IBM Q3 2023 Earnings Preview: 5 Things To Know

IBM executives should touch on Watsonx, GenAI, cloud, Red Hat and Apptio on Wednesday’s quarterly earnings.

Watsonx. Generative artificial intelligence. Cloud, Red Hat and Apptio.

These are some of the subjects likely to come up during IBM’s quarterly earnings call Wednesday, when the Armonk, N.Y.-based tech giant reveals results for the third quarter of its 2023 fiscal year, ended Sept. 30.

Two investment firms that watch IBM appeared mixed on how they expect IBM to do, with interest in IBM generative AI (GenAI) offerings but concerns over when IBM sees revenue from customers.

IBM Third-Quarter Results

In an October report, investment firm Morgan Stanley predicted third-quarter revenue of about $14.8 billion from IBM.

The firm dropped its calendar year 2023 revenue for IBM to $61.8 billion, a 1 percent decrease from the prior forecast.

In an October report, investment firm Bernstein predicted third-quarter revenue of $14.7 billion.

The firm said it sees “some risk of a modest revenue miss this quarter (FY Q3), as well as in Q4.” Wall Street consensus estimates for the fourth quarter are “are below historical seasonality,” however. Plus, “IBM should enjoy a full quarter of revenues from Apptio,” according to the firm.

“We believe IBM is likely to outperform in weaker markets but underperform in a continued recovery,” according to Bernstein.

Bernstein predicts 3 percent to 5 percent of revenue growth for the 2023 fiscal year ignoring foreign exchange rates, likely at the lower end. IBM should maintain its $10.5 billion free cash flow target, according to the firm.

Here are more predictions around IBM’s upcoming quarterly earnings.

Watsonx And AI Products

Analysts on Wednesday’s call will likely want more information around IBM’s AI offerings and investments.

A Bank of America report in October called IBM’s AI portfolio “underappreciated,” describing IBM’s Watsonx offering as making AI deployment “significantly more scalable and affordable” with pretrained enterprise foundation models.

IBM’s AI offerings aim to address the expense, energy intensity and deployment complexity of AI models, according to the Bank of America report.

“IBM’s investment into AI is already seeing a return on investment with 3 highly successful proven use cases deployed internally,” according to the Bank of America report.

Watsonx’s ability to handle repetitive tasks can improve human resources productivity by 40 percent, according to the report. More than 70 percent “of all contact center cases are contained by the AI.”

And 85 percent of Watsonx Code Assistant’s “recommended code gets accepted by the developer,” according to the report.

“Right now IBM sees code generation as the biggest value add right now on the IT side but is still adding functionality in IT automation and AIOps,” according to the report. Bank of America expects Watsonx functionality in product development, threat management and other core business operations.

Analysts may seek updates on the timing of other promised IBM AI offerings, including software development kits (SDKs) for integrating Watsonx into other ecosystems, vector database capabilities and upcoming AI-assisted code products.

Those AI-assisted code products include Watsonx Code Assistant for Z to enhance developer productivity and accelerate COBOL application modernization.

In an October report from investment firm Morgan Stanley, the firm predicted “little Gen AI contribution in the near-term.” But the firm still looks forward to “any AI commentary, particularly for” IBM’s consulting wing.

In a separate October report, the firm said that “IBM’s seat at the AI table remains a show-me story,” with opportunities in the Watsonx offering and in AI consulting.

Morgan Stanley came to that conclusion based on mixed results for IBM in its recent CIO survey. On one hand, “of CIOs using or evaluating LLMs or generative design tools, 16% are using application vendors (up 2 points Q/Q) and 12% are using consulting vendors (up 4 points Q/Q), which reads positively for a vendor like IBM.”

On the other hand, “of those planning to use or evaluate LLMs or generative design tools, 18% expect to use application vendors (down 14 points Q/Q) and 5% expect to use consulting vendors,” according to a Morgan Stanley survey.

Bernstein also called IBM AI “a show-me story,” with “muted stock reaction to date” that “suggests the market assigns limited value to IBM’s ability to participate in AI.”

IBM Consulting

According to the Bank of America report, AI will benefit the IBM consulting business first with software revenue benefits over the next two years.

Assuming a revenue trajectory similar to that of hybrid cloud and Red Hat OpenShift in IBM Consulting, AI could add $1 billion or $2 billion of consulting revenue for Fiscal Years 2024 and 2025, according to the firm.

This also means growth of 4 percent in Fiscal Year 2024 and 7 percent year over year for Fiscal Year 2025 for IBM overall, more than Bank of America’s current 3 percent and 2 percent year-over-year estimates.

For software, Bank of America predicts a similar trajectory to that of Red Hat revenue growth, which doubled each year for the first four years, according to the report. AI revenue in IBM’s software business could reach $100 million annual recurring revenue exiting 2024.

IBM sees a “risk of a 4Q Consulting slowdown being more elevated,” according to the Morgan Stanley report.

For the quarter, Bernstein notes that IBM consulting was historically “a laggard,” but it “has outperformed peers year to date, driven by strong growth in its ISV and hyperscale practices.”

“We would encourage investors to track consulting book/bill and any changes to backlog,” according to the report. IBM “delivered a book-to-bill ratio of 1.1x and 24% signings growth last quarter.”

Bernstein predicts that IBM’s consulting business to grow 11.2 percent in the third quarter, up from 9.8 percent the same period a year ago.

“We believe that the ISV and hyperscalers practices are likely close to 40% of IBM’s consulting business (and potentially growing 20%+), suggesting that the rest of IBM’s consulting business is likely not growing appreciably, if at all,” according to Bernstein.

IBM consulting could be an early indicator for IBM AI growth, according to Bernstein. “While we lack conviction that IBM will ultimately be an AI winner and view AI at IBM as a show-me story, we believe that consultants could be initial beneficiaries of AI as most enterprises are still in the experimentation phase.”

“We would note the comparison to IBM’s Openshift practice, which was virtually non-existent before the Red Hat acquisition and achieved $1B in the first year, and is now ~$2B annually,” according to Bernstein.

Red Hat, Apptio

On the IBM earnings call, analysts may seek observations on how the AI demand has affected IBM’s Red Hat business.

A Bank of America report in October pointed out that “IBM’s hybrid, cloud-native inference stack, built on RedHat OpenShift, has been optimized for training and serving foundation models.”

“Enterprises can leverage OpenShift’s flexibility to run models from anywhere, including on-premises,” according to the report.

The October Morgan Stanley report predicts that Red Hat growth to decelerate to 10 percent year over year, with anything less “a negative surprise.”

Bernstein also predicted about 10 percent in growth rate for Red Hat, “well below … the initial target of 15%.”

“We believe the low end of the range is more likely, especially since the tailwind from deferred revenue writedowns and intercompany adjustments continues to wind down and Red Hat Enterprise Linux (RHEL)—which accounts for the majority of revenues—is likely growing at low to mid single digits,” according to Bernstein. “We also worry that Openshift—while clearly still growing—may be decelerating as well.”

Assessing the value of Red Hat has “been messy due to a combination of deferred revenue write-downs and intercompany adjustments,” according to Bernstein.

“As a result, Red Hat’s underlying revenue growth has decelerated by more than investors may have realized, from 19% in FY 19 to 13% in FY 22 and ~7% in Q1 23 and 8% in Q2 23 … compared to reported growth rate of 11% in Q1 and Q2 and 17.6% in FY 2022,” according to the report. “IBM initially guided for Red Hat to grow 15% this year, but lowered its full year outlook after Q1 to 11-13%.”

Still, the firm liked the longer-term potential for Red Hat and AI, noting that “Red Hat’s solutions are potentially synergistic with the broader AI offerings, and allow for integration with third party public clouds.”

As for Apptio, whose $4.6 billion acquisition IBM closed in August, Bernstein reported that Wall Street expects “ another $50-80M in incremental revenues” from the new subsidiary in the fourth quarter.

Wall Street predicts $17.5 billion in fourth-quarter revenue, according to Bernstein, which would put full-year growth at 2.9 percent ignoring foreign exchange. The firm predicts that IBM brings in $18 billion in the fourth quarter.

Hardware And Mainframe

IBM executives may appear more focused on software and AI offerings lately, but a recent Morgan Stanley report noted an opportunity in hardware.

A survey of CIOs by the firm showed that “we’re now at the point of spending stabilization, as after 5 consecutive cuts dating back to 2Q22, CIOs now expect 2023 Hardware budget growth to remain stable at +1.3% Y/Y, and accelerate 20bps Y/Y, to +1.5% Y/ Y in 2024,” according to the Morgan Stanley report.

The survey showed that hardware “domain expert net spending intentions with IBM improved by 20 points Q/Q, but remain negative at - 24%.”

Customer spending on IBM mainframes was “more resilient than expected over the last 5 years,” according to the report. About “35% of Hardware experts indicate that IBM mainframe & related software spend was stable or increased over the last 5 years due to rising prices, while only 45% said mainframe spend decreased because of lower mainframe capacity.”

But mainframe revenue is “expected to decline over the next 5 years,” according to Morgan Stanley. The report describes IBM mainframe and mainframe software “as melting ice cubes as customers shift to the cloud.”

Financial services customer spending has proven more resilient, according to the report. All financial services respondents to the survey called IBM mainframe spending “stable or increased over the last 5 years and the majority expect this to be the case over the next 5 years.”

Other sectors—including consumer goods, education and transportation—expect that spending to decline.

Bernstein predicts that IBM’s infrastructure business grows 7 percent in the third quarter, down from 8.4 percent the same period a year ago.

Cloud And Software

An October report from Morgan Stanley noted that a recent survey by the firm of CIOs resulted in 10 percent of CIOs calling IBM “the biggest budget share loser due to growth of cloud workloads over the next year.”

That result marked a decrease of 3 points quarter over quarter “and is now worse than mature tech peers for the first time in 5 quarters,” according to Morgan Stanley.

“Similarly, on a 3 year basis, a net 9% of CIOs expect IBM to see the largest budget share loss due to the shift to cloud, a 2 point deterioration Q/Q,” according to the report. “While there can be fluctuation in this question survey-to-survey, we believe it’s something to watch.”

The survey found mixed data points, “making it hard to get a definitive read on spending intentions.”

“Hardware expert net spending intentions on IBM products were stable or increased across the board—rising by 26 points for IT Services, 20 points for IBM Cloud, 16 points for Cloud Paks, 7 points for Security Software, and were flat for Red Hat—but remain negative,” according to the survey.

Bernstein predicts that IBM’s software business grows 25.4 percent in the third quarter, up from 22.5 percent the same period a year ago.

As for IBM’s transaction processing business—mostly made of IBM mainframe software offerings and accounting for 12 percent of total revenues and about 29 percent of total profits in 2022—“IBM has historically guided for TPP to decline mid-to-high single digits,” according to Bernstein.

However, the transaction processing business grew 7 percent in constant currency in the first and second quarters “amid price increases and good transactional performance,” according to the firm. “With ~40% operating margins, it is one of the highest margins offerings in IBM’s business.”

Transaction processing’s strength even helped IBM improve guidance for its software business, according to Bernstein.