IBM's latest earnings report indicates that while free cash flow exceeded expectations, the slowdown in Red Hat's growth has raised significant concerns in the market.
On October 22, IBM reported its financials, revealing that third-quarter revenue and earnings per share both surpassed Wall Street estimates, which also included an upward revision to its annual free cash flow guidance—an encouraging sign for investors.
However, the disappointing revenue from the Red Hat segment has sparked worries among investors who view the software business as a key driver for the company's growth. Here are the main financial highlights from the report:
- **Solid Financial Performance**: The total revenue for the third quarter reached $16.3 billion, a year-over-year increase of 9.1%. Adjusted earnings per share came in at $2.65, exceeding analysts' expectations of $2.41. - **Red Hat's Business Slowdown**: The hybrid cloud segment, which includes Red Hat, experienced a revenue growth of 14% in the third quarter, down from the previous quarter's growth rate and below the analysts' 16% expectation, raising doubts about IBM's growth engine. - **AI Business Booms on Paper**: Since mid-2023, AI business orders have accumulated to $9.5 billion, but 80% of this comes from the lower-margin consulting segment, with the software segment providing only 20%. - **Optimistic Cash Flow Guidance**: The annual free cash flow is projected to be around $14 billion, surpassing the market's expectation of $13.5 billion, with revenue growth projected to exceed 5% on a constant currency basis for the year.
In 2018, IBM completed the acquisition of Red Hat for $34 billion, marking its largest acquisition ever. As such, Red Hat is considered a core driver for IBM’s transition from traditional business to a focus on high-profit software and cloud services.
Despite the company’s CFO Jim Kavanaugh expressing confidence in "the overall growth opportunities for Red Hat," the capital markets appear to trust the data reflecting the emerging trend. After-hours trading saw IBM's stock drop over 5%.
**Red Hat Becomes a Double-Edged Sword** Regarded as a crucial component for growth, the performance of Red Hat's software business has fallen short of expectations. Under CEO Arvind Krishna's strategy, software is positioned as IBM's largest business segment, especially given the pressure on the consulting segment amid economic concerns from clients.
In the third quarter, the hybrid cloud segment's revenue growth of 14% may seem satisfactory, but compared to the previous quarter, it's a clear deceleration and significantly misses the analysts' average expectation of 16%.
For IBM, whose stock has risen 31% this year, this news acts as a cold shower. Much of the prior enthusiasm for its software business hinged on growth expectations from Red Hat and HashiCorp acquisitions.
**AI Narrative and Cyclical Growth** IBM proudly announced that AI business orders have exceeded $9.5 billion since mid-2023, marking an increase from the $7.5 billion disclosed in the July earnings report.
However, a closer examination of the structure reveals that about 80% of the orders originate from the consulting segment, with the software portion accounting for the remaining 20%. Consulting typically has lower profit margins compared to software, along with longer project cycles and higher execution risks. While CFO Kavanaugh emphasizes that:
"More orders are being converted into revenue as customers are putting AI projects into production, which is driving a turning point in consulting business growth."
The data shows that consulting revenue grew only 3.3% to $5.32 billion in the third quarter, just meeting expectations and lacking robust strength. In contrast, the software segment's revenue grew by 10% to $7.21 billion, aligning with expectations but offering no surprises.
The infrastructure segment saw a robust 17% revenue surge to $3.56 billion in the third quarter, mainly benefiting from sales of the new z17 mainframe servers in its second quarter. However, it is believed that mainframe sales exhibit significant cyclical characteristics, raising doubts about the sustainability of this growth.
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