Strong software sales and rising demand for AI services helped counterbalance a decrease in consulting performance and a downturn in infrastructure for International Business Machines (IBM) in their third-quarter earnings report. Despite the company’s earnings surpassing analyst predictions on the bottom line, revenue fell short of expectations. As a result, IBM’s stock dropped approximately 7% by midday Thursday.
Over the past year, IBM’s stock has seen significant growth, recently exceeding its decade-old all-time high, which had set high expectations among investors for the company’s performance. Although the revenue shortfall was disappointing, long-term investors are reassured that there is no need for concern regarding IBM’s outlook.
In the consulting segment, the demand for large-scale digital transformation projects remains robust. However, the need for more discretionary projects is inconsistent amidst challenging macroeconomic conditions. On a constant-currency basis, overall consulting revenue remained stable compared to the previous year, with AI-related bookings contributing to offset weaknesses in other areas. IBM’s CEO, Arvind Krishna, attributed the slowdown in discretionary spending to the geopolitical environment, upcoming elections, inflation, and interest rates. These factors are believed to be temporary, but the duration of their impact is uncertain.
The infrastructure business, which includes mainframe systems and other hardware support, experienced a 7% decrease in revenue year over year during the third quarter. This decline aligns with expectations, as the current generation z16 mainframe is nearing the end of its product cycle. While the next mainframe system has not been announced, IBM has already detailed the forthcoming Telum II processor, expected to power the new system in 2025. Consequently, many customers are delaying upgrades in anticipation of the updated mainframe.
Mainframe revenue decreased by 19% in the third quarter, yet the z16 remains on track to outperform its predecessors. This cycle has been strong for IBM, and with AI capabilities set to be a central focus of the upcoming system, another successful cycle is anticipated.
In contrast, software revenue showed significant growth, increasing by 10% year over year and driving an overall revenue growth of 2% despite challenges in consulting and infrastructure. The software segment saw a 14% increase in revenue from Red Hat, 13% from automation, and 9% from transaction processing. Software now constitutes nearly 45% of IBM’s revenue, a significant increase from 2018 levels. The acquisition of Red Hat five years ago has been a critical factor in this growth, with Red Hat’s revenue doubling and its OpenShift hybrid cloud platform growing from $100 million to $1.3 billion in annual recurring revenue.
IBM has secured more than $3 billion in generative AI-related business, with an increase of over $1 billion in the third quarter alone. Approximately 80% of this stems from consulting signings, while the rest is derived from software sales. The demand for AI services, even within a weakened consulting sector, continues to prevent a revenue decline.
IBM anticipates accelerated revenue growth in 2025, with further details expected in January. The company likely foresees a recovery in consulting, a revenue boost from the new mainframe system, and continued growth in its AI business. The expansion of its high-margin software business is also expected to accelerate free-cash-flow growth.
Despite a mixed performance in the third quarter, IBM has reiterated its free-cash-flow guidance for 2024, projecting at least $12 billion in free cash flow for the year. With a market capitalization nearing $200 billion, the stock is trading at approximately 16.7 times the free-cash-flow outlook. While IBM stock may not be considered a bargain, it appears reasonably priced, considering the temporary nature of the consulting slowdown and the anticipated revenue acceleration in the coming year. In the long term, AI is expected to serve as a driving force, cementing IBM’s leadership in enterprise AI.
