There have been some recent articles arguing that IBMis a bad investment, and that earnings and revenue are about to fall off a cliff. The ironic thing is that while I agree with several of their premises, I think they are quite wrong with their conclusion. Critics are probably right that a cloud will eventually dominate over private data centers. It is also probably true that building and servicing private data centers will become, in the not too distant future, a negative growth industry. Although it will very likely take a decent amount of time to completely fade away. A key point however, is that unlike industries with high fixed operating costs like airlines where a small decrease in volume can quickly turn to losses, in the case of private data centers lower revenue will probably translate to lower earnings and not to losses (as long as the business is properly managed). If earnings from some of these main businesses are properly allocated to key growth areas in a smart way the company can successfully transform itself while providing a good return for shareholders.
The figure below shows the financial roadmap presented by the company at a recent investor presentation. One thing that jumps out immediately is how software is becoming increasingly important. Another impressive point is the amount of money IBM is planning to return to shareholders in the next few years. This shows management is very shareholder friendly, professional, and doing proper planning on capital allocation.
There are three main arguments against IBM fading away:
A) It is positioning itself to be a leader in future trillion dollar industries
A lot of people saw Watson on Jeopardy beat the human champion and thought it was a nice experiment for IBM, but that it wouldn't really have a meaningful impact on its business going forward. The truth is IBM is not investing huge amounts of money just to amuse some TV viewers. In reality the company is planning to use these really smart cognitive computers as a business service. Ginni Rometty, IBM's CEO, said in a recent interview that "...Watson's a service; we will launch an ecosystem where Watson's a service and you build applications around it".
If you are wondering what types of services she is talking about, think about all the possibilities that are suddenly opened with a machine having some decent cognitive abilities, plus the ability to take into consideration huge amounts of information. For instance, it might be able to diagnose patients, recommend movies or books after having a small conversation with you, or make weather or economic predictions. An interesting article on Watson mentions that "IBM said early on that health care is a field where it anticipated commercialization opportunities for Watson. Other markets IBM is eying include online self-service help desks, tourist information centers and customer hotlines."
B) Unparalleled distribution and disciplined M&A
In many cases growth through acquisitions can be a red flag. There are a huge number of examples where a company spent a lot of money in a flashy acquisition just to take a huge write down a little ways down the road. Some of the most recent ones include HP's (NYSE:HPQ) huge write down of its Autonomy acquisition. There are also some serial acquirers like Yahoo! (NASDAQ:YHOO) that have managed to evaporate money at record speeds (think Flickr or Geocities).
So why would it be a good thing that IBM is spending so much money in M&A? For one thing they have been much more disciplined and strategic with their acquisitions. They buy at prices that make sense, companies that have valuable IP, and most importantly, that IBM can quickly scale through its huge international distribution network. This is very similar to how some big pharmaceutical companies leverage biotech acquisitions. In an interview Ginni Rometty explains the process in detail:
Instead of making direct investments in companies, you guys work closely with the VC industry. How does your strategy work?
Let me share with you kind of what we look for and why when we look at an acquisition, because it's a vital piece. In fact, it's so important to how we think of remaking the company, we actually commit over a period of time. We do something called a roadmap, it's a financial roadmap. And the five-year roadmap that started a couple of years ago ends in 2015. We've said we'll acquire $20 billion of companies. So, we're pretty clear about what are the areas I talked about some that we're focused in. So where we'll do acquisitions, they're adjacent. They'll always cluster around strategic areas. The second, they'll typically always be intellectual property. I've got a distribution system that goes to 170 countries. If I acquire properly, you know, you may be successful in one or two countries, or one place; I can scale, and that's part of the value that IBM brings.
C) Very attractive growth initiatives (e.g. Smart Planet)
There are several important growth initiatives already generating very significant amounts of business. Two of my favorites are Smarter Planet and Business Analytics. Through Smart Planet IBM is helping cities operate more efficiently, make better use of resources, and help improve the lives of people. This division has been able to secure big contracts from several governments around the world. Business Analytics on the other hand is all about helping business gain insights to compete more effectively and better serve their customers. Finally, as a smart company IBM is leading, instead of resisting, the change into Cloud and the Next Generation Data Center.
This shows how much they have changed the culture. They have learned not to be a product company. They define themselves now as an innovation company. In the mentioned interview, Ginni Rometty gives a very interesting answer to the question on how she thinks about the company:
Fortune: IBM was once about mainframes, and then PCs and printers. Now IBM is about services, software, Watson. How do you think about the company?
Rometty: Two years ago, IBM had its 100th anniversary, which is when people asked that question the most. And I think one of my biggest learnings has been, never define yourself by a product. I would like us to be thought of as an innovation company. The only way you survive is you continuously transform into something else. It's this idea of continuous transformation that makes you an innovation company.
While the critics are probably right about the decreasing importance of the private data center, they are likely failing to see all the growth vectors the company has. It is making smart acquisitions, and investing huge amounts on R&D (to the tune of 1.6B per quarter). IBM can be compared to a pharmaceutical company undergoing a patent cliff of a few blockbuster drugs, but with some very promising new products in the pipeline, and with a very powerful brand and distribution system. At a TTM P/E of 14 it might not be a steal, but it could certainly be a very decent long-term investment.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.