International Business Machines Corporation (IBM) Earnings

Management highlights

### Business Positioning & AI Strategy - IBM's portfolio is well-positioned to help clients deploy AI at scale securely, cost-effectively, and with enterprise-grade control. Value is shifting toward AI orchestration and data layers, where IBM's differentiation is neutrality, governance, and the ability to orchestrate AI across multiple models, clouds, and on-premises environments. - watsonx Orchestrate serves as the control plane for enterprise AI agent management, paired with Red Hat as a universal foundation for inference and application deployment. Bob serves as an entry point for enterprise developers, with a clear pathway to broader IBM AI platform adoption. - Generative AI-driven demand for consulting services is growing rapidly as clients move from AI pilots to enterprise-wide deployment, requiring business process reengineering to unlock productivity gains. ### Infrastructure Innovation - Z17 mainframe is tracking as the most successful product refresh in IBM history, with 85% of installed MIPS (mission-critical transaction capacity) either stable or growing, and nearly 50% of Z17 clients adopting IBM's AI inferencing capabilities. Clients deploying Watson X Code Assistant for Z grow MIPS capacity 3x faster than non-adopters. - IBM recently launched a smaller Linux One system to expand mainframe addressable market to clients with data center space and cost constraints. Distributed infrastructure (Power, storage) is a fast-growing vector driven by AI adoption and enterprise data growth, with IBM gaining share in storage through differentiated AI-enabled offerings. ### New Growth Initiatives - Following the Mythos release that accelerated open source vulnerability discovery, IBM launched Lightwell, a new subscription offering that provides pre-remediated/validated open source software packages. The offering addresses a multi-billion dollar total addressable market (TAM), with more than 7,500 package versions available in the first two weeks of launch and multiple top global financial institutions as early adopters, priced at $1 million per year per enterprise subscription. - IBM is investing aggressively in quantum computing: it has a letter of intent with the U.S. Department of Commerce to build the world's first pure-play quantum foundry, supported by $1 billion in CHIPS Act incentives, with IBM contributing an additional $1 billion in cash. IBM plans to invest over $10 billion in quantum over the next five years, targeting delivery of the first large-scale fault-tolerant quantum computer (Starling) in 2029. IDC recently ranked IBM first overall among quantum computing vendors. ### Post-Shortfall Corrective Actions - Q2 2026 performance missed expectations due to tens of large capex-driven ELA deals that slipped to later quarters, as clients reallocated budget to secure constrained AI infrastructure ahead of expected price increases. Approximately one-third of the slipped deals have already closed in the first three weeks of Q3. - IBM is accelerating company-wide productivity actions to enhance margins and preserve free cash flow, including leveraging AI to improve software development productivity, increasing sales and marketing efficiency, and optimizing supply chain operations. - IBM is accelerating go-to-market model changes to expand coverage to thousands of additional clients beyond the Fortune 1000, focusing on high-momentum areas including Red Hat, HashiCorp, Confluent, watsonx, and storage. IBM is also adding specialized technical and client-facing talent to support enterprise AI deployment.

Guidance

- Full year 2026 constant currency revenue growth guidance is revised downward to a range of 4% to 5%, from the prior guidance of 5%+ growth. The low end of the range serves as a conservative anchor assuming current spending dynamics persist through H2, while the high end assumes a return to normal pipeline conversion rates. - Full year free cash flow growth guidance is maintained at ~$1 billion year-over-year, with expanded operating pre-tax margin guidance raised to 100 basis points of growth (up from prior guidance) due to productivity actions outpacing original plans. - Software full year growth guidance is revised to 6% to 8%: the high end assumes all slipped Q2 deals close and continued acceleration of recurring software revenue in H2, while the low end assumes continued subdued transactional deal closing. Long-term target of double-digit software growth remains unchanged. - Infrastructure full year guidance is revised upward from low/mid-single digit decline to low single-digit growth, driven by stronger-than-expected demand for distributed infrastructure (power and storage) and continued strong program-to-program performance for IBM Z in H2. - Consulting full year revenue growth guidance is maintained at low to mid-single digit growth, supported by strong generative AI backlog and momentum. - Q3 2026 constant currency revenue growth is expected to be consistent with the full year range, with a 1.5 percentage point headwind from currency translation due to U.S. dollar strengthening. Operating pre-tax margin for Q3 is expected to be similar to Q2 performance.

Segment performance

1. Software: Total revenue grew 5% year-over-year, with flat organic revenue growth. Software represents approximately 45% of IBM's total revenue. 80% of annual software revenue is recurring (subscription/consumption-based), which grew healthily in the quarter, with annual recurring revenue (ARR) of $24.6 billion, up 8% year-over-year. The remaining 20% is transactional revenue (predominantly tied to mainframe enterprise license agreements, ELAs), which fell high single digits in the quarter. By sub-segment: transaction processing software revenue declined 9%, data software grew 18%, and automation software grew 3%. Red Hat growth accelerated 1 percentage point sequentially to 11%, with OpenShift ARR reaching $2.2 billion. HashiCorp posted record bookings and accelerated revenue growth in H1, while Confluent had a strong first full quarter post-acquisition, on track with internal expectations. Segment profit margin expanded 110 basis points driven by ongoing productivity actions. 2. Infrastructure: Total revenue declined 7% year-over-year. While IBM Z (mainframe) performance missed internal expectations, over the first five quarters of Z17 availability, cumulative revenue is nearly 130% of the prior Z16 program (the previous record refresh cycle), which remains the strongest refresh cycle in IBM history. Distributed infrastructure delivered its best quarter of revenue growth on record at 37%, ending the quarter with a record $500 million backlog. Segment profit margin declined 150 basis points due to IBM Z mix headwinds, partially offset by strong margins from distributed infrastructure. 3. Consulting: Signings grew 6% year-over-year, marking the second consecutive quarter of growth. Revenue grew 1% year-over-year, with balanced growth across all consulting service lines (strategy and technology, intelligent operations all up 1%). Generative AI represented 50% of Q2 signings and makes up over 30% of total backlog. Segment profit margin expanded 160 basis points driven by productivity actions.

Risks & headwinds

- Client capex spending prioritization can lead to unforeseen timing shifts for large mainframe-related ELA transactions, which created a material Q2 revenue shortfall and requires downward revision to full year revenue guidance. Persistence of this dynamic through H2 would lead to full year results at the low end of guidance ranges. - Ongoing global infrastructure supply chain constraints require proactive inventory build, which created a near-term headwind to first half free cash flow, even as it positions IBM to meet H2 demand. - Sustained macroeconomic uncertainty could lead to continued client budget reallocation that delays large transactional software and infrastructure deals beyond current projected timelines. - While IBM has not observed client migration off the mainframe, any sustained shift to off-platform workloads would negatively impact core transactional software and hardware revenue.

Analyst Q&A

• Q: Is the Q2 missed demand deferred or destroyed, what milestones indicate normalization, and how do you maintain the $1B free cash flow target despite the Q2 shortfall? /

  A: Management confirms the majority of missed Q2 deals are deferred, not destroyed: approximately one-third of slipped deals have already closed in the first three weeks of Q3, and management expects two-thirds to three-fourths to close within six months. Key milestones for normalization are accelerating revenue growth in H2 (to pull full year results into the 4-5% guidance range) and sustained 120%+ program-to-program performance for IBM Z. The $1B free cash flow target is maintained because productivity actions have exceeded plan, the Q2 inventory build from proactive supply chain strengthening will reverse into a tailwind in H2, and cash tax/capex headwinds were mostly front-loaded in H1. Strong historical free cash flow generation over the past four years (up $6.5B) gives management confidence in hitting the target.

• Q: How do you square the 1-point downward revision to full year revenue guidance with the number of slipped Q2 deals that have already closed? /

  A: The 4-5% full year guidance range reflects different scenarios: the high end of 5% is very close to the prior guidance, and assumes most slipped deals close and continued acceleration of recurring software and distributed infrastructure growth. The low end of 4% is a conservative anchor that assumes buying behavior remains similar to Q2, to ensure profitability and cash flow remain stable even in a slower growth environment. Infrastructure guidance was upgraded 2 points from the prior guide due to strong demand for distributed infrastructure and continued solid Z17 performance, offsetting the downward adjustment to software guidance.

• Q: Do you still maintain a long-term target of double-digit software growth, and what is the outlook for transaction processing (TP) and mainframe? /

  A: IBM remains fully committed to a long-term double-digit software growth target. 80% of software revenue is now high-growth recurring revenue, which has grown from low single digits to ~10% already, and new organic (watsonx) and inorganic (HashiCorp, Confluent) capabilities grow 15-20%, supporting the long-term target. For mainframe, while Q2 revenue was down 42% off a very strong year-ago launch quarter, cumulative five-quarter revenue is still 130% of the prior record Z16 cycle ($1B more mainframe revenue, $3B more associated software revenue). 85% of installed mainframe MIPS capacity is stable or growing, Z offers a 2-15x TCO advantage over off-platform migration, and AI-capable Z clients grow capacity 3x faster than non-adopters. For guidance, TP growth is projected to be low to mid-single digits in H2 2026, with stronger growth expected in 2027.

• Q: What catalyzed early closing of slipped Q2 deals in Q3, and were there internal IBM actions to drive this? /

  A: Deals slipped in Q2 because clients unexpectedly reallocated budget to secure supply-constrained AI hardware that saw 30% quarter-over-quarter price increases, crowding out budget for planned mainframe/software ELA deals. Deals have moved forward quickly because clients realized deferring mainframe/software upgrades would add costly long-term technical debt to their core platforms, and IBM's stable pricing for its software/hardware made closing the deals attractive once clients adjusted their budgets. Most slipped deals are tied to core platform upgrades that clients need to complete eventually, not eliminated demand.

• Q: Why did organic data software underperform the rest of non-TP software in Q2, even with strong Confluent growth? /

  A: Most of the Q2 software revenue shortfall was concentrated in large capex ELA deals, which include not just majority transaction processing software but also meaningful amounts of data software. Most of the automation portfolio has already shifted to subscription, so it was less impacted by the capex spending shift, leaving data software more exposed to the Q2 deal slippage. Management expects data software to return to strong performance over the next 12 months as slipped deals close and demand for AI-ready data infrastructure remains strong.