So What If IBM Beat? After-Hours Shares Plunge as Red Hat Slowdown Spooks Investors

TradingKey - On Wednesday, U.S. tech giant IBM released its third-quarter earnings report, surpassing Wall Street expectations on both revenue and earnings per share while raising its full-year free cash flow guidance — a significant positive. However, the disappointing slowdown in growth of its much-watched Red Hat division has raised deep concerns among investors who view the software business as one of IBM's key future growth engines, causing the company's stock to fall approximately 6% in after-hours trading despite the positive headline numbers.

The report showed that IBM achieved third-quarter revenue of $16.33 billion, higher than the LSEG analysts' consensus expectation of $16.09 billion; adjusted earnings per share reached $2.65, significantly outperforming the expected $2.45.

IBM also raised its full-year free cash flow guidance, now expecting to reach $14 billion, above the previous expectation of $13.5 billion and Wall Street's forecast of $13.6 billion (according to FactSet data). IBM also reiterated that its revenue growth rate on a constant currency basis will "exceed" 5%, a more optimistic outlook compared to the previous "at least" 5% expectation.

“Clients globally continue to leverage our technology and domain expertise to drive productivity in their operations and deliver real business value with AI,” CEO Arvind Krishna said in release.

IBM's consulting division has been impacted in recent years by client concerns about the overall economic environment, making growth in the software business a focal point for investors.

However, Red Hat, a core pillar of IBM's software strategy, saw its sales growth slow from 16% in the previous quarter to 14%.

Prior to the earnings release, Stifel analysts noted that IBM's software business growth was the "focus" for investors ahead of the "seasonally soft" third-quarter report.

"A slowdown in Red Hat revenue and software sales ... will disappoint some that were hoping for accelerating growth in what is a high-margin segment," said Michael Ashley Schulman, chief investment officer at Running Point Capital.

Chief Financial Officer Jim Kavanaugh attempted to reassure the market, stating the company still expects Red Hat's growth to "reach around 15%, albeit on the lower end," and reiterated that Red Hat is the "cornerstone" of IBM's software growth strategy.

Regarding the highly watched AI business, IBM CEO Arvind Krishna revealed that the company's AI business has now exceeded $9.5 billion in size, up from $7.5 billion in the second quarter.

However, a deeper analysis of its structure reveals that about 80% of this AI business revenue comes from the consulting division, with the software division contributing only the remaining 20%. As is well known, consulting business typically has lower profit margins than software business and involves longer project cycles and higher execution risks.

The company is seeing more of its bookings convert into revenue as customers are putting AI projects into production, CFO Jim Kavanaugh said. This is helping fuel an “inflection” in growth for the consulting business, he added.

Additionally, the report showed that IBM's infrastructure division performed strongly this quarter, with revenue surging 17% year-over-year to $3.56 billion.

Kavanaugh explained that the new mainframe computers, equipped with chips designed specifically for AI applications, are being widely adopted by the financial industry, enabling them to maintain strict data residency and encryption rules while adopting AI technology.