IBM Earnings: Automation a Worthy Cost for Customers Amid Conservative Spend; Shares Overvalued

IBM’s IBM third quarter beat our EPS expectations while coming in slightly under our revenue forecasts. While the infrastructure business saw revenue declines, interest in business automation software was healthy as the efficiency gains are seen as a worthy cost to enterprises even amid general budget tightening. We are maintaining our fair value estimate of $126 per share for the narrow-moat IT services provider, which leaves the company overvalued. While we think IBM will continue to have standout parts of its portfolio that will prove to be best-of-breed in their respective areas (like transaction processing software), we continue to believe the new age of IT interoperability will continue and will drive unraveling of the average customer’s spend with IBM. As a result, we think a five-year revenue compound annual growth rate of 2% and margin expansion of just over 2 points is within reason for Big Blue. But we find it difficult to wrap our heads around greater expectations for the firm.

IBM reported revenue of $14.8 billion in the quarter, marking a 4% year-over-year increase in constant currency. Software revenue led the pack, increasing 6% year over year in constant currency as demand for automation of digital systems remains strong. Automation revenue grew by 13% year over year, with AI serving as the backbone of many such solutions. On a less positive note, Red Hat saw deceleration in revenue, which management attributed to consumption-based revenue—like deployment or implementation of the software (which is likely going to other consulting firms). Infrastructure revenue decreased by 3% in constant currency, as IBM is over a year into the product cycle of its z16 mainframe and the firm is seeing declines in infrastructure support. Altogether, we think IBM consulting revenue, which grew 5% year over year in constant currency, is in a solid spot for mild growth long-term, indicated by its 12-month trailing book/bill of 1.15.