ServiceNow, Inc. (NYSE:NOW) JPMorgan 51st Annual Global Technology, Media and Communications Conference May 23, 2023 3:55 PM ET

Company Participants

C.J. Desai – President & COO

Conference Call Participants

Mark Murphy – JPMorgan

Mark Murphy

Okay. Good afternoon, everyone. I am Mark Murphy, Software Analyst with JPMorgan. And it is a real pleasure to be here with C.J. Desai, who is President and COO of ServiceNow.

First of all, C.J., it was great seeing you on stage at your own conference.

C.J. Desai

Thank you.

Mark Murphy

Last week out of Las Vegas and, thank you, I know you’re a popular guy, there’s a lot of demand for you. So thank you for taking the time.

C.J. Desai

Of course, absolutely.

Mark Murphy

Maybe you can spend a moment just giving us a super brief introduction of yourself. And in case there’s anyone in the audience who is not aware of what ServiceNow does, just a super quick brief.

C.J. Desai

Of ServiceNow as well? Okay. I’ll start with ServiceNow. ServiceNow was created in 2004 in San Diego area by Fred Luddy, and he created this as a platform company for any type of workflow automation. So any task that can be automated digitally, he wanted to do that. ITSM, which is our largest product line, was actually the first demo that was created on top of ServiceNow, and became the first biggest use case to get to $1 billion in revenue. So that’s how Fred started the Company.

After that, Frank Slootman became the CEO. Frank hired me in 2016 and said, C.J., we need to hit $4 billion in revenue by 2020. That was Frank’s call with Mike Scarpelli, who is the CFO at the time. And then after Frank was John Donahoe. John stayed with us through 2019 October. And then Bill McDermott came from SAP to take ServiceNow to the next level, and Bill has been here now, 3.5 years. I’m C.J. Desai, and I’m responsible for products, engineering, our cloud, customer service, professional services and a few other things.

Question-and-Answer Session

Q – Mark Murphy

So thank you. That’s a wonderful overview. Thinking back again to last week on stage, Bill McDermott was there and he said, this is the quote, ServiceNow is the intelligent platform for digital transformation, but people still ask me what does ServiceNow do, and that a lot of people still don’t know.

So for this audience, we hear the term workflow often. We hear the term orchestration layer. Amazon and Microsoft would also say, right, that they can handle some workflows. They would also say that they’re a platform for digital transformation. So when you look out at this audience of non-IT professionals, how would you convey this differentiated role that ServiceNow has in the IT landscape?

C.J. Desai

Yes, absolutely. So many companies will claim that they are platform company, that’s okay. And they will say that we also do workflow. And then the term gets used fairly generically at times, Mark, like you said. Here is how I would describe it.

If we take just a simple example that an employee at your firm wants to move, we are in Boston, so let’s use Boston as an example, from Boston to San Francisco. If an employee moves at a bank from Boston to San Francisco, there are so many departments that get involved in making sure that transfer happens, the mobility team from relo, is the payroll going to be different from Boston to San Francisco, is the department changing, the cost center changing, is the employee’s role changing as she moves to, say, San Francisco.

When you think about all of that at a corporation, these are complex workflows that need to be executed digitally for that transfer to happen. And even once the employee is transferred, the first 30 days, 60 days, 90 days in the new role, what are the to-do list training that, that employee has to go through? These are very complex workflows that go across departments in an organization.

The employee doesn’t care. The employees sometimes don’t even know that that’s the name of the department that’s mobility, which will help the employee with the relocation. That’s just an example of an employee just moving from one city to the other. You can think now more complex scenarios in IT landscape that a payroll system is down.

Why did it go down? What was the root cause? How can we get it up and running? And all that storming and forming happens in ServiceNow from an incident management, major incident management perspective. These are extremely complex workflows, and workflow is nothing but a task orchestrated in a certain sequence across systems, across clouds, across people to get work there.

Mark Murphy

Okay. So you used this term storming and forming, and I like that one. ServiceNow has been storming its way into our CIO surveys now for really, if you look back since 2011, right, the Company was still private. ServiceNow would rank consistently near the top in our survey work on, we would look at the spending intentions, we would look at the linkage with digital transformation, we would look at who’s going to be used for cloud. How would you describe to this audience? What is it that has vaulted ServiceNow into that kind of a position? And then, how have you maintained that also for quite so long?

C.J. Desai

Yes. So one of the things is when the Company was created, and most people say but a very few do it, the focus on the end customer and end user for use cases was very special and continues to be special at ServiceNow. We do not sell to small enterprises as some of you, if not all of you know, we only sell to upper end of the mid-market to large to very large to governments. That’s our segment where we do business.

And we are very focused on making sure that our customers get value out of any use case, whether it’s ITSM or whether it’s HR service delivery or customer service management. And if you look at our renewal rates, which are best-in-class, the reason is we work very hard with our customers to make sure they get value out of the platform. And even if we decide to go after certain use cases, that use case is something that they can truly see that ServiceNow.

Like I want to, Mark, give an example, when we entered the HR space, they said the same thing, hey, you do IT, why HR? And we said, we are not system of record. We do not want to be a system of record that SAP, Oracle, Workday and others do, that’s great. We are the workflow or the system of action layer, so that when the actual work that needs to be get done for an employee that spans organizational boundary outside of HR, that’s what we do. And we proved that. And now it’s a decent-sized business with north of 1,000 customers for us.

Mark Murphy

Decent sized. So, we’re commonly hearing out there when we do our field work that once you win the hearts and the minds of central IT within these big organizations that you’re targeting, that then it becomes very easy to expand outward into the other business units. You just mentioned HR.

But people will mention legal, they mention customer support, finance and so on. Can you shed some light on the mechanics of that? In the trenches, how does that IT stamp of approval kind of help grease the skids for ServiceNow so you can spread out across the business units?

C.J. Desai

So a lot of you have been observing technology industry. Mark, I know you have done a lot of work, including the service you mentioned about intentional spend, security being one and a few others in the past on JP surveys.

But one thing I’ll tell you that over last 10-plus years, the number of times I have heard, which has not turned out to be true, that CIO is irrelevant. The — it is all about the developers. The spending is moving to developers. Yes, it is true that some technology spending does move to developers, developers need to be productive, I get it.

So to answer your question, CIO, where which was our first use case at scale, which is ITSM, beginning of the last decade and has continued to grow, that is our core buyer. We have won hearts and minds of CIO. And around 2016, 2017, CIO became aware that ServiceNow can be the ERP for IT.

And that’s not a small term, because a CIO’s job is pretty broad: keep systems up and running; create new digital services; serve lines of businesses, whether it’s HR or sales or whatever, or finance. And we very much focused on CIO being the core of the core, and we were selling to the CIO, versus somebody will sell to Chief Revenue Officer and the CIO has to run a CRM system.

Somebody will sell to the CFO, say, a financial system, that’s the buyer, and the CIO has to run and operate that, versus we had actually product selling to the CIO. So CIO, because we became the ERP for IT, and we have never lost sight of that core buyer and that core stakeholder. And so once you serve the CIO saying, “hey, we are here for you. We are not here, that we are trying to sell to HR or finance like the HCM system with our CFO,” that gave us permission to say, “hey, Ms. CIO, can you introduce us to the CHRO?”

And again, you are going to leverage the ServiceNow platform that you have been leveraging for HR use cases. You are going to leverage the ServiceNow platform for customer support, and that’s what allowed us to gain permission to go to other buying centers.

Mark Murphy

So another element to this that has caught our attention for a long time is the fact that you do have a very integrated platform. Out there at your event last week, I was speaking with one of your very largest partner firms. And he was actually describing what you were just referencing.

He said, many companies have done ITSM, right? And now his term as he said, they’re work-flowing out, right? They’re work-flowing out from there across the rest of the Company, right? HR, legal, finance, supply chain security, the quote was it’s exploding in so many areas, and they’re succeeding with it.

And I stepped back and I said, well, but how? How can this company succeed in so many different parts of the organization? And he basically just said, integrated platform. Integrated platform, people want that. So could you speak to that part of the philosophy? It’s kind of been guiding ServiceNow in a unique direction of integrated platform. And then what are the advantages that it affords you that might not be clear to people in the audience?

C.J. Desai

Yes. So for customers like this partner told you is workflow out, for us it’s platform out. So you start with the platform as the core and some of the mechanics that I shared because our ServiceNow platform has user experience built in, machine learning built-in, workflow built-in, RPA built-in, process mining built in, all of these are, think about building blocks that are part of the ServiceNow platform.

And now when we decide as a company or as an engineering team that we are going to go after a supply chain use case, what I shared is that with one or two scrum teams, somewhere between 7 to 14 to 15 engineers, because the platform provides all core services, we can create a version 1.0 of any use case for, say, a supply chain department.

And then from a customer perspective, customer says, we use you for ITSM, are you telling me it is the same mechanics when we roll it out in supply chain, your portals, your workflows and others? We say yes. And all the user access model that you have built in, security that you have built in will just extend, so you’re not installing yet another platform. And you don’t need to install yet another team to scale that platform.

Mark Murphy

So, this platform keeps broadening. I think at the last update, C.J., we were told there are 11 organic businesses with over $200 million in revenue. So, it’s becoming actually pretty diverse. If you had to pick one or two of those and say, do you work, keep an eye on this because there’s nascent potential here, and this is going to be a durable compounder, where would you tell us to look?

C.J. Desai

I would say the same thing I think I said in 2017, which was now six years ago, to start with. Customer service is an area. We are ServiceNow, customer service, ServiceNow service. That is a large TAM. And when you do industry-specific customer service like a telecommunications or financial services, we believe that the market is large enough and this can become a massive business or ServiceNow outside of IT. So that’s number one.

And number two is we just entered last year what you called out finance and supply chain workflows. Again, we are not trying to be a system of record. But specifically, workflows for procurement department or a supply chain department or a finance accounts payable department, we believe there is enough pain points that ServiceNow can solve. That’s another area that has — it’s an $11 billion TAM is what we disclosed last week, but it has potential to be a very large business.

Mark Murphy

Okay. So — well you gave us a couple of areas to focus on and do the work. I do want to ask you about HR in addition to this. So I recall C.J., this was several years ago, I traveled out to the HR Tech Conference. It was probably in Las Vegas. And it had been a long week.

I walked into the partner pavilion, and I immediately saw a ServiceNow booth, right? Big booth right in the front, very crowded. And I had a brief moment of figuring that I somehow went to the wrong conference, right? I didn’t know about it then. And last week, we were kind of milling about and talking to multiple partners at your event. And several of them called out HR as their number one growth vector.

And so — and they’re saying that they’re getting inbound requests on the HR side. Could you help us understand, then, why is HR a logical extension for you? And maybe which pieces of that are resonating?

C.J. Desai

Yes. So first of all, just at the highest level, the good news for us is we have divided our product lines in four big buckets: Technology workflow; employee workflow; customer workflow; and creative workflow, right? All four of us, four of those workflows are growing nicely for us. So we don’t have this challenge, oh, one has — is declining, and we need to move the R&D and other allocation to the other area. All four are growing nicely, all four of them, okay? So that’s number one.

Number two, HR, which pretty much in its earnest started in 2016, where customers said, hey, for HR case management, onboarding type of challenges or offboarding challenges, ServiceNow can do this thing. What has resonated the most is an employee, in trying to make that employee productive, is something that always has been our focus and take friction away.

To give a very simple example, think about a large bank. And if you want to get something done for — with the finance department, you go to somewhere else. With legal department, you go somewhere else. With your facilities, you want to go somewhere else that, hey, I became a manager, I need an office. We provide a single portal for employees, because employees at the end of the day do not care what the org structure looks like. Okay, there are four lines of businesses, and there is this HR function. They want to go to one place to get help, and they want one place to get things done. And that’s what we have done with HR products.

Mark Murphy

So you’re mentioning the employee portal or I think you call it employee center at times. You have onboarding, you have that piece and then you have this HR agent type of work space. Where do you think it would expand beyond that? Or is there enough to be done there for a while where it’s not necessarily going to be expanding?

C.J. Desai

So, we are expanding on making life easier for managers to manage their employees and what are the workflows required for managers to deal with. Skills is another area that we launched last week. On every job function has skills, career path, right? You need certain skills to be a manager, certain skills to be a director, certain skills to be a VP, whatever it is, or a software engineer. How do you do that skills mapping? How do you have the conversation with your manager in a meaningful way? And there’s another area of focus for us.

And then because of the pandemic, what has also happened as companies have tried to figure out this hybrid workplace where some will say, we allow our employees, or we mandate our employees two days a week, some will say four days, some will say all five days, it varies. How do you do facilities management, and how does employee get that experience that if I’m only coming two days, that means I don’t have a desk that is assigned to me because no corporation will not sign your desk if you’re coming two days. So can I book something? Can I book a conference room? Can I look at the maps? These are other areas within employee experience standpoint that allows us to expand.

Mark Murphy

Okay. So you just mentioned the pandemic. And when you think back on this — if you think back one year at this conference that was the time when we just started to have a few software companies that began calling out some challenges in the demand environment.

C.J. Desai

That’s correct.

Mark Murphy

And then over the summer, ServiceNow was also relatively soon in kind of identifying the change, right, and called out macro cross winds. That was last summer.

C.J. Desai

I think Bill went on CNBC.

Mark Murphy

Yes, that’s the one. That’s what I’m referring to. So most companies kind of recognize the environment was changing a little later, right, or admitted it later. But how do you connect the dots on the macro environment, if you kind of start with the last several quarters? And then how does business confidence feel to you right now today?

C.J. Desai

Yes. I would say 2022 and 2023 from my perspective are very different, right? So 2022, there were a lot of conversations, especially in the first half that we saw, what around supply chain and what does that do to fulfill demand when you talk to companies or corporations, potentially talent shortage and all that.

And then second half of 2022, including this 2023, it has become all about interest rate environment, the cost to serve, profitability focus. And there is not a single conversation, Mark, I have where there is not a conversation about efficiency and automation. And simply put, I’ll just do this pattern matching over 100-plus customers in, say, last month.

They say, we are solving for two things: We want to automate better, while at the same time, our digital agenda is still on because digital is still required, right? But it’s not at all cost, but that’s the efficiency gain that we are solving for. It’s the year of efficiency or a year of productivity and all of that. That pivot happened once the interest rate environment changed at a global scale.

So from our perspective, we are pretty distributed in terms of industry, public sector to financial services, to health care manufacturing, telco media and others. So, we see it all. And that is, I would say, United States of America continues to be resilient for ServiceNow. This is very ServiceNow-specific comment, for us very, very resilient, because we are a workflow automation platform.

So, we see that from a demand perspective, whether it’s IT automation or HR automation or customer service automation. We are seeing also similar things in Central Europe. We are seeing UK turnaround for us this year. And so, I feel, given what we do around digital and automation, we are still seeing demand for ServiceNow.

And customers take — I mean, last week, we had 15,000 in attendance, and there are so many companies that have cut travel budget for profitability and others. We had I would say, median number per customer, 12 to 13 folks being sent, which just tells you that they want to learn more about ServiceNow.

Mark Murphy

There was good energy there, and it was crowded and it was busy. How was the pipeline generation activity?

C.J. Desai

Pipeline, so far — so our sales and marketing team did a great job to make sure that, one, there are still customers who don’t understand that we are the end-to-end intelligent platform for digital transformation, not just IT service management or IT operations management. So, these customers coming in and sending this many folks from line of business and IT, it just opened up.

And I had so many conversations over three days there where customers are like, “I didn’t know you did supply chain, or I didn’t know you did, customers said, Oh, I didn’t know you had field service management product.” So one, our existing pipeline that we need to nurture and mature, a lot of those customers came, and then now it has allowed us to also expand the conversations to say, I didn’t know this.

Mark Murphy

Okay. So you felt pretty good about that.

C.J. Desai

Very good.

Mark Murphy

Okay. So now you do a lot of business in the financial services vertical. We learned when we were out there, some of the banks sent 30 people, 60 people to that event. So you know that’s a big commitment.

But we’re constantly getting questions from investors about whether this regional banking crisis could cause any issues. Maybe you have some deal deferrals, even if it’s not from the regional banks, right, even if it’s from other banks. What are you seeing so far?

C.J. Desai

So, our Q1 numbers when you see — when we reported them in April, we were not impacted while the crisis or, however you want to say it, the phenomena that was happening in the regional banks in Q1. And when I look at the pipeline for this year and out years, right, we look at four, five, six quarters out, there are certain product lines we have besides our core of the core, which is ITSM and ITOM, is still demand for our risk solution in banks specifically.

So, we will have a Chief Risk Officer level conversation or we have digital risk level conversation. Our security products are resonating well with both large and midsized banks. And then between banks and the insurance companies and others, we are also seeing demand for mid-office, back office workflows.

So, we can — and again, banks all of you understand, they are tough customers. You have to prove out the use case, you have to show the value before they make a purchase. The cycles with all the banks have always been long. But they understand ServiceNow really well now and allowing us to expand in other areas besides just IT.

Mark Murphy

So, there were — there was good energy out there. Obviously, it’s not a perfect environment. Obviously, the typical software company has been — growth has been slowing, right, across the entire industry. And nobody has been immune to it.

There were people out there, there were partners out there last week who would recognize that, but then they would also say, it would at least hypothesize that ServiceNow could be a bit recession resistant, they didn’t say recession proof. But we would say, well, why?

They would say because companies they’re consolidating legacy point products, right, onto a modern platform and their feeling is that they do continue to do that even during a slowdown. So is there an element of truth to that? Is there an element of truth to being a little bit recession resistant?

C.J. Desai

Yes. Listen, 2022 was the first year where the word R came out, right? It was in ’22 that, hey, there are parts of economy that may be slowing down despite the labor market being super resilient. And ServiceNow did pretty well. We did pretty well.

If you look at our proxy statements, the demand was there and we executed on that demand. And it exceeded even when we reported our Q4 and fiscal ’22 numbers, it exceeded what was happening compared to the other SaaS companies. It’s what I can compare us against with close to 29% subscription revenue growth in 2022.

And now when we look at 2023, we had a strong Q1. We reaffirmed our guidance. And we won’t do that unless we feel that we are given what we do still in the strike zone of the purchases that the companies are trying to make.

Mark Murphy

Yes. Okay. Well said, well said. So C.J., in the time that’s remaining, let’s switch gears a little bit and go into the topic that’s on everyone’s mind, which is generative AI, right? You spent quite a bit of time at the Analyst Day talking about ServiceNow’s vision.

I’ll tell you what actually stood out to me. When you were on stage in front of the main session, the loudest response from the audience, and it was by far, it was when you were showing this demo of, I guess, I would call it text to code. But basically, someone goes in and someone types in, right, create a workflow for notifying like certain teams if — if there’s a level one incident.

And then the system basically spits out the code right? So, it understands what you’re asking, it spits out the — but it’s in the proprietary ServiceNow…

C.J. Desai

Department, yes.

Mark Murphy

Scripting language, right? And so people kind of went crazy. And then you can — you hit copy, it goes on a clipboard, and you could drop it right into the app, and then it’s live. I mean so — I assume you noticed that response.

C.J. Desai

100%.

Mark Murphy

Yes. I mean how much of a productivity base do you think you can provide to the typical — the admin or a ServiceNow platform owner?

C.J. Desai

So I’ll go to the first principles, okay? And this is super important for all of you to understand. In 2016, when we ended the year, we were $1.3 billion in subscription revenue. Last quarter, we hit $8 billion run rate and will be $8 billion by end of this year, right?

So you think about 8x growth in seven years, that’s a very fast license subscription growth. That’s great because of the use case is this and so on. But our ecosystem has not kept up with it, meaning trained ServiceNow professional. Every large customer I speak to, they say, we cannot find people who understand ServiceNow and how to code in ServiceNow.

So when we showed that demo that you write in natural language something and it spits out ServiceNow code, that was a domain-specific LLM that we created in ServiceNow by feeding ServiceNow proprietary code that we know how to write, because we wanted an accurate code to show 15,000 live audiences because anybody can take picture.

And if that code is faulty, which was a rejects for e-mail address, number of incidents and this and that, that’s a game over. You don’t want that demo, and we did a live demo. The reason you got this really nice applause and people who were cheering and there was like a gasp and all of that, is because every customer is dealing with not having enough ServiceNow professionals, and this just creates more developers on ServiceNow, creates their learning curve faster and ability to modify rules in ServiceNow. That’s it.

And so this allows our ecosystem to expand. Our partners, you mentioned, Mark, have a massive backlog to implement many of our product lines that our customers have purchased and this allows them to scale faster. And we will be able to monetize that. We are providing offerings on the productivity enhancements that they will get.

Mark Murphy

So, and you’re using — you mentioned the domain-specific LLMs. The thought process was, for me was, you have OpenAI, that’s the general purpose LLM. The value-add is going to be the domain specific.

And at first, I heard it as that you’re using a hugging face for that a private company. And then I think later on, I started to realize it seems like that’s also going to include NVIDIA.

C.J. Desai

That’s correct. I could not on Financial Analyst Day, disclose NVIDIA, because Jensen came on Wednesday, and he wanted the press announcement to go after we have announced it for NVIDIA shareholders as well.

Mark Murphy

I see.

C.J. Desai

So we are working with NVIDIA team on IT service management, specific LLM. And Jensen was very proud of his team showed me this morning, the results we are getting with open source LLM that NVIDIA is helping us fine-tune. Because general-purpose LLM with 175 billion parameters, whatever the numbers are, it will continue to increase, that’s interesting, but it’s general purpose.

What our customers want is, “Hey, C.J., I’m a large telco. I use you for these five products. How can I enhance my productivity? And can you please take care of it using gen AI?” And because that’s what — for ServiceNow specific use cases, they don’t want to build a gen AI model, they want us to build the gen AI model, which is why I call it domain-specific. And NVIDIA and hugging face at our partners to be able to do that, where we don’t require 175 billion parameters, and we can still compute efficiently.

Mark Murphy

Okay. Let me finish on observability. At a super high level, so why is observability going to end up being a good fit for ServiceNow? I mean you have incumbents out there. We had Datadog here yesterday. You have other incumbents. They’re pretty modern, right? They’ve been working on metrics tracing, monitoring logs. They’ve been working on it for a long time. Why is it a good fit for you?

C.J. Desai

Here is what I would say: At the highest level, our customers said, you have a right to play here. Because things that come out of observability platform that this particular applications performance is slow, or something changed where this application went down, eventually makes a call to IT service management, where you have all incident repositories.

So our customers said, you should play in this field. And only when our customers say, you should play in this field, we play in that field. Our platform was designed for human workflows, digital workflows, not machine data. Hence, we did the Lightstep acquisition. Lightstep used to do tracing really well, then they added metrics. And now late summer, we are going to add logs. So we will have a full cloud observability solution that integrates with ITSM and ITOM.

That is our differentiation. And given there are multiple solutions out there that are, as you know, you talk to any bank or any manufacturing company or any government, they’ll say we have five of them. That’s totally fine. We are focused on observability at scale, at a cheaper cost that integrates really well with the backbone of IT, which is ERP for IT, which is ServiceNow.

Mark Murphy

Okay, wonderful message to hand on. C.J., I can’t thank you enough for hopping on a plane and flying across to be here with us.

C.J. Desai

Of course, absolutely.

Mark Murphy

Thank you very much.

C.J. Desai

Thank you.

Arista Networks, Inc. (NYSE:ANET) 51st Annual J.P. Morgan Global Technology, Media and Communications Conference May 23, 2023 1:55 AM ET

Company Participants

Ita Brennan – Chief Financial Officer

Conference Call Participants

Samik Chatterjee – J.P. Morgan

Samik Chatterjee

Good afternoon, everyone. So we’ll move to the next session. Thank you, if you can take your seat. I’m Samik Chatterjee, I cover the hardware companies at J.P. Morgan. For the next session, we have Arista. And from Arista, we have Ita Brennan, CFO, as well as Liz Stine from Investor Relations. Thank you both for coming to the conference.

Question-and-Answer Session

Q – Samik Chatterjee

And I’ll really just start off with more sort of a macro question and few questions we’ve been asking most of our companies to comment on. Just remainder of the year where, obviously, the macro backdrop remains a bit more challenging, but as you think about macro risk, what are the biggest risk that you perceive to your business?

Ita Brennan

Yes. I mean, I think certainly the macro overall environment is offering lots of uncertainties. You think about debt ceiling, you think about all the banks, think about interest rates. So there is a lot happening at a macro level. I think when you take that back to the business, we still haven’t seen a tremendous kind of direct impact on the business. We talked about this on the earnings call a little bit where on the enterprise part of our business where we’re really targeting larger, big bet type companies, we’ve seen that continued engagement. In spite of kind of some of these backdrops, obviously, we’d be [foolish] (ph) to ignore those, we’re going to continue to monitor and look at that. Over time, but we haven’t really seen that impact on the business yet.

I think on the hyperscale side of the business, on the cloud part of the business, that’s more of a cyclical question, right? And we’ve talked about this a little bit where we’ve come off some very accelerated growth with cloud where cloud grew triple digits last year. So we do expect that there will be some moderation in that spending. Is that macro? Is that not macro? I mean, I think it’s just more of a — more of a cyclical kind of product cycle related trends and we’ll see where that goes as we move through the year and get some better visibility.

Samik Chatterjee

Okay. Just to follow-up on that, I mean, one of the things, as you mentioned, like you haven’t seen maybe the macro impact you as much. But we’ve seen with a lot of other hardware categories and I think even during the sessions I’ve hosted today, it’s come up that there was a pull forward of capacity by the hyperscalers in terms of their own investments towards capacity. How much of the slowdown you’re expecting is largely a function of maybe a pull forward of demand from their side to add capacity? And when you sort of look forward, it’s more sort of just waiting for them to digest that capacity and move forward? Or is there a change structurally in how they think about their growth rates on public cloud revenues and that’s changing their outlook for how they spend?

Ita Brennan

Yes. I think we had come through a very interesting period from a supply chain perspective where you definitely saw a lot more visibility from these customers in terms of what they needed to deploy, and we were able to kind of lay out deployment plans in advance and over a longer period of time than we would normally see. I think we’ve tried to be — to have a good understanding of what was being deployed and when, and we’re still working through that even now. I think the question is, kind of once you get through those deployments, what does the trajectory of that investment look like as you head into 2024 and beyond. Right? And I think that’s something that — there’s been — these companies are looking at their architectures, they’re looking for efficiencies, et cetera. They’ve talked about wanting to do the things that they need to do for their business. I think their CapEx has been reasonably resilient even through this. So I think we’re just going to have to wait a while to see exactly how that how that plays out. And we probably won’t get visibility to kind of into that time frame until later in the year.

Samik Chatterjee

Okay. Obviously, 1 of the questions that I’m sure you answered all morning is the impact of AI on your business. Largely, I think, obviously, sort of the infrastructure spend is what everyone’s focused on, but maybe flesh it out a bit more in terms of where you see the opportunities? Is there any sort of offset to think of in terms of where the business gets disrupted at the same time. Just help us think through that.

Ita Brennan

Yes. I mean, I think for us, it’s early. Jayshree talked on the earnings call about the fact that we’re at the beginnings of understanding what AI really means and what the technology will look like. We have deployed some AI use cases, but it’s relatively small. I think we look at it as — it’s a good underpinning of kind of future momentum and demand, particularly from some of the larger hyperscale customers. It’s a reason why these technology cycles that are coming — upcoming are going to be important. It’s a reason why everybody is so focused on making sure that those cycles happen and happen in a timely manner. So I think that’s all positive. It doesn’t necessarily mean that tomorrow everything changed. And there isn’t a lot of work to do to get to kind of those new products and to get to those cycles. There isn’t a lot of technology challenges to sort out. But that’s okay too. Right? That’s what — that’s really what we do. And so, AI as a driver for innovation and for new technology changes, speed of deployment, all of that is positive for us. Exactly what it looks like kind of in this time slotted period, it’s really too early to start to fully understand that yet.

Samik Chatterjee

Okay. Since we’re on the topic of AI, any way of sort of that you’ve quantified how big the opportunity for Ethernet switching is, how do you think about the risk from InfiniBand remaining a core part of that market or dominant in that market and Ethernet not being able to displace InfiniBand for the technology?

Ita Brennan

Yes. I mean, I think if you look at the data that we have today, high performance compute use cases, it’s roughly 50:50 split between Ethernet and InfiniBand today. Obviously, that’s almost pre AI, but it is — it does give you some indication or some place to start. Our belief is that, if AI turns out to be so critical and embedded in all of these business processes, if that’s really where this goes, then you’re going to want to deploy this technology pervasively across these large cloud footprints. And I think that’s where we believe that Ethernet has some advanced. Right? In terms of being able to scale, it’s standards based, it’s already deployed in a lot of these footprints already. Its standards based, there’s lots of expertise around it, et cetera. So there’s a lot of advantages when you think about getting to scale that we believe kind of comes with Ethernet.

It’s not completely solved today. We need the new speeds. The team’s working on — Anshul talked about near lossless fabric, but it doesn’t need to be near lossless or lossless fabric. So there’s work to do. But again, if you really think its scale, is your endgame, then we believe Ethernet has a role to play there. That’s where Ethernet kind of has some real advantages. Again, we’re going to have to work through this, but I think — if it’s a scale play, we think Ethernet can have player role there. It doesn’t mean that InfiniBand is not going to have a role, it’s just kind of the scale will in our minds favor Ethernet.

Samik Chatterjee

You mentioned moving to sort of next generation speeds or higher speeds and being critical in that. And obviously, there’s sort of latency, et cetera, that comes into the equation here. Does it change how fast these upgrades cycles are, because you’ve been in the midst of 400 gigs upgrade cycle. Does that 400 gigs sort of naturally then bleed into the next upgrade cycle muting some of the cyclicality that you’ve seen with your customers?

Ita Brennan

I think it’s too early to really know that, honestly. We’ve always want these cycles to go faster, and it seems like every time we’ve done one there’s some really urgent reason for why they have to go faster. I’m not sure how much that actually makes them go faster. Right? So I think there’s definitely going to be energy around trying to have this happen more quickly. But I think experience has taught us that it’s still hard, there’s real work that has to get done, there’s an ecosystem that has to get kind of formed around these deployments, particularly at scale. So I don’t know how much faster it really goes in the end. I think it’s great that there is energy and there is reasons why we want to make this happen faster, but I think it’s — yes, it may still take some time.

Samik Chatterjee

Okay. You mentioned on the last earnings call that you are already qualifying or sort of sampling some products with your customers. Maybe help us think through what that timeline looks like? Where you are today? How much sort of — how much of a timeline does it look like when you’re at that spot to sort of get something commercially into the market? Just trying to think about lead time to revenue here.

Ita Brennan

I mean, we do have some revenue today coming from AI use cases. It’s hard for us to track it exactly, because it’s, obviously, the 7,800 platform that’s being deployed, and it gets deployed into DCI and other use case as well. Right? But there is some — some traction around AI with that platform, but again, it’s small. Right? So I think it’s more — as customers kind of vet the solution and then start to deploy, we’ll start to see some more revenue. But again, I’d go back to Jayshree’s comments on the call. I think it will take some time for it to become a meaningful revenue driver.

Samik Chatterjee

When you say you track the use cases that this might be going into and it’s difficult. I think there has been some confusion on the investor side just given some of the other companies, including semiconductor companies mentioning more sort of exact revenue numbers that they’re doing in terms of AI chips. I mean, is it really that easy to discern at this point what’s going into AI use case for you? What’s not? And how are you classifying it? Are you looking at, like, the customer — do you have visibility into what the customers using it for? Or is it more of like trying to triangulate based on what chips are in those systems?

Ita Brennan

Yes. I mean, it’s not something that I can — that we can count kind of from a financial system with a very nice kind of black and white delineation, right? Which is, obviously, where we’d like it to be, because it’s a multi-use product set. Right? It’s not just an AI platform, and the 7,800 is our [workhorse] (ph) product that we will deploy into large spine use cases across the business. So it’s hard to get a very specific number. It’s much more qualitative when you try to put some numbers around that.

Samik Chatterjee

Okay. I think one of the things that’s come up is, obviously, Arista has gained a lot of share over the years and used the 100 gig and then the 400 gig as a key driver of share gains. As we think about AI, does it create an opportunity for further market share shifts, either in favor or does it open up more of the ecosystem to more suppliers, new suppliers to come in, how do you ensure you stay on top of sort of continuing that progress on market share?

Ita Brennan

Yes. I mean, it all still comes back to execution. Right? I mean, I think we’ve gone through multiple cycles coming into the 400 gig cycle. There was a lot of concern at the investor level about, could we maintain our position? I think we’re very happy with kind of how we came through that cycle. But it’s all about execution. So now you need to go do that again at 800 gig. But I think the more in times of change and customers having new demands, new needs, new use cases, that has favored Arista in the past. Right? And I think that the team is kind of excited about getting involved in some of those and helping to solve some of those use cases. But again, you have to execute. You got to deliver good quality products early in the cycle and have them scale. I mean, that’s the key to this. And so, we just need to stick to the playbook, if you like, and continue to execute on that.

Samik Chatterjee

Just going back to your last Analyst Day, you talked about a five-year revenue CAGR of 20%. As we look to future periods and I think this is again sort of asking you to think about what the AI sort of in relation to magnitude could be, but is this sort of natural to expect that when you think about longer term revenue CAGR, AI is sort of additive to it overall?

Ita Brennan

Yes. I mean, again, I think it’s hard to completely separate those at this point, right? I know some of the industry analysts have tried to put some numbers on kind of what an AI high speed switching, Ethernet switching number would look like. I think it’s extremely difficult to do that. Right? Because, again, it comes back to just how fast can you kind of resolve some of the technology issues, how fast do you have the new products and then, how does it ramp. So I think, for us, again, we come back to it more as it’s underpinning healthy growth, hopefully from the hyperscale piece of the business in particular over a period of time and a good period of time. And I think that’s very positive to come back to kind of, again, what slope the curve is like? I don’t think we have a good answer to that yet.

Samik Chatterjee

Okay. Staying on the topic. I think you said there are some modest amount of revenues that you’re seeing on the AI use cases. I think one of the question that coming up is, how much of the, like, your key customers like Meta have already been doing some level of AI investments, how much have you been able to leverage of that already? Particularly any insights on sort of which technologies each of your customers are trying to favor related to Ethernet versus InfiniBand? And Meta did have a recent announcement in terms of just sort of setting their priorities in relation to how they want to invest in AI versus the non AI sort of infrastructure? How do you think about implications on your switching business from that?

Ita Brennan

Yes, again, I think there’s going to be multiple paths here in terms of how these customers are going to go address this. Right? And it’s — we were talking earlier today about when there is lots of changes and the technology shifts, it’s messy. Right? So there will be — we will see customers have multiple different strategies. We’re going to see them have phased strategies. We’re going to see them try to drive efficiencies and drive better cost outcomes as they move through this. Right? And that’s not unusual when you’ve got kind of new — lots of new products kind of coming to market around the same time. So I think we’re going to have to work through that with each of these customers over the next while. But again, we have that relationship. So we do have kind of that engagement, but it’s going to take some time for us to work through it.

Samik Chatterjee

Ita you keep referring to that the ecosystem needs to build out further like on the Ethernet side, particularly to compete with InfiniBand. Traditionally or historically you’ve sort of taken the approach of more partnering on that side to really help it out. But as you think about where you stand today, is then this sort of a more active evaluation of whether you can sort of wait to partner with companies or do you want to sort of take a more active approach in vertical integrating and helping the ecosystem build out quicker?

Ita Brennan

Yes. I mean, I think the ecosystem — both of these technologies have to evolve if they’re going to satisfy the need. It’s not just that Ethernet has a challenge, you also have InfiniBand being limited in terms of how it scales, et cetera. So there’s going to be need to be development on both sides of that equation. Right? So I think it’s — on our side, it’s more as we move through these speeds, obviously, that will be optics and other things that come with that. We still don’t believe you have to control an individual entity to make that effective. You really want to be able to influence the ecosystem. Right? And I think we do a good job, a very good job of kind of engaging with the different partners and helping to kind of drive a road map, drive an outcome, and not having to choose or become an individual player there. You get a lot more leverage and ability to influence the ecosystem when you’re somewhat neutral. And you can help drive that road map. So I think that’s still the strategy. It has been effective for us, and I think we’ll continue to do that over time.

Samik Chatterjee

Let me open it up and see if any questions the audience has. Just wait for the mic. Sorry.

Unidentified Participant

Hi. Good afternoon. Just on the AI revenue opportunity, is there any sort of conceptual framework you’d be comfortable providing in terms of how to think about that specifically with respect to maybe as an attach rate to GPU sales. I mean, the concept being for every $100 you spend on GPUs, maybe you need making up a number of $10 of networking equipment to prevent any bottlenecks developing in the data transfer network? I mean anything similar to that that you could frame for us to help us quantify or think about that?

Ita Brennan

Yes. I mean, I don’t know that we’re quite there yet. Right? We haven’t offered or that we have enough kind of experience yet to be able to kind of build out that type of framework. Right? We’ve seen some very early data about the network being a bottleneck and causing kind of underutilization of the GPUs in certain cases. But again, that was a very early kind of point in time scenario. So I think we’re not quite there yet where we could kind of create a framework that will be predictive. I think we need to see some more experience before we’re going to be able to do that.

Samik Chatterjee

Any other questions?

Unidentified Participant

Thank you, Ita. You mentioned optics being one of the things that you guys are thinking about or working with? Can you just describe that ecosystem? When do you think that it could be really adopted in scale? I know that there’s a lot happening in innovation, but if you could just elaborate a bit more on your optics comment?

Ita Brennan

Yes. I think as we work towards a new product set, new speed transition, one of the things that’s important is to kind of work with everybody in the ecosystem to make sure that there’s alignment on all of the other pieces that we don’t necessarily control, but that you want to have kind of happen and be viable so that you’re able to kind of move at the speed that switch wants to move at, basically. Right? So we do spend quite a bit of time. The team spends quite a bit of time working with the different players in that optical space to make sure that there’s kind of clarity around what are their optics needs and how can they best be solution as we go through these cycles, right? And again, I’m not probably not the right person to try and get into the very specifics of those technologies, but that’s kind of a — you’ll here Andy, for example. Andy Bechtolsheim, our Founder talk a lot about optics. The reason why is, obviously, because you’re trying to make sure that there is a clean path for kind of the switching and those products coming to market.

Samik Chatterjee

When you think about your business today versus three years ago, would you say there’s been a shift in the importance of owning the customer relationship versus having the best product?

Ita Brennan

I think we’re fortunate that the best product is still super important in networking, right? And even — when you think about kind of these — even these large customers, they tend to want to buy best of breed. They tend to want to focus on and they’re very capable of putting all the pieces together themselves. Right? So they really want, like, technology drivers and technology visionaries, if you like, people who can help kind of plan ahead and solve problems for them. So I think that’s — that engineering to engineering connection is still fundamentally important and then executing against those, right? You can own — you won’t own a customer relationship for very long if you’re not kind of bringing the products and the technology to market and delivering kind of on what you commit to.

Samik Chatterjee

Okay. Let me take this question that came in and see if you have a comment on this. It says, could you comment on Ethernet versus InfiniBand debate? How that is evolving with AI? How could open source AI models change the dependence on vendor specific GPUs and InfiniBand for AI.

Ita Brennan

I’m sorry. Can you read that again?

Samik Chatterjee

Just the reliance on GPU and InfiniBand does the technology, so the same — pretty much the same question.

Ita Brennan

Yes. I mean, I think our view again is best of breed, best solution is what’s going to win out here, right? And they’ll be — each of these pieces will end up being evaluated on their own merits. And again, for the switching piece, we think Ethernet will have a role to play. And when you’re in that Ethernet space, we believe we have a role to play in that. Again, lots of work to do, but I think that’s kind of the — that’s how we see this.

Samik Chatterjee

Let me switch gears here. You’ve talked about engagement with Google as a customer sort of starting to build up a bit and Anshul has talked about it. Any sort of update on that, where’s progress? I think one of the questions we keep getting is then sort of when — how should we think about the insertion opportunity there? When is the right time? Is it really related to AI? Is it more related to sort of think about the next speed, 800 gig, how should we think about it?

Ita Brennan

Yes. I mean I think we’ve talked about this a little bit. There’s always been lots more discussion about it, that’s not necessarily originating from us. But I think, yes, from a technology perspective we’ve done some work. We’ll continue to do work there. At the end of the day, it’s going to be the customer’s decision. Right? If they want to deploy more broadly with the products, I think our job is to make sure we solution any technology gaps, et cetera. And then it’s really going to be up to the customer from there. There’s really nothing new to say to that until and it’s really their decision.

Samik Chatterjee

Okay. Coming back to the core business, if we talk about the 200 gig, 400 gig upgrade cycle, where are you in terms of those upgrade cycles with your two key customers there? And sort of how should we think about the length of that upgrade cycle? What are you seeing in terms of growth rates on those?

Ita Brennan

I mean, I think we saw probably first revenues, real revenues, material revenues and leveraging that silicon. And again, it’s kind of 100 gig, 200 gig, 400 gig. Right? It’s just the silicon’s been used to build its products with various different configurations depending on the customer and depending on their architecture. But we saw that first revenue probably back end of 2021. Right? So we still have — there’s still a fair amount of time left where you will be deploying these products right through until you have the next silicon and then you’ll see those 800 will get added to that, but you’ll also probably have a whole new slew of 100 gig, 200 gig and 400 gig products that leverage that silicon. So the cycles have become — it’s a little bit more complex, it’s not like there’s a black line between one cycle and the next. It’s just leveraging that silicon to get you the best, the densest, the best cost per port kind of at those various speeds. So I think 100 gig’s going to be with us for a long time. It’s just going to transition through the various silicon products.

Samik Chatterjee

Okay. And then sort of if I put that in context of what you just outlined at the start of the discussion in terms of a slowdown in the growth with the cloud companies, because they go through a digestion. So what you’re really sort of indicating is, the slowdown on account of some of the CapEx cuts that they’ve announced. I mean, help us think through sort of when you think about drivers of that slowdown, how much of that is just not as many new data centers coming in versus a slowdown in the upgrade cycle because you’ve gone through the peak of that?

Ita Brennan

Yeah. I think — look, the CapEx actually is — if you look at their CapEx, publicly shared CapEx numbers, it’s been reasonably resilient, right, through this. But there is a lot of — they’ve had a lot of discussion around optimization, improvements, et cetera. They’re sorting through kind of what their priorities are and what those are going to look like. So it’s not like we have perfect knowledge about what happens next with them, but I think having gone through the cycle between 100 and 400, it beholds us to think that there could be some cyclicality there. Right? And we’ll start to understand that better once we get closer to the end of the year. They’ve grown, we definitely think it’s going to moderate off of triple digit growth last year and healthy growth again this year. Where exactly that ends up? We’re just going to have to wait a while to get some bottoms up validity around that. Right? They’ll continue to spend for sure the questions at what level and what does that look like.

Samik Chatterjee

Okay. Pulling back a bit to the aggregate company level, not just cloud. I think most — you don’t disclose backlog or what’s happening with orders, but most of the other networking companies have this dynamic of backlog moderation orders being down double digit. How can we think about and sort of any ballpark way of thinking about your — what you’re seeing, which are the customer verticals you’re seeing sort of the most slowdown in terms of momentum? And in terms of when you think about backlog and sort of winding down that elevated backlog, when do you expect to have that sort of back to a normal level?

Ita Brennan

I mean, I think, look, we never talked about orders on the other side of this as well. For the simple reasons, it didn’t really make any sense, right, to take extended lead times, three, four times, extended lead times, orders were always going to be distorted by that. Right? So we try to stay very focused on let’s understand what needs to be deployed and when, right, and continue to kind of execute against that deployment schedule. What we’ve talked about now is, obviously, lead times are getting better. Visibility will reduce. Right? That’s not necessarily good or bad in itself. Right? It’s really more about when will you know kind of what that next period of time looks like, what that new — that next piece of business looks like. And instead of knowing that 12 months out, you’re going to know that six months out. And we have to work through that. We’re just moving back to a more regular lead time based business. Again, what actually happens is going to be more dependent on the things we’ve talked about. Right? Where do customers want to spend? I think our enterprise businesses remained reasonably robust so far, so we’ll see how that continues. And then we’ve had kind of the hyperscale conversation already.

Samik Chatterjee

Commentable enterprise remaining resilient, that’s [indiscernible] not just the revenue.

Ita Brennan

That’s engagement. I’m going to stay away from the order discussion just because, again, it’s all tied into the whole lead time extension and contraction just to start the whole thing. But engagement with customers, customers upcoming, winning customers, et cetera. I mean, that has remained reasonably resilient.

Samik Chatterjee

Okay. Let me just open it up again and see if any questions or I can move on to other parts of the business.

Unidentified Participant

Thank you. Just as a follow-up to my question before talking about having the best product being key. Is that the best product for the industry or is there any differentiation in terms of the best product for an individual customer? And if you’ve worked with that customer over time, does that put you in a better position to keep producing the best products for them?

Ita Brennan

I mean, I think there’s a base, obviously, level of discipline around software and hardware development that needs span all customers. Right? And then there’s a lot to be said for having these technical engagements, direct technical engagements with the R&D teams on both sides and planning for what that customer specifically needs. Right? I mean, ultimately, you’d like to be building a product that’s as leverageable and transferrable as possible. And we’ll always try to do that and find the best solutions that fit within that framework. But when you’re working very closely with a customer then being able to kind of solve their specific needs is very valuable in building relationships, solving problems, responding quickly to issues and problems, because stuff happens. It’s how fast can you — how quickly can you solve problems, fix problems. Those types of things are what build that customer experience and customer relationship. Can you have your customer look back on the last period of time and say, okay, that was a good strong technology partnership. That’s really important. That everybody remembers everything that ever happened to them in their data center in this industry for a very long time.

Samik Chatterjee

I’ll take this one that came in. How would you describe the relationship with Broadcom and the establishment of a long term supply agreement? Do you think the relationship could change in the future? Any chances of having a second supply?

Ita Brennan

Yeah. I mean, look, we have tried leveraged every merchant silicon option that has come along. So there’s no reticence in our part to go look at other suppliers, and honestly, Broadcom understands that. But it all comes back again to performance. They have executed really well on product by product, multiple families, they’ve moved faster than everybody else. And that’s — at the end of the day, that’s why the partnership works so well, because they’re doing everything that they’re supposed to do, we do what we need to do when you get to a compelling overall system solution. So hopefully that continues. I mean, they’re certainly very vested and interested in continuing to execute well in this space and they’ve been a good partner.

Samik Chatterjee

What is Arista lacking to gain higher traction in the service provider segment?

Ita Brennan

Yes. I think, we did not try to go back and rebuild all of the protocols and all of the software that have been deployed in that part of the business historically. We started out in switching, then we moved to routing. When we moved to routing, it was kind of switch router based product set with a completely new set of protocols to support that routing capability. So we need kind of the — we need the technology to shift towards cloud, which we believe it will eventually because that’s the best most cost effective solution, but it’s going to take time to do that. I don’t think even if we had gone back and retrofitted it, we would necessarily won because there’s lots of suppliers there doing that for a long time. But we believe if and when they move to that more cloud based kind of architecture, then we have a credible seat at the table, but that needs to happen.

Samik Chatterjee

I did want to go back to the long term supply agreements. And I think the biggest thing that stood out from the last earnings report was really the inventory increase on the balance sheet. I mean, you sort of explained some of it as the sort of the product that’s coming in as — on account of the supply agreements that you have and the purchase commitments that you’ve already done. How should we think about when does the inventory on the balance sheet peak on account of that?

Ita Brennan

Yes. I mean, there’s, obviously, lots happening around supply now. We’re very focused on kind of putting all of that back in the box. I mean, you had to kind of take things out of the box to make sure you had products and that you could supply products, now we’re kind of starting to put things back into the box. We’re starting to see lead times come in across a lot of components, and we’ll make sure that we benefit from that and that we leverage that and that we drive that. On the long lead time key components, obviously, we have to still live with the current lead times, and that’s some of what you’re seeing in that inventory build is really the build on raw materials for those key components. I think by the end of the year, we should start to see kind of the inventory flatten out and start to come down. We brought the purchase commitments plus inventory down about $400 million in this quarter just gone. So we’ll continue to drive kind of that back to more normal terms here over the next while, but it’s going to take a while because we knew we were in a multi-year kind of component game. So it’s going to take time to unravel.

Samik Chatterjee

Switching to margins on this question, it says you’ve consistently outperformed on the operating margin. Do you think you could envision the possibility to have a higher optimal gross and operating margin framework in the next three years?

Ita Brennan

I think we’ve still come back to — we’ve talked about this plus or minus 40% as a longer term operating margin model, assuming that we can find things that are accretive to the business and to the growth to invest in. And I think that’s still the way — the right way to think about it. We will outperform that sometimes, especially in periods of accelerated growth, top line growth, because you obviously don’t spend to that peak, you shouldn’t spend to that peak. But I think over time, we will reserve the right that if there’s things we can do that kind of will help the business in the future that we should go and make those investments.

Samik Chatterjee

Last quick one, capital allocation priorities. You’ve been building cash, and I think everyone sort of scratching their head what you do with it.

Ita Brennan

Right now, it’s an inventory to some degree, some of it anyway.

Samik Chatterjee

But how do you think about the uses of it longer term if you continue to sort of partner with companies rather than go the buy route on them?

Ita Brennan

Yes. I mean, we’ve been returning — we just looked at the capital, the repurchase program since its inception, and we’ve returned 50% roughly of what we generated, which is kind of what we set out to do an offset dilution. So I think that’s our baseline. It is opportunistic. We’ll continue to be opportunistic, but that’s kind of the baseline. And then once we’re through the working capital stuff, we can see kind of what do we do with that program in that environment, but for now we want to get through that.

Samik Chatterjee

Great. I’ll wrap it up there. Thank you. Thanks for the time. Thank you everyone.

Ita Brennan

Okay. Thanks for much. Thank you.

General Motors Company (NYSE:GM) Morgan Stanley Annual Sustainability Conference Transcript May 23, 2023 12:00 PM ET

Executives

Kristen Siemen – Vice President and Chief Sustainability Officer

Analysts

Alejandro Zambrano – Head, Transportation, Calvert Research and Management, Morgan Stanley Investment Management

Unidentified Analyst

Okay. Hi, everybody. We’re going to try to wake you up or preempt your food coma right now. But I really am excited with this session and have the privilege of moderating Kristen Siemen, Vice President and Chief Sustainability Officer of General Motors and then to Kristen’s left, we have Alejandro Zambrano [ph], who is the Head of Transportation of Calvert Research and Management, Morgan Stanley Investment Management.

We’re going to have a discussion about the important topic of decarbonizing and decarbonizing the automotive value chain, the automotive business model and some of the challenges and opportunities that Kristen and General Motors company has facing them through this transition.

Just a few remarks from me. I’ve been at Morgan Stanley for almost three decades and I feel more and more of my time spent looking back at the history of the auto industry from the period, for example, from 1908 to 1913, when the Model T was introduced, when the moving assembly line was introduced, when Durant and the founders of General Motors were agglomerating these businesses and coming up with their company over 100 years ago.

And we really are witnessing history again, where the topic of energy transition in autos and the enabling technologies in the supply chain. This is evolving, I mean, we used to say hundreds of billions that got out of style. I always say trillion. I mean this is like dekatrillions. I mean this is tens of trillions of investment and transfer of wealth over decades, because this is not going to be a quick win.

And I spent a lot of time thinking about the trade-offs, okay? The battery supply chain, for example. We all want EVs, right? Everyone wants an EV and that’s great. EVs will help save the world, right? We’ll hold on a second.

Where does your EV come from? Where are those materials coming from? How are those materials sourced, because there’s a couple inconvenient truth about the battery supply chain, the EV battery supply chain specifically which involve geopolitics, up to 90% of the upstream battery supply chain is refined and processed in China, okay, good on China, that’s fine. They had an industrial policy to skate to where the puck was going and they really be in a dominant position there.

But if we want a quick energy transition in the west, are we going to do that while flipping our supply chain to economic rivals and have no control over own economic destiny. The Department of Energy doesn’t think so. The Department of Defense is it also doesn’t think so, doesn’t want to do this.

Then aside from the geopolitical entanglement of the supply chain, we have the ESG and emission inconvenient truth of the supply chain. I was told and it’s been confirmed by many automakers. Kristen, if I’m wrong, tell me that in a nickel-based cathode battery that you’d have to drive a Tesla on solar and wind power for five years just to offset the coal emissions from refining the Grade 2 Pig Iron in Indonesia to the Grade 1 Pig Iron,, to the Grade 1 nickel that then goes in the nickel-based battery.

So we have to — as we get greater transparency on the supply chain on the batteries, not just for emissions, but water usage, land usage, tribal land rights, filed labor issues, anyone I — if you study the cobalt supply chain in the DRC, it’s hard breaking. Where is your blood battery come from?

And so the challenge is to try to solve a major ESG problem and an energy transition problem without creating new challenges faster than we’re solving them. And so that’s what we’re spending a lot of time looking at within the auto industry and trying to pick opportunities and risks along the value chain, all the way upstream, working with our partners in mining and refining and chemicals and cap goods and semiconductors and batteries all the way downstream to electric utilities and recycling and charging infrastructure.

So, with that, and I want to pass it on to you to kind of describe a little bit about what your mission is…

Alejandro Zambrano

Yeah.

Unidentified Analyst

… on the investment management side and how you’re spending your time and then we’re going to go to Kristen and open it up for Q&A.

Alejandro Zambrano

Sure. I think your introduction was great. And yeah, we’re spending a lot of time too. I would say, sometime not too much materiality of intended consequences of the transition. And we’re trying to see in the long-term those are going to play out.

And the IRA, in fact, is quite helpful for us, for my analysis, because it’s making that supply chain quite transparent. It’s making the company disclose information and they wouldn’t disclose otherwise to the public. So it’s given us a lot of visibility on how that supply chain cluster is being built.

But we still need to understand in the long-term how the companies are going to deal with declining authorization rates globally, deal with impact to communities, as you said, of mining of some of the metals in North America, in the U.S. or in FCH [ph] countries that have deal with the U.S. and we want to understand how the business is going to look in nearest. If it’s going to be a company that is twice the size that it is today that is just selling addition — everything that is selling electric is additional to what it sells today or is it going to be a company that is selling of the same size that is just selling dual Bright, Spring [ph] technology and what that — how that’s going to impact the manufacturing footprint on the existing assets.

So will the company still have 90,000 employees in the U.S. in 2035, will the company still have four manufacturing plants in the U.S. in 2035 when the transition continues to happen. And we look at those because, at this point, we believe that we are at a stage of execution of an environmental strategy for the car companies.

So looking at the supply chain will give us a lot of visibility on that and at the targets and how the models are performing. Now they’re starting to come out of the manufacturing facilities. But if we’re building this cluster where it doesn’t exist, we need to understand what the social issues are going to be.

So we’re spending a lot of time looking at how companies’ governance, I guess, strategies are changing as a result, how the Boards are changing as a result, how compensation is changing as a result to ensure that this cluster that is in the process of being built here in North America actually doesn’t face the issues that we have with the energy industry or the mining industry today. We don’t want to be in 10 years, in 20 years where we are today in the extraction of natural resources.

So that’s kind of like the approach we’re taking. And in the end, we care about what could erode value or create value for the business in the long-term. So that’s our challenge. We have to quantify things that are pretty quantifiable. We have to then try to understand how that’s going to make the company stronger and then we have to essentially rank these companies to see which ones are better point for this transition. So that we’re doing at Calvert and that’s the piece of IT that we provide to the larger investment management in Morgan Stanley in understanding how this transition is being carried out.

Unidentified Analyst

Thanks, Alejandro.

Alejandro Zambrano

Yeah.

Question-and-Answer Session

Q – Unidentified Analyst

So, Kristen, also some of the key messages for General Motors sustainability strategy and energy transition and how it might differentiate from some of your competitors?

Kristen Siemen

Sure. So, I mean, we’ve made some big bold goals like a lot of companies, right? Our plan to be carbon neutral in our products and operations by 2040. We plan to eliminate sale type of issues from new light-duty vehicle by 2035. We’ve made some big announcements in the past year of our renewable energy strategy. Our original strategy we set back in 2016 was to be 100% renewable by 2050. We saw that we could actually accelerate that based on a lot of the agreements we had made. We bumped it up to 2035. And then last year we actually — so we can be there in the U.S. by 25%.

So we saw the goal to keep — we actually beat that one by 25 years in the U.S. So that was a big accomplishment for us. A lot of other initiatives in place. But I think at the core at GM, our sustainability strategy is fully ingredient with our business strategy. They’re one and the same. And so it’s doing things to ensure that the company is planning for value, planning for growth, focused on the future, things like energy efficiency, water efficiency, waste elimination.

Those aren’t just good for the environment. They’re very good for the business. And so we continue to focus on how we meet those strategies in and really make sure that the company is resilient and looking at things like sustainable supply chain, et cetera. But they’re really weave together throughout the company.

Unidentified Analyst

So what I like about your background, you’ve been at GM for 29 years.

Kristen Siemen

Yeah.

Unidentified Analyst

27 of those years in product development.

Kristen Siemen

Correct.

Unidentified Analyst

You told me that when Mary called you to say we want you to do…

Kristen Siemen

Well, won’t Mary, who called me, but, yes.

Unidentified Analyst

When you got the call…

Kristen Siemen

Yeah.

Unidentified Analyst

… to be CSO at GM, your response was, why me?

Kristen Siemen

Exactly.

Unidentified Analyst

But I like that you bring to this to the role, the science and the product development background to be able to call BS on something that just doesn’t smell right and to see the challenges and be open and honest and realistic about them.

Kristen Siemen

Yeah.

Unidentified Analyst

So my question for you is, how the hell did you achieve the carbon neutrality 25 years earlier?

Kristen Siemen

So, the renewable energy one is a great example of setting a goal, it was the renewable energy commitment that we achieved early. And when we first set some of these rules, it’s kind of okay, we can see a path to get there, but we’re not exactly sure what the steps are no different than engineering of products and we set goals on price and cost and range and everything else. And you see a path, but it’s not identical, right, of each individual step.

And so, what we did by getting an early working with utilities and projects from a solar lens standpoint, we really found that we were able to not only find projects that were good financially, but some that were in the communities where we are building and really working together.

We participate in founding members of CEBA, Clean Energy Buyers line. And so as part of — we have a four-pillar strategy around renewable energy. The first is energy efficiency. So everything we can save and reduce is good for the bottomline. The second is around sourcing renewables and finding a way to add additionality and really grow that market of decarbonizing. The third is around resiliency in things like backup storage, things like GM energy and things we’re doing there. And then the fourth is around policy. But as we look at that four-pillar strategy and really put initiatives across the Board, it’s been successful.

Unidentified Analyst

And I’d love to know, as you approach the kind of talent of things that GM can do to continually improve efficiency and emissions and sustainability. What we’re — in addition to renewable energy, what were some of the areas of lower-hanging fruit and what are some of the things that are just really like the very high hard-to-reach fruit that, frankly, maybe you need to work with policymakers on achieving.

Kristen Siemen

Yeah. I mean if you look at our — I mean, if you take our carbon footprint as an example, right, less than 2% of our carbon footprint is Scope 1 and 2. So renewables are attacking a very small piece of our carbon footprint.

And the rest is Scope 3, which is the same for most companies. For us, 75% is the customer usage of our vehicles and then the next big — so, obviously, our transition to EVs will take care of that, assuming the grid is decarbonized and we get to charging with green energy 100% of the time. The next biggest piece is our supply chain, which is around 18%.

And so as we look at those, obviously, the transition to EVs, as I said, is that’s our business strategy. It’s a growth strategy. It’s a future of where the industry is heading. On the supply chain, we’re working very closely with our suppliers.

Last year, we issued — actually in 2021, we issued a supplier pledge and ESG pledge, where we’ve asked our suppliers to also sign up for their own both carbon-neutral goals, as well as the minimum score on EcoVadis. So a way for us to ensure that we’re getting at things like labor relations, force labor time labor, et cetera, throughout the supply chain as well.

And so far we’ve had over 70% of our Tier 1 APV have signed on. And what we’re seeing, which is great, is they’re now doing the same thing with their suppliers and so it’s really working as we had hoped and planned that it’s going down through the supply chain to Tier 2s or Tier 3s or Tier 4s to ensure that these things are progressing the way we want to progress.

And then we are helping each other with how to do renewable energy agreements, looking at ways to make this supply chain more sustainable, more resilient, more reliable and so when you ask what’s the toughest, obviously, the transition is the biggest piece in the grid and really getting to green energy across the Board is going to be tough. But it’s those two categories that I’d say we have the most focus on.

Unidentified Analyst

And just one more for me. I want to ask Alejandro. But on the supply chain side, we’re talking for the panel that if we’re going to onshore battery supply chain and we’re going to do the upstream stuff, extraction, refining processing. We’re going to have to do it very differently from the way it’s done. Audi in Far East. What are some of the technologies that GM is investing in right now to help not just accelerate onshore, but to make sure it’s done in a way that is equitable and got in a more renewable way.

Kristen Siemen

Yeah. I mean I think if you look at the agreements we’ve made, and as we talked before, we have all of the raw materials lined up for — to meet our volume goals for 2025 and now we’re working on 2026 to 2030 and we’re well on our way to that.

That’s really looking at how do we bring as much into North America as possible and how do we ensure that it’s done in again, a very sustainable way. And so there’s companies like control thermal resources out in the Salton Sea in California that are able to extract lithium in a less carbon-intensive way.

And so finding solutions like that, finding companies that have commitments and goals, whether it be Hosco, the joint venture in Canada around cathode active materials or some of the things we’ve even done all the way down to Lithium Americas, which is extracting on their own as well.

So trying to find the right partnerships with companies that have the same goals, beliefs and objectives that we do, I think, is really the key to the ultimate solutions. And GM is very committed to ensure that we’re part of that success and we talked to kind of the make versus buy earlier as well and so it’s finding those critical materials and insuring. We learned a lot through the last few years of supply chains and where we have to be strategically engaged in these stuff of the process.

Unidentified Analyst

I’ll stay with the topic then. So something that we’ve observed at Calvert is that especially the Japanese and Korean OEMs are very comfortable being fully vertically integrated. They’ve been like that for a while. But the U.S. OEMs, they basically ended that structure and created the per system of suppliers. With the electrification change, it looks like we’re going back to the vertical integration all the way to the metal in the buying. So my question is, when you’re assessing you brought the lithium, I guess, example, okay, you’re assessing that project, lithium more versus lithium brine but ESG factors coming to that. Is it purely a financial decision or is it — are you taking into account the emerging risks around local communities, water usage, which could in the end, if you going to talk about financial materiality or own brand value.

Kristen Siemen

Right. Yeah. It’s definitely all in. In fact, so one of the things I do at the company is around what we call an Office of Sustainability and this have representative senior leader level representatives from across all of the various functions, everything from purchasing and supply chain to marketing, manufacturing, et cetera. So that we can come together and talk through these major initiatives.

So when we’re looking at a company, when we’re looking at a partnership or a new agreement or initiative to sign on to, we’re all evaluating it for our functions and to ensure that those things aren’t being ignored.

As far as where we engage and where we don’t, when we talked about the vertical integration, in reality, our propulsion systems were very vertically integrated throughout the company for years. And so if we look at electrifying the propulsion system, it’s very consistent with what we’ve done traditionally.

So finding those things where we believe either we need a competitive advantage to be engaged earlier in the supply chain or where maybe there’s a supply risk, et cetera. And so all of that is factored in, including all of the ESG aspects.

Unidentified Analyst

When it comes to — we were doing some analysis recently and roughly 80% of the EV capacity on the passenger vehicle side outside of China is coming from five cell makers that are working with OEMs globally. So we see a very strong concentration there and we see potential emerging risks from our ESG perspective, Alejandro has views on the fundamental side. Have you thought about that? At GM I know you’re working with GM, Samsung, but micros, I believe. Have you thought about it? How would we approach that is?

Kristen Siemen

Yeah. I mean I think the LG partnership is a great example, it’s a 50-50 joint venture on the cell manufacturing. I mean we have one plant producing already in the U.S. The second one is about to come on Board. Third one in construction and the fourth one announced, the fourth one with a new partner.

But GM is very knowledgeable and has a lot of expertise in the manufacturing, the quality effect to take that and partner with the chemistry that LG has. It’s been a very successful joint venture, as well as we continue — I think a lot of people forget you talked about looking back in the industry. GM has been doing electric vehicles for over 25 years, right?

And so there’s still engineers that worked on those early chemistries and early vehicles that are working on it today and advancing. Every day there’s new and more innovations. We just built a new innovation center in our tech center around battery chemistry and cell development.

So that innovation in those new technologies are going to continue to happen every day in advance. And so I think it’s finding the right partners for the right reasons and then also continuing to do our own development as well.

Unidentified Analyst

And the other one, if I may add, I don’t know. I don’t want to take your time, but when — so we are all very excited with the IRA. There’s an expected boom in construction. Labor markets are going to be doing relatively well. We’re starting to think about once this boom passes talking about 2035, when you’re already selling over 1 million EVs. How do you think about that — kind of to my initial point, the size of the business? What’s going to happen to those facilities that cannot be retool, that has to be shut down. What’s going to happen to those communities in those places where you’ve had a footprint for 100 years. Have you thought about that? Do you take into account that when you decide these long-term strategies?

Kristen Siemen

Very much so. And I mean, I think, our track record to-date shows that we do care, right? I mean, we continue to transform our facilities where we are today. So things like Spring Hill or in assembly factory in Detroit Hamtramck. And so even our parts facilities that we’re making compo for some of our ICE engines are now transitioning to build electric drive units.

And so very much a commitment to those communities where we live and work. It’s very important to us. And so I think we’ll continue to evaluate as we go forward and keep making those important and strategic decisions of where it makes a lot of sense. But very committed to be in localized, yah.

Unidentified Analyst

I wanted to give the audience a chance to ask any questions, your questions.

Unidentified Analyst

[Inaudible]

Unidentified Analyst

Just want to make sure people heard that question on autonomous driving and how that factors into your mission?

Kristen Siemen

Yeah. I mean are you asking the question in regards to the carbon footprint aspect of autonomous driving or?

Unidentified Analyst

Yeah.

Kristen Siemen

Yeah. I mean, certainly, if you drive a vehicle, I’ll go back to my engineering things here now. If you drive a vehicle on cruise control, you’re going to get the most efficient performance of the vehicle. And so from a range perspective in that with autonomous driving, we’re certainly — it’s certainly an advantage from that standpoint.

And what it does to — if you look at the bigger ESG aspect and the social piece of what autonomous driving does for communities and offers that freedom, our autonomous vehicles are EV vehicles and so it plays directly into our overall strategy and business strategy.

And again, as we can transition more of the grid from a decarbonized in the grid, be able to charge those with green energy, with the zero emissions gain that plays right into our overall business strategy.

Alejandro Zambrano

Can I add to that just from our research lens? Your question is — involves a lot of trade-offs. I mean, 120 people dying every day in this country in traffic fatalities and growing. 15 times that of serious and capacitating injuries. 3000 deaths globally per day in traffic fatality. So the life-saving injury saving aspect is huge. Anyone in this room has been affected by automobile tragedy. Statistically, there’s a number of you, what I’m talking about.

If you’re able to match supply and demand of transportation as well through autonomous network, there’s hope that you can increase utilization of the car park, which is woefully underutilized is only 4% and we can produce less cars and there’s other ways for GM to make money instead of just making cars, you can have more recurring revenue.

But then there’s the unintended consequence that Elon talked about fairly recently and I agree with, which is, if you take the — if autonomy takes the price per mile traveled down from a $1 mile that $010 mile or some imaginably — unimaginably low number.

We tend to consume more of it and then you kind of have these dystopian kind of views of our infrastructure not being ready for just people sitting in traffic jam just coming away, just consuming some, I don’t know, living a metaverse I know way that your community base level would have taken something.

So this — we’re going to have to see how this goes. I’m very hopeful in our team at Morgan Stanley working with our colleagues, we’re very optimistic on autonomous technology, but we are trying to push. The more we learn, the more we realize, this is maybe the hardest thing you may ever trying to probably and that we try to solve and the regulatory aspect is also incredibly complex. So, there’s some stepping stones along the way and GM Super Cruise technology and other technologies are giving lives today.

Kristen Siemen

For sure. I mean, absolutely. I mean, you could go through all the statistics of, how much safer you are in a vehicle with those systems and particularly Super Cruise, which is very gated on safety, and ultimately, Ultra Cruise, which is coming, which is up to much more roads as well.

And the thing that autonomous also provides is there’s less of accidents. So now there’s less congestion on the road. You figure you’ve got less traffic incidents where you need police or ambulance or that type of thing coming to the scene. And so all of that plays together, I think, ultimately, frees up a lot of things to happen in really advanced things. But the safety aspects are tremendous.

And also the, I am saying again, my parents are aged, I am sorry, to — they’re not as quick as they were 10 years, 15 years, 20 years ago. And so I think of the freedom of what it will continue to give them where people with disability that now can have access to transportation that didn’t have access.

And we continue to follow on everything GM has always done has been gated by safety. I mean I kind of last — going back in my engineering days, we are driving around our text under or I’m sorry, our proven ground 15-plus years ago autonomously. It’s easy when you know exactly what route you’re on and what’s around you. And so, to think of where we’ve come since then it’s really amazing both the technology and capability.

Unidentified Analyst

While the audience thinks of our next great questions and there’s a couple here. Well, I don’t even have to ask if there were, you and then over here. Yes. Please.

Unidentified Analyst

[Inaudible] to describe the common competition with Chinese automakers. And I know in the U.S., historically, we’ve had some protections. I mean there’s some European brands I never even saw on U.S. road until they went outside the country. If that is the reality, what is the company like GM doing to try to, I guess, tackle that or deal with that potential threat?

Kristen Siemen

Yeah. I mean I think at the end of the day, it’s great products, it’s great services it’s a safety record and it’s who we are as a company. And I think we will continue to win based on the products and what’s available.

And there’s very few full-scale automotive companies out there that cover all segments and price points and we have a portfolio announced a number of EVs across that range, as well as other branches that are new to GM, which signify growth and value and opportunity, things like GM Energy.

So energy stores services, backup power generation, our BrightDrop, which is delivery services, both from a vehicle van level perspective, as well as small delivery cards for kind of that last mile. And all of those are new businesses that didn’t exist before and so provide more opportunities for us in the future.

Alejandro Zambrano

I think I heard that point as well earlier today and something that wasn’t route that point came was that most of the Western new OEMs have been working in China via JVs for decades.

Kristen Siemen

Yeah.

Alejandro Zambrano

So if somebody knows the competition that is coming are the Western OEMs, they essentially help build that industry there for decades. So I think it was a little bit Armageddon [ph] in my view how it was proposed, because there’s a lot of knowhow from Western OEMs and how cars are making China, what cars are made and what are the advantages of bringing their own brand.

Kristen Siemen

No. I agree with…

Alejandro Zambrano

What I would say, I mean, you got to make room. I mean, we saw this in the 1970s, after the oil crisis, people were rulings going to buy Japanese car, okay. I guess all that turns out. Then the 1980s and 1990s, no one’s going to buy a Korean car, okay? They’re making really a gas.

No one is going to buy a Chinese core. No, no, no. You don’t — you know these are really good cars. They’re very well made. Companies like GM help the local players make beautifully design and close the door. It’s like from Cocoon now like nice cars and they’re going to come. So what was described as blood bath, I would just say, it’s just another day in the office with General Motors probably, but.

Kristen Siemen

Yeah.

Unidentified Analyst

Question up here?

Q

On the fully autonomous vehicles, first question is, how far we reaching in urban dense areas for the autonomous vehicle, because it’s not by, okay, something you can get central, because there is a safety issue. You need sales close to 100%, right? There’s no margin of error. And the second, how do you think the competition from like Apple or tech companies just even from attracting talent? And third is, you think this is a secular effect that’s like a networking effect that the safer the algorithm, the more people use, the more data, I guess, we can take all markets, I hope business is expect to that?

Kristen Siemen

Okay. So let me try and remember the first question around the safety of autonomous in urban area. I mean, I think, you can see where we’re at with our partners at Cruise and we’re currently offering driverless taxis that you can inhale yourself in San Francisco.

Unidentified Analyst

Yeah. Anyone been in one of these [inaudible]

Alejandro Zambrano

I guess.

Kristen Siemen

At what was — what.

Unidentified Analyst

Amazing.

Kristen Siemen

Thank you.

Unidentified Analyst

No. I don’t think so…

Kristen Siemen

I don’t think everyone heard that word.

Unidentified Analyst

Yes. It’s pretty cool.

Kristen Siemen

It’s incredible. Yeah.

Unidentified Analyst

Yeah.

Kristen Siemen

And there’s, frankly, no more complex area to drive than San Francisco. And now it’s rolling out to other cities as well. Again, gave it on safety and the readiness for the technology. And so I think San Francisco and Cruise have proved what the technology can do and do it safely.

Your second question was around competition from, the automotive industry is not in an easy industry. Building and manufacturing a vehicle, if you’ve never been in the assembly plant is extremely complex and that takes years of optimization, understanding of quality and safety in all of the aspects.

And so I truly believe that we have a huge competitive advantage there based on what we’ve done, what we know and we’ll continue to see that apply across the Board. So — and then your third question was…

Unidentified Analyst

[inaudible].

Unidentified Analyst

Presentation…

Unidentified Analyst

[Inaudible]

Unidentified Analyst

Like at a local level when they take all because of the network effect on data.

Kristen Siemen

I don’t know.

Unidentified Analyst

TBD.

Kristen Siemen

Yeah. I mean, yeah, TBD, I guess, would be the best way to say that. I mean we want to make sure that we protect and we own the customer experience and how the vehicle drives, how it behaves, we talked about make versus buy earlier in the day. Things like our autonomous system that’s ours, right, our HS system, Super Cruise also that’s developed and designed in-house.

Unidentified Analyst

Our view — our take on that answer is, we think it’s winner-take-most at a localized level, not unlike an electric utility or an airline that has a local hub. You’re not going to have every single airline equally represented in every city, they’ll lend themselves to maybe natural monopolies or natural oligopolies over time based on a lot of factors, including geopolitics and the network effect and first-mover advantage as well. So we have about 10 minutes left. I know you love more questions for me, but I want to ask the Wall Street question. How do you make money doing this? I mean it does strike me that beyond the abilities and the installed base of invested capital and human capital that GM has and has brought to bear in energy transition and will continue to do. A critic could say, boy, this is an incredibly easy way to go out of business, trying to get into mining and into technologies that are not fully developed competing against players that might have superior scale and cost to you right now. So how do you reconcile those — the economic sustainability point with the environmental sustainability point.

Kristen Siemen

Yeah. I mean, well, I think that’s what I said at the beginning, right? Our sustainability strategy is part of our business strategy and they play together. I mean we’re in the business to make money clearly. And so I mean those apply agreements that make sense for the future, it’s continuing.

GM is based — it’s a technology-based company that’s been innovating for well over 100 years. We continue to innovate and drop. Our battery technology is using less and less materials, more efficiently, providing more range at lower cost and we will continue to do that and evolve that over the next generation of Ultium platform, et cetera.

So — and I think we know and have shown we know how to scale technologies and so whether it’s things like AVS that start in a smaller segment of the car park and it’ll continue to portray across the rest of the vehicle. So we’ve done it and we will continue to find those opportunities and make sure that their leads together.

Alejandro Zambrano

And actually, can I ask any quick follow-up on that. When looking at the way down to 2035 and looking at the emission goals that you have in the company and taking a position that in 2035 currently is going to have a cost, right?

We’re talking about, I think, it’s 150 million tonnes of CO2. That’s going to be the Scope 1, 2 and 3 for the whole company. If we assume $50 per tonne, that $17.5 billion, if you were to abate it. Have you — is the company developing a strategy for what’s going to happen once we get to the point when we reduced to half our CO2 footprint?

Kristen Siemen

Yeah. I mean our first prioritization is on eliminating it, eliminating as much as we can. So we talked about energy efficiency projects and all the work we’re doing there, the transition to renewables, as well as the grid itself is going to decarbonize over time also, right? And we’re doing everything we can from our small piece, but the rest of the transition is happening as well.

Then when you talk about what’s left, I mean, really, the big technologies that we’re still looking for solutions for our heating and cooling or facilities and paint ovens, are kind of the ones that are left.

And then in our supply chain, we continue to work with them on renewable energy for their facilities, things like signing up with First Movers Coalition for steel, aluminum, sealant and concrete to really drive the demand in the market for green options there as well.

So I think there’s a lot that’s going to happen between, we talked about how quickly we were able to accelerate our renewable energy objective. And I think we’re going to see that happen in other segments, as well as this transition happens, frankly, faster than any of us anticipated.

Alejandro Zambrano

And do you think recycling — battery recycling is going to be a big chunk of that?

Kristen Siemen

Absolutely. I mean we’ve already got — we’ve recycled batteries to-date on things like the Bolt and the Bolts. And we have agreements in place with companies like Lithion to take the raw materials of the batteries, even in the manufacturing process and put them back in.

So — our view of the recyclability thing is really to look at it from the circular economy standpoint. Even things like plastics. I mean we talk a lot about batteries, but plastics is another one where you can add a small percentage of almost — I hate to say anything, but it is almost anything to the plastic materials that we use in the vehicles and it’s using recycled content.

But what’s important is what can we do with it at the end of the life and making sure that we have options there and sometimes what you add isn’t easy to separate at the end. And so we’re really looking at all of our design practices of how do we no longer just build design for assembly, design for serviceability, but how do we design with a circularity view in mind so that it is recyclable or that total picture and everything from how much water something uses to how do we make sure that the sealant we’re using is easily removed to be able to separate the materials. So it’s really holistic within the company.

Unidentified Analyst

Question here, second row.

Unidentified Analyst

Thank you. Given the criticality of EV charging infrastructure and the disparate approaches to passenger light-duty EV charging and medium- and heavy-duty charging. How does all of that fit into GM’s electrification strategy and business model.

Kristen Siemen

Yeah. I mean, the charging infrastructure is extremely important and it’s not something that we’ll be able to solve by ourselves. But we’ve made a lot of commitments in doing a lot to help the transition.

One is we do a partnership with Pilot and P.J. to build out the infrastructure across the major corridors in the U.S. with DC fast chargers, we have a commitment that we’ve made with our dealerships. There is some statistics, there’s over 90% of the U.S. population is no more than 10 miles from the GM dealership.

So we’ve committed to providing our dealerships 40,000 charging stations for them to decide in their community where they should be. That may be at the community center, I say it’s a mom of free boy, I say it should be at the factor field, where the baseball fields we’re waiting for practice to end.

But really to — for people to be able to see that it’s available in their community and that they can move within this EV future. And again, I — maybe I’m an internal optimist, but I do believe that supply and demand drives a lot and innovation continues to happen and so things the charging infrastructure is going to happen pretty quickly.

Alejandro Zambrano

And I would add, it will affect how the cars are designed. So I think of the movie Wall Street, Michael Douglass, Audi’s on the beach in the Hamptons with this brief case found or whatever, a big brick. And then I see batteries today that are where the battery ways as much as a car unlike auto specific.

I really think we’ll look back at today’s EV batteries and EVs and you like how stupid was that? Why was the battery that, because there was no place to charge and range anxiety was deterministic or whether you sold the vehicle or not.

And so I think high speed DC fast charging combined with charging station ubiquity will mean that we can get away with. I mean the vast majority of our vehicles could be sub-50 kilowatt hours. You have a whole range of micro vehicles and megacity vehicles at 30 kilowatt hour batteries that are just so efficiently used in charge really fast, because that again is going to take some time, but it will get there.

Kristen Siemen

Most people don’t drive that far, maybe once a year that people really drive where they would need the full range of watt. But it’s an expectation and a customer desire right now today. I always say that either you could use the analogy that there wasn’t a gas station on every corner when the automobile started. And when we first got cell phones, you behave differently. You charge when charges available, you don’t necessarily go and drain it completely an influential charge.

Unidentified Analyst

We have time for one more or wrap this up over here.

Unidentified Analyst

So…

Unidentified Analyst

Yeah.

Unidentified Analyst

[inaudible].

Unidentified Analyst

Can you speak up.

Unidentified Analyst

At first it was didn’t helpful, I know the transition, including green bonds and congrats for that. And I’m wondering what else can the financial community do to help multinationals like GM accelerate the transition from a finance perspective, perhaps, incentives and other, because I know the spread on green bonds isn’t very — it’s not that much wider than other bonds. So is there more that can be done?

Kristen Siemen

And not my area of expertise.

Unidentified Analyst

Ashish, do you want to…

Kristen Siemen

Do you want to …

Unidentified Analyst

… follow-up…

Unidentified Analyst

[Inaudible]

Unidentified Analyst

And I can tell you just from the Department of Energy and the loan program office, they were kind of radio silent, they weren’t given anything over the last 10 years and that is my contact in D.C. and Mr. Bird’s contact that is changing. This is being like amped up to a level of things I didn’t think I’d see in my professional for not my lifetime, so stay tuned. But with that, Kristen, and Alejandro, thank you for your time and thanks for your questions…

Kristen Siemen

Thank you.

Unidentified Analyst

And that concludes this session. Thanks.

Kristen Siemen

Thank you. Thanks.

Alejandro Zambrano

Thanks.

Kristen Siemen

Thank you. Thank you.

Unidentified Analyst

Thank you very much.

Kristen Siemen

Thank you. Thank you. I appreciate it.

Crown Castle Inc. (NYSE:CCI) J.P. Morgan 51st Annual Global Technology, Media and Communications Conference Call May 23, 2023 2:35 PM ET

Company Participants

Daniel Schlanger – Executive Vice President and Chief Financial Officer

Conference Call Participants

Philip Cusick – JP Morgan

Philip Cusick

Hi and welcome to the 51st Annual JP Morgan TMC Conference. My name is Phil Cusick. I follow the Communications and Media Space. I am pleased to welcome Dan Schlanger, CFO of Crown Castle. Dan joined Crown in April of ’16 and is the Vice President and CFO — Senior Vice President and CFO. Dan, thanks for joining us today.

Daniel Schlanger

Thanks for having me.

Philip Cusick

I promoted you.

Daniel Schlanger

I appreciate being here. Well, not quite, because I’m now Executive Vice President and CFO. But you’re close.

Philip Cusick

I demoted you, sorry.

Question-and-Answer Session

Q – Philip Cusick

Let’s start with a very high level, 2023 is a lower level of activity than ’22. How does that compare to the average of the last three to five years? I’m trying to think about where are we in a longer cycle than just last year. And then how do you think about going forward?

Daniel Schlanger

Yes. It’s a good question because our business moves in relatively long cycles and what we see right now is the core of our business, which is a tower business where we lease space on towers to the wireless carriers. We think grows in the neighborhood of 5% to 6% revenue per year.

Over the last couple of years, we’ve been above that range, close to 6.5% in 2022. And when you look at where we are in 2023, we think we’ll grow around 5%, which is in the range, but on the lower end. And those types of up and downs, with ups and downs within a cycle for us as our carrier customers are deploying new technology, in this case 5G, is normal and what we’ve seen historically to your point, Phil, is that the level of activity we’ve seen over the course of last couple of years and even this year is somewhere in the neighborhood of 50% higher than what you had seen at the average for five years prior to that.

So, even at lower numbers, we’re still well above what historically has been the case, because of those kind of dips and ups. But we do believe over a pretty long period of time, given the nature of the contract structure, given the nature of what the drivers are for our business, which generally boils down to wireless data demand in the US and how quickly it’s growing, we think we can maintain the 5% to 6% growth on towers for foreseeable future.

Philip Cusick

And where are we in the sort of 5G cycle? How many of your towers have been upgraded with mid-band 5G at this point?

Daniel Schlanger

I would say, to answer your question directly, about 50% of our towers have been touched with 5G. Where we are in the cycle though is harder to pinpoint. These cycles take a long time to play out. And the way our customers generally go about deploying a new generation of network technology is, they start on towers where they already have equipment.

In our tower business, that’s called an amendment, because we’re amending a previously in-place lease on our tower. And the reason that our customers start with amendments is because those are the easiest to get done. They are already in the network. The towers are already in the network, they understand the propagation characteristics of that tower, how much traffic is going over that tower and therefore the need on the tower.

And the ability to get more antennas or a new different amount of spectrum on to that one specific asset is better known and they can go faster, because it’s just touching something they already are on. And therefore, when we see a first push into a new generation, it’s try to get the spectrum out as quickly as possible on as many towers as possible, and in doing so cover as much of us as consumers as possible.

When that amendment activity has largely happened, then they move into what we would call densification, which is that — that network is now — it has as much coverage as it can, now they want to make more sites. They want to go on a site that they weren’t previously on and therefore cover a new area or more of one area and that densification comes in the tower on the tower side also, but most of the time after amendments, not always, but that’s kind of the general view.

And where we are now, if we say we’re about 50% of our towers are touched with 5G, we’re somewhere in that amendment cycle moving into the densification cycle.

Philip Cusick

We’re in the amendment cycle, you said about half have been touched with 5G at this point.

Daniel Schlanger

Yes.

Philip Cusick

Do you think that because there is so much spectrum being deployed this time that the overlay is a longer, the lag to densification is longer or you’re already starting to see that densification side?

Daniel Schlanger

We are already starting to see it and I can’t — I don’t know whether it’s longer. I doubt it, because part of what’s going on, it’s just the overall demand for data in the US continues to grow at 20% to 30% per year, which requires more antennas on more towers in order to serve that growth.

And as our customers are hitting one tower, that growth is coming again and they need to hit that tower again as well. I don’t know whether that’s going to elongate substantially. I doubt it. But even if it does, we are in a position where we think we can continue to grow through that period and our customers will continue to be active through that period.

And what we’re seeing now, the reason that we can say we’re moving at least somewhat in the densification phase is, a second part of our business, which we would call small cells, which is exactly the same thing just a vertical structure with an antenna on it, just shorter, which is what I call small, that is a densification play for our customers, because towers can’t get closer together, generally than where they are, and they already exist in most areas.

Getting them too close together causes interference between the two, just the think of the waves, they cancel each other out. And most municipalities don’t allow towers to be built, because they don’t want any more infrastructure where there already is infrastructure that exists. So the next step will be to go onto a small cell, a shorter piece of infrastructure, but by definition, densification, because it will be closer together.

And while our customers were very focused on deploying towers over the course of the last several years, which led to our above average tower growth, they also gave us significant orders for small cells that we are currently building, which means, they were both focused on the coverage of the tower and the densification of the small cell, all at the same time. So we believe that we’re kind of in that transition period.

Philip Cusick

You mentioned densification. When you think about densification, is it more on small cells, than it is on macro?

Daniel Schlanger

No, it’s both. So when we look at — when we say densification in total, it’s both getting towers that are closer together. So, towers exist, but they’re on one tower, not on the other and they want to add equipment to that other tower and then into small cells, because even densification on towers will happen in our opinion before densification on small cells, because towers are more efficient.

To cover a given area of population with cell signal, it’s more efficient to use one tower than several small cells. So just economics dictate that you go through the best and they move on. So the best would be amendments. It’s the easiest and fastest, you go to colocation on towers, then you move into small cells, and we’re already into some of the small cell densification as well.

Philip Cusick

Okay. Verizon signed a deal with Vertical Bridge a week or two ago where they are for new sites and Verizon has talked about getting owners’ economics on sites with Vertical Bridge. Is that something a contract that you looked at, is it — was it sort of out there and bid?

Daniel Schlanger

I’m not going to speak directly to how we go about with negotiations with our customers, but I will say that, it is not new for our customers to try to enter into agreements with other companies to try to build new sites.

We have not built a lot of new sites recently. So, for the past ten years, because the economics we’ve seen for building new sites have not been attractive enough to get our cost of cap, to get our capital allocated. So generally speaking and I can’t say exactly what that deal was, because it’s between two parties that we’re not part of.

But we have not seen a way to make good returns building new towers in new areas, which is what that agreement seem to be focused on, is building out where towers don’t already exist somewhere else. So if you think about as a city expands with new suburbs, we need towers in those new suburbs, those need to be built.

That could be part of this agreement, but building where we already have towers is very unlikely, because it’s hard to compete and hard to get them built. So it’s just not something that from a big picture perspective we’re worried about. And like I said the returns on building new towers have not been attractive enough to allocate our capital to.

Philip Cusick

Okay. Let’s talk about the overall service revenue or revenue growth this year. You’ve gone to $135 million to a $145 million in core leasing activity for the year. How should we think about that sort of split first half to second half and why is that a little bit different this year than some others?

Daniel Schlanger

So that $135 million to $145 million corresponds to about 5% I was talking about earlier. And generally speaking in our business, there has traditionally been a little bit of back half weighting. So there is 40% of the activity in the first half and 60% in the back half. And this year we think it’s likely going to be closer to fifty-fifty than it historically has been. No real reason for that, it’s just how we see the market playing out and that was what we said when we gave guidance in October, it’s still our anticipation, and so what we would call that as kind of level loading through the year and just indicative that we don’t see any type of speed up or slow down as we get to the back half of 2023.

Philip Cusick

How much of those is being contributed by DISH? How should we think about your contribution there?

Daniel Schlanger

Yeah, we didn’t grow — not going to quantify each customer. But overall for DISH, our revenues are — site rental billings are a little less than 3% of our tower business. And overall, if you include all of our revenues, it’s a little less than 2%.

Philip Cusick

Okay. And that — the 3% is really come on over the last two or three years, so is it fair that maybe 100 basis points a year has been contributed by DISH?

Daniel Schlanger

Yeah, all of your math is right. We signed the contract at the end of 2020. So we’re kind of two and half years in and we’ve gotten to that almost 3%. But that doesn’t mean, that’s what we’re going to get going forward. It’s a contract that was structured to provide a pretty substantial minimum payment on a monthly basis to give DISH access to up to 20,000 of our tower sites.

And the reason that we structured it that way was that we wanted to attract as much of the DISH work as we could, because as we would anticipate DISH being successful in building out a network and having consumers on their network, if they needed more capacity, which we would anticipate they would need over time, they would come to our towers first, and generate more amendments and more revenue for us.

So we wanted to be on as many — them be on as many towers as they could. So we gave them access to up to 20,000 towers, meaning that if they went on more towers, they amortize the cost of that minimum payment across more towers.

So each tower got less expensive. The other reason we thought that that would be important was so that we became integral to DISH’s overall network build-out which makes us really key to them meeting their goals of their requirements for maintaining the license on the spectrum of 70% population coverage by June of 2023.

And we think we’re integral to that, because we were among the first places DISH went for towers and we believe that they’ve built a lot of their anchor around our system and have been utilizing us very much. So when you add all that together, we think we’ve incentivized them to be on our towers, put ourselves in a very good position and given ourselves some growth in the process.

Philip Cusick

And are they running in line with or ahead of that sort of minimum use fee?

Daniel Schlanger

Not exactly sure what you mean. So the minimum use fee is no matter how much they run.

Philip Cusick

Okay.

Daniel Schlanger

So that is why it’s a minimum use fee. It doesn’t matter how many towers they go on. But there have been very active with us. They have required us to move very quickly to put a lot of antennas on a lot of sites.

Philip Cusick

How should we think, I mean, Charlie has been very open about slowing his build after we get through this June deadline. Is that part of, I imagine the back half slow down, and should we expect a continued slowdown next year?

Daniel Schlanger

Yes. So we don’t have a back half slowdown, which is what we said earlier. That was part of what we were saying is that we don’t see that there is a back half slowdown in our business. And going into next year, we’ll talk about when we give guidance in October.

Philip Cusick

Okay. That’s fair. Otherwise that visibility on that $135 million to $145 million, at this point late May, the business is effectively fixed for the year.

Daniel Schlanger

Yes. I would say a little differently than effectively fixed. I think that the cycle of the business is long enough that we understand what’s going to happen in the back half of this year. I think that’s the same thing you’re saying.

Fixed sounds like it was contractual. What it is, is that, it takes about six to 12 months from the time that we get an order from our customers to the time that we put the antenna on a tower and start generating revenues. So if you take the average of about nine months, we generally know what the business will look like for the year by March.

And so by May, we feel pretty good about it and we still feel pretty good about where we are. A lot of the business we do is entered into in the year prior, because if we get an antenna on a tower on July 1st of any given year, that means we only have six months of revenue that year, an additional six months next year, so there is actually growth year-over-year.

So that’s the other bucket of growth that we come up with. All of that together as part of the $135-ish million, $140-ish million that we talked about in terms of billings growth for the year or the 5%. So, yes, we feel good about where we are. We generally have a pretty good sense for our business by this time.

Philip Cusick

And where is churn running at this point? You’ve got the Sprint churn for the industry and then there is sort of regular churn for the industry, how do you — how is Crown setup?

Daniel Schlanger

For our tower business, we have one chunk of Sprint churn which happens in 2025 and it’s about $200 million and we don’t have any other real significant Sprint churn on the tower side to speak of. Churn generally in the tower business is 1% to 2% a year and we’re running this year on the low end of that churn.

Philip Cusick

You and I had a conversation about how activity and churn are tied together. I’ve never really understood where 2% churn would come from on a regular basis, because there is not that many customers who aren’t big carriers going away. So what’s the relationship there?

Daniel Schlanger

Yes. Where churn comes from is when they look at their customers, our customers the carriers generally, look at their network and see where there is overlap or not a full utilization of a certain tower and it was — it’s too expensive for them to keep that and so they pull it down in orders, because the network has evolved in a way that made that one tower obsolete.

That’s where most of the churn comes from. As they have more and more activity and putting up more and more sites that may — that activity in and of itself may cause some of that churn to happen, because the more sites they put up, the more the network moves around a little bit, it could on earth, a place where a tower is no longer necessary.

But having said that even in relatively high periods of growth for the last couple of years, our churn has been on the low end of our 1% to 2% range. So we feel pretty good about where we are on the churn side.

It’s a great business, because if churn is 1% to 2%, which it is, we have 3% escalators built into our contract structure, which means that just every time, every year that comes up, we’re growing more contractually than what our churn is, which puts us into long-term growth without having to spend capital, which is what makes the tower business as good of a business as it is.

Philip Cusick

I think what one thing people worry about with Crown is that business has been running very strong and yet if it reverts to normal sort of a slower rate, one thing people worry about, but churn reverts from the 1% where you’ve been toward more of a midpoint 1.5% or 2% that the net growth sort of compresses. Your point is more that, if activity is lower, it’s probably churn is lower.

Daniel Schlanger

Yes. I think that’s true, because like I said, you have to have the activity that generates the place where the churn comes from. So if the network is static, there’s very little churn that’s going to happen in that network. When a different band may be added to a specific tower or a set of towers within that area, it could make one of them obsolete. So, yes, I think that activity and the churn are somewhat tied together. Although I wouldn’t say that correlation is perfect.

Philip Cusick

Right. And what about the services revenue? How is that correlated with activity and is it different by carrier?

Daniel Schlanger

Yes. The activity, so we have a services business, which in essence, it helps our customers put antennas on towers. So there are two parts of our services business as we would call it. One we would call pre-construction services and the other we call construction services. Pre-construction services consist of land work.

So permitting, site acquisition, getting appropriate utilities, that type of thing, is owning those things. In addition to construction drawings and making sure that the tower has a sufficient capacity to put more equipment on. In the construction side of our business, it’s actually managing general contractors that climb a tower, put the antenna on a tower and get it ready to deploy spectrum so we get paid.

So you could put those in sequences that the pre-construction work has to happen first in order for the customer to be ready to go on the site and then construction work happens later for the customer to actually go on the site. So we see early in the activity periods more pre-construction and later in the activity period is more construction.

The pre-construction work is at a higher margin than the construction work. But the construction work generally has higher revenues. So what we have seen over time has been this evolution from higher margin lower revenue pre-construction work into higher revenue lower margin construction work and our gross margins have generally held consistent over the past several years.

Philip Cusick

And so, again, help me with as activity is sort of steady for the next few years, should we anticipate services revenue being relatively steady?

Daniel Schlanger

Yes. I think services are very much tied to where the activity ultimately goes, because we have to have activity no matter how it is structured, we have activity that goes to put a new antenna on a tower, somebody has to provide the service. We don’t provide 100% of the service to our sites. We try to provide as much as we can as long as it’s profitable to us. We think it’s a good ancillary business and revenue stream for us.

Philip Cusick

Do you have the right to do that and sort of right of first refusal on that business or?

Daniel Schlanger

It really depends on what the business is. I think what we really have particularly on the pre-construction side is superior knowledge about our assets than anybody else could have. And because that side of the business is more about what’s on the asset already and what structure you have to put around it to add any antennas and then what permitting and zoning to do and we already have the structure in place, we generally are better equipped or better positioned to get that business than other competitors.On the construction side, it’s a little bit more competitive, because it doesn’t have the same knowledge necessity, knowledge base necessity, which is part of the reason that the gross margin percentages are lower.

Philip Cusick

Okay. Help me think about how fiber and the small cell and tower business has sort of worked together. Is towers and small cells, do you go hand-in-hand with a team to a customer? Does a customer buy your small cells, because of your fiber and your towers or how do we think about that?

Daniel Schlanger

The first thing I would say is that there — towers and small cells are driven by the same underlying business characteristics. So similar customer base of the wireless carriers, similar underlying demand driver, which is wireless demand in the US and similar contract structures.

Although small cells have about 1.5% escalators as opposed to 3% on the tower side. And so, it’s a very similar business, doing this is a very similar thing, which is just putting a vertical piece of infrastructure in place, where an antenna can go at height to be able to deliver wireless signals to your phone. The way our customer buys is really dictated by our customer.

There are very many times where we go in with a consolidated offering of towers and small cells and fiber altogether to a customer and present that as an offering to our customer to say in this area, you need network coverage, we can help you no matter what you do and how can we do so. There sometimes our customers just broken out a little bit more, where they have a tower team and a small cell team that looks at things differently. So it really depends on how our customer wants to buy as opposed to how we want to sell.

But generally speaking, it isn’t that we get small cells because we have towers that is not what happened. I would say what happens more is, we are able to have a conversation with our customer that’s more solution based than product based. So instead of a customer coming to us and saying, hey, we need a tower and we say, we either have it or we don’t, they can come to us and say, hey, we need this coverage area and we can say, how do you want to do so and we can put together a package and that solution based selling is I think we all can agree is generally more effective than just going to somebody and saying which tower of ours do you want.

So having that deeper relationship and understanding what our customer needs are at a deeper level because we have different levels or different ways to address their network needs I think does lead to better relationships and ultimately more revenue for us. But I would not say that you have to be a tower company to be a small cell company nor do you have to be a small cell company to be a tower company.

We do believe there are synergies between the two. And we have noticed and seen how those come to bear because we have negotiated very similarly at times. The one aspect of our business I didn’t address in that as fiber. The way the network is structured is that the wireless signal goes from the antenna to your phone and back to the antenna. But once it hits the antenna, it turns into some sort of signal that then gets transported by fiber.

And in our small cell business, it requires, that small cell requires strands of fiber to the small cell. So we own that — those strands of fiber because that’s actually the shared asset that we’re talking about, because most of the capital of building small cells is in fiber. So whereas the tower becomes the shared asset and anytime you can sell more revenue on that tower, you get better margins, better returns. On the small cell side, it’s how much of that fiber run can you sell to get more small cells on it.

And therefore we are — we own the fiber primarily because we have small cell business that requires fiber in order to operate effectively. And therefore the fiber is part of small cells and as we own that fiber, we also want to add as much revenue to that fiber as we can so we pass buildings, so we pass JPMorgan’s offices potentially and we say, hey, we need to be providing data services, communication services to those offices, those enterprises and we do so, so that we can increase the revenue and increase the returns on the fiber we’ve already built for small cells.

And that synergy is really important, because we want to get as much return as we can and we want to be able to go to as many places as we can to make as much money as we can and help, and that has helped by having more revenue and more return from the fiber, the enterprise side of our fiber business.

And all of that works together, and we have also seen that having that fiber has helped us with our tower customers, which was not really the thesis going in, but we knew it could happen and that was evidenced by the agreement we reached with DISH, the same agreement we were talking about earlier on the tower side, it included fiber as well, which on what they were looking for was one contract or one company to go out and say, okay, we want to build out this network of towers, we want them connected by fiber, but we don’t want to go contract with this company for some towers, this other company for more towers, this company for fiber here, that company for fiber there, so they gave us kind of a big package deal.

And that was important to them more than it was to us. We didn’t go to them and say you have to package these. They wanted that fiber in the agreement overall, because they thought it was an important aspect to which company would be able best to serve them as they build out their network.

Philip Cusick

Help me think about the pace of small cell growth. Last year I think was 5,000. This year you’ve talked about 10,000 and I think alluded to a faster pace going forward. What should we think about the pace through this year and then exiting into next year?

Daniel Schlanger

Yes, to level set where we are, we have about 60,000 small cell nodes, which is the unit of measure we utilize, which is one customer deploying one signal through our small cell. We have 60,000 on-air and 60,000 that are in our pipeline having been contracted, but not yet built. Last year, we put 5,000 small cell nodes on-air. In 2023, we anticipate that we’ll put 10,000 small cell nodes on-air.

Obviously a doubling between those two. And then in 2024 and beyond, we believe we will put more than that on-air and grow our business more because it’s based — that deployment profile is based on basically two large contracts that we signed over the last couple of years. One with Verizon for 15,000 small cell nodes and one with T-Mobile for 35,000 small cell nodes.

Obviously, that’s 50,000 of the 60,000 backlog I just spoke of. So it’s majority of what we have or what we’re building are for T-Mobile and Verizon. And most of Verizon is anchor-build, new small cell systems that are being built and most of T-Mobile is co-location, which is going — putting small cells on networks we’ve already built. So a second tenant, same equivalent of what putting a second tenant on tower would do.

And as we are building out, the pace is really dictated by how quickly our customers want those small cells to be on-air. So, we’re going from 5,000 to 10,000 because our customers are going faster. There is some requirement for them to move and we believe that they will need more and more as we go forward. And therefore, we will build more and more in ’24 and ’25.

Obviously, again, we’ll give more detail on that when we give guidance in October, but that’s the pace that we’re looking at and it’s been an acceleration over time because the 60,000 nodes we have on backlog, obviously are equal to the number of nodes we have built to-date. So that’s a pretty substantial increase in the pace at which we’re deploying small cells. We’ve been in the business for a decade or so, we put 60,000 on-air over that decade. And now we have 60,000 in our backlog over the course of a couple of years that will be built-out over the course of several years, but that’s a significant uptick.

And the number of small cells being built by us in the US, which we think is reflective of the requirement that our customers see to densify the network like we were talking about earlier, because the data demand is coming quickly to them and they need a way to satisfy that demand with new sites. And the only way to do so is through small cells. So the premise of our investment in small cells is coming through and we’re seeing that acceleration over time.

Philip Cusick

How should we think about the mix this year of overlay versus new sites and then maybe going forward? I didn’t realize that Verizon was mostly new sites and that T-Mobile was mostly overlay, obviously the dominant portion is overlay of the two.

Daniel Schlanger

Yes. I think what we’ve said about this year is that, it’s a pretty even split between co-location and anchor builds. Going forward again we’ll give more detail to that, but you can look at the backlog and say of that 50,000 most of Verizon is anchor build and most of the T-Mobile is co-location.

So you can kind of do some rough math around that and see what the generally is in our backlog. What we’re excited about that is that co-location does come with significantly less capital intensity. So you would imagine that moving from 5,000 small cells being built in 2022 and to 10,000 being built in 2023 that there would be an increase in capital.

But for a doubling of the small cell node count, we are increasing capital around 12%, which means we’re having a significantly lower capital intensity going into 2023 than we did in 2022, precisely because we have this a pretty substantial number of co-location nodes being built in 2023, which is just somewhat of a proof point of one of the — one of our thesis — overall thesis in small cells that it follows a very similar pattern as to what towers does, which is you put the first customer on-air, that first customer does not pay for your costs and your cost of capital for having spent the capital.

But the second customer can and get you closer in the tower business, but we believe we can make a return with the second customer in the small cell business. And we’re seeing that come true right now, with that lower capital intensity coming through our numbers for 2023. And what we believe will happen over time is, we’ll continue to have some amount of co-location and some amount of anchor build that will kind of mix with each other. I don’t think you’ll see a substantial increase in yield all of a sudden because all of it’s going to turn into co-location.

But at least we’re having some reasonable mix between the two that we think evens out our returns, because on the anchor builds side, when we build a new small cell system, it’s the return to about 6% to 7% on a gross margin basis or yearly gross margin divided by the capital. And the second tenant when we add another customer to that same small cell system, we get to low double-digits. When we add a third, it gets to mid to-high teens digits returns.

Those are really solid returns based against our cost of capital. And what we’re seeing is, with the move into colocation that we see with a lot of the T-Mobile nodes, we’re actually coming up with examples of how that’s coming true and it’s showing up and our yield does tick-up a little bit, but then it’s brought back down as we build the anchor sites.

Philip Cusick

Is it fair to think that the anchor mix would go up next year, given sort of Verizon’s focus on expansion?

Daniel Schlanger

Yes. We’re going to have to see how it comes out, that’s something we’ll give more in October, because it’s hard to tell. This building a small cell takes us and our customers working together to site each of those small cells and then go build them. When that happens versus when that might happen for other customers and how that lays out between co-location and anchor build happens much closer to when we give guidance, it’s not as clear right now.

Philip Cusick

Okay. Let’s finish up on the balance sheet and AFFO. You’ve guided to AFFO per share growth of 7% to 8% over time, but you noted on the earnings call, there would be minimal dividend growth in ’24 and ’25, just remind everybody how we should think about AFFO and dividend growth over the next two to three years?

Daniel Schlanger

We size our dividend to the cash flow generation of our business and then fund any discretionary capital, including the build of small cells with external capital, predominantly has been debt capital. Because our incremental EBITDA provides leverage capacity that then pays for the CapEx.

So we take the cash flow of the business and return it in the form of a dividend. Because of interest rate headwinds and then the Sprint churn, so ’24 and ’25, ’24 of the interest rate headwinds and ’25 of the Sprint churn, in total, those two things add up to $350 million, $370 million of headwinds to our growth.

And our dividend is $2.5 billion, $2.7 billion, so our goal is to grow our dividend 7% to 8% a year at $350-ish million is about two years of growth. So that’s why we’ve said, the dividend growth will be minimal, even though the activity underlying our business continues to be at pace that will allow us to grow 7% to 8%, we have two discrete events that are taking away from our growth, which leads us to have minimal dividend per share growth over the course of the next couple of years.

And then as we get to the backside over that Sprint churn in 2025, the $200 million I mentioned earlier, when we go into 2026 and beyond, we believe that we can return back to the 7% to 8% growth that we had guided to previously.

Philip Cusick

Makes sense and a good place to leave it.

Daniel Schlanger

Okay.

Philip Cusick

Dan, thank you.

Daniel Schlanger

Thanks, Phil.

Philip Cusick

Thanks, everybody.

Microsoft Corporation (NASDAQ:MSFT) 51st Annual J.P. Morgan Global Technology, Media and Communications Conference May 23, 2023 2:35 PM ET

Company Participants

Mark Murphy – Equity Research Analyst at JPMorgan

Conference Call Participants

Dave O’Hara – CFO

Mark Murphy

Okay. Good afternoon, everyone and welcome. I am Mark Murphy, Software Analyst at JPMorgan and it is a great pleasure to be here again with Dave O’Hara, who is EVP and CFO of the Commercial division of Microsoft. So Dave, first off, welcome and thank you so much for taking the time.

Dave O’Hara

Thank you, Mark. Any time, anybody offers me a trip to Boston, I am here.

Mark Murphy

Yes. I know you recently ran the Boston Marathon.

Dave O’Hara

Did one of the crazier things I’ve done, but yes.

Mark Murphy

Great. Great to have you back here. Maybe you could just briefly introduce yourself and describe some of the teams and some of the products that you oversee within your role and maybe size that business for us.

Dave O’Hara

Sure. So I’m the CFO for the commercial business and sometimes people ask me, what’s the commercial business in Microsoft and I say everything is not consumer, which is sort of the easiest way to define it, but it’s all the names. Everyone is familiar with its Office, Windows and Azure and SQL and Biz Apps all from a commercial perspective. So give or take, it’s sort of a $150 billion a year.

Question-and-Answer Session

Q – Mark Murphy

Okay around $150 billion. So let’s begin with the topic of generative AI and the co-pilots. We have since last year been very outspoken bulls on this topic and we’ve been bulls on Microsoft’s leadership within this category of generative AI. We actually referred to your open AI investment as potentially some of the best money ever spent. And so we’ve noticed that we have Amy and Satya saying that they’re committed to leading the AI platform wave.

Having been with the company for 22 years, what I’m interested in is how would you describe the level of internal excitement and the magnitude of this opportunity for Microsoft to try to go out and lead the AI era?

Dave O’Hara

Sure, sure. That’s certainly the hot topic with customers, with partners and investors. And so I think the urgency and the passion around the topic are very high. A lot of people come and ask us, what do you think about AI? And they’re not even sure what they’re asking yet. They just want to know what’s going on and where is the world going and what do we as a company. These are customers talking. What do we as a company need to do to get in front of it?

So I would say high sense of excitement with customers and partners, high sense of urgency inside Microsoft. It’s been a bit of an expanding circle. When we first made the investment in 2019, it was a relatively small group of people involved. And now it just permeates everything that Microsoft is doing and everything that we’re working on. So it’s a big focus for us, big focus for customers. And I think it’s really early but really, really good signs of interest and demand.

Mark Murphy

So we have been impressed on this topic, Dave, with the product known as the GitHub Copilot. And we started noticing about 18 months ago, we would speak with developers and they would say, well, I wrote code all day long, but 40% to 50% of the code was generated by this GitHub Copilot. And the math on that is pretty staggering when you think about the bottleneck out there in terms of there just aren’t enough developers in the world.

So soon, we’re going to have Copilot for security. We’re going to have it for dynamics. We’re going to have it for Teams and Word and Excel and PowerPoint. We have been told that the previews for these products are going to blow people’s minds

by some of the people that have been in the private previews. Where do you think we’re going to see the greatest AI value creation among all of these products?

Dave O’Hara

Yeah, blow their minds is always an interpretive thing, but I do think they’re very impressive. And to me, having been there watching them be developed, the amazing thing to me was the speed with which they were developed. So when we started out with OpenAI, the logical place to start was with Bing, for all the reasons that make sense.

And so once the Office team got to building some of the Copilot products, just how quickly they came together and how quickly they surfaced in the product and how much direct value add, all was very impressive. And I think certainly from my expectations, exceeded the expectations that we had.

So I think the ability to not only tap into OpenAI and all the benefit it brings, but to make it so usable and drive productivity increases, it’s been impressive with the speed at which that moves. So I think everything is just accelerating, and that’s why our goal as a company is to not only be a leader, but to stay a leader. And to do that, we need to just keep moving really, really quickly. And I think you would see that urgency in everything that we do and everything that we build.

But I think in terms of where do we see the value most, I think it has a lot of value for something like Bing that’s a search engine , but it really has a lot of value for something like Office or Windows or any of the modern work products where you can see big productivity increases.

Mark Murphy

So we definitely see the speed. We’re impressed by it. Everyone out here is also wondering how is Microsoft planning to monetize it. I know you had mentioned you’d talk about Microsoft 365 Copilot monetization in the coming months. But just generally speaking, how do you think about pricing and packaging AI kind of up and down the stack?

Dave O’Hara

Sure. At a general level, there’s really a few ways to think about it. One is we have many of our products that are sold on a per-seat basis. And that works in some instances where you have certain functionality that people use all day, every day. Companies would prefer to pay for that as a per-seat.

There are other products maybe that are more consumption-driven. Data being an example where maybe a per-user construct makes more sense, but maybe a consumption model makes sense. And there are others where you might just have point AI services where people just go out and use it, pay as they go, and they use it for a while, disappear, come back a month later, they use it again. And so I think all of those are opportunities for us as a company. So per-user will see that show up in some places. Consumption will see it show up in others and others will just be services on demand.

Mark Murphy

Okay. So it’s a pretty broad range. The other question we tend to get very frequently from investors is, what is this up-front investment profile going to look like? First, you have to train these large language models, right? And then you’re going to bear the cost of actually operating them as you embed them into all these products. How should we think about, in the short term and then in the longer term, the margin impact for Microsoft as you make those investments?

Dave O’Hara

Yeah, it’s a good question. I think it’s important for folks to just remember, like, to be successful in building a large language model and to operate a large language model. You need a lot of data center capacity. And so you need a footprint, and you kind of — I don’t know that I’d say you have to be a hyperscaler, but it helps to be a hyperscaler to already have all that footprint, and we have that.

And then, after that, it’s a matter of making sure that all the machine capacity is available to do all the inferencing and training. And so, there’s obviously incremental cost to that, and it’s not cheap, and then we have to come up with the right monetization model. But I think the important thing is that, like, in the cloud business, you had to build out that data center footprint first. It took a long time. It was super expensive. What we’re doing now is we’re adding capacity to those data centers that allows us to do the LLMs and so I think that is, I think it means that the margin opportunity probably comes a little quicker than it would have otherwise in a cloud model.

Mark Murphy

It comes in quicker.

Dave O’Hara

Probably a little quicker, just because you already have the data center footprint there, and you’re just taking advantage of what exists.

Mark Murphy

Okay. That’s very encouraging to hear. So, Dave, a moment ago, you mentioned this great speed at which Microsoft is moving in all these directions. How do you think about weighing the — you have this benefit of being first to market by moving quickly with ChatGPT and the copilots. You have this opportunity to gain a leadership position.

You also have a risk of moving very quickly and putting these things out there in the wild. There could be risk around bias. There could be risk around hallucinations. You have to try to protect a customer’s own proprietary data as well, right? How do you think about weighing all of this?

Dave O’Hara

Yeah, it’s obviously a very important question, Mark. We’ve been thought leaders since the very beginning on how — on responsible AI and how we think about managing AI. Sam Altman has been has gone on record several times saying, hey, we need to be regulated. You should come in and regulate us. And so I think everybody is going in with an open mind that we need to make sure that we have some guardrails on how we think about growing the business.

With regard to hallucinations, etcetera, we’re all very aware. We want to eliminate that to the degree possible at all. And so we’re very focused on that. And then from a responsible AI perspective, making sure we’re managing people’s data, making sure we’re abiding by our privacy regulations, making sure that we’re doing things compliantly.

All of that is super important and we’ve been — it’s been a focus of ours for years. It’s sort of one of those things where this seems like it popped up overnight, but again, we started investing back in 2019. I think we came out with our responsible AI principles a few years ago. And so we’ve been at it for a while, and we’ve been trying to drive some thought leadership on how to do this in a responsible way, and we’ll keep doing that.

Mark Murphy

So Satya had recently discussed how he believes AI is going to reshape pretty much every single software category. In our work, we came across a comment saying that this would be the next big battleground in IT. Can you maybe help us, as you look out into the future and you think about all the existing AI-enabled products that you’ve announced, where do you think you’re going to see the largest growth opportunity, and then even beyond that, how are you going to evaluate all the future opportunities for building AI into your products?

Dave O’Hara

Well, I think the very first to sort of answer that in reverse order, the very first area where we’ll go is where our customers can see value. And so we work — I spend a lot of my time, as part of the commercial business, talking directly with customers and partners, and you get a sense for what really matters, and so we’ll go build in areas that really matter.

I also think from a company perspective, one of the very first things we do is we look at the total addressable market and say, how big could this market get? And so if we have permission to play, like if it makes sense for us to be there and it’s a really big market and we think we can deliver that customer value, that’s where we’re going to go.

I think in terms of how do we think about the most immediate ability to monetize, I’ll go back again to I think the work that we’re doing on our productivity tools in office and in modern work more broadly, I think that’s going to have some immediate value. And I also think, just to sort of add on to that, there’s a lot of talk about how AI is going to eliminate jobs. I think what it’ll do is automate a lot of functions, but it does free up time for those workers to go do other things, even within our own finance team.

When we automate functions, it frees up time for our finance team to go work with customers directly and help them understand what they can do and I honestly would rather have my finance team out working with customers than doing manual reporting or something on the back end. And so I think there will be productivity gains. It frees up people to go work on other things. To your point about GitHub, there’s a shortage of developers. I think it expands our capacity to build better products. So there’s a lot of goodness that comes with it.

Mark Murphy

And especially in Office, you have the potential to get this out there in front of — we could dream the dream of putting this in front of a billion people pretty rapidly, right?

Dave O’Hara

Yeah. I’m a bit hard to impress, but the day that the office team came in and did the demos, it’s like, hey, that’s good stuff, and it happened fast.

Mark Murphy

It really did. All right. Let’s shift gears and talk a bit about getting to Azure and talk about this trend we’ve seen around optimizations. And I’ll frame it this way. In our last Microsoft partner survey, we were asking them for how long do they expect to see an elevated level of cloud optimization activity continue? They came back and said, on average, something like four to five quarters and they were basically saying that customers are trying to do more with less in this environment. How does that time frame strike you?

Is it a bit pessimistic, because if you already have a chunk of customers that have done all the optimization that they can do, then some of them would be nearing the end of that.

Dave O’Hara

Yeah. I think it’s natural to say after four quarters, the optimization starts to lap itself, but I do think that from an optimization perspective, first of all, we see optimization as a good thing because I’ve never had a customer come in and say, I need to cut my budget in half. They’re like, hey, I would like to do more, but I’m kind of running up against my budget.

Is there a way you can optimize some of this so we can spend more over there and so generally, if we do it right, the optimization is a growth opportunity, even if it causes a little bit of short-term compression. So we see optimization as a good thing, and we do think they’re going to reprioritize and keep spending their budgets on cloud.

It’s just going to be on new areas of the cloud, but I do think to say after a year, you start to lap. I think on a per-customer basis, that’s true. Some customers have been optimizing faster than others, and so there will always be some of it going on.

Mark Murphy

Okay. So compression, but also it sets the table for growth opportunity.

Dave O’Hara

Compression and expansion at the same time.

Mark Murphy

So on the expansion part of that, Amy had this comment in the most recent earnings call that AI services would contribute one point of Azure’s growth in the current quarter, in this June quarter and so of course, we run the math on that. It equates to something like a $500 million run rate, but, as people pointed out to us, the number of Azure OpenAI customers increased 10x sequentially last quarter. So can we do some combining here and extrapolate that a bit?

Is it logical to conclude that AI services are going to become a pretty meaningful boost to Azure growth if we’re looking out, let’s say, 12 months to 24 months? So in other words, could this be creeping up where it’s actually contributing two, three, four, five points of growth, and it is truly moving the needle for Azure?

Dave O’Hara

Yeah, I would say this, Mark. In the early days of the cloud, we talked about, hey, maybe this market could be $10 billion or $20 billion, and it’s obviously far exceeded that. So I’ve given up trying to predict. Where it’s going to go, I would say a couple of things seem to make sense. One is the cloud still has a lot of growth left, and so I think we’ll continue to see good, solid growth in our cloud business.

Two is AI is pretty new, nascent, and so it would make sense that AI would grow faster than the cloud business, but I don’t think, they almost work in parallel, and so without getting into any numbers, I do think it’s going to be a big growth opportunity for us, and I think it’s given the size of the Azure business and the growth of AI, I think it makes sense to say AI will be a meaningful part of the number at some point.

Mark Murphy

Okay. So one other question here that relates directly to Azure. We have started to hear in our field work that companies are going to fundamentally begin to evaluate across the hyperscaler platforms really increasingly based on their generative AI capabilities, and so given that Microsoft has this very strong early leadership in that arena, do you see a type of a halo effect developing where maybe we start to see Azure actually gaining more share of workloads in the world because, you may have companies out there saying, well, let’s just start moving more data into Azure, right, so that we’re ready when the time comes to use all your best-of-breed AI capabilities.

Dave O’Hara

We certainly get interest from customers on that Mark. We get customers who maybe we weren’t talking to before who call and say, hey, I would love to talk to you about AI, and it gives us an opportunity to open the door for Azure, and since our best AI services run best on Azure, I think it starts conversations that weren’t being started before, so right now, I would say it’s reflected in the conversations we’re having with customers and the conversations we’re having with people who haven’t necessarily been cloud customers or Azure customers that we’re talking to now. How that manifests itself in terms of share, time will tell, but I think it is a big door opener for us that we didn’t have before.

Mark Murphy

That’s a promising trend. Okay, let’s switch gears a bit and talk about Office. So by our estimates, this is approaching $50 billion in revenue. This is a massive business, even out of the $150 billion that you’re responsible for. The O365 commercial is the bulk of that, and when we drill in there, that recently grew 18% in constant currency.

What do you view as the key ingredients or the broader phenomena here that is driving that scale of a business to that level of durable growth?

Dave O’Hara

Azure. You’re talking about Azure? I’m sorry, no, I’m talking about, I meant to say Office. So the Office business, I mentioned this in one of the earlier meetings, but I remember sitting in a meeting a long time ago with Office when it was about a $10 billion business, and the person running it said, I don’t know how we keep growing at $10 billion and that was a while ago. So I think we’ve done a really good job of continuing to deliver a lot of value. So I think you’ve seen an increased functionality in Office that people appreciate and are willing to pay for, but primarily it has historically come from one of three ways.

One is we have seed [ph] growth, and a lot of our seed growth has been in the small to medium business space, but that’s an important space because small and medium businesses become big businesses, and so we’ve seen a lot of good seed growth there.

We’ve seen really good ARPU growth, especially most recently with our E5 SKU, with security which has high demand around telephony in the analytics piece, and so people are willing to pay us to get the additional functionality. So we’ve seen seed growth. We’ve seen ARPU growth, and then we have seen us break into new markets, and I think, so we’ve just continued to add value as we go, and as long as we can convince customers that by spending this money on our productivity tools, they’ll save money elsewhere in their P&L, I think we’ll continue to be successful.

So the onus is on us to make that pitch, make it convincingly, and show them clearly where they’re going to save a bunch of money, and then I think they’ll continue to spend with us. So I think all those growth opportunities, we have a good runway in all those growth opportunities as we move forward.

Mark Murphy

And I want to try to drill into your hinting at the algorithm there, right, the growth algorithm on the office side. So as we drilled into that 18% growth for Office 365, Seeds grew 11%, and then ARPU would have driven something like six or seven points, right, on top of that. And then you mentioned some of the ARPU drivers, right, E5 is a big one, there were some pricing changes, maybe you’re going to have some co-pilot uplift in the future as we learn about the pricing there.

How do you see that growth algorithm evolving on Office 365? And I think we’re wondering if we’re going to get to a point where ARPU is driving a little more of that equation going forward.

Dave O’Hara

I think it depends on the value that we’re adding, and I think that the new functionality that we’re going to come out with in Copilot, I think is probably some of the biggest value we’ve added in a long time, and so I wouldn’t go as far as to say, yeah, ARPU is going to make up a bigger chunk of that, but I could see where somebody could reach that conclusion based on the functionality we’re going to ship. And so I do think that you’ll see a good balance between Seed growth and ARPU growth based on the new functionality we’re bringing.

Mark Murphy

Okay. Let’s move on now and ask you for a moment on security. Again, when we look at our Microsoft partner survey that we run on a quarterly cadence, security is actually usually ranking as the number one product of all Microsoft products in terms of momentum, and partners have actually been reflecting to us that there’s a very high level of inbound interest on the security side. We learned recently that it passed $20 billion in revenue, grew 33%. I think it’s the best kept secret at Microsoft.

Just when you think about the scale and the growth trajectory, and then you look around the world, and so many companies, they say they want to consolidate security providers. So how far do your ambitions reach? And what do you think is differentiating the Microsoft security stack?

Dave O’Hara

Well, I think right now from a security perspective, it’s both a growing business, but there’s always new threats and new places for people to spend money on security products because they really want to protect the enterprise. And so I see that as a market that will just grow honestly forever because I don’t think the security threat ever goes away. I think hackers are trying to do new things every day, and so I think it’s important for us to stay ahead from a product perspective.

I think the thing that we do is we cover the breadth of the enterprise. So there are point solutions out there that competitors that provide point solutions that do a really good job, but they do a really good job in their area, and I think we have more breadth with our solutions, and we can cover more of the enterprise. And so that’s the value prop.

I do think that we offer our products in such a way that if they want a part of the product, they can get it. If they want the breadth of the security offering, they can get it. I think that flexibility adds a lot of value too. But I do think that market above maybe all others will just continue to see growth as long as there’s threats in the world, I think security will be a growing market.

Mark Murphy

Above maybe all others.

Dave O’Hara

Maybe. Maybe. You never know. Like I said, I’ve given up predicting.

Mark Murphy

Yeah. It’s hard to predict the future when it hasn’t even happened yet. That’s what they say. Okay. So I want to come back to GitHub and sort of pointing out, I think Microsoft has been very shrewd in the acquisitions that it’s made over the years. And this is a pretty good example of it. There was a comment recently that GitHub is home to over 100 million developers, and that it had exceeded one billion in ARR scale.

I think back five years, and the estimates at the time were that there were 30 million developers to 35 million developers in the world. So can you bridge the gap on that for me? How did GitHub expand that market to a point that it has 100 million developers?

Dave O’Hara

Yeah. I would remember the days when we were talking about three million developers, five million developers, then 10 million, then 30 million. I think part of what’s happened is we’ve redefined what’s a developer and before it used to be somebody who was known as sort of hard-code coder that wrote software, and now. I think GitHub has sort of democratized what it means to be a developer because the product’s so easy to use and because it has so much flexibility.

The other thing I would say is sort of adjacent to that is our PowerApps strategy because we’ve seen good traction with PowerApps because it’s, again, so easy to use and so easy to build an app. So people that previously weren’t considered developers I think now see themselves as developers. And so that’s helped expand the category of developers. And there’s other — there’s sectors, financial services being a great example, that have just decided that they need to not only be a financial services company, they need to be a tech company. And so they’ve grown their footprint on developers.

And as you noted at the very beginning, there’s a shortage of developers to the degree that Copilot can expand the productivity of a single developer. I think it’s all goodness. We’re not going to run out of — we’re not going to — there will always be demand for developers, at least for the foreseeable future. And so anything we can do to increase productivity is going to help.

And so I think GitHub just got at the forefront of that. But again, these things, when you’re not sort of in the middle of it seems like it just showed up. And we’ve been working on GitHub Copilot for several years and I feel like now it’s just sort of manifesting itself.

Mark Murphy

It was, again, we were hearing about it 18 months ago. And so I’m sure it was making a difference then. I’m sure you had been developing it for a while. Okay, so now I think you said a moment ago that security may have kind of durable growth, perhaps above all else. What about Teams because, so that’s a product that recently surpassed 300 million monthly actives.

So that is still showing strength, even post-pandemic. And you’re continuing to invest in features, those are coming pretty quickly, in Teams. There’s Teams Phone, there’s Teams Room, there’s Teams Premium. How do you think about the evolution of this Teams product and the durability of growth there, especially now that we are in this post-pandemic hybrid type of a world?

Dave O’Hara

Yeah, I think it’ll be good, durable growth. Essentially, we look at it as communication. And so anything that goes along with communication is an opportunity for Teams and so when we started out, we just wanted, sort of a product that people could use to talk business to business. But there’s a big consumer opportunity out there. There’s lots of opportunities to expand the functionality within a business, when you talk about Teams Rooms and meetings and all that. There’s still a lot to be done there, and so I think there’s good, durable growth.

I also think the product is just, getting more functional and better every day. And so there’s a lot of customers out there that probably even haven’t been exposed to it yet. And so lots of good growth left, I think, in Teams and, the product. I hear lots of good comments from customers on the functionality, and so we have — there’s a lot of room to grow.

Mark Murphy

Power Platform. So you did mention Power Platform a moment ago in the context of the GitHub discussion. But that is a product that, in addition to security in Teams, the Power Platform, Power Apps, is the other category. It’s always ranking in our top three to four in terms of Microsoft products with momentum when we run the partner survey.

And I think back, Dave, probably 20 years ago, we had software companies saying we’re going to create a product that’s going to create citizen developers. And I never really believed it, right? I never really saw anything that was going to break through. It feels like this one has. So can you help us understand how did Microsoft crack the code on this ability to get a non-technical user to get them over the hump, right, and to get them creating their own app, people like us in this room.

Dave O’Hara

Yeah, I think there’s a few things that came together well there. One is, apps are, small apps are easier to build than, say, a big app like CRM. And so one is the prevalence or the introduction of apps that were smaller and more functional and very pointed. Two is we did focus a lot on ease of use there. We just really had to get it so that people felt comfortable using it and that they felt like it’s applicable. And then three is we just had to get the pricing and packaging right, which we worked hard on that, too.

So it’s sort of all three had to come together. Like, if there wasn’t, if we were still just writing big, long software packages, Power Apps wouldn’t have any applicability. But these micro apps make it applicable, and we made it easy to use, and I think we priced it right. And we saw customers start out with, give me 6 users, 10 users, 20 users, and then pretty quickly they’re like, well, what would it cost to just license everybody in the company? And so it went viral, at a pretty good rate. I wouldn’t, I don’t know, maybe probably faster than we expected.

And so, but I think it’s all three of those things had to come together at once, or else it probably just wouldn’t have taken off as much. But they’re there, and so now we have it.

Mark Murphy

Dave, I can’t thank you enough for taking the time to be here with us today. It means the world to us, and it’s just incredibly helpful to hear about all the great successes you’re having.

Dave O’Hara

Thanks for having me.

Comcast Corporation (NASDAQ:CMCSA) 51st Annual J.P. Morgan Global Technology, Media and Communications Conference Call May 23, 2023 10:50 AM ET

Company Participants

David Watson – President & Chief Executive Officer, Comcast Cable

Conference Call Participants

Philip Cusick – J.P. Morgan

Philip Cusick

Hi, thanks for joining us. Welcome to the 51st Annual J.P. Morgan TMC Conference. I’m Phil Cusick. I follow the communications and media space here. I am joined by Dave Watson, President and CEO of Comcast Cable. Dave, thanks for joining us.

David Watson

Good to be with you, Phil.

Philip Cusick

Nice to see you. Your role changed a bit recently to be global and the presentation of the company has been shifted a little bit. Maybe just talk about your overall role and how things have changed first.

David Watson

Sure. The group that we developed is the Connectivity & Platforms group to really represent how we’re running the business and looking at scale, looking at innovation, all the things that we do. So it’s the U.S. Cable business. It’s the direct-to-the-consumer, international business with Sky, lumping those things together and taking the best of kind of across the enterprise. And when you look at it, the thing that jumps out, it’s 52.5 million customer relationships, all spending about $100 per. So it’s a pretty good, solid business right from the get-go and positions us well, I think, for the growth areas. And we have a couple that are — not just one, several actually, that within this Connectivity & Platforms group. One is domestic broadband, domestic wireless, international connectivity and then business services. You take those 4 together, you have a $40 billion run rate collection of growth-oriented, high-margin businesses and growing in the high single digits.

So you look at each one of them, 32 million residential broadband customers, loyal, solid base, good churn performance and solid ARPU at 4.5%. The wireless has tons of upside surrounding broadband with that. You look at then connectivity, you have business and international is the — breaking that one down. It’s a $3 billion business, growing at a nice clip. And then business services from 20 years ago, it was 0 revenue. Now we’re approaching a $10 billion run rate, the EBITDA at $5 billion, margins that are approaching 60%. So there’s a good collection there. We know we’re up against some headwinds but — the macro issues but when you come back to it in the first quarter, we grew EBITDA within this category, Connectivity & Platforms 4% and grew, expanded margins by 160 basis points. So we’re off to a good start with this new collection.

Philip Cusick

Okay. So you started with domestic cable and broadband. And I think the big question for a lot of people in the room is where are we in the broadband sort of growth cycle? We had a big wave of growth in COVID. Housing sort of slowed pretty dramatically. Is this a business that can grow in the long term? Or are we sort of done with that period of growing broadband subs?

David Watson

I believe strongly that we will grow customers over time. I think that there are the near-term headwinds, the macro issues, it is intensely competitive. There’s no question that you have a new wave of competitors that enter the marketplace, you have that. But when you think about the reasons why I’m confident of our ability to grow, it’s that we have the best product. It’s ubiquitous. We continue to consistently and steadily have invested in the network, not only for speed but for capacity, coverage, best products, best gateway devices. So I like our competitive position now but in the future, then you look at the ability to surround broadband with products like mobile. And it’s — competitively, I think we’re in good shape. But then you do have these macro headwinds that we’re facing.

So having said all that, you have the 32 million broadband relationships that are solid. Churn is one of the most important metrics in any subscription business, wireless or cable and ours is still below the prepandemic levels. So really solid and we’re able to grow ARPU and we grew that 4.5%. So when you look at growth in the near term, we will get to, I think, longer-term growth opportunities. And one of the reasons you noted in the past is that we’re going to add this year alone about 1 million passings. And the passings are a collection of hyper-builds, fill-in within our footprint and edge outs.

And so in ’22, we added 840,000 and then now with 1 million passings. So you add all those things up over time, I’m pretty confident we’ll get there. But we’re also, I think, very focused on managing the macro issues with discipline, cost controls around video, fixed wireline, phone and just real extreme focus around the margin, high-margin, high-revenue growth areas. That’s our focus; that’s the top priorities for us.

Philip Cusick

Okay. Before I follow up, there are seats in the front if anyone want to come up. I’m not offended if you do, so please come and sit rather than stand. So let me follow up on — you talked about churn. And part of, I think, why churn is down for everyone is that just moves are down pretty massively overall. Is churn down even more than that?

David Watson

I think churn, that’s a significant contributor. The fact that just the macro issues, people are just moving less and so that is a piece of it. But I also felt and when you look at our trending, you have to go back where our trending was before. And our trending for churn was steadily coming down. And it was never at a rate that was — it was best in class for the longest stretch but it kept just getting better prepandemic. So there was the pull forward the macro issues but some of this is just building out the best broadband product in the marketplace. And when you segment the base, then you have an opportunity to deliver value. And then things like mobile, being able to go to double-play households, triple-play households and give them the packaging that they wanted and putting them in the right position, I think all those things have helped churn.

I would also say that focusing on the customer experience, we’ve been relentless on that, taking out unnecessary transactional activity at the same time, improving the experience, that has helped. So I think there’s been a lot of contributors towards good churn performance but certainly, the macro impact is part of it.

Philip Cusick

You mentioned segmenting the base in both on the call and then Brian, last week, mentioned going after more of the low end. And on your website today, I think there’s a $25 offer. Is that something that is a new focus for Comcast and you need to sustain that?

David Watson

No. First off, segmentation, you really got to break it down that every day in a very large subscription business, you have acquisition activity, you have base management, you have retention. I think a lot of people think about segmentation when you think about offers upfront but there’s so much activity that goes on every day with great customer relationships that you are actively managing. So there’s acquisition, base management and retention. We’ve been doing segmentation really forever. So we’ve been at this for quite some time.

And when you look at it, the net impact is this balance between share growth and revenue, ARPU. And so I think we have pretty good performance. And even without subscriber growth in broadband, we like our revenue performance and ARPU. When you think about the — where we start with segmentation, we start in the high end. So we start in the high end and we — I think the network activity that we have, we have this project where we’re upgrading our existing footprint. We’re 20% upgraded with the existing project that we talked about, mid splits going deeper with fiber and then giving 2 gig down and then a really healthy increase to upstream.

So — and then at the beginning of June, we’re announcing that we will be providing throughout the entire footprint multigig symmetrical. So it puts us in a position to be able to constantly be focused on the high end of the base because that’s where the customer is going. The customer is going — there’s just more engagement. When you think about broadband consumption, you have the nonvideo broadband customers using 700 gigabytes. And then you have the sheer amount of WiFi-connected devices. Throughout last year, we had 1 billion WiFi-connected devices. Now granted, there’s a handful of power devices that determine a lot of the consumption but it’s a lot of devices. And what’s happening is there’s kind of a new peak moment that’s emerging. And peak moments are streaming, gaming, all happening in a relatively close period of time.

You manage a network, whether you’re wireless or cable, for these peak moments. And so we start with the high end. But we surround broadband with other products that help us compete in every segment. We do have an announcement that we’ll talk about because mobile has been a great part of our portfolio. But we have — about 1.5 weeks, we’ll be launching a product called — a streaming video product called NOW TV. And NOW TV will be something that we can have as a companion to broadband. It’s a streaming product that really provides the best of Comcast.

And starting with the fact that NOW is a Sky brand and working with Dana and the team over there on that. It has the — it will be — Peacock will be included. It will have a live linear that will have the Xumo fast channels. It will have the best platform that is out there. That is the same platform that fuels X1, essentially Sky and Flex and so voice activity. It’s just a great aggregation platform [ph].

Philip Cusick

Is it box?

David Watson

With video. It will have a — similar to Flex, it will have the puck device that will be available. And — but it’s easy. It will be super easy to get, no contracts, no additional fees and it will be $20.

Philip Cusick

$20 a month or $20 cash?

David Watson

$20 a month. And it will be for us the way we’re able to position, it will be accretive. So we’re able to do this next-generation video tiering with the ability to make it financially accretive. But at the same time, I think it’s going to be a great companion to broadband. So you break down between the 2, you have the book end, you have the high end, multigig symmetrical. That will be…

Philip Cusick

Plus great WiFi.

David Watson

Great WiFi, great devices. And then you have mobile with broadband and you have NOW TV which is a great starter video service, priced attractively but still will be financially accretive for us.

Philip Cusick

And you’re pulling my over-the-air linear channels? Where is the linear?

David Watson

We have a handful of video partners. We have Xumo already has a robust set of fast channels that we’re doing. So we’re — this is all streaming. So it’s a streaming video tier but Peacock will be included, Peacock Premium. So we’re able to give sports, live TV, the film, television, it’s a good collection.

Philip Cusick

I imagine the hope is that we’ll go into your other cable partners that use your technology around the hemisphere anyway?

David Watson

I think it opens up the notion that there’s — there will be a next generation of packaging opportunities that — giving us the ability to reimagine a more, I guess, profitable way of delivering video but packaging it with broadband. And that’s, that next-generation double play or even triple play in that you can combine now mobile, you think about it, it’s a great — you can layer on other streaming products if you want, Peacock’s included. But $20 is a great starting point.

Philip Cusick

Yes. It turns out that aggregating video might be a good business.

David Watson

Yes. It could once again.

Philip Cusick

Someday. Okay. So I do want to go back to the lower end for a second, just one more question there. ACP is something where we were surprised recently to see that Charter gets 4x the revenue in that segment as you do. Is that an opportunity? And do you think that’s a sustainable subsidy that you want to go after?

David Watson

We’ve looked at the ACP as an opportunity, the predecessor, the first-generation product and then ACP. We think it’s a great opportunity. I think we’ve been good stewards of how to run the program and being very thoughtful in terms of eligibility, making sure it’s a good experience like every segment that we do. So we think it’s a very attractive program and we’re all for it. What we want to do is just make sure we’re delivering it to the right customer and doing a good job fulfilling it. So I think it will be an ongoing. We’ll see where it goes long term but we’re right there and participating and trying to get customers that are eligible into the program.

Philip Cusick

And that low end was, I think, a couple of weeks of it was what? First quarter to positive subscribers.

David Watson

To your earlier question, we always do come in. And so what we segment the base, we’ll go in with offers in the $25. You look, there are some $35 offers out there. We’re trialing $50 offers with a mobile extension included; and so there are different offers. We’ve always done that, the ability to go into different geographic areas, test things, learn from it and move on. And the net of this when you do segmentation is still solid ARPU growth in broadband of 4.5%.

Philip Cusick

And the seasonality you’ve talked about is sort of you’ve expected less-than-normal seasonality this quarter as sort of the base evens out through the year a little bit. Is that still something that is valid?

David Watson

I think what’s happening, you have parts of the company, places like Florida, that will have more normal seasonal activity. So people are leaving when they used to leave. And so there’s just beginning to be more normal activity. It’s — I don’t think you can historically completely compare it to where it was but aspects of it will be more normal.

Philip Cusick

Okay. Well, let’s go back to the 1 million passings you talked about. As you said, it was 840,000 last year, 1 million this year. And comments have been that you would like to do more over time if that becomes available. What’s the sort of — what does it look like now to build broadband? And most of this is not subsidized, right?

David Watson

That’s right, right now.

Philip Cusick

Right. So how are you sort of building engines and getting ready for those subsidy programs to come along?

David Watson

Well, first off, when you look at the entire amount of 1 million, it’s — the majority continues to be near term, the fill-ins. And so there’s still activity building out too within our footprint. Then there’s the ongoing hyper-builds for business services. Business services continues to be an awesome business for us, I mentioned earlier. And so a lot of capital dollars go towards business services right from the get-go. But the third one are the edge outs. And so our focus has been to these — that is really a key difference between the 840,000 last year to the 1 million is just more edge outs. And the way we look at it, it’s proximity to current plant, density that we look at, doing it in a profitable way. But it is a new opportunity in that we have a whole portfolio of products to be able to go to these communities with, mobile included and being able to talk about business services, residential, so — but we will be very disciplined in terms of profitable outcomes and how aggressive we are.

But we’re having good success and at the state level, where most of these new programs are focused and handed and the applications are being reviewed and then handed out at the state level. And so we’re winning our fair share. I think most of the benefit of this will begin to be seen next year. This is — a lot of this right now is not grant wins quite yet. We’ll see that activity beginning to show up next year.

Philip Cusick

Has the math on building new footprint changed either your assumptions on penetration or ARPU or margin? Or it seems like this is a bigger focus of the company than it’s been in a long time.

David Watson

I think it’s a unique opportunity. It’s a unique opportunity that you have with the stimulus dollars that are available. It’s a unique opportunity with the range of products that we now have. And then even what I announced earlier, NOW TV being able to show up with an affordable video product right from the get-go that’s streaming, it certainly is a new set of variables that we have. So it is — but we’re still extremely focused on profitable outcomes. But if you get it right in terms of proximity to your existing infrastructure and what we’re talking about is that 200-plus range, 200,000-plus range of edge outs.

And the great part about Comcast is — and again, Brian, Mike and everybody have been — if there are opportunities to do more, we will. And — but we’re very disciplined in how we do it. But I think the addition of the new products has added a little bit better returns but we’re going to look to build out as many as we can. But — and operationally, I think we’re in a good position to be able to pull this off and walking through exactly how to build it. We want to be there for the communities and be that partner where they can count on us for the long run.

Philip Cusick

You said about 200,000, 200-plus thousand edge outs, that’s the number this year.

David Watson

That will be this year.

Philip Cusick

And that’s a good run rate going forward. You think that can ramp?

David Watson

Hard to say. We’ll see where it goes at the state level but we’re going to be aggressive. This is a huge opportunity for us. So I can’t give you the exact number but we’re going to be on this for the next couple of years, I think. My sense of things in terms of funding, it will be available through next year. Different states have different times where they are in terms of the bidding process. Some got out a little bit early and some are going through a different process. So we’re right there arm in arm, trying to help figure out the process with them. But I like that it’s a little bit more seasoned right now. The capital markets are slightly less frothy right now and you have a better line of sight on returns right now. So we’re going to participate fully and completely, I think, going forward.

Philip Cusick

The states that have got to, whether it’s a bidding process, I don’t think anyone is in an award process, are they?

David Watson

No, some states, they’ve had different sources of money for some time. So they have handed out — they’ve started the process of handing out grants already.

Philip Cusick

And have you seen a sort of a bidding down of value in those from some of your competitors? Or it’s pretty reasonable?

David Watson

I could go on for hours talking about…

Philip Cusick

We have 14 minutes.

David Watson

Now it is — they have a very — and it varies by state but they have a whole bidding process on points typically in terms of how you build it, where you build it, time to market, an assortment of different variables that go into it.

Philip Cusick

Yes. Well, I’m going to go back to NOW TV because I thought Brian last week was pretty clear. To paraphrase the way I heard it was video is going over the top, period. We’re going to take a football game and we’re going to put it on Peacock. This is how it’s going to be. And there’s nothing we can do about it, so we might as well get on board. And so how does that change how you think about the Connectivity & Platforms business? And NOW TV is obviously a piece of that. Where do you see our all video watching in 5 years? Is that — like what’s the North Star you’re looking for?

David Watson

Well, clearly, everyone’s seen the data where things have flipped. The — most of the engagement has gone towards streaming. But there’s still moments. So I know there’s a lot of speculation of what happens to sports. But I think there’s still a longer runway there in terms of — but at the same time, what we’re witnessing and we saw it already last fall, there is a new peak moment for broadband connectivity engagement, Thursday nights. So it’s Amazon with football. So we’re all over that.

We think that we’re there for those peak moments. What I mentioned earlier, Phil, is that you look at all those devices, you look at the sheer amount of engagement. I think anyone that thinks about your own personal situation or anybody, you have to ask yourself where do you think broadband is going? And broadband is going to continue to see more streaming. You’re going to see more video games, more applications. And so there’ll be these new peak moments that occur in terms of streaming. But — and the way we look at it is that we go down to the application layer and look at our performance in terms of where our broadband network is and how we built it with one of your points, the great WiFi capability that we have with these gateway devices. And we look at the Netflix scoring in terms of the best ISP. We have the top score for that.

We look at gaming companies in terms of lag rates. We perform extremely well. We got top scores for that. Speed test, we do — so we look at streaming, we look at applications. And I think we’re positioned well for today but where the network is going, we’re building for the future as well. That’s one of the — I think one of the most important parts. There’s not this peak moment a bubble that’s happening. We’re planning out capital, I think, in a very thoughtful way that people can understand and doing that now with this new Connectivity & Platforms group with clear line of sight in terms of how we’re going to spend capital. But we’re getting prepared for where I think the customer is going, not where they’re at right now.

Philip Cusick

You’ve rhetorically asked where broadband is going. I think it’s going up into the right at 35%. It’s not going to stop. So let’s just talk about wireless really quick because this is one of the things that you can layer on top of that broadband connection. And we’ve had these discussions about wireless. We’ve had the carriers here yesterday. And I think everybody’s dinging Comcast and Charter right now and a little more Charter than you, for going after the low end. But what I remember and you mentioned business services, is 15 years ago, Comcast was going after the low end in business services because that was easy and it was sort of free pickings. How should we think about how wireless evolves over the next 5 or 10 years? Has that low-end customer base either gets — you pick them all up or more competition focuses on it and it sort of evens out?

David Watson

Well, we’re clearly a challenger. It’s good to be a challenger in a line of business, business services and mobile. But with mobile, I think we’re uniquely positioned in terms of by the gig and unlimited. But what I said earlier in terms of how we manage going after broadband, very similar way with mobile, where we focus on acquisition, base management, upgrades, downgrades and then retention. Mobile is such a huge part of all 3 of those efforts. And one of the things that we’ve done in the last 1.5 years or so, we’ve rolled out higher tiers of unlimited in terms of performance, in terms of capabilities and it comes at a higher price point. So our mobile ARPU is hanging in there as well because we manage things that way.

And one of the things, too, that we have, we have this companion which is just great WiFi and being able to have WiFi do a lot of the lifting in the home, the 20 million hotspots that we have. So we talked to our customers, not just about that we’re at the low end of the marketplace. We talk about mobile as if we’re the leader because we have built the next-generation mobile capability when you combine great WiFi with great mobile service. So we have a wonderful wholesale deal with Verizon, really like our positioning there but it helps us compete in every single segment. And we think we — whatever they do, we get access to.

So, I think we’re in a good position to compete in every single segment. And not surprisingly, our focus does start in the high end but we’ll compete in every single segment.

Philip Cusick

So Charter talks about — I think it’s 85% of the traffic on phones is off cellular now. Is that a similar number for you?

David Watson

Very much so.

Philip Cusick

Yes. And can that keep going higher as your WiFi gets better and is more ubiquitous? Or is that sort of the right level?

David Watson

Well, we’ll see. One of the questions that gets asked is the offload and that would be with private spectrum not necessarily WiFi but we offload a ton in those public hotspots today. And we think of WiFi as part of our network. We literally manage it that way in terms of capacity, coverage and capabilities. So I think that there may be opportunities. But for our offload approach, we’ll be very opportunistic because we simply don’t have to because we have a great MVNO and it puts us in a position to compete aggressively all over. But we could.

And we look at the 3% of our footprint contributes 60% of the traffic in those spots we’re testing. I think Charter has talked about this too, we’re testing very actively that offload approach with our own spectrum. And we’ll see. There’s not a need to but there could be an opportunity to do it.

Philip Cusick

Yes. 3% of your footprint is still a huge number of square miles.

David Watson

Yes.

Philip Cusick

Yes. It’s a big place. So I want to switch gears quickly to international connectivity recently under your group. How do you think about the opportunities here? And what’s really driving what was a very strong connectivity revenue growth last quarter?

David Watson

Yes. It really is. First off, it is great to be able to work with Dana and the Sky team, very talented group, a great brand, very well regarded in Europe and gives them the opportunity to extend into these profitable categories, broadband and mobile. So when you look at the $3 billion in terms of revenue, 2/3 of its broadband. You had 7 million broadband customers between U.K. and Italy. And mobile is the other 1/3 and that’s U.K. So it is growing in the — take the connectivity business in the U.K. and Italy, growing in the mid-teens and it’s a terrific business. So we — they’ve done a nice job positioning it. They also have a very thoughtful approach towards acquisition, base management, going to and helping upgrade and then retention. But really like their broadband performance and opportunities. And U.K. mobile, more to come. Outside of the U.K., we’ll see but it’s — they’re doing very well so far in the connectivity business, really like the $3 billion trajectory.

Philip Cusick

Is there a need for capital in that business to own some network in those markets? Or MVNO’s fine?

David Watson

I think there are similarities between what we’ve done in terms of being able to strike a really good wholesale deal. I think their approach is capital light as well but then they’re able to deliver a great customer experience in — with the U.K. and then they have great WiFi. So we’re able to help with them with the same gateway devices, the same software layer that we’re able to leverage. And again, think about the 52.5 million at the beginning in terms of relationships. We have a single stack of software that help us fuel the best video platform. And then we have the great operating system for broadband as well that can deliver great WiFi inside their home and that’s international or domestic.

Philip Cusick

What’s the business mix in the European businesses? Can you take that U.S. sort of knowledge and move it over?

David Watson

That is a big opportunity for us. They do a really good job with bars and restaurants, not as much still in the early, early stages of thinking through the business opportunity. And we’re absolutely — that’s one of the ones that we’ll work with them on.

Philip Cusick

This is the regulated wholesale opportunity for fiber the same in business as it is in consumer? Or is it tougher to get access?

David Watson

No, I think you start with small business and I think it’s very similar.

Philip Cusick

Okay. You mentioned the sort of value of putting this all together and 52 million global connections. How should we think about the sustainability of what was really amazing margin growth in the first quarter over time?

David Watson

Well, there is a little bit of the Olympics that we had in the first quarter but the real story to me is just the focus that we have around the revenue growth, the high-margin opportunities that we have in the 4 categories that I talked about, just the fact that we can manage the headwinds but still just go after the business services which didn’t spend a lot of time on but think about just that one area for business services to be able to — from 0 to 20 years ago for it to be the kind of business. And the big part about business services is staying so focused on high-revenue, high-margin opportunities. They have a long runway ahead, really long runway.

Philip Cusick

They’re still shooting higher in terms of customers and potential.

David Watson

And total growth because they have a good balance between — we’re 20% of a $50 billion marketplace. And that’s just within our footprint. If you go off-net and think about business services which we can now do with Masergy, we can now do mid-market and deliver that throughout the world. It grows the addressable market to $70 billion to $100 billion [ph]. So our folks starts with — when you go to margin, it starts with just relentless focus on where is the growth and how we’re going to continue to grow these businesses. So that is the main focus.

And then you go to the cost side and we’ve been very focused on taking out transactional activity, unnecessary things, truck rolls, telephone calls, doing better with digital, doing better with customer service and a disciplined cost control around fixed costs. So just not a lot of drama but a lot of disciplined focus around taking out where you just don’t need it and how you can be a better operator. So when you add all that up, the real story behind margin and you look at where we’re at between legacy and then the fact we — between Connectivity & Platforms, expanded 160 basis points, it’s really the focus around high-margin, growth-oriented businesses. So — and managing the ones that are a little bit harder, video and taking a disciplined approach towards profitability with those categories that have those headwinds.

So I like the runway. I like our position in the marketplace and the growth prospects. So I think the network position, the product position, competitive position, it is intensely competitive, make no mistake about it. But we’ve been at it for some time. We’ve been up against fiber for 20 years now. We’ve learned a lot from it and we’re going to go through this surge where fixed wireless has a little bit of momentum. And until — same thing we saw with fiber. Until you get a little bit of that base built and then you start getting win-backs, you start getting a little bit more fluid activity back and forth, I believe over time that will happen. And so be back to looking at a different story with broadband but we’ll be able to grow the business because of ARPU, multiple products and disciplined approaches towards these growth-oriented businesses.

Philip Cusick

And that sort of — you bring us back to where we started. So as I — we sort of wrap up, it seems like this is a period where you’re growing the business through new products, revenue per user, sort of driving more devices into customers’ homes like NOW TV. At some point, you think the broadband starts growing again. And in the meantime, focusing on costs, is there any sort of new cost program that you’re doing? Or is this just regular way?

David Watson

Every year, as long as I can remember, we’ve been focused on taking a healthy approach towards cost control and a lot of it in cable, we can still get better. There’s still runway for getting better around the customer experience and again doing — if there’s going to be a beneficiary in the AI world, it’s going to be cable. And so there have been lots of winners in that but we will be focused on and already leveraging it and being able to do where there’s a fiber cut exactly where the interval to do a better job getting to it. We’re going to continue to take cost out in a disciplined fixed way. So we’re — I think, positioned well for the future, good focus on where the network is going. And it is — I think it starts with, though, that we still have growth prospects ahead of us in these growing categories in mobile and most certainly broadband. But nice to be able to have good news for the high end, good news for every segment, including the value-oriented segment and being able to leverage our capabilities, like we announced today with NOW TV.

Philip Cusick

Good. Good place to leave it. Thanks, Dave.

David Watson

Thank you, Phil. Thank you, everyone.

Philip Cusick

Nice to see you.

David Watson

Thank you.

Question-and-Answer Session

End of Q&A

Carrier Global Corporation (NYSE:CARR) Wolfe Research 16th Annual Global Transportation & Industrials Conference May 23, 2023 12:30 PM ET

Company Participants

Nigel Coe – Managing Director, Wolfe Research, LLC

Conference Call Participants

Patrick Goris – SVP & CFO

Nigel Coe

…and welcome to the post-lunch period here at the Wolfe Conference. Very pleased to welcome back and start again with Carrier. CFO, Patrick Goris on stage with me. Thanks Patrick for being here and so is Sam Pearlstein, Hear of IR.

So I think we’re just going to the Q&A right. Patrick, unless you want to make some opening comments.

Patrick Goris

No. Q&A is just fine.

Question-and-Answer Session

Q – Nigel Coe

Q&A is good. Okay. So normally, I want to start off with macro kind of trading environment. I think given the announcements you’ve made over the last month or so, I think the portfolio is sort of where I want to start and I wanted to kick off with Wiesmann and just maybe just first and foremost, how do you see the timeline for the closure of Wiesmann? What are some of the regulatory hurdles we need to go through? And what do we need to monitor there?

Patrick Goris

Yeah, and if I just may provide some context as what we’ve done for the acquisition, you can think about carriers since dispensed from United Technologies. We’ve worked on simplifying our portfolio. We sold an asset, an equity investment we had in Beijer. We sold Chubb, what we thought non-core assets. And then what we’ve done is we’ve increased our stake or we’ve acquired businesses in higher growth areas.

One was the acquisition of Toshiba Carrier. Joint venture, it gives us access to a faster growing VRF market, technology we can use in different parts of the world. And then we announced earlier this year, which you were referring to, Nigel, the acquisition of Wiesmann, which provides us basically with immediate access to residential heating and cooling in Europe, a much faster growing end market where Carrier has had very little exposure.

So that being said for context, there are no hurdles that we see that are not the usual hurdles. They’re the normal regulatory requirements or approvals that we need. They’re in Europe. They’re in other parts of the world, including in Asia. That’s why we came up with the timeline around the end of this year. And so that has not changed, although these items are either filed already or are in process of being filed and there is really no change there in terms of the timing.

Nigel Coe

Yeah. I saw some headlines around, the German regulator, some of the public interest of acquiring a Crown Jewel of the German industrial sector. Do you see any issues there?

Patrick Goris

We don’t. But first of all, the reaction we think is understandable because we agree. You mentioned Crown Jewel. We think it is the crown jewel in this part of the market, not just in Germany, but in Europe in general. We actually have — Wiesmann has sales in Asia as well. They have sales in the United States. So it’s much more than just a European player.

They’re always concerned if someone buys a national or the crown jewels of a country or an industry. But we’ve made it very clear that we’re not there to — call it to over-manage the business. They are really good at what they do. We can learn a lot from Wiesmann. We can use their technology in other parts of the world.

We can use their channel to push through additional products that are already in our portfolio. And, frankly, it’s the key reason why the Wiesmann management team will be the Wiesmann — will be the management team of that business going forward. And we actually may fold some of our businesses within Europe underneath that management team because they’ve done such an outstanding job.

Nigel Coe

Right. And I think you mentioned one of the attractions of Wiesmann partnering with Carrier is helping to expand and to invest and to make necessary investments required to meet some of those targets. Maybe just talk about some of the investment spend, kind of the investment capacity expansions you see over the next several years to support the forecast that you have out there.

Patrick Goris

It’s specific to Wiesmann? So if you look at Wiesmann investment profile, they have made some significant investments last year. This year, I think, is about the peak because you basically have an entire industry of their entire business, which is shifting from boilers to heat pumps. And so you need more capacity for heat pumps and less capacity over time for boilers.

In all of our analysis and due diligence, this is the year where it’s the biggest peak. The nice thing is going forward, we think there will be less requirements than this year, also because we have existing facilities in Europe. We have existing facilities in that region that we also acquired through the acquisition of Toshiba Carrier, and there is some space in those facilities.

And so I do not expect that this would have a significant impact on our free cash flow conversion. Actually, if I look at Wiesmann’s free cash flow conversion, the last few years was in that 90% to 95% range with some important investments. So there will be one or two years of some important investments, but I don’t see a change in our free cash flow profile as a result of this. And there are some nice, as I mentioned, some nice synergies there given our footprint in that region as well.

Nigel Coe

Sure. I see the clock’s not ticking, so we have a lot of time. We have a lot of time. We have 30 minutes to go, so that’s good news. Okay, so I lost my train of thought there. So we talked about capacity. How fungible is the boiler capacity with heat capacity? So as the heat pump business falls off, can that capacity be easily repurposed for heat pumps?

Patrick Goris

I believe it is new equipment that you need, hence some of the capital investments required. Also, it’s interesting, the boiler business, we expect it to decline amidst single digits going forward. The boiler business is actually still growing in parts of the world, and so it’s not like, for example, in Asia, in some countries there, their boiler business is still growing. And so it’s not a one-for-one reduction and that’s why we expect also from an overall company point of view for Wiesmann, we expect attractive revenue growth rates going forward.

Yes, amidst single digits decline in boilers, but we expect heat pumps to be growing at an attractive growth rate, so strong double digits, but the price per unit in heat pumps can be about 3X, 4X what it is for a boiler.

So without any volume growth or without any unit volume growth, you can see significant revenue growth, and the margin percent is about the same on a heat pump as it is for a boiler. And so it shows the attractiveness of the opportunity there.

Nigel Coe

Okay. So the boiler business would be falling off much faster than mid-single digits, but offset by in Europe, but offset by growth outside of Europe?

Patrick Goris

It would decrease faster than mid-single digits in Europe. That’s our assumption. But there is still some growth in other parts of the world.

Nigel Coe

Okay, great. So the other part of the portfolio move is the foreign security assets and the commercial refrigeration assets. Maybe talk about how much progress you’ve made towards getting this done. I don’t know what you can tell us, but in terms of how far down the path have you gone there?

Patrick Goris

Well, all the work streams are in flight. The bankers are all engaged, and so clearly we’re in the process of going to market, as I say, as soon as possible, which I expect to be briefly after the summer or at the end of the summer and CCR, commercial refrigeration, I should say, that will be a sale. So that’s very clear there.

And then on the foreign security side, frankly, we have some flexibility. Is it all at once or is it in parts? And so that’s something that we’re looking at to optimize frankly, and we’ve been very clear, we have three priorities. One, we want a clean exit. Two, it’s proceeds, and three, it’s timing.

Nigel Coe

Okay. We’re definitely going to talk about the clean exit in a second. When we think about the foreign security package today, obviously excluding the KFI business that’s gone into Chapter 11, but when you think about the remaining portfolio, it’s a mix of residential and commercial assets. Is that a natural bundle, or do you think that they could be separable?

Patrick Goris

It could be separable, but there are different ways of thinking about it. One way to think about it is residential versus commercial. Another way of thinking about it is the security businesses compared to the fire businesses. And so that’s some of the work that we’re doing now, what is the best way to have a clean exit, maximize proceeds, and then timing. So there are different ways of going at this and so it’s still open whether we sell it all at once or in parts.

Nigel Coe

Okay. But when you say sell, it sounds like sale is more likely to spin at this point.

Patrick Goris

I said sell. I should have said exit, but clearly the reason I said sell is because it’s our preference.

Nigel Coe

Yeah, for sure. Yeah, for sure. And how would you — I don’t know. It sounds like you haven’t gone – so the bankers are engaged, and I’m sure they are. They’re not that busy right now. But as far as sort of the interest out there, how would you sort of characterize that?

Patrick Goris

Strong, and we’re not surprised. Frankly, we’ve had interest in incoming calls way before the announcement. And the reason, frankly, is if you look at fire and security, if you look at each of the businesses that are part of that segment, they tend to be number one or number two in their market.

Tend to be high-margin businesses, tend to be businesses that don’t require an enormous amount of capital to support them. It’s just that we don’t believe we’re the best owners of those businesses. So we’ve had significant interest in incoming calls, and so we’re quite optimistic on the exits here.

Nigel Coe

Great. Maybe a couple more on portfolio before we get into the actual business. So I think you said mid-2024 to have everything done by…

Patrick Goris

Over the course of ’24.

Nigel Coe

Over the course of ’24. It sounds like that could be sort of a conservative timeline. Do you think you could maybe get it done by year-end?

Patrick Goris

This year-end might be a little bit aggressive, but if you — as I mentioned earlier, if we — late summer, if we want to be able to go to market, as I call it, could there be a scenario where we could see some exits earlier, at least some announcements? Could be. We just shared over the course of 2024, we’d rather surprise to the upside than the other way around.

Nigel Coe

Sure. Absolutely. And then you mentioned the desire for a clean exit. Obviously, KFI has been unplugged from that package. Given what you’ve done — well, you haven’t done it. Your subsidiary has declared bankruptcy. It filed for Chapter 11. Does that clean the ring fence, that liability?

Patrick Goris

Actually, in our view, in Carrier’s view, the location of the liability was always crystal clear. It was always in KFI and nowhere else. KFI has been in business for 35 years. It’s a profitable business. It has good customers, good product lines. It has $200 million in sales.

It just happened to have owned a business for eight years, ending in 2013, that manufactured AFFF. Carrier never owned that business. We never got any dividends from that business. We got that business as part of the spin. And so, as it goes with either ring fencing or containing liability, we think it’s a very, very strong position we’re in, and that’s why we’re comfortable with the decision that the KFI board has made. And, obviously, this may impact whether this is a sale or a spin of some of the F&S businesses.

Nigel Coe

Okay. And just finally, this is my final question. And, by the way, guys, I’m going to go out with questions.

Patrick Goris

We still have 30 minutes.

Nigel Coe

I know. It’s like some kind of Twilight Zone kind of situation. But I will be going out to questions of the audience in a moment. But is it possible you can actually exit the remaining businesses, the core businesses, without the KFI approval? Or do you think some kind of resolution around KFI needs to happen before we can finalize the sales?

Patrick Goris

I think it is possible that we could exit parts of fire and security before calling the complete resolution on the Chapter 11 process. I’m not sure there would be a complete outcome or a complete exit without having a clear outcome there in terms of the discharge of any liabilities.

Nigel Coe

Okay. Very clear. Okay, I think that Carrier’s portfolio. Unless there’s any questions out there on portfolio. Any questions?

Unidentified Analyst

Just had a quick question going back to your heat pump comment. You mentioned the pricing was 3 to 4x that of a boiler, wondering are there any material differences in the aftermarket in servicing and maintenance when that shift happens? Like is it more captured in that upfront cost?

Patrick Goris

Yes. Actually, it’s both. And the reason I mentioned this, so the initial cost is a multiple of. But one of the beauties about Wiesmann is it’s — they’re much more than just a heat pump company. They provide their customers an integrated solution, the solar panels, so generation of electricity.

Two, they have home battery storage, energy storage in their homes with batteries; three, and they have the pumps, they have a sanitary hot water and then they have the home energy management systems that optimizes the energy generation, the storage and the usage. And so the initial sale of the heat pump is a multiple of.

But if you then include all these accessories, that provides a significant additional revenue streams and then the opportunity to attach service to all of that. And so — and by the way, this is something that really differentiates Wiesmann because we don’t see anyone else in Europe being able to provide that.

And so it’s much more than the initial heat pump sale. It’s the overall package of solutions sold to customer, being able to attach services and having a level of customer intimacy and basically a dependency of the customer on the company that’s very different than being just a provider of equipment.

And then for us, of course, and I’m adding on to my answer, but the opportunity is to be able to provide the same thing in some other markets, including in North America residential, where we have a very attractive market share where no one provides that complete offering today. And that’s something that, of course, that we’re looking into from a revenue synergy point of view.

Nigel Coe

Anything else? Okay. Let’s continue. Maybe one more question on Wiesmann. We get a lot of questions around the potential competition in the European heat pump market to really explode. So a lot of Asian — very capable Asian competitors coming in. Daikin is obviously expanding capacity. How important is that installation network that Wiesmann has, the 70,000-plus in stores. Is that a wall garden? Are they exclusive to Wiesmann? What protects you from competition?

Patrick Goris

We think that installer base is critical. One, there is a shortage of installers. So we can — or anyone can produce as many units or heat pump units as an he wants unless you have installers that are trained on your equipment, have the loyalty towards your brand. It’s going to be really hard to find someone to sell them to.

So the installers are critical. Wiesmann — and I think that model is somewhat similar to the U.S. Installers in the U.S. tend to have a primary brand, could be 80-something percent of their sales. They tend to have a secondary brand. But the relationships are I mentioned the training, the training academies. It’s really hard to switch. And it’s certainly hard to switch from the number one premium brand in Germany.

And so we, Carrier, when we looked at that market in Europe, we always said technology is not our biggest challenge to enter that market. It is the challenge. And so challenge is one. Two is you may be able to provide or to manufacture and deliver a heat pump. But as I mentioned earlier, the energy transition is much more than selling heat pumps. The opportunity is for that entire integrated solution, and that’s someone that we see Wiesmann being the only one who provides that today.

And so those are two really important elements. And then a third one is having the installed base. The customers know you, the customer know your brand. Wiesmann, I think, for 17 years in a row has been named the number one brand in Germany from a customer loyalty point of view. Very hard to break. And a key reason why we acquired them, obviously.

Nigel Coe

Sure. Okay. Great. Can we just talk about a quick post check on what’s happening out there in the market right now? The field checks on residential are coming in pretty weak right now. Commercial sounds like it’s on fire, and transport, I don’t know. I have no idea about that. But anything you can help with what you’ve seen out there?

Patrick Goris

Yes. We would say that there are parts of our portfolio that have continued to be strong through the first quarter. You mentioned commercial HVAC, I would put light commercial HVAC right next to it or even higher performance there. North American truck and trailer continuing to do really well. The areas that for us have been weaker on our container business. Container is a really good business. It went through a downturn starting in the third quarter of last year. We actually believe our second quarter will be better than our first quarter from a volume point of view in container.

Commercial refrigeration is also going through a weaker period. We expect that to improve in the second half of the year. I’m not sure whether that’s going to be a Q3 or Q4 element. With respect to resi, the item we watch the most is movement. First quarter, as we expected, volumes were down mid-single digit sales with — mid-teens sorry, mid-teens. That’s why Sam is here to correct me.

Mid-teens, volume mid-teens, revenues down high single digits, we think in Q2, sales will be down low single digit for resi. We actually, in our April guide, we assume that volumes will be — or sales will be slightly up in resi in the back half of the year. We’ll know for sure once we look at the movements, particularly in May and in June, as we enter the busy season.

Nigel Coe

Yes. It seems like weather has been unhelpful. Is that fair to say?

Patrick Goris

Yes, we always were warmer summer and colder winters. And so it could be warmer in some parts of our country. But as I mentioned, this can change, as we all know, this can change in a week. And in a week, you have a heat wave and it changes the whole dynamic of our business.

Nigel Coe

For sure. A couple of days of heat changes the whole thing. And then thinking about — obviously, you and Watsco have a very symbiotic relationship. Watsco’s margins have been significantly higher over the last couple of years. It feels like there’s been some transfer between the manufacturers, not carrier, but manufacturers to the distribution channel. Is that the right way to think about it that there’s been more incentives provided to grow?

Patrick Goris

I believe they may have seen the margin expansion earlier than we would have seen. But clearly, we have a tremendous focus internally on one the — not just the price realization, but two, the productivity but also capturing any cost deflation. We have not seen it in Q1. Actually, we didn’t expect that in Q1. We expect to see a bigger benefit from that deflation capture and starting in the second quarter of this year than what we’ve seen in Q1.

Nigel Coe

So we start to see improving margin for metals in the second quarter then a big tailwind in the second half of the year.

Patrick Goris

We actually expect that deflation capture to be higher second half of the year than the first half of the year.

Nigel Coe

And we’re still on track for price cost of $200 million?

Patrick Goris

Yes.

Nigel Coe

Okay. That’s great. And then on the commercial side, any areas of concern out there. I mean there’s a lot of chatter around commercial construction weakness. Are you seeing any pockets of weakness in your portfolio?

Patrick Goris

In North America, for commercial HVAC, we think commercial real estate is less than — or about 10% — a little less than 10% of our total business. The tailwinds we’ve seen in this business is, one, focus on sustainability, decarbonization globally, healthy buildings, some government incentives. But if you look at commercial HVAC, we believe we have leading positions in Asia and in Europe, a very strong offering from a heat pump point of view.

And the biggest opportunity, frankly, we have in that business is in North America where we’re not the number one, two or three player. It’s an area where we’ve made some investments in our product portfolio, magnetic bearing equipment. But also, we’re in the process of seeing expanding some of the mac bearing product line we have in the U.S. and introducing some of the heat pump technology in the U.S. that we’re so successful within Europe.

And so attractive business and of course, the one of the key attractiveness of that business is large installed base and then our opportunity to monetize that installed base with more aftermarket sales. And that is something we’ve been very open about is our number one priority in that business. And frankly, for a company in total, aftermarket is a key priority. And I think it’s fair to say that compared to some of our peers, we started later, but it also means that we more have more opportunity for growth now.

Nigel Coe

If you look at your larger HVAC peers, service revenues have expanded and accelerating to double digits, which is something we haven’t seen before, has there been a change in the dynamic between the big players, the big OEMs and maybe some of the ISPs out there in terms of trade of some tools [ph] the manufacturers with the genuine parts and the predictive maintenance.

Patrick Goris

I think it’s hard to tell. For us, what we know what drove it is, one, historically, it has not been a big focus. We put in a playbook that was used, frankly, in the aerospace industry, which worked really well there. Since we’ve put that playbook in place, we’ve been growing at strong double digits. Q1 was up mid-teens?

High teens. And so that is an area where we have significant more room for growth because we still estimate that today, our aftermarket business is about $5 billion. We still estimate that it’s about 20%, 25% of the total aftermarket revenue available for our installed base. So we capture too low of a piece of that market. Hence, a big focus, whichever business you talk to internally within our company, that is an aftermarket plan, aftermarket leader, aftermarket targets.

Nigel Coe

Very clear. Container. By the way, I wish I had Sam on my shoulder as well. I get lots of numbers wrong. So on the container side, very hard for us to track what’s going on real-time in container. Are you seeing signs of that inflection that you called out? And it feels like your guidance implies that container revenues will be up sequentially. Is that the way you have a plan?

Patrick Goris

The way you can think about it is, we said that typically, container goes through four quarters of a down cycle. For us, that would have started in Q3 of last year. We expect Q2 in unit sales and therefore, revenue sales to be better than Q1 and would expect to see some growth in the back half of the year — year-over-year, the container.

Nigel Coe

Quite some growth in Q2. You have the growth in the second half of the year. Okay. Great.

Patrick Goris

And that’s, again, really attractive business. I don’t know what you know this, but we have over one million sea container units out there. And when we talk about aftermarket for that business, it’s all about finding the units, connecting them and then attaching services to them, whether it’s the Link platform, combined with our sensor technologies like remotely monitor the performance of those sea containers; being able to tell the end customer or the manufacturer or the producer of the medicine for the food to say, this is the temperature at which your goods were throughout the sea journey; being able to provide predictive maintenance ideas to the operators, that’s the aftermarket in container, a tremendous opportunity. And I think by the end of this year, we plan to have well over 100,000 — close to 200,000 units under contract

Nigel Coe

Compared to?

Patrick Goris

Less than 100,000 at the end of last year.

Nigel Coe

All right. We’ve got two minutes. I think the clock is right now is two minutes left. Any questions in the audience? Continue. Going back to residential. I just want to touch on inventories. Again, your big channel partner increased inventories in the first quarter. And they’re talking about more channel burn in the second half of the year. So how do you view inventories across your broad spectrum of channel partners?

Patrick Goris

If I — specific to resi?

Nigel Coe

Resi.

Patrick Goris

We would expect — we don’t expect to see a reduction in field inventories until the back half of the year. If I look at our outlook for resi for this year, high single digits volume down. It would be mid-single digits without any inventory reduction in the field. And so the key question — that’s why I mentioned earlier, the key item for us is going to be watching that movement and is that assumption still valid?

Or maybe it’s going to be better or a little bit worse. We don’t think that we will see that inventory destocking until Q3, Q4. We expect some. The question will be is how much is it going to be more less than what our assumption?

Nigel Coe

And obviously, there’s a huge offset from price and mix this year in residential.

Patrick Goris

Yes. That’s why we expect our revenues in resi still to be about flat year-over-year, even though the declines in volume are high single digits.

Nigel Coe

Yes. Quite nice offset.

Patrick Goris

And it’s the mix up.

Nigel Coe

Yes. So the sea pricing is holding. So that [indiscernible] up on the 10%, 15% mix up. I think it is?

Patrick Goris

Yes. The new units, the SEER units, about 10%, 15% higher price that’s holding.

Nigel Coe

And then the price itself, I mean, just remind us in terms of the pricing actions you’ve taken this year, what’s in the plan?

Patrick Goris

We expect to have about $500 million from an overall company perspective in pricing. That’s about 2%, 3% for the full year. We’ve seen pricing hold in the case that we see additional input cost headwinds will, of course, consider additional pricing. But so far, it’s holding and we don’t see any change in market behavior.

Nigel Coe

Incentives are normal.

Patrick Goris

No change.

Nigel Coe

That’s fantastic. So Patrick Goris. Thanks for the conversation. It’s good chat, and look forward to seeing next year.

Patrick Goris

Thank you.

Visa Inc. (NYSE:V) JPMorgan Global Technology, Media, and Communications Conference Transcript May 23, 2023 10:10 AM ET

Executives

Jack Forestell – Chief Product and Strategy Officer

Analysts

Tien-Tsin Huang – JPMorgan

Tien-Tsin Huang

Thanks. Thanks everyone for filling in here. Always a pleasure to have Visa with us. Jack Forestell has had the pleasure to come in. He’s the Chief Product and Strategy Officer. We are going to do a fireside chat and go through some of the topics that I have collected from the investment community. My name is Tien-Tsin Huang. I cover the payment sector and if we have time at the end, we will ask questions, but we have got a lot to get through. So, Jack, welcome.

Jack Forestell

Thanks for having me.

Question-and-Answer Session

Q – Tien-Tsin Huang

It means a lot to me to have you here. There’s so much to talk about on the product side. But I thought if you wouldn’t mind just kicking it off, you have got a great background. I was just saying I know you from running the merchant business and the merchant acquiring side and so you are such an important person to listen to given all the things that have gone on, on the merchant side, but of course, you moved on to product. You have got a big role now with leading up product and strategy. You are coming from Capital One, especially, I think, the background is fun. But tell us a little bit about your mandate at Visa. Maybe let’s start with that.

Jack Forestell

Yeah. Sure. Happy too, and good morning, everyone. Great to be here. As Tien-Tsin said, I am our Chief Product Officer and our Chief Strategy Officer. So with those responsibilities, I lead the teams that develop our corporate strategy, working hand in glove with our business units and our regional teams around the world, and then, I lead the teams that conceive of, develop and deliver our product road map for the company.

I have been at Visa for about nine years, as Tien-Tsin mentioned, doing a lot of different things, including running our merchant business, various aspects of product, and then before Visa, I was at Capital One for a little more than a decade. So great to be here.

Tien-Tsin Huang

Good. So I guess we will have to start out with some kind of macro question just to get it out of the way, if that’s a question. I know the U.S. It’s been very stable for a very long time here coming off the pandemic. Just a little bit of signs of slowing maybe, but international has been very, very stable. How does that impact your thinking around strategy both in the short- and long-term here?

Jack Forestell

Yeah. Given the seat I sit in, Tien-Tsin, I tend to think about our metrics medium-, long-term. It’s not that we don’t look at the quarterly stuff I do. But when I get our reporting and sort of rifling through trying to find that essential metric that can get to how are users using our platform on the consumer side, how are sellers using our platform on the seller side and how we are doing it, growing and expanding both the scope of the network and the usage.

The best number we probably publish along those lines, I think, is processed transaction growth. And if you look at that number, you can go back and look at it over the time series that we published for a very long time, you will see, we experienced the volatility that you would expect through the pandemic, the boost and then the lapping effects.

But since then, you go back to the middle of 2022 through the end of 2022 and on into 2023, what you will see is remarkable stability in that number and its sort of settling in right now at somewhere just north of 10%, which really reflects growth in the credentialing side, so more consumers carrying more Visa credentials globally, growth in the seller side, so more sellers joining the network, and more transactions happening per user on the network. So that’s the one I look at.

But, yeah, there’s a lot of volatility that happens in any given quarter in any given month, certainly recently. But even going way back in time, there’s always a fuel prices are rising, fuel prices are falling, they are falling right now, so we are seeing average tickets come down that influences our overall purchase volume.

We are lapping some effects of big tax breaks back or big tax refunds back last year at this time, a little shorter, a little smaller this time. So seeing some of that volatility, but underlying, the message is we are seeing real stability with the global consumer and the way they are engaging on our platform.

Tien-Tsin Huang

Yeah. And the beauty of that metric is it cleans out inflation and all these other factors that you just mentioned. So we do get a lot of questions, Jack, around all the stresses in the banking system, on this turmoil that’s going on right now with all the regional bank activity. What do you see, what does that mean and implications for Visa?

Jack Forestell

Yeah. I mean there’s obviously a lot going on and some really serious volatility and some significant failures happening in the banking industry. I guess, what I’d say, though, is it’s been pretty contained.

And when I look at us on a global basis, we work with 15,000-plus financial institutions. In the U.S. alone, we work with somewhere between 8,000 and 9,000 financial institutions and the volatility has been very concentrated in a small number of financial institutions with a fairly specialist set of circumstances.

So when — what we see and in thinking about the U.S. business, when we look at our client portfolio is a really robust set of national, regional and local banks where, again, just stable performance.

We haven’t seen effects on our payment volumes. We haven’t seen effects in risk to our system. Obviously, we are staring at it, we are looking at it, we are stewarding it, we are managing it. But right now, no significant change as a result of what we have seen in the headlines.

Tien-Tsin Huang

All right. Great. Now that’s the power of scale. Let’s talk about consumer payments then. I get this question a lot, Jack, and we just published our handbook looking at penetration and this question, do we see some pull forward in penetration during the pandemic? So how long do you think we have before there is this real conversation of, wow, there may be isn’t that much more penetration left. What’s the time horizon for you as you think about, not only in the U.S., but just some of these developed markets?

Jack Forestell

The cash conversion…

Tien-Tsin Huang

Back to basics. We have to go with the secular stuff.

Jack Forestell

Well, Tien-Tsin, I get why the question comes up. Like you started with, hey, we had an acceleration. The pandemic pulled forward conversion behavior. So consumers who were not using electronic and digital payments and using cash pulled forward. We definitely saw that.

So mathematically, I understand the question of, hey, if there was pull forward and the runway was this long, how much shorter did it get? I don’t want to be glib. But I will just tell you, we study this at the country level. We look at what’s happened from a cash conversion standpoint driven by us, driven by other networks, driven by other non-card payment types.

And I can tell you, yes, the runway got slightly shorter. But the runway was so long. There’s so much cash out there that the amount of pull forward that happened hasn’t substantially changed it from our perspective.

And you think about like even in mature markets around the world, think about Japan and Germany, two of the four largest economies in the world, still cash heavy, right? Think about Latin America, one of our fastest growing markets, up until very, very recently more than 50% of the volume that was running through Visa was ATM transactions, cash out transactions.

Now that’s flipped to a little less than 50%, but it’s only just a little less, right? We still have an enormous amount of runway in emerging markets, we still have plenty of runway in our mature markets, even here in the U.S. still lots of runway. So plenty left to do on the cash conversion side of things.

Tien-Tsin Huang

Agreed. Yeah. And it’s a common question, but I mean, yeah, that secular trend is your friend, as they say. Let’s talk about regulation, if that’s okay, before we dig into some of the products.

Jack Forestell

Okay.

Tien-Tsin Huang

No conversation here is complete without something on regulation. I always like to talk about, whether it was Al in this seat before and Joe, et cetera. But just where do you think the pendulum is with respect to regulation? Does it influence your thinking around product and I’d love to hear your thoughts on Reg II, but maybe just the bigger picture on regulation first.

Jack Forestell

Yeah. Certainly, we have gotten some more clarity on regulation here in the U.S. That’s actually helpful to us and it’s always difficult from a product development standpoint when there’s any degree of uncertainty at all. And so the Reg II clarification at least from my perspective was helpful and just to dig into that one for a second.

The Reg II clarification basically said all issuers must enable two unaffiliated networks on every debit card for the purposes of e-commerce transactions. That was very consistent with our understanding and our thinking, it was kind of our expectation and the direction of travel. Most issuers in the U.S. already do it and we do well in e-commerce transaction routing.

So it was consistent. We are going to see some more issuers come into compliance in the coming months. But if you think about — put yourself in the shoes of a merchant. I mentioned I used to run the merchant business, so I know what that’s like.

The decision about routing a transaction is a multivariate decision. It’s certainly about the price and any small price differentials that might exist. But it’s also really about the quality of the transaction, it’s about the likelihood of success of the transaction and it’s about the risk that’s inherent in the transaction.

And if you think about the capabilities that we deliver through tokenization, our real-time fraud scoring capabilities, our authentication capabilities, we really like our capability set and we think it’s part of the reason why we do so well in transaction routing in the e-commerce space. So we are — we anticipated it. We are set up for it. We don’t see any near-term impacts from it. But, obviously, we are going to keep an eye on it and stay very, very close to it.

Tien-Tsin Huang

I mean we take it for granted, right? We always talk about dial tone quality and sort of the fraud aspect of it and the payment guarantee. I mean, are those some of the examples, maybe just to dig in on what you just said that you get with Visa?

Jack Forestell

Yeah. Absolutely. And I mentioned some of those things.

Tien-Tsin Huang

Yeah.

Jack Forestell

Our tokenization capability, we know brings increases in authorization rate, it brings significant reductions in fraud. We couple that with our real-time fraud scoring capabilities. I mean our ability to take an AI-based fraud model scoring literally of hundreds and hundreds of different variables and deliver that in real time in less than 20 milliseconds to a merchant to help them or an issuer and a merchant to help them make those decisions is, I would say, unparalleled too. Yeah, it’s absolutely a big part of the equation.

Tien-Tsin Huang

Good. So let’s stay with e-comm. We had Dan from PayPal here yesterday. We talked a lot about advanced checkouts. Sure no doubt and we just did a survey recently as well, Jack, talked about how much white space is left for guest checkout. I am always surprised by how big that number is. So I did want to ask you about Click-to-Pay and how that fits and how that compares with the PayPals and some past initiatives around Click-to-Pay and reducing that friction, it feels like there’s still a lot of white space left, but tell us what your vision is here?

Jack Forestell

Yeah. Look, Tien-Tsin, I think, you nailed it. We are on a mission to eliminate the friction from digital payments and it’s actually gotten better through the period of the pandemic. The share of e-commerce payments, digital payments that are happening via Card-on-File, you probably all experienced it.

You might use the same merchant more often. You placed a Card-on-File. When you go back and you revisit that, that experience is actually pretty friction-free. So we have seen the proportions change a little bit.

Tien-Tsin Huang

Yeah.

Jack Forestell

But the white space of guest checkout, as you put it, is still big and it is still full of friction. And that’s what we have pivoted Click-to-Pay to attack. We want — when a consumer shows up and starts entering a card number or those name and address, email credentials, Click-to-Pay can take over and populate, look — hit the Click-to-Pay directory and populate that information for the user on their behalf.

We are working with 50 different enablers, companies like Adyen in 25 different markets around the world. We have got about 19,000-plus merchants live with Click-to-Pay Now and we are working hard to get it out there.

Tien-Tsin Huang

So is there a time line that we should think about this — seeing this more in our day-to-day experience?

Jack Forestell

Yeah. I mean, we are working on it as we speak. So there’s definitely a network effect to it and network businesses always take time. We need to get merchants embedding the experience into their checkout processes. We need to work with our bank partners to get their consumers aware and enrolled in it. So it’s going to take a little bit of time. But, yeah, you should start to see it more and more in the coming months and weeks.

Tien-Tsin Huang

Okay. Good. So maybe bridging to omni and physical world a little bit. I know Tap-to-Pay has been a big topic, it’s crazy. I still remember Blink back in the day around Tap-to-Pay. I know the history was always, Jack, that, right, Tap-to-Pay contactless. It would drive more throughput back to your processed transaction comment to start with. So what have you observed, has there been any difference here? I think there’s been a nice step up, especially in the U.S., any surprises in terms of behavior and follow-through?

Jack Forestell

Well, we have been on this journey for a while now, and look, we know Tap-to-Pay is just simply the best way to pay. It is so simple, so easy. It’s delightful for consumers and for merchants alike. There’s tremendous transaction success. And I’d say, we have been on the journey for a while. We are at a point where about 75% of our transactions are Tap-to-Pay at this point.

So outside of the U.S., we have seen it play out and we know that when users convert to tap to pay, they become more engaged. Most recent numbers I saw were from studying it in the U.S., where a debit user who moves from mag stripe or chip over to Tap-to-Pay spends an extra $65 a month and has two extra transactions a month. So these are like real effects that we have seen globally as we have seen those numbers ramp up.

Now that — we are at 75% overall. We are still only — the numbers escaping is down around 30% in the U.S. So we have got work to do. We are hammering on transit systems, which is one of the keys to get that unlock that daily use of the Tap-to-Pay.

The high frequency transactions, grocery, convenience stores and other spot where we are spending a lot of time, vending, those places that really get the consumer used to it and comfortable with it and then you tend to start seeing it spread out.

We are already, by the way, at a place where 80% of the transactions that are happening in the United States are happening in an environment where it could be a tap transaction. So we have also got some work to do with awareness on the seller side and the consumer side. I mean I find myself standing behind people at checkouts saying, no, you can tap it, just tap. But that’s probably not a scalable way, so we are investing in other ways on the awareness front, too.

Tien-Tsin Huang

My kids are doing it. My kids are doing it…

Jack Forestell

Great to hear.

Tien-Tsin Huang

Speed people up through the line. But, okay, well, that comes back to the whole penetration even in developed markets like the U.S., right? There’s still potential for…

Jack Forestell

So still a long way to go…

Tien-Tsin Huang

more improvement, I think, is the takeaway. Okay. I guess, we should talk about new flows. I talk a lot about consumer payments. That’s what I grew up with.

Jack Forestell

Yeah.

Tien-Tsin Huang

So new flows is still growing with a two in front, 20%-plus percent. I know Visa Direct catches a lot of attention. The most common question I get from investors is really around FedNow and real-time payments and Pay-by-Bank and what does that mean for Visa, what does that mean for Visa Direct. So is it possible for you to maybe go through those? Why they are similar, different, this push payment concept.

Jack Forestell

Yeah. Of course. Well, let me start with, you mentioned real-time payments, FedNow.

Tien-Tsin Huang

Please.

Jack Forestell

Look, we are at a place where most countries around the world have either already or are in the midst of investing to modernize their national payments infrastructure, their ACH infrastructure and the U.S. is absolutely no different.

So investments in TCH real-time payments, FedNow real-time payments in our view are a good thing. We need modern financial infrastructure in the United States. It will be good for the banking industry. It will be good for consumers. It will be good for everybody involved. It’s going to take some time.

And in terms of use cases, what we have seen, and again, we have seen this play out in a lot of different markets around the world as the new infrastructure comes online. What I’d say on use cases is, it all depends on what problems remain to be solved in the market that you are looking at.

So there are certainly markets around the world where penetration of financial inclusion in some parts of the population is low or penetration of long-tail merchants and micro-merchants is relatively low for digital payments. In some of those markets, when RTP comes online, it can get used to help solve those problems.

In other more mature markets, where those problems have already largely been solved, markets like the U.S., a lot of the European markets, we tend to see the center of gravity flow a little bit more into the B2B use cases, commercial use cases, invoicing in places where there’s still a lot of friction left in the system. So that’s just a little background how we think about the evolution of RTP depending on the situation the market is in.

And then you come to the Visa Direct. I mean Visa Direct, it’s — we like to — I mean, I think, of it as a little bit of a Swiss Army knife for high velocity and lower value payments. So if you need to get money from A to B, it could be P2P, it could be business to consumer, it could be government to consumer, it could even be me-to-me, so me to my own account…

Tien-Tsin Huang

Right.

Jack Forestell

…in smallish sizes at high velocity, Visa Direct is the way to do it. It is just the gold standard right now, certainly, in this market. We have got 60 different use cases up and running across 2,000 different programs. So it’s a little difficult to sort of reconcile those 60 use cases in 2,000 programs, how will that play out as FedNow and RTP start to stand up, because those actually haven’t happened yet.

Tien-Tsin Huang

Okay.

Jack Forestell

We have these use cases already up and running. And look, the service is reliable, it is resilient, it is robust, it comes along with the Visa brand, it comes along with the Visa levels of security that I have been talking about in terms of the investments that we make overall.

And it’s up and running and it’s available, you can use it now at scale. So we are pretty confident in our Visa Direct capabilities even in the face of the launch of new RTP capabilities and that’s what we have seen around the rest of the world.

Tien-Tsin Huang

Good. I mean, look, TCH has been around for like five years and FedNow is finally coming and so we have — Visa Direct has been out in the wild for quite some time, but…

Jack Forestell

Yeah.

Tien-Tsin Huang

… I appreciate you, we are asking, we will keep watching them, but it feels like we have got some time to go before…

Jack Forestell

Yeah. It will be a little while.

Tien-Tsin Huang

We can call it any changes. I think maybe building on that, Jack, with thinking about new flows and interoperability, Visa+ was sort of an interesting…

Jack Forestell

Yeah.

Tien-Tsin Huang

… launch and with PayPal, you have been using it to interconnect between Venmo and PayPal leveraging Visa+, which I thought was interesting because that could be sort of intercompany. But talk to us about Visa+ and this idea of true network of networks, interconnections and it does feel like you are getting a little bit closer to the consumer. So talk to us about where you are and how close you are to get to the consumer to effectuate this?

Jack Forestell

Yeah. Visa+ is a lot of fun. We just launched it just weeks ago. I think of it as a new type of credential, bear with me.

Tien-Tsin Huang

Okay.

Jack Forestell

I think virtually everyone in here probably already have, might actually be in possession right now of a Visa credential. It’s represented by a 16-digit number that starts with a 4 and that enables you to pay and with Visa Direct, it also enables you to get paid.

Visa+ is the creation of a Visa+ Payname, which is a new type of credential that can be more intuitive for the user than a 16-digit number. It can be personally identifiable and a little bit more memorable for the user.

And it is a credential that you could use to pay, but maybe more importantly, get paid. So Tien-Tsin, imagine, I needed to pay you and you wanted me to pay you with Visa Direct. You could give me your 16-digit account number, but you probably wouldn’t be that comfortable doing it. But you might be very comfortable giving me your secure Payname and that’s what Visa+ is all about.

And the first use case that we are really going after solving is one that you just described, which is there are several closed loop wallet environments out there and there’s a real problem to be solved. If I am a part of one of those closed loop wallets and you are a part of another one and I need to pay you, it’s actually really hard to do. There’s no good way to do it. It isn’t full of friction.

But with Visa+ and that Payname construct, it’s as simple as, as I just said, you share your pay name with me, I send the money to you, it shows up in real time in the balance in your wallet from my wallet.

So by the way, it’s also pretty early days. We are in pilot mode, we are going to learn a lot, we learn a lot from our clients, we learn a lot from our users, we will develop it, we will enhance it and we will really see how it goes, but we are excited about it.

Tien-Tsin Huang

I need to think of a clever Payname.

Jack Forestell

Grab it before it’s gone.

Tien-Tsin Huang

Yeah. I could make a joke about it, but I am not ready to do it in front of this audience. Good. So I think I would imagine there’s some good demand for this. We heard already from PayPal, I guess, should we expect this to be sort of a step function or incremental in terms of additions, whether it be wallets or other account based systems?

Jack Forestell

Yeah. I mean, look, I don’t want to get too far ahead of ourselves.

Tien-Tsin Huang

Yeah.

Jack Forestell

We have got to prove it out and make sure that it’s got resonance and traction with consumers and our clients, assuming that it does. I am hopeful that we get more and more participants on Board. You think of it as an open platform play, right?

It really creates the ability, if you expand it and imagine it in its ubiquitous form for end users to be able to seamlessly move their money, move their value to the place that they want it to be. If they want it to be in their PayPal account, they can get it there. If they want it to be in their bank account, they should be able to get it there, too. So that’s the vision, but again, super early days.

Tien-Tsin Huang

No. It’s fine. It’s fine and needed. So glad to see that and learn more about it. So let’s shift to value-added services. Again, growing very fast, 20%-plus, and thematically, we have been seeing this a lot and I sort of blame it on software coming into payments, right? We are really pushing more towards ARPU and value-added services. But with Visa’s data and scale, it makes a ton of sense to do more on value-added services. So big picture, how would you rank or tell us more about the pieces that are really driving it and where is the growth potential going forward?

Jack Forestell

Yeah. Well, before I dive into pieces.

Tien-Tsin Huang

Yeah.

Jack Forestell

I would say, you are spot on. I mean there’s — the value-added services business plays a number of different important roles for us and I will go through at least four, okay? One, it actually helps us work with our clients to grow their business. And so forget about the services themselves for a second. We are mostly developing value-added products and services that are generally in the payment space that we can use to work with our clients and actually make their business stronger, better, grow faster, which then accrues value back to us as their network partner, because we are starting to see stronger consumer relationships, seller relationships on their side and more transaction volume pulling through. So stronger customer relationships, or sorry, growing our client’s business is something we probably don’t talk enough about when it comes to value-added services business.

Two, it creates connectivity and just a stronger set of relationships, more retentive value with our clients. We are at a place now where about 50% of our clients are using five-plus value-added services, about 30% or third maybe are using 10 value-added services.

So you can imagine, as those points of connectivity are happening, those services are contributing to growth in our client’s portfolios. That’s bringing us together more closely and creating more of that retentive value.

The third one is the, obvious, where they also create new products and new lines of business for us that drive revenues on a standalone basis and can contribute to the diversification of our revenue portfolio.

And lastly, they also provide a platform for us to develop services that, yes, we can deploy for Visa transactions, but increasingly we are also deploying for non-Visa and non-card type transactions. So there’s a whole set of reasons that we believe the value-added services business is incredibly important to us.

So, sorry, let me now get to your actual question, which I think was, well, what’s — how is the portfolio doing? And we structured the value-added services business by a couple of client segments and then a couple of vertical focuses.

So we have a segment that is about our FI and issuing clients and it’s a set of services that we developed there. We have a acceptance business unit that works with the acceptance and enabler side of it along with merchants directly and then we have a vertical focus on risk, security and identity. And then we have our consulting team that sort of pulls it all together and leverages all those services along with the core and works with our clients to optimize their business.

And Tien-Tsin, I would say, across the portfolio, it’s all doing pretty well. So I hesitate to stack rank how things are going. I might say, look, there are parts of the portfolio that are closer into the core. So within that issuer bucket, there are sets of services that are very close in to VisaNet.

Think about us offering card controls or stand-in authorization capabilities for our issuers or even enhanced reporting and settlement and reconciliation in the financial operations of our banks. Those are continuously in demand.

We still have a lot of upside there in selling those services in markets where the penetration rates are still very low. It’s a little more mature in some of our larger markets, but lots of runway to sell those services in outside of our more mature markets.

The risk product set, also very much in demand. We have had a little bit of a tailwind in the risk product part of our business, particularly in Europe, with some of the regulations around strong customer authentication that required issuers and merchants alike to improve their security in the e-comm space and our products and services have been vital in actually making that happen.

So those are a couple that are kind of near in on the payment side. And we have got our issuer processing business and our scaled merchant gateway business. Those are big scale standalone businesses in their own right that transcend Visa transactions.

They are part of that play that I was talking about, where we can deliver beyond Visa and beyond card-based transactions and then as I mentioned, we wrap it all together with the consulting side of the business.

And increasingly, on the consulting business, we are also pushing into what we call managed services, where we are working with clients to take work off their hands or place Visa professionals inside those client organizations.

It could be in running some of their fraud risk functions and capabilities or it could be in executing on product integrations to help them get to market faster with some of the other pieces of our value-added services and core business.

Tien-Tsin Huang

Good. Now that’s a good summary. So I am just curious, so very clear on the issuing side, things like stand-in processing DPS where that will be in there. Where would tokenization fall, would that be included in value-added services?

Jack Forestell

Yeah. It’s a good question, because it’s a little tricky one. I mean, I think of tokenization, as I was describing Visa+ as another credential. Tokenization is like the next generation of our credential infrastructure. It is a secure and programmable credential.

So again that 16-digit number that you all have in your pocket is slowly getting replaced by a dynamic token that is secured by cryptography and that can then be programmed and bound to function in certain ways with specific use cases. So at that level, it’s really core to who we are and what we do as a payment network.

That said, it also represents an opportunity on the value-added services side. There are services like push provisioning those credentials. There are services like enabling those credentials to be programs so that can provide the visibility for an issuer client to enable their customers to see where all of those credentials are with Card-on-File merchants and turn them on, turn them off, enable them for certain types of transactions and not.

And then, of course, we also have a capability that we manage under a brand we call Token ID, which are a whole set of tokenization capabilities for non-card applications, so think payment account tokenization in the RTP space. So, yes and no, it’s a core part of what we do. We don’t tend to monetize the core Visa token directly.

Tien-Tsin Huang

Got it.

Jack Forestell

Where we see that is, the monetization comes from the enhanced authorization rates and the reduced fraud that we get in the network and the take up that we get on those tokens. By the way, I think we are at 6 billion tokens placed right now, which is somewhere close to 90% higher than it was a year ago this time.

And that growth is becoming — is coming because of that enhanced performance and we like the model that we are using to monetize that right now. That said, we do think, as I was describing, there’s a whole host of value-added services that can come along with the tokenization capabilities that we are deploying.

Tien-Tsin Huang

Okay. Good. No. Thanks for going through that. When I see 6 billion and these big numbers, it’s just hard to fathom some of it. But I also recognize it’s a big change from a credentialing and infrastructure standpoint, which is why I wanted to ask it.

Jack Forestell

Yeah. It’s been quite a journey. I mean, in the nine years that I have been at Visa, we started from zero. And zero to 6 billion even in the space of nine years is — has been breathtaking and a lot of fun.

Tien-Tsin Huang

No. It’s a big lift. So we are — I have a bunch more questions. We have 2 minutes left. I thought maybe just we should probably close it out. So I know there’s so much more to talk about. We are at a tech conference here. There’s so many things I’d love to pick your brain on. But what do you think is not talked about enough, what am I not asking you about as you are sitting here thinking about tech trends in the world in front of us?

Jack Forestell

Well, something you are not asking about, but I can’t say it’s not talked about enough, because I am guessing it’s probably talked about in every room at this conference is AI. And I am incredibly excited about the burst of activity that’s really starting to unfold in the generative AI space, really just in the last six months.

And part of the reason I am excited about it is AI is in our DNA. We have actually been harnessing the power of AI in some way, shape or form going all the way back to the ‘90s. We were using heuristic models and neural nets before it was cool and we have built our own AI and deep learning platform on which we train all the sophisticated fraud and risk management models that I was talking about.

But we have focused a lot of our attention in the AI space on what I would characterize as predictive AI, the use of deep learning to predict the next data point in a series, whether a transaction is fraudulent, whether I am who I say I am.

Generative AI is about actually generating new data sets and predicting a whole new data series and there we just see enormous amounts of potential on a number of different dimensions. I mean, like many companies, we see the transformative potential of creating stronger efficiency within our company and helping our clients do the same, whether it’s customer service, anomaly detection, cybersecurity, we believe there’s massive application of generative AI to those spaces.

We think generative AI can make payments better. The very models that I talked about, we have got 60 different AI based models already in production today. We think there are overlays of generative AI that can actually make those models perform better in orchestration with one another.

And then who knows what the world holds in terms of new product development? But it seems almost obvious that the process of shopping and discovery, and ultimately, commerce is going to be transformed by AI and contextual AI and we are going to make sure that we are ready for that with the best possible embedded digital payments capabilities when that happens and I think it’s probably going to happen pretty fast.

Tien-Tsin Huang

Yeah. No. It feels that way, especially on the transactional side. Well, hopefully, we will get a chance to talk to you about it very soon on the next session.

Jack Forestell

Great.

Tien-Tsin Huang

Jack, thank you for the time. Appreciate the conversation.

Jack Forestell

Thank you. Yeah. Thank you all.

Tien-Tsin Huang

Yeah.

International Business Machines Corp (NYSE:IBM) 51st Annual JPMorgan Global Technology, Media and Communications Conference Call May 23, 2023 11:30 AM ET

Company Participants

John Granger – SVP, IBM Consulting

Conference Call Participants

Brian Essex – JPMorgan Chase & Co.

Brian Essex

All right, there we go. Okay. Good morning, everyone. Thank you for joining us. My name is Brian Essex. I’m a software analyst at JPMorgan. And with me today, I have John Granger, Senior Vice President of IBM Consulting. So he runs that group. And John, thank you for joining me.

Maybe a good place to start is introduce yourself. And you’ve had a lengthy career with IBM and you’re currently leading IBM Consulting. Can you share a bit about your background and the business that you’re running today?

John Granger

Yes. Look, I mean, very quickly, I actually came into IBM through IBM’s acquisition of PwC Consulting in 2002. I was a partner in PwC. And so actually, like many of the leadership per today of IBM Consulting, we still retained quite a lot of that PwC backbone. But I’ve worked in — I’ve run the business for the U.K. I’ve worked — I’ve run IBM Consulting in Europe, I lived in Madrid for a bit. I went and ran our application business for a couple of years in Bangalore, worked in the U.S. And now I’m back based in the U.K.

I mean, just to talk a little bit about our business, Brian, I mean, just — and we’re going to come on to talk a lot more about it, I’m sure. But about 160,000 people, I mean, we’re about — now after the spin-off of Kyndryl, the infrastructure services business, we’re about 1/3 of IBM’s revenue, but perhaps interestingly, 2/3 of IBM’s people. So if you talk about an IBMer, then it’s likely as not, you’re talking about somebody in IBM Consulting.

Question-and-Answer Session

Q – Brian Essex

Excellent. Thank you for that. And there have been quite a few changes recently, particularly under Arvind’s leadership. How would you describe the difference that you’ve seen in management and the way the company is run with the strategic direction now that you have someone that’s a career technologist leading the company?

John Granger

Look, I mean, I think — I mean, all of our CEOs have different strengths. I’ve worked with Sam, I’ve worked with Ginni, I work for Arvind. But I mean, I think Arvind’s strategy, if you had to sum it up in a sentence, is for IBM to deliver transformation powered by the preeminent technologies of our time, hybrid cloud and AI, leveraging the ecosystem. And so if you ask me the difference that he’s made, then I think I’d probably point to three things.

I mean, the first is that with the sell-off of — or the spin-off of Kyndryl and with that strategy as it were, he has simplified our company very significantly. And so in the way that we are now organized and run ourselves, then I’m accountable on the Consulting side for predominantly leading the transformation. My technology colleagues drive the products and technologies that support hybrid cloud and AI. And then we all contribute around the leverage of the ecosystem. So I think, first of all, it’s a much simplified company.

I think the second thing I would say, Brian, is that, look, I mean, I talked to you about that strategy in a sentence, powered by the preeminent technologies of our time, hybrid cloud and AI. Arvind laid that out 3 years ago. So particularly — I mean, I think that, that shows that he has absolutely positioned us in, I think, what you, Americans, call the right neighborhoods. I mean, in terms of hybrid cloud, it’s been a really important focus for enterprise clients. And clearly, with generative AI now coming to the fore, it’s great that we’ve been in this space now for some time.

And then the third thing that I think he’s done, which is perhaps a difference in emphasis from previous administrations as it were, is Arvind is very committed to, as I said, leveraging the ecosystem. So Arvind is passionate about no one company can hope to provide — to have a monopoly on all the technology solutions that a client needs. And therefore, what you’ve got to do is to ensure that you can orchestrate and integrate those solutions to provide value to clients. And so he’s really encouraged that culture at IBM to ensure that we’re making that ecosystem work for us. And I think it’s fair to say that in IBM Consulting, we’ve led the way in that.

I mean, we announced in Q4, I think, I mean, we’ve now grown our AWS business to over $1 billion. We’ve grown our Azure business to over $1 billion. We’ve always had a big SAP business. We’ve got other partnerships with Salesforce and Adobe that are coming through strongly as well. So I think that’s been really important. So the three things I’d highlight then, the simplification of the company, the positioning of ourselves in the hybrid cloud and AI spaces and then how we’re now encouraged to really leverage the ecosystem, which I think has been very beneficial for our clients but also for IBM.

Brian Essex

Excellent. And how has some of the actions that IBM has taken to reposition in the Consulting business help you serve clients differently than the way that you were positioned before?

John Granger

Well, I think the first thing that we’ve done is we’ve got real clarity about what our offerings are, what we call our growth platform. So we’re really clear around three growth platforms. The one is the journey to cloud, application migration, application modernization, the management of cloud in a hybrid cloud environment.

A second growth platform is really around intelligent workflows, Brian, which is that’s where all of our capability lies in terms of our process expertise, talent, finance, supply chain, customer care and so on and so forth, but — and our BPO business as well as our whole data and AI capability. And then thirdly, we have a security growth platform. So those are the three areas that we’re focused in.

And then in terms of how we’ve repositioned IBM Consulting, I think that’s really — we have a very intentional framework that we call transform to grow, which is about ensuring that we double down, if you will, on the few things that will really make a difference, i.e., focus more and more on less and less. So the first of those has been talent. So in the last couple of years, we’ve grown our business now to 160,000.

And that’s not just a big influx of practitioners. That’s also been a strong influx of building up of go-to-market senior talent. We’ve — and it’s not just been about the quantum of talent, it’s also been about the quality. I mean, a lot of certifications that we’ve now driven, particularly with our partners, 66,000 cloud service provider certifications, over 50,000 ISV certifications.

Second thing that we’ve worked on beyond talent has been brand. So previously, before the spin-off of Kyndryl, we were Global Business Services. Well, when you were trying to recruit kids or — you put Accenture, Deloitte alongside Global Business Services, it’s hard to work out what we do. Now we’re IBM Consulting, the choice is very clear. And I think that’s enabled us to not only be successful in recruiting talent but also to ensure that we’ve really reintroduced ourselves to our clients. So I think that brand is something that we’ve stayed on.

A third piece is being client segmentation. As is the way with all good consulting organizations, we’ve been trying to cut the tail to ensure that we go deeper and deeper with the clients that we do have. So we’re very focused on a very curated set of top accounts. Fourth thing would be big transformational deals. I mean, I think there’s a lot of those in the marketplace. And we’ve maybe not had our fair share of those historically. So I think you’ve seen in our signings that we’ve started to pick up much more of those big technology-driven transformation deals.

And then the last two things would be partnerships. So we talked about the ecosystem. I said that we’ve led the way on that. I think our partnership revenue is now approaching 40%. We — as I said, we’ve built these very big businesses with AWS and Azure, so really made a very deliberate pivot to how we work with partners in the market. And the last one then is acquisitions. And in particular, we’ve done 14 acquisitions in the last couple of years, which is a lot more than in the last 14 years.

And many of those acquisitions have been very specifically geared towards underpinning those strategic partnerships. So we bought Nordcloud, for example, in Europe that brought a lot of competencies in AWS. And in Azure, we bought Neudesic, which is the last Microsoft shop standing in — or sizable Microsoft shop standing in North America. And we bought Taos and so on. So we’ve really deliberately focused these acquisitions on reinforcing those partnerships.

So talent, brand, client segmentation, big transformational deals, acquisitions, strategic partnerships, just those six things, stayed laser-focused on those. And that, I think, has been pretty good for us. I mean, we’ve had 8 quarters now of consecutive growth. So, so far, that framework seems to be paying off.

Brian Essex

Great. And then IBM has stated that demand for technology transformation has been and remains pretty robust. What are you hearing from clients on that front in terms of what’s driving their demand?

John Granger

Well, so I think, as I said earlier about our focus on these big transformational deals, I mean, I think it’s very clear that in the marketplace, there is a lot of demand at the moment for technology-driven transformational deals. And you can see that in our signings. We had a very strong Q4. And we had a strong first quarter actually, where normally we drop off a fair bit. We didn’t drop anywhere near as much. You see it in our competitor signing.

So I think it’s clear that, that technology-driven transformation, whereas in previous times of economic uncertainty, you might have said that, that was discretionary and you’d see that fall away, we’re not seeing that happening now. And you ask about where that comes from. I think that’s, I mean, maybe four drivers, a couple of which are still pandemic-related. I mean, I think the whole digital transformation in terms of virtualization of organizations’ and enterprises’ relationships with their clients, with their customers, that still has to work its way through.

So there’s a lot of transformation around that. A lot of work still to do on supply chains. We all experience that every day. The supply chain transformation work has still got a lot to do. But I think the one that came as a result and as a consequence of the pandemic and some of the wage inflation that followed, that is productivity and the whole AI piece. Because clients have clearly felt that the price of some of the skills that they need to get is prohibitive, so how that, I think, has pushed them to think more about productivity. And then of course, you’ve got cybersecurity.

So those are the drivers. For us, we see the market, I guess, it’s probably about — I mean, we think about $800 billion for consulting services growing mid-single digits for the foreseeable future. And about half of that is in the cloud and intelligent workflow space. So to play back to what I talked about earlier in terms of our growth platforms, we had cloud and intelligent workflows as our growth platform. So we think we’re pretty well adjusted for that.

The one area, I guess, in all of this demand though that we and others have called out is North America, the U.S. And I think there’s a different market dynamic going on there. So it’s a paradox in the sense that the appetite for the big transformational, technology-driven deals that I’ve said — I mean, that’s still there. And we’re seeing that in the U.S. market. But I think there’s more pressure on fundamentals that everybody is feeling.

And so I would say that clients in North America have much less contingency. They — if there is work that is not part of this mainstream technology-driven transformation, then they’re more inclined to delay it. For some of the staff augmentation work and some of the enhancements that sort of sit around some of the bigger deals, a bit like pilot fish around a big whale, those things are sort of being held off.

And so whilst I would say that there’s no evidence of any cancellation of work, we’ve seen no backlog reduction, there is a sense of some of the more discretionary work shifting a bit to the right and the pace of it slowing down. So I mean, we’ll continue to work through that. But I mean, that’s the sort of picture, a common drive for large technology-driven transformations but a bit more softness in the U.S. market around some of that discretionary work.

Brian Essex

Is your visibility there better because perhaps customers experienced some of the benefits of transformation during the pandemic that kind of forced their hand and now they want to move faster with you on the transformation?

John Granger

Yes, I think that’s — I mean, that’s indeed how it’s happened. I think that — I mean, the reason this demand is held up is because clients are now seeing it’s a fundamental source of competitive advantage. I mean, it’s not something that they can afford to put to one side.

Brian Essex

Great. And then how would we think about the way that IBM differentiates its Consulting business in the market? And how much is the success of the software business tied to Consulting?

John Granger

So I mean, in terms of — I mean, as you all know, I mean, the consulting system integration market is really crowded. So to say that there’s sort of one magic bullet of differentiation is quite hard to achieve. And so I mean, we think about differentiation in sort of three groups really. The one is being differentiated as part — by being part of IBM. And when I first came into IBM, I wouldn’t have pulled that out. But I think now, I mean, that’s really important.

And the way it is most important, I think, is if you want to do really big, complicated end-to-end transformation possibly with a global footprint, there are really only two players in our marketplace that you would think about, which is Accenture and ourselves. So whether that’s the big cloud modernization and migration that we’re doing for Delta or whether it’s the global SAP implementations that we’re doing, in that category of work, Brian, it’s really only us and Accenture.

And being part of IBM really helps us in that context because of, I mean, not only IBM’s brand but also the financial firepower that IBM has, but also the technology depth that IBM has. That’s really why clients are looking to choose us in that space. But elsewhere, I think, to your point, we also benefit by being part of IBM to be able to use and to leverage IBM’s technology.

So the best example of that is Red Hat, where we’ve built up a business that is now over $2 billion in terms of revenue. So that’s just about 10% of our business overall. And we’ve had $8 billion of signings in Red Hat since the acquisition. So that’s an area where we’ve leveraged IBM’s technology to our advantage. And we’ve got 15 other practices, ranging from Maximo, TRIRIGA, mainframe modernization and so on. So I think that being part of IBM is an important differentiation.

Second part of our differentiation, particularly against some of the other players in the marketplace, is our industry expertise. So we have deep industry expertise. And that’s recognized as such across the piece. And that, along with our understanding of clients, enterprise clients, particularly where we’ve been doing application management for them for many years, means that we have a really good understanding of what their businesses are.

But the last piece and the piece of differentiation that I think is probably the closest that we have to unique differentiation is how our clients experience us. So we have an approach to our work called Garage, which is where we bring clients together in either a virtual or a physical environment with some of our technology, and we actually co-create minimum viable products and then co-execute those, scale them up really quickly. And so we did nearly 7,000 of those last year. They have a very high NPS score.

And we had some independent research done by Forrester actually that said that these — this approach drives 10% more innovative ideas, gets you to market 70% quicker and bring 6x more of those projects into production than otherwise. So I think that experience, how you experience working with us is a really important part of that. So being part of IBM, our industry expertise and how we understand clients and then Garage and how you experience us, that’s what we think about in terms of our differentiation.

Brian Essex

Great. Super helpful. And maybe a conversation with IBM couldn’t be complete without mentioning AI.

John Granger

Yes.

Brian Essex

So maybe we’ll shift over to AI and generative AI. Beginning with a broader view of AI first, how are you helping clients leverage artificial intelligence today?

John Granger

So I do want to split this into two really, and maybe we come back to generative AI. Because I think it’s important to recognize that, as I said earlier, Arvind called AI as a critical area 3 years ago. And so that’s really because we see for clients, this is absolutely essential to their competitive advantage. I mean, being able to do more for less, how you’re able to drive that innovation, productivity, scale, that’s really important as well as the size of the market.

I mean, even before generative AI, analysts like IDC were saying this is going to be $35 billion growing to $65 billion. So it’s a really big marketplace. It’s really important. And we’ve had a big capability here for a long time. So we’ve got 21,000 of our 160,000-odd consultants are in that data and AI space. We’ve done 40,000-odd engagements.

And really, I think our focus has been around four areas. One is customer care. So a good example would be the Veterans Administration, where they’re claims processing. So how do you speed that up? How do you ensure that they can analyze and ingest all those documents really quickly and come to a decision much faster? And so we help them with some — actually some IBM technology but running on AWS that’s now got a 93% extraction accuracy and has really brought that whole decision-making process down from 20 days to 1. That’s a really good customer care example.

If you looked at process operations, then TD Ameritrade, 15 processes around how their customers make margin trades or inquire about their accounts. And so we’ve really been able to use a lot of AI assets to reduce the time for processing really quickly there.

In IT operations, J.B. Hunt, a transportation player, we’ve used automation assets to help them manage their multi-cloud environment. And then sports tournaments, Wimbledon is coming up, they take over 200 million security events over the course of a tournament. And we would help them with that. So I think we’ve been in this space for a while. And so we’ve got a deep understanding of how clients will use that. Then of course, we’ve got generative AI that I think is going to tip the scale of how they’re going to use it.

Brian Essex

Yes. And maybe getting on to that point in terms of generative AI, several weeks ago, IBM launched watsonx to assist enterprises with leveraging generative AI in a safe, secure and private manner. Could you give us an overview of watsonx and what that means for not just IBM Consulting but IBM overall?

John Granger

Yes. Look, I mean, what watsonx is, is it’s an enterprise-ready tool set that uses trusted data in order to accelerate the building and deployment of machine learning and foundation models. And it comes in sort of three segments, if you will.

There’s watsonx.ai, which is the tool set and the studio. There’s watsonx.data, which think of it as a lake house that actually enables you to access not only trusted data but also to throw a fabric over the rest of your enterprise data. And then there’s watsonx.governance, which is the protocols about how you bring all this together.

What I think is interesting about it, Brian, is that as I think about today’s IBM, so I’m talking about big IBM now, not just IBM Consulting, I would say the differentiation is open, deep technology and I think where, I think, we have a brand that is recognized for taking a very principal stance to the introduction of new technology. And I think you can see all of those elements coming through in what we’re bringing forward in this watsonx suite.

So in regard to the first of those, I mean, this is going to be one set of tooling that you can use anywhere, on-prem, on anyone’s cloud, that will actually enable you to run anywhere to build those models and to drive that data. And so we are very strongly of the view that this has to be multi-model on multi-cloud, and that a platform that we’re offering here is only as strong as the ecosystem that it enables.

So Hugging Face, for example, are going to be a big part of this. We’ll bring other partners into it. So I think this Watson suite — this watsonx suite is clearly open. In terms of technology, we’re really shifting now from large language models to the really deep foundation models. And we’re bringing into this capability, the first of those foundation models or that family are going to be around geospatial IT events and chemistry.

And then thirdly, around integrity, you’ve got to have trust embedded in all of these systems. So we’re bringing in protocols around how you explain how the data has worked, how you can be confident about the integrity and so on. So I think that’s very exciting for IBM.

In terms of how we’re going to exploit it in IBM Consulting, well, we’ve announced a 1,000-person CoE. We’re going to build a watsonx business. And we’re going to do that in the same way that I talked about Red Hat. So in the same way that we built a Red Hat business, we’re going to build a watsonx business within IBM Consulting.

The critical thing that I would want to say here, however, is that when we built the Red Hat business, at the same time as we built that $2 billion Red Hat business, we also built this $1 billion AWS business. We also built this $1 billion Microsoft Azure business. So this is not going to be a student body left in total focus on watsonx. We will drive the watsonx business at the same time as we in IBM Consulting take advantage of the other technologies that partners may bring to the market.

Brian Essex

Great. And I think you touched on this a little bit, but I want to kind of emphasize that one of the things we look at in the software space is platform versus product. So I thought your platform approach to Watson was really interesting — or watsonx was really interesting.

So I guess, on that, what’s your perspective of the importance of building a platform more focused on foundation models with cleaner data rather than a large master LLM model with greater volumes of data? Perhaps I don’t know if your customers are addressing some of the shortfalls around — I know there’s a governance segment of the watsonx…

John Granger

Yes. Look, I mean, I think — I mean, so the choice here at the moment is between models that have trillions of — or 1 trillion data elements that are less curated than models that — foundation models that — and I think this is where IBM is placing its emphasis, that may only have 100 billion of data elements but which are much more curated. And I think what’s critical here for business is confidence around the quality of the data, the amount of bias and so on and so forth.

And that is — I mean, that is the fundamental issue, I think. And we in IBM have always been super focused on enterprise. And so what I would say is that at the moment, to your point about what clients are seeing, I’d say, at the moment, clients are experimenting with both types, the broader models and the more narrow.

They’re only experimenting with the broader models where they’re really confident that their data is going to be protected. But they are — they are experimenting with both. But what we see at the moment though is that they — when they are starting to think about how they might go into production and scale, then they’re shifting much more towards the narrower foundation model.

And I’ll give you an example. I mean, where it is more complex for an enterprise, they need to rely more on these narrow foundation models. So think of three or four use cases. So where you’re going to use AI to support employee productivity, for example, you want to put somebody alongside an HR professional. That’s going to be a more — a deeper foundation model.

Where you want to create a new experience, like we did at the Masters, where we generated AI commentary for all of those golf shots, that sort of new experience, you’re going to want a more narrow, focused, curated foundation model. Where you as a legal business, for example, might want to not only change how your own organization operates but disrupt the industry, you’re going to want a narrower foundation model.

Where you’re in code creation perhaps, then a broader model may be more appropriate. But I think enterprise focus is going to be more on those narrower foundation models. That’s what we’re seeing. That’s where IBM is putting its emphasis. So we’re putting our emphasis there not only because of our focus on value and our focus on value for enterprise but also for innovation.

Because when you look at what the open source community is doing and where all the innovation is at the moment, it’s at the moment on those narrower foundation models. So we’re into that space because of where we think enterprise is going to go but also because where we think the innovation is going to come from.

Brian Essex

Excellent. So I guess, next, IBM built a strategy around, as you mentioned, hybrid cloud and AI. And we just spent some time on AI. So maybe to pivot to hybrid cloud, what are some of the main challenges clients are facing as they evaluate moving applications and processes to the cloud? And how is IBM supporting clients’ cloud strategies?

John Granger

Look, I mean, I think in cloud, our experience — and if you think about how you would characterize IBM’s clients, our enterprise clients, you’d say that what actually holds them together is the fact that they all drive mission-critical operations. So whether that’s in financial services, telco, government, health care, that’s the characteristic, I would say, that our client base has in common.

And what we have found with those enterprise clients is that for them, a simple hop to the public cloud is just not an option for reasons of data security, for reasons of the complexity of the large application engines that they run, the cost of actually starting to split those out and to move them over, let alone the Frankenstein’s monster of starting to see different skill groups and tribes building up within your operating model serving different clouds.

For all of those reasons, we see those clients thinking that a hybrid cloud architecture, and by that, I mean a single fabric that sort of runs across an on-prem environment, private cloud and multiple public clouds, that is the architecture that our clients are increasingly focused on. And we in IBM think that we’re really well placed to serve that because we have that architecture in the Red Hat stack.

I mean, that combination of Kubernetes and Linux and containers that Red Hat offers, that can provide that hybrid cloud architecture and fabric that allows you to build your applications once, deploy them anywhere, to skill your people once in that fabric and then use them anywhere and most importantly perhaps, to innovate anywhere with anyone’s technology.

And so that’s what IBM is focused on in this space. And what we in IBM Consulting are focused on is actually helping clients to take advantage of cloud in that sense. So a really good example would be Delta, where we are migrating and modernizing their applications to move to an AWS cloud platform. It actually uses Red Hat OpenShift on AWS, ROSA but domain-by-domain moving those applications to the cloud.

But as importantly, Brian, not just the technical part of it but also reskilling and reschooling their IT operations team into how they will work in agile squads going forward and how they will now work in a new cloud environment. And I could give loads more examples, but that’s the sort of thing that we do within the cloud space.

Brian Essex

Right. Excellent. And then maybe just a macro-related question, given the changing macro environment and the demand environment that you cited, from a productivity perspective, what is IBM doing to drive better productivity within the Consulting business?

John Granger

So I mean, I guess, there’s a couple of things in there. I mean, the one is what we’re doing to improve our margins, frankly. So I mean, I’d cite three things there. The one is price. So we’re doing — we’ve done a lot of work to ensure that we’re taking advantage of all of the cost of living and other provisions within our existing contracts but also leveraging the, what I call, the balance between the value that we create for our clients and the reward that we get.

We run a lot of Net Promoter Score surveys and really, therefore, saying, what is the — if we’re getting a high Net Promoter Score and you’re really valuing what we’re doing, but the reward is not what it’s like, how are we going to balance that out? And those conversations, I think, have been very productive for us in the last 18 months. So we’re doing a lot on pricing.

From a labor point of view, in a consulting business, it’s really about ensuring that you’ve got a really strong pyramid, that you’ve got — because most of your money is made by utilizing your more junior people for as much time as you can. So we’ve been working to ensure that our pyramids are in line. And then thirdly, just the heavy lifting around utilization.

And then the last thing I’d say is that we’re very focused on how we deliver to our price cases, which is how we make sure that the quality of the work that we do actually and the price case that we set out with actually gets delivered with our clients. So those are the things that we do from a margin point of view.

And then in terms of how we, if you will — is it cobbler’s children, I can’t remember, but how we actually apply AI to ourselves, then we’re doing quite a lot of that, particularly in the HR space, where, for example, we run our whole promotion process largely through Watson Orchestrate, which means that all of the data, all of the preparation work is automated. And it’s really only the final decision as to whether it’s remote or not that stays with the manager.

So that’s been very helpful. But also retention tool that has 95% accuracy because, I mean, we’re a people business, so looking at people’s skills, where they’re sitting, what’s happened to them recently and so on and then to be able to decide whether we want to intervene to keep them or not. So those are the sorts of productivity tools that we’re using to ensure that we’re always as efficient as we can make ourselves.

Brian Essex

Got it. Maybe just shift real quick to M&A, I mean, Arvind has mentioned the significant amount of firepower that IBM has. I think they cited — the management team cited kind of a 2/3 software, 1/3 services target model for M&A. What do you think the most likely target profile would be of companies that you might acquire?

John Granger

So in terms of target profile, I mean, to go back to what we talked about earlier and those growth platforms, so I think the first thing is are they capabilities that are going to fall into those growth platforms? So cloud, intelligent workflow, security, will they help us with — particularly with our strategic partnerships?

And then also, you put — across that, you put a market lens. So for example, we’ve identified federal as a market that we want to invest in. And we recently bought Octo, which is a technology and services company in federal, which really helped to build our capability there. So that’s how we look at it from a consulting point of view.

Across all of our acquisitions in IBM, there are really three questions. I mean, does it fit with strategy? Is it going to generate synergy across all of IBM? So whether this is a technology acquisition or a consulting acquisition, we expect it to reinforce either side. And then is it going to be cash-accretive in a reasonable amount of time? And so that is how we’ve thought through that.

Brian Essex

Great. Maybe last question for you, maybe just to wrap it up, what are you the most focused on that is key to the continued success of IBM Consulting?

John Granger

Well, so I think in terms of what we’ve talked about earlier, come as no surprise to say ecosystem and maintaining this open approach and therefore ensuring that we can leverage partnerships. I think taking advantage of technology disruption in the market, of which the present cause célèbre is generative AI. I mean, we’ve got a carry on executing.

But the last thing, I think it’s really important to remember in a consulting business, it’s all about people. And so one of the things that we are trying to stay very focused on is engagement. Because hanging on to your talent is really, really important if you’re going to progress as a business.

Brian Essex

Right. Excellent. With that, I think we’re out of time. So John, thank you very much for joining us.

John Granger

Thanks, Brian. Appreciate it.

Brian Essex

And thank you, everyone, in the audience as well.

Corning Incorporated (NYSE:GLW) Edward A. Schlesinger presents at J.P. Morgan 51st Annual Global Technology, Media and Communications Conference May 23, 2023 9:30 AM ET

Company Participants

Edward A. Schlesinger – Executive Vice President and Chief Financial Officer

Conference Call Participants

Samik Chatterjee – J.P. Morgan

Hi, good morning, everyone. Thank you. Welcome to day two, and I’m Samik Chatterjee, I cover hardware companies at J.P. Morgan, for us kicking it off on day two here is, Corning. I have the pleasure of hosting, Edward Schlesinger, EVP and CFO of the company. Thank you for taking the time to come to the conference.

Question-and-Answer Session

Q – Samik Chatterjee

I’ll get right into the questions, and we can take some audience questions as we go along. I did want to start with a few more long-term topics for you before we get into the more near-term macro, etcetera discussion. Your long-term capital allocation decisions in terms of how you prioritize investments across the different segments of the different market-access platforms, is really where I want to start with. How are you thinking about the exposure that you have across these market-access platforms to consumer versus enterprise or business spending, and how you’re thinking about sort of long-term capital decisions about where to invest?

Edward A. Schlesinger

Yes. Thanks and thanks for having us today. Appreciate it. I would start-off by saying, we apply a very disciplined approach to capital allocation. We have a three, four, five framework that we use to invest three core technologies for manufacturing platforms, and we look to invent new capabilities or combinations of those core technologies, manufacturing platforms across the markets we serve.

We do that through investing in research and development. The majority of our research and development spending is focused on the near-term in terms of revenue opportunities. Think of that as sort of the five year — next five year window. We do spend a decent amount beyond that as well, and then what we look to do is once we feel like we have an opportunity to commercialize, we invest capital. And we try to do that in a very disciplined way where we create a level of certainty in generating a return. We target a 20% return on that invested capital when it’s fully up and running. We look to de-risk that in ways by getting incentives or customer funding or long-term supply agreement.

So, that’s kind of the approach we take, we prioritize organic growth, across the markets that we serve. And if we’re successful in doing that, we generate cash and then our goal is to return that cash to shareholders. And we think we have a lot of organic growth opportunities in the foreseeable future. So, that’s kind of how we’re thinking about deploying capital in the near-term.

Samik Chatterjee

Okay. No, great. The reason I sort of started with that is, you have diversified in markets that you address, but when I look at overall your exposure to consumer spending, you have limited diversification to overall consumer spending as sort of a drive. How you’re thinking about the concentration of revenue drivers to consumer spending? Do you see more opportunities to diversify beyond consumers, the leverage that you have to consumer spending?

Edward A. Schlesinger

Yes. So, if I think about our consumer focused markets, first, display, specialty materials in auto. Our goal is to outperform in those markets. We do that by adding content into those markets and we grow — we tend to grow faster. We look for technology curves, new technology curves, a great example is in the automotive space where the need for glass is becoming more relevant in automobiles.

So, we have an opportunity to leverage up on that curve. We look for replacement cycles or new design cycles, and so that’s our focus in those particular areas. And then we also have markets where we’re chasing sort of a secular trend like in optical communications, the need for broadband or in solar, the need for green energy. So, we think we have a nice diversified group of end markets. And again, our goal is to outperform in the consumer-based end markets.

Samik Chatterjee

Okay. On that front, you mentioned this, in terms of more of the Corning product in every end market, but maybe we can go through the different segments. You did sort of touch on it briefly, but when we look at the different end markets, maybe flesh that out a bit more, how do you think about more Corning as a strategy in each of those?

Edward A. Schlesinger

Yes. I’ll start maybe with specialty materials. So, you can think of what we’ve done over the decade is outperform a relatively flat smartphone market. We’ve doubled the size of our business in that market. I think it’s a good example. We invent new glass compositions. When we sell into the market that allows us to value up in terms of the content we’re providing, we’re selling that a higher price point, so higher sales, higher value. We also add content into the devices we serve in that space. Glass, on the backs of phones was a huge growth driver. camera lenses, is a good example in more recent times, the cover glass that goes on a camera lens.

In our automotive business, we think of that as a $100 per auto market, if you think about it as sort of addressable market for us, but today, we’re much smaller than that. We’re in the $30 to maybe $40 per auto range. We sell substrates and filters primarily in the ICE vehicle space as well as on hybrid EVs. And we’re looking to go from that $30 to $40 up to a $100 by adding interior glass, which is a $30 plus opportunity. And then exterior glass, think of that as windows in the car, lighting, sensors and other glass materials that will go into autonomous vehicles and things of that nature, that’s another $30 plus in terms of content. So, that’s a way to add more Corning into a market.

And then even in the markets where we’re chasing a secular trend, we have opportunities to add more content in. So, if I think about optical communications, we have a product called EDGE Distribution. It’s actually a solution that we sell into a data center, that reduces the labor content to build out the data center, reduces the time to get the data center up and running and it also happens to have a lower carbon footprint. It allows us to sell more content in a growing market as well.

Samik Chatterjee

Just to be clear then in display, how do you think about the more Corning strategy?

Edward A. Schlesinger

Yes. I think in display, the biggest driver for us has been screen size. So, if you think about TV units, have been relatively flat. In fact, they’ve actually been down the last few years, but relatively flat, 20 million to 25 million or so TVs per year, but the market volume has actually grown because TVs are getting bigger. We have Gen 10.5 factories which service these large panel making fabs that make large sized TVs, it allows us to outperform in terms of the volume we get in a market that isn’t growing that much.

Samik Chatterjee

Okay. Okay. Let’s move to the segments. Starting with optical, when you think about long-term demand drivers here, how do you think about those long-term drivers? Do they remain intact, particularly if you go through a recession now in consumer spending? And they have the average consumer spend towards some of these services like 5G broadband were to moderate going forward. How do you think about the long-term demand drivers remaining intact?

Edward A. Schlesinger

Yes. I think in this space, I would first say, I’m cautious right now. I think the biggest indicator for us of what happening in this space is, our orders. Normally, we would see a seasonal increase in orders as we go from Q1 to Q2, and we’re not really seeing that seasonal increase. That could be as big as 10% to 15% if you go back in time, and we’re sort of not seeing that.

So, without that inflection in orders, it’s hard to call an uptick in volume and for sure that could last for a period of time. On our Q1 earnings call, we talked about not really expecting an uptick in sales in this business.

But that said, I think the drivers that are going to drive growth over the longer term are still intact, the need for broadband, the build out of 5G, the build out of cloud computing. I think those things are all intact. There’s a lot of private commitment for that build out and there’s also a lot of public funding for that build out as well. You have the BEAD program here in the United States, which is set to kind of kickoff in the near-term, which will infuse a significant amount of capital into that industry. So we feel very optimistic long-term, but very cautious in the near-term.

Samik Chatterjee

Okay, great. Just on that front though, maybe to look through sort of what’s happened in the last few years, how much of the demand slowdown you’re seeing right now is a function of pull-forward of demand over the last few years? We’ve seen that across many other hardware categories. We feel it sort of looking at current trends, do you really see this as under-shipping demand and you are over-shipping demand for the last few years?

Edward A. Schlesinger

Yes. I think you have two dynamics going on right now. For sure there was no over-shipping or inventory building up in the supply chain. I think that’s definitely a factor. We’re seeing that play out for sure, in some of the customers or deployments that where we participate. But I also think you’re seeing a slowdown in deployment of capital by some of the large telcos and even in the data center space, and our view is that’s a cash conservation approach by those customers in this macro environment, they’re conserving cash.

Again, we haven’t — we talk to our customers all the time. So, we’re relatively close to what they’re thinking about in the near-term. And we haven’t really heard anybody talk about reducing their long-term goals, in terms of whether its homes passed or data center capacity. So, we think those commitments still exist, and we think short-term is cash conservation and some inventory digestion.

Samik Chatterjee

Okay. I’ll move to a question on margins for the optical segment. They were up year-over-year despite lower volumes in 1Q. How sustainable are the margin improvements in the near-term if in the absence of volume improvement? And maybe a follow-up to that, long-term margins in this business, particularly if you sort of think about the right balance between selling fiber and connector products, where should long-term margins be?

Edward A. Schlesinger

Yes. So, as we ended 2022, even really sort of towards the middle of 2022, we acknowledge that our profitability in total wasn’t where we wanted it to be, difficult supply chain environment. We absorbed a lot of inflation. And so we set out to take a number of actions to improve our margins. We talked about that on our fourth quarter and on our first quarter call.

Optical Communications is a business where we enacted all of those things. We increased our price. We improved the way we operate our factories. We talk about that as improving our productivity metrics. Think about it as running a much more efficient factory. And we just took cost out of our business. We still have more work to do in this space but in total and in optical, in particular, in Q1 our margins went up.

Our sales were actually down and our margins went up, which is not what you would typically expect in that kind of an environment. I think that is sustainable for us. We definitely intend to, it continue to improve our margins. In optical, I think we probably need volume to get back to where it was, to see a step-up in margins like a meaningful step-up in margins from where we are.

If you go back to maybe the back half of 2018 or the front half of 2019, those margins were probably about as good as we had in this business. And I think that’s sort of where we aspire to get to when we get our volume back and with the additional actions that we’re taking.

Samik Chatterjee

Okay. Just a clarification there, what’s the pricing dynamic on that front? Is pricing contributing to it? And as some of this demand comes off, what are you seeing on the pricing front?

Edward A. Schlesinger

Yes. Price — we took pricing actions in optical, so that has for sure contributed to it. So far, so good, I think the place where we saw the tightest capacity was in fiber and cable. It’s still reasonably imbalance supply demand. So, I think it’s reasonable to assume that the pricing holds. I have not yet really seen significant deflation in cost. So, I think to the extent that happens, that’ll be something for us to watch. Now that’s positive, but the question is will we be able to hold our pricing increases in that environment.

Samik Chatterjee

Okay. You do give us the split for the optical business in terms of revenue by carrier and enterprise. And if you look at 1Q, carrier was down year-over-year, enterprise was up. The question on that front was going to be, is overall enterprise still holding up a bit better? Is there more risk to downside than in the coming quarters from the enterprise side?

Edward A. Schlesinger

I think in general for us, it’s very customer specific in terms of where we’re seeing declines or where we’re seeing sort of the pacing of projects. Enterprise was down sequentially from Q4 and capital spending at a lot of the large hyperscalers has definitely declined from the run rate where it was. But you’re right, I think the more marked impact was in carrier.

I think again in the near-term, we very much are focused on sort of the order rates. I think we factored in generally speaking both of those sides of the business in terms of how we’re pacing right now.

Samik Chatterjee

Okay. And when you think about a rebound between the two segments, how do you think about that playing out? Do you see it playing out earlier in the enterprise? It sort of, is a shorter overall or down cycle for them or how are you really thinking about it, any signs as well of a rebound from either of them?

Edward A. Schlesinger

Yes, no signs of a rebound at this point in any — again very customer specific, there are certainly customers that are continuing to spend and deploy, but no signs of kind of a general rebound. And, I don’t know that I would say that I think it’ll come as it comes as opposed to it’s more on the enterprise side or more on the carrier side.

Samik Chatterjee

Okay. For some of the other companies I’ve hosted, generally we’ve started with a question about the macro, and maybe this is the right point to ask you in terms of the capital spending hesitation that you’re seeing from your customers. I know there are a lot of macro noise and other things playing out particularly discussions about the debt ceiling. When you think about when those get resolved as you talk to customers, do customers are waiting for some of these discussions to play out and then wait for a more calmer period before they start spending again or any insights from your discussions with customers as to what their inflection or what the trigger might be for them to start spending again?

Edward A. Schlesinger

Yes. I would say I’m not sure that I have any insight on that in terms of how the debt ceiling issue plays out and whether customers are tying their spending to anything in particular other than just their cost, their cost of borrowing or whatever it is, their cost of capital and the consumer demand or the end demand in the markets that they’re in. We continue to pace our own capital and make sure that we’re thoughtful in how we spend and we’ll continue to do that until we see demand pick back up.

In different industries, we’re in different places, for sure, in display, we saw the bottoming out of display much earlier than we did in other industries. And we talked about this in the first quarter. We saw an inflection at the end of Q1 in terms of panel maker utilization coming back.

So, we’re starting to see spending there come back and I expect that to continue in to the second quarter, generally that’s playing out. But in most of the other places, I think it’s still wait and see.

Samik Chatterjee

Okay. Last one on optical, you have the new capacity of the additional capacity you’re bringing on in Arizona, given the broader pullback you seeing, how you’re thinking about pacing it? Is there a more measured approach in bringing that capacity online?

Edward A. Schlesinger

Yes. For sure, we talked about capital in total being slightly less than what we spent in 2022 for the year of 2023. We’ll continue to be very measured in how we spend capital. As I mentioned at the onset, our goal is really to de-risk our return, and so part of doing that is not bringing the capital on too early.

Samik Chatterjee

Okay. Let’s switch to display. Panel maker utilization you commented on what you’ve seen in March, I think the obvious question is going to be, how did it track in the month of April, rate up to general 1Q? And are you still continuing to see that improvement and would your expectations be that we see that improvement continue into 3Q as well?

Edward A. Schlesinger

Yes. I think the good news is, things in Q2 are generally playing out as we expected utilization levels are up. We think, panel makers were producing well below demand for quite some time and inventory is sort of normalized in that industry. So, I think we feel pretty good about the rate of deployment. We talked about our volume being up in Q2 as compared to Q1.

I think it’s probably too early to call anything specific for Q3 or Q4, but given where we are now, we don’t really see anything materially changing from what’s happening in the second quarter.

Samik Chatterjee

Okay. The reason to ask about that is, I think the sequential increase from 1Q to 2Q is pretty significant based on what you’re seeing, are you expecting a similar sequential increase or something more moderate like a panel maker utilization continues to move up as you’re seeing in April. Do you continue to see a strong sequential improvement into 3Q as well?

Edward A. Schlesinger

Yes. I think it’s just probably too early for us to call that, I mean, I would not expect a decline, but I wouldn’t call anything specific for Q3 at this point.

Samik Chatterjee

Okay. Okay. On display pricing, it did decline I think slightly on a sequential basis in the March quarter, that was after, I think, eight quarters of stable rising prices. Why shouldn’t we be thinking of this sort of as the turning point of pricing?

Edward A. Schlesinger

Yes. I think in display, we talk about a favorable pricing environment and I think, definitionally, the way we think about it is of course, we want prices to go up. But if prices are flat or slightly down, that kind of fits into that framework. We’re looking to ensure prices don’t take these big declines like we saw years in the past. And so I think a slight decline is reasonable, especially given the fact that utilization was really low for such a long period of time.

I think the drivers of why we’re in that favorable environment or of the drivers of why we’re in that favorable environment, our competitors being not profitable or losing money actually in the fourth quarter 2022 and in general not being profitable is a good driver for helping to sustain pricing in that industry. So, we feel pretty good about it going forward.

Samik Chatterjee

Okay. Let me open it up here to the audience and see if any questions anyone has. Let me then continue on display. One more question, and this is in the third-party of the public data that we track on display, and I don’t know if you’ve seen this trend overall because on the display side, you cater to more of the larger panels. But clearly through the last year or so, there was a decline or moderation of the average increase in the panel sizes that was evident in third-party data, more recently it has started to reflect, again in terms of the increase year-over-year in panel sizes. How should I interpret that? Is that generally a tailwind for you going forward or because you really are more concerned on the larger sizes, you didn’t see the down moderation on the panel sizes impacting your business? You really won’t be a beneficiary on the up-cycle as well?

Edward A. Schlesinger

Yes. I think, we think of screen size as generally driving a few percentage points of growth for glass in the industry, right. So selling, it means we sell more glass into the industry even if the units are flat. We talked about that as being in maybe an inch and a half of screen size per year. Last year, you’re right, that was low. The overall growth rate was lower than that.

I think an inch, inch and a half is probably the right number to think about for the next several years. It’s certainly favorable for us in general. I don’t know that we’ll get any kind of a significant increase. I think it really just depends on how that plays out, relative to what happened in 2022.

Samik Chatterjee

Okay. Let me switch to specialty materials. You’ve been as you outlined outperforming the underlying market there. As you look forward, is there a lot more sort of in terms of new use cases to look on when you particularly focus on the smartphone market in terms of driving content opportunity or is more of the increase going to come from like wearables and other products that you can go into?

Edward A. Schlesinger

Yes. I think we still have some headroom in smartphones to continue to add new glass compositions, and even new components into the devices. I don’t know that the headroom is the same as what we saw let’s say over the last decade, but I think there’s definitely some headroom. New device categories, for sure, we’ll continue to contribute growth, wearable is a good example. I think longer term you have AR, which is certainly an opportunity in that space.

Samik Chatterjee

Okay. I mean, maybe this is sort of going one level down, but in terms of innovation that you’re working on in that area, what does that pipeline look like because a question that we often get from investors is, you really don’t have that much sort of performance improvement on the smartphone glass to really go after anymore. There’s probably a bit more on the wearable side as you outlined, but in terms of your innovation pipeline, we’ve made these visits to your facilities. There’s always like new features, new sort of characteristics that you’re introducing, what does that innovation pipeline look like?

Edward A. Schlesinger

Yes. We have not talked a lot publicly, so I don’t have anything new to share with specifics on innovation. I mean bendable something — bendable glass is something we’ve talked about. The adoption of that isn’t necessarily significant in the near-term, but I certainly think that glass composition is an opportunity. We definitely have many things in the pipeline. We work very much with our customers directly. So, we typically aren’t sharing anything publicly until they’re ready for us to do that.

Samik Chatterjee

Okay. Can we talk about the opportunity around AR, VR? Have you sized it up? What that means on the glass side? And is that more of a bendable sort of a higher content opportunity than the normal glass you would do on a smartphone?

Edward A. Schlesinger

Yes. I mean, I think the way to think about AR, this is my opinion, I mean the way to think about it is, there’s probably no device today that’s really at scale from a cost or design perspective. So, it means it’s a ways out in time, before it’s something. I don’t know how many units eventually get sold, but I think the content per unit could be significantly greater than a smartphone for Corning.

So, you don’t necessarily need the same number of units to see a relatively large market size. So, if you believe AR is successful. I think it’s certainly a TAM or an addressable market that could be significant for us.

Samik Chatterjee

Okay. The same question, but on the smartphone side and foldable phones.

Edward A. Schlesinger

Yes.

Samik Chatterjee

I think, one of your primary customers is probably now the only customer that hasn’t introduced a foldable phone. So, the question on that front is going to be, when you think about content per smartphone, how much of an uplift could a foldable phone be? What are you working in terms of innovation to make that sort of glass more essential to a foldable phone? And maybe give us some sense of how long before a customer launches a product with you, something that as radical as a foldable phone, how long before do you start engaging with them in developing that product?

Edward A. Schlesinger

Yes. So, the last part of the question, I mean it could be years, the innovation cycle could be long, depending on the customer and depending on the nature what they’re trying to do. So, certainly there could be a relatively long cycle. I don’t have anything new to share in this space. I certainly won’t talk about what any of our customers are intending to do?

Samik Chatterjee

Okay. Yes, please go. Actually just wait for the mic, sorry.

Unidentified Analyst

How do you make sure you’re balancing the margin opportunities in the content per vehicle so you’re not chasing after commodity spaces, where there’s revenue opportunities?

Edward A. Schlesinger

Yes, for us, if I think about auto glass, which is really, where today we have a relatively small business, very large market sized opportunity. We tend to participate where the glass challenge is hard, so the margin opportunity is greater. You can think of on the interior form factor or size, as opposed to a small display screen where you might have a much lower margin. So, that’s the place where we do better. Those are the business opportunities that we chase.

On the exterior, I think it’s still a little earlier to figure out what’s going to happen there. But if you think about like LiDAR or autonomous or semi-autonomous driving, the materials that are going to be required to do a lot of that are going to be higher end glass compositions where again it works well for a company like Corning, as opposed to a generic composition of glass.

So, I think the margin opportunity is good in that space. How it all plays out, it’s just early, really to know. We’ve got a lot of orders in backlog. We’ve got over $1 billion of orders that we’ve won in the auto glass space. Think of that as revenue over a few years of time, not an individual year. And as new model — new car models come out, you’ll start to see that. Most of that’s on the interior, but we are certainly seeing many opportunities to bid on the exterior and in specialized glass opportunities as well.

Samik Chatterjee

Any other questions? Okay. Let me actually follow-up on the automotive question here. There are concerns around the automotive market, but still for the early part of the year, it’s held up pretty well. And I think even if I today look at third-party forecast for automotive, they expect to be modest growth for the year. How — I mean it seems like that should be then a segment that you’re relatively more positive about relative to some of the others for the year. How are you thinking about automotive and help us balance that out with what are you seeing on the diesel side?

Edward A. Schlesinger

Yes. I mean on autos, I think it’s going to be the fourth year in a row, where less cars are built than the end market demand, assuming the end market demand hasn’t really structurally changed. We’re not predicting any real significant growth in units in 2023, that’s kind of how we think about it. We continue to outperform. Recent U.S. emissions, EPA emissions regulations actually bode well. We think that will require new gas particulate filters on U.S. cars starting in the ‘26, ‘27 timeframe, which is a huge opportunity from a content perspective for us.

So, I think there’s definitely room to grow even in the ICE vehicle space, going forward for us. More cars being built would be good, but I don’t have an opinion on when that really starts to tick up.

Samik Chatterjee

Okay. In the time we have left, let me go through a few questions on the financials, mostly cash flow because that’s where I get a lot of questions from investors. So, free cash flow generation for the last couple of years has been good on account of low CapEx investments. How should we think about capital spending intensity going forward? Are we sort of at a point where you need to start investing again in terms higher CapEx, how should we think about the go forward?

Edward A. Schlesinger

Yes. So for ‘23 specifically, we intend to spend a little less capital than we did in 2022. We are trying to be very measured and thoughtful about when we add capital. Our goal is to de-risk the return that we try to get. It’s possible we go through a growth cycle and we need capital. I wouldn’t preclude that from happening, but I think that’s good news in the sense that means we have a level of certainty.

We use many different tools. We’ve been using a lot of tools lately to minimize the out flow of capital like incentives, government incentives or customer funding that helps, take-or-pay contracts also give us a level of certainty on that capital. So, I don’t know that you can ever think of Corning as not being capital intense. It’s capital intense to some extent to melt glass. But our goal is to try to make sure that we generate a return on that capital, that’s reasonable in a short period of time.

Samik Chatterjee

Okay. One, of the questions I did receive from investors over email even before coming to the conference was, clear display business is the one that’s poised to do very well through this year. What does that mean for capital investment through the year, where is display in terms of utilization of your own facilities? Do we need to see a leg of CapEx just to keep up with the growth that you’re probably expecting on the rebound?

Edward A. Schlesinger

Yes. I mean, for sure there’s maintenance of business capital that we need to spend in display. We don’t have any intentions about doing anything significant. I think we have capacity to be able to meet what we would see as increasing demand there.

Samik Chatterjee

Okay. Free cash flow conversion in relation to net income, that’s largely if I remember numbers right on average being around sort of 60%, 70%. Most companies we cover are higher than that, and that’s obviously a function of your capital intensity. But as you sort of look at this model longer term, do you see the areas where you can tweak things to improve that conversion over time?

Edward A. Schlesinger

Yes. I think in the short-term, the best thing we can do is improve our profitability. I talked about that a little bit earlier, our profitability has been impacted by inflation and the global supply chain environment. So, improving our profitability for sure improves cash. Improving our inventory, that also improves our operating cash flow. We can do those things that should improve our conversion a little bit. And I think being more measured on the capital is definitely going to help.

I don’t know that we can convert at a much higher rate than that, but if we can continue to convert at least at that rate and grow, I think you should start to see us improve our free cash flow in total.

Samik Chatterjee

On that front, the ROIC hurdle rate that you have of 20%, is that now largely being followed across all segments or does — do certain segments like display get a pass, because they’ve already been grandfathered in?

Edward A. Schlesinger

Yes. The way to think about it is new capital. So, if we’re going to build a factory or add a significant addition on to a new factory, whatever business is in, that’s the target rate that we go after. Of course, we want it to be much higher than that, but that’s sort of the cutoff for us as we think about where we put our capital.

Samik Chatterjee

Okay. Last one, just you’ve refrained from doing open-market repurchases for a while now. So, I think we understand the buyback that you need to do from Samsung, but how should we think about maybe starting some open-market repurchases? What could the timing for that look like?

Edward A. Schlesinger

Yes. So in 2021, we bought back about 4%, 5% of the company through a transaction with Samsung. We paid for that over three years. In April of ‘23, we made the last payment on that buyback. So, the good news is, we now going forward, we’ll have some firepower because we don’t have to make any more of those payments. That was $0.5 billion we spent in April of ‘23. So, I think the good news is going forward, we have the opportunity to do that. And as I mentioned at the onset, our capital allocation approach is to prioritize organic investment and then to find ways to return cash to shareholders. We pay a nice dividend and we intend to use buybacks as a tool as we go forward.

Samik Chatterjee

Okay. I’ll wrap it up there, we’re close to end of time. Thank you. Thanks for coming to the conference. Thank you everyone.

Edward A. Schlesinger

Thank you.