IBM Stock at a Crossroads After $9.5 Billion AI Update

On Wednesday afternoon, IBM (IBM) , the old International Business Machines, released the firm's third quarter financial results. 

For the period ended September 30, IBM posted an adjusted EPS of $2.65 (GAAP EPS: $1.84) on revenue of $16.331 billion. While the top-line print was good for year-over-year growth of 9.1%, both that top-line result and the adjusted bottom-line result decisively beat Wall Street's expectations. Adjustments were made primarily for acquisition-related costs and for the impacts of tax reform. 

In the press release, CEO Arvind Krishna commented: 

"This quarter we accelerated performance across all of our segments, and again exceeded expectations for revenue, profit and free cash flow. Clients globally continue to leverage our technology and domain expertise to drive productivity in their operations and deliver real business value with AI. Our AI book of business now stands at more than $9.5 billion. Given the strength of our business, we are raising our full-year outlook for revenue growth and free cash flow." 

Yet, the stock has sold off overnight. This is likely because the cloud business, which is mostly composed of the old Red Hat business, saw growth of "just" 14%. The firm still ended the quarter with a generative AI backlog of a rough $9.5 billion. I am thinking, from an execution perspective, that this overnight beatdown (-7.8%) may be overdone.

Segment Performance

• Software generated revenue of $7.209 billion (+10.5%), producing a gross margin of 83.1%, down from 83.2%
• Consulting generated revenue of $5.324 billion (+3.3%), producing a gross margin of 29.3%, up from 28.4%
• Infrastructure generated revenue of $3.559 billion (+17%), producing a gross margin of 57.2%, up from 55%
• Financing generated revenue of $200 million (+10.5%), producing a gross margin of 45.6%, down from 47.2%
• Firm-wide, revenue was up 9.1% to $16.331 billion, producing a gross margin of 57.3%, up from 56.3%

Guidance 

For the full year, IBM now sees revenue growth in constant currency growing by more than 5%. This is inclusive of an expected 1.5% tailwind related to currency exchange rates. 

During the call, CFO James Kavanaugh added, "We continue to expect Software revenue growth of approaching double digits for the full year, (and) mid-teens growth for Red Hat, albeit at the low end." 

He added, "We expect double-digit revenue growth in the fourth quarter with an accelerated growth profile heading into 2026." 

In addition, full-year free cash flow is now seen at roughly $14 billion.

Fundamentals 

For the period reported, IBM generated operating cash flow of $3.081 billion. Out of that number comes capex spending of $410 million and $298 million in a change made to financing receivables. That left free cash flow of $2.373 billion, up 15% from the year-ago comp. To its credit, the firm did not repurchase any common stock for its treasury this quarter but did pay out cash dividends of $1.569 billion to shareholders. 

Turning to the balance sheet, the firm ended the quarter with a cash position of $14.885 billion, and inventories of $1.397 billion. That puts current assets at $32.74 billion. Current assets stand at $35.142 billion. That does include short-term debt of $7.942 billion, which is a bit much, but also deferred revenues of $13.878 billion thanks to that AI backlog. At the headline, the firm's current and quick ratios stand at 0.93 and 0.89, which isn't so hot. However, when you adjust these ratios for those deferred revenues, they improve greatly to 1.54 and 1.47, respectively. 

Total assets amount to $146.312 billion, which does include $79.125 billion in goodwill and other intangibles. At 54% of total assets, I think that is a bit much. Maybe more than a "bit" much. Total liabilities less equity comes to $118.322 billion. That includes some more deferred revenue, but also $55.174 billion in long-term debt. 

The deal is this: I have seen worse balance sheets. A lot worse, but that's a heck of a lot of debt and not really that much cash. This balance sheet is nothing to brag about.

My Thoughts 

I wrote a piece a few weeks ago with a trade idea that would have gotten traders long IBM at a net basis of $296.60 with an out at $275. Anyone who followed that trade suffered a loss of 7.3%. My apologies. At the time, I saw a battle between two competing patterns, a cup with handle, which would have been bullish, and a double top pattern of bearish reversal. Needless to say, the double top won that fistfight.

There is still danger. The pivot for the double-top is all the way down at $233. That could signal a long way to go on the downside. On the other hand, the business is growing, the order backlog is massive, cash flows are excellent. I don't love the balance sheet, but I am more talking about a trade right now than an investment.

Longer-term, IBM may test the downside pivot that I just wrote about. However, to get there, the stock will have to saw a lot of wood. The 50-day SMA at $264 and the 200-day SMA at $258 are both spots where professional money may come to this stock's defense. The stock will trade in that general range on Thursday morning. If the pros do not defend the stock, it will sink well below those levels. If they do defend the stock, we'll know pretty quickly and I will be a buyer, taking advantage of this discount. 

IBM is one of two legacy tech names that I think will be a significant player in the quantum computing space going forward. This could be a trade that becomes an investment if I am right about what portfolio managers do here. If I am wrong? That's why I came up with the 8% rule. Oh, wait. That wasn't me. That was William O'Neil. I adapted it for my own purposes, but he's the one that put it in my head a long time ago.

At the time of publication, Guilfoyle had no positions in any securities mentioned.