IBM's Deal Makes Sense Now and in the Future

IBM's deal to sell off its x86 server division will help the company improve margins and be more competitive in pricing, but the real test comes with what the company bets on in the future, and cloud services is one of those bets.

Jan 30, 2014 at 10:00PM

For the fourth quarter of 2013, IBM (NYSE:IBM) saw its systems and technology division revenue decline by 25%. It was not that big of a surprise, then, when the company announced last week that it was selling its low-end server unit. While this sale is not a retreat from the hardware business, it is in keeping with IBM's long-term move toward emphasizing software and services.

The deal will help improve margins and streamline the company's hardware business, but the true test of success will be where IBM puts in resources going forward. One area that could prove successful is the hybrid cloud.

Hardware decline
IBM is selling its x86 server business to Lenovo for $2.3 billion. The cash is not a huge positive for the company, given that it reported free cash flow of over $8 billion for the fourth quarter. But, IBM is getting rid of a low-margin segment.  

The low-end server business is the second-largest component of IBM's systems and technology group. That group saw fourth-quarter gross margin of 38% and a PTI margin of 4.7%. Compared to the 90.5% gross margin and 47% PTI margin of the software group, it's clear that IBM's margins will get a boost.

Higher margins can help software and services pricing
Higher margins will help IBM be more competitive in pricing its software and services. This will give IBM a competitive advantage over rival Hewlett-Packard (NYSE:HPQ).  

Hewlett-Packard continues to struggle with low margins, and these low margins put further pressure on its enterprise and services divisions. Without selling off some of its low-margin hardware business, Hewlett-Packard will likely continue to struggle, allowing IBM to take a larger lead.

IBM's future in the cloud
While there are several areas that IBM expects to take off in the near future, one of particular interest is the hybrid cloud. This past summer, IBM announced its latest cloud acquisition, SoftLayer, making the company's commitment to the hybrid cloud clear. 

The strategy behind the SoftLayer purchase was to build-out public cloud infrastructure. Combined with IBM's existing private cloud infrastructure, the company becomes one of the leaders in hybrid cloud services. This allows customers more freedom and flexibility in choosing between high-performance data access and secure private storage.

The hybrid cloud market is growing, and some analysts predict that, by 2016, it will become the largest sector in the IT market. There are several competitors to IBM in this area.

Microsoft (NASDAQ:MSFT), arguably, leads the way in hybrid cloud development. While still being somewhat behind in the cloud market, Microsoft made a commitment to the hybrid cloud roughly two years ago and has built out a massive public and private infrastructure. For this reason, the company's Azure offerings will capture a good share of the growth going forward, particularly if, and when, clients move toward more private offerings. 

Compared with Microsoft, Amazon.com's (NASDAQ:AMZN) Web Services has long been a leader in cloud computing. But, the company has resisted the private cloud and, thus, hybrid services, believing that most enterprises will most likely stick to public offerings. This puts Amazon in disagreement with what many analysts are predicting.

If Amazon is correct, it will continue to be a dominant player in the cloud market. If the company is wrong, a large opportunity exists for competitors like IBM and Microsoft to find enormous growth.

Conclusion
IBM has improved its position by selling off its x86 server unit. As a result, the company will see rising margins and will be in better position to compete on price in its software and services divisions.   

But, the future of the company depends on its focus going forward, which currently appears to be the hybrid cloud. There is potential for good growth in the future if mid-size and enterprise customers move toward private cloud offerings and adopt the hybrid cloud. But, if customers remain with public offerings, IBM will further cede ground to Amazon in the cloud arena. Investors should watch this area very closely.

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William Alder has no position in any stocks mentioned. The Motley Fool recommends Amazon.com. The Motley Fool owns shares of Amazon.com, International Business Machines, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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