecedented speed and scale for applications like real-time fraud detection.
Arvind Krishna: Our storage offerings are also benefiting from generative AI as clients address data readiness and need high-speed access to massive volumes of unstructured data. We continue to invest in innovation and make great progress in emerging technologies like quantum computing. This quarter, we expanded Qiskit, IBM's quantum computing software, into a comprehensive stack aimed at optimizing performance on utility-scale quantum hardware. These updates aim to enhance the stability, efficiency, and usability of Qiskit, supporting advanced quantum algorithm development and fostering broader adoption across various industries.
Speaker Change: Our storage offerings are also benefiting from generative AI, as clients address data readiness and need high-speed access to massive volumes of unstructured data.
Speaker Change: We continue to invest in innovation and make great progress in emerging technology like quantum computing. This quarter we expanded Qiskit, IBM's quantum computing software, into a comprehensive stack aimed at optimizing performance on utility-scale quantum hardware.
Speaker Change: These updates aim to enhance the stability, efficiency, and usability of Qiskit, supporting advanced quantum algorithm development and fostering broader adoption across various industries.
Arvind Krishna: The strong momentum and innovation across the portfolio manifests itself in client adoption. In virtually all industries and geographies, clients leverage IBM solutions to help them transform their operations and create better experiences for end users. Names like Virgin Money, Credit Mutual, and Panasonic all turned to IBM in the quarter.
Speaker Change: The strong momentum and innovation across the portfolio manifests itself in client adoption.
Speaker Change: In virtually all industries and geographies, clients leverage IBM's solutions to help them transform their operations and create better experiences for end users.
Speaker Change: Names like Virgin Money, Credit Mutual, and Panasonic all turned to IBM in the quarter. We also continue to strengthen our ecosystem.
Arvind Krishna: We also continue to strengthen our ecosystem. At our Think event, we announce a series of new AI partnerships with industry leaders like Adobe, AWS, Microsoft, Meta, Mistral, Salesforce, and SAP. In May, IBM and Palo Alto Networks announced a partnership to deliver AI-powered security solutions using Watson X.
Speaker Change: At our Think event, we announced a series of new AI partnerships with industry leaders like Adobe, AWS, Microsoft, Meta, Mistral, Salesforce, and SAP.
Speaker Change: In May, IBM and Palo Alto Networks announced a partnership to deliver AI-powered security solutions using Watson X.
Arvind Krishna: As part of this, Palo Alto is acquiring IBM's QRadar SaaS assets, and we are partnering to offer a seamless migration for QRadar customers to XM. IBM will train over 1000 security consultants on Palo Alto Networks products to drive a significant book of business with them. In summary, we are excited to continue delivering strong results. Given our first-half performance, we are raising our expectations for free cash flow to greater than $12 billion for the year. I will now hand it over to Jim to walk you through the details of the quarter. Jim, it's over to you.
Speaker Change: As part of this, Palo Alto is acquiring IBM's QRadar SaaS assets, and we are partnering to offer seamless migration for QRadar customers to XM.
Speaker Change: IBM will train over a thousand security consultants on Palo Alto Network products to drive a significant book of business with them.
Speaker Change: In summary, we are excited to continue delivering strong results. Given our first-half performance, we are raising our expectations for free cash flow to greater than $12 billion for the year.
Speaker Change: I will now hand over to Jim to walk you through the details of the quarter. Jim, over to you.
James J. Kavanaugh: Thanks, Arvind. In the second quarter, we delivered $15.8 billion in revenue. $2.8 billion of operating pre-tax income and $2.43 operating diluted earnings per share, 4% revenue growth at constant currency combined with greater than 200 basis points of operating pre-tax margin expansion drove 17% operating pre-tax income growth and 11% operating diluted earnings per share growth, highlighting our strong execution. And through the first half, we generated four and a half billion dollars of free cash. Our Free Castle Generation is the strongest first half level we have reported in many years.
James J. Kavanaugh: Thanks, Arvind. In the second quarter, we delivered $15.8 billion in revenue, $2.8 billion of operating pre-tax income, and $2.43 operating diluted earnings per share.
James J. Kavanaugh: Our 4% revenue growth at constant currency, combined with greater than 200 basis points of operating pre-tax margin expansion, drove 17% operating pre-tax income growth and 11% operating diluted earnings per share growth.
James J. Kavanaugh: Highlighting our strong execution.
James J. Kavanaugh: And through the first half, we generated $4.5 billion of free cash flow.
James J. Kavanaugh: Our free cash flow generation is the strongest first half level we have reported in many years. We are pleased with these results, exceeding our expectations for revenue, profitability, free cash flow, and earnings per share.
James J. Kavanaugh: We are pleased with these results, exceeding our expectations for revenue, profitability, free cash flow, and earnings per share. Revenue growth was led by software and infrastructure. It is clear that our investments in innovation are yielding results and driving strong organic growth across these segments. Software grew by 8% with solid growth across hybrid platform and solutions and transaction processing and strong transactional performance. Infrastructure had great performance, up 3%, delivering growth across IBM Z and distributed infrastructure. Consulting was up 2% and continued to be impacted by a pullback in discretionary spending.
James J. Kavanaugh: Revenue growth was led by software and infrastructure. It is clear that our investments in innovation are yielding results and driving strong organic growth across these segments.
James J. Kavanaugh: Software grew by 8% with solid growth across hybrid platform and solutions and transaction processing and strong transactional performance.
James J. Kavanaugh: Infrastructure had great performance, up 3%, delivering growth across IBM Z and distributed infrastructure.
James J. Kavanaugh: Consulting was up 2% and continued to be impacted by a pullback in discretionary spending.
James J. Kavanaugh: Looking at our profit metrics, we expanded operating gross margin by 190 basis points and operating pre-tax margin by 220 basis points over the last year, inclusive of about a 30 basis point currency headwind on pre-tax margin. Margin expansion was driven by our operating leverage, product mix, and ongoing productivity in this. Driving productivity is core to our operating and financial model. This includes enabling a higher-value workforce through automation and AI, streamlining our supply chain, aligning our teams by workflow, and reducing our real estate footprint. These actions allow for continuing investment in innovation, with R&D up 9% in the first half.
James J. Kavanaugh: Looking at our profit metrics, we expanded operating gross margin by 190 basis points and operating pre-tax margin by 220 basis points over the last year.
James J. Kavanaugh: Inclusive of about a 30 basis point currency headwind to pre-tax margin.
James J. Kavanaugh: Margin expansion was driven by our operating leverage, product mix, and ongoing productivity initiatives.
James J. Kavanaugh: Driving productivity is core to our operating and financial model. This includes enabling a higher value workforce through automation and AI, streamlining our supply chain, aligning our teams by workflow, and reducing our real estate footprint.
James J. Kavanaugh: These actions allowed for continuing investment in innovation, with R&D up 9% in the first half.
James J. Kavanaugh: This includes investments in both AI and hybrid cloud, as well as infrastructure ahead of our next seed program in 2025, which we expect to accelerate our organic growth profile over time. Our results this quarter reflect broad-based growth and the strength in the fundamentals of our business, with revenue up about $300 million, operating pre-tax income up about $400 million, adjusted EBITDA up more than $350 million, and free cash flow up about $500 million.
James J. Kavanaugh: This includes investments in both AI and hybrid cloud, as well as infrastructure ahead of our NextSea program in 2025, which we expect to accelerate our organic growth profile over time.
James J. Kavanaugh: Our results this quarter reflect broad-based growth and the strength in the fundamentals of our business.
James J. Kavanaugh: With revenue up about $300 million, operating pre-tax income up about $400 million, adjusted EBITDA up more than $350 million, and free cash flow up about $500 million.
James J. Kavanaugh: For the first half, we generated $4.5 billion of free cash, up 1.1 billion dollars year over year. The largest driver of this first-half growth comes from adjusted EBITDA, up about $550 million year-over-year, and timing of CapEx. We are a few points ahead of our two-year average attainment levels through the first half. In terms of cash usage, we returned $3.1 billion to shareholders in the first half in the form of dividends. From a balance sheet perspective, we have a very strong liquidity position with cash at $16 billion, up $2.5 billion since year-end 2023. Our debt balance at the end of the second quarter was flat, with year-end 2023 at $56.5 billion, including $11.1 billion from our financing budget.
James J. Kavanaugh: For the first half, we generated $4.5 billion of free cash flow.
James J. Kavanaugh: Up 1.1 billion dollars year over year.
James J. Kavanaugh: The largest driver of this first-half growth comes from adjusted EBITDA, up about $550 million year-over-year, and timing of CapEx.
James J. Kavanaugh: We are a few points ahead of our two-year average attainment levels through the first half.
James J. Kavanaugh: In terms of cash uses, we returned $3.1 billion to shareholders in the first half in the form of dividends.
James J. Kavanaugh: From a balance sheet perspective, we have a very strong liquidity position, with cash at $16 billion, up $2.5 billion since year-end 2023.
James J. Kavanaugh: Our debt balance at the end of the second quarter was flat, with year-end 2023 at $56.5 billion, including $11.1 billion from our financing business.
James J. Kavanaugh: Putting this all together, our business fundamentals remain solid with continued revenue growth, margin expansion, cash generation, and a strong balance sheet with financial flexibility to support our business. Turning to the segment,
James J. Kavanaugh: Putting this all together...
James J. Kavanaugh: Our business fundamentals remain solid with continued revenue growth, margin expansion, cash generation, and a strong balance sheet with financial flexibility to support our business.
James J. Kavanaugh: Software revenue growth accelerated to 8% this quarter; both hybrid platform and solutions and transaction processing grew as clients leveraged the capabilities of our AI and hybrid cloud platform. This performance reflects the investments we've been making in software, both organically, which drove more than six points of the growth, as well as acquisitions. As mentioned in January, the software revenue growth drivers for the year include Red Hat Growth, the combination of innovation, recurring revenue, and transaction processing, as well as acquisition. Let me spend a minute on each of these elements in Red Hat.
James J. Kavanaugh: Turning to the segments, software revenue growth accelerated to 8% this quarter.
James J. Kavanaugh: Both hybrid platform and solutions and transaction processing grew as clients leveraged the capabilities of our AI and hybrid cloud platforms.
James J. Kavanaugh: This performance reflects the investments we've been making in software, both organically, which drove more than six points of the growth, as well as acquisitions.
James J. Kavanaugh: As mentioned in January , the software revenue growth drivers for the year include Red Hat Growth, the combination of Innovation, Recurring Revenue, and Transaction Processing, as well as Acquisitions.
James J. Kavanaugh: Annual bookings growth accelerated to over 20% this quarter. Within that performance, OpenShift annual bookings were up over 40%, and RHEL and Ansible growth was double-digit. The strength reflects the demand for our hybrid cloud solutions, including app modernization, management automation, generative AI, and virtualization, in a subscription-based business. The majority of revenue is under contract for the next two quarters. Think of it as our CRPO for the next six months.
James J. Kavanaugh: Let me spend a minute on each of these elements.
James J. Kavanaugh: In Red Hat, annual bookings growth accelerated to over 20% this quarter.
James J. Kavanaugh: Within that performance, OpenShift annual bookings were up over 40%, and RHEL and Ansible growth was double-digit.
James J. Kavanaugh: The strength reflects the demand for our hybrid cloud solutions, including app modernization, management automation, generative AI, and virtualization.
James J. Kavanaugh: In a subscription-based business, the majority of revenue is under contract for the next two quarters.
James J. Kavanaugh: Think of it as our CRPO for the next six months.
James J. Kavanaugh: This metric is growing in the mid-teens and accelerating more than five points versus the first half of the year. We continue to bring new innovation to our portfolio, and it's contributing nicely to our software performance. Our new innovation includes generative AI offerings like Watson X or AI middleware. What's the next assistant?
James J. Kavanaugh: This metric is growing in the mid-teens and accelerating more than five points versus the first half of the year.
James J. Kavanaugh: We continue to bring new innovation to our portfolio, and it's contributing nicely to our software performance.
James J. Kavanaugh: Our new innovation includes generative AI offerings like Watson X, our AI middleware, Watson X assistance, the recently announced IBM concert, and others which contributed about a half a billion dollars to our AI book of business inception to date.
James J. Kavanaugh: the recently announced IBM concert and others, which contributed about a half a billion dollars to our AI book of business from inception to date. And we deliver good growth across our recurring revenue base, which is about 80% of our annual software revenue. This is evident in the hybrid platform and solution, where our ARR is now $14.1 billion and up 9% since last year. Transaction processing delivered 13% revenue growth. This performance demonstrates the innovation and value of our mission-critical hardware stack across IBM Z, power, and storage.
James J. Kavanaugh: And we deliver good growth across our recurring revenue base, which is about 80% of the annual software revenue.
James J. Kavanaugh: This is evident in hybrid platform and solutions, where our ARR is now $14.1 billion and up 9% since last year.
James J. Kavanaugh: Transaction processing delivered 13% revenue growth.
James J. Kavanaugh: This performance demonstrates the innovation and value of our mission-critical hardware stack across IBM Z, power, and storage.
James J. Kavanaugh: The combination of growing demand for capacity, good client renewals, and strong large deal performance fueled our results. And notably, our new generative AI portfolio innovation, Watson X Code Assistant for Z, is responding well with clients. Together, these dynamics contributed to both recurring and transactional software revenue growth again this quarter. Revenue performance this quarter also benefited from our focused M&A strategy, including synergies realized across the portfolio. This included the recent Apti
James J. Kavanaugh: The combination of growing demand for capacity, good client renewals, and strong large deal performance fueled our results.
James J. Kavanaugh: And notably, our new generative AI portfolio innovation, Watson X Code Assistant for Z, is resonating well with clients.
James J. Kavanaugh: Together, these dynamics contributed to both recurring and transactional software revenue growth again this quarter.
James J. Kavanaugh: Revenue performance this quarter also benefited from our focused M&A strategy, including synergies realized across the portfolio.
James J. Kavanaugh: Less than 12 months since closing, we have accelerated annual bookings and are seeing an uptick in ARR growth, already in the mid-teens. The synergy between Appdio's FinOps offerings and our broader automation portfolio helps clients manage, optimize, and automate technology spending decisions. Earlier this month, we completed the acquisition of stream sets and web methods from Software AG, and we expect the HashiCorp acquisition to close by year end.
James J. Kavanaugh: This included the recent Aptio acquisition.
James J. Kavanaugh: Less than 12 months since closing, we have accelerated annual bookings and are seeing an uptick in ARR growth, already in the mid-teens.
James J. Kavanaugh: The synergy between Appdio's FinOps offerings and our broader automation portfolio helps clients manage, optimize, and automate technology spending decisions.
James J. Kavanaugh: Earlier this month, we completed the acquisition of stream sets and web methods from Software AG, and expect the HashiCorp acquisition to close by year-end.
James J. Kavanaugh: Looking at software profit, gross profit margin expanded, and segment profit was up over 350 basis points year to year, with the latter reflecting operating leverage driven by our revenue scale and mix this quarter. Our consulting revenue was up 2%, consistent with last quarter and largely reflecting organic growth. In April, we discussed that we were seeing solid demand for our large transformational offerings as clients continue to prioritize driving productivity with AI and analytics. At the same time, we saw a pullback on discretionary projects as clients prioritized their spending.
James J. Kavanaugh: Looking at software profit, gross profit margin expanded and segment profit was up over 350 basis points year-to-year, with the latter reflecting operating leverage driven by our revenue scale and mix this quarter.
James J. Kavanaugh: Our consulting revenue was up 2%, consistent with last quarter and largely reflecting organic growth.
James J. Kavanaugh: In April , we discussed that we were seeing solid demand for our large transformational offerings as clients continue to prioritize driving productivity with AI and analytics.
James J. Kavanaugh: At the same time, we saw a pullback on discretionary projects as clients prioritized their spending.
James J. Kavanaugh: The second quarter buying behavior played out much in the same way. Signings for the quarter were $5.7 billion, driven by solid demand for large engagements across finance and supply chain transformation, cloud modernization, and application development. This contributed to backlog growth of 5% year-over-year and our trailing 12-month book-to-bill remaining over 1.15. Meanwhile, continued discretionary spending constraints impacted our small engagement performance and backlog realization in the quarter.
James J. Kavanaugh: The second quarter buying behavior played out much in the same way.
James J. Kavanaugh: Signings for the quarter were $5.7 billion, driven by solid demand for large engagements across finance and supply chain transformation, cloud modernization, and application development.
James J. Kavanaugh: This contributed to backlog growth of 5% year-over-year, and our trailing 12-month book-to-bill remaining over 1.15.
James J. Kavanaugh: Meanwhile, continued discretionary spending constraints impacted our small engagement performance and backlog realization in the quarter.
James J. Kavanaugh: As Arvind mentioned, our book of business in generative AI from inception to date is greater than $2 billion, and about three quarters of it represents consulting revenue, with strong quarter-over-quarter momentum. Our extensive industry and domain expertise has placed us in an early leadership role, which is crucial at the onset of a technology shift. IBM has both technology and consulting, which is a unique and powerful combination to help clients navigate this technological transition. Similar to previous technological shifts, such as the advent of the internet, globalization, and cloud computing, generative AI is driving the next wave of growth.
James J. Kavanaugh: As Arvind mentioned, our book of business in generative AI, Inception to Date, is greater than $2 billion, and about three-quarters of it represents consulting signings, with strong quarter-over-quarter momentum.
Arvind Krishna: Our extensive industry and domain expertise has placed us in an early leadership role, which is crucial at the onset of a technology shift.
Speaker Change: IBM has both technology and consulting, which is a unique and powerful combination to help clients navigate this technology transition.
Speaker Change: Similar to previous technology shifts, such as the advent of the Internet, globalization, and cloud computing, generative AI is driving the next wave of growth.
James J. Kavanaugh: In a human capital-based business, signings represent clients reprioritizing spend on this technology transition while there is some potential for lift as the total addressable market expands. We are delivering value in two ways. First, partnering with our clients to design and scale AI solutions, whether that be leveraging the AI capabilities of IBM, our partners, or a combination.
Speaker Change: In a human capital based business, signings represents clients reprioritizing spend on this technology transition while there is some potential for lift as the total addressable market expands.
Speaker Change: We are delivering value in two ways.
Speaker Change: First, partnering with our clients to design and scale AI solutions.
Speaker Change: Whether that be leveraging AI capabilities of IBM, our partners, or a combination.
James J. Kavanaugh: Second, we are developing new ways of working, driving productivity, and improving delivery, all with our Consulting Advantage platform. In summary, Gen AI is acting as a catalyst for companies to grow revenues, cut costs, and change the ways they work, creating a significant opportunity for us. We are seeing this already, as IBM is the strategic partner of choice for clients using this technology, including WPP, Elevance Health, and the UK's Department of Work and Pensions.
Speaker Change: Second, we are developing new ways of working, driving productivity and improving delivery, all with our Consulting Advantage platform.
Speaker Change: In summary, Gen AI is acting as a catalyst for companies to grow revenues, cut costs, and change the ways they work, creating a significant opportunity for us.
Speaker Change: We are seeing this already as IBM is the strategic partner of choice for clients using this technology, including WPP,
Speaker Change: Elevance Health, and the UK's Department of Work and Pensions.
James J. Kavanaugh: Turning to our lines of business, business transformation revenue grew 6%, led by finance and supply chain transformation. Data transformation also contributed to growth. In technology consulting, revenue was up 1%.
Speaker Change: Turning to our lines of business, business transformation revenue grew 6%, led by finance and supply chain transformations.
Speaker Change: Data transformation also contributed to growth.
Speaker Change: In technology consulting, revenue was up 1%. Growth was driven by application modernization services.
James J. Kavanaugh: Growth was driven by application modernization services, and application operations revenue declined, reflecting weakness in on-prem, custom application management, partially offset by strength in cloud-based application management offering. Looking at consulting profit, we expanded gross profit margins by 40 basis points, driven by Productivity and Pricing Actions We Have Taken. However, segment profit margin was modestly down, reflecting continued labor inflation and currency.
Speaker Change: Application operations revenue declined, reflecting weakness in on-prem custom application management, partially offset by strength in cloud-based application management offerings.
Speaker Change: Looking at consulting profit, we expanded gross profit margins by 40 basis points, driven by productivity and pricing actions we have taken.
Speaker Change: Segment profit margin was modestly down, reflecting continued labor inflation and currency.
James J. Kavanaugh: Moving to infrastructure, revenue was up 3%. We're capitalizing on the strong and broad-based demand for our hardware platforms, especially IBM Z. Within hybrid infrastructure, IBM Z revenue was up 8% this quarter. We're now more than two years into the Z16 cycle, and the revenue performance continues to outperform prior cycles. Our clients are facing increasing demands for workloads given rapid business expansion, the complex regulatory environment, and increasing cyber security threats and attacks.
Speaker Change: Moving to infrastructure, revenue was up 3%. We're capitalizing on the strong and broad-based demand for our hardware platforms, especially IBM Z.
Speaker Change: Within hybrid infrastructure, IBM's revenue was up 8% this quarter.
Speaker Change: We're now more than two years into the Z16 cycle, and the revenue performance continues to outperform prior cycles.
Speaker Change: Our clients are facing increasing demands for workloads given rapid business expansion, the complex regulatory environment, and increasing cybersecurity threats and attacks.
James J. Kavanaugh: IBM Z addresses these needs with a combination of cloud native development for hybrid cloud, embedded AI at scale, quantum safe security, energy efficiency, and strong reliability and scalability. Increasing workloads translate to more Z-capacity or MIPS, which are up about threefold over the last few cycles. IBM Z remains an enduring platform for mission-critical workloads, driving both hardware and related software, storage, and services adoption. In distributed infrastructure, revenue grew 5%, driven by strength in both power and storage. Power growth was fueled by demand for data-intensive workloads on Power10, led by SAP HANA.
Speaker Change: IBM Z addresses these needs with a combination of cloud-native development for hybrid cloud, embedded AI at scale, quantum safe security, energy efficiency, and strong reliability and scalability.
Speaker Change: Increasing workloads translates to more Z-capacity or MIPS, which are up about three-fold over the last few cycles.
Speaker Change: IBM Z remains an enduring platform for mission-critical workloads.
Speaker Change: Driving both hardware and related software, storage, and services adoption.
Speaker Change: In distributed infrastructure, revenue grew 5% driven by strength in both power and storage.
Speaker Change: Power growth was fueled by demand for data-intensive workloads on Power10, led by SAP HANA.
James J. Kavanaugh: Storage delivered growth again this quarter, including growth in high-end storage tied to the Z16 cycle and solutions tailored to protect, manage, and access data for scaling generative AI. Looking at infrastructure profit, we delivered solid gross profit margin expansion, and segment profit accelerated quarter to quarter to the high teens. Segment profit margin was down 230 basis points in the quarter, reflecting key investments we're making in the business across areas like AI, hybrid cloud, and quantum, and almost a point of impact due to current. Now, let me bring it back to the IBM level to wrap up.
Speaker Change: Storage delivered growth again this quarter, including growth in high-end storage tied to the Z16 cycle and solutions tailored to protect, manage, and access data for scaling generative AI.
Speaker Change: Looking at infrastructure profit, we delivered solid gross profit margin expansion and segment profit accelerated quarter-to-quarter to the high teens.
Speaker Change: The segment profit margin was down 230 basis points in the quarter, reflecting key investments we're making in the business across areas like AI, hybrid cloud, and quantum, and almost a point of impact due to currency.
Speaker Change: Now, let me bring it back to the IBM level to wrap up.
James J. Kavanaugh: We feel good about our performance in the first half, with revenue growth reflecting the investments we've been making, both organically as well as through acquisition. Our focus on execution and the strength and the fundamentals of our business resulted in strong performance in the quarter across revenue, margin expansion, and growth in profitability and earnings. Looking to the full year 2024,
Speaker Change: We feel good about our performance in the first half, with revenue growth reflecting the investments we've been making, both organically as well as acquisitions.
Speaker Change: Our focus on execution and the strength and the fundamentals of our business resulted in strong performance in the quarter across revenue, margin expansion, and growth in profitability and earnings.
James J. Kavanaugh: We are holding our view on revenue. We see full-year constant currency revenue growth in line with our mid-single-digit model, still prudently at the low end. For free cash flow, given the strength in our performance in the first half, we feel confident in raising our expectations to greater than $12 billion, driven primarily by growth in adjusted EBIT. This also includes a modest contribution resulting from the Palo Alto QRadar transaction, largely offset by related structural actions to address stranded costs. We continue to expect the QRadar transaction to close by the end of the third quarter, and the segment.
Speaker Change: Looking to the full year 2024, we are holding our view on revenue.
Speaker Change: We see full-year constant currency revenue growth in line with our mid-single-digit model, still prudently at the low end.
Speaker Change: For free cash flow, given the strength in our performance in the first half, we feel confident in raising our expectations to greater than $12 billion, driven primarily by growth in adjusted EBITDA.
Speaker Change: This also includes a modest contribution resulting from the Palo Alto QRadar transaction.
Speaker Change: Largely offset by related structural actions to address stranded costs.
Speaker Change: We continue to expect the QRadar transaction to close by the end of the third quarter.
James J. Kavanaugh: In software, we had a solid first half performance, up more than 7%. This performance reflects strength in our recurring revenue base and early traction in GEN-AI. With this performance, we are raising our view of growth in software to high single digits for the year. And given ongoing productivity initiatives and operating leverage, we now expect the software segment profit margin to expand by over a point. In consulting, given the continued pressure we have seen on spending related to discretionary projects.
Speaker Change: On the segments, in software, we had solid first half performance, up more than 7%. This performance reflects strength in our recurring revenue base and early traction in Gen AI.
Speaker Change: With this performance, we are raising our view of growth in software to high single digits for the year.
Speaker Change: And given ongoing productivity initiatives and operating leverage, we now expect software segment profit margin to expand by over a point.
Speaker Change: In consulting, given the continued pressure we have seen on spending related to discretionary projects, we now expect low single-digit growth for the year and segment profit margin to expand by about a half a point.
James J. Kavanaugh: We now expect low single-digit growth for the year and segment profit margin to expand by about a half a point. And given the strength in infrastructure in the first half, we now expect it to be about neutral for the year, with segment profit margin in the mid to high teens. With these segment dynamics, we are raising our expectations of operating pre-tax margin expansion to over a half a point year to year.
Speaker Change: And given the strength in infrastructure in the first half, we now expect it to be about neutral for the year, with segment profit margin in the mid to high teens.
Speaker Change: With these segment dynamics we are raising our expectations of operating pre-tax margin expansion to over a half a point year to year.
James J. Kavanaugh: And we are maintaining our view of the operating tax rate in the mid-teens range, consistent with last year. On currency, given the strengthening of the dollar, we now expect a 100 to 200 basis point impact on revenue growth for the year. For the third quarter, we see revenue growth consistent with the full year. For profit, we expect our net income skew through the third quarter to remain a couple points ahead of the prior year, driven by the strength of our business. And again, we expect the gain from the Palo Alto QRadar transaction will be offset by related structural actions to address stranded costs.
Speaker Change: And we are maintaining our view of operating tax rate in the mid-teens range, consistent with last year.
Speaker Change: On currency, given the strengthening of the dollar, we now expect a 100 to 200 basis point impact to revenue growth for the year.
Speaker Change: For the third quarter, we see revenue growth consistent with the full year.
Speaker Change: For profit, we expect our net income skew through the third quarter to remain a couple points ahead of the prior year, driven by the strength of our business.
Speaker Change: And again, we expect the gain of the Palo Alto QRadar transaction will be offset by related structural actions to address stranded costs.
James J. Kavanaugh: In closing, we are pleased with our performance this quarter and for the first half, driving confidence in our updated expectations. We are positioned to grow revenue, expand operating profit, and grow free cash flow for the year. Arvind and I are now happy to take your questions. Olympia, let's get started.
Speaker Change: In closing, we are pleased with our performance this quarter and for the first half, driving confidence in our updated expectations.
Speaker Change: We are positioned to grow revenue, expand operating profit, and grow free cash flow for the year. Arvind and I are now happy to take your questions.
Olympia Mcnerney: Thank you, Jim. Before we begin the Q&A, I'd like to mention a couple of things. First, supplementary information is provided at the end of the presentation. And then, as always, I'd ask you to refrain from multi-part questions. Operator, let's please open it up for questions. Thank you.
Olympia Mcnerney: Olympia, let's get started.
Olympia: 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.
Operator: At this time, we'll begin the question-and-answer session of the conference. If you would like to ask a question, please press star 1 on your telephone keypad. A confirmation tone will indicate that your line is in the question area. You may press star 2 if you would like to remove your question.
Speaker Change: Thank you. At this time, we'll begin the question and answer session of the conference.
Speaker Change: If you would like to ask a question, please press star 1 on your telephone keypad. A confirmation tone will indicate that your line is in the question queue.
Olympia Mcnerney: You may press star 2 if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys.
Operator: For participants using speaker equipment, it may be necessary to pick up your handset before. And our first question comes from Wamsi Mohan with Bank of America. Yes, thank you so much. Your long-term model on transaction processing is low single digits, and you just posted a very strong quarter with 13% growth in the quarter. How should we think about the trajectory of that in 2024 and maybe in 2025? I know, Jim, you noted a few different things, including solid plant renewals and some strong large-deal performance. Was there anything very episodic or unusually large within that mix as well?
Olympia Mcnerney: And our first question comes from Wamsi Mohan with Bank of America. Please state your question.
Wamsi Mohan: Yes, thank you so much. Your long-term model on transaction processing is low single-digit and you just posted a very strong quarter with...
Speaker Change: 13% growth in the quarter. How should we think about the trajectory of that in 2024 and maybe in 2025? I know, Jim, you noted a few different things, including
Speaker Change: solid plant renewals and some strong large deal performance. Was there anything very episodic or unusually large within that mix as well? Thank you so much.
James J. Kavanaugh: Thank you. Thanks, Wamsi. I appreciate the question overall. It is very important. You know, if you take a step back, you know, we continue to be very pleased with our transaction processing performance overall. You know, if you dial back to when we laid out our midterm model, we said we converted this to a growth factor, a low single-digit overall. And if you look at the last couple of years, we've been averaging mid-single digit or better overall. We have shifted this now to a growth contributor. And why is that important?
James J. Kavanaugh: Thanks Wamsi, I appreciate the question overall, very important.
Speaker Change: You know, if you take a step back, you know, we continue to be very pleased with our transaction processing performance overall.
James J. Kavanaugh: You know, if you dial back to when we laid out our mid-term model.
Speaker Change: We said we converted this to a growth factor, low single digit.
Speaker Change: Overall, and if you look at the last couple years, we've been averaging mid-single digit or better overall. We shifted this now to a growth contributor. Why is that important?
James J. Kavanaugh: One, a high source of profit and cash, the fund investment flexibility, and two, it provides a very solid incumbency base for the IBM or multiplier effect. But if you take a look at it, we are capitalizing on the strength that we've seen over the last three programs of our mainframe cycle. It's really demonstrating the enduring value of that platform. Our MIPS over the last few programs are up 3x from an install perspective, and over 80% of our clients are growing MIPS on the mainframe. I think that was a very different picture when you dial back five, seven years ago.
Speaker Change: One, high source of profit in cash, the fund investment flexibility, and two, it provides a very solid incumbency base for the IBM or multiplier effect. But if you take a look at it, we are capitalizing on the strength that we've seen over the last three programs.
Speaker Change: of our mainframe cycle. It's really instantiating the enduring value of that platform. Our MIPS over the last few programs are up 3x.
Speaker Change: from an install perspective, and over 80%
Speaker Change: of our clients are growing MIPS on the mainframe. I think that was a very different picture when you dial back five, seven years ago already.
James J. Kavanaugh: So we've taken that portfolio, we've invested now significantly, which I'll come to around Watson X, Code Assistant for Z, but we've taken that from a down mid-single-digit portfolio to now capitalizing on the stack economics of our mainframe execution and moved that to a low single-digit. Now for the year, as you heard, we are taking up our guidance, just given the strength of the first half, to You know, when you get into 2025, we'll talk about our guidance going forward, but we feel very confident that we can continue growing this, and that's why we're investing and bringing out new capabilities like Watson X, and Code Assistant for Z, which is responding extremely well. Operator, let's take the next question.
Speaker Change: So, we've taken that portfolio, we've invested now significantly, which I'll come to around Watson X, code assistant for Z, but we've taken that from a down mid-single digit portfolio
Speaker Change: to now capitalizing on the stack economics of our mainframe execution and move that to a low single digit. Now for the year, as you heard, we are taking up our guidance, just given the strength of first half, to mid-single digit.
Speaker Change: You know, when you get into 2025, we'll talk about our guidance going forward, but we feel very confident that we can continue growing this, and that's why we're investing in bringing out new capabilities like Watson X-Code Assistant for Z, which is resonating extremely well.
Operator: Our next question comes from Tony Sakonagi with Bernstein. Yes, thank you for taking the question. I'm wondering whether you believe AI signings are really incremental or just a shift in client spending. AI investments in consulting are a shift in spending? Or do you think they're accretive?
Speaker Change: Operator, let's take the next question.
Speaker Change: Our next question comes from Tony Sakonagi with Bernstein.
Tony Sakonagi: Yes, thank you for taking the question.
Tony Sakonagi: I'm wondering, maybe you can discuss how you think about AI signings and...
Tony Sakonagi: Whether you believe they're really incremental or just a shift in client spending.
Tony Sakonagi: And part of the reason I ask the question is if I, you know, it looks like your AI book of business was up about a billion dollars sequentially.
Speaker Change: You're saying three quarters of that is consulting, so that's 700 plus.
Speaker Change: million in consulting signings in the quarter. If I if I take that out, your book to bill and the rest of your business is actually down.
Speaker Change: and despite the strong signing.
Speaker Change: you're lowering your consulting expectations for the year.
Speaker Change: AI investments in consulting are a shift in spending, or do you think they're accretive, or do you actually think they could even be cannibalistic to consulting spend and more broadly IT spend?
Arvind Krishna: Or do you actually think they could even be cannibalistic for consulting spend and, more broadly, IT spend? Tony, let me start, and then Jim will add more color on this topic. First, it's a great question, and he laid out some of the dynamics that were going on there. If we just step back and just look at our comments on the macroeconomic environment. We kind of state that there is discretionary spend pressure in consulting.
Speaker Change: So Tony, let me start and then Jim will add more color on this topic.
Tony Sakonagi: First, it's a great question, and he laid out some of the dynamics that were going on in there.
James J. Kavanaugh: If we just step back and just look at our comments on the macroeconomic environment.
James J. Kavanaugh: We kind of stated that there is discretionary spend pressure in consulting.
Arvind Krishna: When you do have that pressure, but there is a demand for AI, I would look you in the eye and say, probably the bulk of that demand, not all, but the bulk, is indeed a shift from other areas of consulting. We don't actually believe it's cannibalistic to the point you're pointing out.
James J. Kavanaugh: When you do have that pressure, but there is a demand for AI, I would look you in the eye and say, probably the bulk of that demand, not all, but the bulk, is indeed a shift from other areas of consulting.
Speaker Change: We don't actually believe it's cannibalistic to the point you're pointing out.
Arvind Krishna: Now, as time goes on, and as people move from early experimentation and proving out the value to wanting to scale and really get the full benefits of generative AI, we do actually believe at that point, even for consulting, these will turn into accretive and additive, but we are still some time away from when that will happen. That is just to give you some color and acknowledge that the bulk, but not all, is a shift. Jim?
Speaker Change: Now, as time goes on, and as people move from early experimentation and proving out the value to wanting to scale and really get the full benefits of generative AI.
Speaker Change: We do actually believe at that point, even for consulting, these will turn into a creative and additive, but we are still some time away from when that will happen. That is just to give you some color and acknowledging that the bulk, but not all, is a shift. Jim?
James J. Kavanaugh: Yeah, thanks, Tony, for the question. Just building on what Arvind said, I mean, first of all, we're very pleased with the early momentum that we've gotten with our book of business around Gen Ed, both on the technology side with our Watson X platform and now with our open innovation strategy around Rel-AI, OpenShift, Granite Models, and Struck Lab, et cetera. But let's just dive a little deeper into your question about consulting. Because I think when you look at consulting, first of all, why is it so important right now, in the early part of a cycle? It's important because it has to establish IBM Consulting as the strategic provider of choice for enterprises as they're going through what we like to call digital transformation 2.0 with Gen AI.
James J. Kavanaugh: Yeah, thanks Tony for the question. Just building on what Arvind said, I mean, first of all, we're very pleased with
James J. Kavanaugh: The early momentum that we've gotten with our book of business around Gen Ed, both
James J. Kavanaugh: On the technology side, with our Watson X platform, and now with our open innovation strategy around RHEL-AI.
James J. Kavanaugh: OpenShift, Granite Models, and Struck Lab, et cetera. But let's just dive a little deeper into your question about consulting.
James J. Kavanaugh: Because I think when you look at consulting, first of all, why is it so important right now in an early part of a cycle? It's important...
James J. Kavanaugh: because it's got to establish IBM consulting.
James J. Kavanaugh: as the strategic provider of choice.
James J. Kavanaugh: for Enterprises as they're going through what we like to call Digital Transformation 2.0 with Gen AI.
James J. Kavanaugh: Everyone is looking for who is going to be their strategic provider and partner, and I think a billion and a half dollars, over a billion and a half dollars in business in the first 12 months, which, by the way, is in excess of the ramp we saw play out with hybrid cloud and Red Hat, we're off to a pretty good start. Now, to Arvind's point, you know, in every technology, very different dynamics between a human capital-based business and a product IP business. Human capital-based businesses, we do see, and we expect it, clients will shift and re-prioritize spending.
James J. Kavanaugh: Everyone is looking for who is going to be their strategic provider and partner. And I think a billion and a half dollars, over a billion and a half dollar book of business in the first 12 months.
James J. Kavanaugh: which, by the way, is in excess of the ramp we saw play out with Hybrid Cloud and Red Hat. We're off to a pretty good start. Now, to Arvind's point, you know, in every technology shift,
Arvind Krishna: Very different dynamics between a human capital based business and a product IP business.
Arvind Krishna: Human Capital-Based Business, we do see, and we expect it, clients will shift and re-prioritize spending.
James J. Kavanaugh: They're doing that now as they're driving large enterprise transformation projects, which is what our portfolio has been able to capture, and that's why you see nice acceleration and growth in our backlog, up healthy at 5%. But to Arvind's point, we do think once you get through the early cycle, this is an incremental expansion of TAM that drives a long-tail growth factor over time that has multiplier opportunities for us. So when you look at our consulting book of business, let's dive into the sub-segments, you see business transformation services, which a lot of Gen-AI plays out too early right now. That is, how do you transform the way you operate, HR, finance, supply chain.
Arvind Krishna: They're doing that now as they're driving large enterprise transformation projects, which is what our portfolio has been able to capture, and that's why you see nice acceleration and growth in our backlog, up healthy at 5%.
Arvind Krishna: But to Arvind's point, we do think, once you get through the early cycle,
Arvind Krishna: This is an incremental expansion of TAM.
Arvind Krishna: that drives a long-tail growth factor over time that has multiplier opportunities for us. So when you look at our consulting book of business...
Speaker Change: Let's dive into the sub-segments.
Speaker Change: You see business transformation services, which a lot of the Gen AI plays out to early right now. That is how do you transform the way you operate HR, finance, supply chain.
James J. Kavanaugh: We've doubled and accelerated our growth quarter to quarter. What you're seeing is a re-prioritization and dynamic spending decisions by clients because in our AO, where we have a lot of short-term discretionary staff augmentation work, there's a lot of tradeoffs between those two. So it's important for us strategically with our client base, but I think you see how it plays out. Just to wrap up the full picture, software. I think it's fundamentally different.
Speaker Change: We've doubled and accelerated our growth quarter-to-quarter.
Speaker Change: What you're seeing is a reprioritization and dynamic
Speaker Change: spending decisions by clients, because our AO where we have a lot of short term discretionary staff augmentation work, there's a lot of trade offs between those two. So it's important for us strategically what our client base
Speaker Change: Well, I think you see how it plays out now. Just to wrap up the full picture, software, I think it's fundamentally different. Our software book of business now, half a billion dollars through the first 12 months.
James J. Kavanaugh: Our software book of business now, half a billion dollars through the first 12 months. I think, from inception to date, right now, we're about two-thirds subscription, SaaS, one-third perpetual. I think that's contributing nicely to a point of growth. And by the way, that's one of the two components of why we took our software up for the year. I think that's predominantly all lift.
Speaker Change: I think inception, the date right now, we're about two-thirds.
Speaker Change: Subscription, SAS, One Third, Perpetual. I think that's contributing nicely about a point of growth. And by the way, that's one of the two components of why we took our software up for the year. So I think that's predominantly all lift.
Operator: Operator, let's take the next question. Our next question comes from Amit Daryanani with Evercore ISD. Thanks for asking my question.
Speaker Change: Operator, let's take the next question.
Speaker Change: Our next question comes from Amit Daryanani with Evercore ISI.
Operator: I guess, you know, my question is really on the consulting side, and when I think about this business growing low single digits for 24, if I take out some of the M&A contribution, also some of the revenues from the AI book of business that you have at $1.5 billion, is it fair to think that maybe the non-AI consulting piece actually gets worse in H2 versus H1 for you? If you just talk about the puts and takes on the back half consulting expectations versus the front half, that would be really helpful. And then, you know, I'm curious. If you talk to your customers, what is your sense of the duration of this weakness in consulting? And when do you think it will start to come back?
Amit Jawaharlaz Daryanani: Thanks for my question. I guess, you know, my question is really on the consulting side and when I think about this business growing low single digits for 24, if I take out some of the M&A contribution, also some of the revenues from the AI book of business that you have at $1.5 billion,
Amit Jawaharlaz Daryanani: Is it fair to think that maybe the non-AI consulting piece actually gets worse in H2 versus H1 for you? If you just talk about the puts and takes on the back half, consulting expectations, versus front half, that would be really helpful. And then, you know, I'm curious, if you talk to your customers,
Speaker Change: What is your sense on the duration of this weakness in consulting and when do you think it's up to come back? Thank you
Arvind Krishna: Thank you. Hi Amit, so I'll just start and maybe address the second part of your question first. I actually do not believe there's any secular macro trend around; I think that this is temporal based on a number of factors. The geopolitical uncertainty has gone on longer than most people expected, and that weighs into people's heads about what might happen, specifically the war in Europe as well as the war in the Middle East.
Speaker Change: Hi. So, Amit, let me just start and maybe address the second part of your question first and then...
Speaker Change: Thank you.
Speaker Change: I actually do not believe there is any secular macro trend around weakness. I think that this is temporal based on a number of factors we have.
Speaker Change: The geopolitical uncertainty has gone longer than most people expected, and that weighs into people's heads about what that might happen, and specifically the war in Europe as well as the war in the Middle East.
Arvind Krishna: Second, inflation has gone on longer than people expected, which has the unfortunate consequence of higher interest rates, and that begins to bear on people. If I look at those two all together, and then the moment you have higher interest rates and inflation, you have wage inflation, which does impact the bottom line of our clients. You put all of that into perspective, and is this going to go on for another six months? Likely. Is it going to go on for another year?
Speaker Change: Second, inflation has gone longer than people expected, which has the unfortunate consequence of higher interest rates, and that begins to bear on people.
Speaker Change: If I look at those two all together, and that then, the moment you have higher interest rates and inflation, you have wage inflation, which does impact the bottom line of our clients.
Speaker Change: You put all of that into perspective and is this going to go on for another six months, likely?
Arvind Krishna: I'm not so sure, but we've got to get through the second half to be able to go there. So that is why we are optimistic about the medium and long-term direction of consulting. And as Jim answered in a prior question, we do see that this is going to become a tailwind over time, at least for us. Now, in the short term, for the next six months, we do think it holds up a little bit. In terms of answering the specifics and sort of decomposing some of the numbers that you laid out in the first part of your question, I'm going to turn that over to you. Yeah, thanks, Arvind.
Speaker Change: Is it going to go on for another year? I'm not so sure, but we've got to get through the second half to be able to go there. So that is why we are optimistic about the medium and long-term vector on consulting.
Speaker Change: And as Jim answered in a prior question, we do see that this is going to become a tailwind over time, at least for us.
Speaker Change: Now, in the short term, for the next six months, we do think it holds up a little bit. In terms of answering the specifics and sort of decomposing some of the numbers that you laid out in the first part of your question, I'm going to turn that over to Jim.
James J. Kavanaugh: Thanks, Amit, for the question overall. You know, let's put this in perspective, right? Go back 90 days ago, how did we see the year kind of playing out? We said at that point in time that we had backlog growing nicely mid-single-digit, albeit we did talk about durations going up because large-scale transformations were really where the spend was moving to, but we had a solid book to build trailing 12 months over 1.15.
James J. Kavanaugh: Yeah, thanks Arvind and thanks Amit for the question overall. You know, let's put this in perspective, right? You go back 90 days ago, how did we see the year kind of playing out with consulting?
James J. Kavanaugh: We said at that point in time we had backlog growing nicely mid-single-digit, albeit
James J. Kavanaugh: We did talk about durations going up because...
James J. Kavanaugh: Large-scale transformations were really...
James J. Kavanaugh: where the spend was moving to, but we had a solid book to build trailing 12 months over 1.15.
James J. Kavanaugh: We had Gen-AI momentum that was going to continue throughout the year early in the cycle. We had strategic partnerships, Red Hat's growth profile, and we had future acquisitions as we're going to continue to be opportunistic around our M&A criteria and the synergistic value of how consulting plays to our portfolio. If you look right now, 90 days later, as we look at the second half, many of those are still playing out.
James J. Kavanaugh: We had Gen AI momentum that was going to continue throughout the year, early in the cycle. We had strategic partnerships, Red Hat growth profile, and we had future acquisitions.
James J. Kavanaugh: as we're going to continue to be opportunistic.
James J. Kavanaugh: Around our M&A criteria and the synergistic value of how consulting plays to our portfolio
James J. Kavanaugh: If you look right now, 90 days later, as we look to the second half, many of those are still playing out.
James J. Kavanaugh: You got Gen-AI, which arguably we're above our own expectations right now, doubling, by the way, in consulting. Our Gen-AI book of business quarter-to-quarter, strategic partnerships, especially hyperscalers, Red Hat, still growing nicely. What you're seeing at the end of the day, those are large-scale transformations, lower yield.
Jenny: Unknown Speaker You got Jenny I, which arguably were
Jenny: We're above our own expectations right now, doubling, by the way, in consulting.
Speaker Change: Are Jenny and I booked a business quarter-to-quarter, strategic partnerships, especially hyperscalers, Red Hat?
Speaker Change: Still growing nicely. What you're seeing, you know, at the end of the day, those are large scale transformations, lower yield.
James J. Kavanaugh: That's why Arvind and I are saying these are longer-term growth vectors and tails that will play out into 2025, 2026, and beyond as we get that strategic provider of choice. But in the interim, what you're seeing is that spending reprioritization around short-term discretionary that I think everyone in the industry is talking about. We're all dealing with this.
Speaker Change: That's why Arvind and I are saying...
Arvind Krishna: These are longer-term growth vectors and tails.
Arvind Krishna: that will play out into 25, 26 and beyond as we get that strategic provider of choice. But in the interim...
Speaker Change: What you're seeing is that spending reprioritization around short-term...
Speaker Change: Discretionary that I think
James J. Kavanaugh: The key is we have to win that strategic provider of choice in Gen-AI. I would argue we're off to a great start. You look at the competitor numbers overall, we got a billion and a half over a billion and a half dollars in business doubling quarter-to-quarter right now. I think we're in pretty good shape.
Speaker Change: You know, everyone in the industry is talking about, we're all dealing with this. The key is...
Speaker Change: We have to win that strategic provider of choice in Gen AI.
Speaker Change: and I would argue we're off to a great start.
Speaker Change: You look at competitor numbers overall.
Speaker Change: We got a billion and a half over a billion and a half dollar book of business.
Speaker Change: Doubling quarter to quarter right now. I think we're in pretty good shape That's what we're focused on because that will provide the future revenue multiplier effect as we move forward
Operator: That's what we're focused on because that will provide a future revenue multiplier effect as we move forward. Operator, let's take the next question. Our next question comes from Jim Schneider with Goldman Sachs. Thanks for taking my question. Maybe if I could just ask on a different topic for a second, can we maybe talk about the environment you see right now for M&A and your intention to continue to drive through acquisitions? And do you believe you have sufficient skill in open source and DevOps software, in particular?
Speaker Change: Operator, let's take the next question.
Speaker Change: Our next question comes from Jim Schneider with Goldman Sachs.
Jim Schneider: Thanks for taking my question. Maybe if I could just ask on a different topic for a second, can we maybe talk about the environment you see right now for M&A and your intention to continue to drive through acquisitions? And do you believe you have sufficient skill in open source and DevOps software in particular? And can you maybe comment on the attractiveness of multiples in the public market today relative to the private market?
Operator: And can you maybe comment on the attractiveness of multiples in the public market today relative to the private market? Jim, that's a great question and thank you for asking. Look, on overall M&A, I just want to begin with that our strategy has not changed. We are disciplined, and we are focused.
Speaker Change: Jim, a great question, and thank you for asking this.
Speaker Change: Look, on overall M&A, I just want to begin with that our strategy has not changed.
Arvind Krishna: By focused, I mean we stick to the areas that we are investing in, hybrid cloud and artificial intelligence. And by discipline, I mean it has to be not just aligned to our strategy, but we expect synergies from the acquisition, especially the multiples are higher, as you pointed out. And it has to be accretive to free cash flow. If it's larger, definitely within two years, the Outer End of the Range. So, having said that, if I look at it right now, we have HashiCorp out there, so we've got to get through that.
Speaker Change: We are disciplined and we are focused.
Speaker Change: By focused, I mean we stick to the areas that we are investing in, hybrid cloud and artificial intelligence.
Speaker Change: And by discipline, I mean it has to be not just aligned to our strategy, but we expect synergy from the acquisition, especially if the multiples are higher, as you pointed out.
Speaker Change: And it has to be accretive to free cash flow. If it's larger, definitely within two years at the...
Speaker Change: Outer End of the Range
Speaker Change: So, having said that, if I look at it right now, we have HashiCorp out there, so we got to get through that. We expect that to happen in the second half of this year. We just finished a stream set.
Arvind Krishna: We expect that to happen in the second half of this year. We just finished Streamset and Web Methods. And we've done a couple of smaller ones in the consulting space and in other technology talks. What do we see going into this space?
Speaker Change: and Web Methods. And we've done a couple of smaller ones in the consulting space and in other technology talk-ins.
Arvind Krishna: are valuations rich; they're reasonably rich. They're not outrageous, I would say, like they had become in parts of late 2020 and 2021. So I would say that they're more reasonable than then, but they're richer than they were about 18 months ago. There are different dynamics in both the public and the private markets. Public markets are quite variable. I mean, as we can see, some of the multiples, and if you look at multiples to revenue, which is not a great metric, let me just acknowledge that, but it is one that's out there.
Speaker Change: What do we see going into this space?
Speaker Change: Our valuation is rich. They're reasonably rich. They're not outrageous, I would say, like they had become in parts of late 2020 and 2021. So I would say that they're more reasonable than then, but they're richer than they were about 18 months ago.
Speaker Change: There are different dynamics in both the public and the private markets. Public markets are quite variable. I mean, as we can see, some of them are multiples, and if you look at multiples to revenue, which is not a great metric, let me just acknowledge that, but it is one that's out there.
Arvind Krishna: If you look at 6, 7, 8, maybe 9 or 10 times, we can see our way to a large deal, as long as we have sufficient synergy. Now, for very small deals, that's not even a fair multiple.
Speaker Change: If you look at 6, 7, 8, maybe 9 or 10 times, we can see our way there for a large deal as long as we have sufficient synergy.
Arvind Krishna: Very small deals are all about technology and people. In the private market, we were very pleased with what we got done on stream sets and web methods. I would call that a private market deal, not a public market deal. And in that case, I think it all depends upon what the property is, what its growth profile is, and what is the attractiveness of it to the seller versus the buyer, in this case, us.
Speaker Change: Now, for very small deals, that's not even a fair multiple. Very small deals are all about technology and people.
Speaker Change: In the private market, we were very pleased with what we got done on StreamSets and WebMethods. I would call that a private market deal, not a public market deal.
Speaker Change: And there, I think it all depends upon what's the property, what is its growth profile, what is the attractiveness of it to the seller versus the buyer, in this case, us. All of that play into those multiples.
Arvind Krishna: All of that plays into those multiples. I do expect that on the private side, valuations will be slightly less, but then the risk of going public or some other exit is also taken away. And in some sense, you get a discount for taking that risk off the table. For people who are venture-backed, that's different.
Speaker Change: I do expect that on the private side, valuations will be slightly less, but then the risk of going public or some other exit is also taken away, and in some sense, you get a discount for taking that risk off the table.
Arvind Krishna: They're looking at an IPO versus a strategic exit, and those are different multiples. But putting all of that together... We remain in the market, and M&A is an important part of our growth methodology. We maintain a strong balance sheet for that purpose. And we've kind of been clear of that. All that said, this year, we have a big one coming.
Speaker Change: For people who are venture-backed, that's different. They're looking at IPO versus a strategic exit, and those are different multiples. But putting all of that together, we remain in the market.
Speaker Change: M&A is an important part of our growth methodology.
Speaker Change: We maintain a strong balance sheet.
Speaker Change: for that purpose, and we've kind of been clear of that.
Operator: So we want to wait and get that done because part of the discipline is also making sure that we kind of digest them at the right rate and pace and put them into our global go-to market distribution. Operator, let's take the next question. Our next question comes from Ben Reitzes with Mellius Research. Yeah, hey, thank you. Appreciate it.
Speaker Change: All that said, this year we got a big one coming, so we want to wait and get that done because part of the discipline is also making sure that we kind of digest them.
Speaker Change: at the right rate and pace and put them into our global go-to-market distribution engine.
Speaker Change: Operator, let's take the next question.
Speaker Change: Our next question comes from Ben Reitzes with Mellius Research. Please state your question.
Operator: Jim, and Arvind, I wanted to see, you know, if the, it sounds like the margin progress is sustainable for the year. So, while I appreciate that you guide the free cash flow and you've raised it a little bit, do you anticipate us being able to flow through the 25 cents of upside on the EPS line? And, you know, can, does that mean earnings are sustainable in the back half?
Benjamin Alexander Reitzes: Yeah, hey, thank you. Appreciate it.
Benjamin Alexander Reitzes: Jim, I wanted to, and Arvind, I wanted to see, you know, if the, it sounds like the margin
Benjamin Alexander Reitzes: I appreciate that you guide the free cash flow, and you've raised it a little bit. Do you anticipate us being able to flow through the 25 cents of upside on the EPS line? And, you know, can...
Operator: And then, I was just wondering if you have any more info on HashiCorp, you know, in terms of the revenue contribution. Street was looking for about $750 million in revenue next year. And on the dilution, there should be a loss of around 30 cents in interest income. So, just wondering if you have any further views on the net effect to 2025 on that deal. Thanks so much, guys. Hey, Ben, thank you. I appreciate it.
Speaker Change: Does that mean earnings is sustainable in the back half? And then I was just wondering if you have any more info on HashiCorp in terms of the revenue contribution. Street was looking for about $750 in revenue next year. And on the dilution, there's…
Benjamin Alexander Reitzes: There should be a loss of around $0.30 in interest income, so just wondering if you have any further views on the net effect to 2025 on that deal. Thanks so much, guys.
James J. Kavanaugh: Very good question overall. But let's take a step back on your first part of the question around free cash flow. Yes, we're very pleased with the start of the year free cash flow, four and a half billion dollars, up 1.1 billion year to year, four points above historical attainment. It's our largest first half free cash flow generation as far back as I can go and count. So we're off to a pretty good start.
Speaker Change: Okay, Ben, thank you. Appreciate it. Very good question overall, but let's take a step back on your first part of the question around
Speaker Change: Free cash flow, yes.
Speaker Change: We're very pleased with the start of the year. Free cash flow $4.5 billion, up $1.1 billion year-to-year, four points above historical attainment. It's our largest.
Speaker Change: First half, free cash flow generation.
Speaker Change: As far back as I can go and count, so we're off to a pretty good start, and that gives us the confidence overall of how we're positioning second half. But the second half and why we took the guidance up is entirely driven by the strength of the fundamentals of our business.
James J. Kavanaugh: And that gives us confidence overall about how we're positioning for the second half. But the second half and why we took the guidance up is entirely driven by the strength of the fundamentals of our business and flowing through the adjusted EBITDA overachievement. So read that although we don't guide on EPS, the strong overachievement of the 25 cents of EPS, we're flowing that through to adjusted EBITDA. And that flows through to our guide, take up on free cash flow, the rest of the free cash flow dynamics we've been talking about all year long around yes, we got benefits of changing retirement plans and cash tax, that's going to be a headwind and other balance sheet items. None of that changed.
Speaker Change: and flowing through.
Speaker Change: The Adjusted EBITDA Overachievement
Speaker Change: So read that, although we don't guide on EPS.
Speaker Change: The strong overachievement of the 25 cents of EPS, we're flowing that through to adjusted EBITDA.
Speaker Change: and that flows through to our guide take up on free cash flow. The rest of the free cash flow dynamics we've been talking about all year long around, yes, we got benefits to change in retirement plans and cash tax that's going to be a headwind and other balance sheet items, none of that changes.
James J. Kavanaugh: One thing I will bring up, and we said in the prepared remark, but just so there's absolute clarity, we do expect to close the Palo Alto transaction here in the third quarter involving certain assets of our QRadar business that will obviously generate a gain. We're excited about the new strategic relationship between our two great companies overall, but we will take structural actions to offset that gain and address stranded costs. And oh, by the way, to the second part of your question, to accelerate our productivity initiatives in 2025. So you get HashiCorp.
Speaker Change: One thing I will bring up, and we said in the prepared remark, but just so there's absolute clarity. We do expect to close...
Speaker Change: The Palo Alto transaction here in the third quarter around certain assets of our QRadar business that will obviously generate a gain. We're excited about the new strategic relationship between our two great companies overall, but we will take structural actions.
Speaker Change: to offset that gain, to address stranded costs, and oh, by the way...
Speaker Change: to your second part of your question, to accelerate our productivity initiatives in 2025. So you get the HashiCorp. First of all, the strategic transaction stands on its own.
James J. Kavanaugh: First of all, the strategic transaction stands on its own. Arvind went through our M&A criteria. I think there's a very compelling strategic fit around an end-to-end leadership hybrid cloud platform. There's a lot of synergistic value both in product technology and go-to-market, but there's a very attractive financial profile that we talked about 90 days ago. Higher revenue growth profile, adjusted EBITDA accretive in 12 months, and free cash flow accretive to Arvind's point by two years.
Speaker Change: Arvind went through our M&A criteria. I think there's a very compelling strategic fit.
Speaker Change: Around an end-to-end leadership hybrid cloud platform. There's a lot of synergistic value both on product technology and go-to-market
Speaker Change: But there's a very attractive financial profile that we talked about 90 days ago. Higher revenue growth profile, adjusted EBITDA accretive in 12 months, free cash flow accretive, to Arvind's point, by two years. And we do see potential significant near-term costs.
James J. Kavanaugh: And we do see potential significant near-term cost and operating synergies that lead to about a 30 to 40 percent free cash flow margin business over a handful of years. Now, when you look at dilution, we understand dilution.
Speaker Change: and operating synergies that lead to about 30 to 40% free cash flow margin business over a handful of years. Now, when you look at dilution, we understand dilution. I mean, M&A has been an integral part of our financial model for decades.
James J. Kavanaugh: I mean, M&A has been an integral part of our financial model for decades. So, underneath that, we understand the purchase growth of those transactions, the synergies of those transactions, and the balance sheet capital structure implications of those. And with all that said, our model is to grow mid-single-digit revenue and grow operating leverage so we grow free cash flow quicker than revenue. We don't see that changing in 2025.
Speaker Change: So, underneath that, we understand the purchase growth of those transactions.
Speaker Change: The synergies of those transactions, the balance sheet capital structure implications of those, and with all that said, our model is to grow mid-single-digit revenue and grow operating leverage so we grow free cash flow quicker than revenue.
James J. Kavanaugh: We see growth profiles around revenue, around operating leverage, and around free cash flow overall. And that speaks to the diversity or diversification, I should say, of our business model around productivity. We entered the year, raised it to $3 billion, and we're getting out ahead of that again.
Speaker Change: We don't see that changing in 2025. We see growth profiles around revenue, around operating leverage, and around free cash flow overall. And that speaks to the diversity, or diversification I should say, of our business model around productivity.
Speaker Change: We entered the year, raised it to $3 billion, we're getting out ahead of that again, and you see that play out in our margins through the first half, what, up 180 basis points on pre-tax? So we've got many levers to deal with this overall, we know how to handle it.
James J. Kavanaugh: And you see that play out in our margins through the first half, up 180 basis points on pre-tax. So, we've got many levers to deal with this overall. We know how to handle it.
Operator: Operator, let's take the next question. The next question comes from Erik Woodring, with Morgan, about the Red Hat business a bit more. You know, over the last few quarters, you've talked about some very healthy bookings growth numbers ranging anywhere between call it 15% and 20%. But we did see growth obviously decelerate by about a point this quarter, despite, you know, expectations that it would be flat to maybe increasing for the rest of the year.
Speaker Change: Operator, let's take the next question.
Speaker Change: The next question comes from Erik Woodring with Morgan Stanley .
Erik William Richard Woodring: Hey guys, thanks so much for taking my question. Arvind or Jim, I'd love if you could just dig into the Red Hat business a bit more. You know, over the last few quarters, you've talked about some very healthy bookings growth numbers ranging anywhere between, call it 15% and 20%.
Operator: So can you just kind of double-click on exactly what you're seeing with the Red Hat business today? What's the kind of offset to the strong bookings numbers? And how should we think about Red Hat growth now in constant currency for 2024? Thanks so much.
Speaker Change: But we did see growth obviously decelerate by about a point this quarter.
Speaker Change: Despite expectations that it would be flat to maybe increasing for the rest of the year. So can you just kind of double click on exactly what you're seeing with the red hat business today? What's kind of the offset to the strong bookings numbers? And how should we think about red hat growth now in constant currency for 2024? Thanks so much.
Operator: Great question, Eric. So let's just look at the Red Hat business in terms of how the dynamics function between our clients. Unknown Attendee, David Vogt, Wamsi Mohan, Arvind Krishna, Benjamin Reitzes, Jay Gambetta, for what they're consuming, and so the bookings then play out.
Speaker Change: Great question, Erik. So, let's just look at the Red Hat business in terms of how the dynamics function between our clients and ourselves.
Speaker Change: So clients come and create demand, we fulfill that, that shows up as bookings not as revenue because the Red Hat business model is a pure consumption business model.
Speaker Change: Clients pay for what they're consuming, and so the bookings then play out. Now, those bookings are a signal of further demand, and typically they're anywhere from one to three years worth of revenue that the client is pre-committing to.
Arvind Krishna: Now, those bookings are a signal of further demand, and typically, they're anywhere from one to three years' worth of revenue that the client is pre-committing to. When we enter a year, about half the revenue we can look at the bookings of the previous year and say that that gives us. The other half has to come in over the quarter.
Speaker Change: So, when we enter a year, about half the revenue we can look at the bookings of the previous year and say that that gives us, the other half has to come over the quarter.
Arvind Krishna: Now that we have a year, not longer, but a year of the double-digit demand that you're talking about. If I remember correctly, it was 14%, 17%, 14%, 20% in terms of those demands. Now that that full year is there, that points to that for the portion that we can see. And as we get into a quarter, it climbs up from that 50% to 60% to 70% to 80%. And Jim mentioned in his prepared remarks what he called CRPO, or the Revenue Performance Obligations. We see those sitting around mid-teens for the second half of the year, to answer your question.
Speaker Change: Now that we have a year.
Speaker Change: Not longer, but a year of the double-digit demand that you're talking about.
Speaker Change: If I remember right, it was 14%, 17%, 14%, 20%.
Speaker Change: Now that that full year is there, that points to that for the portion that we can see, and as we get into a quarter, it climbs up from that 50 percent to 60 to 70 to 80.
Speaker Change: And Jim mentioned in his prepared remarks what he called CRPO, or the Revenue Performance Obligations. We see those sitting around mid-teens for the second half of the year, to answer your question.
Arvind Krishna: Now, if that's about 80%, then that will translate into low double-digits, which we can look at and feel quite comfortable with. By the way, we see these early signs of demand continue into this quarter and likely the half, which means that we expect to continue to grow in the low double digits going forward. So I hope that that gives you a sense.
Speaker Change: Now, if that's about 80 percent, then that will translate into lows.
Speaker Change: low double digit is what we can look at and feel quite comfortable on. By the way, we see these early signs of the demand continue into this quarter and likely the half, which means that we expect to continue now.
Speaker Change: in the low double digits going forward. So I hope that that gives you a sense.
Arvind Krishna: But I'm also excited by the underlying product capabilities. We see OpenShift, which is extremely important. It plays into containerization. It plays into virtualization. It's an important element of how our clients use hybrid. It has been growing, and the demand there grew again at about 40% this past quarter.
Speaker Change: But I'm also excited by the underlying product capabilities.
Speaker Change: We see OpenShift, which is extremely important, it plays into containerization, it plays into virtualization, it's an important element of how our clients exercise hybrid, it has been growing and the demand there grew again at about 40% this past quarter.
Arvind Krishna: But we also saw acceleration in Linux and in Ansible, where both of those demand vectors grew into the low double digits. Given the size of the Linux business, it's very good news for us going forward. So I hope that that gives you some color on those pieces, and a vector that we have not talked about that will play, probably into 2025 and 2026.
Speaker Change: But we also saw acceleration in Linux and in Ansible, where both of those demand vectors grew into the low double digits.
Speaker Change: Given the size of the Linux business, it's very good news for us going forward. So I hope that that gives you some color on those pieces.
Speaker Change: and a vector that we have not talked about.
Operator: We are very excited by our two open source AI projects inside the Red Hat business, RHEL AI and OpenShift AI. And as people begin to deploy at scale, but not only on public cloud, but also on premise, leveraging their hybrid environment, we expect that both of those will also contribute to the Red Hat business, but that will take more time. Operator, let's take one last question. Thank you. Our next question comes from Matt Swanson with RBC Capital Markets. Thank you.
Speaker Change: that will play, but probably into 2025 and 2026. We are very excited by our two open source AI projects inside the Red Hat business.
Speaker Change: R.L.A.I.
Speaker Change: as well as OpenShift AI. And as people begin to deploy at scale, but not only on public cloud, but also on premise, leveraging their hybrid environment, we expect that both of those will also contribute into the Red Hat business, but that will take more time.
Speaker Change: Operator, let's take one last question.
Speaker Change: Thank you. Our next question comes from Matt Swanson with RBC Capital Markets.
Operator: Yeah, Arvind, if we could pick up right where you left off, can you just give us a little more color on the decision to open up the granite models and the code base, and then really kind of what you're seeing in the market that makes you feel like taking maybe a more developer-focused approach to those? I think, as you put it, fit-for-purpose models is the right long-term strategy. So, Matt, thank you for asking that question, and there was actually a question about developers before also, so I'm sorry we didn't get to it fully.
Matthew John Swanson: Thank you. Yeah, Arvind, if we could pick up right where you left off there.
Matthew John Swanson: Can you just give us a little more color on the decision to open up the Granite models and the code base? And then really kind of what you're seeing in the market that makes you feel like taking maybe a more developer-focused approach to those, I think as you put it, fit-for-purpose models is the right long-term strategy.
Operator: We'll get to that now in this question. Look, the whole question comes down to, there was a thesis out there about a year and a half ago that maybe one, maybe two extremely large models were going to run away with the bulk of the market share. We always felt that it was both technically and economically infeasible, and I'll describe why. If you run an extremely large model on public clouds, the model, by its nature, is going to be expensive because a very large model needs a lot more compute, a lot more network, a lot more storage, and a lot more memory.
Speaker Change: So Matt, thank you for asking that question. And there was actually a question on developers before also, so I'm sorry we didn't get to it fully. We'll get to it now in this question.
Speaker Change: Look the whole question comes down to there was a thesis out there about a year and a half ago that maybe one maybe two extremely large models are going to run away with the bulk of the market share.
Speaker Change: We always felt that it was both technically and economically infeasible, and I'll describe why.
Speaker Change: If you run an extremely large model on public clouds, the model by its nature is going to be expensive because a very large model needs a lot more compute, a lot more network, a lot more storage, a lot more memory, and we can see some of those dynamics play out.
Operator: And we can see some of those dynamics play out. If you can drop the model size, you can drop all of that by 90 percent. I would actually tell you a 99 percent reduction in the compute, memory, and network cost, but let's call it 90 just for the sake of argument. So if you are running, like one of our clients was describing to me, they run a couple of billion transactions through their internal systems each.
Speaker Change: If you can drop the model size, you can drop all of that by 90%. I would actually tell you 99% reduction in the compute and memory and network costs, but let's call it 90 just for the sake of argument.
Speaker Change: So if you are running, like one of our clients was describing to me, they run a couple of billion transactions through their internal systems each day.
Operator: If they had to go service those out to a large public cloud, the bill per day would have come back to be a couple of hundred million dollars. You multiply that by 250, and that's kind of an infeasible cost.
Speaker Change: If they had to go service those out to a large public cloud, the bill per day would have come back to be a couple of hundred million dollars. You multiply that by $250,000, that's kind of an infeasible cost.
Arvind Krishna: If you can drop it by 90%, you're now bringing it down to the $10 to $20 million a day. If you can actually run it using some of our Red Hat technologies on premises, you can drop it by another 50%. You're now talking 5 to 10, and for what it can do, that is a very attractive proposition. So now, getting back to the model. If you have no idea what you're going to do, if you have no idea what you might be looking for, you go to a very large model because it contains all the possible elements. If you have a sense of what you need to do, I need to summarize emails. You need an English language model if you're sitting here in the United...
Speaker Change: If you can drop it by 90 percent, you're now bringing it down to the 10 to 20 million dollars a day. If you can actually run it using some of our Red Hat technologies on premise, you can drop it by another 50 percent. You're now talking 5 to 10.
Speaker Change: For what it can do, that is a very attractive proposition.
Speaker Change: So now getting back to the models
Speaker Change: If you have no idea what you're going to do, if you have no idea what you might be looking for, you go to a very large model because it contains all the possible elements.
Speaker Change: If you have a sense of what you need to do, I need to summarize emails. You need an English language model if you're sitting here in the United States.
Arvind Krishna: If you are going to change your Java or C++ or Python programmers to be more productive, you don't need a model that can write poetry and draw pictures. You need a model that understands programming languages. So we are very, very proud of what our team has done.
Speaker Change: If you are going to go change your Java or C++ or Python programmers to be more productive, you don't need a model that can write poetry and draw images. You need a model that understands programming languages.
Speaker Change: So, we are very, very proud of what our team has done. We can produce models that can do these things. So, these are two distinct models, one for programming, one for business language.
Arvind Krishna: We can produce models that can do these things. So these are two distinct models, one for programming, and one for business language. They are one-tenth or less the size of the extremely large models.
Speaker Change: They are one-tenth or less than that of the size of the extremely large models, but you can look on the leaderboards, they perform quite as well as the largest models.
Arvind Krishna: But you can look on the leaderboards; they perform quite as well as the largest models. So that is kind of what our strategy is. However, if our clients want other models, we are also happy to work with other models, and we have had that perspective. So why open source, since that was part of your question? Why open sources? Because we often find that clients want to increase the model's efficacy by adding their own unique language.
Speaker Change: So that is kind of what our strategy is.
Speaker Change: However, if our clients want other models, we are also happy to work with other models and we have had that perspective.
Speaker Change: So why open source since that was part of your question?
Speaker Change: Why open source is because often we find that clients want to increase the model's efficacy by adding their own unique language. People might want to write emails in a certain way. They might want to program in a certain way. They like comments in a certain style. I call that refining the model.
Arvind Krishna: People might want to write e-mails in a certain way. They might want to program in a certain way. They like comments in a certain style. I call that refining the model. We have a technique called Instruct Lab. But then clients get concerned, wait, if I add my data, I don't want to give that away and put it back into a more public format. Can I keep that to myself?
Speaker Change: We have a technique called Instruct Lab, but then clients get concerned. Wait, if I add my data, I don't want to give that away and back into a more public format. Can I keep that to myself?
Arvind Krishna: So open sourcing our models under the Apache license gives our clients the freedom that what they add onto our underlying open model, they can keep to themselves. Now, to the developer point, putting all of that machinery into Red Hat Linux now gives us an avenue to open it up to developers so they can go experiment and play. By the way, I'll turn around and tell you that for a developer who's not running production, who's just playing with things, like all people do it, on a MacBook, you can begin to play around with models that are in the low tens of billions of parameters.
Speaker Change: So open sourcing our models under the Apache license gives our clients the freedom that what they add on to our underlying open model.
Speaker Change: They can keep to themselves.
Speaker Change: Now, to the developer point.
Speaker Change: Putting all of that machinery into Red Hat Linux now gives us an avenue to open it up to developers so they can go
Speaker Change: Experiment and play.
Speaker Change: By the way, I'll turn around and tell you that for a developer who's not running production, who's just playing with things...
Speaker Change: But all people do it.
Speaker Change: On a MacBook, you can begin to play around with models that are in the low tens of billions of parameters. That's a massive market that opens up. They get the freedom and flexibility that they don't have to give it back to us unless they want to.
Arvind Krishna: That's a massive market that opens up. I am not actually concerned about this giving away the IP, as we have found through whether it's Red Hat, Linux, or whether other people have found through Mongo, or other people have found through Hadoop.
Speaker Change: I am not actually concerned about this gives away the IP, as we have found through, whether it's Red Hat, Linux, or whether other people have found through Mongo, or other people have found through Hadoop.
Arvind Krishna: Enterprises do look for, and the last few days have certainly shown us, patching, security, and backward compatibility. There are a lot of enterprise reasons why people would still do business with us, but the open source nature of what you asked, and I'm so glad you asked, allows us to expand that market to the millions of developers who do run Linux on their home machines, or their corporate machines, or their laptops, and they can go experiment, add their innovation, and either give it back to the community, or actually reserve it for their enterprises.
Speaker Change: Enterprises do look for, and the last few days have certainly shown us, people look for patching, people look for security, people look for backward compatibility, there's a lot of enterprise reasons why people will still do business with us, but the open source nature of what you asked, and I'm so glad you did, allows us to expand that market into the millions of developers.
Speaker Change: who do run Linux on their home machines or their corporate machines or their laptops, and they can go experiment, add their innovation, and either give it back to the community or actually reserve it for their enterprise. So that's how we kind of tap into the whole developer ecosystem.
Arvind Krishna: So that's how we kind of tap into the whole developer ecosystem. Let me now wrap up the call. In the second quarter of 2024, we executed on our strategy to deliver revenue growth and cash generation. We saw strong performance across our portfolio, and we're excited about our early traction in generative AI.
Arvind Krishna: We look forward to sharing our progress with you as we move through the rest of the year. Thank you all. Thank you, Arvind. Operator, let me turn it back to you to close out the... Thank you for participating on today's call. The conference has now ended. You may disconnect at this time.
Speaker Change: Let me now wrap up the call. In the second quarter of 2024, we executed on our strategy to deliver revenue growth and cash generation. We saw strong performance across our portfolio. We are excited about our early traction in generative AI.
Speaker Change: We look forward to sharing our progress with you as we move through the rest of the year. Thank you all. Thank you, Arvind. Operator, let me turn it back to you to close out the call.
Operator: Thank you for participating on today's call. The conference has now ended. You may disconnect at this time.
Operator: and many more.