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spk04: Welcome and thank you for standing by. At this time, all participants are in a listen-only mode. Today's conference is being recorded. If you have any objections, you may disconnect at this time. Now I will turn the meeting over to Ms. Patricia Murphy with IBM. Ma'am, you may begin.
spk06: Thank you. This is Patricia Murphy, and I'd like to welcome you to IBM's second quarter 2021 earnings presentation. I'm here with Arvind Krishna, IBM's chairman and chief executive officer, and Jim Cavanaugh, IBM 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. In addition, to provide a view consistent with our go-forward business, we'll focus on constant currency growth adjusting for the divested businesses for the impacted lines of total revenue, cloud, and our geographic performance. We have provided reconciliation charts for these and other non-GAAP measures at the end of the presentation and in the 8K submitted to the SEC. With that, I'll turn the call over to Arvind.
spk03: Hello, everyone. Thank you for joining us today. It's my pleasure to be speaking with all of you again. We continue to make progress this quarter. Our revenue growth improved to 3% as reported, led by global business services and our software business. And we grew adjusted free cash flow for the first half. Across every industry, Enterprises are using technology to redesign business processes, whether it's automation in manufacturing, telemedicine in healthcare, or omnichannel in retail. These digital transformations are enabled by a hybrid cloud environment. The technology and services we provide to our clients enable their business growth and productivity increases and improve customer experiences. This is why our strategy is focused on hybrid cloud and AI. At the same time, the overall spend environment continues to improve. With the economy reopening in many parts of the world, many markets and industries are getting back on track. We see this in North America and in select industries. Jim will delve deeper into our performance across the different parts of our business. But I want to be clear up front that with our results over the last two quarters, we remain on track to achieve our financial expectations for the year, revenue growth at actual rates, and $11 to $12 billion of adjusted free cash flow. We continue to take decisive steps and make the investments required to execute on our strategy. This includes making acquisitions that strengthen our portfolio, offering new innovations and digital capabilities to our clients, expanding our portal ecosystem, accelerating changes to our go-to-market model, while also instilling more of a growth mindset among our teams and building a more client-centric culture. We are executing the separation of Kindrel, which is still on track to be completed by the end of the year. The recent announcements within our senior team also support and reinforce our strategic priorities. While there have been a number of changes, our comment on Jim Whitehurst, who has stepped down as president, but remains as a senior advisor to me and the rest of the leadership team. Jim worked on many parts of our strategy, including the integration of Red Hat. Nearly three years since we announced the acquisition, there is no doubt this integration has been successful. Jim remains a strong believer in IBM and our strategy. Given his background, I understand his desire to become an investor. Going back to the execution of our strategy, We are pleased with the early signs of progress from the significant changes we are making. But as you would expect, it will take time before we realize the full benefit of these changes. Our strategy around hybrid cloud and AI is resonating among our clients and bears repeating. Hybrid cloud is more than a strategy. It's the reality for our clients today. They have multiple public clouds, private clouds, on-premise workloads, and are dealing with stringent regulatory and security requirements. Our hybrid cloud platform gives clients the ability to flexibly deploy and manage data and applications across any environment. With hybrid cloud, clients can derive two and a half times more value in comparison to other approaches. Our strategy is platform centric. Linux containers and Kubernetes are at the heart of our hybrid cloud platform. allowing clients to write once, run anywhere. Our software portfolio, including cloud packs built on Red Hat OpenShift, runs cloud native. Our GBS experts work with clients across every industry to accelerate their digital transformation journeys through hybrid cloud and AI. Our systems and industry-specific public clouds provide differentiated infrastructure. This platform approach drives compelling economics to IBM and our ecosystem partners. This quarter, we continue to make progress in the execution of our strategy. More and more clients have chosen our technology and services as a lever for business growth. We now have over 3,200 clients using our hybrid cloud platform. That's almost four times the number of clients just prior to our announcement of the Red Hat acquisition. GBS is helping to drive this platform adoption as we modernize and manage our clients' applications in a hybrid cloud environment. This work is accelerating, and we have now grown to 700 GBS Red Hat-based client engagements since the acquisition. Our hybrid cloud platform is proving to be of immense value across industries. One example is telecommunication companies, which are among the largest technology spenders each year. We recently announced that major Telco clients, including Verizon and Telefonica, have chosen IBM's hybrid cloud platform to transform their core networks and bring to life the era of 5G and edge computing. Moving on to AI, we fundamentally believe that core to the competitiveness of every company going forward will be their ability to use AI to unlock real-time value from their data wherever the data resides. Our efforts are focused on bringing our AI technologies to horizontal processes. GBS helps our clients build intelligent workflows and transform their core business process, whether that be a supply chain, talent management, or customer service. This allows them to boost productivity and improve the customer experience. An example of this is the work we are doing with CVS Health. As COVID vaccines began rolling out in the United States, IBM built, in just a few weeks, an AI-powered assistant to help CVS Health deal with the massive influx of calls. Watson Health handles more than 10 million calls in three months, improving the customer experience and reducing costs. Keep in mind, this is for one vaccine and one use case. As use cases expand, the benefits will grow. This is a compelling value proposition and we've recently deployed Watson Assistant to other clients ranging from York University to DFW Airport to PayPal. These examples and others reflect our ability to build powerful AI capabilities for business for which we are also externally recognized. IBM was again ranked number one in IDC's artificial intelligence market for 2020 market share. And IBM has been named a leader in Gartner's 2021 Magic Quadrant for data science and machine learning platforms. Since we announced our new go-to-market model in January, we have made significant changes to our sales model and are providing clients with a more technical and experiential approach. Every client I have spoken to sees the value of this approach. They are pleased to co-innovate with IBM, leverage our garage methodology, and derive value more quickly from our solutions. Of course, we expect the return on these investments, such as improved renewal rates and client expansion, to take time. But time measured in months, not years. We've also been building and expanding a powerful ecosystem of partners who are playing a larger role in helping our clients move along the transformation journey. We're expanding the scope of our partnership with EY. To help financial institutions accelerate digital transformation, IBM and EY recently created the Financial Services Center of Excellence and launched the IBM Tech Hub at EY to strengthen EY's capabilities in hybrid cloud. We also built EY Diligence Edge, an AI platform hosted on the IBM cloud using Watson to drastically decrease the time it takes to do due diligence during mergers and acquisitions. Another partnership that has grown stronger is with Schlumberger. Building on the partnership we announced last year, we've recently launched a new data management platform that clients can leverage to unlock value from the massive amount of data produced by the energy industry. We're seeing growing momentum in our IBM cloud for financial services. Banks have stringent needs driven by compliance, security, and resiliency. Launched last year, The IBM Cloud for Financial Services includes key control and security features built right into its very core. It makes it easier for banks to collaborate with ecosystem partners and vendors. In the second quarter, we reached a milestone of more than 100 ecosystem partners in support of clients like Bank of America and BNP Paribas. While we invest to expand our ecosystem, we are also investing to enhance our portfolio. In the second quarter, we announced a series of products to further differentiate our hybrid cloud and AI capabilities. This includes AutoSQL that automates the management of data without having to move it, CodeNet that teaches AI systems on how to translate code, Watson Orchestrate that augments the personal productivity of professionals, CloudEngine to simplify how developers build cloud-native apps, and Mono2Micro to help companies decide which apps should move to the cloud and to transform monolithic apps into microservices. Red Hat launched new managed services on OpenShift, including API management, Apache, Kafka, and data science services that make it easier than ever to build next-generation applications on OpenShift. Meanwhile, we continue to complement our organic investments with acquisitions. Durbanomic is an ARM provider that helps optimize the performance of any application or resources. It builds on the recent acquisition of Instana for APM and observability and the launch of IBM Cloud Pak for Watson AIOps to automate IT operations with AI. We are reinforcing our ecosystem play in GBS with the acquisition of WEG, the leading Salesforce consulting partner in Europe. These are near term opportunities. At the same time, we are focused on emerging and longer term opportunities such as quantum computing. Quantum is an area of incredible promise, slated to unlock hundreds of billions of dollars of value for our clients by the end of the decade. To help business and society reap the benefits of quantum computing, we have put a roadmap in place to build a thousand plus qubit computer by 2023. we are forging a series of major partnerships to advance the business and science of quantum computing and post quantum encryption. This quarter we have announced we'll join forces with the University of Tokyo in Japan, the STFC Hartree Center in the United Kingdom and the Fraunhofer Institute in Germany. This builds on the partnership we announced last quarter with the Cleveland Clinic. Before I close, I'd like to quickly comment on some of our initiatives around societal issues. This month, we released our 2020 CSR report. In it, you will see our efforts to apply the power of our technologies to advance societal progress, such as applying supercomputing resources in support of COVID-19 research. We have made the important commitment to reach zero greenhouse gas emissions by 2030 without the use of carbon offsets. We're taking a series of actions to increase our diversity representation, and we are being transparent in our diversity and inclusion scores, as you can see in our report. To close, let me reiterate my confidence in our strategy. Our second quarter results demonstrate the progress we are making towards achieving our two financial objectives, sustainable mid-single-digit revenue growth post-separation and strong cash generation.
spk02: Jim, over to you. Thanks, Arvin. As always, I'll start with the financial highlights and then comment on our revenue performance, business model dynamics, and cash and liquidity position before getting into the segments. In the second quarter, we grew revenue over 3%, as reported, to $18.7 billion. We expanded our operating gross profit margin and grew gross profit dollars 4%. We reported operating earnings per share of $2.33. Our adjusted free cash flow was $3.8 billion through the first half, and we generated $11 billion over the last year. And our balance sheet and liquidity position remains strong. We continue to make progress in our revenue performance, led by 7% growth in global business services and 2% growth in software. both at constant currency. As Arvind mentioned, the spending environment is improving. We see this in markets where reopening is progressing, like the United States and Canada, and in several countries in Western Europe. From an industry standpoint, we saw a meaningful improvement in some of the areas that have been more impacted by the pandemic, like travel and transportation, automotive, and industrial products. Globally, we're helping enterprise digitally transform, leveraging our platform approach. IBM's cloud revenue over the last year across software, services, and infrastructure is now $27 billion, which is up at a double-digit rate. This continues to be led by global business services and cloud and cognitive software, whose cloud revenue this quarter was up 30% and 25% respectively. As our revenue performance improves, the fundamentals of our business model remain solid. We expanded operating margins with gross margin up 30 basis points and pre-tax margin up 70 basis points. We've taken actions to streamline and simplify our operating model. As I've said in the past, roughly one-third of the structural actions are to improve global technology services profit profile ahead of the separation of Kindrel. We're realizing these savings and our GTS gross and pre-tax margins are up this quarter. The other roughly two-thirds of the targeted actions address stranded costs from the separation and create financial flexibility which we are investing for future growth. We're ramping investments in skills, innovation, and in our ecosystem. Over the last couple of quarters, we've been aggressively hiring, adding delivery resources in GBS, technical skills in Red Hat, and go-to-market capabilities across the board. We're scaling our garage footprint and skills to provide a more experiential approach to selling and consulting services. We're increasing research spend in areas like quantum, hybrid cloud, and AI. We're accelerating our ecosystem investment. We also completed several acquisitions in the first half of the year to add hybrid cloud and AI software capabilities and skills in strategic GBS ecosystem partners. Now turning to our free cash flow and balance sheet and liquidity position. We generated $3.8 billion of adjusted free cash flow in the first half. This adjusted view excludes $1.2 billion cash impact for the structural actions initiated late last year and transaction charges associated with the separation of Kindrel. These first half charges are consistent with our expectations from the beginning of the year. This $3.8 billion of adjusted free cash flow was up slightly year to year with growth in our underlying business performance, offset by about $700 million of the billion-dollar full-year cash tax headwind we discussed last quarter. With solid cash generation and disciplined financial management, we continue to de-lever while investing in the business and paying a secure and modestly growing dividend. Our cash balance at the end of June was $8.2 billion. This is down about $6 billion from year end. while debt was down about $6.5 billion. We've now reduced our debt by about $18 billion from the peak in mid-2019. In the first half, we also used cash to acquire businesses and return capital to shareholders, roughly $3 billion each. In the second quarter, we also increased our dividend per share for the 26th consecutive year. So now I'll turn to the segment results, starting with cloud and cognitive software, where revenue growth improved to 2% this quarter. This performance was led by growth across both cloud and data platforms and cognitive applications, which are our software growth vectors. These were offset by declines in transaction processing platforms, our value vector. Stepping back, growth factors reflect key areas of importance and investment for our hybrid cloud and AI strategy, including Red Hat, automation, data and analytics, and security. Our success is reflected in our software cloud revenue, which was up 25% this quarter. Transaction processing platforms, as our value vector, drives profit and cash while supporting mission-critical solutions for our enterprise clients. In cloud and cognitive software overall, we again had strong subscription and support renewal rates, and our software deferred income was up over a billion dollars year to year. Moving into the business areas, cloud and data platforms grew 8%, led by strength in our hybrid cloud platform and cloud packs. Red Hat had good performance with normalized revenue growth of 17%. With consistently strong performance in Red Hat and the value of bringing IBM and Red Hat together, we've now achieved our objective of operating earnings per share accretion in two years, so an important acquisition milestone. In the quarter, both RHEL and OpenShift continue to deliver strong growth and take share in the respective markets. Cloud packs, which are built on OpenShift, continue their momentum with our enterprise clients. This quarter, we had strength in Cloud Pak for Integration, which delivers rapid and cost-saving solutions for integration development. Cloud Pak for Business Automation also had strong growth as clients leverage AI-powered automation to solve operational challenges. The acquisition of Turbonomic further extends our automation offerings. In cognitive applications, revenue was up 8%. The growth was fueled by horizontal solutions, including security software and services, maximal asset management, weather, and sterling supply chain. With the acceleration of cybersecurity attacks, clients are increasingly looking for modernized security platforms to detect and respond to ransomware and other attacks. This quarter, we had strength in our integrated software and services offerings, including Cloud Pak for Security, Data Security, and X4 Security Services. IBM security offerings are employed in over two-thirds of the world's 500 largest companies. In the area of supply chain, we are working with several new clients this quarter, as demand for omnichannel solutions have accelerated requirements for sterling order management in industries like retail. Our transaction processing platforms revenue declined. We provide flexibility to our clients in how they purchase this mission-critical software. Since early last year, we've seen a preference for OpEx over CapEx, putting pressure on perpetual licenses in favor of more consumption-like models. This continues, though clients remain committed to our products as we again had strong renewals in our transaction processing platform software. Looking at cloud and cognitive software profit, we grew profit dollars with operating leverage from revenue growth while we continue to invest in new innovations and our ecosystem. Turning to GBS, revenue of $4.3 billion returned to pre-pandemic levels, and revenue growth improved to 7%. Clients are accelerating the rate and pace of digital transformations using cloud and AI to gain operational insights, increase productivity, and create new growth opportunities. We are capturing this market growth through our differentiated offerings in hybrid cloud, including Red Hat, and intelligent workflows. We have seen signings and revenue momentum in both business transformation services which leverage our combined consulting, BPO, and core ERP capabilities, as well as the application modernization and management services we provide around the hybrid cloud platforms of our clients. This is reflected in our performance this quarter. For example, our book to bill in this strong revenue quarter was greater than one, driven by growth in digital transformations across key practice areas such as Salesforce, SAP, Workday, as well as in application modernization and hybrid multi-cloud management. And we continue to see momentum in our small deals, which historically convert to revenue in a shorter time frame. Small deal signings grew at a high teens rate. Moving to revenue, we had continued momentum in GBS cloud revenue, which was up 30% in the quarter. with growth across consulting, application management, and GPS. Our Red Hat practice, which now contributes over one-third of our cloud revenue growth, again had strong results. This quarter, we added over 170 Red Hat client engagements. The 700 engagements since the acquisition have generated over $2.5 billion of signings. In consulting, revenue was up 11%. driven by the investments we are making in building skills in third-party cloud providers like Microsoft and AWS, and in expanding our practices with ecosystem partners such as SAP, Salesforce, and Adobe. Clients are also finding value in our differentiated garage methodology as we work with them to co-create solutions. This unique and scalable approach to innovation and execution is now embedded in the majority of our value propositions across ERP implementation, BPO, and application modernization. We also had strong growth in our intelligent workflow offerings. These are end-to-end offerings which leverage hybrid cloud and AI to transform client processes. They connect consulting and BPO in areas such as finance, supply chain, customer service, and talent transformation, and contributed to our global process services revenue growth of 25%. Lastly, within application management, revenue was up 1% as we continue to transition from managing applications on premise to those that run in hybrid multi-cloud environments. Turning the GBS profit, Our gross profit margin declined 60 basis points this quarter. We are investing to expand on the skills and practices to continue to capture the market opportunity. We are making significant investments in both delivery and go-to-market resources, where we increased our capacity by 10%. We are adding skilled practitioners in high-demand areas such as Salesforce, SAP, Adobe, Microsoft, AWS, and Red Hat. And we are investing to integrate and scale our recently announced acquisitions. Turning to systems, revenue was down 10%, reflecting product cycle dynamics across IBM Z, power, and storage. IBM Z revenue was down 13%. And I'll remind you that compares to a very strong performance last year when we were up 68%. Throughout the last eight quarters, the Z15 client value has been apparent. And the program continues to outpace the strong Z14 program. Another proof point of IBM Z as an enduring platform. This quarter, financial services continue to drive IBM Z. given capacity requirements to address robust market volatility. With security top of mind, purchases were also driven by clients looking for capabilities such as pervasive encryption and HyperProtect to secure mission critical applications and data, both on premises and in the cloud. The value proposition is clear. Z15 is secure, scalable, and reliable. Product cycle dynamics also played out across power and storage. Power revenue was down 5%, an eight-point improvement over last quarter's rate. Storage revenue also declined, driven by high-end storage tied to the IBM Z cycle. Looking at systems profit, pre-tax profit margin was down, reflecting a mixed headwind given where we are in the C15 product cycle. Moving to global technology services, we remain focused on improving the financial profile as we position Kindrel to be a standalone company by the end of the year. You will recall last year we initiated actions for an improved margin, profit, and cash generation profile upon separation. We are seeing the results of these actions in the GTS profit performance this quarter with profit dollar growth and margin expansion. Gross margin expanded 110 basis points and pre-tax margin 190 basis points. GTS revenue declined 4%, a modest improvement from first quarter performance, driven by improving trends in client-based business volumes and project activity. Our current clients continue to value partnering with Kindrel to modernize and manage their mission critical workloads and services. as evidenced by our strong and improving renewal rate of 95%, which is up two points quarter to quarter. These renewals include six deals with a contract value greater than $100 million. One of these is an extension of our relationship with AT&T to provide support for data center migration and consolidation and IBM Z infrastructure management. I'll mention we also extended our software relationship with AT&T. As an IBM strategic global networking provider, AT&T business is playing an important role in the separation of Kindrel, using their expertise for network separation. While our performance with existing clients remains strong, as we would expect, the sales cycles for new logo clients is elongating. as they await further information related to Kendrell. With that, let me give you a quick update on where we are in the separation process. We are continuing to build out the management system and support structure. At the same time, we are making solid progress executing on the necessary financial, legal, and regulatory milestones to enable the transaction. We still expect the Form 10 to be available in the fall. and remain on track to close by the end of the year. To wrap up, let me bring it back to the IBM level. In January, we said we expected an improving financial profile throughout 2021. As I look back on our first half results, our revenue performance improved in the first quarter and then again in the second. And our adjusted free cash flow grew in the first half. Our business model fundamentals are solid. Operating margins are improving, and we're driving profit dollar growth. Importantly, as you've heard today, we've been taking a number of actions to execute our hybrid cloud and AI strategy. This includes strengthening our portfolio, expanding our ecosystem, and implementing go-to-market changes. And we continue to have a strong balance sheet and liquidity position. We've been clear on the metrics we're focused on, revenue growth, and cash flow. For the full year, we continue to expect revenue growth at current spot rates. We maintain this view since January, though I'll remind you since then, we've lost about a point of revenue growth from the dollar strengthening. We also continue to expect $11 to $12 billion of adjusted free cash flow. This adjusted free cash flow excludes about $3 billion of cash impacts for structural actions, and the transaction charges for the spinoff. As we look to the third quarter, we expect second to third quarter revenue dynamics to be in line with the average of the last three years. Looking at the revenue profile, more year-to-year growth should come from the underlying business performance, mitigated by moderating currency benefits. We're continuing to ramp our investments, As I mentioned, we're reinvesting much of the savings from our structural actions, and as a result, this will keep expense levels higher. Our operating tax rate will also be up year to year, though I expect the third quarter rate to be fairly consistent with the second. To sum it up, we made progress in the first half. While there's more to do, we are well positioned to deliver on our 2021 expectations and our financial model post-separation. So with that, let's go to Q&A. I'll turn it back over to Patricia.
spk06: Thank you, Jim. Before we begin the Q&A, 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.
spk04: Thank you. At this time, we'll begin the question and answer session of the conference. To ask a question, please press star one and record your name clearly. If you need to withdraw your question, press star two. Again, to ask a question, please press star one. Our first question comes from Katie Huberty with Morgan Stanley. Your line is open.
spk05: Thank you. Good afternoon. Question, I guess, for Jim. Cloud and cognitive software, as well as GBS, PTI margins are down year on year. I imagine a lot of that is coming from the investments that you walked through, but can you talk about any other factors like mix that are playing into the margin performance in those groups? And also, are you seeing any impact from labor shortages and wage increases, particularly in the services business? Thanks.
spk02: Sure, Katie. Thank you very much for the question. Obviously, those two very important segments that you chose, and software are two of our growth factors within our business model. As we've said entering the year, you know, we guided both on revenue and on cash flow. And we said that we were going to continue to invest significantly within those growth factors as we move forward. And I see, and I think what you see playing out here in the second quarter is that investment starting to ramp up from the first quarter into the second quarter going forward. We are investing in front of demand. because of what we said in the pre-remarks is that we see an encouraging macro and demand profile playing out. And you see that with the strong acceleration in our software base of business quarter to quarter and in our GBS base of business. GBS, by the way, exceeded our expectations and actually got back to pre-pandemic revenue levels overall. But just to really bring it home, One, we're investing. Two, we have high margins in our software base of business already. And the dynamics between Red Hat and the deferred revenue dissipating as we move through the year is really what you see play out in the second quarter overall. We feel very comfortable at the margin level in software. We're going to continue to invest in innovation, ecosystem, and skills. And we feel very good about our GBS business overall. Labor pressures, yes. There is a war for talent going on. We are investing significantly. We're bringing thousands and thousands of GBS practitioners in through the first half, and we feel pretty good about what the profile of that business is going forward.
spk06: Thanks, Katie. Sheila, can we take the next question, please?
spk04: Our next question will come from Wamsi Mohan with Bank of America. You may proceed.
spk01: Yes, thank you. It's nice to see the growth in gross profit dollars two quarters in a row. You have very strong consulting growth and GBS growth, as Jim just alluded, but gross margins compress 60 basis points year-on-year in GBS. It would be nice to see the full leverage in the model come through with both revenue growth and margin expansion to amplify that gross profit dollar growth. So my question is really, how much longer would you need to be in investment mode in GBS and Is it possible that we see in the coming quarters or years, when do we actually see both revenue growth and margin expansion come into the model in GBS? Thank you.
spk02: Wamsi, thanks for the question. So just building on Katie's question up front, we are and will continue to invest in this business as GBS is an essential part of our hybrid cloud platform-centric strategy. It is both the tip of the spear, if you want to call it, in driving the demand from an architectural point of view to our platform that then creates that flywheel effect that we talked about. For every dollar that we land on the platform, we get $3 to $5 of software and $6 to $8 of services revenue. So we're going to invest significantly. Now, with that said, You know, we rebounded off of second quarter. Second quarter, last year when the pandemic hit, we dropped seven points quarter to quarter. We posted down six last year in GBS. We returned back to pre-pandemic revenue levels and exceeded growth expectations. But we're going to continue to invest in this part because of the importance GBS plays to that hybrid cloud platform and and we'll get that profit dollar contribution. And more importantly, you see it play out in our second key metric that we give guidance on, and that's our adjusted free cash flow. And we feel very good about where our adjusted free cash flow is through the first half. It's up year to year. Really taking into account most of the cash tax that when we talked about 90 days ago is pretty much behind us going forward. So our attainment-wise on adjusted free cash flow, which is really going to be a reflection of both top line revenue acceleration and operating leverage and margin as we move forward. Thanks, Mamsi. Can we go to the next question, please?
spk04: Our next question comes from Tony Sacconaghi with Bernstein. Your line is open.
spk12: Yes, thank you. I was wondering if I could ask you a little bit about acquisitions. I think over the last year you spent $3.2 billion on acquisitions. And Arvind, you've said that you expect acquisitions on a sustained basis to contribute about 100 to 150 basis points of inorganic growth per year. So is that what we should be thinking about, about $3 billion in acquisition spend generating 600 to 900 million, that's 100 to 150 basis points of RemainCo? Is that sort of the mental model framework we should think about? And then could you comment specifically on how much acquisitions impacted GBS's reported growth rate and Cognitive Apps' reported growth rate in the quarter? Or just give us a dollar figure for the inorganic acquisition contribution to each of those businesses, please. Thank you.
spk03: Thanks, Tony. Great question. So let's just start with the first part. We're generating, last year if I remember correctly, 10.8 billion of free cash flow for the year 2020. We have said 11 to 12 this year. So if you do the math between dividends, acquisitions, and capital expenditures, you get to the three to three and a half. If you now say that we are going to increase our free cash flow by half a billion to a billion in a given year, then you can expect that number on inorganic activities to go up year-over-year. So the 3 to 3.5 is a fair number for this year. It could go up as we begin to increase our cash flow. We've already said next year we expect to generate 12 to 13, not 11 to 12. So that gives you one sense, Tony, just on the absolute number. The second question you had in there on the GBS. So as we have said and I've said before, 100 to 150 basis points of growth from acquisitions. I would say that GBS is right in the top end of that number. If you look at the second quarter, and if you look at cognitive applications, actually more cognitive software all in, because I think cognitive applications, there was a net, if any, from acquisitions. The number would be at the very, very low number. I mean, maybe a few tens of basis points. Nothing significant yet. Now, the GBS acquisitions give you an immediate return and then grow. had a nice number, but obviously contributing a lot less there. Think of it in the software side, the model is they come in, they do because of deferred revenue, begin to give you some acquisition, revenue over 12 months, but those acquisitions grow very fast. So the contribution actually goes on for multiple years, not just for a single year, from those acquisitions to the overall growth rate. And so that's quite different, GBS immediately, For 150, software much smaller, a few tens. But imagine that all of those build up over time. But it provides a pretty nice tailwind then over two to three years.
spk06: Thanks for the question, Tony. Let's go to the next question, please.
spk04: Our next question will come from Amit Daryanani with Evercore. Your line is open.
spk08: Thanks for taking my question. Good afternoon, everyone. Arvind, I have a question on the hybrid cloud potential because you've talked a fair bit about it today and in the past, and I think most investors really agree that hybrid cloud is the reality, but maybe you could touch on, A, why do you think IBM is better positioned to enable your customers to get there versus some of your peers? And then secondly, what does hybrid cloud mean for your profitability and free cash flow? Because I think to some extent there's a perception, perhaps misperception, that the shift from on-prem to hybrid is negative for IBM's margins.
spk03: Hi, Ahmed. Thanks. And look, so as you correctly pointed out, I mean, I will repeat to you, but I obviously believe it, hybrid cloud is the reality for our clients. Now to get into the more meaty parts of your question. If you look at why would people prefer us for hybrid cloud, If I look at a given large hyperscaler, they'll do hybrid as in their own public cloud and maybe some on-premise means. But the goal is to drive workload onto the public cloud. Who has the credibility to go across multiple public clouds? And that's why you hear me always say both Microsoft and Amazon are our partners, not only our competitors. And that is an important play that IBM has done for many, many decades, where we integrate across the environments that our clients operate in. So that's one part. On a bit more of a technical level, that was the primary reason for the Red Hat acquisition. Red Hat gave us both the platform and the assets to be able to bring a hybrid cloud platform to bear. Because we would all agree, I think all of your listeners and all of your audience would agree, that Linux is a de facto operating system. Red Hat Linux is a de facto for on-premise and private environments. Containers is the standard which people are going to move on to. So if you say you begin really strong on-premise and private, you can take that same exact environment to multiple public. That gives us, we believe, an advantage. Now, let me acknowledge the point you're making. If hybrid cloud is the reality, then everyone is going to start having a play in hybrid. But we believe that our play is advantage for the industries that we serve. That doesn't mean they'll use us exclusively, but they will use us to a large extent. And that is where we are headed there. The second part now for your question, which I think actually plays right in on profitability and cash flow. The way we look at it, over two-thirds of where we'll get our revenue is going to lie in software. If that is the case, then software comes at software margins. I'm not going to debate whether you get a difference in model from on-premise licensing to as a service licensing to term license models. All of those even out and pretty much are washed over two to three years. They are a difference in any given six months, but if I take a two to three-year view, and that is what we really fixed on driving, then all of that evens out, and you begin to get gross margins back up in the 70s and 80s, and you begin to get the profitability and cash flow associated with that. And so that is the answer to that question. By the way, the services based on helping our clients go there, you can begin to see that. And I know that there were a couple of questions earlier on the GBS margin. Look, we are very fixed on driving investment. So if we drive investment a little bit ahead, I'm not gonna tell you years ahead, but maybe one or two quarters ahead of the revenue, or the revenue growth comes, we'll keep doing that, and that'll impact maybe percentages, but by tens of basis points. But it shows up in absolute profit and absolute cash flow, even in that part of the business.
spk02: Yeah, I would just add one thing to that, Arvind, to build on your point. When you look at the IBM company post-separation of Kindrel, the IBM company is going to be roughly around 45% to 50% software as far as composition and mix. That carries with it a high EBITDA profile already today, And just as one example, when you look at our Red Hat base of business today as CFO, I love that. That subscription model that has growth and ARR built into it overall, it's already running well north of the rule of 40 today. So as we shift more and more to software-based contribution, that mix effect will help us, bottom line, in cash also.
spk06: Thank you, Amit. Sheila, let's take the next question.
spk04: Next, we will hear from Matt Cabral with Credit Suisse. You may proceed.
spk10: Yeah, thank you. Within cloud and cognitive, I was hoping to dig a little bit more into Cloud Pax and wondering if you could talk about just more broadly the maturity of the Cloud Pax portfolio and where you are in the integration with OpenShift. And if you could just talk about where you're seeing the impact in terms of customer adoption so far. And going forward, just the contribution from CloudPaks on the financial performance of the software segment from here.
spk03: Yeah. So, Matt, thanks for the question. Let me answer the first part of your question on the architectural elements and the use cases, and then I'll give it to Jim to answer it on the financials. So if you look at the maturity of CloudPaks, I will tell you that every cloud pack we have been selling this year and deploying this year is on OpenShift. We made the move from other Kubernetes platforms onto OpenShift starting in October of 19. And so, yes, of course, let's acknowledge that people who might have purchased prior to 19 would have bought other Kubernetes platforms. And so by last year, 2020, it was all going on to OpenShift. So I think that maturity is complete. Now, if some people have prior versions of software deployed, we observe typically within three years from day one, they do move to the new versions. So I would expect by the end of this year, even the prior deployed would have fully moved and that's done. If you look at customer adoption, cloud packs are a very strong contributor to the 3,200 clients that we mentioned. well over half of them come through cloud packs. And so what are the use cases? Look, the work we're doing with Palantir is a great example. Palantir runs on top of the cloud pack for data. That's a great example of what we're doing. When you hear us talk about Watson Assistant, as in the CVS use case, which handled over 10 million calls in a quarter for COVID-19 vaccines, that Watson Assistant runs on top of a Another cloud pack. So these are great examples of how mature the technology is. I will tell you the OpenShift maturity is complete, and it really helps reinforce both the adoption of OpenShift as well as then clients get very comfortable with deploying OpenShift for other use cases. It's a workload at the end of the day for OpenShift, and as clients get comfortable, they might deploy it for other purposes as well. In terms of the financials, I'll pass it to Jim.
spk02: Yeah, just quickly, Matt, thank you very much for the question. You know, taking a step back, first of all, we're very pleased with our overall progression within our software portfolio. More work to do, but we're making progress. And C&DP, which I'll remind everyone on the call and our investors, is about 50% of our overall software portfolio, and that's where the lion's share of our cloud packs sit. Now, when you look at our C and D P performance, when we look at it on the way we manage the business on a historical normalized basis, we see acceleration. We returned back to growth in first quarter. We accelerated that growth to 4% here in the second quarter. And that is really attributed to the nice momentum we're seeing in cloud packs. You know, we announced cloud packs 18 months ago, two years ago, Given our ELA historical client base, that takes time to churn through that client base. And as you know, last year was the trough of our ELA renewal cycle. We start to improve on that later in the second half. And really, that ELA cycle plays out in 2022. But we actually had a very nice inflection here in the second quarter. Our cloud packs on a NRR cycle. Net revenue renewal, we're north of 100%. So we've said all along, Arvind and myself, that there's going to be shift with cloud packs and there's going to be lift with cloud packs. And now we're starting to see a higher mixed contribution of cloud packs, and we're starting to see where we do have shift, we're getting north of 100% on an NRR perspective, and that's an encouraging trend.
spk06: Thank you, Matt. Let's go to the next question, please.
spk04: Our next question comes from Tinjin Wong with JP Morgan. Your line is open.
spk11: Hey, thanks. Good to talk to you all. Just on the services side, consulting, obviously great, double-digit. You had signings pretty strong here. Do you feel like from a backlog and pipeline perspective that you're starting to reach a little bit of inflection to get some better growth overall, you know, out of the services unit given what you – plus some of the investments that you're making? And then separately, forgive the follow-up question, Patricia, but just on the PPP front, transition processing platforms, is it just a comps issue that we should look for the performance there to get better, or are there other areas that we could be potentially monitoring to see some better performance there, or is it just waiting for that transition? Thanks.
spk02: I'll take that, Arvind. Tinjan, thank you very much for the question. You know, when you look at our services base of business, you know, we deliver $9.2 billion of signings in a quarter. It's up double-digit at actual rate. We did see improvement in our backlog overall. It's really very different dynamics playing out here, as we tried to say in the prepared remarks. We see very strong momentum in our GBS base of business. When you look at our signings in the quarter, we had strong performance. Our trailing 12 months. book the bill is 1.2 through the first half we have roughly double-digit growth in signings across all three sub-segments very good growth this quarter in large deals and we have continued momentum in small deals and we saw improvement in our revenue in our backlog in our revenue realization moving forward and that gives us comfort you know as we said in the prepared remarks we expect about a normal quarter to quarter seasonality overall, we actually see GBS accelerating growth probably about another point from the second quarter overall. In GTS, really what we're seeing is a good performance overall, leveraging our incumbency position and driving strong renewals. We're seeing with that incumbency position finally a turnaround with an encouraging trend on client-based business volumes and project-based services that they're engaging in. Project-based services and our incumbency accounts were up 20% here in the second quarter. But as expected, the new logos, while we have a very healthy pipeline and new logos out there, the sales cycles are elongated, as we said in the prepared remarks. So we see some nice acceleration continuing in GBS overall. But again, with GTS, It's a focus on the fundamentals of the business profile of that. That means margin, profit, and cash. And what I think you've seen in the second quarter, we made some very good progress overall with margins up 110 basis points, pre-tax margins up 190 basis points, and profit dollar growth both in gross profit dollars and in pre-tax profit dollars. Lastly, on TPP, yes, as we talked about many times over the last – year or so, we do see the transition happening in this portfolio with regards to a shift back more and more to consumption-based, annuity-based purchasing versus in 2018 and 2019, we had a much healthier macroeconomic environment, a very cash-rich environment. Clients then shifted to more perpetual licenses. We're seeing that come back. And that's going to play as it played out where we saw the revenue upside in 18 and 19. In 20 and 21, you're going to continue to see the headwind, as we've been saying. We expect that to come back in 2022, back to normal market trend growth rates overall. Thanks, Tingen. Let's go to the next question, Sheila.
spk04: Our next question will come from David Grossman with Stiefel. Your line is open.
spk07: Thank you. Actually, most of my questions have been answered. I just have one follow-up question. I think, Jim, you mentioned revenue retention of greater than 100%, and I wasn't quite sure what the reference point was in software and, you know, whether you have any incremental, you know, data points you can share about revenue retention by business, you know, within a cognitive segment.
spk02: Sure, David. Thank you very much. You know, cloud packs are definitely an essential part as we've invested significantly to containerize our software and optimize it on top of OpenShift, our hybrid cloud platform overall. When we take a look at our cloud packs, we measure and manage. You know, Harvin and I have a dashboard that we look at all of our large enterprise top clients overall, our deployment, penetration within each of those clients, and we're able to see As we transition a client from a traditional middleware to a cloud-based containerized solution, not only can we track the deployment and how that progresses over time, we can see the dollar of yesterday versus the dollar of today as they transition to Cloud Pak, and we measure the net revenue retention. Not only how much come in, whether we're able to upsell, cross-sell with multiple vendors, cloud packs as we move forward. And like I said in the second quarter, we're making progress, much more to do, but we're making progress on the mixed composition of moving more and more to cloud packs. And we're also making progress on capturing more of our clients' wallet share dollar for that same dollar of traditional middleware overall. Hopefully that helps, David.
spk03: Jim, to make it into business terms or a use case, What that tells you is that when they renew, they are actually buying more volume, which means it's beginning to become a larger part of the real estate, technology real estate at a client.
spk06: Very good. Thank you, David. You know we're at the top of the hour, but let's take one more question, Sheila.
spk04: Thank you. Our last question will come from Keith Bachman with Bank of Montreal. Your line is open.
spk09: Hi. Many thanks, team. I wanted to ask Arvind you a question on revisiting on what your growth assumptions or targets are around cognitive. And the particular reference point to my question is this quarter, you generated roughly 2% revenue growth. And it was, you had the benefit of compare, particularly on some of the line items within cognitive. And so not particularly it's good growth but you know still a ways to go to reach your longer-term target so so what happens to change that improves cognitive and Part B the backdrop is if I think about Red Hat and we remain pretty positive on Red Hat even over the next couple years but you still face the uphill battle of the longer-term trends within cognitive db2 is probably declining market and as you've talked about the past transaction processing platforms is also a declining I think, revenue stream over the arc of time. So if you could just revisit on how do you reach your longer-term growth rates within Cognitive? Thank you.
spk03: Hi. Thanks, Keith. Important question and important element of our thesis going forward. So we've been clear that our current Cognitive software will grow mid-single-digit going forward. And you're questioning, Keith, how is that going to be possible? So first and most important element, Red Hat today is sitting at about, in rough numbers, 25% of the business, growing at about 17% this quarter. Let's call it 15% in the medium term. But, as opposed to being 25%, it's going to go up and up to become 35% of the total, and over a longer term, even more. So 15% for one third of the business, you kind of get the contribution from that, which is quite significant. Also as we are both innovating organically, example in Cloud Pax, and we are acquiring businesses that are going to turbocharge, bit of a pun on Turbonomic, our business there on both management as well as on cyber security, we expect to see very high growth rates there. high single digit, that is well above the mid, maybe into the low double digits. Will we see declines in some parts of the portfolio? We've been very transparent. We expect TPP to be between mid and high single digit decline in the mid to long term. But it becomes a smaller and smaller portion of the total, so it has a drag from there. Cognitive applications, we expect to be right in there, but it's the smallest part of the portfolio. It's not the biggest part of the portfolio. And so, to just recap on that, number one, Red Hat, growing in the mid-teens as it becomes bigger, a bigger absolute contributor to the total. The rest of the cloud and data platform with a mixture of both organic innovation and inorganic acquisitions is going to then contribute to growth at or above the mid-single digits in the medium term. TPP, mid-single digit decliner. GOG apps, probably right in line with the model. So hopefully, Keith, that gives you a breakdown into a lot of pieces. By the way, the DB2 that you mentioned declining is very much inside the TPP. So those are not really different questions. DB2 mainframe and TPP are one and the same. So let me just make a couple of comments to wrap up the call. We again made progress in this quarter, but we acknowledge we still have more to do. As we move into the second half, we're continuing to invest and execute on our actions, which includes the separation of Kindle. All of this positions IBM to exit the year in a strong position on a path to sustainable growth, and I look forward to continuing this dialogue with you.
spk06: Great. Sheila, can I turn it back to you to close out the call?
spk04: Absolutely. Thank you. Thank you for participating on today's call. The conference has now ended. You may disconnect at this time.
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