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Six key takeaways from IBM's earnings, from mainframes to Russia, hedging to Red Hat

"We only hedge, give or take, about 35 currencies around the world out of the 100+ that we're in..."

IBM reported its Q2 2022 earnings late Monday – reporting revenue of $15.5 billion, up a healthy 9%, with executives saying Big Blue is now “a more focused, faster-growing, and higher-value company”.

But with a strong dollar and a Russian withdrawal hurting, it wasn't all good news.

Here’s The Stack's six key takeaways from IBM’s Q2 earnings call.

IBM's Q2 2022 earnings: 6 key takeaways

1) Mainframes keep giving…

IBM’s mainframe business is a highly cyclical one and got a strong boost from its recent launch of the new Z16 mainframe line. The company’s  Z Systems revenue spiked 77% year-on-year. CFO Jim Kavanaugh thanked “solid execution around our z16 program [which…] brings the power of embedded AI at scale, cyber-resilient security, and cloud-native development for hybrid cloud to our clients”, adding “we are seeing growth in new workloads like Linux and demand for AI capabilities like real-time fraud detection, leveraging the on-chip AI accelerator.”

IBM’s broader infrastructure segment revenues were $4.2 billion, up 19% or 25.4% at constant currency.

2) Not concerned about a market slowdown…

Several technology companies have slashed their outlooks in recent months amid recession fears. One of the most dramatic recent moves came from memory firm Micron, which said it would sharply trim supply outlook and now expected 130 million fewer smartphones and 50 million fewer PCs to ship this year.

IBM’s leaders appear to hold no such fears and see spending on digital transformation continuing to be robust. The company continues to expect constant currency revenue growth at the high end of its mid-single digit range. Even for consultancy “we continue to see a strong demand profile” said Kavanaugh “and we're capturing it by raising our guidance here and seeing the accelerated consulting performance in the quarter, up 18%”.

He added: “I think that's driven by…  technology being a sustainable competitive advantage in this environment as clients in every industry are moving and accelerating their digital transformation and journey in the cloud.”

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Pressed further on this point, with analysts saying other software firms are seeing longer sales cycles (deals taking longer to close as enterprises tighten their belts) IBM CEO Arvind Krishna added: “I'm a bit more optimistic than many of my peers, both within the industry and across the board, because we see that technology [like AI] is deflationary. So, in an inflationary environment when clients take our technology, deploy it, leverage our consulting. It acts as a counterbalance to all of the inflation and all of the labor demographics that people are facing all over the globe. So, that is the reason [for optimism] on software.

“On consulting correlated to the economic cycle… lot of our consulting is around deploying back-office applications, critical applications, supply chain resilience… worrying about optimization of costs within our clients. Those tend to get more attention actually in a slight down cycle”, Krishna added on the call.

3) Russian pull back, trimmed cash flow forecast sting…

Despite income from continuing operations increasing to $1.47 billion from $810 million vs Q2 2021, IBM projected a revised $10 billion in free cash flow for all of 2022, down from the range of $10 billion to $10.5 billion that it provided in April. Kavanaugh blamed headwinds from an increasingly strong dollar and the suspension of business in Russia, telling analysts that Russia “was a very highly-profitable business for us and that’s going to cost a couple hundred million dollars worth of free cash flow and profit by the way in 2022.”

Despite the strong revenue growth (unthinkable not so long ago after nearly three years of falling or stagnant earnings) IBM shares slid 4% in after-hours trading on Monday on that revised cash flow forecast…

4) Red Hat remains robust

Red Hat OpenShift revenues are now four and a half times what they were, pre-acquisition, Kavanaugh told analysts in a Q&A on the IBM Q2 earnings call: “We had very strong bookings overall in Red Hat here in the quarter. Large deals were up 50%. Red Hat OpenShift bookings were up over 50%...”

Red Hat revenue all in grew 17% at constant currency.

5) Hybrid cloud growth is strong, but good luck drilling down…

IBM said that its “hybrid cloud revenue from our full stack capabilities across software, consulting, and infrastructure was up 19% over the last year. It has grown to $21.7 billion or 36% of our total revenue.”

That’s impressive growth, but given how broadly IBM categorises hybrid cloud and its somewhat confusing recent segment reporting realignment, could mean almost anything: Big Blue doesn’t actually clearly break out “hybrid cloud” performance (it has four key reportable segments – Consulting, Software, Infrastructure, and Financing – and per the quote immediately above, this 19% figure was pulled from across these segments.)

6) A strong dollar is hurting…

The dollar is the strongest that it has been against a basket of major currencies in 20 years. The US Dollar Index is now 50% higher than a decade ago — and has risen more than 20% since the beginning of 2021.

That  strong dollar stung IBM for over six points of growth or $900 million. As CFO Jim Kavanaugh noted, “that's over $200 million more than the spot rates would have suggested 90 days ago… we execute hedge programs that cover the majority but not all of the currency exposure. The combination of the rate and velocity of movement this quarter and the fact that we don't hedge 100% results impact our profit and cash flow.”

He added: “We only hedge, give or take, about 35 currencies around the world out of the 100-plus that we're in. And also important, if not more important, we only hedge 12 months out. We don't do multiyear hedging in this business. We're not speculative. So, when you look at the lasting relevance of a U.S. dollar appreciation, eventually, what hedging does is it mitigates volatility in the near term. It does not eliminate currency. It allows you time to address your business model for price, for source, for labor pools, and for cost structures…”

With the strong dollar having cost IBM 6 points of growth, shareholders would be forgiven for wondering whether its hedging strategy should be more robust. Kavanaugh defended IBM's approach, however, saying: "Currency impacts a human capital-based business, very different than a product-based business... In a human capital-based business, if you think about it, a large portion of your cost structure is a natural hedge because it's in local currency. [That's] very different in a product-based business where a large portion of your cost structure is US dollar-denominated. So, as the dollar at rate and pace and magnitude appreciates, it has a disproportional impact on our high-value, product-based businesses, read that [as] software, and infrastructure. And you saw that play on the second quarter at the gross margin level. Remember, our hedges end up in expense. Gross margin: you see the revenue and the margin implications? So, we understand how to manage currency; we have a robust hedging program in place. We've taken the appropriate cost structure and the appropriate pricing as we deal with that going forward..."

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