International Business Machines Corporation

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. 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. Our presentation also includes non-GAAP measures to provide additional information to investors. For example, we present revenue and signings growth at constant currency throughout the presentation. In addition, to provide a view consistent with our go-forward business, we'll focus on constant currency growth adjusting for the divested businesses or the impacted lines of total revenue, cloud, and our geographic performance. We've 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. So, with that, I'll turn the call over to Arvind.

Arvind Arvindanandamalaiya Rao Hello, everyone. Thank you for joining us today. I'm pleased to be speaking with all of you again. In our last call, we shared our financial expectations for the year, revenue growth, and $11 to $12 billion of adjusted free cash flow. While it's still early in the year and a lot remains to be done, we are confident enough to say that we are on track. Last quarter, I also talked about how the events of the last year have increased the needs for our clients to accelerate their digital transformations. This is continuing, and the overall spend environment is improving, while there are some clear differences by geography and industry. With that as a backdrop, In the first quarter, we posted revenue growth at actual rates and grew free cash flow. We can see signs of progress in a number of areas. Our results in cloud and cognitive software and global business services revenue show they are on an improved tragic rate, including a return to growth in consulting. IBM Z again demonstrated its value as an enduring platform. Meanwhile, we improved margins in our global technology services led by managed infrastructure services. As Jim will explain to you, all of this helped to deliver free cash flow improvement, which is a key focus area. As we move through the year, we will continue to execute on the important changes we are making to the company, from the acquisitions we are making to the investments to expand our partner ecosystem, to the significant overhaul of our go-to-market model that we announced back in January, to the changes we're bringing to our culture to instill more of a growth mindset. As you know, we're also executing the separation of a managed infrastructure services business, now branded Kindrel, which is on track to be completed by the end of the year. These changes are all well underway, though, as you would expect, it will take some time to see the full benefit. I have immense confidence in our strategy around the transformative power of hybrid cloud and AI. and the decisive moves we are making provide a solid foundation for us to unlock future growth. As I've told you before, we see the hybrid cloud opportunity at a trillion dollars, with less than 25% of workloads having moved to the cloud so far. We are reshaping our future as a hybrid cloud platform and AI company. For us, the case for hybrid cloud is clear. Businesses have made massive investments in their IT infrastructure, and are dealing with specific constraints, such as compliance, data sovereignty, and latency needs in their operations. They need an environment that is not only hybrid, but a hybrid platform that is flexible, secure, and built from open source innovation. This gives them a credible path to modernizing legacy systems with advanced cloud services and building cloud-native apps. This is what we have built our platform for, and why we have such confidence in our strategy. IBM's approach is platform-centric. Linux, containers, and Kubernetes are the foundation of our hybrid cloud platform, which is based on Red Hat OpenShift. We have a vast software portfolio, cloud packs, modernized to run cloud-native anywhere. Our GBS expertise is a key factor in driving consumption and in helping our clients accelerate their digital transformation journeys. And our systems and industry-specific public cloud provide differentiated infrastructure. The economics of our platform are designed to drive growth across all of IBM. The platform itself contributes. But then for every dollar a platform spends, clients spend $3 to $5 in software and $6 to $8 in services. IBM, together with our growing ecosystem partners, are positioned to capture that value. Let me now turn my attention to some of the progress and proof points we have seen in the past quarter as we execute on our hybrid cloud platform and AI strategy. In the last quarter, more companies chose IBM to help them realize the potential of hybrid cloud. That includes BNC Bank, Barnate, and Egyptair. We're also helping Siemens replatform MindSphere, their IoT software, on top of Red Hat OpenShift, That makes it possible for them to deploy on both public and private clouds. We now have 3,000 clients using our hybrid cloud platform. We are also focused on helping companies use our rich AI capabilities to drive business outcomes. In the past quarter, we have forged important partnerships with companies like Palantir to simplify how businesses build and deploy AI applications across public clouds, private clouds, and on-premise. As part of this collaboration, IBM and Palantir are creating a new offering called Palantir for IBM Cloud Pak for Data, allowing clients to scale AI with confidence. In addition to Palantir, we continue to expand our AI ecosystem by building on partnerships with companies like Box, Cloudera, and MongoDB. In March, the global research firm Gartner announced positioned IBM as a leader in three Gartner Magic Quadrant AI report, now making IBM a leader in 12 AI Magic Quadrants. This recognition highlights the important work we have been doing to bring new innovations from our research teams in core areas such as natural language processing, trust, and automation. To facilitate our clients' adoption of our focused hybrid cloud and AI solutions, as I said in January, we announced significant changes in our go-to-market model. We drastically simplified our sales model by adopting a single consistent segmentation. We're providing clients with a more technical and experiential approach and are investing in and elevating the role of our ecosystem partners to deliver more value to clients. Finally, we have adjusted the incentive structure for our sales teams to better align our reward system with our strategy. While it'll take time for these changes to yield results, we are seeing some green shoots from our transformation. We are investing in and scaling what we call pre-sales garages to co-create with our clients a lot earlier in the sales process. We've had around 200 of our top clients experience new use cases for our solutions. And our ecosystem strategy and approach with strategic partners is already opening new areas of growth in GBS. I want to spend a minute on innovation. We have a strong pipeline of innovation, and some of these are already differentiating our portfolio. As I said earlier, IBM Z again demonstrated its value this quarter. This is thanks to the critical innovations we bring to each new generation of IBM Z, which continue to spur renewed interest and drive client demand. In fact, Z15 is now shipping the largest capacity in the platform's history. Another innovation we recently put on the market relates to Red Hat OpenShift, the cornerstone of our hybrid cloud platform. OpenShift now includes new capabilities around security and scalability, both of which are critical to enterprise needs. Next up are new Linux and Kubernetes-based innovations that will help businesses extend hybrid cloud to the edge, scale and secure cloud-related applications, and consume technologies on OpenShift as a managed service. Let me now turn to other opportunities we are seizing that will play out over the longer term. We announced that we are embarking on a decade-long partnership with the Cleveland Clinic, who will tap into the power of AI, hybrid cloud, high-performance computing, and quantum computing to accelerate the process of scientific discovery. As part of this collaboration, IBM will install the first on-premises IBM Q System 1 in Ohio within the United States. As you know, this is an area of incredible promise. Quantum has the potential to unlock hundreds of billions of dollars of value for our clients by the end of the decade. To seize this opportunity, we announced a roadmap to build a thousand plus qubit quantum computer by 2023. We remain excited by these developments. You may also have seen the partnership we announced with Intel to advance next-generation logic and packaging technologies. This collaboration will be key in accelerating innovation and enhancing the competitiveness of the semiconductor industry. As we reshape our future as a hybrid cloud platform and AI company, we are continuing to use our scale, scope, and trust to make an impact on important societal issues. For instance, To help tackle the climate crisis, IBM announced a net zero pledge by 2030. We have been transparent in that our efforts are focused on reducing actual emissions without the use of carbon offsets. We also intend to use emerging technologies to remove emissions equal to our residual emissions, leveraging IBM research to help accelerate the discovery of materials for these technologies. Fundamental to our business growth is fostering a culture of conscious inclusion where innovation can thrive and individuals progress. Last year we made a commitment to be more transparent in how we report diversity and inclusion, and last week we released our 2020 Diversity and Inclusion Report. What you will see is that we have increased our diversity representation and achieved best-in-class inclusion scores from our employees. We are leveraging our industry-leading hiring practices, skills development, and advancement opportunities to continue our progress. I'm happy to expand on our ESG efforts in the Q&A. Before I turn it over to Jim, I will close with a comment on our future. Our objectives are clear. Sustainable mid-single-digit revenue growth post-separation and strong cash generation. We are taking actions, investing, and aligning compensation to achieve this, And our first quarter results are another step in the right direction towards our future. Jim, over to you.

Thanks, Arvind. I'll 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 remained 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 and cognitive software and in systems, and consulting returned to growth. We're 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 in over the last 12 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'll 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 basis. This operating leverage enables a higher level of investment. We're 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're building out pre-sales garages, adding go-to-market and delivery capabilities in GBS, and technical skills in Red Hat. and we're 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. This $2.2 billion of adjusted free cash flow is up $800 million year-to-year, driven by profit growth and continued working capital efficiencies. We had both strong cash collections and renewal rates in software. These software renewal rates drove our total deferred income to over $18 billion, which is an all-time high. Our free cash flow performance in the quarter contributed to our cash balance of $11.3 billion. While this is down $3 billion from year end, our debt was down $5 billion. We've now reduced our debt by about $17 billion from the peak. So we've made good progress in deleveraging without sacrificing investments in our business or our solid dividend policy. Now let me turn to the segments. Cloud and cognitive software grew 1%. driven by cloud and data platforms and cognitive applications. Our cloud revenue in the segment was up 34%. This reflects the investments and actions we've taken to capture the hybrid cloud opportunity with solutions like Red Hat OpenShift and Cloud Paks. Our cloud software is now $7.5 billion over the last year, which is about a third of our segment revenue. Across cloud and cognitive software, we continue to increase our subscription and support renewal rates, driving the record deferred income levels I just mentioned. Looking at our software performance by business area, cloud and data platforms, which is about half of our segment revenue, grew at a double-digit rate. Red Hat continued solid performance with normalized revenue growth of 15%, led by Red Hat Enterprise Linux and OpenShift, both of which continued to gain share. With about 3,000 hybrid cloud platform clients, we've now tripled the revenue base of OpenShift since we acquired Red Hat. I'll remind you, we wrapped on the acquisition of Red Hat in the middle of last year. In this quarter, cloud and data platforms delivered 2% normalized growth. In cloud and data platforms, we also improved the year-to-year trajectory across a number of key areas, including integration, data science, and AIOps. In cognitive applications, revenue grew 2% this quarter, led by strength across security software and services. Our security solutions, like Cloud Pak for Security, helped enterprises to manage threats and protect their digital workloads, data, and identities across hybrid cloud environments. And clients opted for accelerated time to value and ease of operation with QRator on cloud to rapidly detect cybersecurity attacks and network breaches. As expected, our transaction processing platforms revenue declined. We provide flexibility to our clients in how they purchase our software. Clients' buying behaviors have been shifting toward more consumption-based models. As a result, we are seeing a continued preference for OpEx over CapEx, putting pressure on perpetual licenses. Though this quarter, we had strong renewals in our TPP software, which I'll remind you provides mission-critical capabilities to our clients. Looking at the profit for this segment, We expanded pre-tax margin while continuing to invest in new innovation and our software ecosystem. Turning to GBS, our year-to-year revenue trajectory improved about four points, with consulting returning to growth. We're capitalizing on the market trends. Clients are digitally transforming their businesses using hybrid cloud and AI to capture new growth opportunities, increase productivity, and create operating flexibility. Our revenue performance this quarter reflects this. GBS Cloud revenue growth accelerated to almost 30%, doubling its growth rate from the prior quarter with strong growth across the portfolio. We see this in consulting where we had strong growth in our advise and build offerings. This reflects expanding practices with ecosystem partners like Salesforce and Adobe and strong momentum in our Red Hat practice. In fact, We doubled the number of Red Hat client engagements from the prior year to over 150, working with companies such as HBO, Marriott, Vodafone, and Honda. We've now signed $2 billion of business in our Red Hat practice inception to date. Within application management, we had growth in offerings which build and move applications to the cloud. This growth was offset by declines in on-premise activity. Our application incumbency enables GBS to be the partner of choice for a client's digital transformation. It is high value to our clients and to IBM, and is an important component of IBM's hybrid cloud strategy and platform adoption. For example, GBS continues to drive one-third of our Cloud Pak revenue, and of those engagements, roughly 80% are with application management clients. we are also capturing the opportunity in business transformation services, or what we call intelligent workflows. Within consulting, we had double-digit growth in offerings which leveraged data and AI to transform client processes in areas like finance and supply chain. And in global process services, revenue growth accelerated to 19%. We had broad-brace growth in areas such as finance and talent and transformation as clients leverage hybrid cloud to scale their activities to capture productivity and gain insights. Turning to profit, we continue to expand GBS gross margin, which was up 100 basis points this quarter. This was driven by our shift to higher value offerings, increased productivity, and improving delivery capabilities which results in better margin realization. In this quarter, we still had some margin benefit from reduced client-related travel. At the same time, we're continuing to invest in GBS, organically and inorganically, to accelerate the revenue performance. We closed two acquisitions in the quarter. We are building and expanding practices in support of ISV partners. And we continue to hire, adding more sales and delivery capacity, contributing to an increase of more than 5% in our go-to-market resources since last year. Systems revenue was up 2%, led by strong performance in IBM Z, while product cycle dynamics continue to play out across power and storage. Our IBM Z revenue was up 49%. That's very strong growth. especially more than six quarters into the Z15 product cycle. We had traction in areas like financial services, where robust market volatility drove demand for increased capacity. Clients also purchased Z15 for its enterprise-grade security and unmatched reliability for regulatory requirements. Simply put, this platform is secure, scalable, and reliable. IBM Z is an enduring platform, developed and optimized to support enterprises' most mission-critical applications. The IBM Z platform is also an important element in our hybrid cloud strategy, attracting new workloads, integrating cloud-native capabilities, including Red Hat, and supporting our industry-specific cloud solutions. And with this quarter's performance, the Z15 program to date has now outpaced the strong performance of the Z14 program. This further demonstrates the lasting value of the IBM Z platform. With solid gross margin performance in IBM Z and Power, our system segment improved gross and pre-tax margins year to year. In global technology services, revenue declined 5%, which is about a three-point improvement from last quarter's rate. Over the last few quarters, we've talked about an impact to GTS revenue from lower client business volumes. This quarter, we saw an improved trajectory in project activity and client-based business volumes, including in some of the industries most affected by the pandemic, such as retail and consumer products. We're encouraged by this trend. Our year-to-year signings performance reflects a difficult compare. Last year, GTS had strong signings growth, driven by large renewals at Anthem and CaixaBank. That said, our midsize deals grew this quarter. Enterprises continue to see the long-term value for GTS to design, run, and manage the most modern, efficient, and reliable technology infrastructures. We see this in both the renewal rates this quarter, which were consistent with history, and in the new logo wins at clients such as Generali and Pitney Bowes. Let me now provide an update on the progress we're making to separate Kindrel, our managed infrastructure services business. Like last quarter, I'll quickly touch on three areas, client engagements, actions to optimize the business model, and the execution of the necessary milestones to enable the transactions. From a client perspective, we're continuing to work with our clients to ensure a smooth transition. We have done extensive client outreach, and over 90% have had a very positive reaction. Clients see the long-term value and benefit for Kindrel to help them build a strong, secure, resilient, and adaptive digital capabilities. Regarding the business model, we have taken several actions to position the business for an improved margin, profit, and cash generation profile. This quarter, we expanded GTS segment gross margin by 60 basis points with contribution from infrastructure services. The project activity and client-based business volumes have a higher margin profile as they utilize existing resources. And so as these volumes recover, we get operating leverage. Additionally, The contract and productivity actions we have taken are just starting to contribute to gross margin improvement. Finally, in addition to establishing a name, headquarters location, and expanding the leadership team, we continue to make good progress on executing the necessary financial, legal, and regulatory milestones to enable the transaction. We remain on track to close by the end of the year and still expect the Form 10 to be available in the fall. Now, I'll bring it back up to the IBM level with a quick summary of the quarter and our view of the full year. Our revenue trajectory improved in the first quarter, driven by cloud and cognitive software, global business services, and strong IBM Z performance late in the product cycle. We continue to improve the fundamentals of our business model with operating leverage, enabling a higher level of investment, and we have a strong balance sheet and liquidity position. We're off to a good start, but as we said, more to do over the course of 2021. We're investing in skills, ecosystem, and innovation as we execute our hybrid cloud platform and AI strategy. We've redesigned our go-to-market model and expect to yield benefits as we move through the year. We're executing the structural actions initiated in the fourth quarter and are continuing through the first half of this year. Some of this will improve the profit profile of our infrastructure services business, but more of the savings will be reinvested in IBM's remaining business. And as I just mentioned, will be working to complete the separation of Kindrel by the end of the year. As we look forward, we're focused on revenue growth and cash generation. For the year, we continue to expect revenue growth at current spot rates and to deliver $11 to $12 billion of adjusted free cash flow. I'll remind you, adjusted free cash flow expectations exclude the $3 billion of cash impacts this year associated with both structural actions initiated in the fourth quarter and the transaction charges for the spinoff. I'll make a couple of comments on revenue and free cash flow for the next quarter. As you've seen, the U.S. dollar has strengthened over the last 90 days, which impacts us by about a point of revenue growth for the year. Despite this, the average of analysts' revenue estimates for the second quarter look reasonable. And as I said, we're maintaining our expectations for revenue growth for the year. We also had a strong start to free cash flow with good profit and working capital performance. Profit growth will continue to contribute to our cash performance. But we also expect over half of the $1 billion full-year cash tax headwind I mentioned in January to hit in the second quarter. And looking at our book tax rate in the second quarter, we expect the rate to be similar to second quarter last year or a couple points higher. Bringing all of this together, we expect to make incremental progress in the second quarter as we deliver on our full year expectations. So with that, let's go to Q&A. I'll turn it back over to Patricia.

Thank you. Before we begin the Q&A with Arvind and Jim, I'd like to mention a couple of items. First, we've included supplemental information at the end of the presentation. And finally, as always, I'd ask you to refrain from multi-part questions. So operator, let's please open it up for questions.

Thank you. At this time, we'll begin the question and answer session of the conference. To ask a question, please press star 1 and record your name clearly. If you need to withdraw your question, press star 2. Again, to ask a question, please press star 1. Our first question will come from Matt Cabral with Credit Suisse. Your line is open.

Yeah, thank you very much. Good to see cloud and cognitive return to growth in the quarter. Just wondering if you could update us on what you're seeing in terms of the underlying demand environment in software and just where you are in dealing with some of the issues that weighed on the more transactional side of the business in Q4. And then software going forward, just wondering how we should think about the cadence of revenue for the balance of the year from here.

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 are talking 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 depend very much by country, and we can all guess which ones are doing better, which ones are doing worse. It does depend upon both COVID rates and the pauses that happen 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've 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. 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 and 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 digits of 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 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've got to go deliver it, Matt.

Thanks, Matt. Can we go to the next question?

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

Thank you. Good afternoon. Arvind, you talked about increased investments in sales resources, technical skills, R&D. We saw M&A pick up this quarter and All of this is meant to drive that mid-single-digit sustainable revenue growth that you've talked about, which I believe you've said that you can achieve next year. Can you just help us at a high level bridge how you get to the 4% to 5% revenue growth? What are the primary sources of growth acceleration at the segment level? How much M&A contribution should we be contemplating? And also, in next year's growth rate, are you baking in the revenue benefit that you'll see as some of the internal revenue becomes reported as external post the spend. Thank you.

Thanks, Katie. It's pretty clear you're 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 might decline, but the overall will be mid-single digit. That could include, I'll call it, any business-as-usual acquisitions. But the current market value, I don't see acquisitions adding a significant amount to IBM's top line. You can do the math with what we can put in. it'll be well less than a point overall. 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, or segmentation, that is not yet really paying off. We see some early signals in the 200 clients doing these things. I do expect that that can contribute a couple of points maybe a bit more for next year, but you'll see that inside our software and our GBS numbers. It's not additive to those. We're also investing about a billion dollars in our ecosystem. That will contribute to improving GBS's growth rate to beyond the pre-pandemic rate. So that then takes me to GBS. We'll this year come back to the pre-pandemic growth rates of two to four, but the mixture of the acquisitions and the go-to-market changes will So 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. Okay, 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're not counting on that to be a contributor because that's only once. It's not every year. So hopefully... Red Hat, contributing together with acquisitions to software in the mid-single digits. GBS, with all the changes we're describing, perhaps better than mid-single digit. Systems, if I take a two- 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 top line a lot. And that's how sort of we get to the mid-single digits sustainably. You might get a one-year benefit from internal going to external, but not permanent. So that's why I don't really count on that. Hopefully that gives you an answer to your different parts of the question.

And as we complete the Form 10 process, which we're well on our way right now, Katie, I would tell you one, as you know quite well, we will be transparent about the strategic commercial relationship we have between IBM and Kindrel going forward, and we will disclose what those relationships are and how we will treat that revenue. But more work to be done and we will come back to you at the appropriate time.

Thanks, Katie. Sheila, can we please go to the next question?

Absolutely. Next we will hear from Tony Sacanaghi with Bernstein. Your line is open.

Yes, thank you for taking my question. I guess this is a clarification or maybe two clarifications. I'm wondering if you can just comment. I think you said that you think consensus revenue estimates for Q2 are reasonable. They're up about $500 million sequentially from Q1. If I look back at normal seasonality, typically revenue is up about $1 billion, and it sounds like IT spend is improving. So if anything, one would expect better than normal seasonality. So I'm wondering whether you're 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 a 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.

Okay, Tony. Thank you for your question, and I'll handle the first part, provide some clarity around our forward-looking guidance, and then turn it over to Arvind for your second part of the question. But as we said in prepared remarks, similar to 90 days ago, in fact, we're even more confident in the position that we put in place with regards to our two most important measures, one, revenue growth, and second, adjusted free cash flow, which is going to provide the fuel for the investments needed for us to capture that hybrid cloud $1 trillion TAM. Now, we reiterated that we're going to grow revenue overall for the year, and that is despite currency volatility, again, with the U.S. dollar appreciating 90 days ago. And we lost about a point of revenue for the year, and we lost about a point of revenue in the second quarter. So now go into your math with regards to our historical quarter-to-quarter. Very close. I mean, the math I got in my head is somewhere around $900 million, $950 million, give or take quarter-to-quarter. We see normal historical attainment across 1Q to 2Q in both our software-based businesses. As Arvind said, we're feeling even more confident given the rebound here in the first quarter. And also in both of our services-based businesses, we see normal historical attainment to that roughly $9 to $950 million. Now, Given our first quarter performance of driving a very strong mainframe cycle, growing 49% in the first quarter, in the seventh quarter of the program, which is unheard of coming off a 60% growth last year, Arvind and I both believe it's very prudent for us as we go forward with our guidance to not count on continued acceleration of our mainframes. We're very pleased with the performance. We're pleased with the value proposition. But I would say against that $900 to $950, I would take a couple hundred million off of that number just based on first quarter's very strong performance in mainframe and that knock including going forward. So let me turn it over to Arvind for the second part. Thanks.

Mr. Attorney, Watson remains critically important to us. To be absolutely clear, Watson is the brand product name for our AI capabilities. You'll see it in the market as Watson conversational agent, but you'll also see it as, for example, our security products with Watson. It is embedded inside our cloud pack for data and called out as Watson. Let me give you a quick example of where we're seeing a huge amount of success. So let me take one of the large entities doing vaccine administration in the United States. When they realized in December they could do this, they suddenly began to realize that they could get tens of millions of calls every quarter. And then how would they handle them? Staff up tens of thousands of people or perhaps deploy Watson. And so far at one of these places, and we have deployed at 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 is in both improving client satisfaction, because you get an instantaneous answer, but also in taking costs 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 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're 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.

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

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

Yes, thank you. Arvind, you said the go-to-market changes have not yet had an impact. Should we expect to see some benefit in the second half of 2021? And if you could maybe address what the cadence of the benefit would be across the business segments where we'll play out first and later that would be helpful. And separately, maybe you can just help us think through what's going on with bookings and backlog. The signings numbers were quite weak relative to the confidence you're expressing on consulting growth. Is there a pause given the upcoming spin or maybe if you could just dig down into that a little bit, that would be great. Thank you.

Thanks, Ramzi. Look, go-to-market changes, Ramzi, always have, I'll call it a bit of a hysteresis loop. They take 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've 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're also investing in our, what we're 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 of a type 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'll see it in our numbers in the second half. and then more going into next year. For the second part of the question, I'll hand it to Jim to talk a little bit about signings. Okay, thanks, Wamsi, for the question.

Let me unpack some of this for you. First of all, printed numbers, signings down 27%, to your point, entirely driven by our large deal renewal comparison the last first quarter in GTS. If you remember, we signed two massive deals last year, with Anthem and Kysha well in excess of a billion dollars a piece in each. But I think this goes to the testament that I've talked about many times on this call, and that is all signings are not created equal. The duration, the mix, the offering, the content, all impact how signings translate into backlog and how backlog then translates into revenue realization overall. So let's talk a little bit about the GTS portfolio because that's where it really centers around here in the quarter. When you look at GTS, I think there's a couple different dynamics playing out. First, yes, greater than $100 million deals. We were down substantially compared to last year just off of that very tough compare. And I'll remind you, we grew GTS signings north of 40% last year. So second, though... is our midsize deals, read that kind of $10 to $100 million, we were up high teens. And embedded in that, we also had another nice quarter of new logos, which means we are out there winning new business, capturing new client value, even in light of the announced separation with Kindle. The second component at the heart of your question, I think, is are we losing business or is business getting paused? I would think one with the new logo wins and second, we have consistent high renewal rates in this business. This business is very sticky from a managed infrastructure services perspective and we have high 90 plus percent renewal rates and we have not seen that change since the announcement. Now with that said, are there pipeline that has built up that naturally some clients are pausing to they wait to see what our Form 10 is? Yeah, and I don't think we expected anything different overall. But when you take all that together, our backlog position overall in GTS and our backlog run out, we actually see continued sequential improvement Nice improvement off of fourth quarter, three points better. And we see that continuing modestly here from one Q to two Q. And that's a reflection of those new logos that are going to start ramping up. And that's a reflection of our midsize deals, which by the way, has changed the duration in that part of the portfolio by one month overall, which is impacting the revenue realization. So we still feel very, very good and very comfortable. We got a very good Pipeline in front of us, and we see better revenue realization.

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

Next, you will hear from Amit Daryanani with Evercore. You may proceed.

Good afternoon. Thanks for taking my question. You know, I guess I was hoping if you could touch a little bit more on the GBS performance, and we saw a nice improvement, I think, from what we saw in December quarter. It was still down, but, you know, a nice four basis points improvement nonetheless. And consulting, I think, was notable that we started to see growth over there. So I was hoping you could just help us understand, you know, 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 and Calendar 21. And then if I could also have you clarify this for me. As you go through the process of splitting up these long-term contracts between IBM and NewCo, you know, why would customers agree to do this without rebidding the contracts or getting a price concession from either IBM or NewCo?

Okay, Ahmed. This is Jim. Let me take your question, and I appreciate the point. We are pretty pleased with the trajectory improvement overall with regards to our GBS business. We improved by four points quarter to quarter. And we talked about 90 days ago, as we went through the pandemic, and Arvind reiterated it here on the call tonight, what we have seen is our clients' acceleration in their digital transformations and their journeys to cloud. And we expected to capitalize on that as we move forward. So if you take a step back and just look at our first quarter performance, and then I'll translate that into what we see with our GBS business going forward. Our first quarter performance really reflects our level and the confidence and the value of our portfolio. Our cloud book of business in GBS doubled its growth rate to 28% here in the first quarter. We have over a $6 billion book of business in cloud and GBS alone, leveraging our strength in application modernization and our cloud transformational services built on top of our Red Hat hybrid cloud platform. Our Red Hat engagements, we increased 150, let alone just in the first quarter overall. And our cloud book of business, is up double digits across all three subsectors. Now, to your point about consulting, very pleased of that leading indicator. We return back to growth. And we've been talking about the last handful of quarters, how the whole journey to cloud with our value proposition about advise, move, build, and manage, that the front end of that equation as clients go through around application modernization is really shows up in our consulting base of business and then translates into our application management business overall and our global processing services business overall, which we saw very nice growth as clients are reimagining how they run their companies and we're capitalizing on what we call intelligent workflows. So we definitely believe that consulting is a leading indicator. Now going forward, We are very confident in getting back in second quarter to our pre-pandemic levels of growth. By the way, our backlog run out in the next 90 days already shows that. But let me give you a little bit of some quantitative components behind why we're so confident. Number one, our book to bill over the last 12 months is well north of one, led by consulting, to your point, which we believe is the front end of that curve. that will lend itself into GPS and into AMS. Second, we continue to have very good momentum in small and mid-sized deals that you know has immediate revenue realization in the near term, which has led, third, to our overall backlog level of growth, strong growth in GPS, consulting in GPS, and improving trend in our AMS business going forward. And then fourth, we talked about up front, we closed on five acquisitions here in the last handful of months. We are very focused on ramping, scaling, and driving that business. So we feel comfortable getting back to pre-pandemic growth here in second quarter. We feel very confident in the full year, GBS delivering growth. And most importantly is that exit velocity in 2021 heading into 2022. GBS is an integral part of that mid-single-digit growth objective that Arvind talked about.

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

Our next question comes from Tinjin Wang with JP Morgan. Your line is open.

Oh, 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, can you maybe go through that a little again? What's changed? What's different? Is it a different or selling motion just 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'm just curious where the effort is there today and how close you are to to adding more partners there or if that's more of a midterm expectation for us to manage or watch for

Okay, thanks, Tinjin. I'll handle the IBM Z discussion and then turn it over to Arvind for the ecosystem. You know, we're very pleased. You know, seven quarters into a Z cycle, growing 49% on a 60-plus percent growth here in the first quarter of last year, a very strong comparison overall, and really kind of breaks the cycle from what we've typically seen. But we saw growth, when you look at it, One, are we capitalizing on the overall encouraging trend from a macroeconomic perspective? Yes. We're also capitalizing on robust trading-based volumes in our traditional FSS-based industry. So capacity needs are driving some parts of our industry consumption. But I'll tell you, we're also seeing, you know, changing regulatory requirements, clients needing backup and recovery. is very essential right now. We saw that play out in the first quarter. And then beyond the FSS industry, we start seeing some good adoption. And we talked about this in prior calls where we see elongated cycles just given some industries are more impacted by the pandemic. But we see now our value proposition of cloud-native applications where we have Red Hat Enterprise Linux, Red Hat OpenShift that runs on our mainframe platform, and also pervasive encryption. Security is at the top of every CIO and CTO's priority list, and the mainframe, by definition, is the most secure, most scalable, most reliable platform out there, and I think you're seeing all of that play out.

Yeah. On the second part of your question, Tenjin, on ecosystem, yes, we have a long pipeline. I expect this number to go into the high tens. Maybe not 100, but definitely into very many more. Let me caution, though. When you say midterm, 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 a big impact at the very end of this year and into next year. So I'll sort of position it like that, but expect that we should be announcing these at a regular cadence.

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

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

Thank you very much. So you've made some high-level but very consistent comments about sustaining the dividend as we approach the spin, and I think most of us on the call understand the reasons for that. That said, in the past, you know, there have been, you know, some criticisms that the company has prioritized returns to shareholders at the expense of growth. And I know you've talked a lot about reinvestment, cost savings among several of their actions. However, you know, in software, cloud, and services, you're going to get some pretty big companies that really don't return capital at your rate. So how do you want us to reconcile that dynamic as you look to reaccelerate and sustain growth in 2022 and beyond?

David, this is Jim. Thank you for your question. I'm not going to talk to other competitors, but I would go check some of those about how much share buyback that they're all doing overall. With that said, I'm only going to talk about IBM. 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 over $14 billion of cash on the balance sheet. We said we were going to generate adjusted free cash flow of $11 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 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, you know, comes up to be about what, 16, 17 billion. So we think from a cash source and use perspective that we've got flexibility to continue to invest and compete in the market both organically and inorganically while delivering 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've 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'll remind you that we took into account $5 billion of debt maturity, $1.5 billion of dividend in the quarter, roughly 600 million in a one-time charges and another 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've seen what 11 acquisitions since Arvind has taken over and we'll continue to capitalize where it makes the right client value in the right IBM value at the right economic equation going forward, but we're not constrained. by sources and uses of cash.

Thanks, David. Sheila, we're past the top of the hour, but why don't we take one more question?

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

Thanks so much for fitting in, Patricia. I appreciate it. Jim, I wanted to follow up on that question. If you could talk a little bit about the drivers of the change in underlying cash flow for this year But what are the key metrics and how should that make us think about your ability to generate cash in the next fiscal year? Obviously, I'm eliminating the charges associated with the separation. If you could just talk about that. And then, Arvind, since I am last, I wanted to sneak in one more. You've talked repeatedly about GBS growing in mid-single digits. I just talked about, you know, picked a number like 5%. If you could just clarify, how much is M&A within that kind of number? And in particular, when you talk about application maintenance, are you assuming that application maintenance grows within GBS? Because I think it's pretty clear that the industry is struggling for growth. And if you're assuming that application maintenance can grow within the envelope of GBS, I'd like to understand why when I think the industry faces challenges. Many thanks for taking my questions.

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 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 will have from the structural actions in fourth quarter and the upcoming spin separation charges, we gave a perspective of 2022 that that would accelerate to $12 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 the revenue growth, the operating leverage that this business can generate with some level of sustainable level of revenue growth, the underlying mixed contribution of that, and the continued productivity that this business drives. You will see profit, growth, and also I remind you of Red Hat, which we achieved being free cash flow accretive in the first year, will continue to drive improvements. Now, we've 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 marks 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 a billion dollar 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 to 13 billion next year.

Thanks. And Keith, you asked one of my favorite questions. How is GB is going to grow and how much will it grow? So when you look at the mid single digits, that's actually our nearer term forecast. Our goals certainly are to make it grow even above that. If you look at the M&A component, look, I mean, M&A could contribute at most a couple of points to that growth. It just would be that would be sort of the upper bound. And we won't necessarily see all of that even this year, but who knows? Because it's hard to predict how much those properties can grow once they're inside IBM as well. But you shouldn't expect more than that. But that's part of our path to make GBS grow faster even than the mid-single digits. In terms of AMS, AMS is really important for a number of reasons. And it all depends on how you define it. If you define it as This is application management and maintenance of those applications that were in place five years ago. By definition, that will shrink because everybody expects massive productivity and they don't expect those to grow. And you kind of see that in the numbers. But why is that incumbency relevant? As you have knowledge of that application base and you now help the client on their cloud transformation journey, then what was that – older application estate now becomes a brand new application estate, and you get growth because you're helping them transform it using AI, using workflows, using cloud. And so that contributes to growth. Whether that shows up in consulting near-term and then AMS long-term, whether that shows up as global business services in the medium term, that's the kind of mix that goes on, but that is why AMS is critical because to giving GBS its kind of fuel in order to grow. But that is why we are confident in the mid to high single-digit growth in the longer term for GBS. So key thanks. But since we are well past the time of 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.

Thanks, Arvind. Sheila, let me turn it back to you to close out the call.

Thank you. Thank you for participating on today's call.