25% of International Business Machines Should Scare Investors!

While IBM's fundamental performance in the second quarter may seem improved, its continued weakness in hardware and especially servers leaves a major hole in its investment outlook.

Jul 21, 2014 at 2:30PM

International Business Machines (NYSE:IBM) exceeded low expectations with its second-quarter earnings as the company continues to shift from an on-premises IT focus to the cloud. However, significant weakness in 25% of its business continues to have a fundamentally crippling effect, especially when peers Hewlett-Packard (NYSE:HPQ) and Cisco (NASDAQ:CSCO) are thriving in these businesses. Nonetheless, should this weakness in 25% of IBM be reason enough for investors to avoid the company?

Which 25%?
IBM's considerable weakness in hardware is no secret to investors, as it's a problem that has been well documented for more than a year. The rise of cloud computing has seemingly replaced the need for certain hardware, and IBM has made investments that have cannibalized much of its hardware business.

In recent quarters, IBM has seen year-over-year losses in excess of 20% in its hardware segment, which unfortunately accounts for 15% of its total business. During its second quarter report, however, hardware actually saw some improvement, as its 11% sales decline was viewed as a positive.

Therefore, with expectations already low for hardware, investors don't seem too concerned with its lack of performance. However, the company's continued problems with servers is a major problem as it's this business that helps connect IBM's other products and services to its enterprise clientele.

During the second quarter, servers saw a whopping 28% sales decline over last year. This segment alone accounts for 10% of the company's total revenue. Combined with hardware, IBM has a major problem: 25% of its business seeing double-digit losses and major market share losses.

Servers are the lingering problem
While 10% of total revenue may not seem like a big deal, for IBM it's over $9 billion worth of revenue and a segment that creates recurring business that is highly profitable. The problem for IBM is that top technology peers like HP and Cisco have penetrated this market with success and are in the process of creating a strong footprint with enterprise clients. With these clients electing to use Cisco and HP's servers, Big Blue is put at risk of losing business in other key segments like storage, chips, and even mainframe sales.

With that said, IBM's second quarter results in servers gives investors an initial glimpse at what should be a continued trend in the server space. During the first quarter, IBM's server business saw a 25% decline in revenue to $2 billion, which consequently cost it a 600 basis point decline in overall market share to 19.1%.

While IBM hurts, others thrive
HP's 2% decline in server revenue was equal to the overall industry's performance. The company finished the first quarter with $2.9 billion in revenue from servers, or more than 10% of its total revenue. While not a growth industry, HP's success and leading market share of 26.5% has undoubtedly helped the company to thrive in other key industries such as enterprise PCs, which saw a 12% boost during the last quarter.

Clearly, HP's success in servers has helped its overall business. However, the real beneficiary of strong server performance has been Cisco, a company that has taken the market by storm. Cisco is relatively new to this space, and server sales account for only 5% of its total revenue.

However, its UCS server offers improved performance with both the deployment of applications and scalability versus older servers. As a result, its revenue soared 37% during the last quarter to $617 million, gaining it 170 basis points of market share to 5.7%.

While servers are still a small piece of Cisco's fundamental pie, it has helped drive the performance of data center switches, which is conveniently another weakness of IBM. Granted, neither HP or Cisco have announced second-quarter earnings, but if the first quarter's performance and IBM's second quarter server sales are any indication, both HP and Cisco are sure to gain even more market share while growing stronger in key businesses like enterprise PCs and switches that consequently hurt IBM.

Foolish thoughts
With all things considered, it's interesting to see the correlation between IBM's weakness in servers and how its peers are stealing market share and outperforming it in other key businesses. IBM is a company with a fundamental weakness that has almost grown accepted on Wall Street. As it continues to suffer in key industries, the company's fundamental outlook will remain challenged. Meanwhile, Cisco and HP are both trading near 52-week highs. As they become more dominant in this key industry, investors should feel confident in their long-term prospects looking ahead.

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Brian Nichols has no position in any stocks mentioned. The Motley Fool recommends Cisco Systems. The Motley Fool owns shares of 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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