IBM Rebuilds Investor Trust as Software Growth Returns

Three months after its worst trading day in decades, IBM beat third-quarter forecasts and raised its cash outlook, but an unchanged revenue range kept investors short of declaring recovery.

Key Takeaways

• Software grew 9% at constant currency, four points faster than in the second quarter, and about three-quarters of the acceleration came from new business rather than recovered deals.
• Operating EPS of $2.95 beat the $2.86 consensus, helped by a lower tax rate. Operating pre-tax margin widened 70 basis points as SG&A fell and research spending rose 14%.
• Shares rose nearly 4% before the release, then fell as much as 5% after hours as IBM held its 4% to 5% revenue range while lifting its free cash flow outlook above $1 billion of growth.

The Shadow of July

IBM entered its third-quarter report carrying the weight of a single day in July. On July 14, eight days ahead of its scheduled call, Arvind Krishna published a letter to investors disclosing second-quarter revenue of $17.2 billion, up just 1%. Software growth had slowed to 5% and infrastructure revenue had fallen 7%. His explanation was specific. In the final weeks of June, clients diverted capital budgets toward servers, storage and memory to secure scarce hardware before prices rose, and mainframe software purchases were deferred. The market did not wait for the details. The shares fell more than 25% that day, their steepest decline since at least 1968, and a company long valued for predictability found itself priced as a source of surprise.

That history defined what the October 21 numbers needed to prove, and they proved most of it. Revenue rose 5% to $17.1 billion, or 6% at constant currency, ahead of the $16.82 billion LSEG consensus and above the base case management had set in July. Operating earnings per share rose 11% to $2.95 against expectations of $2.86, and GAAP diluted earnings from continuing operations climbed 26% to $2.31. “Disciplined execution throughout the quarter drove accelerated revenue growth and strong free cash flow,” Krishna said. The harder question, and the one investors spent the evening on, was whether the quarter marked a return to trend or simply the arrival of business that should have closed in June.

Software Does the Heavy Lifting

The answer begins in software, which produced $7.8 billion in revenue, up 8% as reported and 9% at constant currency. That was four points faster than in the second quarter, and three of the segment’s four businesses grew at double-digit rates in local currency. Red Hat expanded 11%, with bookings back to high-teens growth. OpenShift, its application platform, now carries $2.4 billion in annual recurring revenue and is growing at more than 30%. Data rose 19% on the strength of Confluent, the data-streaming company IBM acquired in March at an enterprise value of about $11 billion. Transaction Processing, the mainframe software franchise whose weakness in June prompted the July warning, recovered 9%. Only Automation declined, falling 3% against a demanding comparison.

Chief Financial Officer Jim Kavanaugh offered the breakdown investors wanted. Roughly two-thirds of the large deals that slipped out of the second quarter closed in the third, and they account for about a quarter of the software acceleration. The remaining three-quarters came from new business. That ratio carries the argument that July was a matter of timing. Krishna was careful not to stretch it. “I do not expect double-digit performance in TP to keep going,” he told analysts, signaling a more normal pace for mainframe software into next year. Management now expects full-year software growth of roughly 7% to 8%, anchoring its plans at the lower end. It sits on a recurring revenue base that rose 8% to $24.9 billion. A book of that size, renewing reliably, gives IBM a floor its hardware and services businesses cannot provide.

Two Cycles Inside the Hardware Business

Infrastructure revenue rose 4% to $3.7 billion, or 5% at constant currency, a figure that conceals two cycles moving in opposite directions. IBM Z sales fell 20% as the z17 mainframe lapped a launch that management describes as the strongest start in the platform’s history. Distributed Infrastructure, which includes storage and Power systems, grew 31%. Storage posted record revenue growth, and IBM exited the quarter with a sizable backlog in the category. The forces that hurt the company in June are now working in its favor. Enterprises are buying the physical capacity that AI workloads demand, and IBM sells enough of it to benefit when they do.

Consulting remains the slowest part of the portfolio. Revenue of $5.3 billion was flat as reported and up 2% at constant currency. Strategy and Technology grew 4% in local currency on application modernization and data work, while Intelligent Operations was flat. Segment gross margin narrowed to 27.4% from 29.3%, and segment profit margin eased to 12.2% from 12.9%. Kavanaugh tied the decline to reinvestment in reusable digital assets as the unit shifts toward services that behave more like software. AI already accounts for about 30% of consulting revenue and 35% of backlog. Krishna’s description of client behavior was measured: large enterprises, he said, have become far more conscious of the tangible return on their AI spending. That restraint may slow some engagements. It also favors a firm whose pitch rests on integrating AI into existing systems rather than funding open-ended experiments.

Where the Quality of Earnings Lies

Profitability improved, though the sources of that improvement deserve attention. Operating pre-tax margin widened 70 basis points to 19.3%. Selling, general and administrative expense fell to $4.62 billion from $4.75 billion even as research and development rose 14% to $2.38 billion. That combination reflects the roughly $5.5 billion in productivity savings IBM says it has extracted through automation and a leaner administrative structure. Software segment margin reached 35.0%, up from 32.9%. Gross margin moved the other way, slipping 50 basis points to 56.8% on a GAAP basis and 20 basis points to 58.5% on an operating basis. Faster-growing hardware and a consulting arm in reinvestment mode are diluting the mix.

Tax shaped the per-share figures as well. The operating tax rate fell to 14.7% from 17.0%, which is why operating earnings per share grew 11% while operating pre-tax income grew 9%. The 26% GAAP increase also benefits from a one-time tax charge in the prior-year quarter. The cash flow statement is less open to interpretation. Free cash flow reached $3.0 billion in the quarter, up $0.7 billion, and $7.8 billion over nine months, a margin management calls the highest in its reported history. IBM now expects full-year free cash flow to rise by more than $1 billion. The balance sheet records the cost of an acquisitive year. Cash and marketable securities of $11.1 billion are down $3.4 billion since December after $11.4 billion in acquisitions, and total debt stands at $63.8 billion, including $12.7 billion within IBM Financing. The board declared a quarterly dividend of $1.69 per share, extending a record of quarterly payments every year since 1916.

A Cautious Market and the January Test

The share price told its own story. IBM rose nearly 4% during Wednesday’s session to close at $251.49, above the average analyst price target of about $243, as investors positioned for a recovery quarter. The reversal came after the release, with the stock trading between roughly 3.7% and 5.1% lower in extended hours. The quarter was not the problem. The outlook was. IBM held its full-year range of 4% to 5% constant-currency revenue growth, which Evercore ISI calculates implies fourth-quarter revenue of about $20.4 billion, a shade below the $20.5 billion consensus. Evercore kept its Outperform rating and $250 price target. Even after Wednesday’s advance, the stock was down 15% for the year against a 13% gain in the S&P 500, and it remains well below its 52-week high of $332.46.

The longer case rests on assets the fourth quarter will not reveal. In July, IBM agreed to acquire HRL Laboratories, the Malibu research institute jointly owned by Boeing and General Motors, adding silicon-spin qubit expertise to its superconducting quantum program. DARPA, the Defense Department’s research agency, has since advanced IBM to the third stage of its Quantum Benchmarking Initiative, and the company will detail its roadmap at a Quantum Day on December 10. The more consequential date is in January, when management presents its 2027 framework. IBM has shown that much of July’s shortfall was deferred rather than lost. It must now show that software can move toward double-digit growth without deals carried over from a bad quarter, and that a company which unsettled its shareholders once this year can again be the stock they bought for its steadiness.