The third-quarter earnings report from International Business Machines(NYSE: IBM) on Wednesday failed to meet expectations. While the bottom line came in ahead of analyst estimates, revenue fell a bit short. IBM stock was down around 7% by lunchtime Thursday.
IBM stock has surged over the past year and recently surpassed its decade-old all-time high. It makes sense, then, that investors were expecting better results from the tech giant. While IBM's revenue miss was disappointing, the good news for long-term investors is that there's nothing to worry about.
Consulting and infrastructure weakness
Nothing has really changed about the story playing out in IBM's consulting business. The company continues to see strong demand for large digital transformation projects, but demand for more discretionary projects is volatile against a difficult macroeconomic backdrop. Overall consulting revenue was flat year over year on a constant-currency basis, with growth in AI-related bookings helping to offset weakness elsewhere.
IBM CEO Arvind Krishna pointed to the geopolitical environment, upcoming elections, inflation, and interest rates as reasons for the pause in discretionary spending. All of this should be temporary, although there's no telling how long the weakness will persist.
The infrastructure business, which includes mainframe systems, other hardware, and infrastructure support, saw revenue tumble 7% year over year in the third quarter. This isn't too surprising. The current generation z16 mainframe is deep into its product cycle, and while IBM hasn't announced its successor, it has detailed the new Telum II processor that will power the next-generation system in 2025. It makes sense that customers are beginning to hold off on upgrades with an updated system looming.
While mainframe revenue was down 19% in the third quarter, the z16 remains on pace to outsell its predecessors. This has been a strong mainframe cycle for IBM, and with AI capabilities being a core focus in the next mainframe system, another strong cycle could be in the cards.
Booming software sales
While consulting and infrastructure revenues were weak in the third quarter, soaring software revenue was enough to drive overall revenue growth of 2%. Software sales jumped 10% year over year, with 14% growth from Red Hat, 13% growth from automation, and 9% growth from transaction processing.
Software now accounts for close to 45% of IBM's revenue, nearly double the percentage in 2018. The acquisition of Red Hat five years ago has been a key driver of this software shift. Red Hat's revenue has doubled since the acquisition, and the OpenShift hybrid cloud platform has gone from $100 million in annual recurring revenue to $1.3 billion.
AI and free cash flow
IBM has now booked more than $3 billion in generative AI-related business, a gain of more than $1 billion in the third quarter alone. About 80% of this comes from consulting signings, with the rest coming from software sales. Even with weakness across the consulting segment, demand for AI services is helping to prevent a revenue decline.
IBM expects revenue growth to accelerate in 2025, with more details to come in January. The company likely expects a consulting recovery, a revenue boost from a new mainframe system, and continued growth in the AI business. Free-cash-flow growth could also accelerate as the high-margin software business continues to grow.
Despite a mixed third quarter, IBM reiterated its free-cash-flow guidance for 2024. The company expects to produce at least $12 billion in free cash flow for the year. With its market capitalization hovering around $200 billion, the stock trades for around 16.7 times this free-cash-flow outlook.
While IBM stock isn't in bargain territory, it still looks attractively priced, given the temporary nature of the consulting slowdown and the likelihood of a revenue acceleration next year. In the long run, AI should act as a tailwind as IBM cements its status as a leader in enterprise AI.
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Timothy Green has positions in International Business Machines. The Motley Fool recommends International Business Machines. The Motley Fool has a disclosure policy.
