Why IBM's End Could Be Near

IBM (NYSE: IBM  ) is having a rough year , producing a negative 6% return so far. The company had a wonderful come-back in the 90s thanks to its cost reductions and shift toward software and consulting, which led to amazing financial performance for a decade.  And since 2002, revenue, gross profit, and operating profit have compounded at annual rates of 3%, 6%, and 12%.

However, the current situation is totally different. IBM may need a transformation and reengineering of its business. According to many IBM fans, that shouldn't be a big problem because IBM has been able to change several times in the past: this is just another time. Bears, on the other hand, keep reminding us that this time is different. What kind of future awaits IBM shareholders in the short and long run?  

Is IBM's end near?

In the first quarter of 2013, for the first time in 8 years IBM missed earnings expectations: sales declined 5%, posing a strong risk to IBM's long-term business, as two-thirds of its revenue base is recurring.

Full-year earnings guidance of $16.70 were just $0.07 below the consensus. But these $0.07  reflected long-term changes in the main markets IBM addresses: a contraction in global demand for IBM's high-end systems & hardware, and growth limits in the private cloud computing segment. These long-term trends started hurting IBM's cash flow already in 2009 and the $0.07  should have been seen as the beginning of a series of disappointments and pain for shareholders. 

Unfortunately, the second quarter results did not show the kind of substantive change that investors were looking forward to. IBM did beat the consensus by a tiny margin.

That was just not enough.

Analysts had kept estimates low but their expectations were actually higher: they tacitly were expecting a major change in business focus, which did not seem to happen. As a result, institutions from Credit Suisse to UBS downgraded the stock. It's simple to understand the downgrades: margins were down 3% from last year. The elephant is spending the same or more money, but making much less than before. 

Source: IBM Investor Relations, Press Release 

Now, similar results coming from other companies in the software and services sector, like Oracle (NYSE: ORCL  ) , show that the whole industry is in trouble. But to make matters worse, IBM still has 34% (hardware + System Z server sales) of its revenue coming from the commodity-like hardware segment, which is even riskier than the services segment, because of increasing competition from Intel's (NASDAQ: INTC  ) cheap machines.

Wrong focus?

In "IBM: The End Is Near" investor Arne Alsin identified a massive paradigm shift as the root of all of IBM's problems. The industry is moving to the public cloud: low-cost yet powerful computing architecture. IBM's main products (e.g. System Z and private cloud solutions), on the other hand, depend on the old paradigm--the private cloud, a soon-to-be legacy business.

Competitors

Oracle is the perfect example of a competitor in the software and services sector. Specifically, in the middleware market, competition between these two giants is fierce, with IBM owning roughly one third of the whole market.  Oracle is also having a tough time trying to keep revenue growth alive. In the latest quarter, new software licenses and cloud subscriptions fell 2 percent to $2.3 billion.

The upside for Oracle is that the company is the leader in the database field. Selling databases to customers is the entrance to selling them systems, infrastructure, software, etc. And as long as Oracle keeps its leading position in the database world, it will not lose its power.

Unfortunately, cloud computing is also a strong risk for Oracle's business, but the company could adapt itself to the new paradigm better than IBM. For example,  it has already been taking advantage of the new shift by providing support of legacy applications to companies that are in the process of moving to the public cloud. If you want to know more about Oracle's cloud challenges, check outmy previous article on Oracle.

In the hardware field, competitor Intel remains a strong value investment, despite a terrible year in terms of stock performance and disappointing dividends. Intel's server and high performance computing business segments are experiencing mild growth. The problem with Intel, though, is not the data server business, but the fact that revenue is too dependent on a shrinking PC market. In 2012, Intel reported full-year revenue of $53.3 billion, of which $34.4 billion (roughly 65%) came from the PC client group and only $10.7 billion (21%) came from the data center group. That being said, Intel also has plenty of upside potential. The company hasn't lost its R&D focus and keeps launching new architecture every 2 years or less: the new "Haswell" architecture maximizes power efficiency and could boast sales. Its  current P/E ratio (12.1) also makes Intel an attractive stock.

Final foolish thoughts

I agree with Alsin in the sense that the demand for expensive, multi-million dollar systems (let them be private clouds or something else) is contracting. Companies are moving to the public cloud instead. Expensive frameworks and commodity-like x86 servers are becoming endangered species.

That being said, I also don't want to underestimate the ability of IBM to change its business radically. Big Blue has done it several times. The latest time was when it exited the PC business in 2004 by divesting its PC unit to Lenovo. This was done 2 years after HPQ acquired Compaq and at a moment where the PC business was still strong. The elephant prioritized the sustainability of the business rather than meeting the street consensus for the next quarter.

A similar strategy and radical changes of focus are in great need again. This goes beyond acquiring companies with strong exposure to the public cloud (IBM recently acquired SoftLayer for $2 billion, 5 times revenue).

Finally, there will always be demand for expensive private clouds, for institutions willing to pay 100% more in price for an additional 5% safety improvement. What IBM needs to do is to reduce the exposure to such business, as soon as possible. In the meanwhile, the safety of having institutional clients and its vast resources will allow Big Blue to survive, but don't expect superb returns during the transition. It's gonna take a while, since it's just starting!


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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 26, 2013, at 12:26 PM, banmate7 wrote:

    You lose all credibility when you reference Arne Alsin. You should read the comment section in the original Alpha article by him. In particular, read my retorts, under the same name, banmate6. I'd ask you to then respond here when you do. I'd be very surprised if you continue to affirm that what Arne and you assert.

    Obviously I think claims of IBMs demise are histrionic. Honestly, articles like this and the one Arne printed make me cringe. It's no wonder so many investors experience inferior returns, listening to pop culture punditry like this. Sorry, but that's how you exactly come off: as a nominally informed internet commenter on finance.

    You should reckon with how much IBM spends on R&D annually, their consistent history of seminal computer science, and their deep expertise across the IAAS, PAAS, and SAAS stack. You also should consider the advantages established vendors with serious cash flow & balance sheets can do in providing the range of SAAS applications...versus small vendors like SalesForce or WorkDay providing a few apps that cannot be integrated...whereas established companies can, will, and continue to provide the spectrum of SAAS with common data models, access to the data, and APIs to build advanced big data analytic apps on top of this...with integrated identity management. IBM in fact just won a $1 billion government contract to provide cloud computing services.

    Oracle, SAP, IBM, and MSFT are well positioned to dominate the cloud...integrating this with significant on site computing that will never go away for many companies. In contrast, SalesForce and WorkDay don't make money. We'll just see in a few years how chasing growth works out versus the aforementioned companies that make serious money.

    Lastly, I suggest you also study databases a bit. Db2 is #2 in market share, yet you dismiss this as a moat while acknowledging it for Oracle's #1 market position. Contradiction, right? You also don't reckon with SAP Hana starting to eat at Oracle.

    Most of all, consider that IBM invented relational algebra and SQL. As I said earlier, count on IBM to innovate seminal computer science. 100 years attests to this.

    The future will be choppy. IBM no doubt has internal issues. There may be new lows. But to call for the end of IBM on the basis of a 1% or so revenue decline is at best foolish. Plain and simple, you and Arne really come off poorly in this regard.

  • Report this Comment On August 26, 2013, at 12:40 PM, Celine191 wrote:

    I’ve taken advantage of the recent downturn in share prices to open a position in IBM because I believe that management’s commitment to R&D demonstrates the strategic thinking that will provide many new products in their pipeline. I’m particularly interest in the Watson system, which I believe is a game changer for any industry that needs to consume and draw inferences from big data.

  • Report this Comment On August 26, 2013, at 1:01 PM, ronbeasley wrote:

    Great idea...let's all sell Warren Buffett's third largest holding and follow the advice of an Internet blogger trying to sell subscriptions to a second-rate newsletter. I really, really hope no one pays any attention to this stuff. And that's about as politely as I can put it.

  • Report this Comment On August 26, 2013, at 1:09 PM, banmate7 wrote:

    @ Celine191 Sentiment does matter in the short term. There is indeed some negativity around IBM & this can drive the share price a bit lower. However, Warren Buffett didn't take a 5% stake in IBM for nothing, as the long term results should be very good.

    I agree with you about IBM's annual $6 billion R&D budget. As I said earlier, it produces seminal computer science. Watson, as you mentioned. But also biological based computing and the requisite languages. Nanotechnology. This is the company that invented relational database computing.

    Yet the author touts Intel and Oracle, respectively on R&D and databases...which I agree with by the way...but strangely ignores this in basically asserting that "the end is near for IBM". Never mind that IBM grew software and services in newer technologies, suffering a 3% revenue decline mostly because of the lower margin hardware business.

    Again, I acknowledge IBM has some serious short term issues. The employee morale issue is huge. If anything can threaten IBM, it's growing discontent with its product management, product development, and sales personnel. R&D remains top notch, but these other areas are problems due to internal financial engineering that is upsetting talented employees.

    I have to believe IBM management will fix such problems. They cannot be so brazen as to ignore this growing discontent. As such, I see the next 2 years as a time to accumulate IBM...which I plan on doing. I'm looking for the ideal entry point.

    I'm certainly not going to invest in LinkedIn, WorkDay, and SalesForce, with their absurd valuations...these companies allegedly being the dire threat to that will ensure that "the end is near" for IBM. Something tells me that when the smoke clears on cloud computing, IBM, SAP, MSFT, and Oracle will have gobbled up or killed the newer companies. I expect the likes of Google and Amazon to join the established ranks, but not the smaller niche SAAS companies.

    Best of luck.

  • Report this Comment On August 26, 2013, at 1:49 PM, techy46 wrote:

    Yep everyone's going to be running their ERP and MRP applications on Apple iToys and Gargle ABots in the public cloud so all their corporate data is available to the NSA and other terrorists for the taking. You guys really are a bunch of fools.

  • Report this Comment On August 26, 2013, at 1:53 PM, geek49203 wrote:

    Totally missed the big points.

    1. IBM has had several government contract fiascos -- Indiana, Texas, someplace in Oz, and Georgia come to mind. Not only were the customers dissatisfied, but IBM lost a boatload of money. They obviously won't be given the chance to lose more money if the bad results continue, not only for services to government, but large service contracts in general. So, the services contracts are a key question here.

    2. Most of IBM's spectacular failures are due to project management, NOT technology. I don't see that mentioned here. Certainly the government projects that I know about are victims of bad project management.

    3. IBM's corporate culture was developed over mainframes which stayed in place for a decade or more, with lifetime employees running them. However, now a large majority of employees are contract employees whose tenure can't average more than 3 years. I guesstimate a 1:4 ration of direct to contract. Should IBM keep this mixture they cannot keep doing their businesses practices, and it will be a real struggle to control internal transaction costs.

  • Report this Comment On August 26, 2013, at 2:10 PM, banmate7 wrote:

    @geek49203 IBM has certainly had some failures. But as I said, they recently won a $1 billion government contract to provide cloud computing services. Overall, I believe they increased government project based revenue.

    I agree with you on the poor project management angle. But this can be fixed. The technology remains outstanding.

    I totally disagree with you about a so called mainframe culture at IBM. IBM has plenty of engineers across the spectrum of technology, especially in databases, search, analytics, and so. The big problem is in not treating the talent with "respect".

    As I said in my other post, IBM pays well enough. But it's the perks & benefits where it fails. Like it or not, leading edge companies need to provide a leading edge culture to stay on top. IBM management must address this.

  • Report this Comment On August 26, 2013, at 5:15 PM, Momintn wrote:

    Magically all of the 3 forward P/Es are close to 10. IBM 10, ORCL 10.8, and INTC 10.8 well below the S&P 500 forward P/E of 15.4. Looks like value to me with IBM having the lowest PEG of 1.0, and Oracle a close second. No reason to buy INTC in my opinion when you can be in every segment of technology by buying IBM.

  • Report this Comment On August 26, 2013, at 5:20 PM, ryanchandler25 wrote:

    @ronbeasley I totally agree.

  • Report this Comment On August 26, 2013, at 7:32 PM, johnnytrader23 wrote:

    @banmate7

    normal type relational databases and sql itself are being displaced by Postgresql (ORDBMS) and other open source tools...

  • Report this Comment On August 26, 2013, at 7:39 PM, banmate7 wrote:

    @johnnytrader This is simply untrue. Most enterprises do not use open source databases. In fact, many vendors in the cloud pay licenses to the major vendors.

    A case in point is SalesForce, which standardizes on Oracle technology.

    Right now, SAP & IBM feature in memory databases that can query in near real time petabytes. Oracle is set to release a version as well.Try this with open source like mysql or postgres. It just won't scale.

  • Report this Comment On August 27, 2013, at 12:14 AM, banmate7 wrote:

    @Momintn I like ORCL, INTC, & IBM, exactly for what you stated: value. These are real companies with diversified products, huge cash flow & balance sheets.

    Yet the pundits tout financially poor companies like SalesForce and WorkDay that enure that "the end is near" for companies like IBM? Americans really need to educate themselves and filter out what is effectively a pump and dump scheme here.

    The irony is that the smart money will in fact buy up the stalwarts, just as they abandon the hot new wave cloud companies. It's too bad that such financial sophistry goes unchecked.

  • Report this Comment On August 27, 2013, at 12:27 PM, soitgoes1001 wrote:

    It is always complicated - HP is in real trouble. That will help IBM. BTW I would short HP.

    IBM still makes good money with it's m/f business and it has purchased some good sw companies. Add in the constant layoffs, IBM might look good in the short run- yes -> go Warren.

    But start to dig a little more - shifting a very large % of your employees from fulltime to contractors is not good for the long run. When a company is too big, people who manage up get promoted - and hire like kind- all working to get promoted and you get fewer people to do the real work. Soon mgmt doesn't understand the value of great technical people so again over time they leave or don't work as hard .... . Don't forget to add in the MBAs with excel that don't know the business/customers at HQ making decisions or really they feed data to the EVPs who then make decisions ... you get the point. The R and D comments are interesting. This is getting long so I will just say don't count on that to pull IBM out. So I am thinking when HP tanks, IBM and Oracle stock will do well in the short run but look hard at the long term.

  • Report this Comment On August 28, 2013, at 12:52 AM, boriswart wrote:

    Any one thinking that IBM invests in R & D has not worked for IBM recently.

  • Report this Comment On August 28, 2013, at 2:04 PM, banmate7 wrote:

    @Boris I just left IBM. I spent enough time at SVL and Almaden. Believe me, IBM invests in R&D. In fact, it's their crown jewel. IBM has some issues, but R&D is not one of them.

    If you want to believe otherwise, I guess we'll agree to disagree.

  • Report this Comment On September 02, 2013, at 4:01 AM, pkiapple wrote:

    Asset's of IBM are now considered as Liabilities, how would such a balance sheet sustain.

    Human are treated as Machines, does any machine have brain...

    This is today's IBM...

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