IBM's Red Hat business growth slowdown raises investor concerns, with after-hours stock price dropping 5% | Earnings Report Insights
Despite IBM's revenue and earnings per share exceeding Wall Street's expectations in the third quarter and raising its full-year free cash flow guidance, the disappointing revenue from the highly watched high-margin software and cloud services segment, Red Hat, has raised concerns among investors who view the software business as one of the key drivers of the company's growth. After hours on Wednesday, IBM's stock fell more than 5%
IBM's latest financial report shows that free cash flow exceeded expectations, but the slowdown in Red Hat's growth has raised deep concerns in the market.
On October 22, IBM released its financial report, which revealed that despite exceeding Wall Street's expectations in both revenue and earnings per share for the third quarter, it also raised its full-year free cash flow guidance, which is a significant positive.
However, the disappointing revenue from the much-watched Red Hat division has raised concerns among investors who view the software business as one of the key drivers of the company's growth. The key points from the financial report are as follows:
- Strong financial performance: Total revenue for the third quarter was $16.3 billion, a year-on-year increase of 9.1%; adjusted earnings per share were $2.65, exceeding analysts' expectations of $2.41.
- Red Hat business slowdown: The hybrid cloud division, which includes Red Hat, saw revenue growth of 14% in the third quarter, down from the previous quarter's growth rate and below analysts' expectations of 16%, raising doubts about IBM's growth engine.
- AI business thriving on paper: Since mid-2023, AI business orders have accumulated to $9.5 billion, but 80% of this comes from the lower-margin consulting division, with only 20% from the software division.
- Optimistic cash flow guidance: Full-year free cash flow is expected to be around $14 billion, higher than the market expectation of $13.5 billion; full-year revenue growth at constant currency is expected to exceed 5%.
In 2018, IBM completed its acquisition of Red Hat for $34 billion, setting a record for the largest acquisition in IBM's history. As a result, Red Hat is seen by the market as the core driving force for IBM to move away from traditional businesses towards a future of high-margin software and cloud services.
Although the company's Chief Financial Officer Jim Kavanaugh stated that he feels "very good about the overall growth opportunities for Red Hat," the capital markets clearly trust the trends reflected in the data more. On Wednesday, after-hours trading saw IBM drop over 5%.
(IBM fell 5.37% in after-hours trading on Wednesday)
Red Hat has become a hot potato
The Red Hat software business, viewed as a key driver of the company's growth, has underperformed expectations.
Red Hat is a core pillar of CEO Arvind Krishna's strategy to make software IBM's largest business segment, especially in the context of the consulting division being impacted in recent years due to clients' concerns about the overall economy.
In the third quarter, the hybrid cloud division, which includes Red Hat, saw revenue growth of 14%. This figure seems good, but compared to the previous quarter, it shows a clear slowdown, and more importantly, it is below the analysts' average expectation of 16%.
For IBM's stock, which has already risen 31% this year, this is undoubtedly a cold shower.
The market's previous enthusiasm for its software business was largely built on the growth expectations of the acquisitions of Red Hat and HashiCorp.
AI narrative and cyclical growth
IBM has boldly announced that since mid-2023, AI business orders have surpassed $9.5 billion, an increase from the $7.5 billion disclosed in the July financial report However, a closer look at the structure reveals that about 80% of the orders come from the consulting department, while the software department accounts for only the remaining 20%.
Consulting business typically has lower profit margins than software business, with longer project cycles and higher execution risks. Although the company's Chief Financial Officer Jim Kavanaugh emphasized:
An increasing number of orders are being converted into revenue as clients are putting AI projects into production, and this is driving a turning point in consulting business growth.
However, data shows that consulting revenue grew only 3.3% to $5.32 billion in the third quarter, just meeting expectations, which cannot be described as strong.
In contrast, the software department's revenue grew 10% to $7.21 billion, meeting expectations but with no surprises.
The infrastructure department's third-quarter revenue surged 17% to $3.56 billion, mainly benefiting from the second quarter sales of the new z17 mainframe servers. However, analysts believe that mainframe sales have significant cyclical characteristics, raising doubts about the sustainability of this growth.
