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John Kelly - SVP and Director, Research

Analysts

Kulbinder Garcha - Credit Suisse

International Business Machines Corporation (IBM) 2013 Credit Suisse Technology Conference December 4, 2013 1:00 PM ET

Kulbinder Garcha - Credit Suisse

Okay. I think we will get started. My name is Kulbinder Garcha. I cover IT Hardware for CS and we are very pleased to have from IBM, Dr. John Kelly, who is the SVP and Director of Research for the company. John, maybe before I kick off into some questions, maybe just a brief introduction of your role at IBM and the purview that you have within the company then we will go into some Q&A.

John Kelly

Great. Great. Thanks. Yes. So, I - organizationally I lead IBM’s global research division which is approximately 3,000 scientists, engineers, it’s our global corporate research. It’s sort of the tip of the innovation arrow for IBM that leads us into new areas, new technologies, new businesses. In addition to that, responsible for directing a lot of our technical strategy across all of our businesses and development labs in the company, so a broad role in technology. In research we have got 12 labs around the world ranging from the U.S. to places like Africa, India and China.

Question-and-Answer Session

Kulbinder Garcha - Credit Suisse

Great. Thank you for that. Maybe if I bring it to the heart of the issue, that I think concerns some investors in IBM, if I put it like this, the roadmap approach of managing the company has certainly served the company well over the last seven or eight years, both in terms of operational performance and in terms of frankly the share price and value to the shareholders. I guess, there is some concern this year has been a bit more challenging, at the same time there are some concerns being elevated with respect to the innovations happening at IBM, whether you are investing enough in next-generation technologies, whether the M&A approach is a right one. So can you speak about what you would talk about in terms of the performance this year? How you think about innovation? Where IBM really directing the result to actually lead the next-generation of IT?

John Kelly

Sure. Sure. Well, first of all, as you mentioned, the roadmap has served us incredibly well. It has, I think, provided a level of transparency to investors, which is unique, in the industry, perhaps in the world. It also has focused us on the important aspects of the business and understanding how to drive the remix of our businesses to higher value and to produce the profit and earnings per share and constantly reinvent ourselves.

Now within that roadmap though, of course, we have major investment categories, we continue to invest approximately $6 billion a year in organic research and development and in that roadmap we had for 2015 $20 billion of acquisitions to supplement and augment our internal organic R&D. So those are two enormous amounts of money for innovation.

How do we do that? So, I think, we have in the sense the best of both worlds here. I know of no other company in maybe any industry, but certainly not in our industry, where we have such a large organic research and development effort and such opportunity for acquisitions.

So we invent many technologies, we invent the Watsons of the world, cognitive computing. We do tremendous amount of work in areas like cloud computing and analytics, core innovation from our laboratories, best and brightest in the world and then when we see opportunities where we didn’t invent it or someone did a better implementation we go out and acquire the company.

And I think what’s unique about us is not only do we do each of those extremely well, but it sort of one in one is a lot more than two here. When we bring together as an example an acquisition of SoftLayer in cloud, with our internal capabilities in cloud and security algorithms and capabilities for cloud, the sum of those two parts is a lot more than the pieces. And so I think this ability to invest organically and acquire is very, very unique and we have complete flexibility in that.

Kulbinder Garcha - Credit Suisse

In terms of then John, in terms of the effectiveness, let’s say, of your investment, can you speak about as the Director of Research, how you measure that. And I guess, one of the things that has concerned us at CS somewhat has been the lack of organic growth in the company combined with - you have to supplement with acquisitions but just the revenue growth hasn’t been fantastic now for some time and maybe one year is too soon to judge.

I think that’s probably the sensible answer but this goes back over a couple of years. So how do you think about the effectiveness of the R&D and then in terms of the, let’s say, the top four priorities where you think IBM need to be pioneering the IT industry and investing very heavily, what would those four areas be do you think?

John Kelly

Okay. Well, I think if you look short-term, yes, our hardware business has had some issues. They are very specific to our UNIX business, very specific to certain geographies, like China, where we are undergoing political change. So those are in my mind tactical issues. We’ve had tremendous innovation in that hardware business and areas like our mainframe business still continue to be very substantial.

If I look at where are we innovating and what are the - I'll give you three areas. I can give you 10 if you’d like but I’ll give you three big areas where innovation is really critical and where I have put the majority of my wood in the corporate research labs behind are the three sort of following areas. One is I’ll call it front office or with the client and that’s around mobile social analytics. And that’s a very fast growing area, not only in the consumer world but with enterprises as the biggest banks in the world retailers are dealing with their new customers and new buying patterns through areas like mobile. So tremendous amount of work around analytics, mobile platforms, managing mobile applications for the enterprise, big area. That’s roughly a third of where I’ve put my wood now going forward.

The second area is cloud. Cloud is the real deal. Cloud is not a passing fad and it is here to stay. And much of what we’ve seen to date is I’ll sort of call it clichéd but Cloud 1.0 it’s infrastructure as a service. That is not what cloud is going to be all about. Cloud and sophisticated value added services on the cloud is where the puck is going. And I think with our acquisition again of SoftLayer and our core organic capabilities, we are going to produce cloud based services at levels of security as an example that no one else in the world can possibly do. So we’ll see new levels of innovation in cloud that will make the sort of first phase of cloud look pretty simplistic going forward.

And then the third area where I’ve put tremendous amount of wood and again approximately a third of my corporate research global labs is around Watson and cognitive computing.

This is again the real deal. I’m more convinced today than I was even a couple of years ago when we introduced Watson to the world that this is a major paradigm shift in analytics and extracting information from vast amounts of unstructured data, whether it’s medical records, pharmaceutical information, retail, client information, nothing does this job like Watson even today, years after we introduced it, and we can talk more about that. But those are the three areas. Front office, mobile social analytics for enterprises, cloud and differentiated value-added cloud services and then Watson, cognitive are the three areas that I placed all my chips.

Kulbinder Garcha - Credit Suisse

Maybe, John, if I touch on two of them, let’s start with cloud. So you obviously have acquired software -- SoftLayer, sorry recently, I guess, with respect to - on the cloud side, I guess the concern is that IBM maybe hasn’t moved quickly enough to embrace that, especially I’m trying to understand, can you speak about what is it about your cloud assets today that would differentiate your offering?

And then speak about maybe the cloud competitive environment, as you see it evolving? And the reason why I said is that, companies like Amazon just seem to have a very different approach to this market, both profitability wise, how they approach it, the scale at which they are going after, and frankly the customers which they seem to have being winning not only in the last year, but the last couple of years, I’m trying to understand is that just they were relatively early and now you think you’ve got the right assets with the rest of IBM’s brand name and that’s going to be differentiating, do you have to build more assets or do you have the right kind of development already in the cloud that you think you can already start having an impact in the market, that’s much more sizeable?

John Kelly

Okay. So, I think the majority of this is we came from different starting points. We both recognized the importance of cloud years ago. Our first efforts in cloud and we built what was probably the world's first cloud inside my research center in Yorktown years ago. But we then went after private clouds for big enterprise customers and so we built and developed internally very sophisticated, very resilient, very secure private clouds for large enterprises.

Our competitor came at it more from public cloud and infrastructure as a service, lowest cost point, et cetera. So we came at it from different ends. We realized recently that we needed to play more on the lower cost side. We needed to have lower cost on ramps for smaller enterprises. And we realized where we think the future of cloud for enterprises is going.

And I guess if I had to put it simply, in the enterprise space systems of record, all of the big databases of banks and retailers and businesses reside historically in private datacenters. Those are by and large either staying on those systems, the big mainframes and UNIX systems or they are migrating to power or to private clouds. That world is evolving and some of that will go to public clouds, but probably not a great deal.

On the other side, a lot of the social mobile and the lighter weight applications in the frontal office where our competitor is successful are analytics lightweight based. We think the unique opportunity for IBM is in - where real enterprises are trying to connect those two dots, in between those two, the system of records, the system engagement. I refer to it as system of discovery.

This is where we and our clients want to innovate. So a real example would be a bank. They have tremendous records on buying patterns, financial records on their customers, but yet the person that comes through the front door of their branch office or through their website or through their mobile device, is coming through a different avenue and they need to bring these two things together. So that they know more about their client, they can offer higher value services as a bank by bringing the systems of records and system of engagements together.

That will occur on a cloud, that service those analytics will pull data from the back office, front office together on a cloud. We are extremely well-positioned to be the winner in that space for the enterprise because we are the only guys that have a majority of that data on our systems and the systems of record.

And with the acquisition of SoftLayer we now have the ability to hit any cost point, any size business on the front-end of this and pull the two together. So we are going after that intersection of those two areas from a cloud perspective.

Kulbinder Garcha - Credit Suisse

Maybe one characterization that I would slightly tend to disagree with would be I guess the idea that some of the hyper scale companies, what surprised me is, the number of large Fortune 1000 companies that are actually engaged with, they do seem to have had some traction along the way, there have been some high profile wins. And I guess there’s two impacts, number one, to the degree they get any of that business, why wouldn’t that be to IBM’s detriment, that’s one question?

And the second one is even if they are not, just the way that they go to market and the way they are priced, isn’t that deflationary for the entire IT industry or for an IBM or how do you guys add value or offset that kind of pressure, I guess, is my question?

John Kelly

Well, I - many, many large enterprises are dabbling around or doing like lightweight things sort of front office things, with the AWS offering. But and that’s okay. And you can also, lots of them are also doing it on SoftLayer. I mean we have as many hosting services and it’s - the cost point is actually below AWS et cetera. But they don’t have access to this core system of record data.

Kulbinder Garcha - Credit Suisse

Right.

John Kelly

And that’s where again it's the intersection of these two where the value add is very unique that we can provide. So we’ll go head to head there, the private cloud for the big enterprise, our space, and the intersection of those two, again we are very, very uniquely positioned.

Kulbinder Garcha - Credit Suisse

Great. And maybe moving on to Watson, I guess, Watson is just three or four years old now…

John Kelly

Yeah.

Kulbinder Garcha - Credit Suisse

…in terms of [inaudible] and I assume it was many years in development.

John Kelly

Yeah.

Kulbinder Garcha - Credit Suisse

I have always struggled to understand how a shareholder or as an analyst I should look at the impact on your business because the theory of it, it sounds it could almost change the world. On the other hand I am trying to think about the product cycle and so in that kind of aspect could you speak about, you have obviously, I guess, marketed it, spoken to lot of customers about it, if you were to today guess about the use cases and where it will be deployed and speak about from a vertical perspective or use case or an application, how should we think about it becoming a meaningful part of IBM’s business over time?

John Kelly

Okay. Great question. Yes. So it's been a couple of few years now since we did the demonstration on jeopardy of this tremendous capability. It -- I am convinced now, it’s not ‘it could change the world’. This is going to change the world in many, many ways.

The use cases we tend to think of at sort of three levels if you will, the highest value use case is one where you are doing discovery of very high value information. And so take healthcare where we focused much of the past couple of years, we are talking drug discovery, cancer treatment, personalized healthcare, where frankly speaking the doctors can no longer deal with the amount of information being generated in electronic health records, in imaging results, in pharmaceuticals and once you bring in genomics and we all have our human genome map and our own specific tumor mutation map, that amount of data is beyond what any human being can deal with.

Those high-value applications are an incredible sweet spot for Watson and every large medical institution in the area of oncology, Memorial Sloan-Kettering, M.D. Anderson, Cleveland Clinic, et cetera are working with us and have trained Watson in Oncology. And that now is beginning to go into production if you will, after the pilot and the training in the last couple of years, that’s the high value.

Below that is more volume, but not the same value as curing cancer for you. Think about call centers or areas where you are doing high volume, deep searches of natural language unstructured data, that’s an incredible business opportunity. And then the third is we are in the process now of opening up Watson as a platform, not just a system. So think about it’s -- they are not APIs, but they are like APIs where startup companies and other companies can build solutions on and around Watson, Watson advisors in their industry and that’s an ecosystem play.

I guess, I would then conclude with Watson will always remain a service and a service on the cloud. We will not, as you think of it - we are not going to sell you a Watson box. It’s not like we are going to go through some manufacturing ramp of Watson. Watson will be a service. It will become a business that is obviously very sticky because it’s a learning system and we will build over time then basically a backlog of Watson applications across these three levels of the stack.

Kulbinder Garcha - Credit Suisse

Do you anticipate - let’s say, if Watson is as successful as you believe over a three to five year view, this incremental to your revenues or does it have some kind of holistic versus what - people are already spending with an IBM, I’m trying to understand all these use cases sound very exciting and I guess no one is doing them today.

But on the other hand, I also see the argument that IT budgets were not growing significantly and they haven’t for many years. And so in that context you have to [cut] [ph] the expense of something, it has become a major segment for IBM.

John Kelly

I think this is completely incremental, because when I meet with all of the clients in these three areas, this is not substituting. Normally the CIO might be there, but they are not making these decisions, it’s the line of business. I’m meeting with the chief doctor at these institutions, they are not the ones that have classically bought IT and they are looking for solutions to bring in some very high-value insights.

And so these are coming out of an entirely different budget within these organizations, and because it’s offered as a service it’s not like the CIO has to stand up a Watson in the datacenter. You’re just going to log on to a Watson service. So, I think this is going to turn out to be nearly completely incremental for IBM.

Kulbinder Garcha - Credit Suisse

Okay. And maybe a couple more, with respect to acquisitions, one of the things that in the early part of the roadmap, I think, worked very well for IBM that you have a very good M&A team. It looks like that you buy - in a very disciplined manner. You drove a lot of revenue synergies, you mixed up to software. The difference I guess just now is compared to three or four years ago is a lot of the software assets you might want to buy just trade on very different multiples.

So, is conducting M&A now as an ongoing way of transforming your business more challenging because the way I am thinking of it is that, if you guys do $4 billion a year of M&A, but you seven times revenue now, not three times, that’s a fairly big difference in terms of what you - the size of business that you can buy, the maturity or even the risk that you end up taking in buying some of these smaller startup type company. So can you speak about, especially over the last 12 to 18 months, has the ability to do M&A for IBM, is it becoming more challenging, do those multiples put you off and what strategy do you have for dealing with that?

John Kelly

Well, first of all we do have a world-class M&A team and not just on the front end but on the implementation and the integration. We have got this down to - of real science and machines. I don’t think it’s fundamentally changing and we’re always we’re not trying to buy what’s important today. We’re trying to buy assets and intellectual property, high IP content where we’re shooting ahead of the duck. Where is the next thing or where do we have a hole in our own organic portfolio that we can plug through these acquisitions.

So we can always hit reasonable size, reasonable multiples in this acquisition cost as long as we’re shooting far enough ahead of the duck and we’re buying within certain size ranges because we’re supplementing our organic. We’re not going for one big kill. We’re never trying to buy revenue. We’re trying to buy heavy intellectual property or customer access with unique IP.

So as long as we stick to that model, I think we’ll be able to stay within our business model. And again such a disciplined process nothing is going to get through that process that’s going to destroy that model.

Kulbinder Garcha - Credit Suisse

Okay.

John Kelly

It’s very disciplined.

Kulbinder Garcha - Credit Suisse

On the mainframe business, a lot of people have been writing about the demise of the mainframe for a long time?

John Kelly

For my whole career.

Kulbinder Garcha - Credit Suisse

Yeah. Including just recently, and so I guess my question is can you speak about the longevity of the mainframe, specifically I think this mainframe cycle that which was launched late last year, or Q4 last year, I think, hasn’t quiet necessarily performed as strong as you would have thought, it has grown obviously the business. But I’m just wondering how do you think about the longevity of it? Is there risk that mainframe saturation is there, or what evidence do you have or what evidence can you give us actually that still at least a stable outlook for that segment of the business and with the software that goes with it?

John Kelly

Yeah. Well, again, first, yeah, what is the application of the mainframe? The mainframe is the gold standard in these system of records where you need a very highly secure, fast, efficient, productive transaction processor in the system of record. That is where this system is designed for and it is the gold standard for that portion of the market.

I do not see that changing. I do not see the demands for that changing. As I said joking in my whole 33 year career at IBM, I’ve somehow worked on our supply technology to the mainframe. It’s transformed itself. I mean it's now running Linux, it’s now has a large portion of the application running on Linux native on the mainframe. So this thing has morphed to stay modern for what it does well.

Current cycle I think it’s right in sort of the average of previous cycles in terms of how it's behaved, in terms of the buying pattern. So we’re pleased with that. The longevity of this, I see no end to it. I mean we have now the next generation system is on its path, per normal, my research teams and the following generation I mean we have this thing down to a clock. Our customers and our clients need this.

And I think there's examples of where new applications are consolidating on Linux on the mainframe where there is huge consolidation power and then there’s new spaces the banking systems in places like China, are being built out on the mainframe. You are not going to build a banking system out on an x86 cluster unless you’re crazy. So it’s whole new geographies and whole new infrastructure that can be build out on the mainframe.

Kulbinder Garcha - Credit Suisse

Maybe finally bringing it back to my initial question, I kind of probed that there’s been a lack of revenue growth, there’ve been some hardware disappointment this year and you were quite clear in saying that you don’t think that’s linked to the roadmap way of managing, you think IBM are investing enough or moving quickly enough in this market that tends to change rapidly.

I guess, maybe ask the question a different way, as the Director of Research for IBM, what kind of things would worry you to think that this roadmap approach may need to change at some point? What do you look for that - can you think about either necessary investments, hurdle risks, or what your products need to achieve or growth you need to have versus the IT segment? What do you think that - when you are looking at it and it will be not necessarily a number or a metric, the [inaudible] you look, and think about actually we’ve done this. And the reason why I asked this question is that, I think it’s fair to say that there’s probably more doubt in the investment community today than it has been in several years of this roadmap approach, the company may have run its course. But then on the –other hand you worked where you have, it's very significant on the research [inaudible]. What do you think - what would worry you to think well, actually we now may need to make a change?

John Kelly

Yes, honestly, I live this every day. It is not the roadmap. It is not the model. This has been extremely good for us, extremely good to keep us focused, extremely good at moving the company to higher margins. Our biggest problem right now is in our hardware and it's in our UNIX system and it's not - it has nothing to do with the model. We were extremely successful in driving our power UNIX business over the past decades. I mean we were ruled out as we were going to lose that business and we made big bets. We went on to basically drive many competitors out of the UNIX business and we dominated traditional UNIX. It was a beautiful thing for us for the past decade.

We missed a market shift to LINUX and to cloud with our power systems plus tactically is the China issue that we discussed.

This has nothing to do with the roadmap or the business model, we missed a market shift. So, we’re $6 billion of R&D and $20 billion of acquisitions. I am not worried that we can’t innovate. We can innovate or out-innovate anyone on this planet, I'm confident in that. We still can hire the best and brightest people in the world. I get in research over 95% of the offers I make that are best in the world, come to work for IBM.

And the few I lose, don't go to our competitors, they go to some university. So we can hire the smartest people in the world. I don't worry about our ability to innovate or buy companies that innovate in spaces we don't. It’s these market shifts or missing a shift of UNIX to the cloud because we’re being successful. Those are the things, even if the guy is the head of R&D, that I worry about that we’re going to miss.

And so I spend much, much more time now with clients and in the marketplace to make sure that we see these things coming with brighter headlights. It has nothing to do with the business model and the roadmap. I think most companies, most heads of R&D would kill for $6 billion a year in R&D and $20 billion of acquisition to supplement in it.

Kulbinder Garcha - Credit Suisse

Great. Very clear. Thank you very much.

John Kelly

Okay. Thank you.

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