Given this economic environment, marked by elevated inflation, historically high interest rates, and significant uncertainty, it shouldn't be surprising that many enterprises are pulling back on their tech spending. Projects that would have been green-lit even a year ago are being delayed or shelved as organizations look to cut spending and preserve cash.
Tech projects that align with those new priorities, however, are still in demand. International Business Machines (IBM -0.14%) has been seeing weak demand for discretionary projects all year, but it's enjoying a tailwind from the kind of digital transformation and application modernization projects that aim to boost efficiency and productivity.
Beating expectations
This solid demand helped IBM deliver third-quarter results that were above analysts' expectations. IBM reported revenue of $14.8 billion, up 4.6% and $70 million ahead of the consensus estimate. Adjusted earnings per share came in at $2.20, up 22% year over year and $0.07 ahead of analysts' average expectations.
Three-quarters of IBM's revenue comes from software and consulting, and both of those segments produced robust growth during the third quarter. Software revenue was up 6% year over year (adjusted for foreign currency shifts) to $6.3 billion. Transaction processing revenue grew by 5%, while revenue from its hybrid platform and solutions segment (which includes Red Hat, AI, data analytics, and security) rose by 7%. Annual recurring revenue for the software business jumped by 7% to $14 billion.
The consulting segment posted 5% revenue growth adjusted for currency exchange changes. Technology consulting was a weak spot with just 1% growth, but business transformation revenue rose 5% and application operations revenue jumped 7%. Strategic partnerships drove a big chunk of this growth, generating 40% of consulting revenue. This portion of consulting revenue is expanding by a double-digit percentage.
The infrastructure segment's revenue declined by 3%, but the mainframe business performed well with 9% growth. IBM's mainframe systems are still widely used in certain industries, including financial services. The z16 mainframe was launched in April 2022, triggering an upgrade cycle that appears to still have legs.
Pretax profit margins expanded in each of IBM's three core segments. Software generated a 23.7% pretax margin, up 1.2 percentage points year over year; consulting had a 10.2% pretax margin, up 0.4 percentage points year over year; and infrastructure enjoyed an 11.8% pretax margin, up 3.5 percentage points year over year.
Sticking with its guidance
IBM maintained its full-year guidance for both revenue and free cash flow. The company expects revenue to grow by 3% to 5% after adjusting for currency, and it anticipates free cash flow of approximately $10.5 billion. If it hits its free cash flow target, this metric will increase by about $1 billion from 2022.
The tailwinds more than compensate for the headwinds, according to IBM CEO Arvind Krishna. IBM expects technology spending to grow faster than GDP even with organizations pulling back in certain areas. IBM's hybrid cloud and artificial intelligence (AI) products and services should continue to thrive as customers look to leverage those technologies to become more efficient.
IBM stock trades for roughly 12 times free cash flow guidance, a valuation that doesn't give the company much credit for its software and consulting-fueled turnaround. While IBM's growth isn't going to be earth-shattering, the company is capable of consistently pushing revenue and earnings higher thanks to strong demand for hybrid cloud solutions and AI.
