2020 will be a growth year for International Business Machines (NYSE:IBM). Thanks to the acquisition of software company Red Hat and a new mainframe system, IBM sees revenue, adjusted earnings per share, and free cash flow rising this year.

IBM's full-year guidance came alongside a fourth-quarter report that beat expectations across the board. The tech giant posted an unexpected revenue increase, albeit a small one, and its bottom line exceeded analysts' projections as well.

While IBM's transformation is still a work in progress, there was a lot to like about its latest results.

The IBM z15 mainframe.

IBM's z15 mainframe. Image source: IBM.

Returning to growth

For the most part, IBM's revenue has been shrinking over the past six years. The decline hasn't been as bad as it appears, because a combination of negative currency effects and divestitures has played a big role. But even on an adjusted basis, the picture hasn't been pretty.

Analysts were expecting another decline in the fourth quarter, but IBM managed to pull a rabbit out of its hat.

Metric

Q4 2019

Change (YOY)

Compared to Average Analyst Estimate 

Revenue

$21.8 billion

0.1%

Beat by $160 million

Non-GAAP (adjusted) earnings per share

$4.71

(3.3%)

Beat by $0.02

Data source: IBM. YOY = year over year. GAAP = generally accepted accounting principles.

Revenue growth looked better after adjusting for a few items. Revenue was up 1% adjusted for currency, and up 3% adjusted for currency and divestitures.

IBM's revenue included a contribution from Red Hat, although only a portion of what the software company would have generated as a stand-alone company. Red Hat contribute $573 million in revenue in IBM's fourth quarter, but it would have generated $1.07 billion in revenue on a stand-alone basis.

Accounting rules related to deferred revenue prevent IBM from recognizing all of Red Hat's revenue. The negative impact will dissipate as time goes on, and IBM will be able to recognize a greater proportion of Red Hat's revenue with each passing quarter. This Red Hat revenue issue hurt earnings in Q4, because IBM still needs to recognize all of Red Hat's costs.

Cognitive software and systems strength

Software and hardware were bright spots for IBM in the fourth quarter, while services lagged behind.

Segment

Revenue

Change (YOY, Constant Currency)

Cloud and cognitive software

$7.2 billion

9%

Global business services

$4.2 billion

Flat

Global technology services

$6.9 billion

(4%)

Systems

$3.0 billion

16%

Data source: IBM. YOY = year over year.

The cloud and cognitive software segment includes Red Hat, so its growth was partially due to that additional revenue. In the systems segment, IBM's new z15 mainframe was the star of the show. Mainframe revenue soared 63% year over year, typical for the first full quarter a new mainframe is shipping. This growth more than offset a steep decline in sales of Power systems.

Total cloud revenue, which spans all of IBM's segments, grew 23% at constant currency during the fourth quarter. For the year, cloud generated $21 billion in revenue. Red Hat, which contributed to the cloud growth, grew its own normalized revenue by 24% in the fourth quarter.

Positioned for growth

IBM's guidance for 2020 was vague on the revenue front, with the company only saying that it expects its top line to rise this year. That's not too surprising, given the additional revenue from Red Hat and the new mainframe.

The company expects to produce non-GAAP EPS of at least $13.35 this year, up from $12.81 in 2019. The accounting issues with Red Hat revenue recognition will continue to have a negative impact on earnings this year. Free cash flow is expected to be around $12.5 billion, up from $11.9 billion in 2019.

Acquiring Red Hat strengthened IBM's position in the hybrid cloud market. It also created various cross-selling opportunities. IBM can accelerate Red Hat's growth by selling its software to large IBM customers with little or no exposure to Red Hat, and it can boost sales of its own software by making it available on Red Hat's platforms.

The real test will be whether IBM can keep growing in 2021 and beyond, once the initial revenue boost from Red Hat and the new mainframe have been lapped. If IBM's revenue declines are truly in the past, the beaten-down stock could be in for quite a recovery.