How Falling Server Sales Affect HP, IBM, and Intel

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With the growth of cloud computing, the traditional server market has lost its cash cow status for many companies. IDC estimates that server sales fell by 3.7% year-over-year in the third quarter, thanks largely to big web companies designing their own servers and having them built by contract manufacturers. Hewlett-Packard (NYSE: HPQ  ) and IBM (NYSE: IBM  ) , the top two server manufacturers, have seen margins decline due to this trend, and Intel (NASDAQ: INTC  ) , the dominant server chip provider, has had to adapt to this changing market.

Proprietary no more
In the old days, companies simply bought servers from companies like HP, IBM, and Dell, and those providers were able to achieve solid margins in the server business. But, as cloud computing has taken off, with the so-called "big four" cloud companies -- Google, Amazon, Facebook, and Microsoft -- rapidly growing their capacity, server companies are increasingly being cut out of the loop. These cloud companies are designing their own servers, buying chips directly from Intel, then farming manufacturing off to Asia.

Four years ago, 75% of Intel's server chip revenue came from Dell, HP, and IBM. Today, that same 75% is split between eight companies, one of which is Google. It's clear that the market has already shifted dramatically, and Intel has a dedicated salesperson for each of these big cloud customers. Small companies that don't need a huge number of servers and don't want to trust their data to a public cloud will likely remain customers of HP, IBM, and Dell, but the proprietary server business is certainly shrinking.

What this means for HP
The No. 1 server vendor, HP, stands to lose the most from these trends. The company derives a significant portion of its profits from server sales, and although HP picked up share in Q3, operating margin continued to decline. The slight increase in revenue from this gain in share likely means nothing long-term, and I see no reason to believe that the server profits will stabilize any time soon.

HP's enterprise group, which is responsible for servers, accounted for 45% of the company's fiscal 2013 non-GAAP operating profit. Operating margin, which sat near 19% in Q4 of 2011, has fallen to 14.5% in Q4 of 2013. What's worse, HP has no other businesses that can make up for these falling profits. Companywide, revenue and profits are declining in almost every division. As server profits slowly dry up, it's hard to imagine where growth is supposed to come from.

What this means for IBM
The No. 2 server vendor is IBM, a company which sells servers based on both the x86 architecture from Intel and its own Power architecture. IBM's server sales collapsed last quarter, likely allowing HP to pick up share, but IBM has a robust, highly profitable business without relying on hardware sales.

Last quarter, IBM had a service backlog of $141 billion, up 6% year-over-year. The company is constantly shifting out of low-margin businesses to focus on high-margin opportunities, and it has become very good at maximizing and growing profits. The IBM of today looks very different from the IBM of 2000, as can be seen from the graphic below.

Pre-tax income by segment

Source: IBM Investor Relations

Hardware has become decreasingly important to IBM, and today the company can easily absorb hardware weakness without significantly affecting the bottom line. While HP is in big trouble due to the shift to the cloud, IBM should be perfectly fine.

What this means for Intel
Sales of x86 servers actually grew by 2.8% in the third quarter, as the big cloud companies design their servers around Intel chips. The vast increase in demand for servers from these companies is clearly a positive for Intel. However, the company has had to accept lower margins as the big cloud companies typically use cheaper, lower-margin CPUs than typical enterprise customers.

This margin sacrifice is necessary in order to keep AMD and ARM-based chips from gaining any significant server market share. Intel's data center group is a bright spot for the company, and Intel expects revenue to grow by 15% annually in the long-term. This likely hinges on the company's chips powering the growing data centers of the big cloud companies, and Intel is making sure that happens. The CPU is one area that companies can't really skimp on, and Intel offers superior performance-per-watt compared to the alternatives.

The bottom line
Much like the PC market, the server market is becoming one where the companies that actually manufacture the servers make very little money, while Intel manages hefty margins. Given HP's reliance on server profits, I don't see a path to growth for the company any time soon. IBM's shift away from hardware is serving it well, and a declining hardware business means little for its bottom line. Intel has serious competitive advantages in the server chip business, and those should allow the company to continue to dominate the industry.

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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 December 11, 2013, at 9:19 AM, techy46 wrote:

    Intel will benefit from SoC engineering were more and more IP is embedded on the System on Chip package. This is true in classic OCs and servers but could also be huge in mobile markets. In reality a mobile device is nothing more then one SoC, SSD, logic board, battery, touch screen and case. All of the other discrete chips are almost gone. What if Intel followed Apple and vertically integrated devices?

  • Report this Comment On December 11, 2013, at 9:34 AM, Momintn wrote:

    Deutsche Bank has IBM on their list of 5 tech companies to buy for 2014. IBM’s income statement shows they make increasing billions in net income every year.

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