Interview with IBM CFO Jim Kavanaugh

0:04Jim Kavanaugh:Over the last three plus years, we've created more value for our shareholders than the prior 111 years combined.

0:24Tom Gardner:That was IBM CFO Jim Kavanaugh. 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 Kavanaugh 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 Anthropik's new COBOL coding tool. Hope you enjoy the conversation.

0:56Matt Frankel:Well, hello, Fools. We're so excited to spend the next half hour or so with the Chief Financial Officer of IBM, Jim Kavanaugh, and Matt Frankel, our Hidden Gems investment analysts, helping out throughout. Jim, thank you so much for this time.

1:10Jim Kavanaugh:Great. Thank you, Tom. I appreciate you having us here and looking forward to an engaging discussion with both of you.

1:16Matt Frankel:Let's hope we don't let you down. 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 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.

1:50Matt Frankel: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 afoot here. And it's a couple of years in at least. Yeah.

2:21Jim Kavanaugh: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 than what we were five, seven years ago under Arvin'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 Arvin has really embedded and instilled in IBM, a cultural transformation.

3:16Jim Kavanaugh: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. What 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.

4:20Jim Kavanaugh: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 in 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 cash flow 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.

5:11Jim Kavanaugh: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. 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.

6:07Jim Kavanaugh: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.

6:57Jim Kavanaugh:You bring all that together, and 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.

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8:26Matt Frankel: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 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, by 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.

8:56Matt Frankel:Jim, 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 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?

9:31Matt Frankel:How does that all weave together, if you can, three questions into one?

9:35Jim Kavanaugh: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 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 is 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.

10:24Jim Kavanaugh: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, to the internet, to the globalization era, to most recently, you know, 10 years ago plus, the cloud explosion technology is always brought competitive advantage it's always brought more productivity read that gdp that's why it's the second most highest contributor to gdp behind health care and i think this is going to be the same thing now to i think your second question had something to do, I think, around labor or human capital, etc.

11:18Jim Kavanaugh:I think around technology and Gen.A.I. Gen.A.I. 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 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.

12:09Jim Kavanaugh: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 party 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 a CFO, I have the fiduciary responsibilities for the company.

13:00Jim Kavanaugh:I also have and been entrusted by Arvin 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.

13:59Jim Kavanaugh: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.

14:14Matt Frankel:You nailed them. You nailed them, Matt.

14:16Tom Gardner: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. 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.

14:47Jim Kavanaugh: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 bug. 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 advantages. 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.

15:32Jim Kavanaugh: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.

16:27Jim Kavanaugh: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 you know 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.

17:10Jim Kavanaugh:Now get to Confluent. Confluent, we're extremely excited. Open source company, you know, 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. 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 occur.

17:56Jim Kavanaugh: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 companies scale AI, because it brings is 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 Confluence. So we couldn't be more excited. By the way, it fits our M &A strategy. What do we look at in M &A?

18:44Jim Kavanaugh:We look for category-leading technologies in 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. Expands our TAM, very important area, so we couldn't be more excited.

19:10Matt Frankel: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 core 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 into cash flow and where to deploy it?

19:31Jim Kavanaugh: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 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 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.

20:18Jim Kavanaugh: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, 100 plus years and we've raised our dividend. We're in Aristocat right around 30 years in a row.

21:00Jim Kavanaugh: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. 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 inorganically, we're going to continue our organic engine.

21:44Jim Kavanaugh: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 a return of value to shareholders. And we're about at that payout ratio that allows us to have a lot of flexibility. So I call that a high quality problem.

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23:16Matt Frankel:Final question is like the ski jump in the Olympics. It's not going to be a long runway 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. Arvind has a 35-year history. You came in as, I believe, stepped in as CFO in 2018, Arvind is 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 Arvind Krishna years mean as distinct from what came before at IBM?