IBM Earnings Edge Estimates. The AI Bet Is Starting to Pay Off, CEO Says.

IBM (ticker: IBM) has been making a big effort to offer generative artificial intelligence tools, and CEO Arvind Krishna told Barron’s the strategy is beginning to pay off. Customers are increasingly adopting IBM’s Watson X AI platform, he said. On the company’s conference call with analysts, Krishna said bookings in the third quarter included “low hundreds of millions of dollars” from generative AI projects, which implies a run rate of about $1 billion a year.

For the quarter, the enterprise technology giant posted revenue of $14.75 billion, up 4.6% from a year ago, and slightly ahead of the Wall Street consensus forecast at $14.73 billion. IBM reported adjusted earnings of $2.20 a share, 8 cents ahead of the Street consensus at $2.12, as measured by FactSet. Under generally accepted accounting principles, the company earned $1.86 a share.

Revenue in IBM’s software segment—which includes its AI platform—rose 7.8% from a year ago to $6.3 billion, about in line with Street estimates; growth was 6% when adjusted for currency. That includes better-than-expected performance by the company’s transaction processing business—offset by a miss by Red Hat, which grew revenue 8% on a constant currency basis, a couple of points short of expectations.

In an interview with Barron’s, Krishna noted that software revenue growth was in line with his previous forecast for an increase in the mid-single-digits range on a constant currency basis. But for Red Hat, the company had expected growth to be more like 10% on a constant currency basis, Krishna said.

“We took our eye off the ball a little bit,” he said. “There’s no fundamental issue, but it was a little bit of an execution miss.”

Consulting revenue was $5 billion, up 5.6%, slower than the Street consensus forecast for 8.7% growth—but consistent with the recent softer growth at rival
Accenture
(ACN). Infrastructure revenue was $3.3 billion, down 2.4%, but ahead of the Street forecast for a 7.5% decline. It was helped by 9% growth in the zSystems mainframe business.

Krishna conceded that growth in consulting was “good but not great,” and consistent with recent earnings reports from other consulting firms. Mainframe demand remains resilient, however, he said, and contributed to the growth in transaction processing in the quarter.

IBM generated $1.7 billion in free cash flow in the third quarter, up nearly $1 billion from the year-ago period. IBM continues to forecast full-year free cash flow of about $10.5 billion, up more than $1 billion from the previous year.

Krishna said IBM has to beat year-ago cash flow performance only by about $300 million in the fourth quarter to hit the company’s $10.5 billion target. “We’re in a much better position than we’ve been in a while,” he said.

IBM also said it continues to see full-year constant currency revenue growth of 3% to 5%. It expects foreign exchange to be about a one percentage point headwind for reported growth.

Non-GAAP operating margin was 15.6%, falling a little short of consensus at 16.6%, but nonetheless 1.7 percentage points higher than the year earlier period. Non-GAAP gross margin was 55.5%, up 1.6 percentage points from the year-earlier quarter.

Krishna also commented on recent cloud spending trends. Both
Microsoft
(MSFT) and
Alphabet
(GOOGL), when reporting financial results on Tuesday, noted that customers continue to look for ways to optimize their cloud spending. Krishna says that trend continues. The CEO also suggested that it partly explains why Microsoft seems to be accelerating when Google’s cloud business is showing slowing growth. 

“Overall there’s some caution around total cloud adoption,” Krishna says. “Cloud is not going away, but the days of 50% and 100% growth are over. Those companies that are entrenched—Microsoft and
Amazon
(AMZN)—are going to keep winning.”

As for the impact of AI spending on overall IT budgets, Krishna sees an issue for the broader software industry. Overall annual IT spending is about $4.6 trillion, with about $2.5 trillion of that for hardware, he noted. That leaves about $2 trillion. But some software companies predict that IT software budgets are eventually going to double from here to cover the added costs introduced by AI applications.

“It has to come from something else? What? Energy? Defense? Food? I don’t think so,” Krishna says.

While Krishna concedes that AI-boosted efficiencies could lead to reduced spending on sales and administrative expenses, the potential savings aren’t big enough to cover the anticipated budget growth. One outcome he foresees is that the number of IT vendors in the market consolidates—and IT market share for large vendors gets bigger.

Write to Eric J. Savitz at eric.savitz@barrons.com