IBM Q2 Earnings: Software Miss Sours a Solid Quarter as AI and Hardware Lead the Charge

IBM shares dropped over 5% Thursday morning after the tech stalwart posted second-quarter results that beat top- and bottom-line expectations but revealed softness in its software margins and revenue. The results were otherwise strong, with the company lifting its full-year free cash flow forecast and reporting double-digit growth across key hardware and AI initiatives. Still, given the stock’s 28% year-to-date rally into earnings, investors took the software miss as a reason to take profits, dragging IBM to the bottom of the Dow.

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Adjusted EPS for Q2 came in at $2.80, well above the $2.65 consensus estimate, while revenue rose 8% year-over-year to $17.0 billion, topping the $16.6 billion forecast. Net income was $2.2 billion, up from $1.83 billion a year ago. IBM’s gross margin expanded 200 basis points to 58.8%, while operating margins also improved, driven by productivity gains and favorable business mix. The results were buoyed by outperformance in infrastructure and consulting, though investors zeroed in on underwhelming software trends as the reason for the post-earnings swoon.

The software segment, long seen as the key pillar of IBM’s transformation story, generated $7.39 billion in revenue, up 10% year-over-year but just shy of the $7.43 billion consensus. The miss was marginal, but it came with an unwelcome narrowing of gross margin in the unit to 83.9%, versus expectations of 84.0%. Red Hat—a key driver of IBM’s hybrid cloud strategy—grew 16% year-over-year, and automation revenue also rose 16%. However, transaction processing was essentially flat, and management flagged some reprioritization of IT spending toward hardware, particularly around the z17 mainframe cycle.

Infrastructure stole the show this quarter, posting a 14% revenue increase to $4.14 billion, well above the $3.76 billion estimate. The star was IBM Z, the company’s mainframe line, which saw a 70% surge in revenue thanks to the launch of the z17 system. Management noted that the new platform’s AI acceleration capabilities and security improvements are resonating strongly with clients. Hybrid infrastructure grew 21%, while distributed infrastructure fell 15%, impacted by product cycle dynamics and Power platform transition. Infrastructure support remained stable, down 1% year-over-year.

Consulting, a segment sensitive to macro headwinds and discretionary budget tightening, rose 3% to $5.31 billion, narrowly ahead of the $5.16 billion consensus. IBM noted some delayed decision-making in project signings and ongoing caution in discretionary spending, particularly in strategy and technology consulting. However, the company continues to see strong engagement around AI projects, with its generative AI consulting business now surpassing $1 billion in quarterly revenue. Management said IBM’s consulting pipeline remains healthy, with backlog up 4% year-over-year.

AI was a standout across the board. CEO Arvind Krishna noted that IBM’s generative AI book of business now exceeds $7.5 billion, up from $6 billion in April and more than triple the $2 billion figure disclosed a year ago. IBM highlighted new product releases in its watsonx platform, deeper AI integrations with partners like Oracle, Salesforce, and AWS, and growing enterprise adoption across industries such as logistics, banking, and consumer goods. Krishna also emphasized that internal AI deployment—what IBM dubs the "client zero" experience—is boosting productivity and accelerating its go-to-market cycle.

Free cash flow was another highlight. IBM reported $2.8 billion in Q2 free cash flow, up $200 million from a year ago, and $4.8 billion for the first half, marking the highest H1 margin in recent memory. Management raised its full-year free cash flow guidance to “more than $13.5 billion,” a modest bump from its previous view. The company ended the quarter with $15.5 billion in cash and marketable securities and a debt load of $64.2 billion, including $11.7 billion tied to IBM’s financing arm. Dividends returned to shareholders totaled $1.6 billion in the quarter.

The outlook remains largely intact. IBM reiterated its full-year constant currency revenue growth forecast of at least 5%, with currency now expected to add a 1.5-point tailwind. The company continues to expect mid-teens growth for Red Hat and low single-digit growth in transaction processing, with infrastructure expected to contribute roughly 1.5 points to total revenue growth. While consulting remains in a holding pattern, management is optimistic about second-half improvements, particularly with GenAI projects gaining traction.

Still, for all the strong headline numbers, investors focused squarely on the software shortfall. As Jefferies analyst Brent Thill put it prior to the report, “software is the key pillar of the bull case for IBM.” The slight miss on both revenue and margin in this segment, especially after a sharp year-to-date run, was enough to trigger a pullback. Shares fell as much as 6% in after-hours trading and were down around 5.5% Thursday morning, giving back a portion of their 2025 gains.

In sum, IBM’s Q2 was a classic case of "strong but not perfect." With infrastructure humming, AI accelerating, and free cash flow robust, the long-term transformation narrative remains on track. But investors expecting flawless software execution—arguably the central element of IBM’s growth premium—were left wanting more. For now, the stock cools, but the strategic trajectory remains pointed up.