Why IBM's End Could Be Near

IBM is having a rough year , producing a negative 6% return so far. The company had a wonderful come-back in the 90s thanks to its cost reductions and shift toward software and consulting, which led to amazing financial performance for a decade.  And since 2002, revenue, gross profit, and operating profit have compounded at annual rates of 3%, 6%, and 12%.

However, the current situation is totally different. IBM may need a transformation and reengineering of its business. According to many IBM fans, that shouldn't be a big problem because IBM has been able to change several times in the past: this is just another time. Bears, on the other hand, keep reminding us that this time is different. What kind of future awaits IBM shareholders in the short and long run?  


Is IBM's end near?

In the first quarter of 2013, for the first time in 8 years IBM missed earnings expectations: sales declined 5%, posing a strong risk to IBM's long-term business, as two-thirds of its revenue base is recurring.

Full-year earnings guidance of $16.70 were just $0.07 below the consensus. But these $0.07  reflected long-term changes in the main markets IBM addresses: a contraction in global demand for IBM's high-end systems & hardware, and growth limits in the private cloud computing segment. These long-term trends started hurting IBM's cash flow already in 2009 and the $0.07  should have been seen as the beginning of a series of disappointments and pain for shareholders. 

Unfortunately, the second quarter results did not show the kind of substantive change that investors were looking forward to. IBM did beat the consensus by a tiny margin.

That was just not enough.

Analysts had kept estimates low but their expectations were actually higher: they tacitly were expecting a major change in business focus, which did not seem to happen. As a result, institutions from Credit Suisse to UBS downgraded the stock. It's simple to understand the downgrades: margins were down 3% from last year. The elephant is spending the same or more money, but making much less than before. 

Source: IBM Investor Relations, Press Release 

Now, similar results coming from other companies in the software and services sector, like Oracle , show that the whole industry is in trouble. But to make matters worse, IBM still has 34% (hardware + System Z server sales) of its revenue coming from the commodity-like hardware segment, which is even riskier than the services segment, because of increasing competition from Intel's cheap machines.

Wrong focus?

In "IBM: The End Is Near" investor Arne Alsin identified a massive paradigm shift as the root of all of IBM's problems. The industry is moving to the public cloud: low-cost yet powerful computing architecture. IBM's main products (e.g. System Z and private cloud solutions), on the other hand, depend on the old paradigm--the private cloud, a soon-to-be legacy business.

Competitors

Oracle is the perfect example of a competitor in the software and services sector. Specifically, in the middleware market, competition between these two giants is fierce, with IBM owning roughly one third of the whole market.  Oracle is also having a tough time trying to keep revenue growth alive. In the latest quarter, new software licenses and cloud subscriptions fell 2 percent to $2.3 billion.

The upside for Oracle is that the company is the leader in the database field. Selling databases to customers is the entrance to selling them systems, infrastructure, software, etc. And as long as Oracle keeps its leading position in the database world, it will not lose its power.

Unfortunately, cloud computing is also a strong risk for Oracle's business, but the company could adapt itself to the new paradigm better than IBM. For example,  it has already been taking advantage of the new shift by providing support of legacy applications to companies that are in the process of moving to the public cloud. If you want to know more about Oracle's cloud challenges, check outmy previous article on Oracle.

In the hardware field, competitor Intel remains a strong value investment, despite a terrible year in terms of stock performance and disappointing dividends. Intel's server and high performance computing business segments are experiencing mild growth. The problem with Intel, though, is not the data server business, but the fact that revenue is too dependent on a shrinking PC market. In 2012, Intel reported full-year revenue of $53.3 billion, of which $34.4 billion (roughly 65%) came from the PC client group and only $10.7 billion (21%) came from the data center group. That being said, Intel also has plenty of upside potential. The company hasn't lost its R&D focus and keeps launching new architecture every 2 years or less: the new "Haswell" architecture maximizes power efficiency and could boast sales. Its  current P/E ratio (12.1) also makes Intel an attractive stock.

Final foolish thoughts

I agree with Alsin in the sense that the demand for expensive, multi-million dollar systems (let them be private clouds or something else) is contracting. Companies are moving to the public cloud instead. Expensive frameworks and commodity-like x86 servers are becoming endangered species.

That being said, I also don't want to underestimate the ability of IBM to change its business radically. Big Blue has done it several times. The latest time was when it exited the PC business in 2004 by divesting its PC unit to Lenovo. This was done 2 years after HPQ acquired Compaq and at a moment where the PC business was still strong. The elephant prioritized the sustainability of the business rather than meeting the street consensus for the next quarter.

A similar strategy and radical changes of focus are in great need again. This goes beyond acquiring companies with strong exposure to the public cloud (IBM recently acquired SoftLayer for $2 billion, 5 times revenue).

Finally, there will always be demand for expensive private clouds, for institutions willing to pay 100% more in price for an additional 5% safety improvement. What IBM needs to do is to reduce the exposure to such business, as soon as possible. In the meanwhile, the safety of having institutional clients and its vast resources will allow Big Blue to survive, but don't expect superb returns during the transition. It's gonna take a while, since it's just starting!

The article Why IBM's End Could Be Near originally appeared on Fool.com.

Adrian Campos has no position in any stocks mentioned. The Motley Fool recommends Intel. The Motley Fool owns shares of Intel, International Business Machines., and Oracle.. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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