International Business Machines Corp at Goldman Sachs Communacopia & Technology Conference Transcript

The following is excerpted from the question-and-answer section of the transcript.

Question: Jim Schneider - Goldman Sachs & Company, Inc. - Analyst : Likewise. Maybe start out strategic macro side of things, global economy still has a lot of uncertainties to it. We assured from our chief economist this morning we've got inflationary pressures, unevenness in key markets. How is IBM adapting to these kinds of shifts? How are you changing your operating model to kind of deliver resilient financial results in this challenging environment? James Kavanaugh - International Business Machines Corp - Chief Financial Officer, Senior Vice President - Finance and Operations Yes, it's a great place to start overall, and hence did a great job this morning talking about it from a Goldman perspective. I would tell you, today's macroeconomic environment can be defined by one word dynamic. When you take a look at it, enterprises are focused around a slew of challenges with regards to interest rate volatility, inflation, demographic shifts, supply chain dislocations, geopolitical uncertainty overall. And clients are looking at technology as a source of competitive advantage. That's why technology always outgrows GDP as an enabler of global business and economic growth overall. But Jim, as you know me quite well, I spent a lot of time talking to many of my peers across the industry. And when you look at it, how do they view technology. They view technology as a source of competitive advantage. In areas around one, it allows them to scale their businesses. Two, it drives efficiency and productivity that enables financial investment capability for them to go compete. And three, more importantly, right now with Gen AI, which I'm sure we'll talk about, is it's a way for them to evaluate new market opportunities, new businesses and new sources of revenue overall. And you talked about IBM. Within IBM as CFO, I have the honor of running all of the operations for the company, too. So in this macroeconomic uncertain environment, around disruption. As a CFO, you've always got to be prepared for multiple scenarios. And we've done a lot of work around IBM, to your point, repositioning our business to form better stability in revenue, profit, and cash. What'd I mean by that? Geographic diversity. We operate in 175 countries around the world. I would say that's a pretty good natural hedge because not all markets operate the same. Industry diversification, 17 different industries we serve, client set. We're actually all enterprise focused. We serve 95% of the Fortune 1000. And our business mix profile, which is high-value recurring revenue that drives that stability in revenue, profit, and cash. REFINITIV STREETEVENTS | www.refinitiv.com | Contact Us consent of Refinitiv. 'Refinitiv' and the Refinitiv logo are registered trademarks of Refinitiv and its affiliated companies. SEPTEMBER 09, 2024 / 6:30PM, IBM.N - International Business Machines Corp at Goldman Sachs Communacopia & Technology Conference So when you take a look at it, that underpins how we've kind of guided 2024. We expected a very dynamic environment. We're seeing that play out. But we're very confident about the macroeconomic environment for technology. albeit we acknowledge short-term dislocations and uncertainty. But our guidance this year, we see revenue accelerating mid-single digit. We see continued operating leverage increases, and we just raised our full year free cash flow guidance to above $12 billion. So we feel pretty good about our ability to compete in this market.

Question: Jim Schneider - Goldman Sachs & Company, Inc. - Analyst : And then I guess IBM obviously has a very long historic history or recently over the past several years, your CEO, Arvind Krishna, when he took over, made some pretty big strategic changes large M&A in software, some divestitures in the services part of the portfolio, you've been integral to all that. How do you plan to sort of differentiate yourself over the next several years in this changing landscape? And how would you position in terms of what inning we are in, in terms of the changes at a strategic level that could drive more transformations for IBM over the next three to five years? James Kavanaugh - International Business Machines Corp - Chief Financial Officer, Senior Vice President - Finance and Operations Yes. Well, thanks for the question overall. There's been a lot of hard work by 280,000 IBMers around the world. But under Arvind's leadership, we are a fundamentally different company today than where we were four, five years ago. When you think about it, Arvind has brought this company a strategic focus around what we believe arguably is the two most transformative technology shifts, that being hybrid cloud and AI, and we repositioned and built a platform-centric business model that's going to capitalize on those two technology transformational SIPs around 75% of our business, now growth vectors, software and services that have integrated capability around our infrastructure portfolio. And third, we built a very attractive economic multiplier effect on those platforms. the platforms being the Red Hat acquisition around Red Hat OpenShift as our leading industry hybrid cloud platform and now around our Gen AI platform with RHEL AI, OpenShift AI and our enterprise AI middleware, Watson X. But that platform economic model is very attractive in that every dollar we land on a platform, we get $3 to $5 of software and $6 to $8 of services. So really a lot of strategic focus, a lot of work on portfolio and now capitalizing on that attractive economic multiple. REFINITIV STREETEVENTS | www.refinitiv.com | Contact Us consent of Refinitiv. 'Refinitiv' and the Refinitiv logo are registered trademarks of Refinitiv and its affiliated companies. SEPTEMBER 09, 2024 / 6:30PM, IBM.N - International Business Machines Corp at Goldman Sachs Communacopia & Technology Conference But I would tell you, Jim, I think the market is moving to what we have been calling as our strategic convictions for the last four or five years under Arvind's leadership. One, we believe technology is the only deflationary force and it's a source of competitive advantage as we talked about. Two, we think that hybrid cloud is the most dominant client architecture you're prevailing today. By the way, 90% plus of enterprises operate in a hybrid multi-cloud environment today. So it is a reality. Third, we're seeing right in front of us, AI is going to be the most powerful form of productivity that we will ever see across enterprise and around the world. And fourth, open source is the new source of innovation. So to your question, Arvind and the team and all of us have been focused on redesigning our operating model to capitalize on those strategic convictions for long-term sustainable value. We've done work around our integrated value thesis, bringing a powerful tech stack with a consulting business at scale, which is differentiated in the market today. Two, we've done work around portfolio optimization. Tremendous strategic capability and acquisitions that we've been able to garner since the Red Hat acquisition, that has really expanded the growth profile, both of our software book of business and our consulting businesses, but it wasn't only acquisitions. We also had to prune our portfolio around areas divestitures of assets that weren't either strategic fit or the financial equation that we wanted. But I'd tell you, one of the most underappreciated components of what Arvind has done is he's opened up IBM to ecosystem partnerships with AWS, with Microsoft, with SAP, I think (inaudible) was up here earlier with Palo Alto, Adobe and go on and on and on. And we've been able to capture synergistic value of IBM with those partners overall. And fourth, I'd be remiss about and say a whole new cultural transformation within IBM around a growth minus around speed, velocity, risk taking. So all that's led to differentiated performance. I mean it's played out our investment thesis, IBM today, higher revenue growth, higher operating margin, strong free cash flow yield and a higher return on invested capital. and put it in perspective to wrap up. Let's talk about three years ago before we came out with our mid-term model, and we spun off Kindrel. We had a business profile that was declining revenue growth. Over three years, we change that to a sustainable mid-single-digit revenue growth profile. We had a business that had dilutive margin operating leverage to a business over the last three years that has generated 700 basis points of improvement in margin. And finally, a business that was stagnating on free cash flow. And over the last three years, we're about double our free cash flow generation. So we feel pretty good about where our position is, and more importantly, always more work to do to drive continuous reinvention, and that's the mindset that we have in IBM.

Question: Jim Schneider - Goldman Sachs & Company, Inc. - Analyst : One more strategic question for you, and that's on M&A. I think, obviously, that's been a core part of the strategy, as we discussed before, Red Hat has obviously performed very well, a number of acquisitions through the years. And this year, some of the software assets you plan to close on (inaudible) by year-end. But maybe just kind of contextualize this in terms of your broader AI strategy, how do all these acquisitions fit together? What is the kind of common purpose or a common technology alignment? What are you trying to solve for customers and clients with this? And should we expect the pace of your software M&A to actually pick up or slow down from here? James Kavanaugh - International Business Machines Corp - Chief Financial Officer, Senior Vice President - Finance and Operations Yes. Great question. I mean, one, I think we've built credibility over the last handful of years under Arvind's leadership about running a very disciplined capital allocation process around, obviously, starting with investing in our business organically and inorganically around where we see a differentiated way to win and to compete and get synergistic value. Two, our capital allocation centers around maintaining a very solid investment-grade balance sheet, focused on debt leverage. And then three, we enable a very attractive return to shareholder dividend policy. But that capital allocation is supported by a capital structure that gives us tremendous financial flexibility to go compete in the marketplace. REFINITIV STREETEVENTS | www.refinitiv.com | Contact Us consent of Refinitiv. 'Refinitiv' and the Refinitiv logo are registered trademarks of Refinitiv and its affiliated companies. SEPTEMBER 09, 2024 / 6:30PM, IBM.N - International Business Machines Corp at Goldman Sachs Communacopia & Technology Conference And M&A has been an instrumental element of us extending our leadership in hybrid cloud and AI, and it's also been a growth vector model of us delivering about 1 point, 1.5 points of revenue growth to IBM's top line. Now we've talked many times, our criteria hasn't changed. Strategic fit, hybrid cloud and AI, synergistic value so we can get the multiplier effect of product, technology, consulting and go-to-market synergies. And three, it has to have an attractive financial profile, read that free cash flow accretive within two years or less. When you take a look at that strategic fit, what are the areas we're focused on. We're focused on where we believe those strategic convictions are where revenue profit pools are going to move. That is going to be around hybrid cloud. That's going to be around data. That's going to be around AI. It's going to be around automation, which we've capitalized on tremendously. It's also going to be around consulting and building out differentiated expertise and capabilities for not only IBM Tech, but also for our strategic partnerships. In terms of synergies, we run a playbook. And we've been pretty consistent since the Red Hat acquisition, a playbook that drives synergies not only from a cost efficiency. But I think you're asking more from a revenue client value perspective around product technology. Let me give you a couple of examples, right? Let's talk about the Red Hat since you started there. Red Hat, when we announced that acquisition in 2018, we saw a very strategic pivot of where the market was going to go around hybrid cloud and around AI. And that was our differentiated point of view of having a hybrid multi-cloud

Question: Jim Schneider - Goldman Sachs & Company, Inc. - Analyst : Relative to Red Hat, you laid out that case fairly articulately. Maybe just talk about what are the other growth opportunities you see for Red Hat

Question: Jim Schneider - Goldman Sachs & Company, Inc. - Analyst : You mentioned consulting. I want to pivot to that one next. It's no secret that, that market has been a little bit weak for the whole industry, broadly speaking, because of the discretionary IT pullback that we've seen. What are you doing that's within your control to sort of reaccelerate growth from here? You talked about the partnerships, but what else is there to it? James Kavanaugh - International Business Machines Corp - Chief Financial Officer, Senior Vice President - Finance and Operations Yes. Well, to your point, right now, we're operating in that extreme dynamic based market environment. As CFOs like myself, are all looking at spending programs around how they drive cost efficiency to create reprioritization of financial flexibility so they can invest for their own sustainable advantage overall. But I would tell you that's not a surprise to us. In any human capital-based business. When you look at it, any major technological shift or macroeconomic volatility, discretionary-based spending consulting-based market, the growth model always experiences some shift in some reprioritization. But we're actually very confident in the medium- to long-term market potential of the consulting business overall to grow on their average 5% to 7% overall, and we're excited about the position of consulting inside IBM to be a key differentiator. Why is it important IBM? One, it capitalizes on that multiplier effect of every dollar we land on Red Hat OpenShift hybrid cloud platform are now Gen AI, we can get $6 to $8 of services revenue over time when we've proven that with Red Hat OpenShift. And through the first year of Gen AI, we already have north of $1.5 billion book of business on Gen AI in consulting. Second, it drives scale and adoption back to our software and our infrastructure in pulling software overall. So where are we excited about our growth model of consulting? One, done a lot of work to reposition our portfolio, our growth platforms, our offerings and service lines in consulting overall. Today, it's about 85% I would say, aligned to where the market is and moving. That is digital REFINITIV STREETEVENTS | www.refinitiv.com | Contact Us consent of Refinitiv. 'Refinitiv' and the Refinitiv logo are registered trademarks of Refinitiv and its affiliated companies. SEPTEMBER 09, 2024 / 6:30PM, IBM.N - International Business Machines Corp at Goldman Sachs Communacopia & Technology Conference transformation, that's hybrid cloud, that's application modernization and that's business transformation overall. So we feel pretty good about that. We actually have a pretty small BPO business that arguably is getting disrupted tremendously. We view that as an opportunity going forward. Second, we're still excited. We have a lot of headroom to grow around those strategic partnerships I talked about earlier. It's about 40% of our business profile right now in consulting. We've moved up the league tables from being nowhere to being in the top 10. Our goal is to get into the top two or three, and that's driving tremendous growth. Three, we're investing significantly in our IBM Consulting Advantage platform. That's our Gen AI platform, leveraging Watson X, RHEL AI, OpenShift AI of really acting our human capital service-based offerings that deliver better value, increased win rates. And then finally, we've been pretty focused on the M&A side of the equation, just given the attractiveness of the assets we bought this year. But M&A is a key growth driver for us, and we're going to come out after market today with an acquisition announcement around OCI and our partnership with Oracle overall. So we feel pretty good about that. But long term, this is a tremendous growth opportunity. It has great synergistic value, and we're going to keep running those plays to gain share, which is what we've been doing.

Question: Jim Schneider - Goldman Sachs & Company, Inc. - Analyst : I want to see if I can get to two more questions, perhaps one on the infrastructure because this is an area, specifically mainframe an area where I think people -- most investors are quite surprised of the performance of Mainframe over the last five years plus, I think much better than people thought. What kind of demand -- where is the demand for mainframe coming from? Is it partly tied to AI? I think there's been some press reports about uses of AI running on a mainframe, which I think surprises a lot of people. Is that accurate? And then how should we think about the Mainframe growth opportunity for IBM going forward over the next several years? REFINITIV STREETEVENTS | www.refinitiv.com | Contact Us consent of Refinitiv. 'Refinitiv' and the Refinitiv logo are registered trademarks of Refinitiv and its affiliated companies. SEPTEMBER 09, 2024 / 6:30PM, IBM.N - International Business Machines Corp at Goldman Sachs Communacopia & Technology Conference James Kavanaugh - International Business Machines Corp - Chief Financial Officer, Senior Vice President - Finance and Operations Yes. Appreciate the question on mainframe. As the CFO, albeit infrastructure is 25% of our total composition of IBM revenue. It's a substantial portion of our profit and cash generation that fuels that investment flywheel into our software, our M&A, our innovation, our go-to-market, our ecosystem. So it is the most enduring platform that is very relevant for today's hybrid cloud and AI era overall. When you take a look at it, we, under Arvind's leadership about five, six years ago, we called a very strategic pivot of increasing significantly our investment in innovation. So today, the mainframe platform is the only platform that has pervasive encryption embedded in the system, the industry's only quantum safe encryption today cloud-native capabilities. We opened up mainframe, the Red Hat OpenShift and other cloud-native applications running on it. We've been putting Gen AI back in 2022 when we announced z16. We have the Telum chip with the AI accelerator on the chip, and we're getting a lot of great resonating from a client perspective. And it's always been the most sustainable energy efficiency. What's driving the value or the shift in the pivot for mainframe to growth? Mainframe over the last three cycles has generated 3 times the installed MIPS capacity and 80% of our clients are growing workloads. We haven't seen that for a long period of time. What's driving that? I think, one, definitely increasing capacity requirements just driven by the volatility of the markets and around digital transformations around enterprises; two, focus on every board, resiliency, cybersecurity, regulatory environment, sovereignty around the world, AI running on mainframe and around energy and sustainability, which is very -- all of those things play to the compelling value proposition, a mainframe. So when you look at it, mainframe is very relevant to AI today. We're working with probably 250-plus customers currently today on AI applications around everything from fraud detection to AML, to clearing and settlement loan prevention and to medical imaging, many different areas. So we feel pretty confident we're going to come out with our new mainframe first half of '25. We think mainframe right now, we've proven it over the last two cycles now that it is a growth factor of IBM, and we think we're well positioned as we enter 2025 with the next mainframe cycle, and we're excited about it.