The financial longevity that Red Hat offers IBM

It’s hard to imagine, but one day IBM may not care much about its proprietary System z and Power Systems platforms. Or more specifically, it may not be able to afford to care as it has for decades

But the good news for Big Blue is that it has a third platform in the Red Hat stack, and that platform is growing as the other “real” IBM systems deals are flat to down, and the even better news is that the IBM’s landmark $34 billion acquisition of Red Hat in October 2018 gives it the ability to transform and modernize these legacy platforms. And so that day of reckoning is being pushed further than it otherwise could have been — and the collective sigh of relief from the System z and Power Systems lines is audible every quarter as Red Hat grows.

Everything that makes Red Hat stronger makes System z and Power Systems last longer. And anything that lasts longer gives IBM the fuel to grow its Red Hat business, because the System z platform is still incredibly profitable when you add in the databases, services, and sometimes even applications that IBM sells for it .

For the quarter ended March, IBM reported a 7.7 percent increase in revenue to $14.2 billion and a 1.8-fold increase in net income to $733 million. Red Hat revenue increased 18 percent as reported (and 21 percent at constant exchange rates) to our calculations of $1.41 billion. So Red Hat is now 1/10th from Big Blue following the spin-off of its Kyndryl managed services business earlier this year. IBM has rebalanced its financials across various groups and divisions and product segments in the wake of the spin-off and restated figures excluding Kyndryl but including Red Hat through the first quarter of 2019. (Red Hat numbers only go back to July 2019, when the transaction closed.)

When IBM announced the deal with Red Hat three and a half years ago, we said the whole point of the acquisition was to give IBM a new story to tell to its large enterprise customers and a new and broader revenue stream among the many hundreds of thousands of companies large companies that are not yet using IBM platforms – like many of them a decade or three ago. But this deal was also about creating a new, higher-level platform business that could (to some extent) run on IBM’s proprietary machinery, but wasn’t limited to those machines either.

We know that Linux drives a majority of MIPS consumption on mainframes and has done so for the last two decades, and Linux therefore represents a majority of OS licenses on System z mainframes. But the revenue for Linux on mainframes is compared to what IBM demands for its z/OS stack, which contains all sorts of things, such as transaction monitors, Java middleware, system monitoring and security, in addition to an operating system and a virtualization environment, dizzying tool. It’s been a long time since we’ve seen price drops for the z/OS stack, but when we did, Linux was between five and ten times cheaper for the same System z engines. And IBM charged a quarter of the price for a z engine running Linux than for one running z/OS.

Linux has some role in IBM’s Power Systems lineage, particularly in HPC and AI deployments, or with AIX and IBM i customers who want to run modern, containerized deployment systems on the same platforms they run mission-critical ERP applications and their run databases. But Linux has never driven the Power platform’s revenue stream and total compute capacity sold as much as the System z mainframe. There’s no reason this couldn’t be the case — IBM just never got the right mix of products and prices right, or people didn’t think the Power system could compete with Linux against an X86 platform with Linux.

The odd thing about Red Hat, from IBM’s perspective, is that most of its revenue comes from OPP – Other People’s Platforms. This seems like a strong argument that IBM should have an ARM or X86 platform, but the company has sold its System x business to Lenovo and doesn’t seem inclined to reopen that volume server business. It would much rather be a software provider at this point, driving the Power Systems and System z lines to where they appear on the horizon. We here at The next platform are not stupid enough to predict when IBM will say enough when it comes to developing new Power and z chips and updating its z/OS, AIX, IBM i and Linux operating systems for them. What we can say for sure is that whenever that day comes, IBM will mothball a lot of processors and motherboards, memory and peripherals and sell them for a long time — maybe a decade — and software support will last even longer will. With very high prices compared to what prevailed on the market at the time.

The deal with Red Hat can easily be paid for by these legacy companies. For the past six quarters, IBM’s “real” systems business based on the Power and z platforms (again excluding databases and applications) made more than what it paid for Red Hat. And with the Power10 and System z16 product cycles just beginning in earnest here in 2022 and likely three more years to go, IBM will get all of its bait back on its Power10 and z16 investments and still have plenty left to build Power11 and z17 processors and systems that use them.

Each quarter we attempt to isolate what we believe to be the “real” systems business, including the servers, storage, core system software, technical support, and financing that IBM provides for its machines. In an updated model, we have plotted Red Hat’s revenue and estimated what we believe to be contributions at the system software level, including support licenses for Red Hat Enterprise Linux, the OpenShift container controller, the OpenStack cloud controller, and related middleware systems management and storage software. Our model assumes that approximately 75 percent of Red Hat’s revenue falls into these categories. And as you can see in the chart below, the Red Hat Effect we anticipated is actually pulling IBM’s systems business up and to the right:

If you take Red Hat out of the equation using our modified old model (modified for the change in groups and segments, but added up to the same sales historically), then this “real” IBM systems business had sales in Q1 2022 of $5.98 billion. increased by 3.5 percent. But with Red Hat’s core systems business in the mix, this “real” systems business brought in just over $7 billion, up 5.4 percent year over year.

IBM only launched System z mainframes in April with the “Telum” z16 processor we wrote about here, so it came as no surprise that mainframe revenue fell 18 percent while companies on the new products are waiting. (IBM has many latent cores in its System z iron, so companies spin up more and more cores as workloads increase, which is why revenue doesn’t stop before a new system is introduced. These core activations are very profitable for IBM.) Distributed infrastructure revenue — ie Power Systems plus storage in IBM’s new financial categories — rose 8 percent for the quarter, driven primarily by sales of the “Denali” Power E1080 NUMA systems announced last September, which are now fully ramped up.

Sales of IBM’s legacy systems and storage, including all those proprietary operating systems, were down 5 percent to $1.69 billion, we estimate, and sales of support for those platforms were up nearly 1 percent to 1 $.53 billion. Infrastructure group sales fell 2.3 percent to $3.22 billion.

The larger software group had revenue of $5.77 billion, up 12.3 percent, with transaction processing software accounting for $1.67 billion (up 28 percent) and hybrid platforms & solutions (which includes Red Hat, databases, security and analytics software) brought in $4.1 billion, up 7 percent. If you exclude Red Hat from this segment, the central legacy part of the business with hybrid platforms and solutions increased by 2.1 percent to around 2.7 billion US dollars.

IBM’s consulting group had revenue of $4.83 billion, up 13.3 percent, and its financing group had revenue of $154 million, down 25.6 percent as Big Blue divested from from financing other people’s hardware and software and also awaits the forthcoming System z16 boom.

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