Another Revenue Decline Expected for IBM

International Business Machines (NYSE: IBM) will report its fourth-quarter results after the market closes on Tuesday, Jan. 21. The report will close out a challenging year, with revenue down in 2019 as the company continues to transform itself. The acquisition of Red Hat is part of that transformation, but it won't help IBM's numbers much in the fourth quarter.

What happened last time

IBM's third-quarter report was a mixed bag: Earnings beat analyst expectations, but revenue slumped by more than expected.

Data source: IBM.

Adjusted for currency and divestitures, revenue was down just 0.6% in the third quarter.

IBM completed the acquisition of Red Hat last July, so its third quarter numbers did include Red Hat's results. However, IBM was able to recognize only a portion of Red Hat's standalone revenue because of accounting rules related to deferred revenue. While Red Hat would have generated nearly $1 billion of revenue as an independent company, IBM was able to recognize just $371 million of revenue.

While Red Hat's revenue contribution was only partial, IBM did have to recognize all of Red Hat's expenses. That's one reason for the steep decline in earnings.

Like its overall results, IBM's segment results were a mixed bag:

Data source: IBM.

What analysts are expecting

IBM is expected to report small declines in revenue and adjusted earnings per share in the fourth quarter:

Data source: Yahoo! Finance.

Once again, IBM will be required to include all of Red Hat's expenses but only a portion of its revenue. Revenue will get a boost from the z15 mainframe, which began shipping at the very end of the third quarter. The tech giant typically enjoys four to five quarters of strong year-over-year growth in mainframe revenue after each major refresh.

Red Hat can drive growth in the long run

IBM should be able to muster some revenue growth in 2020, thanks to Red Hat and the new mainframe. On a stand-alone basis, Red Hat grew its revenue by 20% in the third quarter. With an annual revenue run rate of roughly $4 billion, that's around $800 million of annual growth if IBM can maintain that rate.

Image source: IBM.

IBM can accelerate Red Hat's growth by selling its software to existing customers with little or no Red Hat exposure. IBM sees a $1 billion annual revenue opportunity for every 5% of its large client base that adopts Red Hat.

The benefit of acquiring Red Hat was on display when IBM announced a 10-year, $1.1 billion deal to overhaul Spanish bank Banco Sabadell's IT systems. Banco Sabadell is moving to a hybrid cloud environment, and Red Hat's OpenShift platform is a key ingredient.

IBM's results will continue to be muddled by revenue recognition rules related to Red Hat in the fourth quarter and into 2020. Earnings will be under pressure this year, but IBM expects EPS to begin to benefit from Red Hat in 2021. Also in 2021, Red Hat is expected to add around $1 billion to IBM's free cash flow.

IBM made a big bet on the hybrid cloud when it paid $34 billion for Red Hat. We'll see over the next few years whether that gamble pays off.

10 stocks we like better than IBM
When investing geniuses David and Tom Gardner have a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has tripled the market.*

David and Tom just revealed what they believe are the 10 best stocks for investors to buy right now... and IBM wasn't one of them! That's right -- they think these 10 stocks are even better buys.

See the 10 stocks

*Stock Advisor returns as of December 1, 2019

Timothy Green owns shares of IBM. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.