I have not written about IBM (NYSE:IBM) for a while, but one of my recurring themes is IBM's wholesale transition from what was once the world's premier technology company (admittedly this was decades ago, but their relative and inflation-adjusted historical dominance is clear) into a financial engineering company. For students of the technology company lifecycle, they offer a fascinating career option for once-dominant companies.
This recent quote from a "former IBM exec who spoke on the condition of anonymity" prompted revisiting the company and again asking some questions about their business model and future prospects:
"Realizing this, IBM's become a holding company of sorts, buying assets, integrating them and reselling them as an IBM brand."
"IBM does not want to fund its own development because past history shows we're not very good at it."
IBM has been a remarkably successful stock in recent years (and is about 12% of the gain propelling the DJIA to record highs since the 2009 low) and Wall Street loves the company as a result. Here are returns over the last five years:
Top line growth however looks more like the surf report for a birdbath on a windless day, even as the bottom line is up over 50% in the same period:
IBM's strong bottom line growth has come from cost cutting and financial engineering, not growth in the business. The strategy they laid out in 2007 has worked quite well in terms of profit growth. Like most technology companies, IBM has a "roadmap" of what they're going to do, but uniquely, it is a financial roadmap. Amid the roadmap's blizzard of numbers, revenue growth only merits some hand-waving platitudes. They skillfully focus on profit growth for each segment, obscuring the lack of overall revenue growth. And the billions of dollars in euphemistically described "enterprise productivity" savings have come from squeezing employees, curbing retirement benefits (e.g. shifting from monthly to annual 401k contributions) and moving offshore aggressively (IBM arguably now stands for Indian Business Model). Cringley has chronicled how IBM has become the poster child for cutting your way to prosperity at the expense of customers and employees.
Now Wall Street views technology companies through a different lens, as seen in this comparison of IBM and Microsoft when IBM eclipsed Microsoft in value as well as a recent explanation of the market premiums by a Wall Street analyst. While not quite as absurd as David Einhorn telling Apple how to run its business, catering to Wall Street has taken IBM to a different place than they'd go as a technology company left to its own devices. It isn't a coincidence each successive generation of powerhouse technology company is more open in its disdain of Wall Street. So while IBM's financial engineering strategy has worked brilliantly to date, there are questions about how much longer this strategy will work, much less provide superior returns.
Where is the Innovation?
"IBM does not want to fund its own development because past history shows we're not very good at it."
IBM is the perennial leader in terms of patents issued, garnering them a wave of beneficent press every year. But if we define innovation as requiring both invention and market impact, it is hard to point to a single, material innovation IBM has delivered in the 21st century. Things like Watson or the latest nanotechnology transistor advance are duly milked for PR, but they don't ever seem to turn into world-beater products that move the needle. When specific IBM patents are examined, they tend to be egregious examples of all that is wrong with the patent system and the company often finds itself magnanimously "contributing" what they had touted as great inventions to the public domain in the wake of backlash.
But the biggest innovation challenge for IBM, as we'll elaborate on below, is their also-ran status in cloud computing. My comments from 2008 still hold today:
Meanwhile, on a more serious note, timesharing is back with a vengeance yet there is no sign IBM has ambitions to be a major player in the cloud computing era. Instead they're fiddling with avatars while the on-premise business starts a long, slow burn. Where is the "one billion dollar" data center capex announcement that signals their ambition to play with the Amazons, Googles and Microsofts? Perhaps it is harder to make a "billion dollar" commitment when it requires real dollars as opposed to "soft" and/or exaggerated dollars? Or has IBM committed all its free cash flow to financial engineering, forcing them to watch the next generation of computing from the sidelines? Selling servers and consultants by the hour is a far cry from offering (anything)-as-a-service. In the cloud world, if you build it as a vendor, you also have to be willing to operate it at scale. And enterprise-scale is dwarfed by Internet-scale, so enterprise chops are not enough. Outsourcing "your mess for less" isn't a service. One can only speculate that virtual conference rooms in Second Life are inhibiting IBM's ability to define their strategy. I am still hoping they do OnDemand 2.0 and kill two birds with one slogan.
What about Cloud?
IBM's value proposition since Lou Gerstner brought the company back from the brink has basically been "we'll bring you up to average in IT" with IBM (human) services providing the glue to hold it all together (also known as "your mess for less" though it is intentionally really hard to tell whether the cost savings promised in the IBM sales spreadsheet actually panned out as promised).
We can argue about whether IBM offers IT capabilities at the 50th percentile (or 30th or 60th), but for roughly half of enterprises, IBM offered an improvement on what they could do themselves (and IT is arguably the opposite of Lake Wobegon - a land where everyone is below average. The challenge for IBM is cloud providers are more like 80th or 90th percentile (or higher) in their capabilities and have far better cost structures through software as opposed to busloads of consultants. The fraction of the market IBM can compete for will shrink due to cloud computing as complexity gets engineered out.
At the same time, the pendulum has swung away from outsourcing and in-sourcing now has cachet (perhaps in no small part to the quality of the outsourcing experience), which reverses the tailwind that has propelled IBM since Gerstner.
IBM has half-heartedly rolled out SmartCloud, which is at best difficult to understand (e.g. IBM's definition of self-service is very different than the rest of the industry and requires human involvement to process orders and/or conceal their offerings from critical eyes). Tellingly, their top level message around cloud is a vague plea for open standards which is typically the last refuge of scoundrels and the uncompetitive.
The chip guys used to talk about a "poker chip" which was the cost of a single fab. The cost of a poker chip went up with every generation and now runs in the billions. You need cash to play the game. For cloud, the poker chip is the cost of a cloud-scale data center, which can run into the hundreds of millions of dollars. At minimum, you need a few of them scattered around the globe. To cater to IBM's preferred kind of enterprise customer, you probably need more than a few to offer granular jurisdictional compliance. We see the pretty pictures of massive datacenters belonging to Facebook, Google and Microsoft, but where are IBM's poker chips? If you buy chips to play the cloud poker game, that money is not available for dividends or buybacks (and vice versa). You'd think IBM would be anxious to show the world vast structures stuffed to the gills with mainframes, demonstrating once and for all their claim that mainframes really are the best place to run the most modern workloads. Or maybe they just don't have them.
Some will argue there will always be room for integration between and on top of software services, but cloud leaders are ruthlessly removing humans from the nuts and bolts of IT operations. IBM lacks meaningful or competitive cloud technology assets and per the IBM executive above, they don't seem particularly confident in their ability to develop new technology. The other option is to "move up the stack" and offer business consulting, which is certainly the way IBM positions the company. But contrary to the story, IBM remains extremely exposed to menial IT functions that are disappearing in the cloud era. And their intense focus on cost reduction through off-shoring doesn't add to their business consulting skills. The rise of the cloud brings IBM's inability to innovate to the fore and poses a real threat to their current business model.
Where is the Thought Leadership?
One thing IBM has historically done pretty well is thought leadership. Particularly for a company of their size, they had remarkable discipline in aligning a sprawling empire (at least from the outside) top-down around a common story supported by strong advertising, marketing and top-down sales relationships. Their embrace of Java and then Linux/OSS felt like technology leadership at the time but in fact it represented IBM's outsourcing of technology leadership. They had moved from innovating to endorsing technology and felt comfortable in their ability to remain on top as an integrator of the piece parts. In fact, the more piece parts coming from different centers of gravity, the better for the consultant.
I believe OnDemand was a milestone in IBM's thought leadership history, It was obviously well before its time and presaged a lot of what we take for granted with cloud computing. My theory is IBM quickly discovered they were ahead of the market, and way, way, way ahead of their typical, lower percentile customers who just weren't going to be early adopters. So OnDemand quietly disappeared. Nor are there any obvious technology or product artifacts from the effort. I suspect they still have deep scars from the experience that are impacting their ability to wholeheartedly embrace cloud, even if they had the means to do so.
IBM's most recent storyline has been Smarter Planet and it is a different beast than former campaigns. It unambiguously puts a business value message first, and aims foremost at governments and those selling to governments. This was partly a reflection of the timing (it rolled out in November 2008, in the depths of the financial crisis) and IBM wanted to dine at the trough of government stimulus spending. But it is also also a reflection of the sophistication (or lack thereof) of the typical big IBM customer. Governments are rarely among the most able and discerning of IT customers (yes, there are lots of recent efforts to put a positive spin on their need to do better, but when you look at the lowest percentiles of IT organizations, lets just stipulate that governments are well represented).
Meanwhile, cloud computing has become the high order bit for IT today and IBM is hard to find. They're not only not shaping the discussion to their advantage, they're not really in the debate. Cloud leaders don't use IBM and if you want to seriously play in cloud, IBM is hardly going to make your list of strategic partners or suppliers.
Where is the Customer Success?
IBM does a great job with their advertising and customer case studies, which tends to mask the bigger question: where are the customers with a big IBM technology reliance who are leading their industries through application of technology? What disrupter relies on IBM for their technology and/or consulting services? Who is successfully holding off the disrupters and/or revolutionizing their industry using IBM technology or business consulting? Which of today's startups undergoing explosive growth have done it on an IBM platform? [Pause here and wait for the crickets].
With no offense to (NYSE:SRI) Lanka Bell ("a leading telecommunications service provider" and SmartCloud adopter) or the Memphis Police Department (who did some statistical analysis in SPSS), these are not world-beater customers doing breakthrough things with cutting edge technologies. Those IBM TV ads about Smarter Analytics are really about SPSS, a 45-year old product that IBM had to acquire? How many IBM "big data" case studies are running on good old IMS (which shares a birth year with SPSS)? Granted IBM does a nice job making its late majority adopters look good, but it is hard to find IBM customer examples that live up to the rhetoric.
Broadly, I am seeing much greater enterprise customer awareness of the deficiencies in their in-house and traditional outsourced IT capabilities. As technology moves into broad deployment across all industries, almost every company is now a technology company to a greater degree and has to compete against technology-based startups using 21st century technology. Om Malik makes this point really well by pointing out who is buying technology companies now; it isn't just other technology companies any more. And these are the companies who are IBM's traditional bread and butter customers.
As a result, there is a business imperative to "do better" when it comes to IT. Some companies are even asking how to walk away from all their IT investments, not because "IT doesn't matter", but because it matters so much and the current platforms are such a drag they see starting from scratch as the only option. It will be interesting to see if anyone pulls this off, or if it remains a material advantage for new entrants.
Critically for IBM, this mindset is taking hold amongst companies who historically lived the idea you couldn't get fired for buying IBM. They're actually concluding their IBM dependency might not just get them fired, but it could kill them. I remember visiting one household name a few years ago where they proudly showed me the building full of IBM consultants and the CIO responded to my "you have to get off the mainframe - you're stuck in the land that Moore's Law forgot" pitch with a retort that began with a patronizing "Son, there's something you need to understand…" That company has since seen the light and has decided IBM must play a far less significant role in their future if they want to stay competitive.
And when it comes to creating success for their customers, IBM's pure enterprise footprint looks like an ever bigger liability. They can talk about selling to Chief Marketing Officers all they want, but the reality is IBM can't bring hundreds of millions of customers to the discussion the way an Amazon, Apple, Google or Microsoft can who actually touch customers at scale and can bring that understanding and technology to bear for customers. Watson makes for a nice demo and game show contestant, but how does it really compete with Google Now or Siri in terms of reach (make your own WebSphere joke here) or even scale? The consumerization of IT as much as anything is the world moving away from IBM.
The Case Against IBM
That got really long. To summarize, the good times rarely last forever and IBM is unlikely to continue to outperform:
- Wall Street may love IBM (which is an indictment unto itself…) but mean reversion looks inexorable. IBM has put itself in thrall to Wall Street and achieved superior earnings growth through non-sustainable cost cutting and financial measures. What is good for Wall Street in this case isn't good for customers or the long term success of the company. Historically low interest rates have also been part of the IBM story (borrowing at a rate below your dividend rate to buy back stock is cash flow accretive) and that too will mean revert one of these days.
- IBM is a technology company that doesn't really innovate. Cost cutting only takes you so far; eventually it cuts muscle as opposed to fat. Real technology companies do actual (non-financial) engineering, but IBM has committed its cash to growing EPS. IBM doesn't even bother trying to tell a growth story (they should at least be able to grow with global GDP). Meanwhile, they have lots of legacy business at risk. In particular, IBM makes the bulk of its revenue from busloads of consultants and the plurality of its profits from the mainframe. And a rats' nest of a legacy software rollup doesn't make you a software company, investor relations slides to the contrary (are there any IBM software acquisitions that aren't in harvest mode and have seen material investment?).
- The company is missing the boat on cloud computing. IBM is largely an observer in the biggest trend in IT, which directly undermines the core of IBM's business model. And the legacy software acquisition model of the last decade will not work as well applied to SaaS applications - software services require on-going innovation, don't drag consulting to the same degree and the economics are not as accretive given the capex needs.
- The big industry trends are against IBM. Not just cloud, but also outsourcing swinging back to in-sourcing and the consumerization of IT. IBM is fighting these trends, not setting an alternative agenda.
- IBM's customers are in crisis. Historical affinities of even the most complacent customers will be put to the test in the face of existential, technology-based business threats. You can only paint laggards as technology leaders for so long and if the IT center of gravity is shifting from the CIO to the CMO, IBM's lack of consumer assets or DNA hurts them relative to the competition.
Originally posted here, on Platformonomics.com, on March 30, 2013.
Disclosure: Ironically, I am long IBM, though not by any action on my part, and have been too lazy to do anything about it. This post hopefully will motivate me to rectify that. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.