IBM Corp

Following IBM's early earnings announcement on July 14, which was defined by an underwhelming 1% growth in total revenue, other parts of IBM's second-quarter results largely met expectations. Software annual recurring revenue expanded 8% year over year, and consulting signings grew 6% to $5 billion.

Why it matters: Despite healthy recurring software revenue growth, 20% of IBM's software was still deal-based. With over 10 large deals failing to close in the quarter, transactional software revenue was down in the high single digits, the main reason for IBM's quarterly underperformance. We reiterate our view that the capital expenditure displacement for IBM's mainframe ecosystem should be temporary. One-third of slipped deals have closed since last quarter's end, and management expects two-thirds or more deals to close over the next six months. We like IBM's explicit goal of investing $10 billion in quantum over the next five years, which further reinforces its quantum leadership. The investment scale overshadows smaller quantum pure-plays, and we expect IBM to introduce fault-tolerant quantum systems ahead of competitors.

The bottom line: We lower our fair value estimate for narrow-moat IBM to $225 from $260. Shares currently look slightly undervalued. We see tighter enterprise IT spending that can weigh on IBM's long-term growth, and additional quantum spending may bring incremental margin pressure. We do not think IBM mainframes are losing relevance in the artificial intelligence era, as they still handle over 70% of the world's transaction volume in terms of value. The z17 program outperformed z16 by 30%, highlighting customers' reliance on IBM mainframes that support strong switching costs.

Coming up: Management trimmed its full-year revenue growth guidance to 4%-5%, from 5% and above. Following a 30-basis-point improvement in non-GAAP pretax margin this quarter, management expects to see improvements for the full-year non-GAAP pretax margin as well.

The downward revision of IBM's full-year growth guidance mainly comes from the software segment, which is now expected to post 6%-8% growth, instead of 10% previously. That said, management remains confident that IBM software can return to double-digit annual growth over the long term. To reach this goal, we expect IBM to make additional software acquisitions in the near future. Given IBM's Exemplary Morningstar Capital Allocation Rating, we are highly confident that the acquired companies will deliver strong synergies with IBM's existing offerings.

Strong performance of IBM's distributed infrastructure products led to a raised outlook of low-single-digit growth for the Infrastructure segment, compared with the previous guidance of low-single-digit revenue decline. However, mainframe's performance remains a risk overhang for the infrastructure segment if enterprise IT procurement does not improve materially. While management maintained its low-to-mid-single-digit revenue growth outlook for the consulting segment, we are glad to see that the segment's margin has been improving, indicating stronger pricing power for IBM's AI re-engineering services. We foresee continued resilient performance from IBM Consulting as the company invests in specialized workforces, such as forward-deployed engineers.

Our fair value estimate for IBM is $225 per share, which implies a 2026 adjusted price/earnings ratio of 18 times and an enterprise value/adjusted EBITDA ratio of 13 times. We expect IBM to maintain a companywide revenue growth rate above 5% over the next decade, mainly driven by the strength of its software business. The consulting and infrastructure segments should also contribute positively to IBM’s revenue growth.

We believe IBM’s hybrid cloud software should expand around 10% over the next five years as more enterprise customers adopt Red Hat in an effort to modernize their IT infrastructure. Red Hat should remain a centerpiece of IBM’s strategy, and IBM’s other software categories, including automation, data, and transaction processing, should benefit from a larger installed base of Red Hat. We expect many of IBM’s future acquisitions to happen in the software space, making inorganic growth an important part of IBM’s pivot into software. Overall, we think IBM’s organic software growth is likely to average around 7% over the next five years. And we forecast that IBM’s software revenue as a percentage of total revenue should cross 50% in 2033.

We estimate a low-single-digit annual growth rate for IBM’s consulting segment. Similar to other IT consulting firms, IBM Consulting’s performance is subject to the overall trend of enterprise IT spending, and we expect a rebound in demand over the next several years, driven by AI-oriented projects. IBM keeps a regular refreshment schedule for its Z mainframes, and we think new capabilities around AI should drive maintainable growth for the company’s infrastructure business. The infrastructure segment’s revenue growth will see some cyclicality based on mainframe refresh cycles. Additionally, mass-market adoption of potential quantum use cases can bring further upside to IBM Infrastructure in the long term.

On profitability, we expect to see gross margin expand from 58% in 2025 to 61% in 2035, driven by a continued business mix shift toward the higher-margin software segment. We don’t foresee any meaningful profitability improvement on the segment level over the next decade. As software becomes a bigger part of IBM’s business, we expect to see IBM moderately step up its usage of stock-based compensation, partially contributing to an adjusted EBITDA margin expansion from 28% in 2025 to 35% in 2035.

We assign IBM a narrow moat rating based on the company’s strong switching costs and IBM Consulting’s rich intangible assets. IBM today operates in three segments—software, consulting, and infrastructure. As one of the few vertically integrated technology companies, we believe IBM can cater to all aspects of an enterprise’s IT needs.

Following the acquisition of Red Hat in 2019, software has become IBM’s largest business segment. IBM currently owns software across four categories—hybrid cloud, automation, data, and transaction processing. IBM’s hybrid cloud software, led by Red Hat, coordinates an enterprise’s on-premises and cloud IT infrastructures. On top of the hybrid cloud platform, IBM’s automation, data, and transaction-processing software handles specific business needs, such as lifecycle management and business analytics. IBM Consulting leverages deep domain expertise to provide design, strategy, and implementation that aims to modernize IT experiences, primarily for customers that have an existing IBM footprint. IBM Infrastructure includes its Z mainframes and distributed cloud infrastructure that supports the company’s hybrid cloud and AI solutions by providing local high-performance computing power.

We see strong synergies across IBM’s offerings, with nearly 80% of clients purchasing from more than one segment. For example, clients can come to IBM Consulting for an IT modernization plan that moves IBM’s automation software from an IBM mainframe to a hybrid cloud environment facilitated by Red Hat. The high level of interconnectivity among different IBM systems makes it challenging for clients to switch, supporting a narrow moat derived from switching costs. In addition, IBM has an established reputation in IT consulting. We believe IBM boasts intangible assets in the form of brand, relationships, and expertise that the company has accumulated over its history.

In our view, IBM’s leadership in hybrid cloud software reinforces high switching costs for enterprise customers operating in regulated environments that prioritize resiliency and security. Hybrid cloud allows users in highly regulated industries to enjoy the convenience of cloud while helping them stay compliant with security requirements. With the addition of Red Hat, we believe IBM has built an industry-leading hybrid cloud software portfolio. Red Hat Enterprise Linux orchestrates various computing environments at the enterprise level, while Red Hat OpenShift facilitates application development and deployment at scale. Continued adoption of hybrid cloud that revitalizes the performance of legacy hardware should underpin stable growth for IBM’s software business and help retain customers within IBM’s ecosystem.

Besides its hybrid cloud software, IBM’s automation, data, and transaction processing software is also accretive to the company’s high switching costs. IBM owns a comprehensive portfolio of automation software for optimizing and managing enterprises’ technology investments, which serves as a strong complement to the company’s hybrid cloud and AI products. IBM’s data and transaction processing offerings are already mature offerings. However, we don’t see customers moving away from these products anytime soon. Most IBM transaction processing systems have been handling mission-critical workflows, including bank transactions and air ticket reservations, for decades. The deep integration of IBM systems within some of the world’s largest companies’ existing tech stack means that switching to another system can be prohibitively expensive and time-consuming, let alone the high execution risk, which can render the migration infeasible.

We see both switching costs and intangible assets in IBM’s consulting business. As the only global consultancy within a technology firm, IBM Consulting has deep domain expertise in IBM’s proprietary software and hardware. Clients that still operate legacy IBM technology, such as the Db2 database and the AIX operating system, can benefit from the continuity of IBM’s decades-long understanding of their tech infrastructure. Switching to another consulting firm may lead to a costly ramp-up process and become a potential source of service disruptions. For clients looking to modernize their tech stack with new systems, IBM Consulting also formed strategic partnerships with popular third-party enterprise software suppliers, including Oracle, SAP, and Salesforce. We think the variety of technology solutions IBM Consulting provides is sufficient to meet customers’ demand, reinforcing high switching costs as they embrace hybrid cloud and artificial intelligence.

We believe IBM Consulting’s deep relationships with the world’s largest companies and governments underpin the intangible assets it enjoys. The company’s domain expertise can help clients design and implement mission-critical IT solutions across different industries. We view IBM’s existing reputation and relationships as a crucial factor in helping the company win new mandates, and we are encouraged to see that IBM Consulting has maintained a book/bill ratio of above 1 over the past few years.

We think the robust ecosystem around IBM’s Z mainframe platform warrants high switching costs. Mainframes are almost exclusively used by the world’s largest companies to process millions of transactions within milliseconds. Customers often have the highest requirements for mainframes’ performance and reliability, as each machine can cost millions of dollars. IBM is the dominant mainframe supplier that has built a comprehensive ecosystem to facilitate customers’ high-performance computing demands. The z17 mainframe’s launch marks another step in IBM's modernization of its mainframe lineup by introducing AI-based security and automation capabilities, which should help its infrastructure business stay relevant in the cloud era. Furthermore, innovations in quantum computing should provide additional upside to IBM in the long term.

IBM’s leadership in hybrid cloud can cater to enterprise customers’ demand of keeping sensitive, mission-critical workflows on-premises, especially for regulated industries.

IBM is a forerunner in the quantum computing field, and potential quantum-based use cases in the future can unlock additional growth upside.

Customers value IBM’s capability of providing integrated IT solutions encompassing software, hardware, and consulting services.

IBM’s rich legacy can make it a slow adopter of the latest technology trends, such as general-purpose cloud computing and artificial intelligence.

IBM’s relatively high dividend payout and conservative capital allocation can constrain its capacity to compete with other tech giants.

It can be challenging for IBM to consistently source suitable acquisition targets that drive strong synergy with its existing business, as inorganic growth has become a key revenue driver for the company.