2023-11-28 11:54:08 ET
International Business Machines Corporation (IBM)
UBS Global Technology Conference
November 28, 2023 09:35 AM ET
Company Participants
Jim Kavanaugh - CFO
Conference Call Participants
David Vogt - UBS
Presentation
David Vogt
Good morning, everyone, and welcome to the UBS Global TMT Conference here in Scottsdale, Arizona. I'm David Vogt. I am the enterprise hardware and networking analyst here. And we're excited to have with us this morning at a keynote, IBM and Jim Kavanaugh, Chief Financial Officer.
Before we get started, let me just briefly read a UBS disclosure. So, in the interest of time, I'm just going to say, briefly, look at our website, there are important disclosures on the website. If you don't have them, I can email them to you. But they're at www.ubs.com/disclosures.
With that out of the way, Jim, thank you for joining us today.
Jim Kavanaugh
David, thank you. I appreciate you dressing in big blue color.
David Vogt
We did it on purpose. All blue.
Question-and-Answer Session
Q - David Vogt
So I thought it made sense, maybe if we could start with IBM's strategy evolution since Arvind joined. I know you've been with the Company a long time. Arvind has been with the Company a long time, but he basically kind of took the reins post-2020 -- early 2020. So maybe we could talk about how we got to where we are today. Maybe -- obviously [Technical Difficulty] Red Hat, you spun off Kyndryl and talk to how the portfolio is continuing today and how do you think about the strategy going forward?
Jim Kavanaugh
Yes. Great place to start. Obviously, mentally a different company than what we were a few years ago. Really focused on what we believe are the two most transformative technological shifts that are happening in the world today, that being hybrid cloud and AI. And when you look about it, we built a platform-centric business underneath Arvind's leadership around, first, our Red Hat OpenShift, the industry-leading hybrid cloud platform; and second, we just announced this year in May at our Think conference, our generative AI platform around watsonx overall.
And those platforms carry a very attractive multiplier effect of every dollar that you land on a platform we get $3 to $5 a software, $6 to $8 of services overall. But underneath that strategy of Arvind bringing us all in on hybrid cloud and AI, we've done a lot of work over the last few years around, in essence, reinventing IBM, redesigning our operating model, our portfolio composition. Our portfolio today, now post the Kyndryl separation, is made up of 75% growth vectors of software and consulting, with a very stable, high-value recurring revenue stream that's over 50% of IBM's composition.
But underneath that, we've been very aggressive with a disciplined capital allocation strategy. We've acquired 37 companies over the last four years in areas around client needs and demand, that being hybrid cloud, that being data, that being the AI, that being automation, that being services capability and expertise and assets. And that has driven a very different portfolio composition that enables us to get to a very different revenue profile as a company. But just as important as that portfolio shift of acquisitions is we've divested over 15 different businesses over the last handful of years. Most recently, you talked about the spin-off of Kyndryl. And that has created a very-focused company that now has given us a tremendous amount of investment and financial flexibility to invest in innovation, to invest in go-to-market, to invest in ecosystem, strategic partnerships and to build out expertise, skills and assets in our consulting business.
But when you look at today, if you think about our portfolio and you think about the challenges clients are facing today, and we know them all, we're dealing with single day, high inflationary environment, changing demographics around the world, labor productivity, continued supply chain disruptions, cyber, data privacy, threats and concerns, sustainability. Our portfolio is lined up, I think, extremely well around addressing those because we carry everything from application layer platform of hybrid to data and AI, to automation, to security, to a services portfolio overall. And that's led to really differentiated financial performance the last couple of years. That plays out our investment thesis around IBM, which is higher revenue growth company, higher operating margin, stronger cash flow yield and a higher return on invested capital.
David Vogt
That's a great overview. So maybe -- so with the acquisition of Red Hat, it kind of solidified your hybrid cloud strategy. I’ll come back to AI later, but I know IBM was early identifying hybrid cloud, multi-cloud [Technical Difficulty] well ahead of your peers. So how does that sort of technological sort of footprint that you currently have today with the different sort of assets give you a competitive advantage in the marketplace? When you go to customers that have needs that are potentially unmet today and how they're thinking about the next five years [Technical Difficulty]?
Jim Kavanaugh
Yes. If you go back, we've been talking about hybrid cloud. And in essence, that was the strategic thesis around the Red Hat acquisition overall. At that point in time, this was 2018 when we announced the acquisition, right? We closed in July of 2019. That acquisition, we had a very distinctive point of view of where the market was going at that point in time. When everyone was thinking 100% of the workloads were going to hit the public cloud overall, and public cloud was [Technical Difficulty].
We actually had a point of view that said, one, the world was going to be multi-cloud. And I think hard to argue, it's not today. 90-plus percent enterprises on multiple clouds of [Technical Difficulty], including, by the way, IBM. Second, the world was going to be multi-environment. Workloads are going to be optimized where best, whether that's public, private, on-prem, and now the reality, all the way to the edge. And the third piece, which is very interesting, if you go back to 2018, we said that there was going to be a tighter integration of hybrid cloud and AI through scale.
Now when you look at it, the essence behind the Red Hat acquisition, was us capturing the industry leading horizontal hybrid cloud platform, that being Red Hat OpenShift. By the way, running on top of Red Hat Enterprise Linux -- and it's interesting to note, in 2019, Linux for the first time ever surpassed Windows, the most dominant operating system in the world. But in addition to that acquisition, we had to do a lot around our portfolio to ensure we built out a comprehensive integrated suite of capabilities to leverage that platform overall. And we've done a lot of work around optimizing our software, enabling it to be run on Red Hat OpenShift. So now clients can build once, run anywhere, right?
We built our service capabilities around digital transformation, around application modernization, and our services capabilities drive that scale and adoption of that platform overall. And we have our Infrastructure business that still, today, runs the enterprise most mission-critical workloads, running many industries around the world. But the interesting thing, if you think about now as a retrospective, hybrid cloud today architecture is proven to deliver better innovation for clients and a better superior ROI versus a pure public cloud play, based on studies done by BCG, McKinsey and others, in fact, a 3x differential in ROI versus a pure public cloud players.
That's areas around business acceleration, developer productivity, infrastructure cost efficiency, compliance and security, which is front and center today. And we believe -- to that open strategic thesis, we believe that hybrid cloud is going to be the client's choice of architecture to scale gen AI. And we've built out a whole set of capabilities to go capitalize on that. Now, as I said earlier, the application layer with Red Hat Enterprise Linux and Red Hat OpenShift, the Data & AI layer, with our watsonx platform and our Data Fabric, the management layer with a whole suite of observability from Instana to Turbonomic to our most recent acquisition, Apptio and Red Hat Ansible, all the way to security layer with our Guardium and our QRadar platform overall. So, we feel pretty good about it.
David Vogt
So when you think about the software portfolio as it pertains to hybrid cloud and AI, you referenced the Apptio deal, Turbonomics, you've got a pretty robust security portfolio. When you look at it today -- and I think the target longer term is to grow that business sort of mid-single digits, as you look at the competitive environment today, what do you need out there to remain competitive? I mean it sounds like you've done a -- well, you've definitely done a ton of heavy lifting over the last couple of years. So, how should the investment community think about the software business?
And maybe we could set aside TP for a second, because it's a little bit different. And do you have the portfolio today? And should we think about the software business being durable to grow mid-single digits on a constant currency basis for the foreseeable future?
Jim Kavanaugh
Yes. If you look at our software portfolio today, at the core, hybrid cloud and AI-centric company, we are a software base business at its core, that being the Red Hat OpenShift platform and now watsonx platform all embedded in our software portfolio. Our software portfolio today is, what, north of $26 billion book of business. Over the last two years post the separation of Kyndryl, we've been growing that business at the high end and actually a little bit above that mid-single-digit target already. So, we've been building credibility on consistent execution. And I think it has a lot to do with how we've constructed the portfolio around these two transformative technological shifts. But it's also around the innovation investments we've been plowing in, around transforming our go-to-market and around building out ecosystem capability.
I would tell you, that's one thing that I think is most underappreciated about everything that Arvind has done to focus this company on hybrid cloud and AI, he's done a lot around skill, talent, culture, operating model. The most important thing, I think, that will be written is he's actually opened up IBM to strategic partnerships and ecosystems, which is delivering a lot of value to our software book of business and also to our consulting book of business overall.
So, if you think about underneath that mid-single-digit model that we put out a few years ago, we've been growing above that for the last couple of years. It's really dominated by our hybrid platform and solution component of that business. That's about 70% of our total software business, the remaining 30% is transaction processing. Underneath that is a whole set of capabilities that I think are very pertinent to today's client needs around hybrid platform with Red Hat; around automation and observability, so we span all sets of capabilities with Instana, with Turbo, with Apptio, Ansible and Red Hat; around our Data & AI layer with our data fabric capabilities; and around security.
So, I think those 4 subsegments of our software are in very strong growth profiles overall. And we're actually improving the execution. As I always say, progress, but more work to do. But our model for that is actually high single digit overall, all in. And that's supported by, one, we got a $14 billion ARR book of business that's grown 7% most recently in our October earnings call that we talked about. We've got a very strong NRR business, that's been well in excess of 100%. We continue to bring out new innovation to market with watsonx now, with Apptio and the acquisitions, and we'll continue to be aggressive in that area to meet client needs overall. So, we feel pretty good about it.
David Vogt
And so maybe just drilling down a little bit. So Red Hat is the biggest piece, I guess, when you compile, RHEL, OpenShift, Ansible, I guess, under the Red Hat umbrella. So, is Red Hat sort of the linchpin that pulls everything forward, right? So, it's hybrid cloud, pulls right ones, deploy anywhere. RHEL, obviously, it's the sort of the guts or the brains of the server environment. Is that kind of how you lead when you go to a customer and say, we can offer you a variety of different software solutions predicated on here's a great platform that helps you meet your needs?
Jim Kavanaugh
Yes. Well, I think in any capital allocation and portfolio construct, it always has to be centered around your strategic purpose, but most importantly, aligned to where client needs are today. And it's hard to argue that client needs aren't built around today, hybrid, cloud, AI, data, security overall. So we touch all facets of that. But when you talk about our tip of the spear and how we go to market, it is through a lens of hybrid cloud as a platform-based strategy. Remember, that platform-based strategy delivers a very attractive economic model.
Every dollar -- so just complete the entire multiplier effect, every $1 that we land on that platform, drags $3 to $5 of software, $6 to $8 of services. So, we build around our software. We've done a lot of work to invest and innovate, modernizing our software with cloud packs, as you know quite well, that are optimized on top of Red Hat OpenShift that can be run anywhere. And so, that saves developer efficiency over time, saves infrastructure cost efficiency. So yes, I would tell you the lens is through that hybrid cloud platform and now next up is through our watsonx gen AI platform.
David Vogt
So I think that's a great segue. So AI has been effectively the key theme, I think, within the tech landscape probably going back to January, February with sort of the unveiling of OpenAI and ChatGPT. And in May, I think IBM unveiled a slew of products that are pretty compelling, I think, having demoed and played with it when I was down in Florida. So how do you think about your sort of go-to-market? I know some of the products have availability, general availability today, but how do you think that business builds from a customer perspective, meaning, what are the proof points that you have to demonstrate with your customers to really get them to buy in that we need this cost-saving tool that AI brings to us? Because I think we saw a demo of a call center, right, becoming more efficient reducing headcount and becoming much more automated effectively, for lack of a better phrase. So, can you kind of walk us through kind of what are the proof points and kind of what are the key offerings today that you think are the most relevant to the marketplace today from your perspective?
Jim Kavanaugh
Yes, a great area and great question overall. Let's take a step back. First, we're very excited about the potential of gen AI as a secular growth trend, within our industry and our ability to capitalize on that. And we’ve been investing in AI for business. We are a business enterprise focused versus consumer focused. And we built this horizontal platform to go capture that opportunity. And by the way, based on studies, there's many that have been placed out there, but AI is going to create $16 trillion worth of value-creation by 2030. So, tremendous TAM opportunity for us overall. As you know, what we revealed and announced in May is a whole suite around AI for business and how we're approaching it. So, let me talk a little bit just about the modernization strategy because I think that's critical.
One, we got three tenets to our modernization strategy. First is we have the platform, watsonx for clients to build their solutions on. And underneath that we've got watsonx.ai, which is a next-gen enterprise studio for clients to train, tune, deploy their solutions. We have watsonx.data, which is a data architecture built on open source, by the way. And most recently, just about 1.5-week ago, we announced watsonx.gov, which is an end-to-end toolkit around governing data and AI, very important to client needs overall. So that's the first tenet of monetization.
Second is we've always had an embed strategy around AI into our software portfolio overall, but also embedding with our strategic partnership and ecosystem. That's what's new today versus prior years in history. We've announced partnerships with SAP, deploying our watsonx technology into their solutions, Adobe, E&Y, Qualtrics, Sirion Labs and on and on and on, right? And we're going to continue to announce more and more here in the fourth quarter that we'll talk about on our January earnings overall.
But underneath our embed software, we have capabilities with Watson Code Assistant, which addresses ITOps and DevOps, by the way, delivering about 30% productivity in early use cases overall. We have Watson Assistant, which is actually built around customer care, which is actually generating about 95% accuracy rates right now in all of our POCs that we've been running. And we have Watson Orchestrate, which is what you've seen with our HR solution to go after digital labor that's delivering about 40% productivity overall.
The final pillar of our three-pronged strategy of monetization is we have a consulting business. That consulting business is important because it drives scale and adoption and helps clients deploy their gen AI solutions, which is getting off to a great start.
So, to the heart of your question, we actually see the adoption curve is going to be pretty similar to what we saw early on with hybrid cloud. For the first 12 months, we've built a $1 billion book of business around our consulting business. We don't see that any different with gen AI, in fact, probably even a little bit more just given what's happening with the powerful technology overall. And our platform, we’ve actually doubled our hybrid cloud platform every four years, and we see that pretty consistent right now.
David Vogt
So when you think about the book of business from an AI perspective, I would imagine you're characterizing that as not just software solutions, but also the pull along of the consulting relationship as well. How important is it, do you think that you bring both to bear? Meaning that you have a very large, technically trained workforce, vis-à-vis some other companies that are very focused on more on the software development side and the tools without sort of the ability to help companies implement those tools as they move forward. Do you see that as a competitive advantage? What do you see in the marketplace today in terms of what's going on in the market?
Jim Kavanaugh
Absolutely. Every client is looking at AI to try to figure out how they could create a sustainable competitive advantage. Embedded in that, if you think about our competitive position right now early on in this gen AI space, we actually think we got 4 or 5 differentiating point of views, one of which is the heart of your question. We are the only provider today that provides an integrated technology IT stack around our watsonx platform, and brings to bear the consulting services expertise to actually help clients deploy and run their Gen AI solutions.
But I would tell you the early work, before you can get to deploy that, around data architectures, around security, that's where the consulting value comes into place. First differentiating point is that integrated value thesis of what consulting and technology bring together, and it's been a powerful solution for our clients today. The second is we firmly believe and this is going to be multi-model. We have IBM models. We have proprietary models that we enable. We enable open source models. We enable hyperscaler models, and all the way on-prem, right?
Third, to my earlier point, we truly believe that hybrid architecture is going to be the prevailing architecture to scale AI. And in fact, 60% of enterprises -- based on that BCG and McKinsey study, 60% of enterprises are saying now that they're going to deploy gen AI solutions in a hybrid architecture environment. So I think hybrid will be the winner on how you scale Gen AI. And then fourth, given what we've just recently announced, governance is at the heart. The powerful aspect of gen AI is only going to be able to deliver that $16 trillion of potential TAM opportunity, if clients, enterprises and society trust that AI.
So, we were the first company that actually went out and indemnified all of our models, all of our data, all of our algorithms and with transparency. Others have soon followed overall. So I do think that integrated thesis.
David Vogt
So, maybe just in the interest of time on pure consulting, you've had an incredibly strong track record in the last couple of years. We get questions from investors all the time. What’s sort of underpinning the strength in billings or however you want to define it, vis-à-vis kind of the macro environment out there, right, there's definitive signs of macro slowing, budgets being a little bit of pressure, and I think that's a pervasive statement for not just IBM, but for every company out there. And so often, as an outsider looking in, I think investors struggle with how can consulting, not just IBM Consulting but the industry, continue to grow at mid- to high-single-digit clips if the macro is not supportive? So maybe you can share kind of what's transformed in the business over the last 18 to 24 months, where we sit today and how should we think about your competitive sort of dynamic, vis-à-vis maybe the competitors going forward?
Jim Kavanaugh
Yes. Well, as we talked about consulting is a central and integral part of that hybrid thesis overall. Today, when you look at consulting, we actually have driven a very-focused strategy around digital transformation, journey to cloud, with scaling our hybrid cloud and AI platforms, and also leveraging, as a tip of the spear, pulling our IBM technology and software, right? But underneath that, I think one of the biggest pieces that has changed over the last couple of years, as I stated upfront with Arvind, we've opened ourselves up to very strong strategic partnerships in ecosystems, which you're seeing tremendous velocity growth overall.
And that is a real differentiating point. When you think about, in consulting, we offer business transformation services, we offer technology consulting and we offer application operations that are really centered around OpenShift for a multi-cloud world. And that supports IBM but it also supports our key strategic partners to drive that scale and adoption. And by the way, that attractive economic multiplier of $6 to $8 is I think what you're starting to see the last couple of years. We've been growing that business double digits over the last two years in a challenging market environment, given what I talked about earlier, high inflation, labor dynamics, et cetera.
But I think when I take a step back, if you look at what we've done so far this year, we just reported third quarter earnings in October, we've had four consecutive quarters of strong double-digit signings growth, which has transpired now into a book-to-bill ratio of 1.16, which is a great leading indicator of sustainability and durability of demand. Underneath that, what's selling? We still see very good demand, solid demand for digital transformation and application modernization, our strategic partnerships, remember, we came from nowhere, to now, we've got multibillion-dollar book of businesses with AWS, with Microsoft, with SAP, and next up are going to be Salesforce, which we're close, and with Oracle and Adobe coming up the rear. So, that strategic partnership piece has done well.
But Red Hat, in four years since that acquisition, as a proof point, we now have a 10.5 book of business, $1 billion book of business in four years, $2 billion ARR, so in vastly [ph] acquisitions. We've been investing about -- 40% of our acquisitions have been in consulting, around expertise and key ecosystem. I think those are pieces that are driving that performance. So, if you ask me, I would highlight a couple of things that differentiate us.
One, an integrated thesis around IBM and those key strategic partnerships around those two technological shifts, hybrid and AI. Two, strategic partnerships coming from nowhere to now being relevant. And those partners want to access the IBM's large enterprise incumbency position, so they want to work with IBM Consulting overall. Three, we've been investing both organically skills, capability, expertise and capturing new assets that differentiates us in the marketplace. And four, the execution focus. I have to take my hat off to the team. They're executing well. They're growing market share, growing revenue double digits, growing operating margins overall, and delivering about the 30% of IBM's revenue today and delivering about 25% of our free cash flow. So, a very important part of our portfolio.
David Vogt
So can I ask you a question about the four different pillars. So you talked about strategic partnership shift. Was that sort of a key underpinning of when Arvind joined in early 2020 to kind of open up the relationships of IBM with third parties effectively to grow that business? And if that's the case, what was the reluctance to do that in the past? Was it just we're going to sell IBM and we're One IBM. And obviously, the world is moving to a proliferation of software solutions applications, cloud environments, and it made sense because the hybrid cloud solution was kind of the focus of the business at that point?
Jim Kavanaugh
Yes. Great question overall. First, as we all know, in the information technology industry, platforms win, and the only way platforms win is you have to drive scale through ecosystems. We can't do this all through blue. Now when you take a look at it historically, I think many valuable lessons have come out of this. Number one, whether it's hybrid cloud or now even AI, because we've been investing in our innovation technology around Watson for about a decade now.
One, market readiness. Consumer versus enterprise, very different. Two, we had taken an approach that we were building vertical-based platforms. Very different than a horizontal-based platform, which is part of what Arvind has flipped the strategy to. Hybrid cloud and gen AI now being hybrid platform -- or excuse me, horizontal platform solutions that enable a comprehensive integrated suite of software, infrastructure, consulting to go capture overall. Three, we've learned a lot around monetization strategies, right, and around our go-to-market route to market overall.
So I do think those lessons learned, Arvind now taking the approach of focusing this company around platform-centric that has to be horizontal that then enables us to go scale both IBM with that multiplier effect. And by the way, our strategic partners capture that multiplier effect, too, which is very attractive to them.
David Vogt
All right. So just in the interest of time, I maybe just want to ask one final question on AI and the implications for the IBM sort of financial model over the long term. So, pre this theme of AI, I know you've been working on AI for over a decade, before it became somewhat mainstream, you had a pretty specific financial model out there. How does AI play into your thoughts about the durability or the growth rates of the Company going forward? Obviously, we can set aside infrastructure for a second. You talked about consulting gets dragged along, multiple dollars for every software sold. Is it an accelerant? Is it part of the strategy all along because you have been working on AI forever, effectively? Just how do you think about it? How should investors think about how AI affects the longer term financial model for IBM?
Jim Kavanaugh
Yes. It's a great place to end overall. I mean when you think about Dow back to two years ago when we spun out Kyndryl, at our last Investor Day, we talked about the profile of what we call today's IBM. And that profile was going to be all in on hybrid cloud and AI. It was going to be an investment thesis around a higher revenue growth company, higher operating margin company, strong free cash flow yield and a higher return on invested capital overall.
So, when you look at that today, we've actually been delivering for the last couple of years. We aligned our financial model. The financial model for IBM was mid-single-digit growth, shifting to the growth vectors of software and consulting being 75%; through portfolio mix and productivity, generating operating margin leverage each year about 0.5 point; and delivering free cash flow generation of high single digits overall. I think AI now, with the secular growth opportunity we have, will actually be able to enable us to accelerate that financial profile, which you'll have to wait till our next Investor Day. But we feel pretty confident. We got a lot of work to do. As I always say, progress, more work to do. But we see this as a tremendous opportunity to continue to accelerate overall as we move forward at the end of the day.
David Vogt
Great. So I think we're out of time. So why don't we end it there? Jim, thank you very much. Thank you, everyone, for joining. And look forward to seeing you guys at the next meeting. Thank you.
Jim Kavanaugh
Great. Thank you, David.
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International Business Machines Corporation (IBM) Presents at UBS Global Technology Conference (Transcript)