How IBM's Strategic Transformation Will Pay Off, Eventually

International Business Machines is in transition. After spending years atop the technology hardware industry, IBM suddenly found itself in a precarious position. As the hardware industry crumbled, IBM was forced to switch focus. As one of the biggest companies in the world, IBM can't just change its business model overnight, which has made this a difficult and costly process. 

While IBM's financial performance last year was disappointing, the company deserves credit for sensing troubles in the hardware industry early on, and for being proactive about it. Management is taking the right steps now to ensure prosperity going forward. As part of its projections, IBM has vowed to earn $20 per share in profits by next year. If the shift in focus pays off, the company shouldn't have a problem reaching its goal.

An aging company gets a makeover
IBM is undergoing a huge business shift, which is challenging in many ways. First, IBM is a very mature company; it is more than a century old and holds a market capitalization of nearly $200 billion. No company can turn on a dime, especially one the size of IBM. In addition, its strategic initiatives have a heightened risk profile because IBM operates in the technology industry, where the operating climate changes very quickly.


Nevertheless, management is fully committed to steering the ship in a new direction, and strategy makes perfect sense. For years, IBM was known as the king of computer hardware. But, management read the writing on the proverbial technology sector wall, which said that hardware was not the future.

In response, IBM has decided to become more of a technology consulting business, with a particular lean toward the cloud and software-based services. Since 2000, the percentage of IBM's profits from software and services has steadily increased, while the percentage from hardware has steadily declined.

For example, 85% of the company is now geared toward high-value services and software, with hardware comprising only the remaining 15%, resulting in higher margins. In fact, IBM's pre-tax margin has more than doubled since 2000, from 10% to the current 21%.

The road map to $20 EPS
Throughout this process, IBM has maintained its forecast to earn at least $20 per share in profits by next year. The first part of this equation will be to restore revenue growth, which is where its massive investments in new services come into play. Hardware is a shrinking business, evident by the fact that IBM's systems and technology segment, which houses hardware operations, posted a nearly 19% revenue decline last year. This made it the worst-performing segment for the company by far.

In contrast, IBM is seeing success across several software and cloud-based initiatives. Business analytics revenue rose 9% last year to $15.7 billion. In addition, Smarter Planet revenue jumped 20% and cloud revenue hit $4.4 billion, up 69%.

Another piece of the puzzle is IBM's strong share buyback program. Since 2000, IBM has spent $108 billion buying back its own shares. This has gone a long way toward boosting EPS, since fewer shares outstanding results in higher earnings per share. This was especially true last year. Even though IBM's revenue dropped 4.5%, earnings per share actually increased thanks, in no small part, to IBM's $13.8 billion in share repurchases.

Slow and steady wins the race
On the surface, IBM's results are not impressive. But, IBM is undergoing a massive strategic shift that has been very costly and time-consuming. The simple reality is that the technology landscape is rapidly evolving, and IBM's transition is a necessary, albeit painful, response to changing business conditions.

Although the benefits may be difficult to see right now, IBM and its investors will be better off down the road. Even though IBM is still being weighed down by its collapsing hardware business and the restructuring costs associated with its turnaround, the company is seeing tangible benefits in its software and cloud-based products and services. Focusing on those key growth areas, along with strong share buybacks, will propel IBM to its long-term earnings goal.

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The article How IBM's Strategic Transformation Will Pay Off, Eventually originally appeared on Fool.com.

Bob Ciura has no position in any stocks mentioned. 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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