Last week, after IBM’s report of positive quarterly earnings, CEO Arvind Krishna and CNBC’s Jim Cramer shared their frustration that IBM’s stock “got clobbered.” IBM’s stock price immediately fell by10%, while the S&P500 remained steady (Figure 1)
While a five-day stock price fluctuation is by itself meaningless, questions remain about the IBM’s longer-term picture. “These are great numbers,” declared Krishna.
“You gave solid revenue growth and solid earnings,” Cramer sympathized. “You far exceeded expectations. Maybe someone is changing the goal posts here?”
It is also possible that Krishna and Cramer missed where today’s goal posts are located. Strong quarterly numbers do not a digital winner make. They may induce the stock market to regard a firm as a valuable cash cow, like other remnants of the industrial era. But to become a digital winner, a firm must take the kind of steps that Satya Nadella took at Microsoft to become a digital winner: kill its dogs, commit to a mission of customer primacy, identify real growth opportunities, transform its culture, make empathy central, and unleash its agilists. (Figure 2)
Since becoming CEO, Nadella has been brilliantly successful at Microsoft, growing market capitalization by more than a trillion dollars.
Krishna has been IBM CEO since April 2020. He began his career at IBM in 1990, and had been managing IBM’s cloud and research divisions since 2015. He was a principal architect of the Red Hat acquisition.
They are remarkable parallels between the careers of Krishna and Nadella.
· Both are Indian-American engineers, who were born in India.
· Both worked at the firm for several decades before they became CEOs.
· Prior to becoming CEOs, both were in charge of cloud computing.
Both inherited companies in trouble. Microsoft was stagnating after CEO Steve Ballmer, while IBM was also in rapid decline, after CEO Ginny Rometty: the once famous “Big Blue” had become known as a “Big Bruise.”
Although it is still early days in Krishna’s CEO tenure, IBM is under-performing the S&P500 since he took over (Figure 3).
More worrying is the fact that Krishna has not yet completed the steps that Nadella took in his first 27 months. (Figure 1).
Nadella wrote off the Nokia phone and declared that IBM would no longer sell its flagship Windows as a business. This freed up energy and resources to focus on creating winning businesses.
By contrast, Krishna has yet to jettison, IBM’s most distracting baggage:
· Commitment to maximizing shareholder value (MSV): For the two prior decades, IBM was the public champion of MSV, first under CEO Palmisano 2001-2011, and again under Rometty 2012-2020—a key reason behind IBM’s calamitous decline (Figure 2) Krishna has yet to explicitly renounce IBM’s MSV heritage.
· Top-down bureaucracy: The necessary accompaniment of MSV is top-down bureaucracy, which flourished under CEOs Palmisano and Rometty. Here too, bureaucratic processes must be explicitly eradicated, otherwise they become permanent weeds.
· The ‘Watson problem’: IBM’s famous computer, Watson, may have won ‘Jeopardy!’ but it continues to have problems in the business marketplace. In January 2022, IBM reported that it had sold Watson Health assets to an investment firm for around $1 billion, after acquisitions that had cost some $4 billion. Efforts to monetize Watson continue.
· Infrastructure Services: By spinning off its Cloud computing business as a publicly listed company (Kyndryl), IBM created nominal separation, but Kyndryl immediately lost 57% of its share value.
· Quantum Computing: IBM pours resources into research on quantum computing and touts its potential to revolutionize computing. However unsolved technical problems of “decoherence” and “entanglement” mean that any meaningful benefits are still some years away.
· Self-importance: Perhaps the heaviest baggage that IBM has yet to jettison is the over-confidence reflected in sales slogans like “no one ever got fired for hiring IBM”. The subtext is that firms “can leave IT to IBM” and that the safe choice for any CIO is to stick with IBM. It’s a status quo mindset—the opposite of the clients that IBM needs to attract.
At the outset of his tenure as CEO of Microsoft, Nadella spent the first nine months getting consensus on a simple customer-driven mission statement.
Krishna did write at the end of the letter to staff on day one as CEO, and he added at the end:“Third, we all must be obsessed with continually delighting our clients. At every interaction, we must strive to offer them the best experience and value. The only way to lead in today’s ever-changing marketplace is to constantly innovate according to what our clients want and need.” This would have been more persuasive if it had come at the beginning of the letter, and if there had been stronger follow-up.
What is IBM’s mission? No clear answer appears from IBM’s own website. The best one gets from About IBM is the fuzzy do-gooder declaration: “IBMers believe in progress — that the application of intelligence, reason and science can Strengthen business, society and the human condition.” Customer primacy is not explicit, thereby running the risk that IBM’s 280,000 employees will assume that the noxious MSV goal is still in play.
At Microsoft, Nadella dismissed competing with Apple on phones or with Google on Search. He defined the two main areas of opportunity—mobility and the cloud.
Krishna has identified the Hybrid Cloud and AI as IBM’s main opportunities. Thus, Krishna wrote in his newsletter to staff on day one as CEO: “Hybrid cloud and AI are two dominant forces driving change for our clients and must have the maniacal focus of the entire company.”
However, both fields are now very crowded. IBM is now a tiny player in Cloud in comparison to Amazon, Microsoft, and Google. In conversations, Krishna portrays IBM as forging working partnerships with the big Cloud players, and “integrating their offerings in IBM’s hybrid Cloud.” One risk here is whether the big Cloud players will facilitate this. The other risk is that IBM will attract only lower-performing firms that use IBM as a crutch so that they can cling to familiar legacy programs.
At Microsoft, Nadella addressed culture upfront, rejecting Microsoft’s notoriously confrontational culture, and set about instilling a collaborative customer-driven culture throughout the firm.
Although Krishna talks openly to the press, he has not, to my knowledge, frontally addressed the “top-down” “we know best” culture that prevailed in IBM under his predecessor CEOs. He has, to his credit, pledged “neutrality” with respect to the innovative, customer-centric Red Hat, rather than applying the “Blue washing” that the old IBM systematically applied to its acquisitions to bring them into line with IBM’s top-down culture, and is said to have honored its pledge—so far. But there is little indication that IBM is ready to adopt Red Hat’s innovative culture for itself. It is hard to see these two opposed cultures remain “neutral” forever. Given the size differential between IBM and Red Hat, the likely winner is easy to predict, unless Krishna makes a more determined effort to transform IBM’s culture.
As in any large tech firm, when Nadella and Krishna took over their respective firms, there were large hidden armies of agilists waiting in the shadows but hamstrung by top-down bureaucracies. At Microsoft, Nadella’s commitment to “agile, agile, agile” combined with a growth mindset, enabled a fast start.. At IBM, if Krishna has any passion for Agile, it has not yet shared it widely.
Although IBM has made progress under Krishna, it is not yet on a path to become a clear digital winner.
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The “Cirrus” Power10 processor from IBM, which we codenamed for Big Blue because it refused to do it publicly and because we understand the value of a synonym here at The Next Platform, shipped last September in the “Denali” Power E1080 big iron NUMA machine. And today, the rest of the Power10-based Power Systems product line is being fleshed out with the launch of entry and midrange machines – many of which are suitable for supporting HPC and AI workloads as well as in-memory databases and other workloads in large enterprises.
The question is, will IBM care about traditional HPC simulation and modeling ever again with the same vigor that it has in past decades? And can Power10 help reinvigorate the HPC and AI business at IBM. We are not sure about the answer to the first question, and got the distinct impression from Ken King, the general manager of the Power Systems business, that HPC proper was not a high priority when we spoke to him back in February about this. But we continue to believe that the Power10 platform has some attributes that make it appealing for data analytics and other workloads that need to be either scaled out across small machines or scaled up across big ones.
Today, we are just going to talk about the five entry Power10 machines, which have one or two processor sockets in a standard 2U or 4U form factor, and then we will follow up with an analysis of the Power E1050, which is a four socket machine that fits into a 4U form factor. And the question we wanted to answer was simple: Can a Power10 processor hold its own against X86 server chips from Intel and AMD when it comes to basic CPU-only floating point computing.
This is an important question because there are plenty of workloads that have not been accelerated by GPUs in the HPC arena, and for these workloads, the Power10 architecture could prove to be very interesting if IBM thought outside of the box a little. This is particularly true when considering the feature called memory inception, which is in effect the ability to build a memory area network across clusters of machines and which we have discussed a little in the past.
We went deep into the architecture of the Power10 chip two years ago when it was presented at the Hot Chip conference, and we are not going to go over that ground again here. Suffice it to say that this chip can hold its own against Intel’s current “Ice Lake” Xeon SPs, launched in April 2021, and AMD’s current “Milan” Epyc 7003s, launched in March 2021. And this makes sense because the original plan was to have a Power10 chip in the field with 24 fat cores and 48 skinny ones, using dual-chip modules, using 10 nanometer processes from IBM’s former foundry partner, Globalfoundries, sometime in 2021, three years after the Power9 chip launched in 2018. Globalfoundries did not get the 10 nanometer processes working, and it botched a jump to 7 nanometers and spiked it, and that left IBM jumping to Samsung to be its first server chip partner for its foundry using its 7 nanometer processes. IBM took the opportunity of the Power10 delay to reimplement the Power ISA in a new Power10 core and then added some matrix math overlays to its vector units to make it a good AI inference engine.
IBM also created a beefier core and dropped the core count back to 16 on a die in SMT8 mode, which is an implementation of simultaneous multithreading that has up to eight processing threads per core, and also was thinking about an SMT4 design which would double the core count to 32 per chip. But we have not seen that today, and with IBM not chasing Google and other hyperscalers with Power10, we may never see it. But it was in the roadmaps way back when.
What IBM has done in the entry machines is put two Power10 chips inside of a single socket to increase the core count, but it is looking like the yields on the chips are not as high as IBM might have wanted. When IBM first started talking about the Power10 chip, it said it would have 15 or 30 cores, which was a strange number, and that is because it kept one SMT8 core or two SMT4 cores in reserve as a hedge against bad yields. In the products that IBM is rolling out today, mostly for its existing AIX Unix and IBM i (formerly OS/400) enterprise accounts, the core counts on the dies are much lower, with 4, 8, 10, or 12 of the 16 cores active. The Power10 cores have roughly 70 percent more performance than the Power9 cores in these entry machines, and that is a lot of performance for many enterprise customers – enough to get through a few years of growth on their workloads. IBM is charging a bit more for the Power10 machines compared to the Power9 machines, according to Steve Sibley, vice president of Power product management at IBM, but the bang for the buck is definitely improving across the generations. At the very low end with the Power S1014 machine that is aimed at small and midrange businesses running ERP workloads on the IBM i software stack, that improvement is in the range of 40 percent, provide or take, and the price increase is somewhere between 20 percent and 25 percent depending on the configuration.
Pricing is not yet available on any of these entry Power10 machines, which ship on July 22. When we find out more, we will do more analysis of the price/performance.
There are six new entry Power10 machines, the feeds and speeds of which are shown below:
For the HPC crowd, the Power L1022 and the Power L1024 are probably the most interesting ones because they are designed to only run Linux and, if they are like prior L classified machines in the Power8 and Power9 families, will have lower pricing for CPU, memory, and storage, allowing them to better compete against X86 systems running Linux in cluster environments. This will be particularly important as IBM pushed Red Hat OpenShift as a container platform for not only enterprise workloads but also for HPC and data analytic workloads that are also being containerized these days.
One thing to note about these machines: IBM is using its OpenCAPI Memory Interface, which as we explained in the past is using the “Bluelink” I/O interconnect for NUMA links and accelerator attachment as a memory controller. IBM is now calling this the Open Memory Interface, and these systems have twice as many memory channels as a typical X86 server chip and therefore have a lot more aggregate bandwidth coming off the sockets. The OMI memory makes use of a Differential DIMM form factor that employs DDR4 memory running at 3.2 GHz, and it will be no big deal for IBM to swap in DDR5 memory chips into its DDIMMs when they are out and the price is not crazy. IBM is offering memory features with 32 GB, 64 GB, and 128 GB capacities today in these machines and will offer 256 GB DDIMMs on November 14, which is how you get the maximum capacities shown in the table above. The important thing for HPC customers is that IBM is delivering 409 GB/sec of memory bandwidth per socket and 2 TB of memory per socket.
By the way, the only storage in these machines is NVM-Express flash drives. No disk, no plain vanilla flash SSDs. The machines also support a mix of PCI-Express 4.0 and PCI-Express 5.0 slots, and do not yet support the CXL protocol created by Intel and backed by IBM even though it loves its own Bluelink OpenCAPI interconnect for linking memory and accelerators to the Power compute engines.
Here are the different processor SKUs offered in the Power10 entry machines:
As far as we are concerned, the 24-core Power10 DCM feature EPGK processor in the Power L1024 is the only interesting one for HPC work, aside from what a theoretical 32-core Power10 DCM might be able to do. And just for fun, we sat down and figured out the peak theoretical 64-bit floating point performance, at all-core base and all-core turbo clock speeds, for these two Power10 chips and their rivals in the Intel and AMD CPU lineups. Take a gander at this:
We have no idea what the pricing will be for a processor module in these entry Power10 machines, so we took a stab at what the 24-core variant might cost to be competitive with the X86 alternatives based solely on FP64 throughput and then reckoned the performance of what a full-on 32-core Power10 DCM might be.
The answer is that IBM can absolutely compete, flops to flops, with the best Intel and AMD have right now. And it has a very good matrix math engine as well, which these chips do not.
The problem is, Intel has “Sapphire Rapids” Xeon SPs in the works, which we think will have four 18-core chiplets for a total of 72 cores, but only 56 of them will be exposed because of yield issues that Intel has with its SuperFIN 10 nanometer (Intel 7) process. And AMD has 96-core “Genoa” Epyc 7004s in the works, too. Power11 is several years away, so if IBM wants to play in HPC, Samsung has to get the yields up on the Power10 chips so IBM can sell more cores in a box. Big Blue already has the memory capacity and memory bandwidth advantage. We will see if its L-class Power10 systems can compete on price and performance once we find out more. And we will also explore how memory clustering might make for a very interesting compute platform based on a mix of fat NUMA and memory-less skinny nodes. We have some ideas about how this might play out.
Cybersecurity has always been a concern for every type of organization. Even in normal times, a major breach is more than just the data economy’s equivalent of a ram-raid on Fort Knox; it has knock-on effects on trust, reputation, confidence, and the viability of some technologies. This is what IBM calls the “haunting effect”.
A successful attack breeds more, of course, both on the same organization again, and on others in similar businesses, or in those that use the same compromised systems. The unspoken effect of this is rising costs for everyone, as all enterprises are forced to spend money and time on checking if they have been affected too.
But in our new world of COVID-19, disrupted economies, climate change, remote working, soaring inflation, and looming recession, all such effects are all amplified. Throw in a war that’s hammering on Europe’s door (with political echoes across the Middle East and Asia) and it’s a wonder any of us can get out of bed in the morning.
So, what are the real costs of a successful cyberattack – not just hacks, viruses, and Trojans, but also phishing, ransomware, and concerted campaigns against supply chains and code repositories?
According to IBM’s latest annual survey, breach costs have risen by an unlucky 13% over the past two years, as attackers, which include hostile states, have probed the systemic and operational weaknesses exposed by the pandemic.
The global average cost of a data breach has reached an all-time high of $4.35 million – at least, among the 550 organizations surveyed by the Ponemon Institute for IBM Security (over a year from March 2021). Indeed, IBM goes so far as to claim that breaches may be contributing to the rising costs of goods and services. The survey states:
Sixty percent of studied organizations raised their product or services prices due to the breach, when the cost of goods is already soaring worldwide amid inflation and supply chain issues.
Incidents are also “haunting” organizations, says the company, with 83% having experienced more than one data breach, and with 50% of costs occurring more than a year after the successful attack.
Cloud maturity is a key factor, adds the report:
Forty-three percent of studied organizations are in the early stages [of cloud adoption] or have not started applying security practices across their cloud environments, observing over $660,000 in higher breach costs, on average, than studied organizations with mature security across their cloud environments.
Forty-five percent of respondents run a hybrid cloud infrastructure. This leads to lower average breach costs than among those operating a public- or private-cloud model: $3.8 million versus $5.02 million (public) and $4.24 million (private).
That said, those are still significant costs, and may suggest that complexity is what deters attackers, rather than having a single target to hit. Nonetheless, hybrid cloud adopters are able to identify and contain data breaches 15 days faster on average, says the report.
However, with 277 days being the average time lag – an extraordinary figure – the real lesson may be that today’s enterprise systems are adept at hiding security breaches, which may appear as normal network traffic. Forty-five percent of breaches occurred in the cloud, says the report, so it is clearly imperative to get on top of security in that domain.
IBM then makes the following bold claim :
Participating organizations fully deploying security AI and automation incurred $3.05 million less on average in breach costs compared to studied organizations that have not deployed the technology – the biggest cost saver observed in the study.
Whether this finding will stand for long as attackers explore new ways to breach automated and/or AI-based systems – and perhaps automate attacks of their own invisibly – remains to be seen. Compromised digital employee, anyone?
But perhaps the most telling finding is that cybersecurity has a political dimension – beyond the obvious one of Russian, Chinese, North Korean, or Iranian state incursions, of course.
Concerns over critical infrastructure and global supply chains are rising, with threat actors seeking to disrupt global systems that include financial services, industrial, transportation, and healthcare companies, among others.
A year ago in the US, the Biden administration issued an Executive Order on cybersecurity that focused on the urgent need for zero-trust systems. Despite this, only 21% of critical infrastructure organizations have so far adopted a zero-trust security model, according to the report. It states:
Almost 80% of the critical infrastructure organizations studied don’t adopt zero-trust strategies, seeing average breach costs rise to $5.4 million – a $1.17 million increase compared to those that do. All while 28% of breaches among these organizations were ransomware or destructive attacks.
Add to that, 17% of breaches at critical infrastructure organizations were caused due to a business partner being initially compromised, highlighting the security risks that over-trusting environments pose.
That aside, one of the big stories over the past couple of years has been the rise of ransomware: malicious code that locks up data, enterprise systems, or individual computers, forcing users to pay a ransom to (they hope) retrieve their systems or data.
But according to IBM, there are no obvious winners or losers in this insidious practice. The report adds:
Businesses that paid threat actors’ ransom demands saw $610,000 less in average breach costs compared to those that chose not to pay – not including the ransom amount paid.
However, when accounting for the average ransom payment – which according to Sophos reached $812,000 in 2021 – businesses that opt to pay the ransom could net higher total costs, all while inadvertently funding future ransomware attacks.”
The persistence of ransomware is fuelled by what IBM calls the “industrialization of cybercrime”.
The risk profile is also changing. Ransomware attack times show a massive drop of 94% over the past three years, from over two months to just under four days. Good news? Not at all, says the report, as the attacks may be higher impact, with more immediate consequences (such as destroyed data, or private data being made public on hacker forums).
The key lesson in cybersecurity today is that all of us are both upstream and downstream from partners, suppliers, and customers in today’s extended enterprises. We are also at the mercy of reused but compromised code from trusted repositories, and even sometimes from hardware that has been compromised at source.
So, what is the answer? Businesses should ensure that their incident responses are tested rigorously and frequently in advance – along with using red-, blue-, or purple-team approaches (thinking like a hacker, a defender, or both).
Regrettably, IBM says that 37% of organizations that have IR plans in place fail to test them regularly. To paraphrase Spinal Tap, you can’t code for stupid.
The MarketWatch News Department was not involved in the creation of this content.
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Telos Corporation (NASDAQ:TLS) Q2 2022 Earnings Conference Call August 9, 2022 8:30 AM ET
Christina Mouzavires - Investor Relations
John Wood - Chairman and Chief Executive Officer
Mark Bendza - Executive Vice President and CFO
Mark Griffin - Executive Vice President, Security Solutions
Conference Call Participants
Zach Cummins - B. Riley
Rudy Kessinger - D.A. Davidson
Alex Henderson - Needham & Company
Nehal Chokski - Northland Capital Markets
Brad Clark - BMO
Good day and thank you for standing by. Welcome to the Telos Corporation Second Quarter 2022 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. [Operator Instructions]
Please be advised, today’s conference is being recorded. I would now like to hand the conference over to your speaker today, Christina Mouzavires. Please go ahead.
Good morning. Thank you for joining us to discuss Telos Corporation’s second quarter 2022 financial results. With me today is John Wood, Chairman and CEO of Telos; and Mark Bendza, Executive Vice President and CFO of Telos.
Let me quickly review the format of today’s presentation. John will begin with brief remarks on our 2022 second quarter results and Telos’ strategic priority, and Mark will cover the financials and guidance for the third quarter and full year 2022. Then we will open the line for questions-and-answers where Mark Griffin, Executive Vice President of Security Solutions will also join us.
The earnings press release was issued earlier today and is posted on the Telos Investor Relations website where this call is being simultaneously webcast. Additionally, we have provided presentation slides on our Investor Relations website.
Before we begin, we want to emphasize that some of our statements on this call are forward-looking statements and are made under the safe harbor provisions of the federal securities laws. These statements are based on current expectations and assumptions that are subject to risks and uncertainties.
Actual results could materially differ for various reasons, including the factors described in today’s earnings press release and the comments made during this conference call and in our SEC filings. We do not undertake any duty to update any forward-looking statements.
In addition, during today’s call we will discuss non-GAAP financial measures, which we believe are useful as supplemental and clarifying measures that help investors understand Telos’ financial performance.
These non-GAAP financial measures should be considered in addition to and not as assessed to for or in isolation from GAAP results. You can find additional disclosures regarding these non-GAAP measures, including reconciliations with comparable GAAP results in our earnings press release and on the Investor Relations portion at our website. Please also note that financial comparisons are year-over-year unless otherwise specified.
The webcast replay of this call will be available for the next year on our company website under the Investor Relations page.
With that, I will turn the call over to John.
Thank you, Christina, and good morning, everyone. Let’s begin today on slide three. I am pleased to report that Telos over delivered again on key financial metrics in the second quarter of 2022. Mark will discuss our financial performance later in this call, but at a high level, we delivered $55.8 million of revenue in the second quarter, above our guidance range of $50 million to $54 million, up 4% year-over-year and 11%, sequentially. Gross margin was 37.5%, above our guidance range of 33% to 35%. Finally, we delivered $4.5 million of adjusted EBITDA, above the high end of our guidance range of negative $2 million to positive $2 million and $0.04 of adjusted EPS.
Now, let’s turn to slide four to discuss our latest business highlights and updates. This quarter we announced a new strategic partnership with IBM. Telos is the launch partner for the new active governance service or AGS offering with IBM Security.
Telos and IBM are teaming to provide capabilities to address the significant challenges organizations are facing with cybersecurity and risk compliance. AGS is a unique and comprehensive offering, coupling the Xacta suite of tools with IBM’s services and security expertise to significantly Strengthen the efficiency of clients’ approach to cyber security risk management in today’s increasingly challenging cyber environment. Target customers include large enterprise organizations in global markets such as financial services, healthcare, telecommunications and energy.
We are very excited about this opportunity to partner with IBM, a leading global organization that brings recognized thought leadership and leading capability in the cybersecurity management space. This relationship also enables us to effectively broaden our reach in the global marketplace for sales of our Xacta suite of tools to drive future growth for Telos.
Beyond the IBM partnership, we have continued to maintain momentum in the current environment. Within the Security Solutions business, Telos received Xacta renewals with several key customers, including the Central Intelligence Agency, The U.S. Department of the Interior, The U.S. Environmental Protection Agency, our U.S. Federal Reserve Bank and The U.S. Department of Energy, as well as Salesforce.
The company was also awarded new contracts with a foreign government customer, The U.S. Army Space and Missile Command, The U.S. Department of Homeland Security, Palantir Technologies and OmniHealth.
We continue to focus on the government and commercial space, and in particular, prioritizing regulated industries. The company also received an important Ghost renewal with a classified customer to continue providing support. Additionally, we were awarded up to a 10-year contract to continue and expand our aviation security practice with the U.S. Transportation Security Administration.
Our ONYX technology won first place in the Mobile Fingerprint Information Challenge posted by the National Institute of Standards and Technology.
Finally, the Secure Networks business continued to add to its backlog with new wins, including a new contract to support The U.S. Air Force SIPRNet Enterprise Modernization.
Let me turn now to some comments on the industry landscape and a number of latest initiatives in Washington, D.C., that presents opportunities for Telos. There are indications that Congress plans to boost spending above the level called for by President Biden in his proposed FY 2023 budget.
The House and Senate versions of the Annual Defense Authorization Bill provides for increasing topline defense spending, respectively $37 billion to $45 billion above the level proposed by the President.
We still have to see how the appropriations process plays out this fall to know how much funding will actually be provided for our military customers, but signs are there that the FY 2023 defense budget will see a meaningful increase.
On the non-defense side, as with defense, we will have to wait for Congress to agree on appropriations legislation. But so far, the spending bills under consideration reflect a consensus that more funding is needed for cybersecurity throughout the various departments and agencies.
A great example of this is with CISA, The Department of Homeland Security’s cybersecurity agency. CISA works to detect and mitigate the effects of cyber attacks on federal, state and local governments, and the private sector, and then manage cyber risks to our critical infrastructure. We understand that recognizing the importance of this mission, the draft Senate Appropriations Bill for DHS seeks to provide CISA a 16% increase above last year’s funding.
Congress clearly recognizes that more resources are needed by federal departments and agencies to combat challenges they face in the cyberspace. A major factor in that thinking is the Ukraine situation, which has resulted in continued warnings of potential cyber attacks against U.S. interests, including against U.S. critical infrastructure.
So far, the United States has done an excellent job in preventing what had been expected to be widespread impacts from cyber attacks in retaliation for our support for Ukraine. The policy makers and companies like ours know that the public and private sectors can’t let up and they must continue to follow cybersecurity best practices, including deploying and updating effective cyber defenses.
I will now turn the call over to Mark who will discuss second quarter 2022 financial results and our guidance for the third quarter and full year 2022. Mark?
Thank you, John, and thank you everyone for joining us today. Let’s turn to slide five. As John mentioned, we delivered a strong second quarter, with results that exceeded our guidance on key financial metrics.
We reported revenue, gross margin and adjusted EBITDA above the high end of our guidance range. We also delivered $5.4 million of free cash flow, representing a nearly four-fold increase in free cash flow year-over-year.
Before I turn the year-over-year comparison, I just wanted to remind everyone again, as I did in our last earnings call, that we had a large delivery on a lower margin program in our Secure Networks business last year that’s pulled forward from the second quarter of 2021 to the first quarter of 2021 per the request of our customer.
The accelerated delivery caused with Secure Networks contribution to total revenue to shift from 60% in the first quarter of 2021 to 40% in the second quarter of 2021 and gross margin to shift from 25.9% in the first quarter of 2021 to 42% in the second quarter of 2021, thereby skewing some of the second quarter year-over-year comparisons this year.
So I will provide year-over-year comparisons for the second quarter as usual and also for the first half overall to normalize for the accelerated shipment from the second quarter to the first quarter of last year.
Okay, with that backdrop, I will go into details. For the second quarter, total sales were $55.8 million, up 11% sequentially and up 4% year-over-year. Performance about the high end of the guidance range of $50 million to $54 million was driven by favorable timing variances and pre-existing higher margin programs in Security Solutions and strong supply chain management in Secure Networks.
Security Solutions sales were $30.8 million, up 15% sequentially and down 4% year-over-year, due to lower revenues on a classified program and the completion of the U.S. Census program, partially offset by growth in other pre-existing programs.
Secure Network sales were $25 million, up 7% sequentially and up 17% year-over-year, due to continued strong supply chain management, higher revenues on major programs and favorable year-over-year comparison due to the previously mentioned large delivery that pulled forward from the second quarter of 2021 to the first quarter of 2021.
Turning to profitability and cash flow, second quarter gross margin was 37.5%, above our guidance range of 33% to 35%, primarily due to the margin outperformance in Security Solutions.
Gross margin contracted 449 basis points year-over-year and gross profit declined 7%. The gross margin contraction was driven by a less favorable sales mix between Security Solutions and Secure Networks compared to last year, as well as gross margin contraction within Secure Networks, both of which were the result of the previously mentioned early shipments in 2021.
Security Solutions revenues as a percentage of total company revenues declined from 60% in 2021 to 55% in 2022, as Secure Networks gross margin contracted nearly 700 basis points to 18%. Security Solution gross margins held constant at 53.3%.
Adjusted EBITDA declined by approximately $700,000 due to lower gross profit, partially offset by lower below the line expenses.
Free cash flow improved nearly four-fold to $5.4 million. The improvement in free cash flow continued the trends from the first quarter of more favorable working capital dynamics compared to last year and created an opportunity to begin returning capital to shareholders.
On May 24th, we announced that our Board of Directors authorized a share repurchase program for up to $50 million of the company’s stock. During the second quarter, we deployed $3 million to repurchase over 360,000 shares at a weighted average price of $8.33 and we have continued repurchasing stock daily during the third quarter. During the third quarter till last Friday, we deployed an additional $1.1 million to repurchase nearly 143,000 shares at a weighted average price of $7.86.
Now let’s recap on the first half overall to normalize for the accelerated shipments from the second quarter to the first quarter of 2021. First half revenues declined 3%. Secure Networks revenues declined 11%, as expected, due to the headwind associated with the ongoing wind down of two large programs in 2022. Security Solutions revenues grew 5%, primarily due to the ramp up of a confidential program.
First half gross margin expanded 374 basis points to 37.6% and gross profit increased 8%. The gross margin expansion was driven by a more favorable sales mix within Security Solutions and Secure Networks, as well as gross margin expansion within Security Solutions.
Security Solutions revenues as a percentage of total company revenues increased from 50% in 2021 to 54% in 2022 and Security Solutions, gross margin expanded 638 basis points to 54.5% due to the ramp of high margin progress. Secure Networks gross margin contracted 206 basis points to 17.2%.
Adjusted EBITDA declined $1.3 million due to higher SG&A, offsetting $2.8 million of higher gross profit.
Lastly, free cash flow was $10.3 million higher due to favorable working capital dynamics, driving significantly better cash flow from operations in the first and second quarters. Overall, our first half has performed ahead of forecast and guidance, primarily due to favorable timing differences -- variances between the second half and the first half in orders and deliveries on pre-existing programs and diligent supply chain management.
Now, let’s turn to slide six to discuss our outlook for the third quarter. For the third quarter, we forecast sales in a range of $58 million to $62 million, up 4% to 11% sequentially and down 10% to 15% year-over-year.
We forecast Security Solutions revenues to be down mid- to high-teens year-over-year, primarily due to the completion of the 2020 Census Program in 2021, lower orders expected on a single pre-existing program and lumpiness of perpetual licensing.
We continue to make good progress on the TSA PreCheck program, but revenues for this program in 3Q, if any, are expected to be de minimis. We expect Secure Networks revenues to be down mid-single digits to mid-teens year-over-year due to the ongoing wind down of two large programs coming to a successful completion.
We expect gross margins to be down approximately 350 basis points to 500 basis points year-over-year, primarily due to a slightly lower weighting of revenues to our high margin Security Solutions segment and revenue within both Security Solutions and Secure Networks mixing lower in the quarter.
Below the line expenses, excluding stock compensation expense, are expected to be approximately $1 million higher due to the ramp of R&D and G&A investments during 2021. Adjusted EBITDA is expected to be $3.5 million to $5 million, representing a 6% to 8% mark.
Now, let’s turn to slide seven to discuss our updated outlook for 2022. For the full year, we have narrowed our revenue range from our prior guidance of$226 million to $257 million to our updated range of $226 million to $242 million. There is no change to the low end of the revenue.
Reduction at the high end of the range reflects lower assumption on TSA PreCheck revenues and new business in the second half, partially offset by higher revenues on pre-existing programs within Security Solutions.
We have lowered and widely narrowed our adjusted EBITDA range from our prior guidance of $21 million to $28 million to our updated range of $18 million to $24 million. The reduction at the high end of the range reflects our -- reflects lower gross profit associated with the corresponding revenue reduction, partially offset by lower than previously forecasted below the line expenses. The reduction at the low end of the range primarily reflects the impact of lower than previously forecasted gross margins on Secure Networks in the second half, including on new business.
Overall, we have performed ahead of forecast in the first half, our core business is performing well and we expect that to continue, pre-existing programs are performing well, sequential sales growth is expected to continue into the third and fourth quarters as originally planned, and we are taking a slightly more cautious approach to new business in the second half in part as a result of the more complex macro environment, which could create some headwinds for our new business growth initiatives in the short-term.
With that, I will pass it back to John who will wrap up on slide eight.
Thanks, Mark. In summary, we delivered a solid second quarter during which we formed a new strategic partnership with IBM and outpaced guidance on our key financial metrics. We also delivered gross margin expansion and strong free cash flow in the first half of the year and have begun to return free cash flow to shareholders through share repurchases.
Our core business and pre-existing programs are performing well and we expect that to continue for the balance of the year. We are taking a slightly more cautious approach to new business in the second half of the year and are managing our forecasting expenses accordingly.
With that, we are happy to take questions.
Thank you. [Operator Instructions] Our first question comes from the line of that Zach Cummins with D.A. Davidson, oh, I am sorry with B. Riley. Your line is open. Please go ahead.
Yeah. Thanks. Good morning. Hi, John. Hi, Mark. Thanks for taking my questions. Mark, I -- my question is really geared towards the updated guidance for the year. I mean can you provide a little more granularity around the assumptions you are making for TSA PreCheck and maybe why you are taking a slightly more cautious approach to new business wins here in the second half of the year?
Yeah. Sure, Zach. Thanks for your question. So why don’t I dissect that a little bit for you? So, at the high end of the guidance range, we are taking sales down by $15 million, $11 million of the $15 million is PreCheck net revenue. So we previously assumed $12 million of net revenues for PreCheck at the high end of the guidance, now we are assuming $1 million.
The PreCheck process is progressing well. Obviously, we don’t have the ATO yet and so we felt it appropriate to take that guide down, but certainly, wanted to leave revenue in there as a recognition that we still expect the ATO this year.
The balance of the $4 million, the other $4 million, is really net reductions across the rest of the portfolio, primarily driven by lower assumptions on new business in the second half. The thought there is, even though we are not seeing impact from the more complicated macro environment right now in our core business, our core business is performing very well, it’s not being impacted by the macro environment and you are seeing that in the second quarter results.
But we wanted to acknowledge at least as we scrub the forecast for PreCheck, we wanted to take a broader look at some of the higher risk items in the forecast. For example, anywhere where we are selling new solutions for pre-existing solution to new customers in new end markets, we wanted to take a slightly more cautious approach there.
So that’s the $4 million of additional net reduction. To put that in perspective, at the midpoint of the range that would represent about 80 basis points of year-over-year growth, so a very modest reduction as a nod, in part to the macro environment, but very modest nonetheless.
On adjusted EBITDA at the high end of the guidance, we are taking by $4 million. That is the reduction in the gross profit corresponding to the revenue reduction, partially offset by reduction in below the line expense.
And then at the low end, no change to sales, but what you are seeing in the $3 million of lower adjusted EBITDA is lower gross margin on Secure Networks, primarily in new business in the second half.
Understood. That’s helpful. Much appreciated and best of luck in the coming quarter.
Thanks a lot.
Our next question comes from the line of Rudy Kessinger with D.A. Davidson. Your line is open. Please go ahead.
Hey, guys. So just following up on that question there, I guess, the $4 million reduction at the top end, I am just more conservative ex-TSA and the rest of the portfolio. I guess, I would just ask, the channel and the direct sales reps, are they meeting your expectations from, say, the start this year on pipeline build in sales production as we get into the second half year? And then, secondly, on IBM, do you have anything incremental baked into the guide this year for IBM? And I guess just bigger picture, how big of a driver or growth -- how much can IBM be, say, in maybe 2023?
Hey, Rudy. This is John. I will take first -- I will take the second question and I will ask Mark Griffin to answer the first one. As it relates to IBM, we have a couple of hundred thousand dollars in our model for purposes of this year.
As it relates to the -- how big it can be, we think it could be quite sizable and that’s not a good number -- that’s not me able to provide you -- I am not able to provide you a modeling perspective as yet. What I can say however is that the their pipeline is filling up quite rapidly with what I would consider to be Tier 1 names, large car manufacturers, large banks, large pharmaceutical companies, countries, et cetera, places that I think would be very difficult for us to get into on our own and really what’s happened is that they have embedded Xacta as their launch partner in their advanced -- its governance solutions. So I think it’s got a lot of potential in front of us.
As we put out our guide for 2023, I am sure we will provide you much greater detail. But I am quite happy with how the -- how that relationship is really coming out in a fully blossoming way, much like I had hoped it was going to be with the cloud service providers, but they have been quite, as you are well aware slower. So here IBM is completely embraced it. They are also looking at using it internally. So I think there is a great opportunity for us with IBM in over the next five years to 10 years. And Mark, if you have a mic, can you answer the first question on the sales force?
Sure. Hello, Rudy. Mark Griffin. Commercial adoption is happening, but obviously, we took a more cautious and slower approach than initially planned. We are ongoing and continuing to fine-tune the staff, not only in the sales area, but also increase the capture and business development areas to achieve operational efficiencies and maximize our potential.
So, yes, we are seeing progress. The pipeline is increasing. We are seeing some opportunities that will close in late Q3 and in Q4. But we continue to fine-tune that staff and look for additional opportunities and growth from additional -- look across operations in the sales and Capture BD areas.
Thank you. And our next question comes from the line of Alex Henderson with Needham & Company. Your line is open. Please go ahead.
Thanks. I am going to break little bit, just ask two questions, one just why you think there’s any improvement in TSA. The primary question is on the Xacta. It’s very difficult looking at the numbers to cut through the noise and understand exactly what’s going on with the product. Can you provide us some sense of what the growth rate, based on your current guidance for Xacta on a full year basis? Is it actually producing double-digit growth, is it flat, is it up 20%? What -- can you just provide us some parameters around what the true underlying growth rate is, because it’s kind of lost in the numbers?
Yeah. Hey, Alex. It’s Mark. So on our Information Assurance business for 2022, I mean, as you know, we don’t guide at that level. But I would say, we are probably going to end somewhere in the -- we are probably going to be somewhere in the, call it, low-to-mid single digits on the year, say, mid single-digit on year, higher at the high end of the range but, call it, midpoint -- kind of mid-single digits.
And the reason for the TSA optimism that it actually was going to close, I mean, you thought it was going to close in September, then you thought it was going to close at the end of the year, now we are still thinking it’s somehow going to close and that it’s improved. What makes you think that?
Sure, Alex. This is Mark Griffin. So ultimately we follow TSA guidelines and schedule for launch. We are engaged with them extensively on a daily basis going through their launch plan and their security approvals.
We are getting to the end of that schedule and we are in this process now deploying to our enrollment sites and gearing up training and operational enrollment capabilities for those site. So every indication is we are following TSA schedule. They are positive on our results at this point and we fully expect to launch this year.
So just so I understand, when you say gearing up training, they have been instructed you to train your employees and they are -- they understand that that’s an expense you are carrying and therefore they wouldn’t stretch that…
…ask you do that it would if it wasn’t imminent. Is that the right way we should be reading that?
Yeah. Would you explain a little more about...
…if you could.
Alex, yeah, the entire program is under guidance and policy and procedures from TSA. So every aspect of the program is reviewed and approved by TSA. And so everything we do from approval of sites, to training of personnel, to our soft launch, to our security process and procedures are all controlled by TSA.
So, yes, TSA reviews every document. There are contractual delivery -- deliverables that we have to adhere to on every aspect of this launch. So, yes, TSA is the ultimate approval of when we launch, but we are meeting their schedules and we are doing everything that they are asking in the time frame they are asking for a launch this year.
Thank you. And our next question comes from the line of Nehal Chokski with Northland Capital Markets. Your line is open. Please go ahead.
Yeah. Thank you and congrats on the solid results and commend you, Mark, on especially a clear guidance deck. Thank you very much for that. Where are you guys in terms of percent of software billing sold on a term basis versus perpetual basis now and relative to the one, two and four quarters ago?
That’s a good question. I would say, the majority of what we are selling now, Nehal, is subscription or term versus perpetual and that’s true in our pipeline as well that the vast majority of our pipeline are subscription oriented.
There are a couple of exceptions. There are a couple of government examples that are exceptions, but the vast majority of the remaining pipeline, whether you are talking about ACA or Ghost or you are talking about Xacta, there are going to be subscription based or term based licenses versus perpetual.
Okay. Great. And how much of an impact does that transition have on the projection of low-to-mid single-digit growth for Xacta?
It has a -- it definitely has an impact. I don’t know the number off the top my head. But in the past, when we would do, say, we did $6.5 million in revenue. That was all perpetual. My guess right now is we are at about 60% or 50% perpetual currently and I think going forward it’s going to be -- the vast majority is going to be term or subscription.
And then to be clear, what is -- for every dollar of perpetual that’s capitalized into term, what the...
Basically -- what that basically means is, if I am delivering on a $6 million number for the year and it’s all term, I have got to deliver $12 million of orders by no later than June 30th.
Got it. Great. Thank you. And then my last question is that, Mark you alluded to in terms of a more cautious outlook on the macro being part out for the $15 million take down on the high end of the guidance, but that you are not seeing any impact yet. Why do you think you are not seeing any impact yet?
Correct. So what I am distinguishing between there is our core business. Our core business has been very strong through the first half of the year and including in the second quarter as the macro became choppier. So we are not seeing any impact there. I think it’s really just the nature of our portfolio and the customers and markets that we serve.
And then, for the second half, again, slightly outside of our core business where we are selling either new solutions or pre-existing to new end markets and customers, we just wanted to take a finer point on that forecast. And again, the net effect is only 80 basis points of year-over-year growth.
Thank you. And our next question comes from the line of Brad Clark with BMO. Your line is open. Please go ahead.
Hi. Thanks for taking my question. I want to ask a question about the sort of new business slowdown and how it’s in the guide and so much more of a clarification. And what I am trying to understand is, the deals out there that are sort of being pushed back either by the customers or from Telos’ perspective given the sort of proposed margin profile and it’s more not so good business at this or is it, yeah, it basically trying to understand between those two, more from the customer side or from Telos’ side to sort of push back and delay the new business? That’s it from me. Thank you.
So, it depends on the customer’s side, Brad. The government’s side is always -- it takes longer than people think and that we have mainly built into our guide. On the commercial side, I think, we are actually having success. But what’s happening is they are starting small and building out over time.
So we landed another commercial customer in this quarter. It started out being a six-digit, if you will starting place for it, but we expect it to be more like a seven-digit plus opportunity for us per year as they rollout Xacta throughout their offerings.
So I would say that on the commercial side, there is more of a try it and buy it, they are going to buy it small and then build out over time whereas in the markets that were more well known as in the Federal Government, there is some level of doing a pilot, but it’s a much more controlled pilot and it typically has a very, very specific beginning, middle and an end. And there the customers will go to an enterprise-wide license more quickly just based on the reputation that we have.
Thank you. And we do have a follow-up question from the line of Alex Henderson with Needham & Company. Your line is open. Please go ahead.
Great. Thank you very much. So I was hoping you could talk a little bit about what’s going on with the voice-over-AWS and is your big chunk of the story when you guys came out was that those guys were going to be reselling it starting kind of in the beginning of this year and that they thought it was a big driver of acceleration of the -- their services business, yet that doesn’t seem to be materializing. Can you talk about what the environment is there and why it’s taking so long or not metastasizing?
Metastasizing. That’s a good word. Thank you, Alex. I think it is taking longer. It is frustrating. They continue to use it internally. There are pockets of the organization that still want to build their own capabilities and it is moving but slowly, whereas on the other hand IBM made that -- made the decision not to build, but buy using Xacta as a -- as their launch partner.
And so, there we have a situation that a service provider is using us in the way that I was hoping the cloud providers are going to use us. It doesn’t mean the cloud providers aren’t going to get there. It’s just that they have not got there yet. They do continue to use us. They continue to use us more and more.
On the latest -- one of the latest awards we had that we haven’t announced the name on, it started out in the intelligence community. They see the value of the intelligence community. Now they are bringing us into their Department of Defense side of the business. And then, ultimately, we want to be in a commercial world. So each of the cloud providers has looked at it and gone about it in a little bit of a different way.
In the case of Azure, there has been quite a bit of turnover on the security and compliance side of their house. So we have had to sort of start-over in the case of Azure. And so, each cloud provider has a little bit of a story associated with it, but it is frustrating.
Similarly, can you talk a bit about the Ghost product and the progress or what’s going on there in terms of commercializing it into a product that’s used outside of the government security infrastructure play?
Sure. And actually you made a comment that I’d like to extend a little bit. One of the things that we have learned about our Xacta is that, it’s in the language of the government. And one of the things that we have to do is we have had to really change verbiage, how we describe things that we do inside of Xacta and I will provide you an example.
There is something called a poem in the government world. Poem doesn’t mean anything to the commercial guys. Remediation is the commercial equivalent of a poem. So we had to make changes in the product itself that more reflected what it is that the commercial world want it, which was also something that we had to build in.
As it relates to the -- as it relates to Ghost, we have continued to -- we have got continued progress with JCI offering Ghost as an embedded option with their cameras. Those cameras will -- if you will be hidden on the internet and their security product sales continue to be a very healthy growing business.
We expect a small level of sales out of that to happen late this year with this offering. And again, you have had some -- not turnover but promotions over there. So getting it off the ground has just taken longer than we would have liked.
Having said that, there are other organizations that are looking to do very similar things with JCI and we are in the midst of negotiating those -- with those other players and our hope is that we will be able to roll out some other announcements about how we are building that capability inside of these other players.
Now just to remind you, what we do with advanced cyber analytics is, all of that activity is hidden behind Ghost as well. So there is a -- there are opportunities for us with Ghost, both within our existing customer set, as well as selling through other players.
Since we are going around into the second round of questions, I am going to ask one more, if it’s okay. If not then just let me know. But I was hoping you could talk a little bit about the security networking business. It sounds like some projects were pulled forward in that business into the first half and just the favorable timing comment. Does that mean that you are expecting little less in the back half of the year from Security Networks?
So not in Secure Networks, the dynamic within Secure Networks, the team there is doing a really terrific job of managing their supply chain risk. And so when we set guidance we account for their supply chain risk in guidance and they have been outperforming that risk. So the program management teams there are doing a terrific job and outperforming guidance.
The pull-forward I think that you are referencing is more or less Security Solutions side. We did have some higher margin order on one program in particular within that business that came into the second quarter that we were otherwise expecting to more so come in the second half. So that’s the favorable…
But if you pulled forward the availability of supply then you deployed products sooner than expected. Doesn’t that come out of your pipeline?
I am not sure I understand the question.
You have got an order from a government agency to deploy a, I don’t know, choose a location…
Oh! I think that lapped….
… and you told you can’t deploy because you don’t have the product…
Alex I think you are ….
…referring to last year. You are talking about the pull-forward last year in 2021, the pull-forward on the Secure...
No. I am not. Mark, I am talking about the current environment. You used that as an example because they could not know specifically which projects we are involved. But you have a pipeline of business that you need to deploy gear for in order to get the revenue. If you get the parts sooner than expected…
… then that do reduces your pipeline into the forward period, correct?
That assumes that the pipeline is static, Alex. So the pipeline is not static.
Okay. So there’s no erosion in the outlook for the back half of the year within that because of the pull-forward of parts?
Not the revenue line.
Thank you. That’s what I was looking for.
Yeah. Thanks, Alex.
Thank you. And I am showing no further questions and I would like to turn the conference back over to John Wood for any further remarks.
Oh! Thank you very much, Operator. Well, first, I really well thank our shareholders for your ongoing support. And despite the current environment, I am pleased with our latest performance. And well, our year-to-date has progressed as we have expected. We are taking a balanced approach to the second half and we remain very focused on delivering for our customers and our shareholders. And again, I just want to say thank you to all of you for listening and to the analysts for asking questions and covering our stock. Thanks a lot everybody.
This concludes today’s conference call. Thank you for participating -- this concludes today’s conference call. Thank you for participating. You may now disconnect. Everyone, have a great day.
‘Given its ability to boost innovation, productivity, resilience, and help organizations scale, IT has become a high priority in a company’s budget. As such, there is every reason to believe technology spending in the B2B space will continue to surpass GDP growth,’ says IBM CEO Arvind Krishna.
A strengthening IT environment that is playing into IBM AI and hybrid cloud capabilities means a rosy future for IBM and its B2B business, CEO Arvind Krishna told investors Monday.
Krishna, in his prepared remarks for IBM’s second fiscal quarter 2022 financial analyst conference call, said that technology serves as a fundamental source of competitive advantage for businesses.
“It serves as both a deflationary force and a force multiplier, and is especially critical as clients face challenges on multiple fronts from supply chain bottlenecks to demographic shifts,” he said. “Given its ability to boost innovation, productivity, resilience, and help organizations scale, IT has become a high priority in a company’s budget. As such, there is every reason to believe technology spending in the B2B space will continue to surpass GDP growth.”
[Related: IBM STARTS ‘ORDERLY WIND-DOWN’ OF RUSSIA BUSINESS]
That plays well with IBM’s hybrid cloud and AI strategy where the company is investing in its offerings, technical talent, ecosystem, and go-to-market model, Krishna said.
“Demand for our solutions remains strong,” he said. “We continued to have double-digit performance in IBM Consulting, broad-based strength in software, and with the z16 [mainframe] platform launch, our infrastructure business had a good quarter. By integrating technology and expertise from IBM and our partners, our clients will continue to see our hybrid cloud and AI solutions as a crucial source of business opportunity and growth.”
Krishna said hybrid clouds are about offering clients a platform to straddle multiple public clouds, private clouds, on-premises infrastructures, and the edge, which is where Red Hat, which IBM acquired in 2019, comes into play, Krishna said.
“Our software has been optimized to run on that platform, and includes advanced data and AI, automation, and the security capabilities our clients need,” he said. “Our global team of consultants offers deep business expertise and co-creates with clients to accelerate their digital transformation journeys. Our infrastructure allows clients to take full advantage of an extended hybrid cloud environment.”
As a result, IBM now has over 4,000 hybrid cloud platform clients, with over 250 new clients added during the second fiscal quarter, Krishna said.
“Those who adopt our platform tend to consume more of our solutions across software, consulting, and infrastructure, [and] expanding our footprint within those clients,” he said.
IBM is also benefitting from the steady adoption by businesses of artificial intelligence technologies as those businesses try to process the enormous amount of data generated from hybrid cloud environments all the way to the edge, Krishna said. An IBM study released during the second fiscal quarter found that 35 percent of companies are now using some form of AI with automation in their business to address demographic shifts and move their employees to higher value work, he said.
“This is one of the many reasons we are investing heavily in both AI and automation,” he said. “These investments are paying off.”
IBM is also moving to develop leadership in quantum computing, Krishna said. The company currently has a 127-qubit quantum computer it its cloud, and is committed to demonstrate the first 400-plus-qubit system before year-end as part of its path to deliver a 1,000-plus-qubit system next year and a 4,000-plus-qubit system in 2025, he said.
“One of the implications of quantum computing will be the need to change how information is encrypted,” he said. “We are proud that technology developed by IBM and our collaborators has been selected by NIST (National Institute of Standards and Technology) as the basis of the next generation of quantum-safe encryption protocols.”
IBM during the quarter also move forward in its mainframe technology with the release of its new z16 mainframe, Krishna said.
“The z16 is designed for cloud-native development, cybersecurity resilience, [and] quantum-safe encryption, and includes an on-chip AI accelerator, which allows clients to reduce fraud within real-time transactions,” he said.
IBM also made two acquisitions during the quarter related to cybersecurity, Krishna said. The first was Randori, an attack surface management and offensive cybersecurity provider. That acquisition built on IBM’s November acquisition of ReaQta, an endpoint security firm, he said.
While analysts during the question and answer part of Monday’s financial analyst conference call did not ask about the news that IBM has brought in Matt Hicks as the new CEO of Red Hat, they did seem concerned about how the 17-percent growth in Red Had revenue over last year missed expectations.
When asked about Red Hat revenue, Krishna said IBM feels very good about the Red Hat business and expect continued strong demand.
“That said, we had said late last year that we expect growth in Red Hat to be in the upper teens,” he said. “That expectation is what we are going to continue with. … Deferred revenue accounts for the bulk of what has been the difference in the growth rates coming down from last year to this year.”
IBM CFO James Kavanaugh followed by saying that while IBM saw 17 percent growth overall for Red Hat, the company took market share with its core REL (Red Hat Enterprise Linux) and in its Red Hat OpenShift hybrid cloud platform foundation. Red Hat OpenShift revenue is now four-and-a-half times the revenue before IBM acquired Red Hat, and Red Hat OpenShift bookings were up over 50 percent, Kavanaugh said.
“So we feel pretty good about our Red Hat portfolio overall. … Remember, we‘re three years into this acquisition right now,” he said. “And we couldn’t be more pleased as we move forward.”
When asked about the potential impact from an economic downturn, Krishna said IBM’s pipelines remain healthy and consistent with what the company saw in the first half of fiscal 2022, making him more optimistic than many of his peers.
“In an inflationary environment, when clients take our technology, deploy it, leverage our consulting, it acts as a counterbalance to all of the inflation and all of the labor demographics that people are facing all over the globe,” he said.
Krishna also said IBM’s consulting business is less likely than most vendors’ business to be impacted by the economic cycle as it involves a lot of work around deploying the kinds of applications critical to clients’ need to optimize their costs. Furthermore, he said. Because consulting is very labor-intensive, it is easy to hire or let go tens of thousands of employees as needed, he said.
For its second fiscal quarter 2022, which ended June 30, IBM reported total revenue of $15.5 billion, up about 9 percent from the $14.2 billion the company reported for its second fiscal quarter 2021.
This includes software revenue of $6.2 billion, up from $5.9 billion; consulting revenue of $4.8 billion, up from $4.4 billion; infrastructure revenue of $4.2 billion, up from $3.6 billion; financing revenue of $146 million, down from $209 million; and other revenue of $180 million, down from $277 million.
On the software side, IBM reported annual recurring revenue of $12.9 billion, which was up 8 percent over last year. Software revenue from its Red Hat business was up 17 percent over last year, while automation software was up 8 percent, data and AI software up 4 percent, and security software up 5 percent.
On the consulting side, technology consulting revenue was up 23 percent over last year, applications operations up 17 percent, and business transformation up 16 percent.
Infrastructure revenue growth was driven by hybrid infrastructure sales, which rose 7 percent over last year, and infrastructure support, which grew 5 percent. Hybrid infrastructure revenue saw a significant boost from zSystems mainframe sales, which rose 77 percent over last year.
IBM also reported revenue of $8.1 billion from sales to the Americas, up 15 percent over last year; sales to Europe, Middle East, and Africa of $4.5 billion, up 17 percent; and $2.9 billion to the Asia Pacific area, up 16 percent.
Sales to Kyndryl, which late last year was spun out of IBM, accounted for about 5 percent of revenue, including 3 percent of IBM’s Americas revenue.
IBM also reported net income for the quarter on a GAAP basis of $1.39 billion, or $1.53 per share, up from last year’s $1.33 billion, or $1.47 per share.