International Business Machines is living a case study of a large, established company vying to transform. Over the last decade, the technology elder has struggled to move into areas like cloud and AI. IBM has leaned on a combination of its own R&D abilities and deep pockets to push into modern markets, but has struggled to turn them into revenue growth.
At one point, Big Blue posted 22 sequential quarters of falling revenue, a mind-boggling testament to how hard it can be to turn around a juggernaut. More recently, IBM shrank for another five consecutive quarters, a streak it broke with yesterday’s news that it had beat analyst expectations.
The quarter brought modest, but welcome revenue growth. Perhaps more importantly, the company’s top line expansion was co-led by the old IBM mainframe business and its newest champion, Red Hat.
IBM can be happy for the positive financial news, for now at least, but it needs to repeat the result. The challenge it faces moving forward will include finding a way to continue revenue growth while modernizing its product line and ensuring that its huge Red Hat purchase continues to perform.
As the last decade has shown, it’s not going to be easy.
A look at the numbers
IBM is a large, multi-part business. Unlike a fast-growing SaaS company that reports revenue in a single chunk, understanding an IBM quarter takes a bit more time.
The highlights, however, are easy to understand. IBM’s revenue grew from $21.76 billion in Q4 2018 to $21.78 billion in Q4 2019.
That modest gain, you might think, belies a business in decline; after all, such slim growth is hardly growth at all. But inside IBM’s top line figures are a host of changes. Indeed, IBM has six revenue-generating groups that it reports individually, and is in the process of exchanging services revenue for cloud incomes.
For example, IBM’s Global Business Services and Global Technology Services groups both shrank over the year’s period, while its Cloud & Cognitive Software group expanded over the same time frame.
So was it a wash? No. The two service-focused groups had Q4 2019 gross margins of 27.5% and 35.2%, respectively. IBM’s cloud group’s gross margin was a stellar 79.2% in the quarter, in contrast. So IBM’s raw revenue didn’t grow much, but the quality of its revenue rose sharply over the last year.
The company’s Red Hat business sits inside its cloud line item; some of the group’s $577 million in year-over-year revenue gains come from growth from its new division. Red Hat is, therefore, helping IBM add high-margin revenues as it sheds lower-margin services work.
IBM’s revenue mix shift led to profitability gains, its investors were happy to see. IBM’s quarterly net income grew from $1.95 billion in Q4 2018 to $3.67 billion in Q4 2019. What IBM showed, then, was that the long, hard work that it has done to reinvent itself is starting to pay off — at least to some degree. Whether the improvements to its revenue makeup, margins and profitability are enough to pull itself out of its half-decade slump remains to be seen.
Now let’s talk about the numbers, but from a product perspective.
From mainframes to containers
The big winners in yesterday’s report were mainframes and Red Hat. IBM refreshed its popular Z series mainframes last quarter with its “Z15 mainframe cycle” generating 60% growth. It’s kind of hard to believe that in 2020, IBM is actually making significant money selling computers popularized in the 1950s, but it’s important to remember that these are not your grandfather’s mainframe — these modern machines provide a powerful computing backbone for some of the world’s biggest companies, like airlines and insurance companies. By putting them in a modern context, IBM is keeping a lucrative part of its business alive.
But it’s not just resting on the laurels of early computing success. You may recall that IBM bought Red Hat in 2018 for $34 billion. At the time, we acknowledged that it was a big bet, one it had better not screw up given the cost of the wager. So far, the company seems to be handling their prized purchase well.
Red Hat grew 24%, surpassing a billion dollars in revenue for a single quarter for the first time.
The company sees a big revenue opportunity in hybrid cloud by combining IBM services with Red Hat. “As we look forward, the largest hybrid cloud opportunity is in services, advising clients on architectural choices, moving workloads, building new applications and, of course, managing them,” IBM Senior VP and CFO Jim Kavanaugh told analysts on the company’s earnings call yesterday.
IBM has always made a fair bit of money via consulting services, and it sounds like they see helping companies to manage a hybrid cloud environment as an opportunity moving forward.
As Ray Wang, founder and principal analyst at Constellation Research put it, they had the good sense to leave Red Hat alone. “We are seeing good cross-sell with Red Hat and they have done a good job not mucking it up by leaving them an independent unit, but very aligned with IBM when it makes sense,” Wang told TechCrunch.
With Red Hat pushing forward, some legacy work continuing to perform and IBM largely exchanging low-margin revenue for more profitable incomes, the quarter contained a lot more than modest revenue gains. The growth, however, was also welcome.
The question remains whether IBM can build sustained growth with this formula. The company has, for the most part, tried to move where the technology puck is going in the past decade, but with less than stellar results. As it pushes into the hybrid cloud, it will need to build on this quarter and find ways to gain some consistent revenue momentum in the years ahead.