Interview with IBM CFO Jim Kavanaugh

Over the last three plus years, we've created more value for our shareholders than the prior

hundred and eleven years combined. [MUSIC]

“And that was IBM CFO Jim Cavanagh. I'm Motley Full Producer Macquire.”

Now Motley Full Co-founder and CEO Tom Gardner and Motley Full Contributor Matt Frankel recently talked with Cavanagh 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's stock price over concerns about anthropics new co-ball 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 Cavanagh 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. We're so excited about this. I will say for investors of the Molly Full, 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 are 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 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 of foot here? And it's at a couple of years

“and at least. Yeah, well, thank you Tom, I appreciate it. And I think that's a great place to start.”

Because we today at IBM, we firmly believe we're a fundamentally different company. Then what we were five, seven years ago under Irvin'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 Irvin has really embedded in

still the 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.

“Would 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 have 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 instructually declining portfolio growth and criminally dilute margins and a free cash-relangein that was a stagnant at best to declining. And over the last three plus years, we had built a durable sustainable revenue growth model.

And we have basically almost two and a half times our free cash flow.

“Five plus billion dollars a 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 two X, the S&P 500. And it's well above the S&P tech over the last three to five years. And IBM, time as you know, you've studied us quite well. 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, work, can we take this company going forward to your question? Well,

we laid out at our investor day last year in February. But a year ago, it's 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 has 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 a hundred 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 power. That's kind of how I would sum up the beginning of this discussion. But what I want to tell you now, you don't have to

get a lot of students. The master of the team, the leader of the software, the internet,

“and that's what I'm talking about. You can say that you can do the same thing.”

You're a master of the company, right? But you don't have anything to do? That's right. It's about value for work. Do you do a lot of work with this company? And when you're done, I'm going to buy it. He says, "Catching?" "Safe?" "Viso Stoia?" "He said, "Dangal Tsuruk." "Yes, of course." And those else will be in. This is going to be a bit of a walking tour or a pub crawl because we're going to go in a

couple of different directions and return back, circle back to some points you've just made around productivity and about change management in the culture at IBM today and the changes that have emerged over the last couple of years. But I want to 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 a GPT and said, let's put it into one

question. Let's see how well it did with this. How does organizational disruption from Agentic AI compare with earlier technology shifts like cloud or mobile, where the tools evolved but headcount and core roles largely stayed the same at companies? 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 an 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 from that milk. 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 is technology always been? It is a way to drive productivity and a source of competitive

advantage. I would argue for world's economies, industries, society at large. This next evolution of a Gentic AI is going to be, and I believe the most powerful form of competitive advantage and productivity that we will obviously, or let me personalize, I'll ever see a my professional lifetime overall. But if you go back time and you look at the client server technology shifts, the advent of the services industry, the middleware era, to the internet, to the globalization era,

competitive advantage. It's always brought more productivity, redet, 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, to I think your second question at some of the 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, and every industry without a doubt. By the way, revert back to your first part a question in all of those technological and flexion 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 in 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's 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 an AI. Let me bring it home to myself,

because not only a CFO, I have the fiduciary responsibilities for the company. I also have been entrusted by everyone in the board, everything from the strategy, to the portfolio, to all of the operations of the company. 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 in 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 that. All right. Well, I'm going to do kind of what I'm getting combined to in my questions, and it's because the first one's short. So this

is definitely just a financial question. In your Q4 earnings, you reported that your AI book grew by

three billion dollars to 12 and a half billion. I think it 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 a confluent here in a minute. First around the AI book. First of all, IBM, the employees enterprise AI, where enterprise company that improves the economics around real work, boost and productivity. It driving increased innovation, starting in driving competitive advantages. I talked about technology and it's also feeling growth. Our book of business

we exited 2025 inception to date. So call that almost two years. 12 and a half billion dollar

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, assistants, orchestration. So software book is about,

call that north to $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, McKenzie, 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

are 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 the conflict. Confluent work, extremely excited.”

Open source company. You know, we're very big and open source starting with the initial Linux foundation that we started, but Red Hat acquisition, Hashi Corp, Confluent, plays extremely nicely to our strategy overall. Confluent, leading open source company around data streaming, events, real-time foundational for Jenny I overall. It is going to become the glue. If you think about Jenny I, yes, you've got models. Yes, you've got applications. And by the way,

we've been public. We think there's going to be an explosion in applications that are going to incur. On top of those applications, Matt, as you know quite well, there's going to be multiples of agents that call on those applications. What does Confluent do? It's going to be the smart data platform that is going to be foundational for us to have company 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, fits our M&A strategy. What do we look at in M&A? We look for category leading technologies and structurally growing markets where we can add unique value inside IBM around integration and around deliverance synergies on top of our platforms. This fits extremely well with that overall. Expans 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 a court, one court of the next one year to the next. And that would just be share buybacks, dividends, acquisitions in R&D. So taking those four different games you can play. How do you think about each dollar that comes into cash flow and where to deploy it? Well, discipline the cap in our location.

Always starts with investing back in our business. That is both an organic and in an organic

to the extent we remain discipline around our set of M&A criteria. Strategic fit to our hybrid cloud NI strategy, synergistic value because every dollar we invest in organically, we got to get a multiple synergy. It's got to pull software. It's got to pull consulting. It's got to pull our infrastructure platform. And it's got to have a 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 share the 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

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 on what we were”

five six years ago. And then from there, given the free cash flow generation engine, time that we've been driving here, and the vector of growth. You know, our return to share

all the program, we're approaching about 40 percent from a payout ratio. It gives us a lot of strategic

optionality on how to distribute value back to our shareholders. If we see something that is very attractive, and organically, we're going to continue our organic engine. You can bet on that. That's priority number one. R&D, our research investment, our quantum investment, and the next leg of emerging technology. But if we see something very attractive, that fits our M&A criteria, that will be highly prioritized. Otherwise, we'll look at strategically diversifying how we give out

return to value to shareholders. And we're about at that payout ratio that allows us to, there were a lot of flexibility, so I call that a high quality problem. From what was the verbaflute, we're looking forward to the answer. That's it, and it's still a lot to tell. Stop, ask that the recruiting spirals. With stepstone all-jobs, we'll see all the answers for

one year. In one package to a fixed price. So let's look at the 570 percent cost

property, and there are every time flexible. Now let's take a look at stepstone.de/alljobs. Stepstone, I infarct the richting in talent to finden for all the jobs. Final question is like the ski jump in the Olympics. It's not going to be a long run way to the question, but we're going to give you the opportunity to stick it quickly, because we know we need to respect your time. So be as succinct as you'd like to be. I'd just like to hear from you,

“you have a 30-year history at IBM. Arvin has a 35-year history. You came in as I believe,”

stepped in as CFO in 2018, Arvin to CEO in 2020. We've heard about it through your points in this conversation. So I could probably answer this, but anything special you'd like to give us about what the Arvin Krishna years mean as distinct from what came before at IBM. And maybe if you wanted to go in this direction also, I'd love to hear transformation culture, how you're fair to every employee in this time of great change while relentlessly pursuing the prosperity and success you

want for all the stakeholders of the company with these new technologies. Yeah, well, Arvin and I go back 20 plus years. We became very close when I was the controller, the company back in 2007. He was running parts of our software portfolio overall. We actually built a relationship on the business that ultimately led to a friendship outside, but it was a business relationship on what I would call one day, a mentoring relationship, him deep technologists, me deep business model,

operating model, financial model, et cetera, and we learned from each other. Another day was a reverse mentoring. So we became very, very tight, and our paths have crossed around different portfolio, moves over time, Red Hat being the biggest piece. But what do I think what he's done around this company? Number one, I think we'll go down in history. He is probably engineered one of the most strategic reinventions of an iconic information technology company that's ever existed.

And I say that probably at the end of the day, the reason why we're here 114 on a celebrate 115 years. What is he done? I think if you take a look at back at it, I said to someone earlier this

“morning, I think there's three things that are important, which by the way, go back to”

when Arvin and I were talking when he was interviewing with the succession plan to become the next CEO. As I asked him, I said, what do you want to be known for? Where do you want to take IBM? It's just become CFO. By the way, a lot of there behind the scenes, things have happened

leading up the both of our positions. But number one, he said IBM historically is always delivered

differentiated value over 114 years when we had high value innovation platform models that we could create distinctive advantage. Arguably, we haven't had one since the middleware era in the early 2000s. Alah, his vision, hybrid cloud AI, redhead acquisition and what we done with the portfolio.

the most underappreciated things he's done in the company, creating strategic partnerships,

moving away from historical proprietary IBM to one that is co-optician and strategically complementary to other areas. Point number one. Number two, he had it changed the mindset in this company that we've got to drive durable, sustainable growth, a growth mindset overall. And three,

“I think culturally, what does IBM always been known for? Responsible ethical technology that”

makes a difference in the world, in industry's society at large, technology for good. I think in a very short period of time when you check one, check two, check three, he's well on his path.

And I think that goes back to how I answered your first question. That market valuation and how

the market is looking at us. While that is great, that's in the rear view mirror, all time stock price, all time enterprise value, you know, created more value in the last three years and a previous under 11, what makes us most excited is the engagement and momentum of every IBM or with the

“step in their walk right now. And I think that's a pride statement and that's a relevancy statement”

what clients. So that's kind of how I would wrap it up. Jim Cavanov, the CFO of IBM, thank you so much for this time. We're very happy investors thus far and looking forward to the next five plus years. But I'm learning from you as a business, enjoying the experience of getting to meet you in this situation and making money for putting our money at work. And that's the mission of the Molly

“Fool to create a world that is smarter, happier and richer. And you've given that to us in this”

time. So thanks very much, Jim. Appreciate it. Thank you again. I appreciate your trust and confidence

and investment. We'll keep making it work for you. As always, people on the program may have

interest in the stocks they talked about and the Molly Fool may have formal recommendations for our kids. So don't buy ourselves stocks based solely on what you hear. All personal finance content follows Molly Fool editorial's standards and it's not approved by advertisers. Advertisements are sponsored content and provided for informational purposes only to see our full advertising disclosure. Please check out our show notes. For the Molly Fool Money team, I'm Matt Greer. Thanks for

listening and we will see you tomorrow.