IBM reported earnings this week, and if we’re being honest, the results were rather uninspiring. The company generated revenue of around $15.5 billion, down a disappointing 0.4% from its year-ago result. However, even inside its less-than-stellar report, there were some favorable tidbits for the well-known tech giant.
On the negative side, IBM’s infrastructure business is deep in the doldrums with revenue down 14.6% to $3.6 billion, compared to year-ago metrics. That overall loss includes IBM Z Systems, the company’s mainframe business, falling 30% on its own. Z Systems has been pretty solid for the company in the past, so it’s sobering news to see it doing so poorly.
On the bright side, software revenues were up 7.2% in IBM’s most recent quarter to $6.6 billion with Red Hat leading the way up 11%, making the $34 billion purchase in 2018 look better with each passing quarter. You could even argue that without Red Hat, IBM would be in much worse shape.
CEO Arvind Krishna has been looking to squeeze out modest growth for his company, but Big Blue failed to achieve even that in the second quarter.
Still, as IBM doubles down on its hybrid cloud strategy, where its goal is to act as a trusted partner to manage infrastructure wherever it lives, there are a couple of decent signals for the future, including anticipated revenue growth of 3% to 5% at constant currency rates. And it expects $10.5 billion in free cash flow this quarter, up $1 billion from year-ago results.
Several parts of IBM are contributing to its modest growth trajectory. Apart from rising software revenues, its consulting division had a decent report this quarter, expanding its top line by 4.3% compared to year-ago results to $5 billion. Those folks help large companies manage their hybrid cloud implementations, among other things.
Recently IBM went out and spent a hefty $4.6 billion to buy Apptio, which builds software to help better understand where resources are allocated, whether on-prem or in the cloud. That deal isn’t expected to close until later this year, but it’s clear that it could be a way to squeeze out additional revenue from the hybrid cloud approach, and it could add a layer of revenue to the company’s forward results that will bolster year-over-year comparisons in the future.
What about AI?
IBM also sees AI as being inextricably linked to its hybrid strategy. In May, the company introduced a refresh of Watson, an artificial intelligence platform called Watsonx that takes advantage of the new generation of large language models. While IBM frittered away its head start with Watson, which emerged in 2011 with its famous “Jeopardy” victory, it’s hoping to take advantage of the new interest in AI.
Holger Mueller, an analyst at Constellation Research, thinks AI could be another source of revenue for the company. “They have a good thing going (again) in AI with WatsonX, which provides an attractive combo of being not tied to any particular cloud, having good models, having good data management and a working foundation model stack,” he said.
But there’s a lot of competition offering a similar technology package, and there is no guarantee of success, especially given how the company squandered the promise of the original Watson.
This quarter clearly didn’t go according to plan, but Mueller says with the mainframe business down so much, it didn’t have enough revenue from other categories to make up for it. “Yes, the quarter was disappointing, but we knew it would happen as IBM simply does not have enough software to grow more. But it really would have been OK if the mainframe business did not have its cyclical bad quarter,” Mueller told TechCrunch+.
He says that the company typically has a down quarter in the mainframe business one year after a refresh when everyone who is going to upgrade has already done it. The company released its last mainframe upgrade, the z16, in April 2022.
To sell more software, you need more software to sell
Mainframes aside, the company’s revenue mix makes it plain that software is the key to IBM’s future. Software forms the largest single revenue chunk at the company and is growing the most quickly — 7.2% year-over-year — apart from financing revenues. That revenue category grew by 26.2% in IBM’s most recent quarter, but as financing-related incomes were incredibly modest compared to IBM’s overall size, the impressive growth was largely immaterial to its trailing results. More specifically, it appears that the company’s Red Hat division is the critical pillar atop which IBM hopes to build future growth.
IBM does not break out hard figures from contributing products to its software revenue, instead providing growth metrics for certain drivers of overall category results. From those data points, we can see that Red Hat’s growth of 11% was the fastest expanding piece of the company’s software puzzle.
Put another way, in its most recent quarter, Red Hat not only grew the most quickly of any material portion of the company’s business, but it also did so while helping form the largest piece of IBMs business itself grow. Without Red Hat, IBM’s growth rate would likely have been far more modest and its quarterly results entirely more negative. Red Hat is therefore key to the company’s overall growth story, no small matter given that IBM suffered a lengthy period of declining revenue in the recent past.
How big is Red Hat today? That’s hard to say, but in the quarter that IBM announced it would purchase Red Hat, the company put up revenues of $772 million and a full-year top line of $2.9 billion.
This puts the company’s mammoth deal to buy Red Hat into clearer context. Back in 2018 when IBM announced the transaction, it had seen its share price fall from around $145 at the start of October of that year to around $119 before it announced the deal. Then, after the deal was announced, IBM’s stock fell to around $105 per share as investors fretted about the price of buying Red Hat.
Today with IBM stock worth $138.40 per share, you could argue that the deal has had little impact on its now-parent company’s valuation arc; after all, in crude per-share terms, IBM is worth today roughly what it was before the deal was announced. That’s a simplistic perspective, though.
Our perspective, having watched Red Hat join the IBM corporation and keeping tabs on both since they combined, is that the smaller software company has provided a regular growth drumbeat that kept its parent company in the game. Imagine IBM’s growth trajectory sans Red Hat. How much farther would revenues have fallen? How much less enthused would its investors have been?
Red Hat has therefore proved itself a key, if not cheap, way for IBM to stabilize, giving it room to find perhaps a renewed footing in AI. If IBM’s newly reforged AI ambitions pan out in growth terms, Red Hat will have helped provide a bridge to the company’s next chapter.
Perhaps that’s why the company recently announced the controversial decision to tighten its source code rules (although it denied any pressure from IBM to do so). It’s always possible IBM wants to further juice Red Hat, or Red Hat itself simply saw it as a way to increase control (and therefore revenue), even if the decision has proved contentious in the open source community.
One final factor to consider: Red Hat’s growth is slowing: 18% in Q1 2022 to 12% in Q2 2022, falling to 10% in Q4 2022 before declining further to 8% in Q1 2023. The company’s 11% result in Q2 2023 is stronger than we have seen in some recent periods but is still a deceleration from peak results seen in the preceding calendar year — and investors are taking note. That’s why the IBM-Apptio deal could be key to giving the company another year’s breathing room to ignite home-grown growth instead of leaning on add-on deals to expand its top-line incomes.