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 First Quarter 2022 Earnings Presentation. I am here with Arvind Krishna, IBM’s Chairman and Chief Executive Officer; and Jim Kavanaugh, IBM’s Senior Vice President and Chief Financial Officer.

We will 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. To provide additional information to our investors, our presentation 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 8-K 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 will turn the call over to Arvind..

Thank you, Patricia, and thanks to all of you for joining us today. Our first quarter results reflect the changes we have made to position our business for the future. This solid start to the year reinforces our confidence in our strategy and we now see revenue growth for 2022 at the high end of our mid single-digit model.

What we are hearing from clients is clear. Technology has become a fundamental source of competitive advantage. It is at the very center of how businesses scale and is no longer perceived primarily as a way to cut costs. This is especially true in our current environment.

Harnessing the power of technology such as Hybrid Cloud and AI remains essential as our clients face a number of strategic challenges and opportunities, whether it’s competing for talent, supply chain issues, inflation, cybersecurity or geopolitical instability.

We continue to see a strong demand environment for both technology and consulting, as we help our clients respond to these issues. Over the last two years, we have been optimizing our portfolio, expanding our ecosystem, and simplifying our go-to-market to capture this demand.

This quarter, we again had double-digit revenue growth in Consulting and Software growth reflects solid performance across the portfolio. Our Infrastructure business, as always, reflects product cycle dynamics. Our revenue performance this quarter is a strong indication that our focus, our investments and our actions are paying off.

Before we go further, let me say a few words about the war in Ukraine. We are first and foremost focused on the safety and security of our employees. IBM is providing help, including relocation assistance and financial support to IBMers in the region and matching donations from our employees around the world to non-profits.

In terms of the business impact from Russia, Jim will quantify, but I will say the impact is measurable, but not large. Let me now turn to the progress we are making when it comes to our hybrid cloud and AI strategy.

Hybrid cloud is all about providing a platform that can straddle multiple public clouds, private clouds and on-premise properties that our clients typically have. The platform we have built is open, secure, and flexible. At its core, it is based on Red Hat, which gives clients powerful software capabilities based on open-source innovation.

Our software has been optimized for that platform and helps our clients supply AI, automation and security to make their business work better. Our global team of consultants offers deep business expertise. They do this by co-creating with clients and finding ways to harness the power of technology to accelerate their digital transformation journey.

Our Infrastructure allows clients to take full advantage of an extended hybrid cloud environment. This platform-centric strategy is producing solid results. We have more than 4,000 hybrid cloud platform clients, including 200 added in the first quarter.

This gives us two avenues of growth from the incremental number of clients, but more importantly, it allows us to expand our software, consulting and infrastructure footprint at these clients. Clients such as Charles Schwab, Discover Financial, and the U.S.

Department of Education have all recently chosen IBM’s hybrid cloud capabilities to digitally transform and build new and differentiated experiences and services. Clients also turn to IBM’s AI capabilities to move their employees to higher value tasks and improve their customer experiences.

For instance, IBM is now working with McDonald’s to pilot an automated drive-thru experience with Watson Orders. In addition, TD Securities is using IBM’s AI-powered virtual assistant in support of their precious metals digital store. We were recently recognized in this area as a leader in the Gartner Magic Quadrant.

These highlight our ability to drive innovation in natural language processing and bring these new capabilities to clients. An important element of our platform strategy is our partner ecosystem where we continue to gain momentum.

We see this in IBM Consulting, where signings with our ecosystem partners were up more than 50% to $2 billion this quarter. In the first quarter, we continued to broaden our ecosystem. We announced an expansion of our strategic partnership with SAP, serving as SAP’s RISE premium partner to help clients move workloads to the cloud.

With Adobe, we announced a significant expansion of a partnership around the use of AI-powered weather data on the Adobe experience platform. We are collaborating with Worley and ABB to build a digitally-enabled solution that will help energy companies build and operate green hydrogen facilities more efficiently and at scale.

We also signed an agreement to join the UAE’s network of Industry 4.0 Champions, a major public/private partnership designed to accelerate the digital transformation of the country’s industrial sector. Within IBM, we are making significant changes to the way we work to build a client-centric culture based on technical excellence.

Our new client engagement model based on experiential selling, client engineering and co-creation is strongly resonating among clients. Over the last few quarters, sales productivity is rising, renewal rates are increasing and recurring revenue is growing.

While we are focused on meeting the needs of clients today, we continue to shift to technologies of tomorrow. Most recently, we announced the IBM z16 platform in early April. z16 is designed for cloud-native development, cybersecurity resilience and includes an on-chip AI accelerator. This allows clients to reduce fraud within real-time transactions.

The z16 exemplifies our ability to drive critical innovations to a platform that remains essential to the world’s economy. At the same time, we are bullish on the immense potential that automation represents. We firmly believe that our AIOps capabilities are poised to seize this significant opportunity.

In the last quarter, we announced a new AIOps solution in collaboration with Flexera that is designed to automate software license compliance. Quantum is another example of our commitment to advance the fundamental science of computing.

By deploying the world’s first 127-qubit processor, we are the only company to have an actual operational computer that is available on our cloud. Companies and governments around the world are taking steps to prepare for Quantum. As an example, we have recently forged new partnerships with HSBC and the Government of Quebec.

Delivering organic innovation remains an important and constant focus. At the same time, we continue to make acquisitions to strengthen our portfolio and add value to our clients. In line with this thinking, we completed three acquisitions in the first quarter, Envizi, Neudesic and Sentaca.

Clients, partners, employees and investors are placing a premium on ESG, as the world moves towards a more circular and sustainable economy, clients need help on their journey.

That is why we recently launched the IBM Sustainability Accelerator, a social impact program that applies IBM Technology and Consulting to help populations that are vulnerable to environmental threats.

This is just one of the many efforts we have made around ESG, which you can see in IBM Impact, our first integrated ESG report that we released last week. I will wrap up by saying the results you are seeing this quarter are a direct reflection of our ability to execute against our strategy.

Each quarter, we have continued to strengthen our portfolio, expand our partner ecosystem and drive productivity and simplification through the business. IBM is now a very different company.

We have in effect changed our company’s trajectory and while much remains to be done, we are beginning to reap the rewards of our hard earned efforts and we are confident in our trajectory for the year. Now, let me hand it over to Jim, who will share the details of the quarter and our expectations with you..

Thanks, Arvind. Let me start out with a few of the headline numbers. We delivered $14.2 billion in revenue, $1.5 billion of operating pretax income, operating earnings per share of $1.40 and $1.2 billion of free cash flow.

90 days ago, I talked about the first quarter and the full year in the context of our medium-term model, which is to deliver mid single-digit revenue growth and about $35 billion of free cash flow from 2022 through 2024. These first quarter results are a solid step toward delivering on the year and that model. Our revenue was up 11%.

This includes over 5 points of incremental revenue from the commercial relationship established with Kyndryl last November. Our business entering 2022 reflects a higher growth, higher value mix. It is also a business with more recurring revenue dominated by Software. This quarter, Software revenue was up 15% and Consulting was up 17%.

As we have discussed in the past, these are our two growth vectors and together represent over 70% of our annual revenue. Infrastructure performance, which is influenced by product cycles was flat as compared to last year. The Software and Infrastructure performance each include over 8 points from the commercial Kyndryl relationship.

As a reminder, there is no incremental contribution to IBM Consulting’s growth. Our strategy, as Arvind said, is based on a platform-centric approach to hybrid cloud and AI. Not only do we benefit from the platform itself, but IBM and our partners also generate a multiple of Software and Consulting revenue on that platform.

It’s an attractive economic model. You can see our success in capturing that value in our hybrid cloud revenue, which was up 17% in the first quarter and over the last 12 months. Revenue from our full stack cloud capabilities from infrastructure up through consulting represents $20.8 billion of revenue over the last 12 months or 36% of our total.

Looking at our P&L metrics, we grew operating gross profit dollars, though margin was down, with improvement in software margin offset by Consulting investments and Infrastructure mix due to product cycles. For operating pretax income, we grew profit dollars and expanded margin by 280 basis points.

This profit performance reflects that we are capturing demand in high-value areas like software and profit contribution from incremental sales for the new commercial relationship. We have taken actions to streamline our operations and simplify our go-to-market model, consistent with our more focused platform-centric business.

With the more streamlined business, we are getting operating leverage from strong revenue performance. Our profit dynamics also reflect increasing investments in innovation, our ecosystem and talent. We are increasing investments in R&D to deliver innovation in AI, hybrid cloud and emerging areas like Quantum.

We are investing in our ecosystem organically and inorganically. For example, one of the three acquisitions Arvind mentioned was Neudesic, which adds key hyperscaler capabilities to address hybrid multi-cloud demand. And as we have discussed, over the last several quarters we have been aggressively hiring.

We are adding capabilities and skills to support our garages and client engineering centers, client success managers to help clients get the most of their IBM solutions and technical talent across our business. Now, we are operating in an inflationary environment, and costs, especially the cost to attract and retain talent, are escalating.

We are addressing this through pricing, which will help over time. The Other item I will mention is the impact of a strengthening dollar. We execute hedging programs, with the majority of our hedging gains reported in Other income and expense. These gains mitigate the currency impact in revenue and gross profit.

And then looking at net income, we expanded operating net income margin by 130 basis points. This reflects an operating tax rate of 16%, which was up significantly from last year. Turning to free cash flow, we generated $1.2 billion in the quarter.

I will remind you we have gone back to our traditional all-in free cash flow definition, which includes payments for the structural actions initiated at the end of 2020. The $1.2 billion is about 12% of our full year expected range, consistent with history.

The anomaly from that historic attainment was last year, with 23% of our full year free cash flow realized in the first quarter due to the unique dynamics of the Kyndryl separation. In terms of uses of cash for the quarter, we invested about $700 million in acquisitions and we returned $1.5 billion to shareholders in the form of dividends.

We also issued $4 billion of debt in early February, which supports maturities later in the year. This results in a March cash position of $10.8 billion and debt of over $54 billion. Turning to the segments, Software delivered strong revenue growth, up 15%.

This includes over 8 points from the recurring Kyndryl software revenue, in line with our expectations. Software performance was driven by good growth in both Hybrid Platform & Solutions, and Transaction Processing, the latter benefiting significantly from the Kyndryl content. Our software is central to a hybrid cloud value proposition.

Within the segment, hybrid cloud revenue was up 25%, now representing $8.8 billion over the last year. And subscription and support renewal rates grew again this quarter, contributing to a software deferred income balance of over $11 billion.

Hybrid Platform & Solutions revenue grew 10% this quarter, inclusive of about a point-and-a-half contribution from the Kyndryl commercial relationship. We have driven focus within this portfolio around the most strategic hybrid cloud and AI needs of our clients, Red Hat, data and AI, automation and security.

Growth was pervasive across all business areas this quarter. Red Hat revenue all-in was up 21%. Revenue growth continues to be fueled by good performance across the Red Hat portfolio, and we again gained share across both RHEL and OpenShift, the foundational hybrid cloud offerings.

Red Hat’s hybrid cloud offerings continue to transform enterprise IT and deliver new innovations. For example, this quarter we announced a new partnership with NVIDIA to accelerate AI applications. Automation delivered 5% revenue growth this quarter. Growth was led by AIOps and management and integration.

We have invested in AI-powered approach to automation and our solutions are resonating with clients as they address growing complexity, digital shifts and skill shortages across their businesses. We extended this AI-powered automation strategy this quarter with the joint Flexera solution Arvind mentioned earlier. Data and AI revenue grew 4%.

These offerings help our clients accelerate data-driven agendas by connecting and governing all of their data and infusing AI to enhance decision making.

Performance this quarter reflects client demand across the portfolio, including continued adoption of data fabric, expansion of our data management footprint, a focus on sustainable operations with asset and supply chain management, and needs for reliable data sharing with information exchange.

We had growth in solutions like Cloud Pak for data, DB2 and Maximo Application Suite, just to name a few. Security revenue grew 8%, building on strong performance in the first quarter of last year when we were up 14%. With the evolving cybersecurity environment, we delivered growth this quarter in threat management and data security.

We continue to see good client demand for Cloud Pak for security, and integrated and open security platform that advances clients’ zero trust strategy while leaving data where it is. And we have been investing in security innovation, including a new SaaS endpoint solution following the ReaQta acquisition.

Looking across the performance of our Hybrid Platform & Solutions, our annual recurring revenue or ARR is up 9% year-to-year. Transaction Processing delivered 31% revenue growth this quarter, including 28 points from the Kyndryl content. The overall dynamics are much like last quarter.

We wrapped on weak performance in the first quarter of last year, which was down 15% and we continue to see strong renewals of these critical software offerings, building on the expanded zSystem’s capacity and traction we have gotten through the strong z15 program.

Looking at software profit, we delivered operating leverage given the strong and broad-based revenue performance this quarter. Our pretax margin was up 7 points and puts us on track for a full year software margin in the mid-20s.

Just as in Software, Consulting is capitalizing on strong demand profile, growing both revenue and signings at double-digit rates across all business lines and geographies. Revenue growth accelerated to 17%, while bookings were up over 40%. Our book-to-bill remains solid at 1.1 for the quarter and over the last year.

Clients trust IBM to execute their complex business transformations, leveraging our deep industry expertise and the investments we have been making in skills, capabilities, our ecosystem and in scaling our acquisitions. We are positioned to capture demand and drive adoption of our hybrid cloud platform.

Consulting’s hybrid cloud revenue grew 32% on trailing 12-month basis to $8.3 billion, which makes up 45% of the Consulting business. We continue to see strong demand and momentum in our Red Hat-related engagements this quarter, nearly doubling Red Hat-related signings year-to-year.

Our strategic partnerships also contributed to our performance in the quarter. Revenue from these partnerships grew solid double digits led by Salesforce, SAP, AWS and Azure.

And now turning to our lines of business, business transformation revenue grew 19%, bringing together technology and strategic consulting to transform critical workflows at scale.

The growth was broad-based, with particularly strong growth in our practices centered around customer experience, talent and data transformations, as well as supply chain and finance applications. In Technology Consulting, where we architect and implement clients’ cloud platform and strategies, revenue was up 19%.

Growth was pervasive, led by our engagements around developing and modernizing applications for cloud deployments. Finally, application operations revenue grew 14%. This business line focuses on the management of applications and cloud platform services required to run hybrid cloud environments.

Growth was broad-based in this space as well, led by Cloud Application Management. Moving to consulting profit, our pretax margin expanded about 1 point, delivering operating leverage and benefiting from IBM’s more streamlined G&A and go-to-market structure.

Our consulting gross margin reflects the significant investments we have made over the last year, fueling our revenue growth. We are investing in our partner ecosystem, expanding our reach. We continue to scale the 12 acquisitions we made in the last 18 months including two which closed in the first quarter.

And we are investing in talent across our workforce, up-skilling existing resources, adding certifications and bringing in technical skills in areas of hybrid cloud and AI. Consulting is where we are most impacted by the competitive and inflationary labor market, which puts pressure on profitability.

We expect to capture value through price in our engagements and recognize it will take a few quarters to appear in our margin profile. Turning to Infrastructure segment, revenue performance was flat versus last year. Hybrid infrastructure revenue declined 2%, offset by growth of 4% in infrastructure support.

The Kyndryl content contributed over 8 points to infrastructure with consistent benefit across the two business areas. Within Hybrid Infrastructure, the zSystems revenue was down 18%. We are now in the 11th quarter of z15 availability. z15 has been a very strong program, both in revenue performance and capacity.

In fact, we ship more z15 MIPS than in any other program. Building on that momentum, we have just announced our newest solution, IBM z16. Arvind commented on the three differentiated capabilities of z16, embedded AI at scale, cyber resilient security and cloud-native development for hybrid cloud.

Distributed infrastructure delivered 8% revenue growth this quarter. Client demand for S/4 HANA data-intensive workloads on our newest POWER10 high-end systems fueled this performance. Looking at infrastructure profit, the pretax margin was down 3 points reflecting where we are in our IBM Z product cycle. Now let me take it back up to the IBM level.

We focused our business on a platform-centric, hybrid cloud, and AI strategy. Over the last couple of years, we have been taking steps to optimize our portfolio, streamline our operations and allocate capital, to execute that strategy and improve our financial profile.

Our first quarter results reflect these very significant changes and put us on track to our full year expectations for our two key measures of revenue growth and free cash flow. 90 days ago, we expected to grow revenue at mid single-digit rate at constant currency before the incremental Kyndryl sales.

With the strong start to the year, we now see revenue growth at the high end of that mid single-digit range. On top of that, we expect about 3.5 points of growth for the year from the commercial relationship with Kyndryl spread over the first three quarters. And then looking at currency, with the strengthening U.S.

dollar at mid-April spot rates, currency will now be a 3-point to 4-point headwind to revenue growth for the year. For free cash flow, we continue to expect $10 billion to $10.5 billion in 2022. As I said earlier, this is an all-in free cash flow definition and includes the cash impact associated with our 2020 structural actions.

Before getting into the segments and color on the second quarter, I will comment on the business impact of our Russian operation. Our business in Russia is not large, but it’s concentrated in high-end Infrastructure and Software. Last year, business in the country contributed about $300 million of revenue and about $200 million of profit and cash.

For this year, we expect no contribution from Russia, which puts us closer to the low-end of our free cash flow range. Now, let me provide some color on our expectations for segment performance for the year.

In Software, we got off to a good start and we haven’t changed our view of constant currency revenue growth or the contribution from the external sales to Kyndryl. We also remain on track to a software pretax margin in the mid-20s range for the year.

In IBM Consulting, with our first quarter revenue and signings performance, we are taking up our view of Consulting revenue to a low double-digit growth rate for the year. With continued investment in talent and a competitive labor environment, we now expect a pretax margin approaching 10%, which is up a couple points year-to-year.

This reflects improving performance in the second half as we realize price increases in our contracts. Our infrastructure revenue performance, as always, reflects product cycle dynamics. This year, we would expect performance above the model, given the launch of our z16 late in the second quarter.

This will contribute to second quarter performance and ramp further in the second half. On top of that, we are planning for about 4 points to 5 points from the external sales to Kyndryl in 2022. We see a mid- to high-teens pretax margin for the full year.

These segment revenue and margin dynamics would yield about a 4-point year-to-year improvement in IBM’s pretax margin for the full year. In terms of tax, we continue to expect a mid- to high-teens operating tax rate, which is a headwind to our profit growth. Let me comment on a couple items specific to the second quarter.

At current spot rates, currency would be a 5-point headwind to revenue growth. We expect to close the sale of the Healthcare Software assets, with a gain utilized to address stranded costs. And we expect a 4-point to 5-point year-to-year improvement in operating pretax margin and a tax rate in the high teens.

Based on our solid first quarter performance and view of the year, we are on track to our midterm model. And now, 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, and then, second, as always, I’d ask you to refrain from multi-part questions. Operator, let’s please open it up for questions..

Thank you. Our first question comes from Wamsi Mohan with Bank of America. Your line is open..

Yes. Thank you. Great to see the solid revenue performance and the organic growth guide uptick here. Arvind, a lot of investor conversations now are focused around concerns of the economy steering itself into a recession given the tightening that we are seeing from the fed.

Can you maybe characterize how IBM, which has a pretty defensive portfolio, could fare in a recessionary environment given that there have been structural portfolio changes? And a quick one for Jim, you are maintaining your free cash flow guide despite the incremental headwinds from FX and some of the other macro elements you pointed to including Russia, Ukraine.

Can you maybe just help us think through how you are offsetting free cash flow impact from FX? Thank you..

Wamsi, always good to hear from you. Just a comment on the economy and I will call it demand. We are seeing very strong demand. As I said in my prepared remarks, I think, technology has shifted from being just one aspect of a business to being the source of competitive advantage.

When that happens, Wamsi, we think and we believe and the past couple of quarters have borne this out, that demand for technology is going to sit at 4 points to 5 points above GDP. Even if GDP falls to flat or there’s a quick recession or if it’s a very slight recession, we see demand staying strong and continuing.

Now, I will acknowledge if you have something much more catastrophic, that’s different. But for all the scenarios that we do outline and we do look at, we see that demand is going to continue in a growth phase for the foreseeable future.

Jim?.

Yeah. Wamsi, thanks for the question. Just to add to Arvind’s point here right up front about the composition of our portfolio.

Now today’s new IBM, that composition being much more skewed towards growth vectors, Software and Consulting, and our solid recurring revenue base that offers us on any economic shocks and I think that’s what you are referencing, Wamsi, in -- if you look at past economic shocks overall.

But to your question about free cash flow, let me spend a minute on free cash flow and just give you a perspective and unpack it a little. We are maintaining our guidance at $10 billion to $10.5 billion for 2022.

Again, I will remind everyone that’s an all-in free cash flow consistent with IBM’s post-separation baseline and consistent with our mid-term model of a cumulative about $35 billion over the next three years. That basically is growing north of $2 billion of free cash flow in 2022. We started out the first quarter.

We delivered $1.24 billion in free cash flow. That’s about 12% attained. And by the way, that’s pretty consistent with where we have been, arguably prior to the last three years, four years, we were in the high-single digits. So we are off to a pretty good start. Now, I spent time last quarter talking about headwinds and tailwinds.

On the tailwinds side, we talked about, hang on, we are doing some technical difficulties here. Thank you very much. Hopefully that is better and you can hear me. I am going through headwinds and tailwinds on free cash flow overall. When you look at free cash flow, we talked 90 days ago.

We have got tailwinds on remaining about $0.5 billion of structural actions in 2022. We have got about $0.5 billion of working capital efficiency, given our Mainframe cycle and volume dynamics. And we have got a couple $100 million with regards to modest cash tax tailwinds overall.

The rest of that $2-plus billion of free cash flow generation has to come from operating profit. Now, when you look at the first quarter, many of those tailwinds are all in front of us. Our operating profit, that’s the acceleration in revenue, and operating margin by segments, that will continue as we move forward as part of our guidance.

Our working capital actually was a use of cash in the first quarter as we prudently built up our inventory position just given the supply chain disruption going on in the marketplace. We secured our supply for the anticipated z16 and we also got most of our structural actions behind us.

So we have got a lot of tailwinds going forward that gives us confidence in that $10 billion to 10.5 billion. And the only headwind which we called out in our prepared remarks is the unfortunate situation with regards to the war in Ukraine and we quantified that overall..

Okay. Thank you, Wamsi.

Can we please go to the next question?.

Our next question comes from Amit Daryanani with Evercore. Your line is open..

Thanks for taking my question. Congrats on a strong topline here. I guess my question is really around, you are raising your top line guide from mid-single digits at the higher end of the mid single-digit range.

Could you just talk about what is driving this range, is it organic or is it really the deals that you have done that give you better conviction on the growth trajectory? So the uplift in guide organic versus inorganic to help us understand it better? Maybe related to that, there’s a lot going around what’s happening in Europe very specifically and any spillover potentially from Russia.

So I’d love to hear what you see in Europe if there is any spillover from Russia? Thank you..

Hi, Amit. Let me begin by answering the question on both pieces. So if you look at it, we have always said, our model for acquisition contribution has typically between a point to point-and-a-half for the year and so that remains steady in that range. We don’t really look at that as coming up yet.

I will take it certainly if it gets above that, but that is not the case. So what we are seeing right now is strong demand on what you would call the organic part of the portfolio and we can see that in the Software portfolio, we can see that in the strong Red Hat growth.

Consulting is largely, by the way, organic growth that is driving it, because we printed 13% of actuals, 17% at constant currency and only a few points of that was acquired growth. So I will say much more organic than acquired. Acquired is in the range that we have called out before.

So when you talk about Europe, Jim quantified, certainly Russia is direct and we quantified its impact in direct terms, that $300 million we don’t really expect to see this year at all.

Now, when we look at overall growth in Europe, we are still seeing and it is likely because we are in much more I will call it mission-critical applications, we have much more in fundamental transformations at our clients and with the focus on financial volumes, on critical systems, on telecoms, utilities, healthcare, government, we tend to see that right now the demand profile in Europe is staying strong and so we are not seeing at least at this point that demand profile coming down.

As things go on, that could evolve. As I have said before, it’s our jobs to be concerned about all of these things and we have been watching them very carefully. But with our book-to-bill ratios in Consulting, which is kind of a leading edge, we see right now that the demand profile is continuing and has not slowed down at this point..

Okay. Amit, thanks for the question.

Let’s go to the next one, please?.

Our next question comes from Toni Sacconaghi with Bernstein. Your line is open..

Yes. Thank you. I wanted to just discuss a little bit the profitability side of the equation. So you beat relative to expectations on revenue, but not on EPS. You have raised your full year guidance for revenue, but not on free cash flow.

So I just want to explore the dynamics there, are you seeing incremental pressure just in Consulting and are there other areas? And then I was hoping you could answer two very specific clarifications. One is your operating margin expansion was 280 basis points year-over-year, but obviously you had very high margin Kyndryl contribution.

So if we ex out the Kyndryl contribution, what was the change in operating profit PTI percentage year-over-year? And then, secondly, how much is the Healthcare asset sale gain and it sounds like that will be included in free cash flow, could you confirm that as well? Thank you..

Okay. Toni, I will try to handle each one of those. Maybe I will start with the last one first and then go backwards, if it’s okay with you. Thanks for the question. So, healthcare, yes, as we talked about 90 days ago, we still expect to close on the Watson Health divestiture late in the second quarter. It is embedded in our forward-looking guidance.

As you know, it is now consistent with what we have been doing with all divestitures. It is now in our Other segment. By the way, history has been restated, so our Software segment and our Other segment are apples-to-apples year-to-year with regards to this.

We do expect the lost profit in the second half and the lost revenue, but we do expect a modest gain in the second quarter and we will utilize that gain to address stranded costs. So it’s embedded in our guidance. No impact to second quarter.

But obviously we are dealing with the lost revenue top line in the second half, and in light of that, we still took up our guidance to the high-mid single-digit overall. It is -- in our free cash flow, there’s no impact to that overall either. So on operating margins, you asked about 280 basis points.

Yes, we are very pleased with our performance, solid start to the year, progress more to do, as Arvind and I have always said. This is a journey. We have given a mid-term model. You all understand our mid-term model.

But let me put the profit margin contribution in perspective, because, yes, as we have been transparent both in revenue, and by the way in free cash flow, because our free cash flow is a post-IBM separation baseline, we have got to grow $2-plus billion of free cash flow. Both of those normalize out Kyndryl.

But let’s talk about the Kyndryl contribution, because you are right, the pretax income and pretax margin there’s a benefit from the Kyndryl sales. And there’s also -- I am getting an echo. Hopefully we can take care of the technical difficulty. The echo sounds like it went away.

But when you take a look at the topline revenue growth, we grew IBM overall 11% at constant currency, all-in. We said within that constant currency, about a little over 5 points is due to the Kyndryl external sales.

So call that about 50% of our contribution of growth came from Kyndryl and about 50% of our contribution came from our broader client segments overall. IBM grew revenue in the first quarter by $1 billion externally from last year.

So about $500 million of Kyndryl contribution give or take round numbers and about $500 million from our broader set of clients. You apply standard margins, because as you can all appreciate for competitive commercial reasons, we are not going to give exact profitability of any client overall.

But if you apply standard margins against that, you get against our $500 million of profit contribution, you get about two-thirds of it coming from Kyndryl sales and about one-third of it coming from IBM. And I will remind you we are on the back end of a very successful Mainframe cycle.

And that back end, we were down a couple hundred million in infrastructure profit.

So growing IBM both with incremental sales of Kyndryl and with our broader client base on the back end of a Mainframe product cycle, we are pretty pleased with the operating leverage we see in our business and that gives us the confidence in that free cash flow guidance of $10 billion to $10.5 billion..

Okay. Thanks, Toni.

Let’s go to the next question?.

Our next question comes from Erik Woodring with Morgan Stanley. Your line is open..

Great. Thank you very much for taking the call. Really nice performance on Red Hat and Security with growth in both, they are holding up relative to 4Q or accelerating. There was a partially offset, I guess, by a slowdown in automation a bit.

But maybe if you could just take us a little deeper, and help us understand really the puts and takes for each of the Software businesses. What surprised you in the quarter? What was more challenged? And then, lastly, just what was the growth contribution from acquisitions in Software in the quarter? Thanks..

Yeah. So, Erik, this is Arvind. Let me start with addressing some of these and Jim will help with some of the precise quantification. So if you look at this overall contribution that you are going through in all of these, let me first address the Kyndryl piece, because that may be in some of your -- behind some of your questions.

The Kyndryl contribution was largely in our Mainframe Software segment in the TPP segment. So I will put it there and there we pointed it out. I think 28% of the 31% comes from Kyndryl. Probably as an absolute amount, we expect that to stay going into next year, but obviously, it won’t contribute to growth going forward after this October.

Now, as we look at some of the others, a lot of it comes down to the focus and nimbleness in which we are now operating the company, where we have a Technology segment and a Consulting segment. I believe that that is what contributed. Certainly there was demand in the market for security because you asked that question.

But the nimbleness and the focus of our teams now allows us to go fulfill that demand and that is why you saw that growth rate come up by 7% to 8% between the fourth quarter, just looking at quarter-to-quarter dynamics. Then when you look at Red Hat, I think, the execution was very good.

But Red Hat has been in the upper teens and that is where we expect it to keep performing for the rest of this year and that speaks to both the quality of the portfolio and the demand that’s in the market. Of course, we always have to keep executing against that demand. So I think no real puts and takes in there in these three.

Now when we come to the data and AI and automation, I do believe that with some of the acquisitions we did last year and being able to fulfill the demand against those that led to the second half of last year having an accelerated growth rate in automation. And we do expect it to remain within our model.

Our model calls for mid single-digit growth in both automation and data and AI.

That said, let me just tell you that my instinct from listening to our clients, from seeing what they want to do and from looking at all of the shifts happening in demographics, meaning tech skills are very hard to get, I anticipate that for the market at large, there will be more and more demand in both in automation and in AI.

Now the execution is on us to go fulfill against that demand..

Yeah. I would just add, Arvind. Erik, thank you very much for the question. Software is obviously an integral part to our hybrid cloud platform-centric thesis overall and Arvind went through the portfolio and the dynamics, but let me add some of the KPIs to that.

So it gives you some of the fundamentals underneath the pervasive growth across Red Hat at 21%, automation at 5%, data and AI growing 4% and security with a nice rebound delivering return on the new innovation we brought to market.

But when you look underneath it, our Hybrid Platform & Solution, our growth vector, which is about 75% of our Software segment, nice growth double digits overall. Underneath that, we have got an ARR, now a subscription book of business about $13 billion, that is now accelerating, growing 9% overall from an ARR perspective.

We have seen nice acceleration in Cloud Pak portfolio underneath that, with a flywheel effect. We are getting NRRs that are north of 100%, I think this quarter it was about 105%. So we have had now three or four consecutive quarters of that flywheel effect.

And we are seeing strong renewals across the early parts of our ELA cycle, which is just beginning and that strong renewal is leading to a record deferred income balance north of $11 billion right now and growing nicely. So we feel pretty good about our Software portfolio, a lot of execution in front of us, though..

Thanks, Erik.

Sheila, let’s go to the next question, please?.

Our next question will come from Kyle McNealy with Jefferies. Your line is open..

Hi. Thanks very much for the question. I’d like to see if we could put a bit of a finer point on the timing when you think the benefit from new pricing and the changes you are making in Consulting will offset some of the cost inflation you are seeing.

I believe earlier in the call, you said, that it would take a few quarters to get the benefit, but then you mentioned that second half 2022 Consulting margins will improve based on the pricing coming in.

So should we expect better pricing helps Q3 and is there any way you can quantify how many points of margin you might get back by the end of the year? Thanks..

Yeah. Thanks, Kyle. Arvind, I will take this one overall. Kyle, great question. I mean, we are obviously operating in an environment of accelerated demand in the Consulting space and I think you see we are capitalizing on that.

And we have been talking about this since the second half when we were looking at all of our indicators across the portfolio and our enterprise clients, we saw a pretty robust demand environment and we made a conscious strategy to invest in building out skills capabilities, ecosystem partnerships.

And we started if you remember beginning of 2021 investing significantly in acquisitions to build out scale for our hybrid cloud adoption overall.

Now, you couple that with the highly inflationary environment right now that we started seeing play out in the latter half of 2021 and we said at that point in time that when you couple the investments we have been making, which is conscious, to build that capability, because Consulting.

As I have always said, is the tip of the spear that provides tremendous value in pulling IBM technology and driving scale and adoption of our hybrid cloud platform that you couple that with the inflationary environment, you are seeing the pressure on our gross margins. Now, I will tell you, let me try to quantify a little bit of this.

When you look at our gross margins, we were down about 350 basis points in Consulting. Arguably off the toughest compare that we will face in 2022. The compares get easier. So we will acknowledge that right off the bat.

Number two, when you look at the inflationary environment, we have been seeing within that 350 basis points about 150 basis points is due to the accelerating cost of talent acquisition. The remaining 2 points or so is about a point of acquisition, which as you know, as you get ramp and scale, those become very quick accretive.

We expect that to be accretive as we get into latter half of second quarter and into third quarter. And then we have been investing, when we saw that robust demand environment, we invested a significant amount of capability and capacity. In the early innings of that, you have underutilization. We knew that.

That’s why we had to get after our G&A structure to optimize and streamline, by the way, reinventing IBM through automation, digitization, everything our clients are doing, we have been doing inside IBM. That’s been mitigating the profit impact overall. So I think you will start seeing improvement as we get into third quarter.

But we will make sequential improvement here in the second quarter overall. But I will tell you again gross margin improvement will turn accretive in third quarter and the second half, but in a pretax operating margin, we have guided to approaching 10%. That’s up a couple points. We will see that improvement throughout the year..

Thanks, Kyle.

Let’s go to the next question, please?.

Our next question comes from Brian Essex with Goldman Sachs. Your line is open..

Great. Thank you. Good afternoon and thank you for taking the question. Great to see the stability on the Software side, particularly Red Hat growth, but I guess, on the Consulting side.

Arvind, maybe I’d love your perspective or perhaps you can share some of what you heard from conversations regarding the sustainability or durability of digital transformation in Consulting spend.

And maybe to pivot on Wamsi’s question earlier, we all know Consulting tends to be discretionary in nature, but would love your view on your portfolio of Consulting business and how that might fare in a more, I guess, difficult macro environment where customers may kind of sharpen the pencils on their budgets.

Is it different than, say, system integration application engineering Consulting spend?.

Yeah. So, Brian, thank you for the question. And it is one that we think a lot about and we talk a lot to our clients about to understand where they are. So if you look at the makeup of our Consulting portfolio and that is we have very little of what I would call the Infrastructure Services. Those all went with Kyndryl.

So what we have left is helping clients, and Jim, talked about the very high growth rates with some of our ecosystem partners, that is Consulting around topics like Salesforce and Adobe and public Clouds. Even in difficult environments, we believe that the adoption of those platforms is going to continue with all of our clients.

Second, as we look at digitization, so digitization is not just taking something and coloring -- just coloring it and making it digital.

But if we look at it as being one of the primary ways to address the labor demographics issue, meaning the shortage of high skill labor that is there pretty much globally, then we believe that that actually continues even in a difficult environment, because it gives our clients a way to go address that.

If I take, for example, airline scheduling, if you take re-booking of passengers, if I take quote to cash, where you cut across all of the silos, if I take much more real-time impact of revenue and omnichannel, these are all examples of our Consulting projects, which we see carrying on even through a difficult environment.

So when I look at that that tells me there’s a sustainability and durability. I don’t see the number of trained people and experts coming up suddenly, and so consequently, I think, that because of that, because there is a shortage of technical talent in the world, it will continue to go well even in a constrained economic.

But, Brian, let me acknowledge. When I say constrained, I mean, if we enter what I will call a mild recession or a quick recession. If you get something deep and sustained, I will put my comments a little bit to the side and we will have to then go look at that again.

But I think that, because of the makeup of our portfolio, I think, it will actually fare quite well..

Thanks, Brian.

Sheila, let’s go to the next question?.

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

Thank you. I wanted to just follow up an earlier question on the Consulting gross margins. Historically GBS has operated at a lower gross margin than its peers with the difference somewhere in the kind of 400-basis-point to 500-basis-point range.

And I appreciate all of your commentary about GBS margins including the cyclical items and the investments there impacting margins currently.

However, looking beyond that, are there structural differences that explain that dynamic or with many of the strategic changes and investments in the business that are underway, is a peer group margin achievable, and if you think it is, what timeframe do you think you can achieve that?.

Yeah. Why don’t I address that? Thank you, David, for the question overall. When you take a look at the Consulting margin, let’s just take a step back and mark it in to your point. The competitive benchmark right now I would say is probably low- to mid-teens.

We are not going to be a pure-play industry, excuse me, India Consulting-based company that has a very different value proposition. But if you look at some of the peers that we benchmark, you are in the low- to mid-teens. We have talked about our mid-term model.

Now, that mid-term model as we put out aligns to an integrated IBM thesis of hybrid cloud as a platform-centric business built on the foundation of Red Hat.

GBS or excuse me, Consulting has an integral role of not only being a pure-play competitor, but they play a very essential role in driving the scale and adoption of our Software portfolio and also pulling through our Technology. And by the way, we have talked many times about how well they are doing in building up a Red Hat practice.

I think inception to date, about a $4.5 billion book of business on top of our hybrid cloud platform-centric thesis and they drive about depending on any quarter, 20% to 30% to 40% of our Cloud Paks. But we talked about our mid-term model that we would get in the low double-digit margin range. That is a three-year picture.

So I think we have already given that.

At high single-digit revenue growth, the investments we are going to make, the integrated value it delivers IBM, you take that high single-digit revenue growth, you take low double-digit approach into the low teens, we are in a competitive playing field and it’s an integral part of IBM that drives that software portfolio and that profit.

So we feel pretty comfortable that that mid-term model answers your question..

Thanks, David.

Sheila, let’s take one last question?.

Thank you. Our last question will come from Jim Suva with Citigroup. Your line is open..

Thank you. Saving the best question for last I guess. A lot of time has already been spent talking about the various segments except really not your Mainframe segment. So maybe I will take a question on that is, you laid out three really nice enhancements to Mainframe.

Is that enough you think to make Mainframe be growing over the past cycles or competitive with past cycles? Because people that have been calling for the death of Mainframe for a decade and that death has been greatly exaggerated.

I am just kind of thinking about these enhancements, could it actually be more? And then on the profit side of Mainframe, companies like Citigroup, we order Mainframes well in advance but the components have changed with pricing. Is there anything we should be conscious of for the profitability of the new Z Mainframe rolls out? Thank you..

So, Jim, let me start with answering your question on the capabilities of Mainframe driving growth in Mainframe and then ask Jim to address the profitability side.

So if I look at the demand side on Mainframe, a lot of our clients are seeing additional volumes, because Mainframe serves really well as a system of record as that transactional engine that helps drive our clients’ business.

If there is volatility in the markets, if there is 10%, 20%, 30% volume increases, which we are sensing many of our clients see, that is the primary driver of growth.

And the second driver of growth where we talked about resiliency is everybody is now wanting to be 24x7 and because of all of the issues around not just resiliency due to physical issues or software errors, but also because of cyber, people are much more concerned, and that drives additional capacity if people want to make sure that there is a working copy of their application and data set available at some other place and that is why you heard us talk about that.

Then, as the volumes go up, we know that there is always an indication of fraud that can go up. And because of the fraud, we embedded AI into the processor, so you can now make your fraud decision in line with the transaction decision.

And you can imagine whether it’s processing credit cards, whether it’s moving money, all of those capabilities are going to drive that. So if I pack all of that and then unpack it, Jim, I will tell you that we saw over the last three years more growth and better adoption of Mainframe than we have seen in prior cycles.

We expect from early signals that we are going to see that continue over the next couple of years. That said, we have got to go out and execute. We have got to make sure that our clients actually are able to quickly deploy these applications that they use and that will allow us to grow the Mainframe over this coming cycle as well..

And I will just wrap it up, Jim. Thank you very much for the question. Mainframe is obviously an essential element of our innovation and value strategy overall. We operate the Mainframe as a platform-centric model. So on top of that Mainframe, we have mission-critical software as you know quite well. We have storage, high-end attach.

We have maintenance that goes to it. When you look at the z15 cycle, we actually, it’s the first time in a few cycles our profitability of that stack is actually increased really due to where Arvind ended, which is the most successful are ship MIPS cycle that we have ever had from a program.

Our installed MIPS capacity now is up over 45% from the prior programs. We have got roughly about $80 million MIPS that are out there today. That’s our opportunity set to deliver tremendous value to our clients, but also monetize that value in many different ways.

But you touched on some and I just want to wrap up, because I want to talk a little bit about how Mainframe plays into second quarter and in the summary in the prepared remarks, we talked about the high level of second quarter.

But when you look at second quarter from a topline revenue perspective, Mainframe is going to have a major contribution in the historical quarter-to-quarter. If I look at it from a history of the last three years, we typically do about $900 million of revenue quarter-to-quarter, 1Q to 2Q, all in.

And by the way, that excludes the Kyndryl component of this. But when you take a look at this year, we expect 2Q to be a couple hundred million dollars above that historical quarter-to-quarter of $900 million. So call it about $1.1 billion, a little bit more. Underneath that, Mainframe is going to be a substantial contributor to that.

Albeit shipped late in second quarter and also that underlying fundamental business performance is offsetting, as I said in prepared remarks, the continued dollar strengthening, so currency versus history will be a hurt against that.

So we will more than offset that currency and that dollar strengthening with a better than historical 2Q revenue compare and Mainframe is going to be a very big piece of it. So Arvind, let me turn it back over to you then..

All right. Thanks, Jim. Let me just make a couple of comments to wrap up the call. Our performance this quarter reflects the actions we have been taking. We have strengthened our portfolio, we are leveraging our ecosystem and we are streamlining our business.

While I acknowledge there is always more to do, we are pleased with the start to the year and I look forward to speaking with all of you again soon..

Thanks. Sheila, let me turn it back to you to wrap up the call..

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