Olympia McNerney:

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. 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. For example, all of our references to revenue and signings growth are at constant currency. 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 filings. So with that, I'll turn the call over to Arvind.

Jim 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. 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, highlighting our strong execution. And through the first-half, we generated $4.5 billion of free cash flow. 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. 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. 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 to pre-tax margin. Margin expansion was driven by our operating leverage, product mix and ongoing productivity initiatives. 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 continued investment in innovation with R&D up 9% in the first-half. This includes investments in both AI and hybrid cloud as well as infrastructure ahead of our Nexi 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. For the first-half, we generated $4.5 billion of free cash flow, up $1.1 billion 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 uses, 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 of $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 business. 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 segments. Software revenue growth accelerated to 8% this quarter. Both hybrid platform and solutions and transaction processing grew as clients leverage the capabilities of our AI and hybrid cloud platforms. This performance reflects the investments we've been making in software, both organically, which drove more than 6 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 acquisitions. Let me spend a minute on each of these elements. In Red Hat, 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. This metric is growing in the mid-teens and accelerating more than 5 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 watsonx, our AI middleware, watsonx Assistants, the recently-announced IBM Concert and others, which contributed about $0.5 billion to our AI book of business inception to-date. And we delivered good growth across our recurring revenue base, which is about 80% of the annual software revenue. This is evident in hybrid platform and solutions, 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. 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, watsonx Code Assistant for Z is resonating 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 Apptio acquisition. 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 Apptio'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 StreamSets and webMethods from Software AG and expect the HashiCorp acquisition to close by year end. 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 prioritize their spending. 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. 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. 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 technology transition. 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. 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. We are delivering value in two ways. First, partnering with our clients to design and scale AI solutions, whether that be leveraging AI capabilities of IBM, our partners or a combination. Second, we are developing new ways of working, driving productivity and improving delivery, all with our Consulting Advantage platform. In summary, GenAI 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. Turning to our lines of business. Business transformation revenue grew 6%, led by finance and supply-chain transformations. Data transformation also contributed to growth. In Technology Consulting, revenue was up 1%. Growth was driven by application modernization services. Application operations revenue declined, reflecting weakness in on-prem custom application management, partially offset by strength in cloud-based application management offerings. Looking at consulting profit, we expanded gross profit margins by 40 basis points, driven by productivity and pricing actions we have taken. Segment profit margin was modestly down, reflecting continued labor inflation and currency. 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 cybersecurity threats and attacks. 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 translates 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. 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 currency. Now, let me bring it back to the IBM level to wrap up. 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. Our focus on execution and the strength in 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, 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 EBITDA. 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. 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 GenAI. 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 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, we now expect low-single-digit growth for the year and segment profit margin to expand by about 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-teens 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. And we are maintaining our view of 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 basis-point to 200 basis-point impact to 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 SKU through the third quarter to remain a couple of points ahead of the prior year, driven by the strength of our business. And again, we expect the gain of the Palo Alto QRadar transaction will be offset by related structural actions to address stranded costs. 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.

Operator:

Thank you. At this time, we'll begin the question-and-answer session of the conference. [Operator Instructions] And our first question comes from Wamsi Mohan with Bank of America. Please state your question.

Jim Kavanaugh:

Thanks, Wamsi. I appreciate the question overall. 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 mid-term model, we said we converted this to a growth vector, 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 shifted this now to a growth contributor. And why is that important? One, 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 instantiating the enduring value of that platform. Our MIPS over the last few programs are up three times from an installed 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 already. So, we've taken that portfolio. We've invested now significantly, which I'll come to around watsonx 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 move that to 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. 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 watsonx Code Assistant for Z, which is resonating extremely well.

Operator:

Our next question comes from Toni Sacconaghi with Bernstein.

Arvind Krishna:

Yes. So Toni, let me start and then Jim will add more color on this topic. First, it's a great question and you laid out some of the dynamics that were going on in there. If we just step back and just look at our comments on the macroeconomic environment, we kind of stated that there is discretionary spend pressure in Consulting. 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. 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. So, that is just to give you some color and acknowledging that the bulk, but not all is a shift. Jim?

Olympia McNerney:

Operator, let's take the next question.

Amit Daryanani:

Thanks for taking 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 bill -- 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 front half, that would be really helpful. And then, you know, I'm curious, if you talk to your customers, what is your sense on the duration of this weakness in Consulting and when do you think it has to come back? Thank you.

Jim Kavanaugh:

Yes. 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? We said at that point in time, 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-bill trailing 12 months over 1.15. We had GenAI 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 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 to the second-half, many of those are still playing out. You got GenAI, which arguably were above our own expectations, right now doubling, by the way, in Consulting, our GenAI book of business quarter-to-quarter, strategic partnerships, especially hyperscalers, Red Hat still growing nicely. What you're seeing, you know, at the end of the day, those are large scale transformations, lower yield, that's why Arvind and I are saying these are longer-term growth vectors and tails that will play out into '25, '26 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, you know, everyone in the industry is talking about. We're all dealing with this. The key is we have to win that strategic provider of choice in GenAI. And I would argue we're off to a great start. You look at competitor numbers overall, we got $1.5 billion over $1.5 billion book of business 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:

Our next question comes from Jim Schneider with Goldman Sachs.

Arvind Krishna:

Hey, Jim, great question and thank you for asking this. Look, on overall M&A, I just want to begin with that our strategy has not changed. We are -- we are disciplined and we are focused. 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 synergy 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 at the outer end of the range. 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 StreamSets and webMethods and we've done a couple of smaller ones in the Consulting space and in other technology tuck-ins.

Arvind Krishna:

What do we see going into this space? Our 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 are 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 multiple to revenue, which is not a great metric, let me just acknowledge that, but it is one that's out there. If you look at six, seven, eight, maybe nine or 10 times, we can see our way there for a large deal as long as we have sufficient synergy. Now, for very small deals, that's not even a fair multiple. Very small deals are all about technology and people. In the private markets, 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. 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. 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. They are looking at 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 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 at the right rate and pace and put them into our global go-to-market distribution engine.

Operator:

Our next question comes from Ben Reitzes with Melius Research. Please state your question.

Jim Kavanaugh:

Hey, Ben, thank you. Appreciate it. 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 of $4.5 billion, up $1.1 billion year-to-year, 4 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 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 and flowing through the adjusted EBITDA overachievement. So, read that, although we don't guide on EPS, the strong overachievement of the $0.25 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 change in retirement plans and cash tax that's going to be a headwind and other balance sheet items, none of that changes. One thing I will bring up and we said in the prepared remarks, but just so there's absolute clarity, we do expect to close 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 to offset that gain to address stranded cost. And oh, by the way, 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 -- 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 on 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, free cash flow accretive to Arvind's point by two years. And we do see potential significant near-term cost in operating synergies that lead to about a 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. So, underneath that, we understand the purchase growth of those transactions, 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. 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. 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.

Operator:

The next question comes from Erik Woodring with Morgan Stanley.

Arvind Krishna:

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. So, clients come in 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. 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-year to three-year worth of revenue that the client is pre-committing to. 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. Now that we have a year, not longer, but a year of the double-digit demand that you're talking about, if I remember right, it was 14%, 17%, 14%, 20% in terms of those demands. Now 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. Now, if that's about 80% and that will translate into 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 in the low double digits going forward. So, I hope that that gives you a sense. 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 exercise hybrid. It has been growing and the demand there grew again at about 40% this past quarter. But we also saw acceleration in Linux and enhanceable where both of those demand vectors grown to the low double-digits. That given the size of the Linux business is 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, but probably into '25 and '26, we are very excited by our two open-source AI projects inside the Red Ad business, our RHEL AI 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.

Operator:

Thank you. Our next question comes from Matt Swanson with RBC Capital Markets.

Arvind Krishna:

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. 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. We always felt that 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, a lot more memory, 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%. 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. So if you are running a -- like one of our clients was describing to me, they run a couple of billion transactions through their internal systems each day. 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 $100 million. You multiply that by 250, that's kind of an infeasible cost. If you can drop it by 90%, you're now bringing it down to the $10 million to $20 million a day. If you can actually run it using some of our Red Hat technologies on-premise, you can drop it by another 50%. You're not talking 5% to 10%. For what it can do, that is a very attractive proposition. So, now getting back to the models. 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 States. 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. 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. They are one-tenth or less than that of the size of the extremely large models. But you can look on the leader boards, 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 is part of your question? 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. We have a technique called InstructLab, 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? 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 as they can go experiment and play. By the way, I will 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. 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. 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, 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, I'm so glad you did, allows us to expand that market into the millions of developers who do run Linux on their own 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. So, 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. We look forward to sharing our progress with you as we move through the rest of the year. Thank you all.

Operator:

Thank you for participating on today's call. The conference has now ended. You may disconnect at this time.

Looking to the full year 2024, we are holding our view on our 2 primary metrics:

revenue and free cash flow. We see full year constant currency revenue growth in line with our mid-single-digit model, still prudently at the low end. And for free cash flow, we expect to generate about $12 billion driven primarily by growth in adjusted EBITDA.

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 multipart questions.

Operator:

[Operator Instructions] Our first question comes from Amit Daryanani with Evercore.

James Kavanaugh:

Thanks, Amit. I appreciate the question. Let's take a step back because I think you're seeing some interesting dynamics in the consulting industry overall. And let's bifurcate it between how you asked the question. Let's look at real demand that's being measured in bookings, and then let's talk about what's happening with the revenue realization.

Wamsi Mohan:

Arvind would love to get a little bit more of sort of a macro demand backdrop. I mean I know Jim mentioned the tightened discretionary spending in some areas. How do you think about the risk of that sort of filtering more broadly as you go through the course of the year, especially given your guidance calls for an accelerating trend here?

Arvind Krishna:

Thanks, Wamsi. So let me address your thought about the demand profile globally. So if I look at where we are right now and where we project for the rest of the year, demand is actually quite strong. I would put it as very similar to 2023. This is backed up by IMF GDP estimates, which are now north of 3% for the global business.

James Kavanaugh:

Okay. Thank you. Thanks, Wamsi, for the question. As Arvind indicated in the prepared remarks, we couldn't be more excited about the powerful combination of HashiCorp with IBM and Red Hat together. We talked about it in the prepared remarks, we've been very disciplined in our set of criteria around M&A. And this fits strategically. It has tremendous synergistic value to our hybrid cloud and AI portfolio and it has an attractive financial return overall.

Operator:

Our next question comes from Toni Sacconaghi with Bernstein.

Operator:

Our next question comes from Ben Reitzes with Melius Research.

Arvind Krishna:

Ben, let me take the first part of those questions. We are very, very pleased with Red Hat. If I look at Red Hat now, we have had mid-teens or better bookings growth for the last 3 quarters, third quarter, fourth quarter and first quarter. That, combined with the growth we are seeing in OpenShift as well as in both Ansible and RHEL, OpenShift growing almost 40%, gives us a lot of confidence. So bookings growth plus OpenShift plus what we're seeing in the revenue now at 9% tells us that we should see that Red Hat growth continue or accelerate through the year.

Operator:

Next question comes from Erik Woodring with Morgan Stanley.

Arvind Krishna:

Erik, let me just maybe address the macro points on it, and I'll let Jim talk to some of the numbers here. We are going to remain incredibly disciplined on our M&A strategy. We kind of said it, but I just want to repeat, we've got to find things that meet our strategy, we've got to have some synergy opportunities at IBM, and it has to be financially accretive within the second year. So if we find things that meet that and we are committed, I'll say, to both our dividend and our investment-grade ratings, then that is kind of the picture we go in. Now within that, we believe we have some level of flexibility and that is what we will operate in. So that gives you a sense there.

James Kavanaugh:

Yes. Arvind, just building on your point, we are very confident in the capital structure of this company. We are committed to maintain a very solid investment-grade balance sheet. We are focused on debt leverage, obviously. But our primary capital allocation is to invest in our business, both organically and inorganically, and to maintain an attractive return to shareholder program with our dividend policy. So with all that said, just to reaffirm what Arvind indicated, we will remain in the market prudently evaluating complementary tuck-in opportunities that fit our M&A strategy, and we got the capability of doing that.

Brent Thill:

Arvind, on the Software business, I mean, you've been ranging somewhere between 3% to 8%, 9% growth. Many have asked, it seems like the overall market is growing faster. What's going to take to unlock this incredible portfolio you've built to effectively maybe monetize at the rate the industry is growing out? Is there something that's causing friction to unlock that true potential of the Software business? Or are we just being too focused on the short term? What do you think unlocks that value in getting you to your closer TAM of the growth?

Brian Essex:

Another Red Hat one. Maybe, Arvind, if you could maybe give us a little bit of sense of what's going on in the pipeline there and whether or not you're seeing a substantial benefit in the Red Hat pipeline from the VMware acquisition, both on the consulting side as well as the software side. Are you seeing a lot of migration? And how much of an opportunity do you think might be there longer term to capture more share of that market?

Matthew Swanson:

I think I might try a qualitative version of an earlier question around gen AI. And I think just we see so much of the news feed being around kind of the hype cycle, and obviously, growing $1 billion book of business shows you're monetizing it. Can you just talk about maybe the pain points that enterprises are looking to address when they first come to you or when those consulting relationships start? Like, how much of a plan is in place versus how much they're looking to you to kind of hold their hand in terms of this gen AI journey?

Operator:

Thank you. Thank you all for participating on today's call. The conference has now ended. You may disconnect at this time.

Olympia McNerney:

Thank you. I'd like to welcome you to IBM's Fourth Quarter 2023 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. For example, all of our references to revenue and signings growth are at constant currency. 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 filings. So with that, I'll turn the call over to Arvind.

Jim Kavanaugh:

Thanks, Arvind. In the fourth quarter, we delivered $17.4 billion in revenue, $4.2 billion of operating pretax income and operating earnings per share of $3.87, and we generated $6.1 billion of free cash flow. This wrapped up another solid year, where we continue to deliver durable growth in our repositioned business aligned with client priorities of digital transformation and driving productivity. Taking a step back, let me touch on a full year before I go into additional details of the quarter. Our revenue for the year was nearly $62 billion, up 3% and in line with our expectation 90 days ago. We generated $10.3 billion of operating pretax income and operating earnings per share of $9.62. Our free cash flow was $11.2 billion, our strongest level of cash generation since 2019. Revenue performance for the year was again led by software and consulting. Software grew by over 5% with good growth across Hybrid Platform & Solutions and Transaction Processing. Consulting revenue was up over 6% with solid growth every quarter and broad-based growth across all 3 lines of business, highlighting the durability of our results and differentiated client offerings. Infrastructure was down 4%, reflecting product cycle dynamics. Our revenue growth and productivity initiatives led to margin expansion and strong free cash flow generation. For the full year, we expanded operating gross profit margin by 130 basis points with every segment growing margin across every quarter. Our operating pretax margin expanded by 40 basis points, in line with our expectations and driven by strong productivity gains and operating leverage. And this includes a 110-basis point headwind from currency dynamics. Now turning to a deeper dive on the quarter. Our revenue was up over 3%. Software revenue was up 2%. Our fourth quarter performance reflects continued growth in our recurring revenue and a wrap on last year's seasonally strong transactional performance. Consulting had another solid quarter with 5.5% revenue growth, which is a sequential improvement in the growth rate. We had good signings performance and a trailing 12-month book-to-bill ratio over 1.15. This continued momentum in consulting is reflective of how we work with clients, the investment we are making in skills and talent, velocity in our strategic partnerships, and our integrated value proposition. We had great Infrastructure performance this quarter. Revenue was up 2% with growth in both zSystems and distributed infrastructure. This performance is particularly notable given it's the seventh quarter of the z16 cycle and in our seasonally largest quarter, again, highlighting the innovation we are bringing to this mission-critical platform. Looking at our profit metrics. We expanded operating gross margin by 140 basis points and operating pretax margin by 110 basis points, inclusive of 150 basis point currency headwind to pretax margin. Currency impacted operating pretax profit growth in the quarter by over $200 million. Margin expansion was driven by our operating leverage and ongoing productivity initiatives, which allowed for continued investments to drive innovation in our portfolio. You can see this in our higher R&D expense. Our operating tax rate was 14%, which is flat versus last year and our operating earnings per share of $3.87 was up 8%. We remain laser-focused on our productivity initiatives as we digitally transform our business processes and scale AI within IBM. This includes simplifying our application and infrastructure environments, streamlining our supply chain, aligning our teams by workflow, reducing our real estate footprint, and enabling a higher value-added workforce through automation and AI-driven efficiencies. Against a target of $2 billion in annual run rate savings by the end of 2024, which I mentioned back in April of last year, we have already achieved over $1.5 billion. Our productivity initiatives have allowed us to increase our investments in innovation, technical and industry skills and go-to-market capabilities, including our ecosystem. And we have accomplished this while simultaneously growing our profit margin and free cash flow, which in turn has increased our financial flexibility. This remains our playbook going forward. And given our success to date, we now believe we can achieve at least $3 billion in annual run rate savings by the end of 2024. Overall, the combination of our revenue and margin performance resulted in 9% growth in our operating pretax profit for the quarter. This contributed to our free cash flow performance. For the year, we generated $11.2 billion of free cash flow, up $1.9 billion year-over-year. The largest driver of this growth comes from $900 million of adjusted EBITDA. For better transparency, we have included a view of our adjusted EBITDA performance in our supplemental slides. Our free cash flow growth also reflects benefits of about $400 million from working capital efficiencies, which is consistent with what we've been suggesting throughout the year. CapEx was also down about $400 million, reflecting actions to optimize our real estate portfolio. These actions reduced our net CapEx although had limited benefit to our profit performance. In terms of cash uses for the year, we invested over $5 billion to acquire nine companies, and we returned over $6 billion to shareholders in the form of dividends. Looking at the balance sheet. We ended the year with a strong liquidity position with cash of $13.5 billion, which is up $4.6 billion year-over-year. Total debt is up $5.6 billion over the same period. And our debt balance ended the year at $56.5 billion, including approximately $12 billion of debt associated with our financing business. Our retirement-related plans remain in a strong financial position. At year-end, our worldwide tax-qualified plans are funded at 111% with the U.S. at 123%. Turning to our segments. Software grew 2% with growth across both Hybrid Platform & Solutions and Transaction Processing. This quarter's performance, again, reflects growth in our high-value recurring revenue base, which is up mid-single digits. I'll remind you this comprises about 80% of our annual software revenue. Transaction processing with its strong base of recurring revenue delivered revenue growth of 4%. Clients continue to value this portfolio of mission-critical software, supporting growing workloads on our hardware platforms like zSystems. This, together with price increases, contributed to growth in both recurring and transactional software revenue in transaction processing for the year. Hybrid Platform & Solutions revenue was up 1%. Within this performance, Red Hat revenue was up 7%, automation was flat, Data & AI was up 1% and security declined. Looking across Hybrid Platform & Solutions. The strength of our recurring base of business is evident in our ARR, now $14.4 billion and up over 7% since last year. We also faced a tough compare here in the fourth quarter, wrapping on seasonally strong transactional performance, including strength in ELAs, as we discussed at the start of the year. What played out in the fourth quarter reflects just these dynamics. And while transactional revenue overall was significant, it was down year-to-year a little more than expected. In Red Hat, revenue performance was similar to last quarter as we continue to see dampened growth in consumption-based services. Our future growth indicators are encouraging. Red Hat annual bookings were up 17%, including double-digit bookings growth across all 3 key offerings

Operator:

[Operator Instructions] Our first question comes from Wamsi Mohan with Bank of America. Please state your question.

Jim Kavanaugh:

Thanks, Wamsi. I appreciate the question overall. We're obviously very pleased. The team has executed extremely well in 2023, our strongest free cash flow since 2019, $11.2 billion, up $1.9 billion year-to-year. I think it's important, to your point, before we get to '24, to take a step back a year ago and talk about how we guided the year. And by the way, we've been consistent every quarter about our guidance of about $10.5 billion. The reason I think it's important because it goes right at the heart of your question, which is the quality and sustainability and why we here at IBM had the confidence in the guide of about $12 billion. We said a year ago about $10.5 billion. It was predominantly going to be driven by the improving fundamentals of our business, read that sustainable revenue growth, operating leverage, and that, by the way, is our model $750 million year-to-year. On top of that, remember, we had an opportunity gap coming out of fourth quarter 2022. We said we would get working capital efficiency of $400 million, and then we would have modest structural action tailwind offsetting modest cash tax headwind. That kind of brought it all together, $750-ish million from improving fundamentals of the business, $400 million. Now how did 2023 play out? Number one, the improving fundamentals of our business, we had a very strong second half both on our top line revenue, our portfolio mix, our productivity. And we delivered $900 million of growth and adjusted EBITDA year-to-year, which, by the way, we gave you as far as increased transparency. On top of that, we got the $400 million worth of working capital efficiency, very consistent. Then we've got and we capitalized on all of the productivity actions that we have done. We capitalized on being opportunistic on some real estate rationalization. That's why our CapEx was down about $400 million. By the way, full transparency, that's timing. That was a 2024 item. We got that in 2023, so let's put that aside. And then we've got about $100 million worth of cash tax that came in a little bit better. So I would say, against that, very strong high-quality sustainability that sets the baseline for '24. 2024 really is simple as we said in the prepared remarks. One, we see very consistent growth in the fundamentals of our business around revenue profile, margin and productivity that we will get a similar level of growth year-to-year in adjusted EBITDA. By the way, that's above our model again as I'll state, so that we did $900 million last year, we'll get it again. With that, we will also have benefits from the changes in retirement plans that many of you have written about. But offsetting that, we got higher cash taxes year-to-year, and we've also got CapEx that we are going to continue to invest for the long-term sustainable leadership of this company. So it's really in 2024 entirely driven by the business model of our adjusted EBITDA growth. So thank you, again, Wamsi, for the question.

Amit Daryanani:

Thanks a lot, and good afternoon, everyone. I guess my question will be focused on the software side. When I think about the calendar '24 guide of, I think, slightly above the mid-single-digit medium-term target that you folks have, can you maybe talk about how do I think about the split between organic versus inorganic in '24? And if you could also perhaps unpack, what do you expect to see across some of the key segments like Red Hat -- which I think was somewhat below your expectations in '23 and then also the TPP side would be really helpful. Thank you.

Arvind Krishna:

Thanks, Jim. And Amit, the second part of that is all of the innovation that we are delivering. When we play it up against the demands in the marketplace, our AI platform is going to be a part of what fuels innovation. And as I think you all understand when people like one part of the portfolio, they tend to also leverage other parts of the portfolio. Other than the AI portfolio automation, which really helps our clients with productivity, Jim mentioned Apptio or Apptio, Turbonomic the whole category called AIOps in the market, we believe, is going to be a big driver of demand for us. And on the mainframe, let's remember, TP does get driven by increased MIPS, and Jim talked about the increased MIPS that are out there. Those MIPS, coupled with the innovation we do in that part of the portfolio, drive the growth. So it's very well balanced. You have M&A, you have Red Hat innovation, you have AI innovation, automation innovation and TP innovation. And that is really what comes together to give us that growth and give us the confidence of being able to deliver all of that growth.

Toni Sacconaghi:

Yes. Thank you. I have one clarification and one question, please. So just on the free cash flow, Jim, I'm wondering, can you give us a bridge from net income, which I think The Street is expecting is about $9 billion or a little over for fiscal '24 and how you get to $12 billion in free cash flow, not from 2023 levels but from net income levels? And maybe in that, can you just clarify how much do you expect depreciation expense to be? And how much do you expect CapEx to be and how big a contributor is that? And then secondly, on the AI book of business, I think you said low hundreds of millions that doubled. So should we be thinking $300 million to $400 million? And it sounds like a third was in software. Was that revenue recognized during the quarter? And then the other couple of hundred millions were consulting signings? Can you just elaborate specifically on exactly what the book of business means?

Arvind Krishna:

Thanks, Jim. So Toni, on the AI book of business, this is not all revenue in the quarter. I would just begin with that statement to set it straight. At this stage, we wanted to start looking at what is our momentum, what is the sentiment from our clients. So we went to a measure that is more reflective of, I'll use the word signings. What is the commitment the clients are making to us? Consulting is straightforward. It is the signings. Consulting signings are anywhere from 12 to 24 months on average is how much time they play out over there. And on software, it's what they're committing to. And we are using SaaS ACV. So it's a 12-month commitment, which is typical for as a service as well as, since we do offer our portfolio both ways as license or as a service, it includes the license piece as well. Now over a long-term, let's call it a couple of years or more, yes, the book of business should turn into an amount of revenue in a quarter, but that's going to take a bit of time to catch up. But we felt that this gives the better indicator right now of what is our traction and what is our acceleration in that part of the business.

Ben Reitzes:

Yes. Great. Hey, thanks a lot. Wanted to ask about consulting. And Jim, you mentioned and disclosed high teens bookings growth in 2023 and just at 8% off a pretty difficult comp. I was wondering how that's going to play out in terms of revenue yields in '24 and into '25. Does that give you more confidence that the second half of '24 is going to have a pickup in Consulting revenue reported? And then for Arvind, if I could just sneak more on consulting. Your top competitor has much easier comps in terms of bookings and revenue over the next 12 months. Do you think you could continue to outperform them in the next year? Thanks.

Arvind Krishna:

Thanks, Jim. So Ben, as opposed to trying to directly compare with 1 other or 2 other people, can I take it back to the market, if you don't mind. The overall consulting market seems to be in the 4% to 6% range. So we benchmark there to make sure that we're trying to take share and that we have the offerings which appeal to clients, which also allow us to keep a healthy margin in the business. So when we look at it from those 2 lenses, we are going to be absolutely focused on taking share, which is why we are guiding to a higher 6% to 8% number is where we feel it will be. Then we go back to do we have the bookings that justify that? Yes, the booking is justified. But as you all know, that is some but not all of the revenue in the year. So we feel it's prudent to then guide it into the 6% to 8%, not higher. So you combine it with the offerings we have, we are also very, very focused compared to many of the players out there who are much larger. We are very focused on our strategic partners, and we are very focused on digital transformation and data and AI as opposed to a much broader swath of offerings that other people have. That gives us confidence in our growth rate, as Jim pointed out, for our Consulting business.

Brent Thill:

Thanks. Arvind, I'm just curious if you could just give us your view of the business climate, just how things are feeling in the last quarter versus quarters before we're continuing to hear of a defund some of these software budgets from CIOs. And I'm just curious if you're hearing and seeing the same thing that we're seeing in our work.

Operator:

Our next question comes from Erik Woodring with Morgan Stanley. Please state your question.

Jim Kavanaugh:

Yes. Let's start with the bigger picture. all we laid out a midterm model. We set our software portfolio would grow mid the way coming from a prior cycle that we were very low single digits overall. And we finished this year up over 5%. We finished a 2-year CGR already 2/3rds into our model at the high end of the model at 6%. Is that our aspiration? Absolutely not is what Arvind has the entire team focused on. And that's why we continue to fuel investment into new innovation both organically and organically. But let's take a step back how we set the year up. We set the year up, we said the year was going to be predominantly driven by the strength of our recurring revenue annuity portfolio, which, by the way, high value, 80% of our software revenue. That's our subscription-based models, our SaaS models, our TP software, et cetera. And we said that was going to grow mid-single digit. We actually delivered on that. We said then, second, prudently coming off of a peak ELA cycle, and you understand our ELA cycle extremely well in 4Q '22 that we expected a headwind. Now let's go back 90 days ago. 90 days ago, we were sitting year-to-date 6.5% total software segment, which gave us the confidence of taking up our guidance to the high end of the mid-single-digit model. What was driving that? Both HP&S was up 7%, TP was up 6% and underneath that, we were seeing very solid growth in our transactional business both volume and NRR with new clients. Now we get the fourth quarter and the ELA rep hit us. By the way, the ELA cycles give or take, they're in these ranges. They're on average about 3 years. They get probably somewhere around 40 to 50-plus percent in year 1, and then it tails off. So it's the biggest impact we'll see. We got through that in the fourth quarter, and we still delivered over 5% on a 2-year CGR, we're at the high end of the model. Now when you look at full year performance, Red Hat up 9%, automation, I'm directionally correct, 4% or 5%, Data & AI, 4% or 5%, security, yes, we got an execution gap on security. We got an opportunity to go fix in 2024. So I think it's actually glass half full. The innovation we're fueling in organically, the M&A portfolio, which is scaling nicely with a strategic fit, that gives us the confidence on why we're actually taking up and accelerating our growth in light of Brent's question in 2024.

Matt Swanson:

Yes. Thank you guys so much. Congratulations on both the free cash flow and then also obviously the free cash flow going into next year. Maybe focusing even more so on the Software side and just thinking so on that 2.5 points of growth that's expected to come from the Red Hat. I mean you've talked about the consulting strength that you're hearing around both cloud and application modernization. Are there any other signs you're hearing specifically from like pipeline or customer conversations about an improving demand environment for Red Hat specifically? And then maybe just as like a caveat, how maybe some of the cloud cost optimizations impacted Red Hat in 2023?

Operator:

Thank you. Our last question comes from Brian Essex with JPMorgan. Please state your question.

Jim Kavanaugh:

Yes, sure. I appreciate that, Brian. Thank you very much. I mean, I think Arvind has been very clear for the last 3.5, 4 years since he's come on. First of all, let's talk criteria. We always get asked size this, size that. Size is not a criteria. It is entirely, and I complement him and the entire team, he's very focused on strategic fit to a hybrid cloud and AI platform-centric company. Those targeted areas are always centered around hybrid cloud, data, automation, security and oh, by the way, both software IP asset and consulting expertise on both sides. So strategic fit. Second, we run this platform-centric model to create a synergistic multiplier effect in our business. So when we look at every single week a set of targeted candidates, we're looking at the synergistic effect because as a CFO, when we deploy $1, we're looking for a multiplier of hardware, software services on top of that. And then third, financial attractiveness. It has to be high growth, recurring revenue, highly profitable and free cash flow accretion in a quick period of time. That will vary based on software, it will vary based on consulting. But I think you're going to continue to see us be opportunistic in the marketplace. We've got the right capital structure. We've got the right finflex. We ended with, what, $13.5 billion of cash on the balance sheet. So we feel pretty good about our position, and we will capitalize on that to the extent it hits and fits those criteria. So thank you for the question.

Olympia McNerney:

Diego, let me turn it back to you to close out the call.

Patricia Murphy:

Thank you. I'd like to welcome you to IBM's Third Quarter 2023 Earnings Presentation. As the operator just mentioned, I'm Patricia Murphy, 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. 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 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 filings. So with that, I'll turn the call over to Arvind.

Jim Kavanaugh:

Thanks, Arvind. I'll get right into the financial highlights of the quarter. We delivered $14.8 billion of revenue, $2.3 billion of operating pre-tax income, and $2.20 of operating earnings per share. Through the first three quarters of the year, we generated $5.1 billion of free cash flow. Reported revenue growth was 4.6%. This includes just over 1 point of growth from currency translation, which is significantly less than the currency rates suggested in July. In fact, currency movements over the last 90 days impacted our third quarter revenue by about $250 million. At constant currency, our revenue was up 3.5%. As is typical, I'll focus the discussion on constant currency. Arvind talked about clients' priorities in today's environment, which are driving solid growth in our Software and Consulting offerings. I'll remind you, Software and Consulting are our two growth vectors, and together make up about three quarters of our revenue base. Software revenue was up 6%, as clients leverage their data for insights and automate their IT in a hybrid environment. We had good growth in both Hybrid Platform & Solutions and Transaction Processing revenue. Our Consulting business had another solid quarter with 5% revenue growth, strong signings performance, and a book-to-bill ratio greater than 1.15 over the last year. We are capitalizing on our continued momentum in the market, as we help clients get value from hybrid cloud and AI and leverage our strategic partnerships. Our Infrastructure revenue was down 3%, with growth in zSystems. More and more we are seeing clients embrace IBM Z in their hybrid cloud environments, especially in regulated industries. This growth was offset by declines in Distributed Infrastructure and Infrastructure Support. IBM's revenue growth, together with a good portfolio mix and yield from our productivity initiatives, generated strong margin, profit and free cash flow performance. Operating gross margin expanded 160 basis points, and operating pre-tax margin expanded 170 basis points. Within that PTI margin, we absorbed a year-to-year currency impact of over 150 basis points. Despite that headwind, our margin expansion was broad based, with improvements in every business segment. Driving efficiency and productivity has always been part of our operating and financial models. These ongoing productivity initiatives enable reinvestment in the business, increase financial flexibility and contribute to margin expansion. Our activities range from simplifying our application environment to digitally transforming our business processes by applying AI at scale. We are ahead of pace to achieve our target of $2 billion in annual run-rate savings by the end of 2024. While there is still more to do, I am pleased with our progress. The combination of our revenue and margin performance yielded strong profit growth. Operating pre-tax profit was up 17% to $2.3 billion. We generated $1.7 billion of free cash flow in the quarter, and over $5 billion year-to-date, which is up $1 billion versus last year. Free cash flow growth through the first three quarters was driven primarily by cash sourced from our operating profit performance. We also had working capital efficiencies driven by solid collections. These growth drivers were partially offset by higher performance-based compensation payments earlier in the year. In terms of cash uses, year-to-date we spent about $5 billion on acquisitions and returned $4.5 billion to shareholders through dividends. Our resulting cash balance at the end of September was $11 billion. That's up over $2 billion from year-end, but with the acquisition of Apptio in the third quarter, cash is down over $5 billion from June. Our debt balance is now $55 billion, also down from June. Putting this all together, our business fundamentals are solid, with sustainable revenue growth, margin expansion, solid cash generation and a strong balance sheet with financial flexibility to support our business into the future. Turning to the segments. Software revenue grew 6%, with contribution from Hybrid Platform & Solutions and Transaction Processing. This performance reflects growth in both our transactional revenue and our recurring revenue base, which is about 80% of our annual Software revenue. In Hybrid Platform & Solutions, revenue was up 7% with growth across Red Hat, Automation and Data & AI, as we execute our platform-based approach to hybrid cloud and AI. Red Hat revenue was up 8%. We continue to deliver good growth in OpenShift and Ansible, both gaining share again this quarter. Clients are committing to our hybrid cloud approach with annual bookings up 14% in the quarter. This includes double-digit growth across RHEL, OpenShift and Ansible, partially offset by headwinds in consumption-based services. IT and business automation are top client priorities, and we've been investing to capture the opportunity. This quarter, our Automation revenue grew 13%, with pervasive growth across all business areas. We had strength in AIOps and Management driven by good performance in Instana, Turbonomic and now Apptio as clients look to optimize business outcomes and boost productivity. Data & AI revenue was up 6%. Growth areas include Data Fabric and Customer Care as enterprise clients are both preparing for and adopting generative AI solutions, leveraging watsonx. We also grew in Asset & Supply Chain Management as we help enterprises run sustainable operations. Security revenue declined 3%. We delivered growth in security software driven by Data Security and Identity & Access Management. This was more than offset by declines in managed security services. Looking across these businesses, our Hybrid Platform & Solutions ARR has grown to $14 billion, up 7% since last year. In Transaction Processing, revenue was up 5%. Throughout this year, we've been talking about how the success of the last couple of zSystems cycles is driving demand for this mission-critical software. This, together with price increases, contributed to year-to-date growth in both recurring and transactional software revenue in Transaction Processing. Moving to profit for the Software segment, we expanded gross and pre-tax margins. Our pre-tax margin was up 120 basis points, even while absorbing over 2 points of impact from currency. We continued to deliver operating leverage, driven by our revenue scale and mix this quarter. Our Consulting revenue was up 5% with growth across all three lines of business and geographies. With another quarter of strong signings, as I said, our trailing 12-month book-to-bill ratio is now over 1.15. Clients continue to prioritize transformation projects that enable cost savings and productivity. These results are a proof point that we are well positioned to meet these needs in today's complex environment. IBM's focused hybrid cloud and AI strategy has become even more of a differentiator as clients' interest in generative AI continues to ramp. We are helping clients understand how AI can be used to automate tasks, make better decisions with speed and improve customer experiences. We've made a series of AI announcements over the last few months demonstrating continued advancement of our strategic partnerships. We are providing clients with the opportunity to accelerate their transformation and deploy generative AI responsibly, whether that be leveraging AI capabilities of IBM, our partners, or a combination. Today, our strategic partnerships account for about 40% of Consulting revenue and have continued to grow double digits across revenue and signings. In aggregate, our hyperscaler partnership revenue was up over 40%, and signings essentially doubled year-to-year. Additionally, our Red Hat practice, which helps clients optimize how they build, deploy and manage applications for a hybrid cloud environment has continued to grow at a double-digit rate, with over $1 billion of signings in the quarter. All of what I've just mentioned, from market demand, to how we're positioned and partnering, to our investments to drive growth, is reflected in our overall Consulting revenue performance. You can see that play out across our three lines of business. In Business Transformation, revenue grew 5%, again led by data and technology transformations, including AI and analytics-focused projects. Finance and supply chain transformations also contributed to the growth. In Technology Consulting, revenue was up 1%. Growth in cloud-based application development and modernization work was partially offset by declines in on-prem application-focused projects. In Application Operations, revenue grew 7%, driven by both cloud application management and platform engineering services. In platform engineering, we help clients design an application environment that runs securely and smoothly at scale. Moving to Consulting profit, we expanded gross margin 150 basis points. Pre-tax margin expanded 40 basis points to just over 10%. Our year-to-year margin performance reflects productivity actions we've taken, mitigated by increased labor costs and about 1 point of pre-tax margin impact from currency. Moving to the Infrastructure segment, revenue was down 3%. Hybrid Infrastructure revenue was flat, while Infrastructure Support declined 7%. Within Hybrid Infrastructure, zSystems grew 9% in a seasonally smaller revenue quarter. z16 revenue remains well ahead of prior cycles after six quarters of availability. The program strength reflects both growing enterprise workload requirements and the economic value at scale of the platform in traditional processing and Linux consolidation. In fact, installed MIPs capacity for Linux on Z has grown more than four-fold over the last decade. Clients continue to value the security, resiliency and hybrid cloud capabilities of the zSystems platform. Distributed Infrastructure revenue was down 6% as compared to a strong growth in last year of 21% as we introduced innovation across Storage and Power10. This quarter, we had growth in Power offset by declines in Storage. In the Infrastructure segment, we had strong gross and pre-tax margin performance. Pre-tax margin expanded 350 basis points, reflecting benefits from portfolio mix with our zSystems performance and productivity, while absorbing over 1 point of impact from currency. Now let me bring it back up to the IBM level to talk about our expectations before we go to Q&A. Just about two years ago, we introduced Today's IBM, a more focused business with a platform-based approach to hybrid cloud and AI. Since then, we've continued to invest organically and inorganically, bring new products and innovation to market, expand our ecosystem and our talent base, and drive productivity across our business. The result is a business that addresses today's client needs, with a stronger financial profile. Our third quarter performance reinforces this progress with 3.5% revenue growth, gross and pre-tax margin expansion and strong free cash flow generation. Now, with three quarters of the year behind us, we are holding our full year view of our two primary financial metrics, revenue growth and free cash flow. We continue to expect constant currency revenue growth of 3% to 5%, and free cash flow of about $10.5 billion, that's up $1.2 billion over last year. We've had solid revenue performance all year in our growth vectors of Software and Consulting. We still expect Software revenue growth at the high end of its mid-single digit model, and Consulting revenue in the 6% to 8% range. Infrastructure revenue, of course, reflects product cycle dynamics. In total, with one quarter to go, it's prudent to assume the low end of IBM's 3% to 5% range. We are making great progress in our productivity initiatives. The work we are doing to digitally transform our business not only makes us more nimble by simplifying and streamlining our processes and operations, but it also frees up spend for reinvestment, provides financial flexibility and delivers operating leverage. This contributes to solid margin and free cash flow performance. We continue to expect about a 0.5 point of operating pre-tax margin improvement, and we see a mid-teens tax rate for the year. Our free cash flow performance has been driven primarily from our profit performance. Through the first three quarters, we're up $1 billion year-to-year, and we've delivered nearly 50% of our full year expectation, which is ahead of our historical attainment. While, as always, we are reliant on a seasonally strong fourth quarter, we're on track to achieve about $10.5 billion for the year. As I look specifically at the fourth quarter, with the recent currency movements, we now see currency to be neutral to a 1-point headwind to revenue growth. That's nearly $600 million worse than 90 days ago. I'd expect constant currency revenue growth in the fourth quarter to be similar to the third. That's despite a tough compare from last year's strong ELA contribution in Software and the large z16 transactional performance in Infrastructure. This demonstrates continued momentum in our underlying business. Bring it all together, we've clearly got a higher-growth, higher-value business with strong cash generation, a business well-positioned for the future. Arvind and I are now happy to take your questions. Patricia, let's get started.

Operator:

Thank you. At this time, we'll begin the question-and-answer session of the conference. [Operator Instructions] Our first question comes from Amit Daryanani with Evercore. Your line is open.

Arvind Krishna:

Hi, Amit. So, thanks for the question. And it's actually wonderful to talk about this. So, generative AI, just for me to very quickly reiterate the use cases, we found that our clients were really climbing on to on code, on customer service, and on, I'll call it, general digital workers, which is productivity in every enterprise function. So, if you look at code, to a person, every one of the clients said, we don't intend to get rid of any developers, but this allows us to take care of the tech debt that we've accumulated and makes every developer more productive. Amit, I'll kind of point out, most enterprises are very quick to realize, if you are more productive, that means you have a competitive advantage to your peers. And if they have a competitive advantage to their peers, they'll take share without spending more on labor. That's an incredible long-term competitive advantage. When you go to customer service, there is a cost takeout aspect, but it's not 100%. But there is probably a 20% to 30%. If you can have more calls, more chats answered by AI, that means you can have much more volume with a smaller number of people. So, there is both. Also, I'll point out to our audience, AI does not get tired. It doesn't get angry. It doesn't get upset. So, there is a NPS improvement you get along with it. And then on the third one, on digital workers, there likely is a small productivity improvement, but I would call it more in the 4%, 5%, 10%, not 20% 30%, 40%. So, in the macro headwinds you're mentioning, higher interest rates, tougher to get skilled people, all of the issues around the geopolitical uncertainty that causes some of the concern might have caused a pause in some other environments. The AI side, and to be candid, the hybrid cloud side, offers them a way through that without having to decrease their ambitions for next year. And I think we're seeing every one of them play to that. And I think that these are more fundamentals, these are more core processes than some of the other areas that people were worrying about two or three years ago. When two or three years ago, people were worrying a lot about, what do I do to keep all our employees happy? And can I add up all the tools for that? I think there's much less of a focus on that area.

Operator:

Next we will hear from Wamsi Mohan with Bank of America. You may proceed.

Jim Kavanaugh:

Yeah, thanks, Wamsi. I appreciate the question. Obviously, we're very pleased overall with our Software segment performance growing 8%, actual 6% at constant currency, really led pretty pervasively with growth across the board. Automation led Red Hat at 8%, as you said, and I'll come to that in a second, but data and AI overall. Really underpinning all that is like we said, starting the year

Operator:

Our next question comes from Toni Sacconaghi with Bernstein. You may proceed.

Jim Kavanaugh:

Great. Toni, thanks very much for the question. I appreciate it. And I know Patricia really appreciates sticking to one question given it's her last call leading and piloting, and we thank her for all her efforts, but we'll have more time to celebrate in January. But as you stated, we remain confident in what our guidance is overall with regards to top-line revenue growth, 3% to 5%, albeit, as we said, low end. And that's just practically speaking given we have one more quarter to go. We said we expect similar performance, fourth quarter, as we just executed in third quarter, constant currency revenue growth, right? Let me unpack that to your point. First of all, at the macro level, historically, we would generate quarter-to-quarter about $2.9 billion-ish of revenue. Last year, by the way, we did $2.6 billion, up quarter-to-quarter in revenue. That $17.3 billion number in that ballpark, you're not too far off, is about equivalent to last year. It's about $2.6 billion. But I would tell you one thing underneath that, Toni, is we've seen a very different dramatic change in the currency FX U.S. dollar strengthening. To tune about $300 million, if you go look at the math, back into '19, 2020, 2021. So, underneath it, pretty consistent quarter-to-quarter performances last year, which by the way, I would highlight, was the peak of our ELA cycle last year and it was our strong first fourth quarter in a z16 environment. We're going to match that even taking into account the FX headwinds overall that we called out going forward. One last thing that I'll put and then I'll get into the color is, on a profit basis, although you didn't ask that, historically, profit, we generate somewhere, if I remember correctly studying over the weekend, about $1.3 billion quarter-to-quarter. You look at our operating pre-tax margin, which we recommitted 0.5 point for the year, that puts you in a profit range of, I don't know, $1.7 billion, $1.8 billion quarter-to-quarter. So, you see the fundamental operating leverage of what's happening to our business. So, you put all that together, we still believe we have a very confident year at that 3% to 5%, by the way, led by Software, delivering 3 points of that IBM growth. Consistent, I would say, very good performance competitively in Consulting, driving about 2 points of IBM's growth. Infrastructure around the product cycle downside, we said beginning of the year and we're consistent, it's about 1 point hurt to IBM. And then, you got the divestiture impact of about 0.5 point. You put all that together, I think that's a pretty good year overall and pretty much on top of our model.

Operator:

Next we will hear from Matt Swanson with RBC Capital Markets. Your line is open.

Arvind Krishna:

Yeah, thanks. Let me try to address your question here. Look, I think the concerns that people have are coming around, are these models accurate? How accurate are they? Do they result in things that may cause long-term liability? People are worried about the conversation because they hear and they read that whether it's artists, whether it's authors, whether it's code writers are suing some of the producers of large language models. You alluded to governance. That comes more around life cycle and how do you carry it out over the long term. Coupled with this are some people's concerns. If you add their own private data into a model, now what happens to the model? Where is it protected? Where does it stay? Do others learn from it? So, if you begin to unpack all of that, we begin to say, all right, for models that are IBM produced, we will give you indemnification, meaning, we are confident in our ability to stand by the data we have used to train, what is being used to be output, and we'll stand behind the same indemnification as we provide for all enterprise software. As you would expect, that's hard for us to do for open source models. But we believe that that takes care and that is why we are so excited about code and customer service to start with, because that's where we believe that people can benefit from this indemnification. Talking about the governance and the life cycle side, people are also worried about some of the long-term deployment, because an enterprise may well deploy a model for five or 10 years. So, the governance tools that allow you to keep a lineage of the data, used to train a model, and then, for those adding private data, we give them a commitment that data stays with them and the refinements of that model go nowhere else, helps to mitigate some of the fears and uncertainty around those issues. I do believe that this is going to play out well over the next few years, but I also want to point out there are many cases where people are not worried about some of these risks. If you're giving a quick website response, you could well use a model that may have some of these risks, because the danger in using any of those other areas is small. So that is how it's playing out right now. I expect to see a lot of deployment in 2024 going into full production across the world of whether you use the word large language models or foundation models or generative AI.

Operator:

Our next question comes from Ben Reitzes with Melius Research. Your line is open.

Jim Kavanaugh:

Ben, thanks very much for the question. As I said earlier, pleased with the team overall in Consulting, not only on the signings and booking, but our revenue is well positioned for that 6% to 8%, which gave us confidence to reiterate that. But also the fundamentals of that business, right, we talked a lot about this over the last handful of years. We're getting good operating leverage in that business, good cash contribution. So, all in all, pretty pleased overall. When you look at the bookings overall, I mean, let's just put some statistics. Let me talk about kind of headwind, tailwind overall, because I think what you're trying to get at is the confidence level Arvind and I and the team have about this book of business going forward into fourth quarter and into '24. We're still seeing very good demand overall in areas around digital transformation, application modernization, and where there's real technology value, productivity, cost efficiency, quick payback. Is there pressure on discretionary-based activity and that like? Absolutely. But you know what, we've seen that all year long. We haven't seen really any substantive change in the macro and the client buying behaviors overall. But that has enabled us to grow 30%-plus. By the way, it's strongest bookings quarter we had quite a period of time and now we've got a trailing-12 month book-to-bill of 1.16 I think the strongest in about two-and-a-half years overall. Now, underneath that, what's going on? One, we've opened up IBM to strategic partnerships. We're seeing great ecosystem velocity and strategic partnership growth. Signings were about 50% year-over-year. Hyperscalers underneath that, 2x signings. Our hybrid cloud and application modernization, Red Hat, we signed north of $1 billion alone in the quarter. Now that's $10 billion inception to date. We got acquisitions that are now accretive and scaling nicely. So, I think from that aspect, you look at the top-end growth, we feel pretty confident about the 6% to 8% for this year, and we feel confident about the value and the growth contribution of the growth factor of consulting in our book of business heading into 2024. Now, with that said, headwinds wise, yeah, listen to every other services consulting company, there are macroeconomic challenges, without a doubt, uncertainty, but we got to go out and compete every single day here. And duration, I would say, not only we had great signings growth, we're monitoring our backlog realization. Our duration, by the way, this year has went up by a couple of months, but that revenue will play out over time. And all in all, if I sum it up, I think we're taking share. I'm pleased with the team.

Operator:

Our next question will come from Erik Woodring with Morgan Stanley. Your line is open.

Jim Kavanaugh:

Yes, thanks, Erik, I appreciate the question. So, similar to -- I think Toni asked something similar to this overall. When you look at IBM, 3% to 5%, just practically speaking, one quarter to go, we said, oh, it's better to say we're prudently at the low end of that range. Now, let's talk about it by segment. Software, you dial back 90 days ago. We said that we were very excited about the announced acquisition of Apptio. We said that we expected that to close in early fourth quarter. Team did an outstanding job. We got through that regulatory approval. We closed it mid-August. But when we announced that acquisition in July, we actually given our first half performance, both in our recurring revenue streams and the strength of that, but also in our transactional book of business. We actually took our full year guidance up to the high end of the range. Now we closed it -- and by the way, we said Apptio would be about 0.5 point on the full year. Now we closed it, what, a month, month-and-a-half earlier? Okay, so that 0.5 point of contribution on Apptio might be 70 basis points of contribution on a full year. We still feel very confident. By the way, through three quarters we're up 6.5%. That's above our mid-term model. Yes, we have the peak wrap on ELAs last year, but very interesting, underneath our third quarter year-to-year performance, we're growing transactional revenue. Very different profile than what we started out in January, which I think prudently we said we expected transactional revenue was going to be a headwind to us. What's happening? The new innovation we're bringing to market is actually creating much more volume of new ELA content that by the way is contributed about 1.5 point of growth above our expectation. And we're also getting great [closing in] (ph) NRR of 7 points versus history. So, we think like we just finished above our model in third quarter on constant currency on Software, we said in the prepared remarks, we expect a pretty similar fourth quarter at the high end overall, so we're maintaining Software. If you look at Consulting, we said 6% to 8% overall. By the way, year-to-date, we're up 6%. Actually, 6.4% to be exact. And we look at fourth quarter overall, we just talked about in Ben's question, our strong bookings, our book-to-bill at 1.16, the tailwinds on hybrid cloud around strategic partnerships, I think we feel pretty good about our overall guidance.

Operator:

Our next question comes from David Grossman with Stifel. Your line is open.

Jim Kavanaugh:

Yeah, David, thanks for the question overall. We'll spend a lot of time in January talking about 2024 free cash flow, but I'm glad you actually asked the question because we've been talking about free cash flow all year long. It's one of Arvind and IBM's two important metrics, revenue growth, free cash flow generation. We called out $10.5 billion, by the way, up $1.2 billion this year off of last year where we grew $2.8 billion year-to-year. And we said that's above our annualized model. Our annualized model is about [$750 million] (ph) per year coming on off the I&E and the business fundamentals. You look through the third quarter, we're up now $1 billion year-to-year. We're at $5.1 billion, very high quality by the way. Of that $1 billion, $700 million of it is cash sourced from operating profit overall, so that's the improving fundamentals of our sustainable revenue growth and our operating leverage and productivity we're driving in this business. And as I said all year long, I was very transparent in January, repeated it in April, said it again in July, and now let's say it again, when we look at that $1.2 billion free cash flow growth year-to-year, we're going to get most of it through cash source from profit, read that about $800 million to $900 million, and we said that we would get working capital efficiency this year. Why? Because of our 4Q '22 opportunity gap that we missed. And we called it out transparently in January. We're seeing that play out. You do the puts and takes. Yes, we're going to get a little bit of a modest tailwind on structural actions this year that will offset cash tax headwinds. But you look at the underlying $1.2 billion free cash flow growth, it is a high quality, fundamentally driven out of our revenue growth and operating leverage. Now, you look to '24, we'll spend a lot more time on cash tax, a lot of that is going to be predicated on where we actually finished fourth quarter overall. But we feel confident with the actions we've been putting in place, and we've got to earn the credibility and discipline here closing out a free cash flow quarter, by the way, that's $5.4 billion.

Operator:

Our last question will come from Brian Essex with JPMorgan. Your line is open.

Arvind Krishna:

All right. Thanks, Brian, for the question. So, Consulting is going to be the tip of the spear, but it's not going to be the only, because some clients do have enough expertise inside to do things on their own. As we approach clients, trying to use, I'll call it, a big public chatbot to perhaps improve some service is not where they look to us, and we've been very clear that's not where we are going to go, and we do not actually serve up any of those services. However, I'll take maybe some quick examples as I go through. So, with a large, I'll use the word financial services company. They want to use generative AI to dramatically improve the productivity of their developers. They actually use their own proprietary languages, not only the common languages that are available outside. They are then asking the question, who can I trust to augment their model, give it to me, and I don't really want to get into all the details of how I might use it, but I want them to provide the technology. In this case, Brian, we would work with them to augment the model using their language and their data and their code snippets. We would do it in a way that they are completely comfortable, meaning 100% that that leaks nowhere else. They would take back the model. It now becomes an as-a-service deployment in their private cloud infrastructure, and we monetize it as is typical for as-a-service software. I'll take another example that we are building out with Dun & Bradstreet, and I mentioned that briefly on the call. In that case, it is consulting led. They want to work with consulting to use watsonx in this case, but to help them create solutions that let their clients get greater insight, aka helps D&B monetize their data better. So, in that case, it is absolutely consulting led. I think without consulting, we would not have landed that deal. Let me go to others, because there are also examples where our Consulting team is using both what's available with Azure OpenAI, as an example, to go win deals because they have built up their expertise. They've also built up expertise on Amazon's Braket platform, and they're going forward with winning deals on those. In that case, they're coming in with the methodology, with knowledge, with the thousands of trained consultants who know how to work on those platforms, and they are working with the clients to go do that. I think these are all examples of what is working. I think you are trying to also ask is it going to be Consulting or is it going to be Software? Look, we didn't say much on the call on this topic. We just characterized it as low hundreds of millions of dollars of booking. But in the absence of anything else, think of that as maybe half and half between Consulting and Software, which does tell you that a couple of points of growth for both those units came from the generative AI that we've been putting out. And I think that's the best way to think about it in terms of what's happening right now. And we are certainly expecting and planning that that will only increase as the quarters go on. All right. So, let me now wrap up the call. This third quarter performance reinforced our confidence in the strategy and in our ability to deliver value to enterprise clients in today's environment. We're excited of the opportunities ahead of us, and I look forward to taking through -- you through our continued progress and our view of 2024 in January. Thank you all.

Operator:

Thank you. Thank you for participating on today's call. The conference has now ended. You may disconnect at this time.

Patricia Murphy:

Thank you. I'd like to welcome you to IBM's Second Quarter 2023 Earnings Presentation. 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. For example, all of our references to revenue and signings growth are at constant currency. We have provided reconciliation charts for these and other non-GAAP measures at the end of the presentation which is posted to our investor website. Finally, some comments made in this presentation may be considered forward-looking under the Private Securities Litigation Reform Act of 1995. These statements involve factors that could cause our actual results to differ materially. Additional information about these factors is included in the company's SEC filings. So with that, I'll turn the call over to Arvind.

Jim Kavanaugh:

Thanks, Arvind. As always, I'll start with the key financial highlights of the second quarter. We delivered $15.5 billion in revenue; $2.4 billion of operating pretax income; $2.18 of operating earnings per share and through the first-half nearly $3.5 billion of free cash flow. In the second quarter, we had modest revenue growth at constant currency, and that includes over 1 point of impact from the businesses we divested last year. Currency rates continue to be a headwind to growth with dollar strengthening over the last 90-days; currency impacted our reported revenue growth by 80 basis points, which is about a 0.5 point worse than what spot rates suggested in April. As is typical, I'll focus my comments on constant currency. Revenue performance was again led by software and consulting. These are growth factors that together represent about three quarters of IBM's revenue and contribute to a solid base of recurring revenue and profit. Software revenue was up 8% with good growth across both, hybrid platform and solutions, led by Red Hat and Data & AI and Transaction Processing. IBM Consulting revenue growth of 6% was also broad-based, with growth across all three lines of business and geographies. Our infrastructure revenue in any quarter reflects product cycle dynamics. Infrastructure revenue was down 14%. This, as expected, had a disproportional impact to IBM's overall revenue growth this quarter, given the very successful launch of z16 in the second quarter last year. Looking at the two-year compounded growth rate, infrastructure revenue was up. Turning to our profit metrics, operating gross margin expanded 140 basis points, driven by our portfolio mix and productivity. We had good performance this quarter with gross margin improvements in every reportable segment. Our operating pre-tax margin was down 70 basis points. Last year we had a gain of about $230 million from the sale of our healthcare software assets. Without the year-to-year impact of the divestiture gains, our operating pre-tax margin was up 70 basis points. This is a better indication of our ongoing operational performance. Let me comment on a couple of items within our expense profile that impacted our pre-tax income performance. As we discussed in the last couple of earnings calls, we address the remaining stranded costs from our portfolio actions, resulting in a higher level of workforce rebalancing activity this year, about $115 million in the quarter. Workforce rebalancing impacted our year-to-year pre-tax margin expansion by another 60 basis points. And then currency remained a year-to-year headwind, not only to revenue, but also to our expense and pre-tax profit. The combination of translation and hedging impacted operating pre-tax profit growth by about $150 million and operating PTI margin by about 80 basis points year to year. As I've discussed in the past, this disproportionately impacts our product-based businesses. We have good momentum in our underlying operational profit performance. I mentioned a strong business mix, but we're also making progress on our productivity initiatives. We're digitally transforming IBM as Client Zero simplifying workflows, and deploying AI across our processes. From IT operations to HR to source-to-pay. The productivity benefits free-up spend for reinvestment and contribute to margin expansion. Turning to free cash flow, we generated $2.1 billion in the quarter and nearly $3.5 billion in the first-half. This first-half performance is up over $100 million year-to-year and keeps us on track to our full-year expectation. Growth is driven by the cash from our profit performance, working capital efficiencies, and lower payments for structural actions. This was mitigated by higher performance-based compensation payments, given last year's strong results and higher cash taxes. In terms of cash uses through the first-half, we returned $3 billion to shareholders in the form of dividends and spent about $350 million to acquire six companies. Later this year, we expect to close the acquisition of Apptio, which complements and advances our IT automation capabilities. From a balance sheet perspective, we continue to have very strong liquidity position with over $16 billion of cash that's down over $1 billion since March, and up $7.5 billion since December. Our debt balance at the end of the second quarter was over $57 billion, which is up $6.5 billion from year-end. You'll recall earlier in the year, we were opportunistic in accessing the debt market and issued debt to prudently get ahead of 2023 and 2024 maturities, as well as capital allocation priorities. Turning to the segments, software revenue growth accelerated to 8% this quarter. Both Hybrid Platform & Solutions and Transaction Processing grew, as clients leverage our hybrid cloud and AI platform capabilities. This performance again reflects growth across both our recurring revenue base, which is about 80% of annual software revenue, as well as transactional revenue. In Hybrid Platform & Solutions revenue was up 7%, fueled by growth in Red Hat, Data & AI, and automation. Our Hybrid Platform & Solutions ARR is now over $13.6 billion and up 7%, reflecting the importance of our strategic offerings with our clients. Red Hat revenue grew 11%. OpenShift, our leading hybrid cloud platform grew more than 30% in the quarter and now has $1.1 billion in annual recurring revenue. Ansible also delivered double-digit growth and gained market share this quarter. In automation, revenue was up 2%, reflecting growth across integration, application servers, and business automation. As clients drive enhance business value through productivity and performance optimization. Data & AI revenue was up 11%. The broad-based growth included areas like data management and business analytics, giving enterprise needs for data visualization, organization, analysis, and insights as the underpinnings for AI workloads. Security revenue declined 1%. We delivered growth in security software, driven by data security with Guardium Insights. This was more than offset by declines in security services this quarter. In Transaction Processing, revenue grew 10% off of an easier compare last year. The increase in zSystems installed capacity over the last couple of cycles and strong software renewal rates reflect the importance of zSystems platform in a hybrid cloud environment. These dynamics contributed to both recurring and transactional software revenue opportunity again this quarter. Putting this together with price increases, we had strong performance in transaction processing. Moving to profit for the software segment, our pre-tax margin was up by 0.5 point, while absorbing over 1 point of impact from currency. We delivered operating leverage, given both the revenue scale and mix this quarter. Consulting revenue was up 6%. In April, we discussed that we were seeing sustained demand for larger transformations that delivered meaningful ROI. At the same time, other projects considered to be more discretionary predominantly in the United States. The second quarter client buying behavior played out much in the same way. Our signings were solid, up over 20% with double-digit growth in both large and small engagements. This takes our book-to-bill ratio up to 1.1 over the last 12 months. We address continued demand for technology-driven transformations as clients prioritize projects that drive cost savings and increase productivity. Turning to our lines of business and consulting, growth across our service offerings was broad-based. Business transformation grew 5%, driven by data and technology transformations, including AI and analytics-focused projects. Digital transformations continue to be underpinned by clients embracing a hybrid cloud strategy. Technology consulting grew 5% and application operations grew 8%, as we again saw strength in cloud-based application services across development, modernization, and management. Contributing to growth across the business, our strategic partnerships grew signings and revenue double-digits with solid performance from partnerships with AWS and Azure. Our Red Hat practice also grew signings and revenue double-digits. We have an annualized revenue run rate in excess of $2 billion. Moving to consulting profit, we expanded both gross and pre-tax margins a 180 basis points. Our margin expansion is a reflection of the pricing and productivity actions we've taken, more than offsetting the increased labor costs and investments. Turning to the Infrastructure segment, revenue was down 14%, reflecting product cycle dynamics. This impacted both hybrid infrastructure and infrastructure support. Within hybrid infrastructure, the zSystems revenue declined 30%. We've wrapped on strong revenue performance last year, up 77%, when z16 launched in the seasonally strong quarter. Through the first five quarters of availability, revenue is well ahead of prior cycles. The z16 brings the power of embedded AI at scale, cyber resilience security, and cloud-native development for hybrid cloud to our clients. For example, clients are adopting IBM's z16 and the Telum processor as the foundation for real-time AI insights across significant volumes of data. Distributed infrastructure revenue was down 6%. Let me remind you, we are wrapping on strong growth last year, up 17% driven by strength in Storage and Power10 high-end systems. Moving to infrastructure profit, we expanded gross margins 200 basis points, while pre-tax margin was down 40 basis points, including about 1 point of impact from currency. Now that I've gone through the segment results, let me bring it back up to the IBM level to wrap up. We feel good about our first-half performance, with momentum in our growth vectors of software and consulting and a solid recurring revenue base driven by our high-value software. We're delivering strong gross margin performance, with growth across our segments driven by portfolio mix and productivity. Our overall year-to-year profit dynamics as expected reflect the impact of last year's divestiture. As we look to the full-year of 2023, we're holding our view of the year on our two primary metrics

Operator:

Thank you. At this time we'll begin the question-and-answer session of the conference. [Operator Instructions] Our first question is from Wamsi Mohan with Bank of America. You may go ahead.

Arvind Krishna:

Wamsi, so thank you for the question. And as you noted, I'm very excited by our progress on AI, and what is going to do for our clients most importantly and then return of course for us as we monetize it. Our monetization is largely going to be through consulting and software and I'll explain that. Infrastructure will benefit, but I would not call that a direct monetization route. So let me start with consulting. If you noticed, I talked about and Jim talked about what we have done with hybrid cloud aka OpenShift in consulting, where we began with this journey in 2019, our book of business was to be precise and to round it out zero. In the first year, we signed about $1 billion of business. And at this point, we have inception to-date signed $9 billion with an annual run rate of $2 billion in consulting. I would tell you and expect that we'll play out AI in a similar way. I hesitate to call it anything else until we get six months or so down the road, in which case then we'll have more knowledge. Now on the software side, we are very, very excited by the initial reaction to the watsonx platform. the number of projects we have going on, the client interest, it really is something which we are very, very pleased by. So what's the model to think of it on? As I think about how OpenShift, which was a Red Hat product came in, in 2019, it grew literally doubled each year for the first four years. And at this point, the revenue is about 10 times of what it was and it came in. And right now we have quantified it at $1.1 billion on our annualized run rate basis. So that gives you a sense of the excitement we have around these projects, these technologies, and what it could do for us as you begin to go forward. Now third and most important, but I don't want to quantify it is the fact that AI will infuse in models every single product we have, whether it's sustainability, whether it's our database products, whether it's our consulting projects, whether it's inside the mainframe of the Telum. But I'm not including those in those first two categories. So with that, let me give it to Jim for the TPs question.

Patricia Murphy:

Thanks, Wamsi. Let's go to the next question, please.

Amit Daryanani:

Yes, thanks for taking my question. Yes, I guess, I was hoping you could spend a bit of time on the consulting side and the growth did decelerate there a little bit from 8% in Q1 to 6%. I'd love to understand how does that 6% growth in consolidated Q2 stack up versus your internal expectations? And then given the deceleration we saw in June, maybe just talk about what gives you confidence that the growth rate holds up, and that's 6% to 8% range for the back half of the year when some of your peers have actually talked about that market decelerating a bit? Thank you.

Patricia Murphy:

Thanks, Amit. Let's take the next question, please.

Toni Sacconaghi:

Yes. Thank you. I just wanted to clarify, when you talked about feeling comfortable with Q3 estimates was that both the revenue and an EPS statement? And then my question is on software, I think you were looking for 200 basis point margin improvement for the year and now you're saying 150 to 200. Can you speak to that? And also when we look at the improved software revenue growth, is that just improvement in transaction processing because you're way above your forecast in Apptio or is there something beyond that? And related to that, are you modeling any substantive revenue from AI and consulting or in software this year? And why would that not impact your outlook if you were? Thank you.

Arvind Krishna:

Yes. Thanks, Jim. So Toni, I'll comment quickly on the color on revenue from AI, both in software and consulting. So as I said, in consulting, we are expecting a number of projects to get signed. By the way, as Jim mentioned, some of that is getting baked in. And you're seeing that in the strong signings that we have in consulting in the second quarter with the over 20% growth in signings, and a lot of that was indeed data and AI consulting projects. Ditto in software, I'd just note that we had double-digit growth in the data and AI subsegment of software, and no doubt that some of that is colored by clients doing more around AI with us than they have historically. So we expect to see it. But I do want us to be sort of all in, all in with 2023, including the AI color. We see software at the high end of our model, and we see consulting as in the range that Jim just laid out. So while we are very excited about it and we see a lot of traction on AI, it is included in the estimates that we just gave.

Operator:

Thank you. Next question is from Shannon Cross with Credit Suisse. You may go ahead.

Arvind Krishna:

Thanks. Shannon, great questions. So when I look at AI by geography, at one thought of simple level, I would tell you that over the last six months, the interest in AI spans across all markets, all industries. So it is a international phenomenon, not confined to the U.S. Now we've got to dig under it. Then if I look at the maturity of clients to actually have their enterprise ready to embrace AI to be able to interact with their clients, their employees, that does vary. I have to acknowledge it. The North American market is probably the most further ahead on this. I think Western Europe comes second, likely together with some of the more advanced and developed markets in South America. Following that then is Asia and all of what would we call the Global South. Japan has a strong interest, but they tend to be cautious on adopting technology, not necessarily in experimenting. In experimenting, they'll be pretty quick. And then it will go into South Asia, where always, I think technology adoption tends to lag by a year or two behind the West. So that gives you some sense of that. But that said, every government, every enterprise, every CEO, every CIO that I talk to wants to talk about AI, what it can do to their company, what should it be in their country. And all of the questions around sovereignty of models and data and privacy and not depending only on a few international players come into the conversation, and that's why we talk a lot about private models and models that can be left behind with the client, because that is coming up more and more. And so that, I hope, gives you some color on how this is going to play out. Coming to the next part of your question on Apptio. Look, the key drivers of this acquisition are pretty straightforward. When we look at and talk to CIOs, CFOs, CEOs, they're all getting worried about their spend across the hybrid landscape. What do I spend on my first public cloud? What is it on my second? What is it on a SaaS property? What am I spending on my own data centers? So to give people a virtual cockpit that really lets them span across this, not just in terms of the third-party spend, but also the people and the process spend, is something they're all deeply, deeply interested in. And more than a few CEOs I've talked to said it really gives them a handle on what's going on and where the money is being spent. That, I think, is going to play in right away. And you went right to the second value prop. With that spend data coming in across enterprises, the aggregate anonymized across the asset is the $450 billion. Now helping people benchmark, who does this better than you? Who does this process better? Who can do this with fewer total spend on a public or a private resource? It's interesting to people because benchmarks is a great way to guide oneself to better performance. We expect that over time, we'll be able to monetize that into a large language or a foundation model and be able to give people even better predictors or where they can take their spend, too. That's why we are so excited about it. And I think the last part of your question was KPIs. Look, as we look to get Apptio much more international, while our footprint is, I'll call it, maybe two-third, one-third outside the U.S. and in the U.S., they're almost inverse. So as we can put it into our distribution channel, that will be one big expansion as we go over the next year or so. The second one is we believe we have a great chance to also increase the penetration in our larger clients. So those are two big metrics while we continue the success in the growth rate they've had using their own channels.

Operator:

Thank you. Next is Erik Woodring with Morgan Stanley. You may go ahead.

Arvind Krishna:

Erik, so I might sound somewhat repetitive to those of you who have heard me over the past two years on this topic. So if I just sort of maybe just step back and say, taking unusual actions off the table for a moment, we had talked about a total Finflex let's call it, circa $20 billion over a three-year period. That includes the ability to raise additional debt if we so desired. We've been spending circa about $3 billion a year for the last couple. So that tells you what's the capability and the flexibility that we have. You asked about valuations, and I hope my answer that tells you that we are always on the lookout, and I'll get to which categories because you asked that also. On valuations, I wouldn't call it so much that today is restrictive. What I could say is that while some of at least the reports I was reading, we're talking about valuations perhaps coming down in multiples over this year. It doesn't seem that that's the case. They've not gone up in any, kind of, tremendous way, but they have not come down. But the market is what the market is. So if we find properties that meet our criteria, and my criteria are pretty straightforward. Doesn't align with our strategy, and I'll call those areas out in a moment. Doesn't actually give us synergy, meaning can we the combined entity grow faster than the individuals could before, right, just about it in very financial terms. And if it is larger, it has to be accretive. And by larger, I mean it's not a tuck-in, meaning it's not a few hundred million. It's larger than that, then it's got to get accretive, let's say, within two years at the latest. So if it meets those criteria, it's certainly an attractive proposition. The areas we are in, we don't want to open up more strategic lane, so to speak. Our areas are hybrid cloud, data and AI, automation, cyber and those consulting properties, which in turn help these. So that's kind of the lanes we're in. And if I look at the latest one, Apptio, I'd say it kind of hits three out of my four. It hits hybrid cloud because it helps you deploy those. It is a big data and AI property because that's what they use. And it is automation because it takes out human labor cost from many of those processes. So it was actually a very, very good fit. And if any of you have suggestions for similar things, we are all ears, and you can certainly write to me.

Operator:

Thank you. Next is David Grossman with Stifel. You may go ahead.

Arvind Krishna:

So David, let me address the first part of your question on pricing. Look, I'd like to be careful. TP certainly benefited this year, but the biggest part of the benefit has been the mainframe cycle and the capacity and value that our clients see. Yes. Was there a price increase? Given the labor inflation of 2022 and some ongoing in ’23, given the strong dollar, effectively, there was pricing increase, because of those factors, and that got taken well by the market, because of the value they see on that. Would I expect to see similar pricing on TP and then I'll come to other parts of both consulting and software? I doubt, David, that it will be on the same range because, definitely, I think we would all agree, ‘22 had a high inflation. And because our costs go together with the labor and the dollar, I don't think it will be as strong as that, but I would expect maybe moderate increases based on just the pricing in TP. Now consulting has also got both labor and inflation built in. And when we are seeing 6%, 8%, 10% increases in labor cost, it is, I think, appropriate to be able to pass some of that on, albeit with a lag. And you heard Jim talk in his prepared remarks about that, that is some of what is coming through in consulting. If there remains underlying labor inflation, I fully expect to be able to pass that on, again, with a bit of a lag to clients in consulting because, otherwise, that's not a healthy business to go on. I think on the rest of software, except TP, I would expect that as labor inflation is there, those elements do come in effectively on pricing, renewal rates and so on. But I'd also say it's a competitive market, and you have to remain competitively priced to where the others are. So I would say it's in those two

Patricia Murphy:

Hey, thanks, David. Let’s see if we squeeze two more in. Let’s go to the next question.

Keith Bachman:

Hui, many thanks for the question. Arvind, I wanted to direct this to you, if I could. You've talked about the success you've had, even at these early stages of signing new AI offerings in the consulting side of the business? How are you thinking about the supply side of the business? And what I mean by that is, as you look at over time, the software development process, as you talked about that in Orlando, is going to become much more efficient. And so if your consulting business is really a seat-based model that drives revenue and if those developers are increasing productivity by, I don't know, 30%, 40% because it's gen AI, presumably, clients will want that back. So how do you think about the disinflationary forces associated with gen AI on delivery side of the model, which is, I think, separate and distinct from the opportunities associated with new demand sources? And Jim, if I just sneak one in to you, to if you could talk about the total MIPS growth, not just the cycle growth, but the total MIPS growth that you've recently experienced as we look out over the next couple of years. Just trying to understand what the pricing increase, how that may -- how you may be able to use pricing on TP to leverage that MIPS? That's it for me. Many thanks.

Jim Kavanaugh:

Yes. Keith, thanks for the question. On mainframe overall, pretty pleased given where we're at, GA plus four quarters in. So we wrapped on last year. Remember, we talked a lot last year. We came out with, unlike the prior programs. We came out with a second quarter launch in a highly seasonal transactional quarter, and we grew 77% last year overall, and we wrapped on that this year. I think we printed down 30% here in the second quarter. But a two-year CGR, so far, our five quarters in its most successful program and mainframe that we've had. Now why is it important? Yes, definitely, the value we deliver to clients, whether it's embedded AI, it's scale, cyber resilient security, cloud native development, but it's important internally to us, because it's a platform that drives a multiplier effect, to your question, around transaction processing. And we've been talking about this 2 times installed MIPS shift -- MIPS capacity over the last program. That was actually the z15 program over z14 because we're only 5 quarters into z16. But if you fast forward right now into z16, five quarters in, we're 120% to 130% up on an installed MIPS capacity already. And you know the tail of that usually happens in the outer path of the next three or four quarters before we come out with the new one. So we feel pretty good, and that's why we had the confidence entering this year, Arvind, and I, to take up the transaction processing model to actually low single-digit growth from being down mid-singles. So we see that continuing. Thanks for your question.

Operator:

Thank you. Our final question comes from Ben Reitzes with Melius Research. You may go ahead.

Arvind Krishna:

Ben, thank you for the question, and I deeply appreciate your asking it in that form. Look, when we look at -- let me start with our extreme advantage when clients have data that they like to train models on and they absolutely want to preserve the intellectual property in that data, they do not want the learnings, I mean, I can go through three forms. Almost everyone will say, look, we're not going to take our data and give it to anybody in direct form. Okay. Next, how about learnings in the model itself from the data? Do you use that implicitly or explicitly or not at all? Three, the very fact that you're asking a certain kind of question can in turn reveal information. I'll use the word from my college training of site channel information. I'm sure that all of you also understand what that word could imply. So for people who are worried about all that, which we estimate to be at least 30% of the overall AI opportunity. Think about a bank dealing with regulatory compliance. Think about a pharma company dealing with reports to the FDA. Think about a health care company worried about some, kind of, side effect on something. Think about a chemicals company worrying about their proprietary formulations, not just watson, the literature. So as you go through all of these, there are lots and lots of examples where people want to train models. Maybe it's a refinement of a larger known model. So to your point on other models, and I'll come to that. So we found that there's a lot of opportunity, and those are the questions that people are asking us. Then next, a number of people are, critically, they have great models. They're great for big public consumption. They are great because everybody kind of has the same need for productivity. But there is also a world right now from the partners we work with, there's already over 100,000 open source models in addition to the models that we IBM provide. How do you pick from those models? Which one is appropriate? And we have taken a conscious strategy that we are not going to constrain the model that our clients want. So on our consulting teams, we will work with all the models, our own open source and other models so we can help our clients decide on which is the best one for them. Look, 30-years of being here has shown us that trying to help the clients navigate through the extreme complexity of this world is helpful to us, and we can become much better advisers and gain revenue in the process. So hopefully, that gives you a sense of how we are going to win here and get our fair share of this market. So given that we just passed the top of the hour, let me wrap up the call. We are in a really good position as we enter the second half of the year. Solutions meet today's client needs, new innovation we are bringing to market, and there is momentum and productivity in our underlying operations. As always, we need to execute to capture the opportunity in front of us, and I look forward to sharing our progress with you as we move through the rest of the year.

Operator:

Thank you. Thank you for participating on today's call. The conference has now ended. You may disconnect at this time.

Patricia Murphy:

Thank you. This is Patricia Murphy, and I'd like to welcome you to IBM's first quarter 2023 earnings presentation. 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. For example, all of our references to revenue growth are at constant currency. We have provided reconciliation charts for these and other non-GAAP measures at the end of the presentation 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. More information about these factors is included in the company's SEC filings. With that, I'll turn the call over to Arvind.

James Kavanaugh :

Thanks, Arvind. I'll start with the financial highlights of the first quarter. We delivered $14.3 billion in revenue, $1.4 billion of operating pre-tax income, $1.36 of operating earnings per share and $1.3 billion of free cash flow. Our revenue for the quarter was up about 4.5% at constant currency. That includes over 1 point of impact from the businesses we divested. Currency rates impacted our reported revenue growth by 4 points. That is over $100 million more than spot rates would have suggested 90 days ago. As always, I'll focus my comments on constant currency. Revenue growth this quarter was led by Software and Consulting. Software revenue was up nearly 6% and Consulting up 8%. These are our growth vectors and now represent about three-quarters of our annual revenue. Our infrastructure revenue was flat with continued strength in z Systems. All three of our geographies grew, with high single-digit growth in both EMEA and Asia Pacific. Across our business, more than half of IBM's revenue is recurring, led by high-value software which is growing at mid-single-digit rate. Looking at our profit metrics for the quarter. Operating gross margin expanded 80 basis points. We expanded gross margin in all segments with a strong portfolio mix overall. Operating pre-tax income, excluding the impact of workforce rebalancing, was up 12%, and margin expanded 130 basis points. You'll recall back in January, I mentioned we were planning to address remaining stranded costs from our portfolio actions and we anticipated a charge of about $300 million. As we executed our plan, we took a charge of $260 million in the first quarter, and we expect to complete this action in the second quarter. This workforce rebalancing charge primarily addresses indirect support function. We are no longer including workforce rebalancing charges in our measure of segment profit to provide a view of our segment results consistent with our ongoing operational profile. At the IBM level, including the workforce rebalancing activity, operating pre-tax income was down 4%, and margin was down 50 basis points. Within our margin performance, we absorbed a significant currency headwind. The combination of translation and hedging impacted operating pre-tax profit growth by about $160 million and operating PTI margin by 70 basis points year-to-year. As I've discussed in the past, this essentially impacts our product-based businesses. Mitigating that, the change in useful lives of our server and networking equipment provides a 50 basis point year-to-year benefit to operating PTI margin, which is included primarily in our infrastructure segment. Taking it back up a level, IBM's profit performance this quarter benefits from improvements in business mix and ongoing productivity initiatives. We've been digitally transforming IBM, much in the same way we're helping our clients with their transformation, using both IBM and third-party capabilities. Think of IBM as client zero. We are driving G&A efficiencies by reimagining and transforming the way we work. This includes optimizing our infrastructure and application environments as well as redesigning our end-to-end business processes. Let me give you a few examples. Across IBM's IT environment, we're realizing the value of hybrid cloud. We reduced the average cost of running an application by 90% by moving from a legacy data center environment to a hybrid cloud environment running on Red Hat OpenShift. We've been simplifying our application environment. By standardizing global processes and applying AIOps, we are reducing our application portfolio by more than 35%. We've automated over 24 million transactions with RPA, avoiding hundreds of thousands of manual tasks and eliminating the risk of human error, and we're deploying AI at scale to reengineer our business processes. We're doing that in areas like HR and talent, finance and end-to-end processes like quote to cash and Source to Pay. For example, in HR, we now handle 94% of our company-wide HR inquiries with our AskHR digital system, speeding up the completion of many HR tasks by up to 75%. These productivity initiatives free up spending for reinvestment and contribute to margin expansion. Turning to free cash flow. We generated $1.3 billion in the quarter. This is up $100 million year-to-year and puts us on track to our full year expectation. Growth is driven by our profit performance and working capital efficiencies as well as lower payments for structural action. This was mitigated by an increase in capital expenditures and higher performance-based compensation payments, given last year's strong results. In terms of cash uses, we returned $1.5 billion to shareholders in the form of dividends. From a balance sheet perspective, we have a very strong liquidity position with cash over $17 billion, which is up nearly $9 billion from December. We have been opportunistic in accessing the debt market and issued debt early in the year to prudently get ahead of 2023 and 2024 maturities. Our debt balance at the end of the first quarter was over $58 billion, up nearly $8 billion from year-end. Turning to the segments. Software revenue grew nearly 6%, in line with software's mid-single-digit model. We had growth in both Hybrid Platform & Solutions and transaction processing. This performance captures the benefits of our growing recurring revenue stream, which is about 80% of annual software revenue with continued strong renewal rates. This, together with growth in software transactions this quarter demonstrates clients' commitment to our hybrid cloud and AI platforms. In Hybrid Platform & Solutions, revenue was up 5%, fueled by growth across all business areas. We continue to see client demand for broad capabilities across Red Hat, automation, data in AI and security. Red Hat revenue grew 11% with growth across all major offerings. We have particular strength in our hybrid cloud platform, OpenShift; and Ansible, our IT automation solution. Both offerings also continue to take market share this quarter. Automation revenue was up 2%, driven by integration and application servers, given client demand for improved IT performance and costs. In data and AI, revenue grew 3%, reflecting growth across data management, business analytics and asset and supply chain management. Many of these offerings, like Db2, serve as the underpinnings for modern AI and mission-critical workloads. Security revenue was up 2% with growth across security for hybrid cloud, which includes both identity and threat management and security for data. Bringing this all together, our Hybrid Platform & Solutions ARR is now at $13.5 billion. In transaction processing, revenue grew 6.5%. The software remains core to our clients' hybrid cloud strategies. The strong performance over the last couple of system cycles drove significant capacity growth. In fact, installed MIPS growth during our z15 cycle was 2x that of z14. This translates to software opportunity and contributed to growth in both recurring and transactional revenue. Layering in this year's price increases, we delivered good performance in Transaction Processing this quarter. Moving to profit for the Software segment. Gross margin was up and pre-tax margin was flat this quarter with the latter absorbing nearly 1 point of impact from currency. Consulting revenue was up 8% and I'll remind you, we had a strong growth in the first quarter of last year. Our book-to-bill ratio over the last 12 months was 1.07. Signings in the quarter grew 7% with similar performance across both larger and smaller engagements. We continue to see broad demand for projects that deliver technology-driven transformation, leveraging a hybrid cloud environment. Within the quarter, demand was solid for cloud modernization offerings, and we had one of our largest Red Hat signings quarters ever. More recently, clients are particularly focused on driving productivity and cost reductions with greater agility and faster time to value. This is contributing to signings growth from digital transformations in areas such as talent, finance and supply chain transformation. In terms of revenue, while we had solid growth overall, we have seen some clients in the U.S. pull back on more discretionary projects, impacting backlog realization within the quarter. Bringing it back up to the global level, Business Transformation grew 6%, Technology Consulting grew 4% and Application Operations grew 13%. Revenue growth was led by data and customer experience transformation project, in addition to cloud application development and management. Our hybrid cloud expertise and depth and breadth of strategic partnerships differentiate IBM Consulting in today's market. Red Hat consulting revenue, now over $2 billion annually, continue to grow at a double-digit rate. And our strategic partnerships continued strong growth, making up over 35% of our revenue in this segment over the last 12 months. Moving to consulting profit, we expanded both gross and pre-tax margins. Our pre-tax margin of about 8% in the quarter was up 50 basis points year-to-year as we continue to benefit from the productivity actions we've taken. Turning to the Infrastructure segment, revenue was flat. Hybrid Infrastructure revenue was up 4% and Infrastructure Support revenue was down 4%. Within Hybrid Infrastructure, z Systems revenue was up 11%. This was a fourth quarter of z16 availability, and the solid program performance has outpaced that of prior cycles. In addition to capabilities around embedded AI at scale, cloud-native development for hybrid cloud and cyber resilience security, clients are also leveraging z16 for its energy efficiency. For example, consolidating Linux workloads on a single z16 system can reduce energy consumption by up to 75%. We continue to see strong growth in shipped MIPS for new Linux workloads on z16. Distributed infrastructure revenue was flat. Growth in storage was offset by declines in power as we have wrapped on the launch of the Power10 high-end systems. Moving to infrastructure profit. We expanded both gross and pre-tax margins. The 80 basis point improvement in pre-tax margin reflects benefits from both the z Systems' product cycle and changes in useful life, partially offset by nearly 2 points of currency impact. Now let me bring it back up to the IBM level to wrap it up. When we first introduced today's IBM back in October of 2021, we provided a midterm model for revenue growth, margin expansion and free cash flow growth. We delivered on that model throughout last year and now have a good start to 2023. In the first quarter, we delivered constant currency revenue growth in line with our mid-single-digit model, expanded gross margin, drove productivity in our underlying business and grew our free cash flow. Looking at full year 2023, as always, I'll start with our two primary metrics

Operator:

[Operator Instructions] Our first question will come from Shannon Cross with Credit Suisse.

Arvind Krishna :

Shannon, thank you for the question. And as you can imagine, we spend a lot of time both digesting and making our own estimates based on what our clients are saying. So you said geography, verticals and then within technology segments, so let me try to unpack it a little. So on a geography level, a lot of the uncertainty that is in the media here, certainly in North America is not there in Asia at all. If I look across Japan, India, the Middle East, which kind of covers the broad swath of Asia, with the exception of China, we don't see any of that playing out. The geopolitics around China is a slightly different piece but I think everyone is subject to that right now. Then if I come to Europe, it's actually been stronger than I would have predicted six months ago, but that is because of my point on technology as a deflationary force. When we look at the mixture of interest rates, inflation, wage inflation, demographic, meaning labor shortages, supply chain resiliency, cyber, technology is actually the only answer companies have against all that. Now that does apply to the larger enterprises who are our primary customers. When I come to the United States, we did see some slowing down in consulting projects, as I said. But that is because consulting is somewhat discretionary. However, we are not seeing people cancel projects. What they are doing is slowing them down, meaning pushing to the right, which is why we took the numbers down for consulting, believing that, that may spread in some sense to other parts of the globe as well. Software, we are seeing demand remain very steady. We're not seeing any signs of weakness in software. Admittedly, we are in B2B software. We are not in any B2C segment. And in infrastructure, I think it's less of a macro. It's much more, in our case, a product cycle issue that is playing through. I hope that gave you some color on why we have confidence in the demand, weakness in 1 particular area, which we think will likely play through. But I want to caution that weakness is not us shrinking. It just says that double-digit rates went down into the 6% to 8%, which is still healthy.

Operator:

Our next question comes from Amit Daryanani with Evercore.

Arvind Krishna :

So Amit, let me just take the first part of your question on the linkage between consulting and software, and then I'll hand it to Jim for other parts of the question. So I think that if I look at the consulting, it's not going to spread to software in our belief. Remember, our consulting is comprised if you just want to break it down into sort of three parts. We work with a lot of other partners including on the public clouds, including with large software providers, and we tend to do these projects for our clients. I keep cautioning, it's slowing down but still in the 6% to 8%, not in a rate lower than that. Yes, there is a linkage to software but a lot of our software is running critical systems for our clients, and we don't see those very subject to what we see in the current macroeconomic environment. And so that's what gives us confidence on those. Also, I think the movement towards hybrid cloud and the ability to take advantage of AI for enterprise productivity is perhaps going to be a tailwind as we enter the second half of the year because I do think that clients are going to do a lot of automation and a lot of cost cutting, which will likely benefit elements of our software portfolio. Jim?

Patricia Murphy:

Okay, sure. Let’s go to the next question please.

Toni Sacconaghi :

I was just wondering if you could comment a little bit about Red Hat. I think I recall your guidance was for mid-teens growth for the year. And in the first quarter, it was 11% at constant currency but ex deferred revenue accounting was probably 7% or 8%. So how do we get confident that the back half of the year where there's little to no deferred revenue accounting contribution can be fundamentally like 17%, 18%, so an acceleration from 7% or 8% to 17% or 18%. And then secondly, can you comment just on the impact of software pricing? Are you only seeing that in Transaction Processing? Or are you seeing in other parts of the software business? And how should we be thinking about sort of the magnitude of the impact of price increases?

James Kavanaugh :

Yes. Thanks, Arvind, and thanks, Toni for the question so we can get some clarity out here because I know this has been a hot topic of all of my discussion with investors over the first quarter, especially in light of the macroeconomic environment. First of all, as Arvind indicated, we're pretty pleased with the performance overall of our Red Hat portfolio. 11% growth here in the first quarter, off of, by the way, the toughest compare last year at 21% growth overall. And by the way, just to put this to rest, the operational growth compared to the GAAP growth is very similar in the first quarter. So the combination of deferred revenue, which, by the way, is de minimis, it's like in the single million dollars and the intercompany, to get a bridge from operational to GAAP is a rounding error in the first quarter. And by the way, we continue to expect that as we go forward. So the number that we report, and by the way, we're, what, four years into this acquisition now and we continue to talk about deferred revenue. But let's put that aside. Underneath the performance of 11%. Red Hat OpenShift's strong performance here in the quarter, growing north of 40%. We talked about 90 days ago, we put the number out there. Now that we've got to a $1 billion ARR business, we're seeing very good momentum in OpenShift as the leading hybrid cloud platform overall. And our Ansible portfolio, to Arvind's point, is scaling nicely and taking share on top of that. Now what's going to drive the growth in the second half of that 11%? We called the year now at 11% to 13%. I think being prudently cautious. We have a strong renewal available base that will start kicking in, in the second half. So I think that's really the core to the answer about the renewal base on the subscription. But just wrapping up Red Hat and the discussion I have with investors, taking a big step back, we're pleased overall. We're four years into this acquisition. We have quadrupled the Red Hat revenue from pre-acquisition in 3.5 years. And around the multiplier effect, we've accelerated our software portfolio, and we've accelerated our consulting portfolio to a high -- mid- to high single-digit growth business overall. So we're very pleased overall.

Operator:

Yes. Our next question will come from Wamsi Mohan with Bank of America.

Arvind Krishna :

Sure, Wamsi. Look, I'll answer it in terms of what I'm seeing on the business, and I'll let Jim then put some precise numbers on it. We actually -- when we spoke to all of you in January, we were saying about 1/3 in the first half and 2/3 in the second half. Now we are saying actually a little bit more than 1/3 in the first half and the remaining in the second half. So actually, we are actually bringing it up a little bit despite taking on the restructuring charges and some of the Kyndryl associated charges that we're absorbing in those numbers. So what gives me confidence is when we look at the underlying performance in the first quarter, not all of our actions and productivity play out right in the quarter. But we are seeing enough green shoots in all of them to be able to predict those increases, of 1 point in consulting, the 2 points in software, et cetera, as you play through the year. And that allows us to have confidence in both the PTI and the cash flow despite the revenue numbers that we are projecting going forward. And I think actually, Q1 is a good down payment towards that, Wamsi. Despite the restructuring charge, we increased free cash flow by $100 million, and so that actually all goes together towards our numbers. Jim, anything you'd like to add to that?

Patricia Murphy:

Thank you, Wamsi. Let’s go to the next question please.

Lisa Ellis :

Wanted to ask about the impact of the recent banking mini crisis we've had over the last 6 weeks or so. What impact are you seeing on your business, given how much work IBM does with financial services firms? Like are you seeing any disruption? Or maybe on the flip side of that, any acceleration in demand for products and services, say, in like the risk management area?

Patricia Murphy:

Let’s go to the next question please.

Erik Woodring :

I guess, Arvind, maybe if you can just give us an update on how you're thinking about M&A, just given the broader macro environment, some of the comments you made about the consulting business, interest rates, your cash balance. If you could just bring it all together, maybe just provide an update today and if anything has changed relative to 90 days ago?

Patricia Murphy:

Thank you, Erik. Sheila, let’s go to the next question.

David Grossman :

Arvind, maybe you could talk a little bit more about the pricing dynamic in the marketplace and the pricing environment, given the shifting macro that we face. And perhaps you could help us better understand how to think of pricing and its impact on revenue growth this year and just prepare us for some of the potential outcomes and pricing and its impact on revenue growth next year?

James Kavanaugh :

I would just add one thing. It goes without saying as Arvind continues to coach me, pricing optimization is always a direct reflection of the value that you have and the differentiation you have within your offering portfolio overall. So we talked about the consulting side. By the way, fourth consecutive quarter of nice improvement on price margins. You're seeing that play out in the gross margin up 90 basis points. But our software-based portfolio, where we do have differentiation overall, we talked about 90 days ago, right, we had some price optimization. You're seeing some of that play. And in the first quarter, probably about 1 point. For the full year, we think of our mid-single-digit model might be a couple of points. So somewhere in that ballpark, David.

Operator:

Our last question will come from Kyle McNealy with Jefferies.

Arvind Krishna :

Kyle, great question. I'm not sure we have an hour so I'll try to my answer into 2 or 3 minutes. So we see a lot of opportunities. You used the word foundational models. So I think that, look, just for everybody else, AI has gone through sort of 4 generations very quickly from expert systems in the '80s and '90s, to machine learning, through about 2010, deep learning for the last decade and now this era of large language models and generative AI. We believe it has a tremendous application to the B2B side of AI inside enterprises. I kind of capture it as AI for business as opposed to AI for consumers. A lot of the excitement out there is on AI for consumers, and I think it's going to be a home run for those companies that are going down that path. But there's a lot of industries where people still worry about their data. They are careful about what's used to train the data. They cannot have an answer that occasionally inserts some friction into the answer. They need an answer that is from reliable sources only. Then the second part is a lot of these techniques, what people don't realize is it takes down the cost of deploying AI. What we are seeing is that a large language model can be trained and then do 100 tasks with very minor additional training. So yes, the first training is a lot more expensive, maybe 4, 5 times. But then if you can do 100 tasks for almost no additional cost, you can see that the overall is a 4 to 5x benefit in terms of time to value and productivity. So what are some examples? We did a preview of AI for ITOps around a product called Ansible. We're calling it Project Wisdom is our internal code name, but it shows that you can get 60% to 80% of the code that our IT operations person might write, gets written by the AI. Well, that's a 3x to 4x productivity for that individual. That's one example. Another example that we use, and you can see that play through in our customer care examples, which are multitudeness whether it's order-taking at McDonald's or CVS Health or Bradesco Bank, where we can now do 10 to 15 to 20 languages as in Spanish, French, English, German, for the cost of effectively 1 language from the past. So that shows through in the speed of deployment that we can do there. The areas that we are focused on to go drive all this is customer care, IT operations, digital labor and an example of that is what Jim talked about in our internal service centers and in cybersecurity. You'll see it come through sometimes directly, like I talked about in Wisdom, sometimes embedded with one of our software partners and sometimes as a piece of one of our products, be it our data lake products or our cybersecurity products, so in all those 3 flavors, consulting with clients, products from IBM and products with ISVs.

Patricia Murphy:

Sheila, I'll turn it over to you to wrap up the call.

Patricia Murphy:

Thank you. This is Patricia Murphy and I'd like to welcome you to IBM's Fourth Quarter 2022 Earnings Presentation. 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. Provided additional information to our investors, our presentation includes certain non-GAAP measures. For example, all of our references to revenue growth are at constant currency. We have provided reconciliation charts for and other non-GAAP measures at the end of the presentation, which is posted to our investor website. Finally, some comments made in this presentation may be considered forward-looking under the Private Securities Litigation Reform Act of 1995. These statements involve factors that could cause our actual results to differ materially. Additional information about these factors is included in the company's SEC filings. So, with that, I'll turn the call over to Arvind.

Jim Kavanaugh:

Thanks, Arvind. I'll start with the financial highlights of the fourth quarter. We delivered $16.7 billion in revenue, $3.8 billion of operating pre-tax income and operating earnings per share of $3.60. In our seasonally strongest quarter, we generated $5.2 billion of free cash flow. Our revenue for the quarter was up over 6% at constant currency. While the dollar weakened a bit from 90 days ago, it still impacted our reported revenue by over $1 billion and 6.3 points of growth. As always, I'll focus my comments on constant currency. And I'll remind you that we wrapped on the separation of Kyndryl at the beginning of November. The one-month contribution to our fourth quarter revenue growth was offset by the impact of our divested health business. Revenue growth this quarter was again broad-based. Software revenue was up 8% and consulting up 9%. These are our growth vectors and represent over 70% of our revenue. Infrastructure was up 7%. Within each of these segments, our growth was pervasive. We also had good growth across our geographies, with mid single-digit growth are better in Americas, EMEA and Asia Pacific. And for the year, we gained share overall. We had strong transactional growth in software and hardware to close the year. At the same time, our recurring revenue, which provides a solid base of revenue and profit also grew, led by software. I'll remind you that on an annual basis, about half of our revenue is recurring. Over the last year, we've seen the results of a more focused hybrid cloud and AI strategy. Our approach to hybrid cloud is platform-centric. As we land a platform, we get a multiplier effect across software, consulting and infrastructure. For the year, our hybrid cloud revenue was over $22 billion, up 17% from 2021. Looking at our profit metrics for the quarter, we expanded operating pre-tax margin by 170 basis points. This reflects a strong portfolio mix and improving software and consulting margins. These same dynamics drove a 60 basis point increase in operating gross margin. Our expense was down year-to-year driven by currency dynamics. Within our base expense, the work we're doing to digitally transform our operations provides flexibility to continue to invest in innovation and in talent. Our operating tax rate was 14% which is flat versus last year. And our operating earnings per share of $3.60 was up over 7%. Turning to free cash flow. We generated $5.2 billion in the quarter and $9.3 billion for the year. Our full year free cash flow is up $2.8 billion from 2021. As we talked about all year, we have a few drivers of our free cash flow growth. First, I'll remind you, 2021's cash flow results included Kyndryl related activity including the impact of spin charges and CapEx; second, we had working capital improvements driven by efficiencies in our collections and mainframe cycle dynamics. Despite strong collections, the combination of revenue performance above our model and the timing of the transactions in the quarter led to higher-than-expected working capital at the end of the year. This impacted our free cash flow performance versus expectations. Our year-to-year free cash flow growth also includes a modest tailwind from cash tax payments and lower payments for structural actions, partially offset by increased CapEx investment for today's IBM. In terms of cash uses for the year, we invested $2.3 billion to acquire eight companies across software and consulting, mitigated by over $1 billion in proceeds from divested businesses, and we returned nearly $6 billion to shareholders in the form of dividends. From a balance sheet perspective, we ended the year in a strong liquidity position with cash of $8.8 billion, this is up over $1 billion year-to-year and our debt balance is down nearly $1 billion. Our balance sheet remains strong, and I say the same for our retirement-related plans. At year-end, our worldwide tax qualified plans are funded at 114%, with the US at 125%. Both are up year-to-year. You'll recall, back in September, we took another step to reduce the risk profile of our plans. We transferred a portion of our U.S. qualified defined benefit plan obligations to insurers, without changing the benefits payable to plan participants. This resulted in a significant non-cash charge in our GAAP results in the third quarter, and we'll see a benefit in our non-operating charges going forward. You can see the benefit of this and other pension assumptions to the 2023 retirement-related costs in our supplemental charts. Turning to the segments. Software revenue grew 8%, fueled by growth in both hybrid platform and solutions and transaction processing. We concluded the year with seasonally strong transactional performance as well as a solid and growing recurring revenue base in software. In hybrid platform and solutions, revenue was up 10%, with pervasive growth across our business areas

Operator:

Thank you. At this time, we’ll begin the question-and-answer session of the conference. [Operator Instructions] Our first question will come from Amit Daryanani with Evercore. Your line is open.

Jim Kavanaugh :

Thanks, Amit. This is Jim. I appreciate the question. So let's start there. We saw a solid free cash flow generation in 2022, up $2.8 billion year-over-year. Now as you remember, we entered 2022. We talked about a very strong free cash flow generation engine. And we put in place a guidance for 2022 well in excess of our model of $750 million year-to-year. First, as we were very transparent, we were going to get at least about half of that out of the Kyndryl related spin dynamics. That's the charges and CapEx. And we were going to get a little bit more than half of that out of our base operations overall. And I think when you look at 2022, what happened we got impacted by two external factors. Number one, the unfortunate humanitarian crisis with the war in Russia and Ukraine, and we exited that business, the right decision. Second is unprecedented US dollar appreciation. I think last time I looked, the rate, the breadth, the magnitude of the change is the most we've seen in multiple decades. We got hit with that. But we're able to overcome some of that with the fundamental underpinnings of our business overall and still delivered almost $3 billion of free cash flow year-over-year. By the way, Russian currency by themselves is over $600 million of profit and cash we had to absorb. So now to your question about 2023, we guided, as you heard in the prepared remarks, a $10.5 billion, that's up $1.2 billion year-over-year, and again, above our $750 million year-to-year. The underpinnings of that, though, are going to be very different in 2023. Given the improving business fundamentals of our now sustainable revenue growth with a high value mix contribution, we see then continued operating leverage. So our cash PTI is going to deliver a substantial amount of that free cash flow generation year-over-year. We're still going to get working capital efficiency. So our realization will definitely be up over 100%. But that's really given the volume dynamics of what happened in the fourth quarter with a very strong and accelerated growth profile as we went through fourth quarter, we finished extremely strong on our transactional business in the month of December. So that now creates an opportunity for free cash flow generation in 2023 and that's in our guidance. And then there are some other puts and takes. Yes, we'll get modest structural actions tailwind, but they're going to be offset by a cash tax headwind for the year. So that kind of plays out 2022 and 2023 now. How does that relate to a mid-term model? First of all, we're one year into that mid-term model. And as I talked about, the dynamics in dealing with the decision to exit our Russia business and the significant US dollar appreciation, I quantified it for you over a $600 million impact on profit and cash. But as you all know quite well, that's not a one-time impact, that will continue over a multi-period and it definitely puts pressure on our mid-term model to the tune cumulatively about over $2.5 billion. So, we are entirely focused on how we execute this company on a sustainable revenue growth profile and generating that $10.5 billion of free cash flow. So it enables us, with the right ample financial flexibility, to continue to invest in our business and return value to our shareholders overall.

Operator:

Our next question comes from Wamsi Mohan with Bank of America. Your line is open.

Arvind Krishna:

Yeah. Thanks Wamsi, for the question. So, I'll address your transaction processing question first and then all of software right after that. So some of you have heard me talk about that transaction processing would be a mid-single-digit decliner in the past. And that's effectively, Wamsi, is what you asked, what's going to be different. As we look at our business there and we look both at the underlying MIPS growth, as well as the criticality of that software, as well as our ability to have some very modest pricing uplift, we would now look at that business as being a slight increaser as opposed to a modest decliner. So, I think, if you are looking at that one, Wamsi, low single-digit increases for transaction processing is what we think is appropriate for the short to medium-term model looking forward. Now, that does help in overall software. So first, let's look at software and decompose it. Software, as Jim mentioned in his prepared remarks, is almost 80% recurring revenue. We see that recurring revenue increasing consistent with our model of the mid-single digits, based on both the consumption, the usage, as well as what we have seen through '22 in people renewing that base of software business. Then, I will acknowledge to you that '22 was a great ELA year, '23 will be not as good as '22. But with the transactional piece of the business being less than 20%, that has a much smaller impact on the overall growth rate. As you put all that together, we see the mid-single digits as being appropriate for the software business.

Operator:

Our next question comes from Toni Sacconaghi with Bernstein. Your line is open.

Arvind Krishna:

Yes. Toni, thanks. So, you're completely accurate that these numbers are slightly below our expectations from the beginning of the year. I will ask Jim to comment and give you a lot more color on it. But let me first comment on your statement of, we have a double mandate of revenue growth and free cash flow growth, but I want to also be clear, revenue growth has -- which manifests itself in client satisfaction, higher NPS from our clients, better consumption of both software and consulting from our clients, which allows them to consume more and more over time is what we are focused on. And it's an and we have to deliver the free cash flow growth. Jim mentioned in a response to the first question that we were not expecting the business and Russia to get shut down, that impacted it a little bit. We were not expecting the currency headwinds to be as severe as it turned out to be. That's certainly impacted. And I'll acknowledge, an inflation as in wage inflation showed up and impacted our margins in consulting a lot more than we were expecting. Now an answer could have been to not hire people and to not give that but that would have resulted then in lower capacity at the end of this year, which would not have allowed us the confidence into the growth, both in consulting and in software that we are now committing for 2023. So as we balance those, it becomes a business decision to say, we are going to keep going on increasing capacity, which results in healthier revenue and it will result in improving margins, but that flows through into 2023 as opposed to giving it all to us in 2022. So Toni, that's kind of how we think about balancing the investments in the business versus a quarterly result. And I'll ask Jim to comment a bit more on some of the specifics of what you were asking.

Patricia Murphy:

Thanks for the question Toni. Let's go to the next question.

Shannon Cross:

Hi, can you hear me?

Shannon Cross:

Okay. Interesting. Yes. Arvind, can you talk a bit about AI and how it runs through your business? There's obviously so much discussion right now about OpenAI and Microsoft making investments? And I guess I'm trying to think about how we should think about IBM monetizing it, capitalizing on it, how you think about your competitive position relative to others. I don't know if there are examples you can give where you're utilizing it. But I'm just -- I'm wondering, as AI gets more and more of a -- becomes more and more of a discussion point apparently for 2023 and you have such a long history with it, how we should think about where you are now and where you're going to take it? Thank you.

Patricia Murphy:

Shannon, thank you very much. Sheila, can we go to the next question.

Erik Woodring:

Hey, guys. Good afternoon. Thanks for taking the question. I wanted to just touch on the consulting business. Signings were very strong in the December quarter, up 17%. Your quarterly book-to-bill was an improvement from the September quarter. Can you maybe just, again, just step back and elaborate on the environment, what we're in, what you saw in 4Q that potentially stood out to you where strength in signings is coming from changes to contract duration? Maybe just double-clicking on the consulting business. Just to help us understand what gives you confidence to be kind of at the high end of your midterm model for 2023? Thanks.

Patricia Murphy:

Erik, thanks for the question. Let’s go to the next one please.

Lisa Ellis:

Hi, good afternoon. Thanks for taking my question. Maybe following on that, I had a broader question, Arvind, on the overall demand environment you're seeing. I think with earnings coming in from various enterprise tech players so far, we're seeing a pretty wide range of signals about how the demand environment is shaping up for 2023. Can you just comment a bit on what you're seeing from your large clients, say, relative to this past year? Thank you.

Patricia Murphy:

Thanks, Lisa. Let’s go to the next question, please.

David Grossman:

Thank you. So you had a very good transactional momentum in the software business in the fourth quarter, and you provided some good high-level commentary in your prepared remarks about the business and the broad-based growth may reflect many of those changes that you've been talking about in the go-to-market strategy and sales changes. That said, Arvind, can you talk specifically or identify any product-specific changes in software that you think may be driving that momentum and that may suggest your competitive positioning is shifting in any of those three non Red Hat segments. And then just one other thing -- just sorry about the two-part question, but just for Jim, I just wanted to clarify with that working capital headwind in the fourth quarter that you talked about reverses in 2023. Thank you.

Jim Kavanaugh:

Yes. I would just build on that, Arvind. I mean, Software book of business today, it's an integral part of our hybrid cloud platform thesis. It is the foundation. We eclipsed $25 billion for the first time ever here in 2022. So over 40% of IBM's revenue and two-thirds of our EBITDA. So when you look at it, we are a hybrid cloud AI platform-centric company overall and software is right at that course. So why that recurring revenue stream and the improvements we've been seeing throughout 2022. And as Arvind answered earlier, getting that back to a growing contribution, not only helps the competitiveness and market share of our top line, but I think all of you understand the marginal dollar of that book of business is in the 90-plus percent range, as we move forward. So David, I think you also asked a question about clarification. Free cash flow growth, $10.5 billion about, up $1.2 billion year-to-year, above our model of $7.50 billion. That will be driven based on the fundamental improvements of our underlying revenue growth and operating leverage and cash PTI, but there will also be, yes, a working capital efficiency contribution to our cash generation next year, really just the volume dynamics of what played out in the fourth quarter. We'll get that back.

Operator:

Our last question will come from Kyle McNealy with Jefferies. Your line is open.

Arvind Krishna:

Okay. Look, I think that first and I'll address your point of new application versus existing pretty directly. The point about the lower end of the mid-single digit is largely from the fact that Infrastructure segment will be a headwind going into 2023, whereas it was a tailwind in 2022. I wouldn't read anything more than that into our low end as opposed to the middle of the range. Now, for us, I don't really see that. I see that our clients do want to do new development. Now, from our perspective, if somebody is doing an expanded sales force deployment, I call that a new application. If somebody is doing a new application on Azure or if they are moving, well, they never really directly move. They always talk about refactoring, putting in new function, integrating with other applications they might have in their shop, or that they buy a SaaS properties, we consider all that new development. And so, for us, our consulting teams are largely doing that new development for our clients. And in that process, they tend to use OpenShift from Red Hat, it tends to use Red Hat Linux, they tend to use our AI automation. Our AI automation then surrounds all those things to make them much more resilient, much more robust, much more secure, and those are the capabilities we bring. So we are not really seeing that divergence, I will tell you straightforwardly, but there is likely a focus that in that new application, is it helping automate things more? Is it helping make things I call it straight through as opposed to with a lot of manual intervention. That is probably a bigger focus. Maybe we don't see it because we kind of call that play in late 2021, because we kind of saw those things coming and becoming more important. And we decided to invest in them, both in technology and in consulting. Patricia, with that being the last question, let me now make a couple of very quick comments to wrap up the call. 2022 was an important year for us. As Jim said, it was the first full year of the new IBM. The results we delivered reinforce our confidence in our strategy and our model. While there is always more to do, we are pleased with our position as we enter 2023, and I look forward to continuing this dialogue as you roll through the year.

Operator:

Thank you. Thank you for participating on today's call. The conference has now ended. You may disconnect at this time.

Patricia Murphy:

Thank you. This is Patricia Murphy, and I’d like to welcome you to IBM’s third quarter 2022 earnings presentation. I’m here with Arvind Krishna, IBM’s Chairman and Chief Executive Officer; and Jim Kavanaugh, IBM’s Senior Vice President and Chief Financial Officer. 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. Provided additional information to our investors, our presentation includes certain non-GAAP measures. For example, all of our references to revenue growth are at constant currency. We have provided reconciliation charts for these and other non-GAAP measures at the end of the presentation, which is posted to our investor website. Finally, some comments made in this presentation may be considered forward-looking under the Private Securities Litigation Reform Act of 1995. These statements involve factors that could cause our actual results to differ materially. Additional information about these factors is included in the company’s SEC filings. With that, I’ll turn the call over to Arvind.

Jim Kavanaugh:

Thanks, Arvind. I’ll start with the financial highlights. In the third quarter we delivered $14.1 billion in revenue, $2 billion of operating pre-tax income at a margin of nearly 14% and operating earnings per share of $1.81. Through the first three quarters of the year, we generated over $4 billion of free cash flow. Revenue was up 15%, which includes about five points of contribution from sales to Kyndryl. While we’ll discuss our results today at constant currency, I’ll mention that with the continuing strengthening of the U.S. dollar, currency translation impacted our reported revenue growth by more than eight points or nearly $1.1 billion. As Arvind said, our revenue growth this quarter was pervasive. Software revenue was up 14% and consulting up 16%. These are our growth vectors and represent over 70% of our revenue. Infrastructure was up 23%, reflecting solid product cycle dynamics. Software and Infrastructure include about eight and nine points of growth respectively. From the commercial relationship with Kyndryl, more than half of our revenue is recurring and this annuity content, which is driven by software, continues to grow. Performance was also broad-based by geography. Americas, EMEA and Asia Pacific revenue were all up double digits and we gained share overall. These revenue results reflect the execution of a more focused hybrid cloud and AI strategy based on a platform-centric approach and leveraging a broad ecosystem of partners. Our full stack capabilities across software, consulting and infrastructure delivered 20% growth in hybrid cloud revenue over the last year to over $22 billion. Looking at our profit metrics, operating pre-tax income was up and margin expanded by 180 basis points year-to-year. These profit dynamics reflect our portfolio shift toward higher value led by software. This mix shift is contributing to profit and margin. Our pre-tax profit also includes the contribution from incremental sales to Kyndryl. Like our clients, we are focused on digitally transforming our own operations, applying AI and automation to drive productivity and efficiency in the spend base. This provides flexibility to continue to invest in talent, innovation and our ecosystem in an inflationary environment. 90 days ago we spent some time talking about currency dynamics. I’ll remind you of a few of the key points. A stronger dollar impacts our revenue and gross profit dollars. We execute a hedging program which defers versus eliminates the impact of currency. The gains from these hedging programs are reflected primarily in other income and expense, but with the rate and magnitude of the movements and because we don’t hedge all currencies, we do have a currency impact to our overall profit and cash flow. Wrapping up the discussion on profit dynamics, the currency impacts and a good amount of investments are in gross profit, while the mitigating hedging benefits and operational productivity are reflected primarily in expense. As a result, pre-tax income is a better indicator of our profit performance. Our operating tax rate was about 16%. Compared to last year tax is a significant year-to-year headwind to operating net income and operating EPS growth, which were both down modestly year-to-year. Turning to free cash flow. We generated $4.1 billion in the first three quarters. That’s up over $900 million year-to-year. We’re wrapping on payments related to the Kyndryl separation and the 2020 structural action and driving working capital efficiencies. In terms of uses of cash in the first three quarters, we invested over $1 billion in acquisitions, which was more than offset by proceeds from divested businesses. And we returned nearly $4.5 billion to shareholders in the form of dividends. From a balance sheet perspective, we issued debt in July to prudently get ahead of our 2023 maturities. Our debt balance is up since June but down nearly $1 billion since December. We ended the quarter in a strong liquidity position with cash of $9.7 billion. This is up over $2 billion from year-end and well in excess of the minimum cash required for our business. Turning to the segments. Software revenue grew 14%. This includes about eight points of Kyndryl contribution. Both of our revenue categories, hybrid platform and solutions and transaction processing through this quarter. This performance reflects our strong and growing recurring revenue base, which is about 80% of our annual software revenue. And Software’s hybrid cloud revenue is now $9.2 billion over the last year, up 20%. In hybrid platform and solutions, revenue was up 8%, including about 1.5 contribution from the Kyndryl commercial relationship. The growth was broad-based. Red Hat revenue all-in grew 18%. As a leader in open source technologies for the enterprise, Red Hat’s performance was again fueled by market share gains across RHEL, OpenShift and Ansible this quarter. With our enterprise incumbency and global scale, we continue to see an increase in large deals as well as strong cross-sell and upsell across Red Hat solutions. Automation revenue grew 3%. This quarter’s performance reflects continued adoption in areas like AIOps and management and integration, while we’re also wrapping a strong acquisition content from last year. We’re bringing innovation to our clients this quarter such as new Instana Observability capabilities for z Systems in a hybrid cloud environment. In data and AI, revenue was up 4%. Let me highlight just a few of the growth areas this quarter. Data management fuels advanced analytics. Data fabric helps clients discover and unlock the value of their data wherever it resides, and information exchange enables the timely and secure flow of complex B2B information. And offerings like Envizi and Environmental Intelligence Suite are resonating with clients as they prioritize sustainability efforts. Security revenue was up 6%, with growth in both data security and threat management. In data security, we’re seeing adoption of Guardium Insights as we continue to deliver new product innovation. Brent management growth was led by Cloud Pak for Security, which helps clients prevent and respond to modern threats across disparate security feeds. Across hybrid platform and solutions, the annual recurring revenue, or ARR is now $13 billion and up 9%. Transaction processing revenue was up 33%, including about 26 points of Kyndryl contribution. The increase in z Systems’ installed capacity over the last couple of cycles and continued strong renewal rates are recognition of the importance of this platform in a hybrid cloud environment. As a result, the transaction processing annuity base is now growing. Looking at software profit, we delivered operating leverage, given the solid revenue growth and new Kyndryl commercial relationship. Our pretax margin was up more than four points over last year. Consulting revenue grew 16%. This is the fifth consecutive quarter of double-digit growth. This strong performance was again broad-based with revenue growing at double-digit rates across all business lines and geographies. Over the last year, our book-to-bill ratio is 1.05. Clients trust IBM’s deep industry expertise and co-creation approach throughout their hybrid cloud and digital transformation journeys. As IBM Consulting designs and enables enterprise hybrid cloud strategies, this business delivered $8.9 billion in hybrid cloud revenue over the last year. That’s up 28%. Our Red Hat consulting practice continues to be a meaningful contributor to revenue growth, growing strong double-digits as we add new engagements. Since IBM acquired Red Hat just over three years ago, Consulting has led nearly 1,400 Red Hat engagements with over $6.5 billion in aggregate bookings. Strategic partnerships also contributed to performance, continuing to grow revenue at a double-digit rate. Turning to our lines of business. Business transformation revenue grew 14% as clients look to IBM to help them transform critical workflows at scale. Growth in business transformation was pervasive, driven by supply chain, finance, data and client experience transformations. Working with our partners like SAP, Salesforce and Adobe, we help our clients optimize their operations and improve the way they engage with their customers. In technology consulting, where we architect and implement clients’ cloud platforms and strategies, revenue was up 17%. Once again, growth was led by cloud application development and cloud modernization, including our Red Hat practice, which as I mentioned, grew strong double digits. Application operations revenue grew 17%. IBM helps clients optimize their operations and reduce costs by taking over the management of clients’ applications in hybrid and multi-cloud environments. We leverage AI to help predict problems before they happen and monitor our clients’ different environments with dashboards, enabling action to be taken quickly. Moving to Consulting profit. Our pre-tax margin of about 10% is down year-to-year though up nearly 3 points from the second quarter. As we’ve discussed in prior quarters, Consulting is most impacted by the labor cost inflation. Those dynamics continue to put pressure on the margin profile. However, coming out of the third quarter, we are seeing signs of progress. Our utilization rates are improving as we exited the quarter, our acquisitions are scaling and are on a path to margin accretion, and we’ve seen two quarters of price margin improvement year-over-year that will benefit our margin profile going forward. Moving to our Infrastructure segment. Revenue grew 23%. This includes about 9 points from the incremental Kyndryl content. Hybrid infrastructure revenue grew 41% and Infrastructure Support revenue grew 5%, including about 11 and 7 points of Kyndryl benefit, respectively. Looking at hybrid infrastructure, zSystems revenue nearly doubled, driven by continued adoption of our newest program, z16. This latest program combines embedded AI at scale, cloud-native development for hybrid cloud and cyber resilience security. In fact, z16 is the industry’s first quantum-safe system, delivering 25 billion encrypted transactions per day for clients. And as Arvind mentioned, we just introduced our newest LinuxONE server, a highly scalable Linux and Kubernetes-based platform with capabilities to reduce clients’ energy consumption. zSystems remains an enduring platform, playing an important role in a hybrid cloud environment. Distributed Infrastructure revenue was up 21%. Recent innovation across the portfolio enabled broad-based growth within both storage and power. These include the expansion of our Power10 server family earlier this quarter and refreshes to the flash storage solutions throughout this year. Looking at Infrastructure profit, pre-tax margin was up 1 point year-to-year, reflecting mix benefits from the growth in zSystems. Now let me take it back up to the IBM level, and I’ll shift the focus to the full year and the fourth quarter. Over the last year, we’ve continued to invest and make portfolio changes to advance our hybrid cloud and AI strategy, streamline our go-to-market and digitally transform our own operations. Our more focused strategy and portfolio is aligned to client needs. Our revenue performance so far this year demonstrates that. And based on this revenue performance in the first three quarters, as Arvind said, we now see constant currency revenue growth above our mid-single digit model for the year. On top of that, Kyndryl sales add about 3.5 points of growth, primarily in the first three quarters of the year so it’s essentially behind us. U.S. dollar continues to strengthen. And at mid-October spot rates, currency translation will now be about a 7-point headwind to growth for the year. As I mentioned earlier, this impacts profit and free cash flow as well. Looking at free cash flow, our other key metric, we continue to expect to generate about $10 billion for the year. That’s up over $3 billion from last year. A large part of that growth comes from the wrap on the Kyndryl spin-related and structural payments. But we’re also driving working capital efficiency and improving operating profit profile. We expect strong free cash flow performance in the fourth quarter, while we continue to face some external headwinds, including appreciation of the U.S. dollar and exit of our Russia operations. In terms of segment performance for 2022, our view of software has been consistent all year. We continue to expect revenue growth in line with our mid-single digit model range, plus 5 to 6 points from sales to Kyndryl. And we still see software pre-tax margin in the mid-20s range for 2022. Our IBM Consulting revenue growth has been great, and we’re taking our view up to a mid-teens revenue growth rate for the year. While we’re still operating in a competitive labor environment, we see some encouraging signs in our Consulting margin profile exiting the third quarter. We now expect a Consulting pre-tax margin for the year at the low end of our previous 9% to 10% range, which is up about a point year-to-year. Our Infrastructure revenue performance, as always, reflects product cycle dynamics. With the strong launch of our z16 earlier this year, Infrastructure revenue performance will be above the model level for the year, and that’s before the 5 to 6 points from sales to Kyndryl. We expect Infrastructure pre-tax margin in the mid-teens. Looking specifically at the fourth quarter, we expect all-in constant currency revenue growth at the high end of the mid-single-digit range. At current spot rates, currency translation has increased to an 8 to 9-point headwind to revenue growth in the fourth quarter. That’s up 2 to 3 points from 90 days ago. And then I’ll remind you, in a couple of weeks, we’ll reach the anniversary of our separation of Kyndryl. While the external sales to Kyndryl will remain in our revenue and profit base, we’ve essentially wrapped around the year-to-year contribution to our revenue and profit growth and margin expansion. As we enter the fourth quarter, we look forward to closing out our first calendar year of today’s IBM. As always, we’ll provide a view of 2023 during our fourth quarter earnings report in January. Patricia, now let’s go on to the Q&A.

Operator:

Thank you. [Operator Instructions] Our first question will come from Amit Daryanani with Evercore. Your line is open.

Arvind Krishna:

Yes. Amit, thank you. Thank you both for the comment and those questions. So let me answer the first part, how do we feel about revenue and demand going forward? First, if you just look at the data going backwards, we see pretty strong demand and we saw double-digit growth in Europe, double-digit growth in Asia and double-digit growth in the Americas. But let me add some color on that as we look forward. And it is with a couple of contextual elements, as you said, on your portfolio. One, we are B2B. We have almost no B2C business, as if almost no, I could say none, but there is the weather business which has got a little bit of element of B2C in it, but it’s tiny. So one is B2B. Second, we’ve done a lot of work over the last three years, and our portfolio is largely in mission-critical areas, areas that are around automation, areas that are about leveraging AI for enterprise productivity. And I think that, that productivity theme is going to play out over actually not just this remaining part of this year but for the next half decade, maybe the full decade. Color. In the Americas, I find a very robust business environment. I find that most enterprises want to invest. They are leveraging technology to scale their business. If I go to Asia, it’s very similar. Very little change from the past, I think going into the next few months, at least. In Europe, I think we shouldn’t put our head in the sand. I think that with the mixture of energy and inflation, you can sense that there is some caution creeping into the conversations, albeit not in the data and not yet in what we are doing as business there. But we’d be foolish not to prepare that there could be a bit of a downturn in Europe only. But let me now put all of that back into context. So you’re saying Americas, Asia, fine. If I get to Europe, Western Europe, ballpark 20% of global GDP. Even if you have a massive impact, 5% to 10%, that’s a 1% to 2% impact on a global level all-in. Technology is typically 3% to 4% ahead of GDP growth. That says there’s still a robust technology environment in there. So I think that’s the sort of the two parts of your question that that we are addressing with that.

Operator:

Thank you. Our next question will come from Toni Sacconaghi with Bernstein. Your line is open.

Jim Kavanaugh:

Okay. Toni, this is Jim, I’ll take the first part of the question and Arvind can wrap up about our portfolio and the confidence we have in positioning 2023. When you take a look at our third quarter performance, we’re obviously very pleased with the entire IBM team and what we’ve been able to execute. Continuing to instantiate the value of today’s IBM, which is a very focused hybrid cloud and AI platform company. But let’s dial back 90 days ago. 90 days ago we said all in we were going to be at high single digit revenue growth and we were going to generate about 200 basis points of operating leverage. When you now play that picture of what played out in the third quarter, we are capitalizing on that focused IBM hybrid cloud AI strategy and capitalizing on the accelerated demand from our clients that Arvind talked about up front. And we’re getting revenue dollar contribution that is falling to the bottom line with regards to profit. Our profit’s up 23%. Now with that said, when you look at the profile of the contribution, it was very pervasive and broad based. It was double digit growth across all three of our major segments and double digit growth across all of our markets around the world. And within that software contributed about 3 points of growth ex Red Hat to IBM, consulting delivered about 5 points of growth and infrastructure delivered about 3 points of growth to IBM. And within infrastructure, to your question on mainframe, mainframe basically came in about exactly what we guided to 90 days ago. Remember, we talked about at length the first time in 20 years that we announced a mainframe new innovation in a second quarter and how it was going to change the seasonality of that business. And we had a very strong second quarter, which by the way, we took up revenue guidance in April 4. We talked about 90 days ago how third quarter was going to play out and fourth quarter and we pretty much executed to that. So we feel pretty good about our book of business. So, Arvind turning over to you.

Patricia Murphy:

Okay. Thank you, Toni. Let’s go to the next question, please.

Wamsi Mohan:

Yes. Thank you and congrats on the solid results. Arvind, can you talk about what you’re seeing in the more transactional parts of the business and the context of particularly Q4, which is your largest transactional quarter. Any change in pipeline or conversion rates of that pipeline? Any color there would be helpful. And if I could maybe Jim on the cumulative free cash flow that that you guys just endorsed. How should we think about the step up in cash flow and what would be the key drivers of that outside of the top line growth conversion? What are the other moving pieces that that would help in, in bridging that gap? Thank you so much.

Jim Kavanaugh:

So Wamsi to that point, as you know, our two key measures of success since Arvind has taken over as Chairman and CEO has been revenue growth profile, converting this portfolio into a sustainable growth orientation and second free cash flow generation. So, we can have the financial flexibility to continue to invest in our business. And on that, we said maintaining guidance of about $10 billion. I’ll remind everyone that $10 billion is up over $3 billion year-to-year, first. And it’s up $2 billion from what we published as IBM’s post-separation baseline when you normalize out all the Kyndryl-related activity. So as we spoke about, and Arvind just kind of concluded before he turned over to me, 90 days ago, this takes into account the external headwinds we’ve been talking about this year. One, being the orderly wind down in the exit of our Russia business, which we’ve already taken into account. We’ve been transforming our business and cost structure to take into account losing that high value profit and cash. And second is the continuance strengthening of the U.S. dollar. Now the latter, let’s be honest, it definitely puts pressure and our midterm outlook, but we’re three quarters into that midterm outlook right now. We do have a robust hedging program because we are not immune. I mean, we do business in 170 countries around the world, over a 100 currencies. As we talked about 90 days ago, we do not hedge, a 100% of our currencies. And second, we don’t hedge out more than 12 months. Very important point. So currency is a real impact to profit in cash overall. Now, we hedge to provide us time to take the operational actions that’s price, that’s sourcing strategies, that’s cost structure, and the productivity initiatives that Arvind and I have put within the business. So right now, it’s early in this midterm outlook. We’ve got a headwind on the U.S. dollar until it stabilizes. We are taking the appropriate actions, but let’s be honest, we are all focused on completing 2022. We have a very big fourth quarter in front of us. We’ve got to do roughly $6 billion of free cash flow in the quarter. That’s about 60% of our free cash flow, by the way to put that in perspective, from 2017 to 2020, we did at or better than $6 million of free cash flow. So, we’ve got the right portfolio. We’ve got the right set of operational actions, and that’s what we’re focused on. Where are we going to get that headwind/tailwind? One, we completed our structural action. So that’s all behind us, and we’ll continue to get the Kyndryl tailwind for the next three months. Second, we expect a very solid working capital quarter with regards to the mainframe cycle and the pure volume dynamics of what’s happening with our accelerated revenue growth profile. And third, we’re going to continue driving a higher revenue profile, get operating cash out of that by driving operating leverage in our business. So that’s what our focus is on completing 2022. And we will talk in January about where we’re at and where the dollar’s at.

Operator:

Our next question will come from Erik Woodring with Morgan Stanley. Your line is open.

Jim Kavanaugh:

Yes, Erik, thank you very much. I appreciate the question and I appreciate the compliments and I’m sure the entire IBM team has worked extremely hard pleased with this quarter. Well, let’s talk about Consulting. We talked all year long, remember you dialed back to January. We were talking about what we were seeing in the marketplace about an accelerating demand profile driven by our clients’ digital transformations, journeys to cloud, and that we were going to invest upfront and get ahead of that demand profile both in skills, capabilities, ecosystems, acquisitions, why? Because Consulting plays an integral part to our hybrid cloud thesis. It is that tip of the spear. It drives the multiplier effect. It drags the scale and adoption to our hybrid cloud platform, and it pulls our IBM technology. Now, with that said, when you look at it that investment profile coupled with a highly inflationary environment. We’ve seen pressure on our gross margin level throughout the year. But we’ve been making that up on an operating pre-tax margin because Consulting, along with our Infrastructure and Software are yielding the benefits of a much more focused streamlined G&A structure, now post-separation of Kyndryl and a much more effective and aligned streamlined go-to-market model that’s playing out. But when you look at it, 3Q year-to-date, our revenue profiles growing high teens. We’re getting dollar contribution, and we’re seeing 3Q year-to-date at about 30 basis points worth of margin. Now, as I said in the prepared remarks, we talked about three core actions throughout the year, acquisitions, utilization, price. And around those we saw green shoots exiting third quarter. Our acquisitions right now, we’re on a steady state where they’re going to be margin accretive in the fourth quarter. Second, we exited the quarter in a pretty challenging seasonal quarter of a third quarter with higher utilizations. That’s a great sign. And third, for the second quarter a row, we got price optimization in price margins that are up. That has led to our sequential improvement in margins from 2Q to 3Q by three points. And by the way, we expect that to continue in the fourth quarter. Margins up sequentially and year-to-year. And that price optimization really as you would expect, always translates back then into the value proposition of your offerings where we have value in application modernization, Red Hat, our hyperscaler and strategic partnerships. We’re seeing a nice margin accretion that’s playing out and that’s going to fuel the fourth quarter here and first half of 2023.

Operator:

Our next question comes from Shannon Cross with Credit Suisse. Your line is open.

Arvind Krishna:

Shannon, let me start by this thing. First, let me explain our rationale and our principles for acquisitions because it’s important to understand that it’s not so much size. Number one, they’ve got to fit our strategy. Our strategy being hybrid cloud and AI. And in Consulting, those which add to our ecosystem growth and our talent. So that limits the universe of what we would look at. Two, especially if it’s going to be larger, it’s got to be accretive. Whether we talk about at the end of the first year or definitely in the second year, it’s got to be accretive to cash flow. Three, there’s got to be synergy with IBM. Like Jim mentioned about the $6 billion in inception to date signings and the 1,400 projects that consulting did with Red Hat, that synergy, meaning that we would not have gotten that revenue and that book of business if we had not done that acquisition. So then if I say that those are criteria, those would be criteria that would open up if there is something that is larger with the correct valuation and the correct economic returns for the company. Now, to your point on interest rates. Certainly, interest rates have an impact, but we’d also like to say there are multiple vehicles on how to raise cash, because the overall fin flex and we had talked about $20 billion of fin flex over the period, but there are other vehicles for also raising cash when we are an attractive target for the acquisition to come into. Jim?

Patricia Murphy:

Thanks Shannon. Let’s go to the next question.

Keith Bachman:

Hi, many thanks and echo the congratulations and strategic correction. Jim, I just wanted to see if you could provide a clarification, what was the M&A contribution this quarter, and if you could give any distinction on the M&A contribution that the software. And then my broader question it relates to going back to services. The signings was down about 2% in constant currency for the quarter. How do you anticipate signings unfolding and what does that pretend for next year’s growth, particularly as we look at a bumpier economy, particularly in Europe? And so Arvind, you mentioned that you’re affirming the mid-single digit total revenue growth, but if you could just talk a little bit about the services business in particular, which I think is perhaps has a bit more risk associated with some of the consulting activities in a tougher economic climate? Thank you.

Arvind Krishna:

Yeah. So thanks Jim. So Keith, let me just maybe use the opportunity to remind everybody of what we had talked about as our midterm model, which was sort of the three-year model that we had laid out last October. We had said that we expect software to grow in mid-single digits, so I think 4% or 6%, and we had said consulting to grow in high single digits. And we had said that infrastructure will be about flat, this year will be a good year because the product cycle and then probably somewhere in late 2023 or 2024 we’ll get the flip side of that up from this year. But then you get into consulting, our long-term model was not in the teens, which it has done this year it was in the high-single-digits. So the book-to-bill combined with the shorter term signings gives us confidence that we will be able to maintain that model. Look, I think consulting to the point I think you’re all trying to ask, the nature of our consulting business is very different than some others. The bulk of our consulting business is in digital transformation, helping our clients move to cloud, not just our cloud but AWS and Azure amongst it. It’s on properties that I think are fairly essential to our clients SAP, CRM, Adobe are great examples. As you begin to wrap around help them move to cloud, both public and hybrid, help them do digital transformation, help them take advantage of these massive productivity SaaS properties that I just named. Even in an inflationary environment, even when the economy is not doing well, these tend to be the projects that stay the course, but maybe the signings come in smaller chunks and as long as we deliver well then people tend to sign up for more and more going forward. And that’s sort of a bit of color of what we’ve seen play out already this year and we expect that to maybe increase next year.

Operator:

Our last question will come from David Grossman with Stifel. Your line is open.

Jim Kavanaugh:

Yes, David. Thank you and thanks for the compliments really goes out to the entire IBM team overall. When you take a look at our free cash flow posture one, I think we have quantified back in earlier this year in April about our Russia business, orderly wind down right decision, unfortunate humanitarian crisis that continues right now, but that was about a $300 million revenue profile and about a $200 million profit and cash profile overall. As I said yes, that’s been an impact this year, which is one of the reasons why we went down to about $10 billion as we stated. But again, we’ve been taking, knowing that decision, we’ve been taking the right operational actions to drive the productivity knowing that 2023 and 2024 we won’t have that. So that’s point number one. Point number two, the structural actions yes, north of $500 million that’s behind us this year. Remember that becomes a tailwind in 2023 and 2024. That’s why I’ve said multiple times before free cash flow is not going to be linear when we look at 2022, 2023, 2024. One we will have the wrap on that in 2023 plus second the exit costs of getting rid of that stranded cost, you get ROI on that activity overall. The big wildcard if you want to use it is what’s going to happen to the U.S. dollar. Now you see what’s happened to us this year. This year, third quarter let’s put it in perspective as I said a little over eight point gap between constant currency and actual rates. As you’ve seen in our backup charts, it’s about a $1.1 billion revenue by the way, that’s about a $0.15 profit and EPS impact in a quarter that we’ve had to overcome operationally. Now that again will continue to the extent the U.S. dollar doesn’t devalue over time. We are taking the appropriate measures. We’re running our scenario models or stress testing our business. We’ve got a long path into 2023 and 2024, but it’s going to come from the actions I talked about price, sourcing and cost structure. Each of those pieces are going to have to overcome that. And the beauty of our hedging program is it buys us time to smooth out the volatility of earnings right now. So we are focused on that. We’ll talk a lot more about where we see the U.S. dollar 90 days ago from now and what that means for 2023 cash as we go forward. Now, one last thing I want to put in place that fourth quarter cash is very important. That $6 billion give or take in us delivering that about $10 billion that is going to come out predominantly out of our operational profit driven by one, that revenue growth at the high end of our model all in, by the way anniversary of Kyndryl, we got two more weeks and we anniversary that, that is offset by basically Watson Health, so all-in high single-digit model is a good representation of today’s IBM. Second, we expect 2.5 points of operating margin in the fourth quarter. Why is that important? Yes, it’s going to deliver that free cash flow in the fourth quarter, but it also gives the investor a perspective now that we’re basically anniversarying the year-to-year contribution at Kyndryl; you see the healthy operating leverage at this portfolio now that we were reposition can deliver. So with that, I’ll turn it back over to Patricia.

Patricia Murphy:

Gail [ph], let us turn it back over to you to close out the call.

Patricia Murphy:

Thank you. This is Patricia Murphy, and I'd like to welcome you to IBM's Second Quarter 2022 Earnings Presentation. I'm here with Arvind Krishna, IBM's Chairman and Chief Executive Officer; and Jim Kavanaugh, IBM's Senior Vice President and Chief Financial Officer.

James Kavanaugh:

Thanks, Arvind. I'll get right into the financial highlights. In the second quarter, we delivered $15.5 billion in revenue; $2.5 billion of operating pretax income, which is a margin of 16.2%; and operating earnings per share of $2.31. In the first half of the year, we generated $3.3 billion of free cash flow. Our revenue was up 16%. This includes nearly 5 points of incremental revenue from Kyndryl.

Patricia Murphy:

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 multipart questions. Operator, let's please open it up for questions.

Erik Woodring:

Just one for me here. Obviously, we saw a bit of a deceleration in the Red Hat business. So would just love to hear what you're hearing from them and any impact that you could share with us on the deferred that's been a part of this business for a while? So that's it.

James Kavanaugh:

Yes, Erik, thanks. Just building on what Arvind said, 17% growth overall, taking share both in our core RHEL but also in our hybrid cloud platform-centric foundation, Red Hat OpenShift. By the way, Red Hat OpenShift, 4.5x now the revenue pre-acquisition. We had very strong bookings overall in Red Hat here in the quarter. Large deals were up 50%. Red Hat OpenShift bookings were up over 50%, which positions us very well with our backlog and a strong NRR. So we feel pretty good about our Red Hat portfolio overall.

Operator:

Our next question will come from Amit Daryanani with Evercore.

James Kavanaugh:

Yes, Amit, thank you very much. So let's take a moment to go through this because I think it's very important when you look at our 2 key measures of success. You talked about it. Revenue growth Arvind's put in place to run this company and free cash flow growth.

Toni Sacconaghi:

I was wondering if you could just comment on whether you still expect $35 billion in free cash through 2024 and what the bridge for that is? And then you mentioned that revenue sequentially would be a little lighter than usual in Q3 because of the mainframe. I think you're typically down about $850 million. The mainframe is like $500 million to $700 million a quarter. So maybe it's a $100 million headwind. So is that sort of the dimension that you're thinking about for Q3? Or are there other factors at work?

James Kavanaugh:

Yes. Thanks, Toni. If you go back to what I said in the prepared remarks, we typically -- I think the number is actually about $1 billion sequentially in revenue, Toni, overall. But we've actually given pretty explicit guidance on third quarter. We said that we were going to be all in high single digit at constant currency here in the second quarter. So let me address your question from that dynamic because we gave -- we've given that explicit quarter-to-quarter and what's going to happen to constant currency total revenue.

Operator:

Our next question comes from Wamsi Mohan with Bank of America.

Arvind Krishna:

Great. So Wamsi, let me address the first part of your question. We had very balanced performance in constant currency across geographies and actually across the different businesses. Now because of currency, the actual performance will be different in different geographies, but double-digit performance in the Americas, in Europe as well as in Asia Pacific.

James Kavanaugh:

Yes, Wamsi, thanks for the question. Let me give you a step back from an overall perspective, and then I'll come into the third quarter. We maintained the guidance to your question about high single-digit -- or excuse me, high end of our mid-single-digit revenue growth before the incremental Kyndryl contribution for the year. Arvind just went through the portfolio dynamics of that.

Brian Essex:

Jim, I was wondering if you could -- I appreciate the comments on the consulting side of the business. I was wondering if you could dig in a little bit there. I appreciate kind of the pricing dynamics you discussed. But I think if we look at this from both the demand side and the supply side, could you share any thoughts on what you're seeing if there's -- if anything is changing there? So from the supply side, hiring, attrition, wage inflation changing or stabilizing. On demand side, I noticed that it's great to see the improvement in constant currency growth sequentially. Nice to see the acceleration, but it looks like business transformation moderated a little bit while we have improvement in technology consulting and application operations. So maybe if we could walk through supply dynamics and the demand dynamics to see what's changing within that business and what's driving your confidence in the performance for the rest of the year?

And we talked about as we came into 2022 that we were going to go take the appropriate actions around our price optimization but that, that would take time to get rolled through our P&L, and that's what we kind of expect in the second half of this year. So when we look at all in, demand still see solid. The supply side of the equation, we've been optimized with a very disciplined, strategic investment process. And when we look at second half, we are looking at:

one, easier comps; two, scaling the acquisitive accretion of our acquisitions, where actually we saw some good green shoots here in the second quarter; three, getting effective increase in utilization of our capacity; and four, price optimization continue to play through. So we saw nice improvement in our price margins that will play out in the second half as we move forward. So hopefully, that gets you a little perspective.

Kyle McNealy:

So the strengthening dollar generally comes with a translation impact but also some demand destruction in nondollar-denominated markets. So are you able to size how much that demand-related impact might be, which would actually make your reiterated guidance for the high end of your mid-single-digit range for the full year for the core look even a bit better? Also connected to that, what is your sense if you have some perspective on how well international customers are positioned to be able to absorb the currency fluctuations?

Operator:

Our next question will come from David Grossman with Stifel.

James Kavanaugh:

Yes, David, thank you very much for the question. At its core, we actually took some conscious strategy back in fourth quarter '20, if you remember. At the time, we announced the intent to spin off Kyndryl that we were going to try to get out in front of stranded costs. And as you see now, we've executed on additional portfolio actions with the divestiture and closure of our health care software assets across the board.

Keith Bachman:

Arvind, I wanted to direct it to you, if I could. I? wanted to see if you could look out over the horizon a little bit longer. Some of the software companies have talked about some of the pipelines in a deep sales cycle are starting to extend and I just wanted to see if you're seeing any economic impact. And then more specifically, I wanted to see if you could comment, historically, consulting has been highly correlated to economic cycles. And this is going back last 15, 20 years. And I just wanted to see as we're heading into late '22 and more importantly '23, how do you think the consulting business is prepared for some potential economic downturns? Or just more broadly, how do you think about the growth potential there?

Arvind Krishna:

Okay. So Keith, a lot to unpack in that question. If I look at our pipelines, our pipelines are remaining pretty healthy. So I would tell you that right now, what we are seeing is that the second half at this point, looks pretty consistent to the first half. When we look at our pipelines, whether it's in Red Hat or mainframe software or Automation, Data & AI, Security and by geography.

Patricia Murphy:

[ Kayla ], let me turn it back to you to wrap up the call.

Patricia Murphy:

Thank you. This is Patricia Murphy, and I’d like to welcome you to IBM’s First Quarter 2022 Earnings Presentation. I am here with Arvind Krishna, IBM’s Chairman and Chief Executive Officer; and Jim Kavanaugh, IBM’s Senior Vice President and Chief Financial Officer. We will 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 non-GAAP measures. For example, all of our references to revenue and signings growth are at constant currency. We have provided reconciliation charts for these and other non-GAAP measures at the end of the presentation and in the 8-K submitted to the SEC. Finally, some comments made in this presentation may be considered forward-looking under the Private Securities Litigation Reform Act of 1995. These statements involve factors that could cause our actual results to differ materially. Additional information about these factors is included in the company’s SEC filings. So, with that, I will turn the call over to Arvind.

Jim Kavanaugh:

Thanks, Arvind. Let me start out with a few of the headline numbers. We delivered $14.2 billion in revenue, $1.5 billion of operating pretax income, operating earnings per share of $1.40 and $1.2 billion of free cash flow. 90 days ago, I talked about the first quarter and the full year in the context of our medium-term model, which is to deliver mid single-digit revenue growth and about $35 billion of free cash flow from 2022 through 2024. These first quarter results are a solid step toward delivering on the year and that model. Our revenue was up 11%. This includes over 5 points of incremental revenue from the commercial relationship established with Kyndryl last November. Our business entering 2022 reflects a higher growth, higher value mix. It is also a business with more recurring revenue dominated by Software. This quarter, Software revenue was up 15% and Consulting was up 17%. As we have discussed in the past, these are our two growth vectors and together represent over 70% of our annual revenue. Infrastructure performance, which is influenced by product cycles was flat as compared to last year. The Software and Infrastructure performance each include over 8 points from the commercial Kyndryl relationship. As a reminder, there is no incremental contribution to IBM Consulting’s growth. Our strategy, as Arvind said, is based on a platform-centric approach to hybrid cloud and AI. Not only do we benefit from the platform itself, but IBM and our partners also generate a multiple of Software and Consulting revenue on that platform. It’s an attractive economic model. You can see our success in capturing that value in our hybrid cloud revenue, which was up 17% in the first quarter and over the last 12 months. Revenue from our full stack cloud capabilities from infrastructure up through consulting represents $20.8 billion of revenue over the last 12 months or 36% of our total. Looking at our P&L metrics, we grew operating gross profit dollars, though margin was down, with improvement in software margin offset by Consulting investments and Infrastructure mix due to product cycles. For operating pretax income, we grew profit dollars and expanded margin by 280 basis points. This profit performance reflects that we are capturing demand in high-value areas like software and profit contribution from incremental sales for the new commercial relationship. We have taken actions to streamline our operations and simplify our go-to-market model, consistent with our more focused platform-centric business. With the more streamlined business, we are getting operating leverage from strong revenue performance. Our profit dynamics also reflect increasing investments in innovation, our ecosystem and talent. We are increasing investments in R&D to deliver innovation in AI, hybrid cloud and emerging areas like Quantum. We are investing in our ecosystem organically and inorganically. For example, one of the three acquisitions Arvind mentioned was Neudesic, which adds key hyperscaler capabilities to address hybrid multi-cloud demand. And as we have discussed, over the last several quarters we have been aggressively hiring. We are adding capabilities and skills to support our garages and client engineering centers, client success managers to help clients get the most of their IBM solutions and technical talent across our business. Now, we are operating in an inflationary environment, and costs, especially the cost to attract and retain talent, are escalating. We are addressing this through pricing, which will help over time. The Other item I will mention is the impact of a strengthening dollar. We execute hedging programs, with the majority of our hedging gains reported in Other income and expense. These gains mitigate the currency impact in revenue and gross profit. And then looking at net income, we expanded operating net income margin by 130 basis points. This reflects an operating tax rate of 16%, which was up significantly from last year. Turning to free cash flow, we generated $1.2 billion in the quarter. I will remind you we have gone back to our traditional all-in free cash flow definition, which includes payments for the structural actions initiated at the end of 2020. The $1.2 billion is about 12% of our full year expected range, consistent with history. The anomaly from that historic attainment was last year, with 23% of our full year free cash flow realized in the first quarter due to the unique dynamics of the Kyndryl separation. In terms of uses of cash for the quarter, we invested about $700 million in acquisitions and we returned $1.5 billion to shareholders in the form of dividends. We also issued $4 billion of debt in early February, which supports maturities later in the year. This results in a March cash position of $10.8 billion and debt of over $54 billion. Turning to the segments, Software delivered strong revenue growth, up 15%. This includes over 8 points from the recurring Kyndryl software revenue, in line with our expectations. Software performance was driven by good growth in both Hybrid Platform & Solutions, and Transaction Processing, the latter benefiting significantly from the Kyndryl content. Our software is central to a hybrid cloud value proposition. Within the segment, hybrid cloud revenue was up 25%, now representing $8.8 billion over the last year. And subscription and support renewal rates grew again this quarter, contributing to a software deferred income balance of over $11 billion. Hybrid Platform & Solutions revenue grew 10% this quarter, inclusive of about a point-and-a-half contribution from the Kyndryl commercial relationship. We have driven focus within this portfolio around the most strategic hybrid cloud and AI needs of our clients, Red Hat, data and AI, automation and security. Growth was pervasive across all business areas this quarter. Red Hat revenue all-in was up 21%. Revenue growth continues to be fueled by good performance across the Red Hat portfolio, and we again gained share across both RHEL and OpenShift, the foundational hybrid cloud offerings. Red Hat’s hybrid cloud offerings continue to transform enterprise IT and deliver new innovations. For example, this quarter we announced a new partnership with NVIDIA to accelerate AI applications. Automation delivered 5% revenue growth this quarter. Growth was led by AIOps and management and integration. We have invested in AI-powered approach to automation and our solutions are resonating with clients as they address growing complexity, digital shifts and skill shortages across their businesses. We extended this AI-powered automation strategy this quarter with the joint Flexera solution Arvind mentioned earlier. Data and AI revenue grew 4%. These offerings help our clients accelerate data-driven agendas by connecting and governing all of their data and infusing AI to enhance decision making. Performance this quarter reflects client demand across the portfolio, including continued adoption of data fabric, expansion of our data management footprint, a focus on sustainable operations with asset and supply chain management, and needs for reliable data sharing with information exchange. We had growth in solutions like Cloud Pak for data, DB2 and Maximo Application Suite, just to name a few. Security revenue grew 8%, building on strong performance in the first quarter of last year when we were up 14%. With the evolving cybersecurity environment, we delivered growth this quarter in threat management and data security. We continue to see good client demand for Cloud Pak for security, and integrated and open security platform that advances clients’ zero trust strategy while leaving data where it is. And we have been investing in security innovation, including a new SaaS endpoint solution following the ReaQta acquisition. Looking across the performance of our Hybrid Platform & Solutions, our annual recurring revenue or ARR is up 9% year-to-year. Transaction Processing delivered 31% revenue growth this quarter, including 28 points from the Kyndryl content. The overall dynamics are much like last quarter. We wrapped on weak performance in the first quarter of last year, which was down 15% and we continue to see strong renewals of these critical software offerings, building on the expanded zSystem’s capacity and traction we have gotten through the strong z15 program. Looking at software profit, we delivered operating leverage given the strong and broad-based revenue performance this quarter. Our pretax margin was up 7 points and puts us on track for a full year software margin in the mid-20s. Just as in Software, Consulting is capitalizing on strong demand profile, growing both revenue and signings at double-digit rates across all business lines and geographies. Revenue growth accelerated to 17%, while bookings were up over 40%. Our book-to-bill remains solid at 1.1 for the quarter and over the last year. Clients trust IBM to execute their complex business transformations, leveraging our deep industry expertise and the investments we have been making in skills, capabilities, our ecosystem and in scaling our acquisitions. We are positioned to capture demand and drive adoption of our hybrid cloud platform. Consulting’s hybrid cloud revenue grew 32% on trailing 12-month basis to $8.3 billion, which makes up 45% of the Consulting business. We continue to see strong demand and momentum in our Red Hat-related engagements this quarter, nearly doubling Red Hat-related signings year-to-year. Our strategic partnerships also contributed to our performance in the quarter. Revenue from these partnerships grew solid double digits led by Salesforce, SAP, AWS and Azure. And now turning to our lines of business, business transformation revenue grew 19%, bringing together technology and strategic consulting to transform critical workflows at scale. The growth was broad-based, with particularly strong growth in our practices centered around customer experience, talent and data transformations, as well as supply chain and finance applications. In Technology Consulting, where we architect and implement clients’ cloud platform and strategies, revenue was up 19%. Growth was pervasive, led by our engagements around developing and modernizing applications for cloud deployments. Finally, application operations revenue grew 14%. This business line focuses on the management of applications and cloud platform services required to run hybrid cloud environments. Growth was broad-based in this space as well, led by Cloud Application Management. Moving to consulting profit, our pretax margin expanded about 1 point, delivering operating leverage and benefiting from IBM’s more streamlined G&A and go-to-market structure. Our consulting gross margin reflects the significant investments we have made over the last year, fueling our revenue growth. We are investing in our partner ecosystem, expanding our reach. We continue to scale the 12 acquisitions we made in the last 18 months including two which closed in the first quarter. And we are investing in talent across our workforce, up-skilling existing resources, adding certifications and bringing in technical skills in areas of hybrid cloud and AI. Consulting is where we are most impacted by the competitive and inflationary labor market, which puts pressure on profitability. We expect to capture value through price in our engagements and recognize it will take a few quarters to appear in our margin profile. Turning to Infrastructure segment, revenue performance was flat versus last year. Hybrid infrastructure revenue declined 2%, offset by growth of 4% in infrastructure support. The Kyndryl content contributed over 8 points to infrastructure with consistent benefit across the two business areas. Within Hybrid Infrastructure, the zSystems revenue was down 18%. We are now in the 11th quarter of z15 availability. z15 has been a very strong program, both in revenue performance and capacity. In fact, we ship more z15 MIPS than in any other program. Building on that momentum, we have just announced our newest solution, IBM z16. Arvind commented on the three differentiated capabilities of z16, embedded AI at scale, cyber resilient security and cloud-native development for hybrid cloud. Distributed infrastructure delivered 8% revenue growth this quarter. Client demand for S/4 HANA data-intensive workloads on our newest POWER10 high-end systems fueled this performance. Looking at infrastructure profit, the pretax margin was down 3 points reflecting where we are in our IBM Z product cycle. Now let me take it back up to the IBM level. We focused our business on a platform-centric, hybrid cloud, and AI strategy. Over the last couple of years, we have been taking steps to optimize our portfolio, streamline our operations and allocate capital, to execute that strategy and improve our financial profile. Our first quarter results reflect these very significant changes and put us on track to our full year expectations for our two key measures of revenue growth and free cash flow. 90 days ago, we expected to grow revenue at mid single-digit rate at constant currency before the incremental Kyndryl sales. With the strong start to the year, we now see revenue growth at the high end of that mid single-digit range. On top of that, we expect about 3.5 points of growth for the year from the commercial relationship with Kyndryl spread over the first three quarters. And then looking at currency, with the strengthening U.S. dollar at mid-April spot rates, currency will now be a 3-point to 4-point headwind to revenue growth for the year. For free cash flow, we continue to expect $10 billion to $10.5 billion in 2022. As I said earlier, this is an all-in free cash flow definition and includes the cash impact associated with our 2020 structural actions. Before getting into the segments and color on the second quarter, I will comment on the business impact of our Russian operation. Our business in Russia is not large, but it’s concentrated in high-end Infrastructure and Software. Last year, business in the country contributed about $300 million of revenue and about $200 million of profit and cash. For this year, we expect no contribution from Russia, which puts us closer to the low-end of our free cash flow range. Now, let me provide some color on our expectations for segment performance for the year. In Software, we got off to a good start and we haven’t changed our view of constant currency revenue growth or the contribution from the external sales to Kyndryl. We also remain on track to a software pretax margin in the mid-20s range for the year. In IBM Consulting, with our first quarter revenue and signings performance, we are taking up our view of Consulting revenue to a low double-digit growth rate for the year. With continued investment in talent and a competitive labor environment, we now expect a pretax margin approaching 10%, which is up a couple points year-to-year. This reflects improving performance in the second half as we realize price increases in our contracts. Our infrastructure revenue performance, as always, reflects product cycle dynamics. This year, we would expect performance above the model, given the launch of our z16 late in the second quarter. This will contribute to second quarter performance and ramp further in the second half. On top of that, we are planning for about 4 points to 5 points from the external sales to Kyndryl in 2022. We see a mid- to high-teens pretax margin for the full year. These segment revenue and margin dynamics would yield about a 4-point year-to-year improvement in IBM’s pretax margin for the full year. In terms of tax, we continue to expect a mid- to high-teens operating tax rate, which is a headwind to our profit growth. Let me comment on a couple items specific to the second quarter. At current spot rates, currency would be a 5-point headwind to revenue growth. We expect to close the sale of the Healthcare Software assets, with a gain utilized to address stranded costs. And we expect a 4-point to 5-point year-to-year improvement in operating pretax margin and a tax rate in the high teens. Based on our solid first quarter performance and view of the year, we are on track to our midterm model. And now, Patricia, let’s go to the Q&A.

Operator:

Thank you. Our first question comes from Wamsi Mohan with Bank of America. Your line is open.

Arvind Krishna:

Wamsi, always good to hear from you. Just a comment on the economy and I will call it demand. We are seeing very strong demand. As I said in my prepared remarks, I think, technology has shifted from being just one aspect of a business to being the source of competitive advantage. When that happens, Wamsi, we think and we believe and the past couple of quarters have borne this out, that demand for technology is going to sit at 4 points to 5 points above GDP. Even if GDP falls to flat or there’s a quick recession or if it’s a very slight recession, we see demand staying strong and continuing. Now, I will acknowledge if you have something much more catastrophic, that’s different. But for all the scenarios that we do outline and we do look at, we see that demand is going to continue in a growth phase for the foreseeable future. Jim?

Patricia Murphy:

Okay. Thank you, Wamsi. Can we please go to the next question?

Amit Daryanani:

Thanks for taking my question. Congrats on a strong topline here. I guess my question is really around, you are raising your top line guide from mid-single digits at the higher end of the mid single-digit range. Could you just talk about what is driving this range, is it organic or is it really the deals that you have done that give you better conviction on the growth trajectory? So the uplift in guide organic versus inorganic to help us understand it better? Maybe related to that, there’s a lot going around what’s happening in Europe very specifically and any spillover potentially from Russia. So I’d love to hear what you see in Europe if there is any spillover from Russia? Thank you.

Patricia Murphy:

Okay. Amit, thanks for the question. Let’s go to the next one, please?

Toni Sacconaghi:

Yes. Thank you. I wanted to just discuss a little bit the profitability side of the equation. So you beat relative to expectations on revenue, but not on EPS. You have raised your full year guidance for revenue, but not on free cash flow. So I just want to explore the dynamics there, are you seeing incremental pressure just in Consulting and are there other areas? And then I was hoping you could answer two very specific clarifications. One is your operating margin expansion was 280 basis points year-over-year, but obviously you had very high margin Kyndryl contribution. So if we ex out the Kyndryl contribution, what was the change in operating profit PTI percentage year-over-year? And then, secondly, how much is the Healthcare asset sale gain and it sounds like that will be included in free cash flow, could you confirm that as well? Thank you.

Patricia Murphy:

Okay. Thanks, Toni. Let’s go to the next question?

Erik Woodring:

Great. Thank you very much for taking the call. Really nice performance on Red Hat and Security with growth in both, they are holding up relative to 4Q or accelerating. There was a partially offset, I guess, by a slowdown in automation a bit. But maybe if you could just take us a little deeper, and help us understand really the puts and takes for each of the Software businesses. What surprised you in the quarter? What was more challenged? And then, lastly, just what was the growth contribution from acquisitions in Software in the quarter? Thanks.

Jim Kavanaugh:

Yeah. I would just add, Arvind. Erik, thank you very much for the question. Software is obviously an integral part to our hybrid cloud platform-centric thesis overall and Arvind went through the portfolio and the dynamics, but let me add some of the KPIs to that. So it gives you some of the fundamentals underneath the pervasive growth across Red Hat at 21%, automation at 5%, data and AI growing 4% and security with a nice rebound delivering return on the new innovation we brought to market. But when you look underneath it, our Hybrid Platform & Solution, our growth vector, which is about 75% of our Software segment, nice growth double digits overall. Underneath that, we have got an ARR, now a subscription book of business about $13 billion, that is now accelerating, growing 9% overall from an ARR perspective. We have seen nice acceleration in Cloud Pak portfolio underneath that, with a flywheel effect. We are getting NRRs that are north of 100%, I think this quarter it was about 105%. So we have had now three or four consecutive quarters of that flywheel effect. And we are seeing strong renewals across the early parts of our ELA cycle, which is just beginning and that strong renewal is leading to a record deferred income balance north of $11 billion right now and growing nicely. So we feel pretty good about our Software portfolio, a lot of execution in front of us, though.

Operator:

Our next question will come from Kyle McNealy with Jefferies. Your line is open.

Jim Kavanaugh:

Yeah. Thanks, Kyle. Arvind, I will take this one overall. Kyle, great question. I mean, we are obviously operating in an environment of accelerated demand in the Consulting space and I think you see we are capitalizing on that. And we have been talking about this since the second half when we were looking at all of our indicators across the portfolio and our enterprise clients, we saw a pretty robust demand environment and we made a conscious strategy to invest in building out skills capabilities, ecosystem partnerships. And we started if you remember beginning of 2021 investing significantly in acquisitions to build out scale for our hybrid cloud adoption overall. Now, you couple that with the highly inflationary environment right now that we started seeing play out in the latter half of 2021 and we said at that point in time that when you couple the investments we have been making, which is conscious, to build that capability, because Consulting. As I have always said, is the tip of the spear that provides tremendous value in pulling IBM technology and driving scale and adoption of our hybrid cloud platform that you couple that with the inflationary environment, you are seeing the pressure on our gross margins. Now, I will tell you, let me try to quantify a little bit of this. When you look at our gross margins, we were down about 350 basis points in Consulting. Arguably off the toughest compare that we will face in 2022. The compares get easier. So we will acknowledge that right off the bat. Number two, when you look at the inflationary environment, we have been seeing within that 350 basis points about 150 basis points is due to the accelerating cost of talent acquisition. The remaining 2 points or so is about a point of acquisition, which as you know, as you get ramp and scale, those become very quick accretive. We expect that to be accretive as we get into latter half of second quarter and into third quarter. And then we have been investing, when we saw that robust demand environment, we invested a significant amount of capability and capacity. In the early innings of that, you have underutilization. We knew that. That’s why we had to get after our G&A structure to optimize and streamline, by the way, reinventing IBM through automation, digitization, everything our clients are doing, we have been doing inside IBM. That’s been mitigating the profit impact overall. So I think you will start seeing improvement as we get into third quarter. But we will make sequential improvement here in the second quarter overall. But I will tell you again gross margin improvement will turn accretive in third quarter and the second half, but in a pretax operating margin, we have guided to approaching 10%. That’s up a couple points. We will see that improvement throughout the year.

Operator:

Our next question comes from Brian Essex with Goldman Sachs. Your line is open.

Arvind Krishna:

Yeah. So, Brian, thank you for the question. And it is one that we think a lot about and we talk a lot to our clients about to understand where they are. So if you look at the makeup of our Consulting portfolio and that is we have very little of what I would call the Infrastructure Services. Those all went with Kyndryl. So what we have left is helping clients, and Jim, talked about the very high growth rates with some of our ecosystem partners, that is Consulting around topics like Salesforce and Adobe and public Clouds. Even in difficult environments, we believe that the adoption of those platforms is going to continue with all of our clients. Second, as we look at digitization, so digitization is not just taking something and coloring -- just coloring it and making it digital. But if we look at it as being one of the primary ways to address the labor demographics issue, meaning the shortage of high skill labor that is there pretty much globally, then we believe that that actually continues even in a difficult environment, because it gives our clients a way to go address that. If I take, for example, airline scheduling, if you take re-booking of passengers, if I take quote to cash, where you cut across all of the silos, if I take much more real-time impact of revenue and omnichannel, these are all examples of our Consulting projects, which we see carrying on even through a difficult environment. So when I look at that that tells me there’s a sustainability and durability. I don’t see the number of trained people and experts coming up suddenly, and so consequently, I think, that because of that, because there is a shortage of technical talent in the world, it will continue to go well even in a constrained economic. But, Brian, let me acknowledge. When I say constrained, I mean, if we enter what I will call a mild recession or a quick recession. If you get something deep and sustained, I will put my comments a little bit to the side and we will have to then go look at that again. But I think that, because of the makeup of our portfolio, I think, it will actually fare quite well.

Operator:

Our next question comes from David Grossman with Stifel. Your line is open.

Jim Kavanaugh:

Yeah. Why don’t I address that? Thank you, David, for the question overall. When you take a look at the Consulting margin, let’s just take a step back and mark it in to your point. The competitive benchmark right now I would say is probably low- to mid-teens. We are not going to be a pure-play industry, excuse me, India Consulting-based company that has a very different value proposition. But if you look at some of the peers that we benchmark, you are in the low- to mid-teens. We have talked about our mid-term model. Now, that mid-term model as we put out aligns to an integrated IBM thesis of hybrid cloud as a platform-centric business built on the foundation of Red Hat. GBS or excuse me, Consulting has an integral role of not only being a pure-play competitor, but they play a very essential role in driving the scale and adoption of our Software portfolio and also pulling through our Technology. And by the way, we have talked many times about how well they are doing in building up a Red Hat practice. I think inception to date, about a $4.5 billion book of business on top of our hybrid cloud platform-centric thesis and they drive about depending on any quarter, 20% to 30% to 40% of our Cloud Paks. But we talked about our mid-term model that we would get in the low double-digit margin range. That is a three-year picture. So I think we have already given that. At high single-digit revenue growth, the investments we are going to make, the integrated value it delivers IBM, you take that high single-digit revenue growth, you take low double-digit approach into the low teens, we are in a competitive playing field and it’s an integral part of IBM that drives that software portfolio and that profit. So we feel pretty comfortable that that mid-term model answers your question.

Operator:

Thank you. Our last question will come from Jim Suva with Citigroup. Your line is open.

Arvind Krishna:

So, Jim, let me start with answering your question on the capabilities of Mainframe driving growth in Mainframe and then ask Jim to address the profitability side. So if I look at the demand side on Mainframe, a lot of our clients are seeing additional volumes, because Mainframe serves really well as a system of record as that transactional engine that helps drive our clients’ business. If there is volatility in the markets, if there is 10%, 20%, 30% volume increases, which we are sensing many of our clients see, that is the primary driver of growth. And the second driver of growth where we talked about resiliency is everybody is now wanting to be 24x7 and because of all of the issues around not just resiliency due to physical issues or software errors, but also because of cyber, people are much more concerned, and that drives additional capacity if people want to make sure that there is a working copy of their application and data set available at some other place and that is why you heard us talk about that. Then, as the volumes go up, we know that there is always an indication of fraud that can go up. And because of the fraud, we embedded AI into the processor, so you can now make your fraud decision in line with the transaction decision. And you can imagine whether it’s processing credit cards, whether it’s moving money, all of those capabilities are going to drive that. So if I pack all of that and then unpack it, Jim, I will tell you that we saw over the last three years more growth and better adoption of Mainframe than we have seen in prior cycles. We expect from early signals that we are going to see that continue over the next couple of years. That said, we have got to go out and execute. We have got to make sure that our clients actually are able to quickly deploy these applications that they use and that will allow us to grow the Mainframe over this coming cycle as well.

Arvind Krishna:

All right. Thanks, Jim. Let me just make a couple of comments to wrap up the call. Our performance this quarter reflects the actions we have been taking. We have strengthened our portfolio, we are leveraging our ecosystem and we are streamlining our business. While I acknowledge there is always more to do, we are pleased with the start to the year and I look forward to speaking with all of you again soon.

Operator:

Thank you for participating on today’s call. The conference has now ended. You may disconnect at this time.

Patricia Murphy:

Thank you. This is Patricia Murphy, and I'd like to welcome you to IBM's Fourth Quarter 2021 Earnings Presentation. I'm here with Arvind Krishna, IBM's Chairman and Chief Executive Officer; and Jim Kavanaugh, IBM's Senior Vice President and Chief Financial Officer. 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. I'll remind you the separation of our managed infrastructure services business, Kyndryl, was completed on November 3. As a result, our income statement is presented on a continuing operations basis. Our results also reflect the incremental revenue from the new commercial relationship with Kyndryl. Because this provides a onetime lift to our growth, we will provide the contribution to our revenue growth for the next year. In the spirit of providing additional information to investors, our presentation also includes non-GAAP measures. For example, all of our references to revenue and signings growth are at constant currency. We have provided reconciliation charts for these and other non-GAAP measures at the end of the presentation and in the 8-K submitted to the SEC. Finally, some comments made in this presentation may be considered forward-looking under the Private Securities Litigation Reform Act of 1995. These statements involve factors that could cause our actual results to differ materially. Additional information about these factors is included in the company's SEC filings. So with that, I'll turn the call over to Arvind.

James Kavanaugh:

Thanks, Arvind. Let me start out with a few of the headline numbers. We delivered $16.7 billion in revenue, 58% operating gross margin, operating pretax income of $3.5 billion and operating EPS of $3.35 for continuing operations. Last January, we said we expected performance to improve over the course of 2021 as we start to benefit from the actions we've taken. We have seen progress in our constant currency revenue growth rate every quarter and now again in the fourth. This is the first view of IBM post separation. We had solid revenue performance, up nearly 9%. I'll remind you, this includes the incremental revenue from the new commercial relationship with Kyndryl, and we said we would be transparent on the contribution to our revenue growth for the first year. This quarter, our revenue growth includes about 3.5 points from the new relationship. Excluding this, IBM's revenue was up 5%. We have aligned our operating model and segment structure to our platform-centric approach. In the fourth quarter, Software was up 10%, and Consulting was up 16%. These are our 2 growth vectors and together represent over 70% of our annual revenue. Infrastructure, more of a value vector, tends to follow product cycles and was up 2%. The Software and Infrastructure growth each include nearly 5 points from the new Kyndryl relationship while there is no contribution to Consulting's growth. Our platform-centric model has attractive economics. For every dollar of hybrid platform revenue, IBM and our ecosystem partners can generate $3 to $5 of software, $6 to $8 of services and $1 to $2 of infrastructure revenue. This drives IBM's hybrid cloud revenue, which is up 19% for the year. Post separation, revenue from our full stack cloud capabilities from Infrastructure up through Consulting now represents $20 billion of revenue or 35% of our total. Looking at our P&L metrics. Our operating gross profit was up 3%, and the $3.5 billion of operating pretax profit was up over 100%. Operating net income and earnings per share also grew. Let me highlight a couple of items within our profit performance. First, the year-to-year pretax profit reflects $1.5 billion charge to SG&A last year for structural actions to simplify and optimize our operating model and improve our go-forward position. We're continuing to invest to drive growth. Throughout the year, we have been aggressively hiring, with about 60% of our hires in Consulting. We're scaling resources in Garages, sign engineering centers and customer success managers, all to better serve our clients. We're increasing investments in R&D to deliver innovation in AI, hybrid cloud and emerging areas like Quantum. We're ramping investment in our ecosystem, and we acquired 15 companies in 2021 to provide skills and technologies aligned to our strategy, including capabilities to help win client architecture decisions. Regarding tax, our fourth quarter operating tax rate was 14%. This was up significantly from last year but roughly 2 to 3 points lower than what we estimated in October due to a number of factors, including the actual product and geographic mix of our income in the quarter. Let me spend a minute on our free cash flow and balance sheet position. Our full year consolidated cash from operations was $12.8 billion, and free cash flow was $6.5 billion. These are all-in consolidated results and include 10 months of Kyndryl and the cash paid for the 2020 structural actions and spin charges. IBM's stand-alone or baseline free cash flow for the year was $7.9 billion, which is aligned to our go-forward business. This excludes Kyndryl charges and pre-separation activity but includes the IBM portion of the structural actions. Payments for these IBM-related structural actions and deferred cash tax paid in 2021 contributed to the year-to-year decline in the stand-alone results. In terms of uses of cash for the year, we invested over $3 billion in acquisitions. We continue to delever, with debt down nearly $10 billion for the year and over $21 billion since closing the Red Hat acquisition. And we returned nearly $6 billion to shareholders in the form of dividends. This results in a year-end cash position of $7.6 billion, including marketable securities and debt of just under $52 billion. Our balance sheet remains strong, and I'd say the same for our retirement-related plans. You'll remember that over the last years, we've shifted our asset base to a lower risk profile. In 2021, the combination of modest returns and higher discount rates improved the funded status of our plans. In aggregate, our worldwide tax qualified plans are funded at 107%, with the U.S. at 112%. Now I'll turn to the details by segment, and I'll remind you we have put in place a simplified management system and segment structure aligned to our platform-centric model. And within the segments, we're now providing new revenue categories and metrics that will provide greater transparency into business trends and drivers. IBM Software delivered double-digit revenue growth in the quarter. This was driven by good revenue performance in both hybrid platform and solutions and transaction processing, the latter benefiting significantly from the new Kyndryl content. Software is important to our hybrid cloud strategy and our financial model. Our hybrid cloud revenue in software is up 25% for the year to more than $8.5 billion. And subscription and support renewal rates continue to grow again this quarter, contributing to a $700 million increase in the software deferred income balance over the last year. Hybrid platform and solutions revenue was up 9%. This performance is an indication of the strength across the software growth areas focused on hybrid cloud and AI. It's worth mentioning this includes only a point of help from the new Kyndryl commercial relationship. Let me highlight some of the trends by business area. Red Hat revenue, all in, was up 21%. Both infrastructure and app dev and emerging tech grew double digits as RHEL and OpenShift address enterprise's critical hybrid cloud requirements. With this performance, we're continuing to take share with our Red Hat offerings. Automation delivered strong revenue growth, up 15%. As Arvind mentioned, there is strong market demand for automation. We had good performance in AIOps and management this quarter as we address resource management and observability. Clients are realizing rapid time to value from Instana and Turbonomic, 2 of our automation acquisitions. And integration grew with continued traction in Cloud Pak for Integration. Data and AI revenue grew 3%. We have particular strength in data fabric, which enables clients to connect siloed data distributed across the hybrid cloud landscape without moving it. You'll recall, we talked about the data fabric opportunity back in October. We also had strong performance in business analytics and weather. Within these solutions, clients are leveraging our AI to ensure AI models are governed to operate in a fair and transparent manner. Security revenue declined modestly in the quarter driven by lower performance in data security, while revenue grew 5% for the year. As we called out in our recent investor briefing, security innovation is an integral part of our strategy. In December, we launched a new data security solution, Guardium Insights, with further plans to modernize the broader portfolio throughout the year. This quarter, we also completed the acquisition of ReaQta, which leverages AI and machine learning to automatically identify and block threats at the end point. Putting this all together, our annual recurring revenue, or ARR, is now over $13 billion, which is up 8% this quarter. This demonstrates the momentum in our hybrid platform and AI strategy, including Red Hat and our suite of Cloud Paks. Moving to transaction processing. Revenue was up 14%. This is above our model driven by a few underlying dynamics. First, all of the growth in transaction processing came from the new Kyndryl commercial relationship, which contributed more than 16 points of growth. Second, I'll remind you that we're wrapping on a very weak performance in the fourth quarter of last year, which was down 26%. And lastly, we had some large perpetual license transactions given the good expansion in the IBM Z capacity we've seen this cycle. While the new capacity is important, what's just as important is the continued strong renewal rates this quarter. These are both good proof points of our clients' commitment to our infrastructure platform and these high-value software offerings. Looking at software profit. We expanded pretax margin by 12 points, including nearly 10 points of improvement from last year's structural actions. Turning to Consulting. Revenue grew 16% with acceleration across all 3 revenue categories. Complementing this strong revenue performance, our book-to-bill was 1.2. Clients are accelerating their business transformations powered by hybrid cloud and AI to drive innovation, increase agility and productivity and capture new growth opportunities. Enterprises are turning to IBM Consulting as their trusted partner on this journey. They are choosing us for our deep client, industry and technical expertise, which drives adoption of our hybrid cloud platform and pulls through key technologies. Consulting's hybrid cloud revenue grew 34% in the quarter. For the year, cloud revenue is up 32% to $8 billion. Offerings and application modernization, which are centered on Red Hat, contributed to this growth. The Red Hat-related signings more than doubled this year and are now over $4 billion since inception. This quarter, we added over 150 client engagements, bringing the total since inception to over 1,000. Our strategic partnerships also drove our performance. Revenue from these partnerships accelerated as the year progressed and was up solid double digits in the fourth quarter led by Salesforce, SAP, AWS and Azure. Turning to our business areas. Our Consulting's growth was led by business transformation, which was up 20%. Business transformation brings together technology and strategic consulting to transform critical workflows at scale. To enable this, we leverage skills and capabilities in IBM technologies and with strategic ecosystem partners such as SAP, Salesforce and Adobe. Our practices are centered on areas such as finance and supply chain, talent, industry-specific solutions and digital design. This quarter, we had broad-based growth, reflecting strong demand for these solutions. In technology consulting, revenue was up 19%. Technology consulting architects and implements cloud platforms and strategies. We leverage hybrid cloud with Red Hat OpenShift and work with providers, such as AWS and Azure, in addition to IBM Cloud. This quarter, we continue to see good performance in application modernization offerings that build cloud native applications and that modernize existing applications for the cloud. Finally, application operations revenue grew 8%. This business line focuses on application and cloud platform services required to operationalize and run in both cloud and on-premise environments. Revenue growth was driven by offerings, which provide end-to-end management of custom applications in cloud environments. Moving to consulting profit. Our pretax income margin expanded about 8 points, including just over 9 points from last year's structural actions. We're in a competitive labor market, and we continue to have increased pressure on labor costs due to higher acquisition, retention and wages. While we still expect to capture this value in our engagements, it will take a few quarters to appear in our profit profile. So now turning to the new Infrastructure segment. Revenue was up 2%. The Kyndryl commercial relationship contributed about 5 points of growth, which is higher than we expected in October. In this segment, we brought together hybrid infrastructure with infrastructure support, which was formerly technology support services. This allows us to better manage the life cycle of our hardware platforms and to provide end-to-end value for our clients. Hybrid infrastructure and infrastructure support revenue were up 2% and 1%, respectively, with pretty consistent contribution from the new Kyndryl relationship. Hybrid infrastructure includes IBM Z and distributed infrastructure. IBM Z revenue performance, now inclusive of both hardware and operating system, is down 4% this quarter. This is the 10th quarter of z15 availability and the combination of security, scalability and reliability continues to resonate with clients. This program continues to outpace the strong z14 program, and we ship more MIPS in the z15 program than any program in our history. Our clients are leveraging IBM Z as an essential part of their hybrid cloud infrastructure. And then in distributed infrastructure, revenue was up 7% driven by pervasive strength across our storage portfolio. Looking at infrastructure profit. The pretax margin was up over 9 points but essentially flat, normalizing for last year's structural action. Now I'll wrap up with a discussion of how our investments and actions position us for 2022 and the longer term. We've been laser-focused on our hybrid cloud and AI strategy. Our portfolio, our capital allocation and the moves we've been making are all designed to create value through focus for our clients, our partners, our employees and our shareholders. We took significant steps during 2021. The most impactful portfolio action was, of course, the separation of Kyndryl. We've also been allocating capital to higher growth areas, investing in skills and innovation and expanding our ecosystem. We've aligned our business to a more platform-centric business model. And we're simplifying and redesigning our go-to-market to better meet client needs and execute on our growth agenda. Bottom line, we're exiting 2021 a different company. We have a higher growth, higher value business mix, with over 70% of our revenue in software and services and a significant recurring revenue base dominated by software. This will result in improving revenue growth profile, higher operating margin, strong and growing free cash flow and lower capital intensity, leading to a higher return on invested capital business. We also continue to have attractive shareholder returns through dividends. In October, we laid out a model for IBM's performance over the medium term defined as 2022 through 2024. The model is focused on our 2 most important measures of success

Operator:

. Our first question comes from Amit Daryanani with Evercore.

James Kavanaugh:

Sure. Amit, thank you very much for the question. First, let's just ground everyone because I want to make sure we have absolute clarity as we're returning to reporting all-in free cash flow to, one, align to our consistency of IBM's post-separation baseline, to your point, the $10 billion in 2020 and, more importantly, to align to our forward-looking guidance, which we talked at Investor Day, with a midterm model of $35 billion cumulatively over 2022 to 2024. For 2022 specifically, as you heard me say, we expect free cash flow to be between $10 billion and $10.5 billion all-in. And that puts us right on track for the $35 billion, mainly, Amit, because it includes still the remaining structural actions charges of about $0.5 billion in 2022. And when you look at that, because of structural actions, you're not going to have linearity in that $35 billion throughout 2022 to 2023 to 2024. So let me talk just a little bit so we get clarity around the drivers, to your point, at the heart of your question. First, we do have about $0.5 billion remaining in the cash impacts from the structural charges, as I stated earlier. That means year-to-year, it's about $1 billion, give or take, benefit. Second, we anticipate about $0.5 billion of working capital efficiency just based on our AR dynamics around volume. And also, we're entering a mainframe cycle late in the first half. Third, very minimal tailwind with regards to cash tax, which basically means the majority of this has to be delivered on our operational profit and invest less, I should say, investments in capital expenditures. And that's going to come from revenue growth at our model, mid-single digit, before we add on Kyndryl; operating leverage, which we talked about, about 4 points improvement for the year; a mainframe cycle; and us continuing to address the remaining stranded costs from the separation of Kyndryl as we move forward. So we feel very comfortable, one, $10 billion to $10.5 billion puts us in position to that $35 billion; and two, more importantly, that this cash provides us with ample financial flexibility to continue to invest in our business, both organically and inorganically, and return significant value to our shareholders with our committed dividend.

Kathryn Huberty:

Arvind, I couldn't agree more with your comments about the structural uplift in IT spending from technology diffusion across all sectors. But as you think about the stock market volatility over the last several weeks, is there any reason to believe that there could be some near-term cyclical impact from that volatility? And then maybe if you can also comment on whether the recent pullback in software valuations increases the likelihood that you might look at doing bigger M&A this year.

Operator:

Our next question comes from Toni Sacconaghi with Bernstein.

James Kavanaugh:

Toni, I'll take this. Thank you very much for the question. A handful there to address overall. So if I got it correctly, first of all, yes, we talked about our guidance, coming off of a very solid fourth quarter, gives us confidence in the foundation to really build on our midterm model. And we said 2022 would be the next step. We have progress, more work to do, mid-single-digit growth pre the Kyndryl contribution, operating margins up about 4 points and then free cash flow, as I answered Amit, at $10 billion to $10.5 billion. So when you look at that operating profit overall, first of all, yes, we're very transparent in our 2 key measures of success. Number one, the contribution of revenue growth. And we said we're going to be up mid-single digit prior to adding the Kyndryl 3 points roughly for the year. And the second key measure, which we've got our entire business, our operating model, aligned to, is free cash flow generation. And we're very transparent in our free cash flow generation that, that is all-in, with a baseline -- IBM post-separation baseline of $7.9 billion we reported in '21 going to $10 billion to $10.5 billion, on its way to delivering $35 billion cumulatively over time. Within that, I gave you the breakout of the bridge on cash flow. No matter how you cut it, we are going to invest more in capital expenditures this year. But when you take out the working capital efficiency of $0.5 billion, a very modest cash tax tailwind, and you take out the $0.5 billion of structural charges, you get substantial operating profit growth. And I would tell you, although we're not going to disclose based on commercial competitive reasons around the profitability of Kyndryl overall, and I don't think you would expect us because we don't do that with any strategic partner or client, that, that is a minimal component of the required operational profit improvement for 2022 overall. So we feel pretty good about the confidence in our guidance. It positions us on that midterm model, and it gives us tremendous financial flexibility to continue to invest, to extend our hybrid cloud leadership, invest in innovation to bring on new technology and return significant value back to our shareholders overall. I think that was the first one. The second one, acquisition revenue contribution. Obviously, we've got work to do to close this. This won't close until later in the second quarter. And at that point in time, we will disclose information around Watson Health and what the implications are to our guidance overall, and we'll update investors as we always do.

Wamsi Mohan:

Arvind, as you think about the midterm model and layer in some of these puts and takes that you guys highlighted in 2022, you could have up to maybe a couple of points of benefit from M&A and maybe up to a point from mainframe. As you look into 2023, some of these elements will turn into headwinds, particularly maybe up to 2 points from infrastructure. What are the things that you're looking at that should grow better than 2022 and 2023 to offset some of this to get back to that mid-single trajectory? And Jim, can you address 2022 seasonality for revenue growth and cash flow given the Kyndryl separation and really very different timing on the Z cycle?

James Kavanaugh:

Yes. Wamsi, thank you very much. A very important question when we think about 2022, just building on what Arvind just said right there. If you think about the revenue growth profile and how it's going to play out in 2022, as we stated earlier, we expect the mainframe cycle this year, and that will happen late in the first half. So read that minimal contribution in 2Q and then mostly in the second half. But second, really, the big point I want to get out is, you can quite expect, due to the separation of Kyndryl, which was a highly annuitized-based business, I think we're going to have a different business skew throughout 2022 on top of the product cycle that I just talked about earlier. I would expect somewhere in the neighborhood, around profit, to be about 40-60 first half, second half. But I would tell you, underneath that 40% in the first half, it's going to be skewed more towards second quarter just given the new introduction of our mainframe cycle. And also last year, we had a very strong first quarter mainframe. We grew over 20%. So we're wrapping on a GA plus 11 quarter at the end of its cycle on the most successful mainframe program we've had, program to date. We're very late in that cycle. So I would expect more of that profit to be in second quarter and again 40 to 60 first half, second half.

James Suva:

Both Jim and Arvind, you guys have done a tremendous amount of heavy lifting and work over the past couple of years, all the way from integration of Red Hat to spin out of Kyndryl. Looking ahead now, just strategically, my one question is, are we looking at the core company as now it's really time to harvest everything? Or are there still some more transformational or pruning or spinning out going on? And I'm not referring to the Watson Health, I'm talking about more bigger things. It seems like now it's time to start harvesting things, but maybe I'm not hearing your comments correctly.

Operator:

Our next question comes from David Grossman with Stifel.

James Kavanaugh:

Yes. Well, David, as we've talked, since Arvind has come on and taken over as Chairman and CEO, we have aligned our portfolio. We've aligned our capital investment allocation structure. We've aligned the operating model in this company. And I'm a very big believer in focus. And that focus is around 2 measures

Kyle McNealy:

This one is about the trajectory of the Infrastructure business given the moderation in growth that you saw last quarter in Q3 and then the better performance you saw this quarter. Do you got any added confidence now after the performance this quarter that we won't see another soft quarter like in Q3 before we get into the next IBM Z cycle in the second half of the year?

Operator:

Our last question will come from Brian Essex with Goldman Sachs.

Arvind Krishna:

Thank you, Brian, for the question. So to go to the middle part of your comment, I would call it that we are in the early innings, not the middle or late innings, of the growth in Consulting. I wouldn't call it a very first inning, maybe the first inning was 2021, but early innings. So I think we have a long way to go on this. Now I think that leads to the first part of yours, what are the anecdotes or what are the customer conversations that lead us there. Everyone is looking on how do you deploy technologies, be it Salesforce, Adobe, cloud technologies, to go improve their processes. It's actually the conversation has changed from 3 years ago. It's not about cost savings. It's actually much more about how can you deploy these technologies to improve a process

Operator:

Thank you. Thank you for participating on today's call. The conference has now ended. You may disconnect at this time.

Operator:

Welcome and thank you for standing by. At this time, all participants are in a listen-only mode. Today's conference is being recorded. If you have any objections, you may disconnect at this time. Now I will turn the meeting over to Ms. Patricia Murphy with IBM. Ma'am, you may begin.

Arvind Krishna:

Thank you Patricia. And thanks to all of you for joining us today to discuss our third quarter performance. At our recent investor briefing, laid out our Hybrid Cloud and AI strategy, and our approach to delivering strong free cash flow and sustainable mid-single-digit revenue growth starting in 2022. For the last year-and-a-half, we've been taking actions and investing to execute our strategy. This quarter, we reported modest revenue growth and delivered solid free cash flow, generated over $11 billion of adjusted free cash flow over the last year. We also made tangible progress in our key growth areas of software and consulting. With that, I will acknowledge that in other areas of the business, we fell short of our expectations. This was during the end of the cycle and global technology services clients, pausing ahead of the public filing of the Form 10 and separation of Kyndryl, have made further progress in the Kyndryl separation in the last two weeks and announced a distribution date on November 3rd, which is ahead of our original schedule. We've done a lot to prepare Kyndryl for this moment. We took structural actions to improve the private profile, the management team is in place, employee transfers and the vast majority of client contract innovations are complete. We're now even more certain that separating this business creates value through focus. That said, the people of GTS have been a part of IBM for a long time. And it is with mixed emotions that we're reporting on this segment for the last time. And just yesterday, you heard from Martin and his management team strategy and value . The separation is just one of the many actions we are taking to focus our business on hybrid cloud and AI and improve our financial profile. To give you some color of IBM's performance excluding Kyndryl, we delivered 2% revenue growth this quarter. That compares to 1% in the second quarter and minus 1% in the first quarter. These results reflect a strong demand for technology products and services that help our clients advance their digital transformation. Our software revenue growth was led by Red Hat, security, automation and cloud backs across our software. Global Business Services, soon to be IBM Consulting, accelerated revenue growth to a double digit rate. Software and consulting are our 2 main drivers of growth, and this was certainly true this quarter. I will now expand on the progress we made in the third quarter toward our future. As I have described in the past, we have a platform - centric approach. Time to meet clients wherever they are in their journey. The platform we have built is open, secure, and flexible and continues to gain traction in the marketplace. I have more than 3500 clients using our hybrid cloud platform. Not only fueled our Red Hat revenue performance, but also provides a solid base for the multiplier effect across software and services. IBM Consulting is helping to drive this platform adoption. And this quarter had over a 180 new Red Hat engagements. Our teams work alongside our clients to co-create business products and solutions. So far we have done more than 4,000 IBM Garage engagements. In the last quarter, more clients are leveraging our platform capabilities and our expertise to unlock business value. We announced DISH is using IBM software and services to help automate their cloud-native 5G network. Cloud Pak for network automation, which is excused with AI, automation, and orchestration capabilities used by DISH to fine-tune speed levels or coverage areas depending on the needs of our clients. Building on a partnership spanning half a century, we announced Credit Mutuel is creating an IBM technology and skilled hub in France. The new hub will help Credit Mutuel leverage AI, data, cloud, and IBM Z. Also announced a new agreement with CaixaBank, one of the largest banks in Europe to put its digital capabilities with IBM Cloud for financial services and the new IBM Cloud multi zone regions in Spain. CaixaBank will leverage IBM Consulting industry expertise to move to a Hybrid Cloud approach for modernization. This quarter, we continued to leverage our ecosystem to drive what we described at our Investor Briefing as a flywheel of growth. That is, the more we grow, the more our partners grow and vice versa. We’re partnering with select DSI’s to bring joint solutions to market. This quarter, Atos announced the setup of the FS Cloud Center of Excellence to help financial services customers with their digital transformation journey. Also have continued momentum and revenue growth from our partnership with industry-leading ISVs and hyperscalers. Quarter, we're partnering with Adobe to help the British pharmacy chain Boots transform their e-commerce platform and deliver new digital customer experiences. While we invest in partnerships, we also invest organically and inorganically to deliver innovation. We made 16 acquisitions since April 2020, including Boxboat and Bluetab in the third quarter. These will strengthen our Hybrid Cloud consulting capabilities. In the same manner, we are organically developing new innovations that matter to our clients. I'll mention a few new introductions, starting with our innovations in software. In the quarter, Red Hat introduced a new –re-architected version of the Red Hat Ansible Automation Platform. Red Hat also launched a new version of its Advanced Cluster Management for Kubernetes. These two products are now more tightly integrated, which helps drive hybrid cloud automation. In addition, the latest version of Red Hat OpenShift became generally available. IBM Cloud Pak runs anywhere that OpenShift runs. They use common services such as logging, metering, monitoring, and security, and are infused with innovations and capabilities from IBM Research to deliver much more value than containerized code. In this quarter, we launched Cloud Pak for security, SaaS, as well as new versions of Cloud Pak for integration, Cloud Pak for network automation, and the Maximo application suite. Also recently announced, our Environmental Intelligence software suite, a product based on our Cloud Pak for data and leveraging our weather capabilities, it's designed to help companies measure, monitor, and predict environmental outcome, but also to help simplify ESG reporting. As you know, we made a commitment to be net zero greenhouse gas emissions by 2030. We will leverage this solution to inform management as we take action to reach this goal. In our systems business, we recently launched Power 10. Power 10 has unique hardware innovations including a processor specifically optimized for data intensive workloads such as SAP S/4HANA . During the quarter, we also announced the Telum processor. This 7-nanometer microprocessor is engineered to help clients get insights from their data at the speed of the workload. At the same time, we've continued to see quantum computing as a promising area of opportunity that will play out in the longer term. Our teams are hard at work to move this exciting field forward. Investors will have an opportunity to learn more about this within the next month. Let me quickly highlight one ESG announcement we made recently. Help protect the rights and privacy of cloud clients; we have joined other major companies in the tech industry, Amazon, Google, Microsoft, Salesforce, and SAP to establish the trusted cloud principles. This initiative is consistent with our longstanding focus on trust and transparency. Before I transition to Jim, let me reiterate three messages we conveyed during our investor briefing. First, we are optimizing our portfolio to drive mid-single-digit revenue growth starting in 2022. Second, we are increasing our focus and agility to better serve clients. Third, we are generating strong free cash flow that enables our investments while providing attractive shareholder returns. This quarter, we took another step towards the future. While much remains to be done, we are confident we can achieve our midterm objective. Jim, over to you.

Patricia Murphy:

Thank you, Jim. Before we begin the Q&A, I'd like to mention a few items. First, several references were made today to IBM's new segment structure, which will be effective immediately prior to the Kyndryl separation. We've provided information on the new segment, scope, and naming in an article posted to our investor website at the beginning of this month. Second, supplemental information is provided at the end of the presentation with the schedule of the availability of recapped financial information for IBM post-separation. And finally, as always, I ask you to refrain from multi-part questions. Operator, let's please open it up for questions.

Q - Wamsi Mohan:

Yes, thank you. Arvind, there seems to be a lot of concerns around the actual separation in terms of potential disruptions. You noted on this call that you saw some hesitation or pause in spending. Do you feel, given the changes that you have put in place, also with sales comp, do you feel comfortable about the trajectory of the business once you get past this threshold of near-term disruption that you highlighted? And if I could, Jim, you noted about 2.5 billion one-time bump from Kyndryl in 2022. Can you maybe calibrate that number for 2021 as well? That would be helpful. Thank you.

James J. Kavanaugh:

Thanks, Wamsi. To your second question, you remember back at -- on October 4th at our Investor Day, we talked about the strong strategic relationship between IBM and Kyndryl going forward.

Patricia Murphy:

Thanks, Wamsi. Let's go to the next question.

Toni Sacconaghi :

Yes, thank you. And I think, Arvind, you touched on this in the first question, but perhaps let me ask it a little more directly. So this quarter, IBM grew at 1.9% for RemainCo versus a comparison of constant currency at minus 3.5%. The comparisons get about two or three points more difficult looking into next year, and you have to accelerate your growth rate to get to mid-single digit growth by two or three points. So effectively, adjusting for compares, the growth rate has to improve about five percentage points relative to what you did this quarter to hit that mid-single-digit target. Beyond a product cycle in Mainframe and the UNIX, given you talked about taking time for investments to pay off, what is going to seemingly pretty suddenly change the growth profile, adjusting for comps by potentially four or five or six points over the next few quarters? And do -- how long do you continue to expect to invest, i.e. have pressure on operating margins, particularly in Software and GBS going forward? Thank you.

James J. Kavanaugh:

To that point, I can't resist but go into the numbers. So let's just -- Toni, great question. Thank you very much. Let's talk about this quarter. Again, IBM, ex - Kyndryl, delivered about 2% growth. By the way, that's an accelerating trend as we talked about in prepared remarks from about flat through the first half to now growing 2%. Yes, offer an easier compare -- we acknowledge that, but let's take a look at the revenue contribution analysis of what contributed to that two points. Now I'll tie it back to what we said on October 4th, as our mid-single-digit growth rate model. We set across our 3 segments

Operator:

Our next question comes from Katy Huberty with Morgan Stanley. Your line is open.

Arvind Krishna:

Thanks, Katy. Totally. Actually even Jim acknowledged that we fell maybe a half-point short of our own expectations and we could've done better. Here is where I see it doing better. First, the one that performed exactly according to what we wanted was Red Hat. Red Hat gave us 17%, which is pretty much what we wanted and expected. If I now look at our transaction processing platform, it was a little bit below what we would like because we have been saying that in a long-term model that should be more mid-single digit decliner but this quarter it was a high single-digit decliner. We think that as we get past, because that is coupled, I won't call it identical, but it is coupled to some of the infrastructure cycles, I expect that to come back starting in early '22 or maybe late in '21. Then on our category that is today called AI applications, we were minus 1%. There I would expect us to get back to mid-single-digit growth. Now you see if I put it all together, do we expect to see a tiny bit of pausing from people because of everything going on? Yes. Two, we are turning our incentive models. I spoke on it on the prior question very briefly. Our incentive models for our sales team are going to be very heavily tuned towards software going forward in '22. That I believe will result in much better performance because the only way that they will get anywhere near the target incentives are to make this up a number. That is probably for the first time that that's been true in a long, long time at IBM. So Katy, that's my view on what, happened there and how we will improve going forward.

Operator:

Our next question comes from Tien-Tsin Huang with JP Morgan. Your line is open.

James J. Kavanaugh:

Yeah. Tien-Tsin, this is Jim. I'll take that as we move forward. As I stated earlier and Arvind commented in the prepared remarks, we do see a very robust demand environment out there. We called it as we were going through fourth quarter; we called a very conscious strategy, GBS. Now, IBM Consulting again plays a very integral role to our Hybrid Cloud platform - centric business model. Why? Because it drives scale and adoption to our platform and it also pools IBM technology, while taking advantage of the ecosystem and partnership and skill and capability. So we started aggressively adding skill, capacity, expertise, ecosystem partnerships, and scaling acquisitions. I think we just announced today our eighth GBS acquisition in the last 12 months overall. So it was a conscious strategy and we believe that that flywheel effect of GBS that turns into the multiplier of driving our platform, pulling our Software, and driving a very robust economic equation for our Ecosystem partners is essential in our long-term strategy. Now, with that said, we saw margins down 310 basis points. We saw pretax margins down a 110 basis points. Within that though, we grew gross profit dollars and we grew pretax dollars. We're about generating growth in top-line at around generating cash contribution, and GBS delivered that today. I would also mention that GBS accelerated their margins quarter-to-quarter tremendously. Pretax margins were up 5 points quarter-to-quarter, and they've been accelerating their gross margins sequentially every single quarter this year. So we delivered over 13 points of pretax margin in the third quarter and our model, as we said on October 4th, was low teens. So we feel pretty comfortable, we see a very good book of business and we continue to see in fourth quarter IBM Consulting delivering double-digit revenue growth and margin dollar and profit dollar and cash dollar contribution, while pulling our Software and Hybrid Cloud platform.

Operator:

Our next question comes from Jim Suva with Citigroup. Your line is open.

Arvind Krishna:

Jim, great question. And by the way, I would tell you that I don't think that this year is unique. Maybe there's a touch more issues going on, but I don't think it's unique. I remember 2001 really well; I remember 2007 just before the financial crisis. This is a continuous movie in the technology industry. Now, you said the 3% signings growth. I wouldn't look at the 3%. I would look at our book-to-bill ratio, which is 1.1. And so book-to-bill gives a much better signal of what the demand is for our forward-looking revenue and demand in our IBM Consulting business. Labor has to be managed. We have a global level model. We've put people everywhere. And as Jim just mentioned in answer to the prior question, that yeah, when you do have inflation in your labor cost, there is an element of it that's going to price through for that side of the business. In all the rest of the business, actually, I'm not so worried about labor cost. I'm worried about getting the right talent, maybe, but that is always a worry that I have, and I've been paranoid that for 30 years, that's not unique. And I think it's similar to many of your businesses, Jim, not just yours, but all of your colleagues here on this call. The right talent is far more important. And while labor cost is important, in the end of the day, its maybe 15%, 20% of the total costs in expense that is critical towards the other businesses, because you can manage the rest. That answer to you is, no, it's not something that needs to be modeled in, I don't believe so. But we always have to worry about it in terms of how do we price, how do we get the labor pools, where do we put the labor pools and all of those elements.

Operator:

Our next question comes from Keith Bachman, Bank of Montreal. Your line is open.

Arvind Krishna:

Okay. Keith, I'll take the first part of that question on Cloud Paks. So Cloud Paks are not just bundled and they're not just containerizing Software. I'll tell you right away, if all you do is bundled Software, you'll actually get a price deflation. If all you do is containerize Software, there'll be no plus or minus. It's just a different way of delivering it. I'll take one of the Cloud Pak s to maybe use it as a quick exemplar. If I take our Cloud Pak for data, if I now turn around and tell you that whether we take some of our integration Software, whether we take a database Software like DB2, and that's all you provide through that, you're right; there's neither plus nor minus. I think it will stay where it is. However, it's not just putting those in as options. A lot of Cloud Pak for data is actually new innovation. It includes methods around data fabric, it includes methods around how do you federate data, both from public clouds and from other repositories that are probably not IBM's inside the clients on-premise environment. It contains the data catalog; it contains these ways to be able to do some computations without even moving the data. That new content added to some of the existing content, so we take advantage of our incumbency or we get lift because there is more usage overall for these technologies than there was before, is why we're so excited about Cloud Pak and it gives us both. Yes, some of it is just going to be a movement, but a lot of it is actually increased usage. And hopefully that made the example clear on how we're driving innovation into the portfolio with that one example. So Jim, I'll give it to you to address the -- I don't know whether to phrase maintenance as ARR or NRR.

Patricia Murphy:

Very good. Thank you, Keith. Victor, let's take one last question.

David Grossman:

Thank you, and thanks for squeezing me in here. Just two really quick ones. First, how much, if any, of the revenue with Kyndryl is activity-based, which may be dependent on their own execution? And then secondly, Jim, you mentioned the ELA cycle starting up, I think early 2022. Perhaps you could share with us just how much of a headwind that it's been and which segments its impacted most. Thanks.

Arvind Krishna:

Thanks, Jim. Look -- First I'd like to thank all of you for your questions. I thought they were really getting into the details and hopefully it helped -- our answers helped you understand our business a lot better. Let me just make a couple of comments to wrap it up. I hope you took away, is that we've continued to make this progress this quarter in the key areas. Both myself and Jim highlighted them in our key areas of growth and in our value vectors as you go forward, especially looking into '23. But we'll also acknowledge that we always have more to do. Importantly, we are on the threshold of the IBM of the future and we expect to exit the year in a position that delivers on our midterm model, starting in 2022. That is the sustainable mid-single-digit revenue growth and the increasing free cash flow that fuels all the investments. With that, I look forward to speaking to all of you again.

Operator:

Thank you for participating in today's call. The conference has now ended. You may disconnect at this time.

Patricia Murphy:

Thank you. This is Patricia Murphy, and I'd like to welcome you to IBM's Second Quarter 2021 Earnings Presentation. I'm here with Arvind Krishna, IBM's Chairman and Chief Executive Officer; and Jim Kavanaugh, IBM's Senior Vice President and Chief Financial Officer. 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.

Jim Kavanaugh:

Thanks, Arvind. As always, I'll start with the financial highlights and then comment on our revenue performance, business model dynamics, and cash and liquidity position, before getting into the segments. In the second quarter, we grew revenue over 3% as reported to $18.7 billion. We expanded our operating gross profit margin and grew gross profit dollars 4%. We reported operating earnings per share of $2.33. Our adjusted free cash flow was $3.8 billion through the first half, and we generated $11 billion over the last year. And our balance sheet and liquidity position remain strong. We continued to make progress in our revenue performance, led by 7% growth in Global Business Services and 2% growth in software, both at constant currency. As Arvind mentioned, the spending environment is improving. We see this in markets where reopening is progressing, like the US and Canada, and in several countries in Western Europe. From an industry standpoint, we saw a meaningful improvement in some of the areas that had been more impacted by the pandemic like travel and transportation, automotive and industrial products. Globally, we are helping enterprises digitally transform, leveraging our platform approach. IBM's cloud revenue over the last year across software, services and infrastructure is now $27 billion, which is up at a double-digit rate. This continues to be led by Global Business Services and Cloud and Cognitive Software, whose cloud revenue this quarter was up 30% and 25% respectively. As our revenue performance improves, the fundamentals of our business model remain solid. We expanded operating margins, with gross margin up 30 basis points and pre-tax margin up 70 basis points. We have taken actions to streamline and simplify our operating model. As I've said in the past, roughly one-third of the structural actions are to improve Global Technology Services' profit profile ahead of the separation of Kyndryl. We are realizing these savings, and our GTS gross and pre-tax margins are up this quarter. The other roughly two-thirds of the targeted actions address stranded costs from the separation and create financial flexibility which we are investing for future growth. We are ramping investments in skills, innovation and in our ecosystem.

Operator:

Thank you. At this time, we'll begin the question-and-answer session of the conference. Our first question comes from Katy Huberty with Morgan Stanley. Your line is open.

Jim Kavanaugh:

Sure, Katy. Thank you very much for the question. Obviously, those two very important segments that you chose GBS and Software are two of our growth vectors within our business model. As we've said, entering the year, we guided both on revenue and on cash flow and we said that we were going to continue to invest significantly within those growth vectors as we move forward. And I see -- and I think what you see playing out here in the second quarter, is that investments starting to ramp up from the first quarter into the second quarter going forward. We are investing in front of demand because of what we said in the pre-remarks is that we see an encouraging macro and demand profile playing out and you see that with the strong acceleration in our software base of business quarter-to-quarter and in our GBS base of business. GBS, by the way, exceeded our expectations and actually got back to pre-pandemic revenue levels overall. But just to really bring it home

Operator:

Our next question will come from Wamsi Mohan with Bank of America. You may proceed.

Jim Kavanaugh:

Wamsi, thanks for the question. So just building on Katy's question upfront. We are and will continue to invest in this business as GBS is an essential part of our hybrid cloud platform-centric strategy. It is both the tip of the spear, if you want to call it, in driving the demand from an architectural point of view to our platform that then creates that flywheel effect that we talked about for every dollar that we land on the platform, we get $3 to $5 a software and $6 to $8 of services revenue. So we're going to invest significantly. Now with that said, we rebounded off of second quarter. Second quarter last year when the pandemic hit, we dropped 7 points quarter-to-quarter. We posted down 6 last year in GBS. We returned back to pre-pandemic revenue levels and exceeded growth expectations. But we're going to continue to invest in this part because of the importance GBS place at hybrid cloud platform and we'll get that profit dollar contribution and more importantly, you see it play out in our second key metric that we give guidance on and that's our adjusted free cash flow. And we feel very good about where our adjusted free cash flow is through the first half. It's up year-to-year really taken into account most of the cash tax headwind we talked about 90 days ago is pretty much behind us going forward. So our attainment wise on adjusted free cash flow, which is really going to be a reflection of both top line revenue acceleration and operating leverage and margin as we move forward.

Operator:

Our next question comes from Toni Sacconaghi with Bernstein. Your line is open.

Arvind Krishna:

Thanks, Toni. Great question. So let's just start with the first part. So we are generating -- last year, if I remember correctly, $10.8 billion of free cash flow for the year 2020. We have said $11 billion to $12 billion this year. So if you do the math between dividends, acquisitions, and capital expenditures, you get to the $3 billion to $3.5 billion. If you now say that we are going to increase our free cash flow by $0.5 billion to $1 billion in a given year and you can expect that number on inorganic activities to go up year-over-year. So the $3 billion to $3.5 billion is a fair number for this year. It would -- it could go up as we begin to increase our cash flow. We have already said, next year we expect to generate $12 billion to $13 billion, not $11 billion to $12 billion. So that gives you one sense Toni, just on the absolute number. The second question you had in there on the GBS. So as we have said and offset before 100 basis points to 150 basis points of growth from acquisitions, I would say that GBS is right in the top end of that number. If you look at the second quarter and if you look at Cognitive applications actually more product Cognitive Software, all in, because I think Cognitive applications there was a net, if any, from acquisitions, the number would be at the very, very low number, I mean, maybe a few tens of basis points, nothing significant yet. Now, the GBS acquisitions give you an immediate return and then grow at a nice number, but obviously contributing a lot less there. Think of it in the software side, the model is they come in, they do because the deferred revenue begin to give you some acquisition, but over - revenue over 12 months. But those acquisitions grow very fast. So the contribution actually goes on for multiple years not just for a single year from those acquisitions to the overall growth rate. And so that's the slight difference. GBS immediately, about 150. Software, much smaller few tens. But imagine that all of those build up over time, that it provides a pretty nice tailwind then over two years to three years.

Operator:

Our next question will come from Amit Daryanani with Evercore. Your line is open.

Arvind Krishna:

Hi Amit, thanks. So as you correctly have pointed out, I mean I wouldn't repeat you, but I obviously believe it, hybrid cloud is the reality for our clients. Now to get into the more meaty parts of your question. If you look at -- why would people prefer us for hybrid cloud? If I look at a given large hyperscaler, they'll do hybrid as in their own public cloud and maybe some on-premise means. The goal is to drive workload onto the public cloud. Who has the credibility to go across multiple public clouds, and that's why you hear me always say both Microsoft and Amazon are our partners, not only our competitors and that is an important play that IBM has done for many, many decades where we integrate across environments that our clients operate in. So that's one part. On a bit more of a technical level that was the primary reason for the Red Hat acquisition. Red Hat give us both the platform and the assets to be able to bring a hybrid cloud platform to bear, because we would all agree, I think all of your listeners and all of your audience would agree that Linux was the de facto operating system. Red Hat Linux is the de facto for on-premise and private environment, containers is the standard which people are going to move on to. So, if you see we begin really strong on-premise and private you can take that same exact environment to multiple public that gives us, we believe an advantage. Now let me acknowledge to the point you're making if hybrid cloud is the reality then everyone is going to start having a play in hybrid, but we believe that our play is advantage for the industries that we serve. That doesn't mean they will use us exclusively, but they will use us to a large extent and that is where we are headed there. The second part, now for your question, which I think actually plays right in on profitability and cash flow. The way we look at it, over two-thirds of where we get our revenue is going to lie in software. If that is the case and software comes at software margins, I'm not going to debate whether you get a difference in model from on-premise licensing to as a service-licensing, to term license model, all of those even out and pretty much on a wash over two year to three years. They are a difference in any given six months, but if I take a two year to three year view and that is what we really fixed on driving then all of that evens out and you begin to get gross margins back up in the 70s and 80s, and you begin to get the profitability and cash flow associated with that. And so that is the answer to that question. By the way the service is based on helping our clients go there. You can begin to see that, and I know that there were a couple of questions earlier on the GBS margin. Look we are very fixed on driving investments. So we drive investment, a little bit ahead, I'm not going to tell you years ahead, but maybe one or two quarters ahead of the revenue, while the revenue growth comes, we'll keep doing that and that will impact maybe percentages, but by 10s of basis points, but it shows up in absolute profit and absolute cash flow even in that part of the business.

Patricia Murphy:

Thank you, Amit. Sheila, let's take the next question.

Matt Cabral:

Yes, thank you. Within Cloud and Cognitive, I was hoping to dig a little bit more into Cloud Paks, and wondering if you could talk about just more broadly the maturity of the Cloud Paks portfolio and where you are in the integration with OpenShift. Can you just talk about where you're seeing the impact in terms of customer adoption so far? And going forward, the contribution from Cloud Paks on the financial performance of the software segment from here?

Jim Kavanaugh:

Yes, just quickly Matt, thank you very much for the question. Taking a step back, first of all, we're very pleased with our overall progression within our software portfolio. More work to do, but we're making progress. And C&DP, which I'll remind everyone on the call and our investors is about 50% of our overall software portfolio and that's where the lion's share of our Cloud Paks sit. Now when you look at our C&DP performance, when we look at it on the way we manage the business on a historical normalized basis, we see acceleration. We return back to growth in first quarter, we accelerated that growth to 4% here in the second quarter. And that is really attributed to the nice momentum we're seeing in Cloud Paks. We announced Cloud Paks 18 months ago, two years ago, given our ELA historical client base that takes time to churn through that client base. And as you know, last year was the trough of our ELA renewal cycle. We start to improve on that later in the second half and really that ELA cycle plays out in 2022, but we actually had a very nice inflection here in the second quarter. Our Cloud Paks on NRR, net revenue renewal were north of 100%. So, we've said all along Arvind and myself that there is going to be shift to Cloud Paks and there's going to be lift with Cloud Paks. And now we're starting to see a higher mix contribution of Cloud Paks and we're starting to see where we do have shift we're getting north of 100% on NRR perspective and that's an encouraging trend.

Operator:

Our next question comes from Tien-Tsin Huang with J.P. Morgan. Your line is open.

Jim Kavanaugh:

I'll take that, Arvind. Tien-Tsin, thank you very much for the question. When you look at our services base of business, we delivered $9.2 billion of signings in the quarter, it's up double digit at actual rate. We did see improvement in our backlog overall. It's really very different dynamics playing out here as we tried to say in the prepared remarks. We see very strong momentum in our GBS space of business. When you look at our signings in the quarter, we had strong performance, our trailing 12 months book-to-bill is 1.2. Through the first half, we have roughly double-digit growth in signings across all three sub-segments. Very good growth this quarter in large deals and we have continued momentum in small deals and we saw improvement in our revenue, in our backlog, and our revenue realization moving forward and that gives us comfort. As we said in the prepared remarks, we expect about a normal quarter to quarter seasonality overall. We actually see GBS accelerating growth probably out another point from the -- from the second quarter overall. In GTS, really what we're seeing is a good performance overall. Leveraging our incumbency position and driving strong renewals. We're seeing with that incumbency position finally a turnaround with an encouraging trend on client base business volumes and project-based services that they are engaging in project-based services and our incumbency accounts were up 20% here in the second quarter, but as expected the new logos. While we have a very healthy pipeline in new logos out there, the sales cycles are elongated as we said in the prepared remarks. So we see some nice acceleration continuing in GBS overall, but again with GTS, it's a focus on the fundamentals of the business profile that means margin profit and cash and I think you've seen in the second quarter, we made some very good progress overall with margins up 110 basis points, pretax margins up 190 basis points and profit dollar growth, both in gross profit dollars and a pretax profit dollars. Lastly on TPP. Yes, as we talked about many times over the last year or so. We do see the transition happening in this portfolio with regards to a shift back more and more to consumption base, annuity base, purchasing versus in 2018 and 2019 we had a much healthier macroeconomic environment, a very catch --cash-rich environment, clients then shifted to more perpetual licenses. We're seeing that come back and that's going to play as it played out where we saw the revenue upside in '18 and '19. In '20 and '21, you're going to continue to see the headwind as we've been saying. We expect that to come back in 2022 back to normal market trend growth rates overall.

Operator:

Our next question will come from David Grossman with Stifel. Your line is open.

Jim Kavanaugh:

Sure, David. Thank you very much. Cloud Paks are definitely an essential part as we've invested significantly to containerize our software and optimize it on top of OpenShift our hybrid cloud platform overall. When we take a look at our Cloud Paks, we measure and manage, Arvind and I have a dashboard that we look at all of our large enterprise top clients overall, our deployment penetration within each of those clients and we're able to see as we transition a client from a traditional middleware to a cloud-based containerized solution, not only can we track the deployment and how that progresses over time we can see the dollar of yesterday versus the dollar of today as they transition to Cloud Paks and we measure the net revenue retention. Not only how much come in whether we are able to upsell, cross-sell with multiple Cloud Paks as we move forward. And like I said in the second quarter we're making progress, much more to do, but we're making progress on the mix composition of moving more and more to Cloud Paks and we're also making progress on capturing more of our clients' wallet share dollar for that same dollar of traditional middleware overall. Hopefully, that helps David.

Patricia Murphy:

Very good. Thank you, David. You know, we're at the top of the hour, but let's take one more question, Sheila.

Keith Bachman:

Hi, many thanks team. I wanted to ask Arvind, you a question on revisiting on what your growth assumptions or targets are around Cognitive. And the particular reference point to my question this quarter you generated roughly 2% revenue growth and it was -- you had the benefit of compare particularly on some of the line items within Cognitive and so not particularly -- it's good growth, but still a ways to go to reach our longer-term target. So what happens to change that improves Cognitive and Part B the backdrop is if I think about Red Hat and we remain pretty positive on Red Hat even over the next couple of years, but you still face the uphill battle of the longer-term trends within Cognitive Db2 is probably declining market as you've talked about in the past transaction processing platforms is also a declining I think revenue stream over the arc of time. So if you could just revisit on how do you reach your longer term growth rates within Cognitive? Thank you.

Patricia Murphy:

Great. Sheila, can I turn it back to you to close out the call?

Patricia Murphy:

Thank you. This is Patricia Murphy and I’d like to welcome you to IBM’s First Quarter 2021 Earnings Presentation. I am here with Arvind Krishna, IBM’s Chairman and Chief Executive Officer; and Jim Kavanaugh, IBM’s Senior Vice President and Chief Financial Officer. We will 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.

Jim Kavanaugh:

Thanks, Arvind. I will get right into the numbers. In the first quarter, our revenue of $17.7 billion grew 1% as reported. We expanded our gross profit margin and grew gross profit dollars. We reported operating earnings per share of $1.77. Our adjusted free cash flow was up, resulting in $11.6 billion over the last year and our balance sheet and liquidity position remain strong. As Arvind said, we made progress, but more to do. You can see this progress in our revenue with an improvement in the trajectory of our constant currency results. Our revenue was up in Cloud & Cognitive Software and in Systems, and consulting returned to growth. We are capitalizing on clients’ digital transformations and journeys to cloud. We take a platform approach to hybrid cloud and AI, with capabilities in infrastructure, software and cloud services. Across these, our cloud revenue was up 18% in the quarter and over the last twelve months, and now stands at over $26 billion for the last year. The fundamentals in our business model also continued to improve. We expanded operating gross profit margin this quarter by 110 basis points. I will remind you how we manage our business. We manage our services businesses at the gross margin level, while we look to capture the value of our product-based businesses at the pre-tax margin level. We had good margin expansion across our segments on those bases. This operating leverage enables a higher level of investment. We are investing in innovation, in skills and in our ecosystem as we execute on our hybrid cloud and AI strategy. Our hiring was up year-to-year, with thousands of people hired in the quarter. We closed six acquisitions since mid-December. We are building out pre-sales garages, adding go-to-market and delivery capabilities in GBS, and technical skills in Red Hat. And we are increasing R&D in areas like AI and quantum to drive innovation. Our year-to-year expense dynamics reflect this investment, though it was offset by lower workforce rebalancing charges year-to-year and lower travel expense in the current environment. Let me round out the financial highlights with some color on our strong free cash flow and balance sheet and liquidity position. We had a good start to the year with $2.2 billion of adjusted free cash flow, and $11.6 billion over the last year. This adjusted view excludes the cash impact of over $600 million for the structural actions initiated in the fourth quarter and transaction charges associated with the separation of our managed infrastructure services business.

Operator:

Thank you. Our first question comes from Matt Cabral with Credit Suisse. Your line is open.

Arvind Krishna:

Matt, thanks for the question. Look, I think, that the spend environment overall is improving, Matt. I think I can say that, definitely compared to the fourth quarter and we talked in the fourth quarter about various pauses in buying. We didn’t really see that in the first quarter. Now that said, I do have to acknowledge there are some differences by geography and industry. When you look in the underlying results, you can see the Americas was stronger. There are pockets in Asia that depends very much by country and we can all guess which ones are doing better, which ones are doing worse. It does depend on both COVID rates and the pauses that happened then due to business circumstances. We do sense a bit of caution in Europe and you can see that in the numbers. So you can sort of expect that. You can also see that there are going to be differences by industry. Those most impacted are the obvious ones, travel, tourism and all others that then get touched by those. So that’s a color of what’s happening. However, as I have iterated before, we do see our clients accelerate their digital transformation and as they accelerate their digital transformation, our hybrid cloud thesis comes to play very strongly. Our multi-Cloud, which is multiple public Clouds, as well as private come into play. All the reasons that I mentioned around sovereignty and choice come into play and you can see that then in our Red Hat results. So then explicitly addressing your Cloud & Cognitive Software, we expect Red Hat to maintain itself in the mid to high-teens. That will show through in the Cloud and Data platform results being strong. We expect our applications, our AI applications, to remain in the single-digit software growth, and we can see that, we talked about the strong demand for security in there. I do expect to see continued declines in our TPP software, but it doesn’t really worry us. I mean, those are things where if I look at a two-year or three-year CAGR, we expect to see mid-to-high single-digit declines. But in any given period, it can be a little bit lumpy and we see that there. And so we expect this to carry on through this year. Second quarter, I would be somewhat optimistic, but we have got to go deliver it, Matt.

Operator:

Our next question will come from Katy Huberty with Morgan Stanley. You may proceed.

Arvind Krishna:

Thanks, Katy. It’s pretty clear you are a good student of what we say and publish. So let me try to unpack your question. Let me first talk about how do all these investments result in mid single-digit revenue growth. So if you look at it, we keep saying Red Hat at mid- to high-teens, leading to overall software in the mid-single digits. That will include the TPP mod decline but the overall will be mid single-digit. That could include I will call it any business as usual acquisitions. But the current market value, I don’t see acquisitions adding a significant amount to IBM’s topline. You can do the math with what we can put in. It will be well less than a point overall. We can just -- I think we can say that. Then if I look at our go to market investments, whether that’s technical resources, garages, client success managers, our segmentation, that is not yet really paying off. We see some early signals in the 200 clients doing this. I do expect that can contribute a couple of points maybe a bit more for next year. But you will see that inside our software and our GBS numbers. It’s not additive to those. We have also investing about $1 billion in our ecosystem. That will contribute to improving GBS growth rate to beyond the pre-pandemic rate. So that then takes me to GBS. We will this year come back to the pre-pandemic growth rates of $2 billion to $4 billion, but the mixture of the acquisitions and the go-to-market changes should take them higher than that by the end of the year into next year. Now, you asked also about will internal revenue contribute to this. Katy, the internal revenue is a one-time change. So we have talked about sustainable mid single-digit revenue growth not just for one year. So while it might help next year, we are not counting on that to be a contributor because it’s only once. It’s not every year. So, hopefully, Red Hat contributing together with the acquisitions of software in the mid-single digits, GBS with all the changes we are describing perhaps better than mid-single digits. Our systems if I take a two-year to three-year view kind of flattish, but in any given year it might increase or decrease but not by a whole lot. It doesn’t impact the topline a lot and that’s how sort of we get to the mid-single-digit sustainably. So you might get a one-year benefit from the -- from internal going to external, but not permanent. That’s why I don’t really count on that. Hopefully that gives you an answer to your different parts of the question.

Patricia Murphy:

Thanks, Katy. Sheila, can we please go to next question.

Toni Sacconaghi:

Yes. Thank you for taking my question. I guess this is a clarification or maybe two clarifications. I am wondering if you can just comment. I think you said that you think consensus revenue estimates for Q2 are reasonable. They are up about $500 million sequentially from Q1. If I look back at normal seasonality, typically revenues up about $1 billion and it sounds like IT spend is improving. So if anything one would expect better than normal seasonality. So I am wondering whether you are being conservative or there were some one-time things that happened in Q1, but why wouldn’t you underwrite normal or better than normal seasonality, which I have as about a $1 billion sequential increase in revenues? And then separately, Arvind, could you just clarify, when you talk about IBM as an AI company, what role does Watson play in that? I don’t think that name was really mentioned on the call. There’s speculation about Watson Health. Maybe you can give us an update on how Watson fits into IBM as an AI company and specifically what’s happening with Watson Health and Watson Financial? Thank you.

Arvind Krishna:

Thanks. So, Toni, Watson remains critically important to us. To be absolutely clear, Watson is the brand product name for our AI capabilities. You will see it in the market as Watson Conversational Agent, but you will also see it as, for example, our security products with Watson. It is embedded inside our Cloud Pak for data and called out as Watson. Let me give you a quick example of where we are seeing a huge amount of success. So let me take one of the large entities doing vaccine administration in the United States. When they were -- when they realized in December they could do this, they slowly began to realize that they could get tens of millions of calls every quarter and then how would they handle them? Staff of tens of thousands of people or perhaps deploy Watson. And so far at one of these places and we are deploying a lot more than one, 5 million calls handled in the quarter with over 70% handled by Watson. You now think about extrapolating this over the year. So that would make it 20 million in four quarters and with the confidence building up on one program you could imagine it going to others. This is a lot more straightforward to do and where I think AI excels in handling issues in both improving client satisfaction, because you get an instantaneous answer, but also in taking cost out and those are rare in our industry where you get both together. We see lots and lots of opportunities here. We also see a lot of Watson being embedded on how to automate data cleansing, on how to do AI operations, on dramatically improving the resilience of people’s IT infrastructure. So, Toni, to net it out, Watson remains really important. AI is in the early parts of its journey. Not us, consultants have estimated $16 trillion of global productivity over the decade. We are maybe 5% of our way into that journey. Watson will be the tool that unlocks that for our clients albeit in areas like IT, in data, in conversation, in call handling and in all these areas where we excel and we have a large footprint with our clients.

Operator:

Our next question comes from Wamsi Mohan with Bank of America. Your line is open.

Arvind Krishna:

Thanks, Wamsi. Look, go-to-market changes, Wamsi, always have I will call it a bit of a hystericist loop. It takes time to take impact. We rolled them out in the beginning of January, but then you have to -- there’s a human part to this. You have to assign people to accounts. There is some level of learning, there’s some level of changes and all of that just takes months to flow through. I wish I could do it quicker, but I have got to acknowledge it takes months. That’s why you hear me say it will take time for us to see the benefit. Where will we see the benefit? We would expect to see improved productivity for our sales teams that cover our large accounts. That will result in better software growth and in better GBS growth. I do expect to see that in the second half. I expect to see even more of it going into 2022. As we are also investing in what we are calling our ecosystem, to be clear, that is investments whether it’s in Schlumberger or Siemens or Palantir, just to name some from this last quarter. But before that, relationships we had with Box and Slack and Adobe and Salesforce and SAP. You expect to see all of those play out in the improved growth both in software and in GBS. So you kind of sort of unpack those and you see that. Now, when I talk about why would I see more productivity in our top accounts? Well, the 200 garage engagements that I mentioned, you expect that all of those will build pipeline, oftentimes we might never have had in the past. So that is why you begin to see improved yield in the top accounts. So I expect to see some definite, we will see it in our numbers in the second half and then more going into next year. For the second part of the question, I will hand it to Jim to talk a little bit about signings.

Patricia Murphy:

Thanks, Wamsi. Let’s go to the next question, please.

Amit Daryanani:

Good afternoon. Thanks for taking my question. I guess I was hoping if you could touch a little bit more on the GBS performance. We saw a nice improvement I think from what we saw in the December quarter, it was down, but a nice 400 basis points improvement nonetheless. And consulting I think it was notable that we started to see growth over there. So I was hoping you could just help us understand, if you should think about consulting growth as a leading indicator to what GBS can do and would we expect this to be positive growth for GBS in calendar 2021? And then also have you clarify this for me, as you go through the process of splitting of these long-term contracts between IBM and NewCo, why would customers agree to do this without rebidding the contract or getting a price concession from either IBM or NewCo?

Patricia Murphy:

Thanks, Amit. Let’s go to the next question, please.

Tien-Tsin Huang:

Hey. Thank you so much. Thanks, Pat. Just maybe a stupid question, clarification. Just the strength in System Z at this point in the cycle, what -- can you maybe go through that a little again? What’s changed -- what’s different, is it a different buying or selling motion, just trying to understand that a little bit better? And then just on the ecosystem strategy, Arvind, opening new areas of growth, is there a pipeline for more deals like a Palantir and others? I am just curious where the effort is there today and how close you are to adding more partners there or if that’s more of a mid-term expectation for us to manage or watch for?

Arvind Krishna:

Yeah. On your second part of your question, Tian-Tsin, on ecosystem, yes, we have a long pipeline. I expect this number to go into the high 10s, maybe not 100, but definitely into very many more. Let me caution, though, when you say mid-term, it’s not multiple years. Each of these takes about six months to become real and then another few months to become into real revenue. So I would not expect that new ones we announce now will have an impact much before the end of the year. However, they will have big impact at the very end of this year and into next year. So I will sort of position it like that. But expect that we should be announcing these at a regular cadence.

Operator:

Our next question comes from David Grossman with Stifel. Your line is open.

Jim Kavanaugh:

So, David, this is Jim. Thank you for your question. Let me -- I am not going to talk to other competitors, but I would go check some of those about how much share buybacks they are all doing overall. But with that said, I am only going to talk about IBM. And we feel very confident in our capital allocation process and our disciplined financial management system overall. Let me remind you 90 days ago how we entered the year. We entered the year I think I talked about the sources and uses of our cash. We think entering the year we had $14 -- over $14 billion of cash on the balance sheet. We said we were going to generate adjusted free cash flow of $11 billion to $12 billion in the year and that we were going to continue to optimize our IGF portfolio and set of offerings to be a captive aligned to our hybrid cloud and AI strategy, and that would give us another $3 billion to $5 billion. So we had from a source perspective about $30 billion overall. When you take that against the uses in the year, we talked about a $3 billion charge for the structural actions in 2021 and our one-time charges for the separation that goes against that $30 billion. We talked about $8 billion of debt maturities against that and we talked about our dividend being $6 billion overall. So that comes up to be about, what, $16 billion, $17 billion. So we think from a cash source and use perspective, that we have got flexibility to continue to invest and compete in the market both organically and inorganically, while delevering to support a very strong balance sheet overall with a single A rating and also deliver given our investor base, deliver a secure and modestly growing dividend overall. And what you have seen in the first quarter I think only strengthens that position. We still ended the quarter with over $11 billion of cash on the balance sheet. And I will remind you that, we took into account $5 billion of debt maturity, $1.5 billion of dividend in the quarter, roughly $600 million under one-time charges and another $1 billion plus in acquisitions and still ended with $11 billion overall. So we feel very confident and we will capitalize whether there’s any inorganic opportunities and you have seen, what, 11 acquisitions since Arvind has taken over. And we will continue to capitalize where it makes the right client value and the right IBM value at the right economic equation going forward. But we are not constrained by sources and uses of cash.

Operator:

Thank you. Our last question will come from Keith Bachman with Bank of Montreal. Your line is open.

Jim Kavanaugh:

Thanks, Keith, for the question overall. So let me handle the free cash flow and then Arvind can talk about GBS. As we said 90 days ago, which we reiterated here tonight on the call, we feel confident in the forward-looking guidance of $11 billion to $12 billion of adjusted free cash flow in ‘21. And if you remember 90 days ago, to give the investor a perspective of the sustainability just given the $3 billion worth of charges we would will have from the structural actions in the fourth quarter and the upcoming spin separation charges, we gave a perspective of 2022 that that would accelerate to $12 billion to $13 billion of adjusted free cash flow. When you look at the underpinnings of both ‘21 and then 2022, I think you start seeing the fundamentals of our business model. And that is returning back to revenue growth, the operating leverage that this business can generate with some level of sustainable level of revenue growth, the underlying mix contribution of that and the continued productivity that this business drives. You will see profit growth and also I remind you Red Hat, which we achieved be it free cash flow accretive in the first year will continue to drive improvements. Now, we have been making great progress on working capital efficiency and I would tell you our collections rate. We didn’t talk about it, although in the prepared remarks. I talked about our record deferred income given the strength of our software renewal position overall. All of those will continue to generate improvements going forward. But that is going to be needed in 2021 because we got about $1 billion cash tax headwind with all of that in front of us. With I would say, probably, 60% to 70% will hit in the second quarter. So once we get through that cash tax headwind here, we feel pretty comfortable and confident in that cash generation machine, leveraging sustainable revenue growth and operating leverage in the business on our way to $12 billion to $13 billion next year.

Arvind Krishna:

So, Keith, thanks, but since we are well past the hour, let me just make a couple of comments to wrap up the call. We had a good start to the year. We expect to continue our progress over the course of the year as we execute our strategy and realize benefits from the investments and actions we are taking. We will exit 2021 in a stronger position than we started the year and I look forward to continuing this dialogue with you.

Operator:

Thank you. Thank you for participating on today’s call. The conference has now ended. You may disconnect at this time.

Patricia Murphy:

Thank you. This is Patricia Murphy, and I’d like to welcome you to IBM’s Fourth Quarter 2020 Earnings Presentation. I’m here with Arvind Krishna, IBM’s Chairman and Chief Executive Officer; and Jim Kavanaugh, IBM’s Senior Vice President and Chief Financial Officer. 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.

Jim Kavanaugh:

Thanks Arvind. I’ll go through our performance and then wrap up with a perspective of how the actions we’ve taken in 2020 position us to deliver on these financial objectives. In the fourth quarter, we delivered $20.4 billion of revenue. We expanded our gross profit margin. With a significant charge for structural actions that improve our go-forward position, we reported operating earnings per share of $2.07. We generated free cash flow of $10.8 billion for the year. And we have strong liquidity with a cash position of over $14 billion. The fourth quarter is our seasonally largest transactional quarter, and I’ll remind you that a year ago we had a very strong software performance and our first full quarter of z15 availability. We knew that given our product cycle dynamics and the pressure from the current environment that the fourth quarter of 2020 would be our most challenging, in terms of year-to-year revenue performance. Ninety days ago, we expected revenue and operating earnings per share to be in line with historical third to fourth quarter seasonality. In 2020, our fourth quarter revenue came in slightly below our typical seasonality, while EPS was at the higher end of the historical range, before the charge for structural actions. And we had a good finish to the year in free cash flow. The challenging environment we’ve seen since March continued, with a shift in clients’ buying behaviors and priorities. Given the level of macroeconomic uncertainty, more clients tended to move toward shorter duration engagements, impacting our software revenue. But we did have a good IBM Z performance relative to where we are at in the product cycle. We also continue to see good demand in offerings that support our clients’ digital transformations, and we’re driving strong adoption of our hybrid cloud platform. Arvind mentioned we now have 2,800 clients using our hybrid cloud platform. For perspective, that’s more than a thousand new enterprise clients since we acquired Red Hat. Red Hat continued its strong performance with normalized revenue growth of 17%. That’s slightly higher than the third quarter rate, driven by subscription growth. Strong subscription bookings contributed to over 20% backlog growth, and the Red Hat backlog is over $5 billion for the first time. Global Business Services continues to drive adoption of OpenShift and IBM Cloud Paks, and over the course of 2020 we accelerated the number of GBS engagements using Red Hat technology, with 260 engagements for the year. We’ve discussed the economics of a platform model, with the software and services revenue multiple anywhere from 3x to 8x the platform revenue. Our full stack cloud capabilities, from infrastructure up through our cloud services, generated over $25 billion of cloud revenue in 2020, which is up 20% over the prior year. IBM is a high value business – generating ample profit and free cash flow to invest for future growth and support our dividend policy. We again expanded our operating gross profit margin, up 70 basis points in the fourth quarter and 130 basis points for the year, with expansion across software, services and systems. This operating leverage at the gross margin level enables higher investment in innovation, in skills and in ecosystem. Our fourth quarter pre-tax profit also reflects a charge of over $2 billion for structural actions to simplify and optimize our operating model, and reinvest the savings to accelerate growth. This charge is $260 million, or about $0.25 of EPS less than what we discussed back in October, driven by a few countries, primarily in Europe, with government restrictions on certain employment actions in the current environment. This charge did not have much impact on our fourth quarter cash flow, and we generated over $6 billion of free cash flow in the quarter, and $10.8 billion for the year. Our free cash flow performance in 2020 was driven by working capital improvements and contribution from Red Hat, net of related interest. This was offset by increases in net capital expenditures to scale our cloud infrastructure, and workforce rebalancing payments from previous actions. We continued to have high free cash flow realization, which was well above 100% as expected. We ended the year with a cash balance of $14.3 billion, which is up over $5 billion while our debt was down $1.4 billion, with $4.5 billion of debt maturities in the fourth quarter. Now, let me turn to the segments, starting with Cloud and Cognitive Software. Revenue was down 7% in the quarter, and gross margin was up 20 basis points. This year has proven to be a challenging transactional environment, especially in the fourth quarter, which is our largest transactional base. As I said, we had particularly strong software performance a year ago, when revenue was up 10%. The fourth quarter of 2019 was the peak of our Enterprise License Agreement or ELA cycle, which renew about every three years, on average. With the uncertainty our clients are facing in the current environment, we’re seeing many of them opt for shorter duration ELAs. This dynamic, in combination with the large seasonal volume of ELAs in the fourth quarter, pressured the fourth quarter’s software revenue performance. At the same time, our renewal rates for subscription and support improved this quarter, in fact it was the strongest year-to-year increase in some time. This is evidence of our clients extending their commitment to our software solutions. In this environment, our hybrid cloud and AI solutions like Red Hat and Cloud Paks are resonating with clients. In Cloud and Data Platforms, revenue was up 6%. Red Hat delivered double-digit growth in both Infrastructure and App Development and emerging technologies. We continue to gain share in both product areas, instantiating the importance of our hybrid cloud platform and the Linux foundation to our clients. Earlier this month, Red Hat announced plans to acquire StackRox, a leader and innovator in container and Kubernetes-Native Security This further enhances Red Hat OpenShift, the industry’s leading enterprise hybrid cloud platform. Within cloud and data platforms, we’re also building out our integration offerings, bringing AI-powered automation across the portfolio through key partnerships and new innovation. During the quarter, we acquired Instana, an application performance monitoring and observability company. We also expanded our partnership with ServiceNow to develop a joint solution around Watson AIOps, an IBM solution which helps enterprises to self-detect, diagnose and respond to IT anomalies in real time. And we continue to enhance the Cloud Pak for automation, which grew at a strong double-digit rate this quarter. Our Cognitive Applications revenue was down less than 2%. We had growth in security, fueled by our modernized Cloud Pak for Security and services. This was offset by a weaker performance in solutions concentrated in industries more impacted by the current environment, like Tririga, which is focused on commercial real estate. As expected, our software performance was most impacted by Transaction Processing Platforms. Clients’ prioritization of OpEx over CapEx was amplified this quarter. With our strong seasonal mix toward transactional revenue and the ELA dynamics I just described. In Cloud and Cognitive Software, we remain focused on our hybrid cloud and AI strategy and will continue to invest in our portfolio as we head into 2021. In Global Business Services, revenue declined 5%, which was about a point sequential improvement from the third quarter. And we had gross margin expansion of 260 basis points. Our book-to-bill in the quarter was strong, contributing to backlog growth for GBS. While there remains some market uncertainty, clients are looking to accelerate their digital reinventions by leveraging business transformation services built on hybrid cloud. Our offerings are aligned to this high-value opportunity with a clear focus on reimagining workflows using AI and modernizing the underlying application infrastructures through hybrid cloud. We see this in our GBS results. First, our GBS cloud revenue grew at a double-digit rate for the quarter and the year. And is now almost $6 billion annually. Second, our Global Process Services’ revenue returned to growth, as we deliver efficiency and flexibility to our clients’ processes by infusing innovative technology and redesigning workflows. And third, our consulting signings grew 8%, driven by advisory work for application modernization, and enabled by our unique and experiential Garage Methodology. In Application Management, our performance reflects a continued shift from traditional on-prem services to building and managing cloud applications. Our incumbency in Application Management creates the opportunity and trust to be the partner of choice for their digital journey. This GBS incumbency plays an important role in driving adoption of Red Hat’s hybrid cloud platform. As I mentioned earlier, our GBS Red Hat engagements accelerated through the year. We had 75 engagements in the fourth quarter, with clients including BMW, Humana, Samsung Electronics, Ikea and Costco. And, similar to last quarter, approximately one-third of our quarterly Cloud Pak revenue resulted from GBS engagements. To continue this momentum, we are investing in ecosystems, resources, offerings and skills. Arvind mentioned we have announced five GBS acquisitions in the last few months. Nordcloud and Taos provide cloud native development, multi-cloud migration, and platform engineering solutions that advance our clients’ cloud journeys. And, 7Summits, a leading Salesforce partner, Truqua, a leading SAP partner, and Expertus, a leading digital payments solutions provider, are collectively at the center of our clients’ digital transformations. Finally, the investments we have made in our delivery capabilities, such as our innovative dynamic delivery model, have resulted in improved delivery quality, which are reflected in our net promoter scores and our gross margin expansion. Turning to Systems, revenue was down 19%, driven by product cycle dynamics, while our gross margin expanded 380 basis points. We saw the product cycle dynamics play out in IBM Z, Power and Storage. Power revenue was down at a level consistent with last quarter, and Storage revenue was also down, driven by high-end storage tied to the IBM Z cycle. IBM Z revenue was down 24% as we’ve wrapped on the strong growth in the fourth quarter last year, when we were up 63%. 90 days ago, I mentioned that clients in sectors like banking and financial markets made purchases early in the cycle to manage through robust market volatility, while those in select other industries focused on cash preservation, elongating z15 adoption. We’ve made up ground in the quarter, and improved adoption in some of the lagging industries. IBM Z delivered growth for the year despite a second half wrap on the product cycle and within a challenging environment. This reflects the importance of this high-value, secure and scalable platform with cloud native development capabilities. Based on this performance, we expect z15 to be fairly consistent with prior cycles. And, looking back over a longer period of time, our installed base of MIPS is over 3.5 times the level of a decade ago, with 60% of our install base now in new workload areas like Linux. The Systems portfolio continues to deliver critical and lasting value to our enterprise client base, in support of our hybrid cloud strategy. Turning to GTS, while revenue was down 8%, we expanded gross margin by 70 basis points. We had strong contract renewals and added a number of new clients. As Arvind mentioned, at the beginning of October we announced the spinoff of our Managed Infrastructure Services business into a separate public company, which we’re referring to as NewCo for now. We are making good progress on that work and remain on track to complete by the end of the year. As we discussed in October, this process is complex and includes working with clients to ensure a smooth transition to NewCo as the world’s leading infrastructure services provider, optimizing the business model to improve its financial profile and executing upon the necessary financial, legal and regulatory milestones to enable the transaction. I’ll give you some additional color on each of these three areas. First, from a client perspective, we are deeply engaged with our clients that make up the $62 billion of backlog, and they are strongly supportive. We are seeing client confidence in NewCo’s long-term value proposition to manage and modernize mission-critical infrastructures. This quarter we had wins at clients such as the Dutch Ministry of Defense, Fung Group, and Bankinter. In the fourth quarter, we signed 11 new logo deals, which is more than double the prior year, and one of the highest in the last couple of years. Our renewal rates of existing contracts this quarter were also at the higher end of our historical performance. However, while we had a strong pipeline as we entered the quarter, with the announcement, as expected some negotiations were extended, resulting in some deals moving out of the quarter. Secondly, we are optimizing the NewCo business to have a leaner and more efficient operating model. We continue to take a disciplined approach to improving our margins and overall financial profile. As part of this, a considerable portion of the $2 billion charge for structural actions was for GTS. We also have taken steps to restructure existing contracts and further reduce activity in lower value offerings. These actions impacted our revenue performance this quarter, but contributed to the gross margin expansion of 70 basis points. All of this positions NewCo for an improved margin, profit, and cash generation profile. Lastly, NewCo has an unparalleled operational footprint; it has approximately 90,000 employees and operates in roughly 115 countries. And, as you know, Managed Infrastructure Services is an integrated business, not only within IBM but within GTS. We are executing on our detailed plan to achieve the milestones to create a standalone company. Today, we are working with Works Councils on employment terms, establishing NewCo's legal entities across the world, drafting the agreements which outline the on-going relationship between IBM and NewCo, and developing audited financials. We expect the Form 10 to be available in the fall, at which time we will conduct investor outreach. We’ll continue to update our progress as we move through the year. This is a good place to pause, and turn it over to Martin Schroeter, NewCo's new CEO.

Jim Kavanaugh:

Thanks Martin. Now, before the Q&A, I want to bring it back up to the IBM level with a summary of the actions we are taking, and the resulting expectations for 2021. These actions span our portfolio, our operating model and our capital structure. After building a foundation in hybrid cloud, and accelerating Red Hat platform adoption, we are now separating Managed Infrastructure Services to better align to our platform strategy and improve the financial profile of both businesses. At the same time, we are increasing investments

Operator:

Thank you. At this time, we’ll begin the question-and-answer session of the conference. Our first question comes from Wamsi Mohan from Bank of America. Your line is open.

Arvind Krishna:

Hi, Wamsi. Thanks for the question. Look, we expect to see improving software performance through the year, both in 2021 and headed into 2022. As Jim said in the prepared remarks, a lot of the shortfall in software came from the TPP segment. And in that segment, as you know, we tend to have very large deals that tend to come in the fourth quarter. So it was somewhat unique in 2020, and that is not something we expect to see at the same scale going forward. So the headwinds in some sense were reduced because of the reduction in that aspect. Then on the positive side, we expect to see continued Red Hat growth. We expect to see continued growth from our Cloud Paks. We expect to see continued growth as the salesforce changes we have made drive a much greater focus across IBM on this part of the portfolio, both in cloud and data platform and on the AI applications. We also expect to see, as Jim mentioned, that as the security and the IoT assets within the applications become larger and larger with the growth there, they will more than compensate for some of the other pieces that may not be so big, because just the law of compounding is going to get us there. And lastly, remember, other than all the organic actions, we are also doing inorganic actions. You saw us announced both Instana and StackRox in the last couple of months. And these and other future acquisitions would also drive growth because they help the entire portfolio, not just acquired pieces. Jim?

Patricia Murphy:

Okay. Thank you, Wamsi. Can we go to the next question, please?

Amit Daryanani:

Thanks for taking my question, and nice to hear your voice, Martin. I guess, the question really is on the GTS side and the spin of NewCo. The revenue trajectory on GTS, the drop was sort of notable, I think, it went down to 8% decline versus the 4%, 5% trend line for the last few quarters. I’d love to understand from Arvind or Martin, what are you hearing from your customers? I mean, do you see this as a reflection that they're perhaps pausing their decision until the spin is done or perhaps in picking up calls from your competition as this is going on? I'd just love to understand what's driving that dynamic there? And then, Jim, if you could remind me, when does the Form 10 get publicly disseminated, that'd be great?

Amit Daryanani:

So with that, let me give it to Jim, both to sort of add a little bit more color on the financials there and to just to repeat what he said about the Form 10?

Patricia Murphy:

Thank you, Arvind. Let's go to the next question, please Ivey.

Toni Sacconaghi:

Yes, thank you. If I just kind of stand back from the results this quarter, typically your revenues are up $3.4 billion from Q3 to Q4. That's the average of your last three years and there's very little movement off of that average. This year was $2.8 billion. So at least in my eyes, it looks significantly worse. And I understand there were some issues around transaction processing, I understand year-over-year comps, but this is a sequential change, which seems to be notably below trend and I hear your assurances around the current spending environment. I guess the question is, and the elephant in the room is how do you know that there isn't something more sinister afoot here that there is an accelerated migration to the cloud that you are not, IBM is not participating in? Or your – particularly some of your software offerings in cloud and cognitive are not as competitive as you might think and that's ultimately what's being reflected here. And I guess to that end as well, maybe Arvind, you can directly address why the confidence in mid single digit growth in 2022? It sounds like at constant currency, IBM is going to be flattish or maybe slightly down in 2021. So what drives the 500 basis point improvement, which on a huge company like IBM is really, really notable? How much of that do you expect to be in organic? Thank you.

Arvind Krishna:

Thanks, Jim. And Toni, I'll address some of the software pieces, but you asked the question about the mid single digit growth in 2022. So Toni, let me try and just deconstruct it a little bit. Red Hat continues to have very strong performance, mid to maybe high teens growth and as it gets bigger and bigger that's a bigger contributor to the total. Second GBS is going to return to pre-pandemic levels by mid-year and we actually expect it to accelerate from there, so into 2022 we'll see better growth from there. In systems, as you know, we are not going to see the product cycle dynamics as headwinds but as tailwinds going into 2022, albeit the absolute numbers are not as you see that big, our ecosystem investments that we're making. They benefit both GBS and software. And by ecosystem, I mean, both small and big partners that we work with were pulling both services and software. So when we see, for example, Salesforce or Adobe or ServiceNow, or Workday, they all tend to pull a lot of our services work. We also partner by the way with the other hyperscaling clouds, both Microsoft and Amazon, and that tends to pull a lot of GBS work. On the other side, we are also partnering with a lot of smaller software vendors and they tend to pull a lot of our software along with it. So that is there. Now you asked about the inorganic and organic. I'll call it the business as usual in organic is included in my mid single digit assessment. So by business as usual, it's just what we do. You've seen us do this for the last three quarters now, the deals like that would be included and that, for example, we did Instana and StackRox and software. Now, we did five others in services. They're not very large, but they do tend to pull the overall business. That is what gives me confidence that as we get through all of this, we got a one, two, three growth vectors, and one kind of flat vector going into 2022. And that is what gives us confidence about the overall growth going there.

Operator:

Our next question comes from Katy Huberty with Morgan Stanley. Your line is open.

Arvind Krishna:

Yes. So Katy, while I start on why we gave the guidance on revenue and on free cash flow and then I think Jim will get into the details on your other parts of the question. Look I've been sort of clear. I want to measure the company on revenue growth. Revenue growth is the most important metric that I'm focused on. And so, we talked about the revenue growth both for this year and for next year, which is unusual for us. The second part in order to get revenue growth, we need to be able to do investments. Investments are driven by free cash flow. And on free cash flow, it's a very clean number. So you can see what that is as we have talked about that with complete transparency both on what it is going to be and why it will grow also from 2021 to 2022. That's also what we're going to measure our people on internally and that will let then our investors know what we're measuring on. So that's why those are the two numbers that we are focused on driving, that's the numbers we're focused then on giving you, so you can hold us accountable to those. Jim?

Patricia Murphy:

Okay. Thank you, Katy. Ivey could you please take the next question?

Matt Cabral:

Yes, thank you. I want to build on those last comments around GBS and just dig a little bit more. It looks like apps management was still the major drag, despite a little bit of an easier compare versus the third quarter. Just wondering if you could unpack what's going on underneath there? And going forward, just how would you think about the potential of some pull through from Red Hat related work, is it like a re-platform and modernize some legacy on-prem apps? And just bigger picture the path back to growth for apps management and what that looks like from here.

Patricia Murphy:

Thank you, Matt. Can we please take the next question?

Tien-tsin Huang:

Thanks. Thanks for extending the call for us here. I think Katy asked about EPS. I'm not sure if I heard in your answer, any call-outs on EPS cadence first half versus second half beyond the $260 million in charges and enormous seasonality? I know you are not giving formal guidance, but I thought I'd ask anyway. But on the revenue side, just thinking about, I know you've said a lot again on revenue, but if you're looking at revenue growth for fiscal 2021, I know you talked about revenue growth in fiscal 2020, but of course COVID hit and the world changed. So how has your outlook this year for growth different from this time last year in terms of your conviction? I heard some of the drivers were just really here asking about conviction and visibility.

Jim Kavanaugh:

Yes, I would just add to that Tien-tsin. Thank you for the question. Again, as Aravind talked, this is a mindset change on how we want to operate the company. We've defined the strategy all in focused, aligned our portfolio, aligned our operating model. Now it's about growth and it's about driving that operating free cash flow, which is going to fuel that investment. So around that, we talked about that trajectory overall. First of all, I should have mentioned – I mean as you can see in the supplemental chart, although we said revenue growth at current spot rates, you see that that's predominantly a first half discussion. It's about three to four points of tailwind in the first half and that dissipates quickly in the second half overall, which is why the fundamentals of the underlying business by segment will have to improve. And we expected them to improve as we move through the year. The other thing I will tell you underpinning, it's a fair question. As I stated, I think we've built the credibility over the last few years that we know how to drive operating leverage within this business. So you can expect, we grew our gross margins this year, I think about 130 basis points, 70 basis points in the fourth quarter, you can expect that we're going to continue to drive operating leverage in this business, and we'll have margin expansion in 2021. And second, the other variable that you always ask me and we talk about, and we try to be very transparent underneath it is our tax rate. And while we operate in 100 plus countries around the world, the geographic product mix can impact that dramatically tax structures, audits, et cetera, can change it. From our perspective, we finished fourth quarter at what I think 10.4% from an operating tax rate, pretty consistent by the way of third quarter and pretty consistent last year. And just given what I said earlier, one on the booked tax rate, we're going to have a headwind on cash taxes. I would expect our tax rates to go up a few points from that 10.4%. So it gives you a little bit more color underneath the revenue profile, the operating leverage and tax. And again, we're just trying to change your mindset here.

Operator:

Our next question comes from David Grossman from Stifel, Nicolaus. Your line is open.

Arvind Krishna:

Hi, David. Look this is something I'm deeply, deeply passionate about. So I'm happy to talk about this. Look every model has its time and then it's time to evolve. We are evolving in reaction to client needs, and we’d sort of operate it which I would call it a more homogeneous model that kind of went across all our segments, all our clients for a long time. So what are we doing? There is a set of clients who do tend to buy I'll call it a lot of IBM. Let's call them they need the integrated value of IBM. We’re calling that the first segment. So in this first segment, we are also going to make extra investments and then being able to experience IBM technically, so we are using the term garages. We'd have people who go in there and work side-by-side with the client, while virtually right now. As well as being able to have a lot of focus on deployment and we'll pay the people on deployment, not on selling. So this first segment is going to have that attention with extra testing. So they should see a lot of positive. And we expect to see growth coming out of our garages and our deployment managers. Then there is a segment which is largely going to be channel ready. So there we do get, as Jim talked about operational leverage, we don't need the other people. The channel is quite capable, but rather put more money into the channel and work with them to go after that. That's the other end of the spectrum. Then there is a set of clients, let's call it between these two spectrums. They tend to buy mostly from one or two parts of IBM. So they deeply value the specialists, but they don't need the generalists who were covering them. So we are going to take that money and as I said pour it into more specialists who can then cover those clients. So there is a first segment which does have a integrated value. There is a, the top half of the second segment which is going to be much more specialists, you can think of them as being technology-led sales by and large. And then there is going to be a large part, which is ecosystem-led, where the system integrators, resellers, distributors, et cetera. We believe that this simplicity is going to drive a lot more outcome for us and for our clients. And by the way, we are also going to ensure that this is the structure that all parts of IBM have. So it's not that different parts of IBM, but how slightly different clients segmentations. It's completely consistent across all. This we believe unlocks a few points of revenue growth. So you said impactful, I expect that this will unlock a few points of revenue growth albeit let me acknowledge that it probably takes six months to flow through the system.

Patricia Murphy:

So we've gone pretty long here. Why don't we just – Arvind, do you want to make just a quick comment to wrap it up?

Patricia Murphy:

Ivey, I’m going to turn it back to you to close out the call, please.