International Business Machines Corporation

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.

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

Thank you, Patricia, and thanks to all of you for joining us today. Our fourth quarter results reinforce our confidence in our strategy and model. With solid revenue growth, we are on track to the mid single digit trajectory we had laid out in our investor briefing last October. The trend we see is clear. Across industries, clients see technology as a major source of competitive advantage. They realize that powerful technologies embedded at the heart of their business can lead to seismic shifts in the way they create value. This reality of technology being about a lot more than cost will persist and explains why clients are eager to leverage hybrid cloud and artificial intelligence to move their business forward. Our fourth quarter results illustrate the strong client demand we see in the marketplace for our technology and consulting. IBM Consulting again had double-digit revenue growth as our ecosystem play continues to gain momentum. Software revenue growth reflects strength in Red Hat and our automation offerings. Infrastructure had a good quarter, especially with regards to IBM Z and storage. Over the last year and a half, we have taken a series of actions to execute our hybrid cloud and AI strategy and improve our revenue profile, optimizing our portfolio, increasing investments, expanding our ecosystem and simplifying our go-to-market. As we start to yield benefits from these actions, our constant currency performance improved through 2021. Our most significant portfolio action was the separation of Kindrel. You'll remember we had initially expected the spin by the end of the year and we completed it in early November. As we discuss our results, we'll focus on the new basis and structure that encompasses today's IBM. As we look to 2022, we expect mid single digit revenue growth before Kindle and currency and 10 to 10 and a half billion dollars of free cash flow for the year. Both of these are consistent with our medium term model. Let me now spend a few minutes on what we are seeing in the market, how we address it and the progress we are making. We are seeing high demand for our capabilities in several areas. Clients are eager to automate as many business tasks as possible, especially given the new employee demographics. This dynamic is likely to play out over the long term. They are also using AI and predictive capabilities to mitigate friction in their supply chains. Cybersecurity remains a major area of concern as the cost of cybercrime already in the billions of dollars, rises each year. As clients deal with these challenges and opportunities, they're looking for a partner they can trust and who has a proven track record in bringing about strategic transformation projects. This is why our strategy is focused on helping our clients leverage the power of hybrid cloud and AI. Hybrid cloud is about providing a platform that can straddle multiple public clouds, private clouds, and as a service properties that our clients typically have. Our approach is platform-centric, and the platform we have built is open, secure, and flexible. And it provides a solid base for the multiplier effect across software and services for IBM and our ecosystem partners. It starts with Red Hat, which offers clients unique software capabilities based on open source innovation. Our software, which has been optimized for that platform, helps our clients apply AI, automation, and security to transform and improve their business workflows. Our consultants deliver deep business expertise and they co-create with our clients to advance their digital transformation journeys. And our infrastructure allows clients to take full advantage of an extended hybrid cloud environment. This strategy along with the differentiated capabilities you bring to bear to our clients, have led to an increase in platform adoption and new business opportunities across the stack. We now have more than 3,800 hybrid cloud platform clients, which is up 1,000 clients from this time last year. IBM Consulting continues to help drive platform adoption with about 700 Red Hat engagements for the year. Clients like Dun & Bradstreet, National Grid, AIB, and Volkswagen have all recently chosen IBM's broad hybrid cloud and AI capabilities to transform their processes and move their business forward. As I look back on the year, we had good success in broadening our ecosystem to drive platform adoption and to better respond to client needs. During our investor briefing, we talked about strategic partnerships that will yield billion-dollar businesses within IBM Consulting. As we move towards that, we had more than 50% revenue growth this year in partnerships with AWS, Azure, and Salesforce. This adds to the strong strategic partnerships we have with others such as SAP, Oracle, and Adobe. We're continuing to broaden our ecosystem reach. In the fourth quarter, we announced an expansion of our strategic partnership with Salesforce to run MuleSoft integration software on Red Hat OpenShift. We also created a host of new consulting services with SAP to help clients accelerate their journey to S4 HANA. Together with Deloitte, we announced Dapper, an AI-enabled managed analytics solution. And we have expanded our partnership with EY to help organizations leverage hybrid cloud, AI, and automation capabilities to transform HR operations. We have also recently announced a host of new strategic partnerships with Cisco, Palo Alto Networks, and TELUS, all focused on the deployment of 5G edge and network automation capabilities. During 2021, we have been making changes to increase our focus and agility. and build a stronger client-centric culture. This includes putting experiential selling, client engineering, and co-creation at the heart of our client engagement model. We have completed thousands of IBM Garage engagements, and today we have nearly 3,000 active engagements. We've invested in hundreds of customer success managers to help clients capture more value from our solutions. And we have upgraded our skills with fewer generalists and more technical specialists. This is resonating well with our clients and is starting to contribute to our performance. The most important metric, of course, is revenue growth. But we are also pleased to see our client renewal rates increasing and our recurring revenue base growing. We are starting to see signs of sales productivity improvements with average productivity per technology seller increasing from the first to the second half. At the same time, innovations that matter to our clients remain a constant focus, and our teams have worked hard to deliver a series of important innovations in the past quarter. Starting with AI, we added new natural language processing enhancements to Watson Discovery. We're also combining and integrating products, such as Turbonomic, Instana, and Watson AIOps, to offer a complete set of AI-powered automation software to address the significant demand. This quarter, Red Hat announced that the Ansible automation platform is now available on Microsoft Azure, bringing more flexibility to clients in how they adopt automation. In partnership with Samsung Electronics, IBM announced a breakthrough that reorients how transistors are built upon the surface of a chip to enable tremendous increases in energy density. In quantum, we unveiled Eagle, a 127 qubit quantum processor. This is the first quantum chip that breaks the 100 qubit barrier and represents a key milestone on our path towards building 1,000 qubit processor in 2023. While organic innovations are important, we continue to acquire companies that complement and strengthen our portfolio. We made five acquisitions in the fourth quarter and a total of 15 acquisitions in 2021. Two weeks ago, we announced the acquisition of Envisi. Many consumers are willing to pay more for products that are made by companies that are more environmentally sustainable. As the world continues to move towards a more circular economy, what clients need is the ability to manage and measure their progress. Envizi's capabilities complement our own and help us respond to that client demand. Sustainability is important across a number of stakeholder groups, including clients, employees, and investors. We're continuing to make good progress and are particularly proud of our diversity and inclusion goals and our ability to attract and retain talent. Our efforts were recently recognized by Just Capital who named IBM as one of America's most just companies. Let me now close by emphasizing, once again, how our fourth quarter results strengthen the conviction that we have in our ability to deliver our model of mid-single-digit revenue growth. Jim will take you through the fourth quarter and then provide more color in 2022. Jim, over to you.

Thanks, Arvind. Let me start out with a few of the headline numbers. We delivered $16.7 billion in revenue, 58% operating gross margin, operating pre-tax income of $3.5 billion, and operating EPS of $3.35 for continuing operations. Last January, we said we expected performance to improve over the course of 2021 as we start to benefit from the actions we've taken. We have seen progress in our constant currency revenue growth rate every quarter, and now again in the fourth. This is the first view of IBM post-separation. We had solid revenue performance, up nearly 9%. I'll remind you, this includes the incremental revenue from the new commercial relationship with Kindrel. And we said we would be transparent on the contribution to our revenue growth for the first year. This quarter, our revenue growth includes about three and a half points from the new relationship. Excluding this, IBM's revenue was up 5%. We have aligned our operating model and segment structure to our platform-centric approach. In the fourth quarter, software was up 10% and consulting was up 16%. These are our two growth factors and together represent over 70% of our annual revenue. Infrastructure, more of a value vector, tends to follow product cycles and was up 2%. The software and infrastructure growth each include nearly five points from the new Kindle relationship, while there is no contribution to consulting's growth. Our platform-centric model has attractive economics. For every dollar of hybrid platform revenue, IBM and our ecosystem partners can generate $3 to $5 of software, $6 to $8 of services, and $1 to $2 of infrastructure revenue. This drives IBM's hybrid cloud revenue, which is up 19% for the year. Post separation, revenue from our full stack cloud capabilities, from infrastructure up through consulting, now represents $20 billion of revenue, or 35% of our total. Looking at our P&L metrics, our operating gross profit was up 3% and the $3.5 billion of operating pre-tax profit was up over 100%. Operating net income and earnings per share also grew. Let me highlight a couple of items within our profit performance. First, The year-to-year pre-tax profit reflects $1.5 billion charge to SG&A last year for structural actions to simplify and optimize our operating model and improve our go-forward position. We're continuing to invest to drive growth. Throughout the year, we have been aggressively hiring with about 60% of our hires in consulting. We're scaling resources in garages, fine engineering centers, and customer success managers, all to better serve our clients. We're increasing investments in R&D to deliver innovation in AI, hybrid cloud, and emerging areas like quantum. We're ramping investment in our ecosystem. And we acquired 15 companies in 2021 to provide skills and technologies aligned to our strategy, including capabilities to help win client architecture decisions. Regarding tax, our fourth quarter operating tax rate was 14%. This was up significantly from last year, but roughly two to three points lower than what we estimated in October due to a number of factors, including the actual product and geographic mix of our income in the quarter. Let me spend a minute on our free cash flow and balance sheet positions. Our full year consolidated cash from operations was $12.8 billion and free cash flow was $6.5 billion. These are all in consolidated results and include 10 months of Kindrel and the cash paid for the 2020 structural actions and spin charges. IBM standalone or baseline free cash flow for the year was $7.9 billion, which is aligned to our go-forward business. This excludes kindle charges and pre-separation activity, but includes the IBM portion of the structural actions. Payments for these IBM-related structural actions and deferred cash tax paid in 2021 contributed to the year-to-year decline in the standalone results. In terms of uses of cash for the year, we invested over $3 billion in acquisitions. We continued to delever with debt down nearly $10 billion for the year and over $21 billion since closing the Red Hat acquisition. And we returned nearly $6 billion to shareholders in the form of dividends. This results in a year-end cash position of $7.6 billion. including marketable securities, and debt of just under $52 billion. Our balance sheet remains strong, and I'd say the same for our retirement-related plans. You'll remember that over the last years, we've shifted our asset base to a lower risk profile. In 2021, the combination of modest returns and higher discount rates improved the funded status of our plans. In aggregate, our worldwide tax qualified plans are funded at 107% with the US at 112%. Now I'll turn to the details by segment. And I'll remind you, we have put in place a simplified management system and segment structure aligned to our platform centric model. And within the segments, we're now providing new revenue categories and metrics that will provide greater transparency into business trends and drivers. IBM software delivered double-digit revenue growth in a quarter. This was driven by good revenue performance in both hybrid platform and solutions and transaction processing, the latter benefiting significantly from the new Kindle content. Software is important to our hybrid cloud strategy and our financial model. Our hybrid cloud revenue in software is up 25% for the year to more than $8.5 billion. And subscription and support renewal rates continue to grow again this quarter, contributing to a $700 million increase in the software deferred income balance over the last year. Hybrid platform and solutions revenue was up 9%. This performance is an indication of the strength across the software growth areas focused on hybrid cloud and AI. It's worth mentioning, this includes only a point of help from the new Kindrel commercial relationship. Let me highlight some of the trends by business area. Red Hat revenue, all in, was up 21%. Both infrastructure and app dev and emerging tech grew double digits, as RHEL and OpenShift address enterprises' critical hybrid cloud requirements. With this performance, we're continuing to take share with our Red Hat offerings. Automation delivered strong revenue growth up 15%. As Arvind mentioned, there is strong market demand for automation. We had good performance in AI ops and management this quarter as we address resource management and observability. Clients are realizing rapid time to value from Instana and Turbonomic, two of our automation acquisitions. And integration grew with continued traction in Cloud Pak for integration. Data and AI revenue grew 3%. We have particular strength in data fabric, which enables clients to connect siloed data distributed across the hybrid cloud landscape without moving it. You'll recall we talked about the data fabric opportunity back in October. We also had strong performance in business analytics and weather. Within these solutions, clients are leveraging our AI to ensure AI models are governed to operate in a fair and transparent manner. Security revenue declined modestly in the quarter, driven by lower performance in data security, while revenue grew 5% for the year. As we called out in our recent investor briefing, security innovation is an integral part of our strategy. In December, we launched a new data security solution, Guardium Insights, with further plans to modernize the broader portfolio throughout the year. This quarter, we also completed the acquisition of Reacta, which leverages AI and machine learning to automatically identify and block threats at the endpoint. Putting this all together, our annual recurring revenue, or ARR, is now over $13 billion, which is up 8% this quarter. This demonstrates the momentum in our hybrid platform and AI strategy, including Red Hat and our suite of cloud packs. Moving to transaction processing, revenue was up 14%. This is above our model, driven by a few underlying dynamics. First, all of the growth in transaction processing came from the new Kindrel commercial relationship, which contributed more than 16 points of growth. Second, I'll remind you that we're wrapping on a very weak performance in the fourth quarter of last year, which was down 26%. And lastly, we had some large perpetual license transactions given the good expansion in IBM Z capacity we've seen this cycle. While the new capacity is important, what's just as important is the continued strong renewal rates this quarter. These are both good proof points of our clients' commitment to our infrastructure platform and these high-value software offerings. Looking at software profit, we expanded pre-tax margin by 12 points, including nearly 10 points of improvement from last year's structural actions. Turning to consulting, Revenue grew 16% with acceleration across all three revenue categories. Complementing this strong revenue performance, our book to bill was 1.2. Clients are accelerating their business transformations powered by hybrid cloud and AI to drive innovation, increase agility and productivity, and capture new growth opportunities. Enterprises are turning to IBM Consulting as their trusted partner on this journey. They are choosing us for our deep client, industry, and technical expertise, which drives adoption of our hybrid cloud platform and pulls through key technologies. Consulting's hybrid cloud revenue grew 34% in the quarter. For the year, cloud revenue is up 32% to $8 billion. Offerings and application modernization which are centered on Red Hat, contributed to this growth. The Red Hat related signings more than doubled this year. They're now over $4 billion since inception. This quarter, we added over 150 client engagements, bringing the total since inception to over 1,000. Our strategic partnerships also drove our performance. Revenue from these partnerships accelerated as the year progressed. and was up solid double digits in the fourth quarter, led by Salesforce, SAP, AWS, and Azure. Turning to our business areas, our consulting's growth was led by business transformation, which was up 20%. Business transformation brings together technology and strategic consulting to transform critical workflows at scale. To enable this, We leverage skills and capabilities in IBM technologies and with strategic ecosystem partners such as SAP, Salesforce, and Adobe. Our practices are centered on areas such as finance and supply chain, talent, industry-specific solutions, and digital design. This quarter, we had broad-based growth reflecting strong demand for these solutions. In technology consulting, revenue was up 19%. Technology consulting architects and implements cloud platforms and strategies. We leverage hybrid cloud with Red Hat OpenShift and work with providers such as AWS and Azure in addition to IBM Cloud. This quarter, we continue to see good performance in application modernization offerings, that build cloud native applications and that modernize existing applications for the cloud. Finally, application operations revenue grew 8%. This business line focuses on application and cloud platform services required to operationalize and run in both cloud and on-premise environments. Revenue growth was driven by offerings which provide end-to-end management of custom applications in cloud environments. Moving to consulting profit, our pre-tax income margin expanded about eight points, including just over nine points from last year's structural actions. We're in a competitive labor market, and we continue to have increased pressure on labor costs due to higher acquisition, retention, and wages. While we still expect to capture this value in our engagements, it will take a few quarters to appear in our profit profile. So now turning to the new infrastructure segment, revenue was up 2%. The Kindle commercial relationship contributed about five points of growth, which is higher than we expected in October. In this segment, we brought together hybrid infrastructure with infrastructure support. which was formerly Technology Support Services. This allows us to better manage the life cycle of our hardware platforms and to provide end-to-end value for our clients. Hybrid infrastructure and infrastructure support revenue were up 2% and 1% respectively, with pretty consistent contribution from the new Kindrel relationship. Hybrid infrastructure includes IBM Z, and distributed infrastructure. IBM Z revenue performance, now inclusive of both hardware and operating system, is down 4% this quarter. This is the 10th quarter of Z15 availability, and the combination of security, scalability, and reliability continues to resonate with clients. This program continues to outpace the strong Z14 program. and we ship more MIPS in the Z15 program than any program in our history. Our clients are leveraging IBM Z as an essential part of their hybrid cloud infrastructure. And then in distributed infrastructure, revenue was up 7%, driven by pervasive strength across our storage portfolio. Looking at infrastructure profit, the pre-tax margin was up over 9 points. but essentially flat normalizing for last year's structural action. Now I'll wrap up with a discussion of how our investments and actions position us for 2022 and the longer term. We've been laser focused on our hybrid cloud and AI strategy. Our portfolio, our capital allocation, and the moves we've been making are all designed to create value through focus for our clients, our partners, our employees, and our shareholders. We took significant steps during 2021. The most impactful portfolio action was of course the separation of Kindrel. We've also been allocating capital to higher growth areas, investing in skills and innovation, and expanding our ecosystem. We've aligned our business to a more platform-centric business model. And we're simplifying and redesigning our go-to-market to better meet client needs and execute on our growth agenda. Bottom line, we're exiting 2021 a different company. We have a higher growth, higher value business mix with over 70% of our revenue in software and services and a significant recurring revenue base dominated by software. This will result in improving revenue growth profile, higher operating margin, strong and growing free cash flow, and lower capital intensity, leading to a higher return on invested capital business. We also continue to have attractive shareholder returns through dividends. In October, we laid out a model for IBM's performance over the medium term, defined as 2022 through 2024. The model is focused on our two most important measures of success, revenue growth and free cash flow. As we enter the new year, I'll talk about our expectations for 2022 performance along those dimensions, starting with revenue. We expect to grow revenue at mid single digit rate at constant currency. That's consistent with the model. On top of that, in 2022, The new commercial relationship with Kindro will contribute an additional three points of growth spread across the first three quarters. Currency dynamics, unfortunately, will be a headwind. At current spot rates, currency is roughly a two-point headwind to reported revenue growth for the year and three points in the first quarter. For free cash flow, we expect to generate $10 to $10.5 billion in 2022. To be clear, this is an all-in free cash flow definition. The adjusted free cash flow view we provided in 2021 was useful, given the significant cash impact associated with the separation and structural actions. Now in 2022, despite the fact we still have nearly a half a billion dollars of impact from the charges, we're focusing on a traditional free cash flow definition. The $10 to $10.5 billion reflects a year-to-year improvement driven by lower payments for the structural actions, a modest tailwind from cash taxes, working capital improvements, and profit growth resulting from our higher growth and higher value business mix. With this performance, we're on track to our model. So now let me provide some color on our expectations for segment performance. Because this is a new segment structure, I'm going to spend a little more time and provide perspective on constant currency revenue growth and pre-tax margin in the context of our segment models. In software, as we benefit from the investments in innovation and our go to market changes, we're seeing progress in our software growth rate. In 2022, We expect growth at the low end of the mid single digit model. And then another five to six points of revenue growth from our external sales to Kindrel. We expect software pre-tax margin in the mid 20s range for the year. We have solid momentum in IBM consulting revenue and expect this to continue into 2022 as we help clients with their digital transformation. This momentum and our book to bill ratio support revenue at the high end of our high single digit model for the year with double digit growth in the first half. We expect low double digit pre-tax margin for the full year with improving performance through the year as we make progress on price realization. Infrastructure revenue performance will vary with product cycle. In 2022, With a new IBM Z introduction late in the first half, we expect performance above the model and a slight contribution to IBM's overall growth. On top of that, we're planning for about two to three points from the external sales to Kindrel in 2022. This supports a high teens pre-tax margin rate for the full year. These segment revenue and margin dynamics we yield about a four-point year-to-year improvement in IBM's pre-tax operating margin for the full year, and two to three points in the first quarter. In terms of tax, we expect a mid- to high-teens tax rate, which is a headwind to our profit growth. Bringing this all together, we expect mid-single-digit revenue growth before Kindrel and currency, and $10 to $10.5 billion of free cash flow for the year, both in line with our midterm model. Patricia, let's go to the Q&A.

Thank you, Jim. Before we begin the Q&A, I'd like to mention a couple of items. First, supplemental information is provided at the end of the presentation. In addition to our regular materials, we've included a summary of our new segments for your reference and historical data on segment pre-tax income. And then second, as always, I'd ask you to refrain from multi-part questions. Sheila, 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 comes from Amit Daryanani with Evercore. Your line is open.

Thanks a lot for taking my question and thanks for all the clarity. Jim, I want to go back to the $10 to $10.5 billion free cash flow number for Canada 22. I know there's a lot of moving parts here, so it's lower than what I think many have been modeling. And if I think about the analyst-based framework we have talked about, it was supposed to be a $10 million free cash flow in 2020. adding $750 million, if I remember correctly, annually. So that would put this somewhere in the $11.5 billion range, I think, is what I would have expected. So can you just talk about, either relative to that, if you want, what is the delta-2 free cash flow? What are the puts and takes? That would be really helpful.

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

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

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

Thanks, Katie, for the question. And thank you for also noticing and acknowledging the robust IT spending environment Look, Katie, I mean, like if I react to every stock market intraday volatility, that's a full-time occupation. I think today showed that they're actually, these cycles are hard to predict. And if I back up and look at our clients, I think they are not really reacting to these volatilities. We saw this in the middle of 2020 also, not just in 2021 and 2022. For the first time, despite a down business cycle in 2020, we saw people actually decide to keep up their IT spending. Now, I'll acknowledge in 2020, they did put a break on capital spending within IT, but they all acknowledged that IT spending was critical to how they would come out, and that showed up in 2021 spending. So I suspect, look, We are not as much expert on this as many of you on this call, but I would suspect that this volatility we are seeing recently will not have much of an impact. Now, if it becomes into an overall bear market correction, that would be different, but I don't think we're anywhere close to that. I think in terms of near-term cyclical impacts, I don't really see them. Our clients tend to be people who are in much more the What we provide technology for is much more in the critical applications. People need them for doing online payments. They need them for authorizations, reservations, retail banking, healthcare, telecom, within the government for critical applications. So we don't tend to see much of a short-term cyclical impact. Now on your last question, valuations, look, I'm always clear, valuations, M&A has to have an economic benefit for our company and our shareholders. As valuations come down, certainly some targets may become more approachable that were not previously approachable. And I've said before, look, we have a little over $20 billion of flexibility over the next three years. So I'll just leave it at that. That's our total flexibility. As prices come down, certainly more things come within range.

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

Our next question comes from Tony Sakonagi with Bernstein. Your line is open.

Yes, thank you. Really, just some clarifications. You talked about the year-over-year improvement in PTI of about four points. It looks like the year-over-year Kindle contribution of $1.8 billion in revenue should come in at extremely high marginal contribution, maybe 70%. And then you're going to have a year-over-year contribution from fewer charges. So maybe you could dimension each of those and talk about whether you believe underlying PTI will improve. And then similarly, if you could just clarify your expectation for the acquisition contribution to revenue in 2022. And you didn't mention the divestiture of Watson Health. how we should think about that. Is that in addition to, should we be factoring in on top of the guidance or does your guidance include the divestiture of Watson Health's revenues? Thank you.

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

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

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

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

Yes. So, Bamsi, thanks. Let me address the first part of the question, the mid-single-digit growth in 2022 going to 2023. Let me remind you, when we did our investor day in early October, we talked about that the mid-single-digit growth comes from about two points of that for IBM, comes from the consulting growth, about between one and two points comes from the Red Hat growth, and then we would get some from infrastructure, a.k.a. mainframe, but there's more than mainframe. There's storage in there, and there's also power product cycles, and then organic infrastructure, organic software. If you put that all together, you would get more than mid-mid single digit in a given year. We begin to see cycles of that. For example, on mainframe, when we say it comes late in the first half, that means it's really a second half 22 contribution, That carries on then into the first half of 23, maybe until the third quarter, maybe longer, depending on the cycle. If I look at Red Hat, fully expect that to carry on. If I look at consulting, we expect that to carry on. So if I look at all the underlying components, and then as I bake in the acquisitions into staff pair, those will begin to contribute a bit more and a bit more each year. You asked about the overall... acquisitions, I think that'll give us about a point each year, which is what we had said before. But that is inside what I talked about, the two points and the one to two points and the point and the point. And so that is the thesis here. And by the way, so if you look at what I laid out, 22 and 23 look remarkably similar, not that different.

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

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

Absolutely. Our next question will come from Jim Suva with Citigroup. Your line is open.

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

Jim, let me take that. This is Arvind. Look, I think that we have done a lot of the heavy lifting we need. fundamentally believe that we have the right portfolio and we have the right focus to be delivering on our midterm model. Maybe I didn't quite understand the word harvest. I wouldn't say harvest. We have the correct portfolio to be able to grow where our clients have got demand and where the market has demand. We are now approximately a 30% consulting company, a 70% technology company. It's about a little bit under half is software. If I look in software, yes, there is a portion that is very much focused on transaction processing. We believe that model is going to be a mid-single-digit decliner over the very long term. And if you look at some of the dynamics that Jim Cavanaugh talked about, you kind of see that then if you go over the past couple of years. Then if I look at automation, security, data and AI, I think these play very much into where there is a lot of demand in the market. If I look at consulting, that's how clients are going to go get their projects on digital transformation completed. And then if you look at hybrid infrastructure, we're quite focused in infrastructure on the areas that align to our high-value model. If I look at both storage and mainframe, they give us a lot of benefit to also help drive the other parts of the portfolio. If I got it right, Jim, to your question, no, you should not expect any major... strategic divestitures like we just have talked about with Kindrel, I think those are behind us. Now we have the portfolio that allows us to deliver on our medium-term model.

Very good. Jim, thank you. Let's go to the next question, please.

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

Thank you. This is a question for Jim. You know, Jim, if we take your revenue growth comments about 22 and the margin comments, it would just seem to yield net income below your free cash flow guide. And obviously, I'm assuming the new model, given the combination of software and professional services, would yield free cash flow of about 1x on a conversion basis. So if that math is right, can you help reconcile the difference between the implied EPS guide to that 10 and 10 and a half billion in free cash flow.

Yeah. Well, David, as, as we've talked, uh, since Arvin is, is come on and taken over as chairman and CEO, we, we have aligned our portfolio. We've aligned our capital investment allocation structure. We've aligned the operating model in this company. And I'm a very big believer in focus. And that focus is around two measures, revenue growth and free cash flow. So I am not gonna talk about EPS guidance. And by the way, EPS, as you know quite well, there are many ways of getting to an EPS number. But I've given the breakout of the revenue growth overall. We've been very transparent mid-single digit. We said we're gonna get an operating leverage improvement of about four points. We broke that out by segment. We're gonna get software. We expect up to mid-20s. on our path to approaching 30 in our midterm model. We said around consulting at the high end of our high single digit revenue growth model, we're gonna approach about 10% coming off of about an eight and a half point margin business in 2021. And then infrastructure given we've got a product cycle, we expect above model on revenue as Arvin answered earlier. It'll be a slight contribution to IBM and we expect the operating margins infrastructure to be in the high teens when you take all those components that what I what I just brought out and then you do the free cash flow bridge you get to quite healthy profit contribution to deliver that free cash flow and I think David that is the focus that Arvind's got 250,000 IBMers mobilized on revenue growth that operating margin by segment to deliver a the product mix and productivity and that free cash flow. And that's what we're going to continue to guide on as we move forward. Thanks, David. Let's go to the next question, please.

Our next question comes from Kyle McNeely with Jefferies. Your line is open.

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

Kyle, maybe I'll start there. The third quarter, I think we stated even when we finished the third quarter that we saw a pause on some of the CapEx purchases and infrastructure. because people were digesting what to do around the kindle separation. That particular factor I do not believe is going to show up again. Now that said, as Jim said a bit earlier in answer to one of the other questions, this is the 11th quarter of mainframe. When we look at that, we do expect softness on mainframe in the first quarter, but not in the remaining quarters. I'd say that that's the only critical dynamic that could be different if we look at quarter to quarter. But that is expected and baked in in what we're talking about for the year and what we're talking about in terms of infrastructure performance, which for the year we do expect it to be better in 22, but more of that in the second half, as Jim pointed out earlier. Very good.

Thank you, Kyle. Sheila, let's take one last question.

Thank you. Our last question will come from Brian Essex with Goldman Sachs. Your line is open.

Hi, thank you. Good afternoon, and thank you for taking the question. Maybe for Arvind, you know, some really nice business transformation technology consulting growth, and I'd love to hear your comments, or at least if you can reflect on customer conversations and what those have been like and how you might characterize some of that business activity, whether you feel as though we're in the early stages, maybe the middle innings of technology transformation efforts, how would you frame that business and how much of that business is a leading indicator for Red Hat and automation growth?

Thank you, Brian, for the question. So to go to the middle part of your comment, I would call it that we are in the early innings not the middle or late innings of the growth in consulting. I wouldn't call it the very first inning, maybe the first inning was 2021, but early innings. So I think we have a long way to go on this. Now, I think that leads to the first part of yours, what are the anecdotes or what are the customer conversations that lead us there? Everyone is looking for how do you deploy technologies, be it Salesforce, Adobe, cloud technologies, to go improve their processes. It's actually, the conversation has changed from three years ago. It's not about cost savings. It's actually much more about how can you deploy these technologies to improve a process. Is it how do I do omni-channel and multi-channel? Is it how do I do resilience in my supply chain? Is it about how do I use every warehouse and store as a point of delivery, not just for physical, but for physical or online commerce? As you begin to look across these topics, and then as we look at the added cyber threats that come in, these do create a huge pull from clients on how do you improve the end-to-end customer experience, how do you improve the resilience of their supply chain, How do you improve the experience for employees? How do you begin to use, I'll use the word bots because I'm a technologist. Others may use the word digital worker. That's probably a more correct word to take care of all the upcoming, I'll use the word demographics on the skill shortage that is endemic in technology now. And that is sort of playing in. By the way, I don't believe that the skill shortage is because of COVID. I do believe COVID may have exacerbated or created a pull-in of those demographics, but those, I think, are going to last us for the decade. Now, I think that that is a leading indicator of automation, Red Hat, cybersecurity growth, for sure. I would call it, it's not identical, meaning you're not going to see the same percentage from one to the other, but you absolutely will see correlation that is significant between those And when Jim talked about the number of Red Hat engagements, and then we talk about the garage engagements from consulting, those are then proof points of that correlation. So Brian, thank you for the question. And that is, by the way, why we see a lot of our confidence in the next few years of revenue growth. So first, Pat and Jim, thank you guys for answering your part of the questions. Let me now make a couple of comments to wrap up. And I'm going to end where I started the call. We've been taking actions that position our business to address the attractive hybrid cloud and AI opportunity. Our fourth quarter results and expectations for 2022 are a first glimpse of today's IBM, and they reinforce our confidence in our strategy and our model. I hope that all of you are as excited about our future as I am and I look forward to speaking with all of you again soon.

Sheila, can we turn it back to you to wrap up the call?

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