Why IBM Doubling Down on Hardware Is the Wrong Course of Action

IBM will invest $3 billion over the next five years to develop more efficient microprocessors, just when everyone thought it was getting out of hardware. Here's why this decision might backfire.

Jul 14, 2014 at 1:00PM

International Business Machines (NYSE:IBM) management has pledged to produce $20 per share in operating profits by the end of next year. That would represent 23% growth from its profits last year. To get there, management is counting on continued cash flow from its new areas of focus such as cloud-based services, as well as aggressive cost cuts and billions of dollars' worth of share buybacks.

IBM is also making an aggressive push back into hardware. It announced that it is going to invest $3 billion over the next five years to expand the research and development of chips. The company will try to find a way to build smaller, more efficient chips that are capable of delivering faster connections. This is a clear attempt to inject life back into its hardware group, which has struggled mightily for several quarters in a row as technology hardware more broadly appears to be in structural decline.

Of course, it's worth noting that IBM's strategic initiative isn't without its challenges. It's about to go up against some established competition from the likes of Intel (NASDAQ:INTC). Intel has been making the same innovative push into smaller, more efficient chips for some time now.

As a result, IBM seems like it's heading into a crowded field. It previously signaled a desire to sell off underperforming hardware units, but is now backtracking on that.

Is the investment going to be a poor allocation of shareholders' money?

Doubling down on hardware
IBM's problems in its hardware business are plain to see. Revenue in the systems and technology group fell 23% last quarter. Meanwhile, other non-hardware-related segments are performing relatively well. IBM is growing nicely in middleware. Revenue from WebSphere grew 12%, while revenue from Tivoli software increased 7%.

IBM is doing some great things in cloud solutions. Cloud revenue jumped 50% last quarter. For cloud delivered as a service, the company reached an annual run rate of $2.3 billion, which doubled year over year.

Given the intense decline in technology hardware and the relative success of its other businesses, IBM's decision to double-down on hardware is curious to say the least. Management seems to be fighting against the current in its efforts to get its hardware business growing again. A better strategy might be to simply continue selling off hardware assets, which it's already proven a willingness to do.

IBM plans to sell its X86 server business to Lenovo Group Limited (NASDAQOTH:LNVGY) for $2.3 billion. That seemed like a signal that it intended to gradually get out of hardware, rather than plow additional resources back into a business in decline.

IBM trying to conquer unfamiliar territory
The goal for IBM is to try to develop smaller chips in terms of nanometers, but that's an endeavor fraught with difficulty. Even Intel, the largest semiconductor company in the world by sales, is having difficulty in its own chip-shrinking ambitions. Intel's latest development was the ability to shrink its microprocessors down to 14 nanometers, a 36% reduction in size from its previous microprocessors. Even it has hit a wall and has had to delay completion of the initiative, however.

Developing new processor capabilities and building semiconductor facilities are time-consuming and extremely costly to do. If IBM wants to get serious, it likely will have to go beyond a few billion over five years, which means it's got to be sure of what it's about to do in order for investors to have patience.

Investor confidence won't last forever
Keeping investors' faith will be difficult, especially considering IBM's whiffs over the past couple of years. Its share price badly underperformed the overall market's robust gains last year and the company is simply losing momentum. Total revenue fell 5% last year, and it's off to an equally unimpressive performance in 2014.

The fact that hardware was the major contributor to its woes while non-hardware businesses thrived, especially since IBM wants to divest considerable hardware assets, makes its $3 billion investment a curious one. If it's going to hit its future earnings projections, it needs to make sure this investment doesn't backfire.

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Bob Ciura owns shares of Intel. The Motley Fool recommends Intel. The Motley Fool owns shares of Intel and International Business Machines. 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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