Chapter 1: What major shifts are happening at IBM?
Over the last three plus years, we've created more value for our shareholders than the prior 111 years combined.
That was IBM CFO Jim Cavanaugh. I'm Motley Fool producer Matt Greer. Now, Motley Fool co-founder and CEO Tom Gardner and Motley Fool contributor Matt Frankel recently talked with Cavanaugh about the new IBM and about what AI means for IBM's future. Now, I should note that this interview was recorded on February 10th.
prior to the big decline in IBM stock price over concerns about Anthropic's new COBOL coding tool. Hope you enjoy the conversation.
Well, hello, Fools. We're so excited to spend the next half hour or so with the Chief Financial Officer of IBM, Jim Cavanaugh, and Matt Frankel, our Hidden Gems Investment Analysts, helping out throughout. Jim, thank you so much for this time.
Great. Thank you, Tom. I appreciate you having us here and looking forward to an engaging discussion with both of you.
Let's hope we don't let you down.
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Chapter 2: How is IBM transforming under Arvind Krishna's leadership?
We're so excited about this. I will say for investors of The Motley Fool, we have eight recommendations of IBM. Those investments have done quite well for us. We take a very long-term perspective with our investment strategy. So we're always looking to hold our investments for at least five years.
Obviously, there's so many transactions in the marketplace and so much excitement about trading and sports betting and all the other things that people get drawn into. But we're very convinced that the best returns come in the equity markets to those who find businesses that are Making improvements, solving the problems of the world, generating cash flow from it.
And so it is within that frame that we begin our conversations. I'll just start, Jim, with maybe the standard question. You might expect that investors or some investors may still think of IBM as legacy services and hardware versus software AI companies. and all of the R&D investments that IBM has been making. But what would definitively change that perception, do you think?
What milestones should investors be watching as proof that we have a real transformation afoot here? And it's that couple of years in at least.
Yeah, well, thank you, Tom.
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Chapter 3: What role does AI play in IBM's future strategy?
I appreciate it. I think that's a great place to start because We today at IBM, we firmly believe we're a fundamentally different company than what we were five, seven years ago under Arvind's leadership now as he's taken over the reins of the IBM company. But we've embarked several years ago on a major strategic transformation that I would argue was all about reinventing IBM.
It was everything, Tom, from portfolio optimization and a bunch of moves around that I'm sure we could talk about to underlying fundamental operating and business model transformation. to arguably the most important piece of what Arvind has really embedded and instilled in IBM, a cultural transformation. We are a very different company.
And it starts with our strategy, a very focused strategy around what we believe are the three most transformative technological shifts that we're seeing today. Hybrid cloud, AI,
and emerging right now and becoming reality very soon quantum and if you take a look at it we have done a ton of work around building a software-led platform-centric company to capitalize on those three strategic shifts with a very important integrated value proposition of infrastructure.
So yes, we still have a infrastructure led by the most enduring platform mainframe, but we also have a software business that we could talk about and a consulting business that brings an integrated value proposition together that has a multiplier effect of every time we land a platform dollar. Now, to your point, what is it going to take? Well, let's just put this in perspective.
You've been following us, and we really appreciate the recommendations from you and the team overall, your trust, your confidence, and the investment overall in our great company. But what we've done over the last handful of years, we've taken a company that was in structurally declining portfolio growth,
incrementally diluted margins and a free cashflow engine that was stagnant at best to declining. And over the last three plus years, we have built a durable, sustainable revenue growth model. We've improved our operating margins over the last three and a half years by a thousand basis points. And we have basically almost two and a half times our free cash flow.
five plus billion dollars of growth over the last three years. And by the way, the market has rewarded us on capitalizing on that. Put it in perspective, over the last three, five years, our TSR is about 2x the S&P 500, and it's well above the S&P Tech over the last three to five years. And IBM, Tom, as you know, you've studied us quite well.
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Chapter 4: How does IBM's approach to hybrid cloud differ from competitors?
We just celebrated our 114 year anniversary. And over the last three plus years, we've created more value for our shareholders than the prior 111 years combined. Hit all-time stock price, all-time market value, all-time enterprise value overall. So now you say, well, where can we take this company going forward to your question?
Well, we laid out at our investor day last year in February, about a year ago to almost a day here today. And we said that we were going to fundamentally build the next leg of our shareholder value creation model that is built on three pillars, accelerating this revenue growth even faster in this company, five plus percent led by double digit growth in our software book of business.
Two, continued operating margin leverage about 100 basis points per year. We think we've got significant headroom still to go. And three, a free cash flow engine that is going to grow faster than revenue, expanding free cash flow margins each year that creates investment flexibility.
You bring all that together in the way I kind of summarize it to investors, our investment thesis, higher revenue growth, higher operating margin company, strong free cash flow yield. high return on equity and a very attractive return to shareholder program with our dividend policy. That's kind of how I would sum up the beginning of this discussion, Tom.
When Johann Rall received the letter on Christmas Day, 1776, he put it away to read later. Maybe he thought it was a season's greeting and wanted to save it for the fireside, but what it actually was was a warning delivered to the Hessian colonel, letting him know that General George Washington was crossing the Delaware and would soon attack his forces.
The next day, when Raw lost the Battle of Trenton and died from two colonial Boxing Day musket balls, the letter was found, unopened in his vest pocket. As someone with 15,000 unread emails in his inbox, I feel like there's a lesson there. Oh well, this is The Constant, a history of getting things wrong. I'm Mark Chrysler.
Every episode, we look at the bad ideas, mistakes, and accidents that misshaped our world. Find us at ConstantPodcast.com or wherever you get your podcasts.
This is going to be a bit of a walking tour or a pub crawl because we're going to go in a couple different directions and return back, circle back to some points you've just made around productivity and about change management and the culture at IBM today and the changes that have emerged over the last couple of years. But I want to
a turn right now to what's happening with AI, agentic AI and IBM's business. I've bundled three questions together in one. In fact, I had these three questions and moments ago, I just turned to GPT and said, let's put it into one question. Let's see how well it did with this. Jim, how does,
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Chapter 5: What impact does quantum computing have on IBM's operations?
And now here's where we're getting the blended question. So how is this disruption different than cloud or mobile? And are clients finding that effective AI adoption requires rethinking their team structures and their roles rather than just layering in AI onto existing workflows? And if so, third part,
What share of IBM's consulting engagements include AI-driven workforce transformation or change management? How does that all weave together, if you can, three questions into one?
Okay. Well, you'll have to help me because I'm actually, as a CFO, I'm not very good at multiple part questions, as you know from our earnings calls. But I'll revert back to you and you can refresh my memory. But let's take your first one, right? And then we'll go from there. What is in the history of the information technology industry? What has technology always been?
It is a way to drive productivity and a source of competitive advantage. I would argue for worlds, economies, industries, society at large. This next evolution of agentic AI is going to be, and I believe the most powerful
form of competitive advantage and productivity that we will ever see or let me personalize i'll ever see in my professional lifetime overall but if you go back tom and you look at the client server technology shifts the advent of the services industry the middleware era the to the internet, to the globalization era, to most recently, you know, 10 years ago plus, the cloud explosion.
Technology has always brought competitive advantage. It's always brought more productivity. Read that, GDP. It's why it's the second most highest contributor to GDP behind healthcare. And I think this is going to be the same thing. Now, I think your second question had something to do, I think, around labor or human capital, etc. I think around technology and Gen AI.
Gen AI will influence every workflow, every job, every skill in every industry, without a doubt.
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Chapter 6: How is AI influencing workforce transformation at IBM?
By the way, revert back to your first part A question. In all of those technological inflection shifts that have happened, we have gotten more GDP growth. We have gotten more labor and human capital growth. Is it in the same areas and disciplines? No. Because the value equation has to change. New industries were created. New markets were created. New companies were created.
New skills, new job disciplines were created. And that's the evolution, I think, naturally of what technology does. I think the same thing is going to happen with AI overall. AI will influence. Now you bring it back, and I think I remember your third part of your equation around consulting.
By the way, I would argue today that is a huge differentiator in the IBM company because we are the only integrated information technology company that brings an innovative tech stack across hardware, software, services, platforms, AI, hybrid cloud, quantum, with a consulting business at scale across 175 countries that drives platform adoption and scale overall.
I will tell you in AI, let me bring it home to myself, because not only as CFO, I have the fiduciary responsibilities for the company. I also have been entrusted by Arvind and the board, everything from the strategy to the portfolio, to all of the operations of the company. So when you think about how we're deploying AI to productivity, This is tough work.
To reinvent a company, it requires you to fundamentally change and rethink how you run workflows in a company. How do you run HR? How do you run supply chain? How do you run procurement? How do you run finance? How do you run sales development optimization? The consulting aspect of bringing industry domain knowledge
And strategy, technology, business consultancy is essential, I think, for companies because companies to get the scale and value realization of AI, they have to fundamentally change the way workflow gets done. Yes, it starts with data, but it's all about workflow optimization, and it ultimately is going to change operating and business models. So consulting plays a very important role.
Hopefully I kind of touched your three, if I vaguely remember.
You nailed them. You nailed them, Matt. All right, well, I'm going to do kind of what Tom did and combine two of my questions, and it's because the first one's short. So this is definitely just a financial question.
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Chapter 7: What are the financial implications of IBM's AI growth?
In your Q4 earnings, you reported that your AI book grew by $3 billion to $12.5 billion, I think was the total. So just for investors watching who might not know exactly what that represents, can you kind of break down what that means and how investors should think about its growth?
And the second part is how does the acquisition of Confluent, how does that play into your AI strategy from a long-term perspective? And how will that strengthen that number even further?
Sure. I mean, we're extremely excited about the Confluent. If you hopefully can see over my shoulder, we have a little of the props around some of the acquisitions and capabilities, but I'll come to Confluent here in a minute. First around the AI, first of all, IBM, deploys enterprise AI.
We're an enterprise company that improves the economics around real work, boosting productivity, driving increased innovation, starting and driving competitive advantage, as I talked about technology, and it's also fueling growth. Our book of business, we exited 2025, inception to date, so call that almost two years, $12.5 billion book of business.
By the way, in the quarter, it was north of $3 billion, to your point, so thank you. Underneath that, it's really made up of, again, platform model, because we participate in all facets of models, software, agents, assistance, orchestration. So software book is about, excuse me, north of $2 billion. By the way, in 2025, up nearly 80% overall.
The remaining, call that north of $10.5 billion is our consulting book of business. That's our strategy and technology advisory work around AI, that's our data transformation services to get companies ready to scale and deploy AI, and that's our intelligent operations where we do application modernization, hybrid Cloud architecture, etc. So that gives you a little bit of the background.
We're extremely excited about where we think AI is going. You look at studies that have been produced, whether it's BCG, McKinsey, you name it, you know, they're calling trillions, like four trillions of value creation over time around AI when it's at peak. And oh, by the way, interesting thing on that, just a little sidebar, only about a quarter of that is productivity.
Three quarters of that is actual new sources of growth, new industries, new companies, new markets. And having an innovative tech stack and a consulting business at scale plays to our advantage. Now get to Confluent. Confluent, we're extremely excited. Open source company.
We're very big in open source, starting with the initial Linux foundation that we started, but Red Hat acquisition, HashiCorp, Confluent plays extremely nicely to our strategy overall. Confluent, leading open source company around data streaming, events, real-time foundational for Gen AI overall. It is going to become the glue. If you think about Gen AI, yes, you've got models.
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Chapter 8: What does the future hold for IBM's consulting services?
What does Confluent do? It's going to be the smart data platform that is going to be foundational for us to have companies scale AI because it brings the integration of applications, of data, of security, of governance, of intelligence together. Think models, applications, agents, and the connectors of all that is going to be the underlying data connector around Confluent.
So we couldn't be more excited. By the way, it fits our M&A strategy. What do we look at in M&A? We look for category-leading technologies in structurally growing markets where we can add unique value inside IBM around integration and around delivering synergies on top of our platforms. This fits extremely well with that overall.
Expands our TAM, very important area, so we couldn't be more excited.
Just a quick follow-up. Let's just take these four factors, and if you have a formula for them or how you evaluate them from one quarter to the next, one year to the next, and that would just be share buybacks, dividends, acquisitions, and R&D. So taking those four different games you can play, how do you think about each dollar that comes in of cash flow and where to deploy it?
Well, discipline to capital allocation always starts with investing back in our business. that is both an organic and an inorganic to the extent we remain disciplined around our set of M&A criteria, strategic fit to our hybrid cloud and AI strategy, synergistic value because every dollar we invest inorganically, we gotta get a multiple synergy.
It's gotta pull software, it's gotta pull consulting, it's gotta pull our infrastructure platform, and it's gotta have an attractive financial profile. So our capital allocation strategy always starts with the biggest value creator, which is utilizing cash, in the most productive and effective way to create long-term sustainable competitive advantage.
From there then, as a CFO and public company, you've got to look at any excess cash above your leverage ratios on how you would have an attractive return to shareholder program. Given our investor mix, and by the way, we've been doing a very good job of changing that over time, but we have a very sticky, a very loyal retail base. They love the dividend and we remain, we've been very transparent.
We remain committed to a secure, modestly growing dividend over time. I think right now we've given a dividend for what, a hundred plus years and we've raised our dividend. We're in Aristocat right around 30 years in a row. And we feel very confident. We've been able to grow into a pretty attractive, still attractive,
dividend yield at a very appropriate now payout ratio, much better than where we were five, six years ago. And then from there, given the free cash flow generation engine, Tom, that we've been driving here and the vector of growth, You know, our return to shareholder program, we're approaching about 40% from a payout ratio.
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