In IBM's Second Quarter 2023 Earnings Presentation, Patricia Murphy welcomed the participants and introduced Arvind Krishna and Jim Kavanaugh. She noted that the presentation would include certain non-GAAP measures and that there could be forward-looking statements. Arvind Krishna then stated that the results reflected continued solid execution of IBM's hybrid cloud and AI strategy, with strength in software and consulting, and solid cash generation. He noted that clients were turning to IBM to speed up their transformation journeys, modernize applications, and optimize their business workflows.

IBM is leveraging its hybrid cloud and AI capabilities to bring new innovations to market, expand partnerships, and make investments in targeted growth markets. IBM is also collaborating with Air Canada, Diageo, and Nokia to improve customer satisfaction, optimize business workflows, and enhance financial performance. These collaborations aim to help clients tap into their commercial, operational, and financial data.

IBM recently announced its plans to acquire Apptio to bolster its hybrid cloud and AI capabilities. AI has the potential to add up to $4.4 trillion annually to the global economy and IBM is focusing on enterprise AI to take advantage of this potential. IBM has already built products such as Watson Orchestrate, Watson Assistant, and Watson Code Assistant to address specific enterprise use cases. They have also recently released Watsonx, an AI and data platform that can be used to accelerate generative AI workloads. Samsung is one example of a business that is exploring generative AI with Watsonx.

Citi, NatWest, and SAP are all using IBM Watson AI for various use cases, and IBM is partnering with other companies to create innovative solutions. IBM's watsonx platform allows companies to use open-source, IBM, or co-created models, and IBM has over 20,000 data and AI consultants to help companies create their own models. IBM is investing in products and skills to take advantage of the AI opportunity.

IBM has unveiled several new technology innovations, such as Watsonx, OpenShift AI, and IBM Hybrid Cloud Mesh, to help clients with their sustainability agendas. Additionally, IBM recently demonstrated a breakthrough in quantum computing, using error mitigating techniques, to produce results at a scale of 100-plus cubits. This is part of IBM's strategy to better align their services with the needs of their clients, and they are confident they will achieve their full-year expectations and deliver sustainable revenue and free cash flow growth.

In the second quarter, IBM delivered $15.5 billion in revenue, $2.4 billion of operating pretax income, and $2.18 of operating earnings per share. Software and consulting revenue both saw good growth, while infrastructure revenue was down 14% due to product cycle dynamics. Operating gross margin expanded 140 basis points due to portfolio mix and productivity, and operating pre-tax margin was up 70 basis points when excluding the gain from the sale of healthcare software assets.

IBM reported a higher level of workforce rebalancing activity in the quarter, resulting in a 60 basis point impact on the year-to-year pre-tax margin expansion. Currency also had a negative impact on pre-tax profit growth by about $150 million and 80 basis points year-to-year. The company is making progress on their productivity initiatives and generated $2.1 billion in free cash flow in the quarter and nearly $3.5 billion in the first-half. They returned $3 billion to shareholders in the form of dividends and spent about $350 million to acquire six companies.

In the second quarter, IBM's software revenue grew 8%, with growth in Hybrid Platform & Solutions and Transaction Processing. Hybrid Platform & Solutions ARR is now over $13.6 billion and up 7%, driven by Red Hat, Data & AI, and automation. Red Hat revenue grew 11%, with OpenShift growing more than 30%, and Ansible gaining market share. Data & AI revenue was up 11%, while Security revenue declined 1%. IBM also has strong liquidity, with over $16 billion of cash and a debt balance of over $57 billion.

In the second quarter, IBM experienced growth in security software and transaction processing, driven by the importance of their zSystems platform in a hybrid cloud environment. Consulting revenue was up 6%, driven by large and small engagements, and the book-to-bill ratio was 1.1 over the last 12 months. Business transformation grew 5%, mainly due to data and technology transformations, including AI and analytics-focused projects.

IBM saw growth in their technology consulting and application operations, with double-digit growth in strategic partnerships with AWS and Azure, and an annualized revenue run rate of over $2 billion. Gross and pre-tax margins were expanded by 180 and 200 basis points respectively. The Infrastructure segment saw a 14% decline in revenue, with a 30% decline in zSystems revenue and a 6% decline in distributed infrastructure revenue. Pre-tax margin was down 40 basis points, including a 1 point impact from currency.

IBM expects its overall year-to-year profit dynamics to reflect the impact of last year's divestiture. Revenue growth is expected to be 3-5% in constant-currency and free cash flow of about $10.5 billion is expected. Operating pre-tax margin is expected to expand by 0.5 points and the tax rate is expected to be in the mid-to-high teens range. In software, revenue growth is expected to be at the high end of the mid-single-digit model and the pre-tax margin is expected to expand 1.5-2 points. In consulting, the business has been repositioned to address today's client needs.

Arvind discussed the initial traction around AI and the major announcements IBM has made regarding it. He went on to explain how IBM plans to monetize AI in the short to medium term. He concluded by mentioning that the analysts' estimates for the third quarter look reasonable and that IBM is on track to deliver revenue growth, expand margin, and grow free cash flow for the year.

Arvind Krishna explains the potential monetization of AI through consulting and software. He mentions that they have already signed $9 billion with an annual run rate of $2 billion in consulting, and have seen initial success with the Watsonx platform, with many projects and client interest.

OpenShift has grown significantly since its introduction in 2019, now boasting an annualized run rate of $1.1 billion. AI will be infused into all of Red Hat's products, from sustainability to consulting projects. In the second quarter, Red Hat's software performance accelerated to 8%, with double-digit growth in the hybrid platform, solutions, and transaction processing businesses. This performance led to an increase in guidance to the high-end of the mid-single-digit model. Transaction processing is an important part of Red Hat's business model, providing a source of profit and cash, as well as an incumbency position for the IBM multiplier effect. Red Hat saw an inflection shift in TP in 2023.

Jim Kavanaugh responds to a question from Amit Daryanani about the consulting side of the business, which experienced a deceleration from 8% growth in Q1 to 6% in Q2. Kavanaugh explains that the 8% growth in the first half of the year was due to an easier compare to last year, and that the company expects to sustain low-single-digit growth on a sustainable basis. He also states that the company is confident that the growth rate will remain in the 6-8% range for the second half of the year, despite some of their peers expecting a deceleration in the market.

In the first quarter, there was a change in buying behavior that impacted backlog realization, but the company still posted relatively strong growth. In the second quarter, there was no substantive change in client buying behavior and the company experienced 6% growth, as well as strong signings growth in areas such as digital transformation, application modernization, data and technology, and AI. The company exited the quarter with a strong book-to-bill ratio and good strategic partnership velocity. The company is continuing to monitor client buying behavior and backlog realization.

Jim Kavanaugh answered Toni Sacconaghi's questions about the company's software margin improvement, revenue growth, and AI and consulting revenue. He stated that the company's full-year guidance was raised to the high-end of their model, which includes the Apptio acquisition, and that they had seen pervasive performance in the first-half of the year. He also noted that they had expected a 5-6 point growth in annuity revenue and a 1 point headwind on transactional revenue.

Apptio is expected to close in the early fourth quarter and is expected to be a very quick and accretive business. IBM is also expecting a number of AI projects to get signed, which was reflected in the second quarter with a 20% increase in signings.

Arvind Krishna discussed the interest in AI across all markets and industries, noting that North America is the most mature in terms of embracing AI. He mentioned that Apptio's acquisition was driven by key performance indicators and the $450 billion of anonymized data that it brings.

Apptio's acquisition was driven by the need for a virtual cockpit to help CIOs, CFOs, and CEOs manage their hybrid landscape spend across public cloud, SaaS properties, and data centers. This cockpit will also help track people and process spend. AI is being adopted quickly in Western Europe and South America, while Japan is quick to experiment but tends to adopt more cautiously. Adoption in South Asia tends to lag behind the West. Privacy and sovereignty of models and data are important considerations.

Arvind was asked about how he and his team are thinking about M&A today, in light of the Apptio deal. He was asked what their appetite is for further M&A, what end markets they are targeting, and if valuation is becoming more restrictive. Arvind's message was that they are still open to making other acquisitions, and that they are looking at different end markets and solutions.

Arvind Krishna explains that the company has the capability to spend $20 billion over a three year period, including the ability to raise additional debt. He states that the market has not changed drastically in terms of valuations, but they are always on the lookout for properties that meet their criteria, which include alignment with their strategy, synergy, and accretivity. He lists the areas they are interested in as hybrid cloud, data and AI, automation, cyber, and consulting properties.

Arvind Krishna discussed the favorable impact of pricing on the transaction processing portfolio and the benefits that clients have seen from it. He noted that there was a price increase due to labor inflation in 2022 and the strong dollar, which was taken well by the market. He also stated that he does not expect to see similar pricing on other parts of consulting and software.

David and Jim both emphasize the importance of pricing for value and note that in a highly inflationary environment, pricing optimization is necessary to remain competitive. They suggest that pricing and labor inflation should be taken into account in order to remain profitable, and that this should be done with a bit of a lag. They also note that the renewal rates are a strong indication that the portfolios provide value to clients.

Arvind has discussed the success of the AI offerings in the consulting side of the business. Keith Bachman is asking how the company is thinking about the supply side and the disinflationary forces associated with gen AI on the delivery side of the model. The company expects to see $400 million to $500 million in working capital for the year, and the remaining piece of the $1.2 billion of free cash flow growth year-over-year is the fundamental improvement in the operating discipline of their revenue and operating margin and cash from profit.

In the short-term, IBM's consulting team works on optimizing business processes and cutting across silos to help businesses roll forward. In the long-term, gen AI and large language models will have a 30% productivity impact on the mission-critical systems that IBM works on, such as financials, supply chain, and cyber resilience. Despite the disinflationary effect, IBM believes this will be an advantage since they can share the value of the technology with the client and win more work while needing a smaller labor pool to drive revenue.

IBM has implemented a code assistant for Ansible developers, which increases productivity by up to 60%. IT deployment overall increases productivity by 10-30%, but it will take a few years before clients have full confidence in the technology. IBM's mainframe program has been successful, with a two-year CGR up 77% last year and 30% this year. IBM's mainframe program is important as it drives a multiplier effect and has already seen a 120-130% increase in installed MIPS capacity five quarters in.

IBM has an advantage when it comes to AI because of their consulting and software, allowing clients to preserve their intellectual property and data. Clients can choose how to use the learnings from the model and data and can also ask questions without revealing too much information.

IBM has identified that at least 30% of the AI opportunity involves dealing with regulatory compliance, reports to the FDA, side effects, and proprietary formulations. IBM's consulting teams work with all models, including open source and IBM models, to help clients decide which is the best model for them. With 30 years of experience, IBM is looking to become better advisers and gain revenue in the process.

Patricia Murphy thanked the participants for attending the call and then turned it back to Sue to close out the call. She mentioned that solutions meet today's client needs, new innovation is being brought to market, and there is momentum and productivity in their operations. She looked forward to sharing their progress with the participants as they move through the rest of the year.

This summary was generated with AI and may contain some inaccuracies.