Expectations were somewhat muted going into International Business Machines' (NYSE:IBM) fourth quarter. After three successive quarters of year-over-year revenue increases, growth eluded IBM in the third quarter, as the favorable currency exchange rates that had buoyed results turned against the company, taking flat year-over-year growth and turning it negative.

In its results released on Jan. 22, IBM revealed that it suffered the same ill effects in the fourth quarter, as revenue again declined year over year. Still, an unexpected earnings beat and higher-than-expected guidance gave investors cause for optimism.

A woman standing in front of an IBM Z Server.

Image source: IBM.

Mixed results

For the fourth quarter, IBM generated revenue of $21.8 billion, down 3% year over year and in line with analysts' consensus estimates. Adjusted net income, which excludes $1.9 billion in tax charges, came in at $4.4 billion, resulting in adjusted earnings per share of $4.87, ahead of expectations of $4.84. 

Similar to last quarter, foreign currency exchange rates took a toll, as revenue would have been down just 1% after adjusting for exchange rate differences.

Major Business Segments

Q4 2018

Q4 2017

YOY Change

Cognitive solutions

$5.45 billion

$5.43 billion

0.4%

Global business services

$4.32 billion

$4.15 billion

4.1%

Technology services & cloud platforms

$8.93 billion

$9.20 billion

(2.9%)

Systems

$2.62 billion

$3.33 billion

(21.3%)

Data source: IBM Fourth-Quarter 2018 Financial Release. YOY=Year over year.

Each of the major business segments was affected to some degree by the changes in currency. 

Revenue from cognitive solutions was essentially flat year over year (up 2% in constant currency), led by growth in solutions software, including analytics and artificial intelligence offerings.

Global business services jumped 4% year over year (or 6% adjusting for currency) from strength in consulting, application management, and global process services.

Technology services and cloud platforms fell 3% year over year (or flat in constant currency), the result of growth in hybrid cloud revenue.

Systems revenue fell 21% (down 20% adjusted for currency changes), primarily the result of the winding down of the refresh cycle for the IBM Z server.

The much-ballyhooed strategic imperatives

IBM has been focusing much of its resources on a transition from its legacy businesses to its so-called strategic imperatives -- high-growth next-generation businesses that include analytics, cloud computing, security, and mobile.

That initiative is producing some degree of success. Revenue from this group of businesses increased to $11.5 billion during the fourth quarter, accounting for 53% of the company's revenue. For the full year, strategic imperatives amounted to $39.8 billion, 50% of IBM's total sales. The company said that the group was negatively impacted by the IBM Z server refresh cycle winding down, but IBM saw double-digit growth across analytics, cloud, and security excluding the IBM Z.

Red Hat

During the company's earnings conference call to discuss the results, IBM's management provided more details for its high-profile acquisition of Red Hat (NYSE:RHT). This amounts to a $34 billion bet on the hybrid cloud-computing market. In the joint press release announcing the deal, the companies pointed out that "research shows that 80 percent of business workloads have yet to move to the cloud, held back by the proprietary nature of today's cloud market."

IBM CFO Jim Kavanaugh said businesses "are concerned about the secure portability of data and workloads across cloud environments, about consistency in management, [about] security protocols across clouds, and in avoiding vendor lock-in." He also cited IBM's "decade-long partnership" with Red Hat as providing momentum for the future, saying that the deal "positions us as the leader in hybrid, multi-cloud world."

The acquisition is expected to close in the second half of 2019.

A look ahead

For 2019, IBM is guiding for diluted earnings per share (EPS) of at least $12.45 and adjusted EPS of at least $13.90. The difference of $1.45 is comprised of acquisition-related costs associated with Red Hat, retirement-related costs, and charges related to the enactment of tax reform. The company also projects free cash flow of $12 billion. This guidance excludes any impact from the Red Hat acquisition, as much will depend on when the deal closes.

IBM's projections slightly exceeded analysts' consensus estimates, which called for adjusted EPS of $13.79 on revenue of $78.82 billion. The higher-than-expected guidance was welcome news for investors, who bid up the stock by 8% in the wake of its earnings report.

IBM was able to close the year with more than 50% of its revenue from strategic imperatives, amounting to $39.8 billion. To put this into context, IBM had set a goal to reach $40 billion, or about 40% of sales by 2018. The company still has a long way to go sustain brisk growth, but IBM is making progress on the long and winding road.

Check out the latest IBM earnings call transcript.