IBM Red Hat business growth slows, sparking investor concerns; shares fall 5% after hours | Earnings Report News

```

IBM's latest financial report shows free cash flow exceeded expectations, but slowing growth at Red Hat has sparked deep market concerns.

On October 22, IBM released its financial report. Despite both third-quarter revenue and earnings per share surpassing Wall Street expectations, and a major positive in raising its full-year free cash flow guidance,

The much-watched Red Hat division's revenue was disappointing, triggering concerns among investors who regard the software business as a key driver of the company's growth. Key points from the earnings report are as follows:

Solid Financial Performance: Third-quarter total revenue was $16.3 billion, up 9.1% year-on-year; adjusted earnings per share were $2.65, above analyst expectations of $2.41.Red Hat Business Stalling: The Hybrid Cloud division, which includes Red Hat, saw third-quarter revenue grow by 14%, lower than the previous quarter’s growth rate and below analysts’ 16% forecast, raising doubts in the market about IBM’s growth engine.AI Business Booming on Paper: Since mid-2023, AI business orders have totaled $9.5 billion, but 80% came from the lower-margin consulting division, with only 20% from the software segment.Optimistic Cash Flow Guidance: Full-year free cash flow is projected to be about $14 billion, higher than market expectations of $13.5 billion, and full-year revenue is expected to grow over 5% at constant currency.

In 2018, IBM completed its $34 billion acquisition of Red Hat, marking the largest acquisition in IBM’s history. As a result, Red Hat is seen as the core driving force for IBM to move away from its traditional business and head toward a future focused on high-margin software and cloud services.

Although CFO Jim Kavanaugh said he "feels very good about the overall growth opportunity for Red Hat," the capital markets clearly trust the trends reflected in the data more. On Wednesday after the US market closed, IBM fell more than 5%.

(IBM fell 5.37% after hours on Wednesday)

Red Hat Becomes a Hot Potato

Red Hat, regarded as a key driver of the company's growth, has underperformed expectations.

Red Hat is the core pillar of CEO Arvind Krishna’s strategy to make software IBM’s largest business segment, especially given that the consulting segment has been hit in recent years by clients’ concerns about the overall economy.

In the third quarter, the Hybrid Cloud division (which includes Red Hat) reported revenue growth of 14%—a number that looks decent, but is a clear slowdown from the previous quarter and, more importantly, below the analysts’ average forecast of 16%.

For IBM stock, which has already risen 31% this year, this was undoubtedly a cold shower.

The market’s previous enthusiasm for its software business was largely based on expected growth from acquired assets like Red Hat and HashiCorp.

AI Narrative and Cyclical Growth

IBM has been high-profile in announcing that, since mid-2023, its AI business orders have exceeded $9.5 billion, up from $7.5 billion as disclosed in its July financial report.

But a closer look at the composition reveals that around 80% of orders are from the consulting division, with the software division accounting for only the remaining 20%.

Consulting typically has lower profit margins than software, and its projects have longer cycles and higher execution risks. Although CFO Jim Kavanaugh emphasized:

More and more orders are turning into revenue as clients move AI projects into production, saying that this is driving a turning point in consulting business growth.

But looking at the data, third-quarter consulting revenue grew only 3.3% to $5.32 billion, just meeting expectations and hardly robust.

By contrast, the software division’s revenue grew 10% to $7.21 billion, meeting expectations but offering no surprises.

The infrastructure segment’s third-quarter revenue surged 17% to $3.56 billion, mainly benefiting from the second consecutive quarter of new z17 mainframe server sales. However, analysts believe mainframe sales are highly cyclical, and the sustainability of this growth is questionable.

Risk Warning and DisclaimerThe market carries risks, and investments should be made cautiously. This article does not constitute personal investment advice, nor does it take into account the special investment objectives, financial situations, or needs of individual users. Users should consider whether any opinions, viewpoints, or conclusions in this article are suitable for their particular circumstances. Investments based on this article are at your own risk. ```