IBM (IBM +0.98%) has had a rough 2014. Hardware sales have been weak all year and are only getting weaker, software and services revenue contracted in the most recent quarter, and companywide revenue is set to decline for the third straight year. IBM has abandoned its 2015 earnings goal of $20 per share, and the company expects earnings per share to decline in 2014 after an almost uninterrupted rise over the past decade.
It is easy to be pessimistic regarding Big Blue's future after considering its recent struggles, but 2014 has very much been a transitional year for the company. IBM sold off low-margin businesses, invested in growth initiatives, and laid off a significant number of employees. Let's look back at the difficulties IBM has faced in 2014 and examine what it all means for the company.
Hardware sales are falling off a cliff
Despite the word machines in International Business Machines' name, hardware has become a diminishing part of the business. In 2004, hardware accounted for about one-third of IBM's total revenue. By 2013, this percentage had fallen to just 14.4%, with software and services making up the lion's share of IBM's sales.
During 2014, hardware revenue declined across the board. Here's a summary of how each hardware product performed during the most recent quarter:
|
Hardware |
Year-Over-Year Revenue Change |
|---|---|
|
System z (Mainframes) |
(35%) |
|
Power Systems |
(12%) |
|
System x (x86-based servers) |
(10%) |
|
Storage |
(6%) |
|
Other |
(29%) |
Source: IBM.
Hardware has been the main reason for IBM's declining revenue over the past couple of years, and the company took two important steps in 2014 to fix this problem. First, much like it did with its PC business 10 years ago, IBM sold off its System x business to Lenovo. System x servers are powered by Intel processors, and there's very little differentiation between vendors. IBM has a history of divesting businesses that become commoditized, and its sale of System x continues this trend. This move will remove a few billion dollars in low-margin annual revenue.
The second move was to get rid of its semiconductor manufacturing operation. IBM paid GlobalFoundries $1.5 billion to take the unprofitable business off of its hands, and the company will now outsource production of its Power microprocessors. Semiconductor manufacturing is extremely capital-intensive, and IBM simply doesn't have the volume to make it profitable. Previously, IBM manufactured the CELL processor for the PlayStation 3, but with Sony moving to an x86 processor for the PS4, the business became a money pit for IBM.
System z, IBM's mainframe business, and Power Systems, its servers built around its Power processors, are the two most important hardware businesses left. While mainframe sales fell hard during the third quarter, sales tend to be cyclical, with each new release seeing a sales spike followed by a sharp decline. Many companies still rely on IBM mainframes, particularly financial firms, and the mainframe business remains strong for IBM.
Power Systems are a different story. Servers powered by Intel chips have largely become the standard, and IBM recently opened up its Power architecture as part of the OpenPOWER initiative in an effort to grow its Power business. IBM has teamed up with companies including Google and NVIDIA to create an ecosystem around its Power chips, and already the company has won a major supercomputer contract featuring next-generation Power chips and NVIDIA GPUs.
While hardware has been dragging IBM down, the worst parts of the business are now gone. IBM's mainframes and Power Systems are differentiated from the rest of the server market, and the mainframe business in particular remains a stable source of profit for the company. With IBM's Power architecture well-suited for Big Data applications, the future looks much brighter for IBM hardware than it might seem.
A software and services slump
IBM is the third-largest software vendor in the world, and its services business is its largest source of revenue and profit. These businesses have been growing slowly, but in the third quarter things took a turn for the worse. Both software and services revenue declined, and margins fell across the board. What's worse, the services backlog, which is an indicator of future services revenue, fell by 7% year over year to $128 billion.
This backlog decline suggests more pain is in store for IBM's services business, but a single bad quarter should not be taken as the beginning of a new trend. The rise of the cloud does threaten IBM's business, but the company is aggressively investing there to make sure it doesn't fall behind. IBM signed three high-profile multibillion-dollar deals within the last month, for a mix of traditional information-technology outsourcing services and cloud services, and this suggests the company's services outlook might not be as dire as it appears.
IBM's results going forward will likely be choppy, with the company navigating a market in which cloud services are increasingly in demand. What's clear is that IBM's bread-and-butter services business is far from dead. It is simply transitioning, and any transition will be messy in the short term. IBM's existing relationships with enterprise customers will be an asset, and while the services business could be pressured in the short term, I don't see any real reason to believe IBM faces an insurmountable challenge.
This was a year of change for IBM, and the next few years will likely be as well. The company shed low-margin hardware businesses, leaving only core segments in which IBM can claim an advantage. The company is embracing the cloud, and IBM's massive services business is adjusting, albeit in a somewhat painful way for investors. There's work ahead for IBM in 2015 and beyond, and while the market has punished the company for its disappointing results, long-term investors should take a serious look at Big Blue.
