Q3 2024 International Business Machines Corp Earnings Call
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Speaker Change: Now I will turn the meeting over to Olympia Mcnerney Ibm's Global head of Investor Relations Olympia you may begin.
Olympia Mcnerney: Thank you I'd like to welcome you to IV in third quarter 2024 earnings presentation, I'm Olympian Mcnerney and I'm here today with Arvind Krishna Ibm's, Chairman, President 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.
Olympia Mcnerney: 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. For example, all of our references to revenue and signings growth are at constant currency. We've provided reconciliation charts for these and other non-GAAP.
Olympia Mcnerney: 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.
Olympia Mcnerney: And about these factors is included in the company's SEC filings, so with that I'll turn the call over to Arvind.
Speaker Change: Thank you for joining us today, let.
Arvind Krishna: Let me start by discussing the quarter before I get into more detail on the execution of our strategy.
Arvind Krishna: We delivered double digit revenue growth in software with the re acceleration in Red hat and continued strength in transaction processing.
Arvind Krishna: Infrastructure reflects product cycle dynamics with <unk>, well ahead of prior cycles, highlighting customer adoption and continued reliance on the mainframe.
Arvind Krishna: In consulting we continue to navigate an uncertain macro environment with results at the lower end of our expectations.
Arvind Krishna: We generated strong operating profitability and the highest level. The first nine months cash generation in many years, while overall revenue performance was mixed.
Arvind Krishna: We continue to reposition our portfolio towards a higher growth higher margin business that is well positioned to address client needs around hybrid cloud and artificial intelligence.
Arvind Krishna: I'll start with a few thoughts on the macroeconomic environment.
Arvind Krishna: Acknowledges spending remains strong.
Arvind Krishna: Businesses view technology as a source of competitive advantage, allowing them to scale operations improve productivity and drive growth.
Arvind Krishna: However, a pause in discretionary spending is impacting our consulting business.
Arvind Krishna: This is due to economic uncertainty, which stems from several temporary factors, including geopolitical issues upcoming elections, and the changing landscape of interest rates and inflation levels.
Arvind Krishna: The consulting market remains dynamic with significant opportunity as clients prepare for AI.
Overall, we are confident in our business and our ability to capture these opportunities.
Arvind Krishna: Now turning to our performance.
Arvind Krishna: Software is nearly 45% of our total revenue up from the high <unk> in 2018.
A testament to our focus on organic innovation and repositioning our portfolio you can see this in our quarterly results as we delivered strong and accelerating software revenue growth of 10%.
Arvind Krishna: Including Red hat at 14%.
Arvind Krishna: Seven points of organic growth and strength across our key platforms.
Speaker Change: Southwest segment profit margin was about 30%.
Speaker Change: Our recurring revenue base, which is about 80% of annual software revenue continues to deliver strong growth.
Speaker Change: Here are for hybrid platform and solutions now stands at $14 9 billion up 11% year over year.
This quarter marks the five year anniversary of our acquisition of Red hat and I am proud of our accomplishments together.
Speaker Change: Since IBM announced the acquisition Red AD revenue has grown to approximately $6 5 billion doubling in size and delivering a mid teens CAGR.
Speaker Change: Opens you have scaled from about $100 million in are our two $1 3 billion expanding more than 10 times.
Speaker Change: Red Hat has also continued to diversify its global footprint expanding into many new countries since acquisition.
Speaker Change: We continue to drive innovation announcing new capabilities, including answerable to dock five rail AI and open shift AI.
Speaker Change: Red Hat was also named a leader for the second consecutive year in the 'twenty 'twenty four Gartner magic quadrant for container management.
Speaker Change: We continue to gain traction in enterprise AI.
Speaker Change: Our book of business related to generative AI is now over $3 billion inception to date up more than $1 billion quarter over quarter. The.
Speaker Change: The mix is roughly one fifth software and full first consulting signings.
Speaker Change: This performance has placed us in an early leadership position, which is crucial at the onset of any technology shift.
Speaker Change: The AI portfolio. We have built is designed to give clients a comprehensive set of tools to deploy AI within their enterprise.
Speaker Change: Really AI and open shift AI allow clients to build a consistent AI Foundation based on open source technology, while Watson X provides an AI middleware platform.
Speaker Change: Assistance are designed to help clients become more productive using AI across a variety of business processes from God to HR customer service and more.
Speaker Change: Consulting is helping clients design and execute AI strategies.
Speaker Change: We also continue to see our infrastructure segment play a larger role as clients bring AI to their data.
Speaker Change: Choosing the right model is top of mind for our clients.
Ibm's granite family of AI models, a fit for purpose.
Speaker Change: Earlier this year, we released code models was 8% to 34 billion parameters.
Speaker Change: This month, we updated credit models, making them approximately 90% more cost efficient than larger models.
Speaker Change: This model can be traded weeks instead of months and are easier to fine tune for specific tasks.
Speaker Change: Rabbit models are available and Watson, <unk>, and Red hat and our ultra integrated into offerings from partners like AWS, Salesforce Qualcomm and S&P.
Speaker Change: Globally clients are turning to IBM to transform their operations with technology.
Speaker Change: This quarter, we announced new collaborations with Natwest, Telefonica, Samsung Sds Toyota systems, and many others.
Speaker Change: As the U S. Open IBM delivered AI generated match report summaries and we are collaborating with ESPN to enhance their sports coverage through advanced AI insights.
Speaker Change: We also continued to deepen our relationships with key technology partners, including Dell, Intel, Microsoft Oracle, Salesforce S&P and service now.
Speaker Change: We remain focused on delivering innovations to the market.
Speaker Change: For example, this quarter, we announced denim to Ibm's next generation processor for Z and aspire accelerator, which will significantly enhance ibm's. These AI capabilities and processing power for enterprise scale applications.
Speaker Change: Investments in emerging technologies also remains a focus for IBM.
Speaker Change: Earlier this month, we opened Europe's first IBM quantum data center.
Speaker Change: This is the second IV important datacenter deployed globally, which will greatly advanced our goal of expanding access to the world's most performance quantum computers.
Speaker Change: Before I conclude let me touch on our outlook.
Speaker Change: The momentum in our software strategy can be seen in our year to date results.
Speaker Change: Our revenue guidance for the fourth quarter reflects this progress balanced by macro dynamics and consulting and infrastructure product cycle dynamics.
Speaker Change: We remain confident in our free cash flow guidance, which we raised in July driven by continued strength in our operating margin performance.
Speaker Change: Overall, our portfolio is well positioned to deliver an upward inflection in growth in 2025.
Speaker Change: Im excited about the opportunities ahead of us and we'll share more details with you in January.
I will now hand over to Jim to walk you through the details of the quarter Jim over to you.
Thanks, Arvind in the third quarter, we delivered $15 billion in revenue $3 $8 billion of adjusted EBITDA to $5 billion of operating pre tax income and $2 30 operating diluted earnings per share and.
Speaker Change: And through the first nine months, we generated $6 6 billion of free cash flow.
We are pleased with the solid operating profitability and free cash flow generation of the business.
Revenue growth combined with a 100 basis points of operating pre tax margin expansion drove 8% operating pre tax profit growth and 5% operating diluted earnings per share growth.
Speaker Change: Our revenue growth for the quarter was up 2% at constant currency.
Speaker Change: Software growth accelerated to 10% with strength across our key platforms of Red hat automation data and AI and transaction processing.
Consulting was flat and continue to be impacted by a dynamic market environment as clients re prioritize spending.
Speaker Change: In infrastructure was down 7%, reflecting product cycle dynamics.
Speaker Change: Our portfolio mix operating leverage and yield from productivity initiatives generated strong gross margin operating profit and free cash flow performance.
Speaker Change: These results represent our highest third quarter levels of gross margin and free cash flow in many years.
Speaker Change: We expanded operating gross margin by 210 basis points and operating pre tax margin by 100 basis points over last year.
Speaker Change: Year to date operating pre tax margin is up 150 basis points well ahead of our guidance provided in July of over 50 basis points of improvement in 2024.
Speaker Change: In September we closed on the Palo Alto Q radar transaction.
Speaker Change: Generating a pretax gain of about $350 million in the quarter.
Speaker Change: As we've previously discussed this was substantially offset by the charges, we took to address stranded costs and accelerate our productivity initiatives.
Speaker Change: These productivity initiatives allowed for continued investment to drive innovation, which you can see in our higher R&D expense up 10% year to date.
Speaker Change: Year to date, we generated $6 $6 billion of free cash flow up $1 $5 billion year over year.
Speaker Change: The largest driver of this year to date growth comes from adjusted EBITDA up about $800 million year over year.
Speaker Change: This quarter, we realized $500 million in proceeds from the Palo Alto Q radar transaction.
Speaker Change: As I mentioned last quarter for the full year, we expect only a modest contribution of free cash flow given payouts from structural actions, we have taken and foregone profit from the queue radar business.
Speaker Change: Through the first nine months of the year, excluding the impact of the Q radar transaction, where several points ahead of our two year average attainment levels.
Speaker Change: In terms of cash uses year to date, we returned $4 $6 billion to shareholders in the form of dividends from.
Speaker Change: From a balance sheet perspective, we have a strong liquidity position with cash of about $14 billion our debt balance at the end of the third quarter was flat with year end 2023 at $56 $6 billion, including $10 4 billion from our financing business.
Speaker Change: Turning to the segments software revenue growth accelerated to 10% with broad based growth across the portfolio.
Speaker Change: This reflects the repositioning of software around key growth platforms hybrid cloud automation data and transaction processing, where we deliver a differentiated value proposition to address clients' most pressing needs.
Speaker Change: Growth this quarter was fueled by the same performance drivers we've highlighted throughout the year.
Speaker Change: <unk> had accelerated contributing about three five points of growth to software.
Speaker Change: The combination of innovation and recurring revenue contributed about three five points to growth.
Speaker Change: And our focused M&A strategy contributed about three points of growth.
Speaker Change: Let me take you through some more details on each of these.
Speaker Change: Red hat revenue growth accelerated to 14% up six points sequentially, we gained market share across each of our key solutions with open shift in ansible growing more than 20% and ROE growing in the double digits. This.
Speaker Change: This strength reflects the demand for our hybrid cloud solutions as clients continue to prioritize application modernization and open shift containers and ansible automation to optimize their it spend and reduce operational complexity, we saw strong acceleration in red hat.
Speaker Change: <unk> business, while the consumption based services business stabilized as we expected.
Speaker Change: Looking at our revenue under contract over the next six months. This metric continues to grow in the mid teens as our annual bookings grew double digits in the third quarter.
Speaker Change: We are excited about the opportunities ahead of us, including generative AI early client interest in our virtualization solution and after the deal completion potential synergies with Hashi Corp.
Speaker Change: We delivered strong growth in our recurring revenue base and are seeing momentum from innovation across our software portfolio.
Speaker Change: Hybrid platform and solutions.
Speaker Change: <unk> was $14 $9 billion up 11% year over year, driven by strength across automation data and AI and red hat.
Speaker Change: Transaction processing grew 9% in the quarter.
Growing capacity solid renewal rates and continued customer interest in our new generative AI product Watson xcode assistant for Z contributed to growth.
Speaker Change: We continue to invest in bringing innovation to market launching new offerings like rally I, Ansible, 2.5, and updated capabilities to our family of assistance, including the recently announced Watson Xcode assistant with advanced features for enterprise Java applications.
<unk> had also announced a partnership with Dell that makes rally is a preferred platform for AI deployments and Dow power edge servers.
Speaker Change: This innovation is driving organic growth acceleration with increasing contribution from our core Watson next middleware in data and AI Watson ex orchestrate and IBM concert in automation.
Speaker Change: And our AI embed strategy across our software portfolio.
Revenue performance. This quarter also benefited from recent software acquisitions.
Speaker Change: August marked the one year anniversary of the <unk> acquisition, and we are seeing strong synergies with our automation capabilities and broader software portfolio driving continued acceleration in bookings and air growth since close. Additionally.
Speaker Change: Additionally, the stream set some web methods assets are now part of the software business and we continue to expect the Hashi Corp acquisition to close by the end of this year.
Speaker Change: Moving to software profit, we expanded gross margin and segment profit was up over 120 basis points from last year as we continue to deliver operating leverage driven by our revenue performance.
Speaker Change: Consulting revenue was flat, which was at the lower end of our expectations.
Speaker Change: As we discussed throughout this year, we are operating in a challenging macroeconomic environment and see no change in client buying behavior.
Speaker Change: At the same time clients are re prioritizing their it budgets to prepare for generative AI while.
Speaker Change: While demand for large digital transformations remained solid our overall signings decline for the second consecutive quarter as we wrapped on record third quarter signings from last year.
Speaker Change: Despite the weak current demand environment, we are well positioned to capture growth from generative AI.
Speaker Change: We continue to build a solid generative AI book of business with about $1 billion of new bookings in the quarter as we partner with our clients to design and scale AI solutions and develop new ways of working.
Speaker Change: This early momentum is important engaging with clients as they architect their AI strategies is establishing IBM consulting as a strategic partner of choice.
Speaker Change: In the third quarter, our Red hat practice, which helps clients optimize how they build deploy and manage applications for a hybrid cloud environment continue to grow at a double digit rate with this quarter being the largest single quarter of signings since the acquisition of Red hat.
Speaker Change: Additionally, within our strategic partnerships, both our AWS and Azure practices continue to contribute robust revenue growth.
Speaker Change: Turning to our lines of business business transformation revenue grew 2% driven by strength in transformation projects for data finance and supply chain.
Speaker Change: Both technology consulting and application operations declined in the quarter.
Speaker Change: While there was strength in cloud based application services across modernization development and management, we continue to see clients re prioritizing spending away from on Prem customized services.
Speaker Change: Looking at consulting profit, we expanded gross profit margin almost one point and delivered segment profit margin of 11% a sequential improvement of two points, reflecting yield from our productivity actions.
Speaker Change: Moving to the infrastructure segment revenue was down 7%, reflecting product cycle dynamics.
Speaker Change: Infrastructure was down 9% and infrastructure support declined 3%.
Speaker Change: Within hybrid infrastructure IBM Z revenue declined 19% in what is now the 10th quarter of Z 16 availability disease 16 program continues to exceed prior cycles delivering revenue growth in eight of the last 10 quarters and program to date installed mips or up or.
Speaker Change: 30%.
Speaker Change: Our clients continue to face increasing demands for workloads, given rapid business expansion complex regulatory environments, and increasing cyber security threats and attacks.
<unk> remains uniquely positioned to address these demands with the technologies that our latest program offers embedded AI at scale quantum safe security and cloud native development for hybrid cloud disc.
Speaker Change: Distributed infrastructure revenue was down 3% with product cycle dynamics impacting our power business, while we saw solid growth in storage, which continues to take share.
Speaker Change: For infrastructure profit, we expanded gross profit margin of 120 basis points across the portfolio this quarter.
Speaker Change: At the same time segment profit margin was down 110 basis points driven by continued investments in innovation for our next generation of products.
Speaker Change: Now, let me bring it back to the IBM level to wrap up.
Through the first nine months of the year, we have grown revenue by 3% expanded our operating pre tax margin by 150 basis points and grown free cash flow by $1 $5 billion. We have made solid progress in transitioning our portfolio to a higher growth higher margin business.
That is well positioned as we head into next year.
Speaker Change: With nine months of the year behind US let me now focus on the fourth quarter.
Speaker Change: We expect revenue growth in our fourth quarter to be consistent with the third quarter levels.
Speaker Change: Software revenue growth has accelerated throughout the year and this should continue.
Speaker Change: We expect low double digit fourth quarter revenue growth for software led by Red hat growth in the mid teens and continued strength in transaction processing.
Speaker Change: This now represents strong high single digit growth for the year.
Speaker Change: Consulting revenue was up 1% year to date impacted by challenging macroeconomic environment.
Speaker Change: We expect fourth quarter revenue performance to be similar to the third quarter.
Speaker Change: This represents the weaker end of our prior expectations of low single digit revenue growth for the year and.
Speaker Change: And given we are at the end of a multiyear product cycle. We now expect infrastructure to be about a one point impact to IBM for the full year.
Speaker Change: On currency given the strengthening of the dollar we now expect currency to be about a half a point headwind to revenue growth in the quarter and about a point impact of revenue growth for the year.
Speaker Change: Now turning to profitability for the full year, we are raising our expectation for operating pre tax margin expansion to about a point year to year well above our model.
Speaker Change: The strength of this performance is driven by our revenue scale portfolio mix and productivity initiatives, enabling operating leverage while providing investment flexibility.
Speaker Change: Actions taken in the third quarter help accelerate our productivity initiatives and we now believe we can achieve approximately $3 $5 billion in annual run rate savings by the end of 2024 up from $3 billion drill.
Speaker Change: Drilling down on segment margins, we expect software segment profit margin to expand by well over a point for the year.
Speaker Change: Consulting segment profit margin is now expected to be flat and we continue to see infrastructure segment profit margin in the mid to high teens.
Speaker Change: Consistent with last year, we are maintaining our full year view of operating tax rate in the mid teens range.
Speaker Change: For free cash flow given the strength of our performance year to date, we remain confident in delivering greater than $12 billion of free cash flow for the year driven primarily by growth in adjusted EBITDA.
Speaker Change: We are on track to grow revenue expand operating profit and grow free cash flow as we close out 2024.
Speaker Change: This positions us well as we look forward to 2025, we are confident in our portfolio and growth trajectory as we head into 2025, given the acceleration in software the opportunities ahead of us and Red hat, our new mainframe cycle and the associated hardware and software.
Speaker Change: Stack, our generative AI positioning and contribution from acquisitions.
Speaker Change: Arvind and I are now happy to take your questions Olympia, let's get started.
Olympia Mcnerney: 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.
Olympia Mcnerney: Thank you.
Speaker Change: At this time, we'll begin the question and answer session of the conference.
Speaker Change: If he would like to ask a question. Please press star one on your telephone keypad.
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Speaker Change: Starkey followed by the number two if you would like to remove your question from the queue.
Speaker Change: For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys.
Speaker Change: Our first question comes from Amit <unk> with Evercore ISI. Please state your question.
Speaker Change: Good afternoon, everyone. Thanks for taking my question.
Speaker Change: I guess.
Speaker Change: You talked to at the end of your comments about how IBM.
Speaker Change: Got it.
Speaker Change: Oh yeah.
Speaker Change: Yes.
Speaker Change: Yeah.
Speaker Change: Organically and twenty-five ASEAN.
Speaker Change: And if I think about the segment I think the interest of decided somewhat easy to see where the C 17 cycle, but I would love to hear your thoughts on you know how does that inflection pan out on software and consulting, especially consulting after a few quarters of muted growth. Thank you.
Speaker Change: Hey, Thanks, Amit first thank you very much you are picking up on the comment on upward inflection for 25 that is something which we have worked really hard.
Speaker Change: Steve and that I'm really proud of what the whole team has gotten there could be specific on the parts that you just touched on.
Speaker Change: About the upward inflection on software and consulting so if I look at software first of all with Red hat, having just delivered 14% are fixed.
Speaker Change: <unk> similar performance for.
Speaker Change: For the next quarter and given that we get at least six to nine months worth of a look ahead based on the CRP all Red hat, we expect that to carry on into next year that could easily.
Speaker Change: Ill, then provide a significant amount of lift to software, perhaps about three points of growth for software overall.
Speaker Change: Two we've got very good traction both in our Gen AI products as well as in our automation suite and.
Speaker Change: You can look at our pipelines and expect that those will be maintained.
Speaker Change: Given we have also seen a lot of mainframe deployment.
Speaker Change: Underlying capacity, they're going to power ahead.
Speaker Change: Mainframe or the TPS software you put that together with the already announced M&A of Hershey Cup.
Speaker Change: And then planned M&A that we will have over the year and that gives us a lot of confidence on software.
B.
Speaker Change: At our likely above the model that we had laid out a few years ago. So I think that gives you the pieces and software and consulting.
Speaker Change: I acknowledged in the call that there is some macro issues that will impact.
Speaker Change: Discretionary labor so that is a piece that is there but that is kind of baked in now to what we've been doing but as we look forward our book of.
Speaker Change: To book ratio at 1.14 tells US that there is a lot of pent up demand as we see this gen AI pipeline turn from signings into revenue and we expect to see growth there and we have a very healthy book of business with the hyper scaler and with our ISP partners as Jim had talked about.
Speaker Change: We put all of that together and we expect to see positive upticks on consulting you'll note I'm not trying to quantify that as deeply as I did in software, but it will be upwards, but.
Speaker Change: That together with what we'll see in infrastructure, maybe expect to see significant upticks.
Speaker Change: Starting likely around the end of the first half and that gives us the confidence in 'twenty 285.
Speaker Change: Operator, let's take the next question.
Speaker Change: Our next question comes from Toni <unk> with Bernstein. Please state your question.
Speaker Change: Thank you for the question I just wanted to follow up largely along those lines Arvind.
Speaker Change: Ivy MSA portfolio of many different things and some years things go really well like TPP. This year and other things don't go very well like consulting this year, but if I look back at the last four years and maybe that's not the right timeframe May correct me.
Speaker Change: <unk> growth this year will be 3% or less and growth has been 3% and three of the last four years and so I understand that the setup for 2025 is good because of the mainframe cycle and acquisition.
But.
Speaker Change: Okay.
Speaker Change: Why is why should that not be viewed as a one off just like this year, maybe as a one off and being below your 4% to 6% model of less than 3% growth and specifically for next year.
Speaker Change: Do you think that's helping signings will inflect positively in Q4 because.
Speaker Change: They've been negative the last two quarters. So if they don't start to pick up then the leading indicator for consulting actually does not point to growth.
Speaker Change: <unk> for 2025.
Speaker Change: Yes.
Speaker Change: So if you can address those questions that'd be great. Thank you.
Speaker Change: Tony.
Speaker Change: Let me build on the comments I made in response to <unk> question, and then address some of the points you made Tony.
Speaker Change: So.
Speaker Change: I'm not sure I would acknowledge that 3% growth only.
Speaker Change: While that has been true in many of these years 2022 was definitely far above that.
We acknowledge that that will also perhaps a one off.
Speaker Change: With the kindred revenue now being recognized into.
Speaker Change: Your company as opposed to in truck company.
Speaker Change: Despite that we actually had higher revenue than that despite what we explicitly modeled out for the kindred piece.
But let me acknowledge at least in two of the last four years. It was around 3% so what gives us confidence.
Speaker Change: I've got began to Amir's question, we've been really audit work rebuilding our portfolio to be both sustainable and have a lot more value for our clients in terms of the innovation, we are delivering them as well as our ability to manage the cost and complexity that they have and.
Speaker Change: They're all leveraging technology to drive a much larger part of their own businesses, that's kind of the macro that under that the fact that 7% of our software growth. This year was organic in this last quarter not at all Acquisitiveness gives us confidence about how well that software is being used.
Speaker Change: 80% of our software is actually now on a recurring revenue basis that is up significantly over the last few years.
Speaker Change: Those out at us real demand in that part of the portfolio.
Speaker Change: Rather than say, it's 80% there and it generated a 10% that gives us confidence on the organic basis software, even going into next year and as far as we can see the mainframe software will maintain.
Speaker Change: Perhaps mid single digit growth not maybe high single digit growth going into next year, but that gives us really good tailwind for what we're trying to do there.
And while I called out how shake up which is sort of already been announced we do expect as we get through that deal to do a lot more M&A, even going into next year and since our cash flows have gone up from four years ago that gives us more ability.
Speaker Change: To do M&A without any other actions to speak off.
Speaker Change: On your consulting side.
Sure.
Speaker Change: While the last year and if I go more than four years ago, having flat on that.
Speaker Change: Dave the confidence were getting there is from the quality of the signings.
Speaker Change: And from the yields that we expect.
Speaker Change: The overall signings this year have been lower than last year, but is the signings didn't yield then they don't mean very much so as the yields we worry about and the backlog that we get that we worry about and we are seeing those begin to turn not amusing.
Speaker Change: I'm using the word began to turn I don't expect consulting to inflect like software and go into double digits, but I do expect it to turn into a tailwind for us.
Speaker Change: In terms of being positive growth as we're going and that's why I believe this may be a tale of two halves consulting maybe very modest in the first half, but much better in the second half based on what we can see in terms of the signings of the offerings and as the Gen. AI book of business turns into real revenue.
Speaker Change: Most all of our clients I hope that that gives you a sense and I know, we don't talk on infrastructure and to acknowledge the mainframe cycle, but I also want to call out credit.
Speaker Change: Inside the infrastructure business. There is also a recurring revenue business, which.
Speaker Change: Our hardware maintenance business and that is also a piece that has gone from being a headwind to potentially close to flat next year. So just an ear to ear that could well be a four five point tailwind on that part of the business.
Speaker Change: Operator next question.
Speaker Change: Thank you. Our next question comes from <unk> Mohan with Bank of America. Please state your question.
Speaker Change: Yes. Thank you so much.
Speaker Change: Tim in your comments you noted no change in client buying behavior in consulting, but if we.
Speaker Change: Look at what happened with your AI book of business, which is up meaningfully a meaningful part of that being in services.
Speaker Change: It would indicate that the underlying consulting business ex that.
Speaker Change: Kind of deteriorated. So I was wondering if you could reconcile that comment.
Speaker Change: With with what's happening in and consulting and secondarily.
Speaker Change: You noted year to date <unk> margin performance of 150 bps improvement, but the fiscal year as guided to about 100 basis points, but he also noted sort of realizing peer to $5 billion of annual run rate savings. So can you just talk about some of the profit dynamics in the fourth quarter, how we should think about some of the puts and takes over.
Thank you so much.
Speaker Change: Sure <unk>. Thank you for the question overall as Arvind and I said in the prepared remarks, we're obviously operating in a.
Speaker Change: Very dynamic uncertain macroeconomic environment around the entire consulting market overall, yes, we posted flat revenue growth overall by the way up 1% year to year to date, so slight deterioration underpinning that I think there is multiple dynamics that are playing.
Speaker Change: And let me try to unpack some of these first to your question about the opportunity statement.
Speaker Change: And yes Gen AI, albeit we're very early in the cycle right. Now we are very focused on ensuring we get an enterprise lead position and establishing consulting as a strategic.
<unk> of choice and we're building that book if you look at our book of business right. Now, we exited 90 days ago IBM above $2 billion that was about 75% consulting now, we're north of $3 billion and about 80% consulting so underneath that.
Speaker Change: We are actually seeing the last two quarters about $1 billion book of business each quarter being generated now within that those are mid to long term digital transformation Gen. AI based deals by definition higher duration.
Speaker Change: <unk> lower revenue yield and I think we've spent time last quarter talking about it about three to four points less yield than traditional book of business overall, but it's important because it's building that backlog growth that Arvind just answered Tony's question on overall, because we believe albeit were.
Speaker Change: Early this is a long term growth vector with a multiplier effect across our platforms. Our software our infrastructure that is an integral part of the integrated value thesis with consulting gear now mitigating some of that growth is the high yielding revenue.
Speaker Change: Short term discretionary projects those yields are about four to five points above what we're seeing in <unk> right. Now so I think youre seeing the early cycle dynamics that will put pressure on has put pressure on our topline consulting revenue, but and that's why we guided fourth.
Speaker Change: Quarter, consistent but more importantly, I would look at the glass half full we are becoming the strategic provider of choice, we're winning in the Gen AI space around consulting and that's going to fuel our growth factor around fueling 2025, now with regards to profit equation.
Speaker Change: We're very pleased with our fundamentals of our business and the underpinnings of that.
Speaker Change: We drive operating leverage in this business three different ways, one high value portfolio mix, that's why software as an integral part of our model approaching 45% of revenue that growing 10% is a strong profit contributor overall to as we get the high value leverage of our recurring.
Speaker Change: Revenue stream overall and productivity and three we get that $3 $5 billion that we are looking for coming out. We're well ahead of that year to date as you said I think we're being very prudent on how we're guiding the fourth quarter right now and we will talk 90 days from now we fully expect.
Speaker Change: By the way that all drops to the quality and sustainability of free cash flow.
Speaker Change: B up well over $1 billion with north of $12 billion. This year and will be set up very nicely for 2025.
Speaker Change: Operator, let's take the next question.
Speaker Change: Our next question comes from Ben Reitzes with Melleous Research. Please state your question.
Ben Reitzes: Yeah, Hey, thanks, guys.
Ben Reitzes: Jim We've previously spoken about.
Ben Reitzes: High single digit growth potential for free cash flow at this company.
Ben Reitzes: I was wondering.
Ben Reitzes: You've made a lot of comments about 2025 do you think thats possible still in 2025, given the hashi acquisition and I want to also see if you can.
Address it if consulting were to remain flat does the mix shift still still support that thanks a lot.
Speaker Change: Yes, Ben Thanks, very much for the question a lot of interest as you know quite well from our investors on this particular question of our model I am not going to get into the specifics as you would probably not expect me to about actual quantification I think Arvind and I have both said, we feel very confident about our strategy.
Speaker Change: <unk>, our portfolio and our growth opportunities heading forward into 2025, well, let's take a step back right.
Speaker Change: Three years ago, when we laid out our mid term model Arvind transition. This company from a no growth company to a mid single digit company.
Speaker Change: A company that was roughly about 10 points of our pre tax margin to accompany thats going to exit this year in the high teens growing 7% to 800 basis points over three years and a company that was stagnant to declining free cash flow and we will probably grow free cash flow by the way exiting 2024.
Speaker Change: Pretty much on top of the absolute number we set in 2022. So I think we've made a lot of progress now when you talk about going forward, we've talk about upward growth inflection all of you understand the portfolio mix composition in this business.
Speaker Change: The productivity mindset of what we drive in this company and their competitive business model positioning, which I would argue we still have a lot of headroom to continue to grow.
Speaker Change: Our model has always been to drive operating leverage that enables us to drive free cash flow faster than revenue and I would fully expect that even with.
Speaker Change: Hershey dilution that we all acknowledge we are very excited we're hoping to close that still by the end of the year, but that transaction stands on its on its own strategic value and attractive financial model and a synergistic value, we get across our portfolio of software and consulting.
Speaker Change: And we've got that embedded in our model and we still feel very confident grow free cash flow faster than revenue.
Speaker Change: Operator, let's take the next question.
Operator: Our next question comes from Jim Schneider with Goldman Sachs. Please state your question.
Jim Schneider: Thanks, and thanks for taking my question I was wondering if you could maybe comment on the rate at which Youre seeing.
Jim Schneider: Consulting work and the consulting side and you do have a translate into revenue and the sort of the time to commencement is that what's giving you.
Jim Schneider: A bit of a increased confidence on the on the inflection in consulting or the slow improvement in consulting going into next year and then maybe just kind of separately talk about if you could the types of M&A targets that you're thinking about in software and how long it might be different than what you've done in the past or are you thinking of things that are.
Jim Schneider: In any way different from the sort of open source.
Jim Schneider: The structure and Dev ops.
Jim Schneider: Are deals that you've done in the past and how that might be changing thank you.
Speaker Change: Great Jim Thank you.
Speaker Change: Take the first part of your question Arvind can handle the second part about the.
Targeted areas around M&A.
Arvind Krishna: As we stated we feel very good about the strong start in our Gen. AI book of business around consulting, let's just put some numbers to it right.
Arvind Krishna: IBM north of $3 billion grown over a 1 billion quarter to quarter. The consulting book of business approaching $2 $5 billion, you put that in perspective against the last technological shift that we can see within our business that being hybrid cloud in red hat and we're about to ex that run rate because we.
Arvind Krishna: Did about $1 billion in the first 12 months. So we're seeing a very nice acceleration and we've talked enough about this being very early in the cycle.
Arvind Krishna: But that $2 $5 billion book of business, that's up almost a $1 billion quarter to quarter and it's growing 35% now when you look at it the underpinnings as I said earlier. These are mid to long term strategic digital transformation journey ideals.
Arvind Krishna: Higher duration durations are probably approaching high 40 months overall compared to way.
Arvind Krishna: Average duration and consulting that's in the low twenties.
Arvind Krishna: Point number one point number two I talked about revenue European lower about three to four points lower revenue yields kind of hovering around mid to high single digit revenue yield and again, that's about 3% to four points less than traditional but I can't stress enough I think these curves will inflect as we move.
Arvind Krishna: Into 2025, because as we start wrapping around the short term discretionary pullback that's impacting that traditional near term revenue, we're going to start seeing this long term growth vector pickup as we go forward, which then has multiplier effects of our software and our hardware going forward.
Speaker Change: Thanks, Jim.
Speaker Change: Jim Let me address the second part of your question.
I've been very clear about our M&A strategy it has to fit our existing strategy.
Speaker Change: And in this case for software, which you asked about the three areas would be what are we doing around hybrid cloud.
Speaker Change: I'd say, how she is a great example of something in there what are we doing around automation.
Speaker Change: There was probably a great example, there, but some others like turbo anomic and its data.
Speaker Change: And then what are we doing around data and AI, where I would tell you that portions of software AG fell into that camp.
Speaker Change: Reason that I want to stick to the lanes. We are in is because we get a massive amount of go to market synergy and distribution synergy with IBM, which is the second element of the strategy there has to be synergy with IBM.
Speaker Change: Target could not have realized on their own otherwise there isn't economic return for our investors. So those two pieces are all essential right now now when we did read had five years ago and I think that that was implicit in your question. We did open up a new lane.
A big open source play and we have stuck to that through the right discipline and with that Brian name, but not everything needs to be open source. So let me be clear on that after it was not open source turbo gnomic was not open source.
Speaker Change: When we do find an open source property that fits all our criteria. We would certainly look at it but that is not our lens or a filter on looking at things the filter and lengths of looking at things what are the three areas that I mentioned as being our strategic fit now you made a comment about two <unk>.
Speaker Change: And as they go about their big headroom, we see a lot of headroom on these topics and helping people manage their infrastructure better take cost out.
Speaker Change: As the labor complexity, leveraging our data better do AI at more cost efficient methods and everything that we see today as we go through all of this once we begin to run out of headroom that we might add some areas, but I don't see that happening for some years at this point.
Speaker Change: Operator, let's take the next question.
Speaker Change: Our next question comes from Brent Thill with Jefferies. Please state your question.
Brent Thill: Thanks, Jim really good margin on software, 30% well above past Q3s.
Brent Thill: How sustainable is this 30% margin and any way to frame that going forward. Thanks.
Speaker Change: Yes, Brent Thank you very much for the question.
Speaker Change: Obviously very pleased with our software performance is core to our strategy overall.
Speaker Change: So software being about 45% of Ibm's revenue composition, and two thirds of our profit.
Speaker Change: And most importantly to Arvin's last question here that he just answered integral to our hybrid cloud and AI platform centric model. It's all built around software overall by the way.
Speaker Change: You probably noticed we did hit the rule of 40 here in the third quarter, we feel confident that we continue to strategically reposition our business and by the way the margin inflection we've seen over the last three years and software has been both a combination of that revenue inflection of getting.
Speaker Change: Into more end markets with the strategic focus both organically and Inorganically that arvin talked about hybrid cloud automation data and by the way the inflection of transaction processing, which I'll remind all of you is a high margin high profit.
Speaker Change: Contribution overall, so that coupled with the productivity initiatives are enabling us with the financial flexibility to continue to invest in innovation, while still generating margin and operating leverage going forward. So we feel pretty confident about that continuing similar to how I answered. The earlier question we see.
Speaker Change: A lot of headroom in front of us on an operating margin continuing both for IBM and for software.
Speaker Change: Operator, let's take the next question.
Speaker Change: Our next question comes from Erik Woodring with Morgan Stanley. Please state your question.
Erik Woodring: Great. Thank you very much for taking my question, Jim I wanted to maybe ask the consulting AI question, maybe a different way, which was last quarter. You had noted that consulting AI projects were largely cannibalizing other areas of consulting spend and I'm just curious at what stage.
Erik Woodring: Do you think these smaller durations signings turn into recognized revenue and some materiality that could really impact the trajectory of the consulting business and then second in what situation or environment would we see AI consulting projects.
Erik Woodring: And from Cannibal Cannibal cannibalizing, the traditional business to becoming incremental to traditional consulting. Thanks. So much.
Speaker Change: Yeah, great and thanks, Eric for the question overall.
Speaker Change: As we talked about.
Speaker Change: Maturity of Jenny I, we're very early in the cycle. The key for US is the win this early leadership position that would be the <unk> strategic provider of choice and I think we are.
Speaker Change: Carrying our own to say the least right now given the $2 $5 billion book of business now with that higher duration lower revenue yield there is revenue yield in the quarter.
Speaker Change: Don't want to leave anyone without the impression it's just about three to four points below what our traditional or because of the longer duration.
Speaker Change: I just do some of the mathematics around it very quick.
Speaker Change: First we're going to start wrapping on the pulled back when we started talking about the short term pause in discretionary spending as clients are looking at cost productivity to fuel investment into gen. AI projects that have longer duration, we'll start wrapping on that as we kind of.
Speaker Change: Get through the first half of next year, that's point number one point number two that inflection curve. When we just look at what we experienced historically with the red hat generation because in every technological shift human capital and consulting base business, you're always going to see re prioritization, we've seen it with <unk>.
Speaker Change: Cloud technology shift we've seen it with the Internet, we've seen it with globalization and we've seen it when we went through the hybrid cloud side on Red hat that kind of puts it in as Arvind and I have been talking here, while we feel very confident in that upper a growth inflection and twenty-five.
Speaker Change: Consulting is going to be more of a second half 'twenty five play as we move forward and by the way with that upward inflection. The key is backlog, we got to get the volume of demand here in the fourth quarter to Tony's question and we got to still continue building that volume of demand in the first half because then that will be.
Speaker Change: Build a multiplier effect that will be a nice healthy.
Salting growth orientation like we were at about a year ago.
Speaker Change: Okay, operator, let's take one last question.
Speaker Change: Thank you and the next question comes from Matt Swanson with RBC capital. Please state your question.
Matt Swanson: Yeah, Thanks for taking my questions.
Matt Swanson: Or when you talked about the latest edition of the granite models being 90% more cost efficient trained in weeks.
Speaker Change: We've taken a really pragmatic kind of ROI focused approach to Gen. AI could you just talk a little bit about what you're hearing from enterprises and customers that are kind of supporting that direction of development.
Speaker Change: So it would be Matt and thank you for that question and we are picking up on the ground at models.
Speaker Change: Look as I started talking to customers on this topic about a year and a half ago. There was a lot of excitement around.
Speaker Change: Jan AI deployment inside the enterprise, but you could see some people are beginning to do the math and say hang on but really use this at full scale.
Speaker Change: All of the transactions that happen inside or enterprise than the bill could easily become tens of millions of D, which very quickly becomes multiple billions a year and while that was advantageous to do it they didn't see that kind of cost being affordable so.
Speaker Change: So we sat back and said.
Speaker Change: How big do these models need to be because of the size of the model determines.
Speaker Change: Or did determine previously performance as well as the cost.
Speaker Change: And so the question became could we do a model that tens of billions of parameters and was as good but for a more constrained set of tasks.
Speaker Change: Kind of be a little facetious.
Speaker Change: Look if you're running a big consumer model and you have no idea is the person go to ask you to summarize a document or a piece of effects, which they do or they are going to ask you to redeploy them or a haiku all translate finish to French. Okay. You got to have a model that does all of those things, but we need a model that can summarize the business documents.
Speaker Change: But at a much higher quality that allows us to bring our model with about in this case to be precise eight to <unk> 30 billion parameters that is as good as the biggest models for those tasks, but doesn't do all those other things.
Speaker Change: For the enterprise that does 100% of their use case.
Speaker Change: And literally in this case could run with 97% more efficiency.
Speaker Change: They're giving it to people with the indemnity.
Speaker Change: The licensing that they could actually refine it and the old or the refinement or any improvements to the model back to US. We think is a winning hand as enterprises deploy more and more of generative AI.
Speaker Change: So with that let me now wrap up the call.
Speaker Change: In the third quarter of 284, we accelerated our software performance, including Red hat.
Speaker Change: We are excited about the positioning of our portfolio and our growth prospects would relate ratified.
Speaker Change: And we look forward to sharing our progress with you as we close out the year. Thank you.
Thank you Arvind operator, let me turn it back to you declared that the com.
Speaker Change: Thank you for participating on today's call. The conference has now ended you may disconnect at this time.