Given the stresses and strains on IBM's (NYSE:IBM) operating model, a day of reckoning appears to be fast approaching. It won't be the end of the company per se, but it'll be the end of their business model as it's currently configured. The company reports earnings one week from today (July 17), and if it's anything like the Q1s report, shareholders should brace themselves. It could get ugly.
In Q1, as you may recall, IBM missed earnings expectations for the first time in eight years. If it hadn't been for a fortuitous change in the estimated tax rate (cough), the earnings miss would've been 34 cents (instead of 5 cents). The more important metric is sales. Sales declined 5% in the first quarter, a dramatic drop when you consider two-thirds of IBM's revenue base is recurring.
Revenue is the key metric to watch in next week's report. Unless IBM can generate top-line growth and soon, management's plan to reach $20 in earnings by 2015 falls apart.
How Did IBM Get Into This Mess?
As I suggested in an article last December ("Is IBM In Trouble?") and again in April ("IBM: A Disaster In The Making"), IBM is the victim of a massive paradigm shift. The IT industry is moving toward lower cost, off-premise, multi-tenant computing architecture (known as "the cloud"), and away from capex-heavy, on-premise computing. IBM will make a lot less profit in the cloud -- which is why the company is straddling the fence, trying to embrace the low-margin cloud while defending a declining high-margin legacy business. It's not a workable strategy, and someday soon IBM management will have to take a "time out" (i.e., pull earnings guidance) to craft a strategy more appropriate to the environment.
The biggest problem facing IBM right now: The model is not designed to deal with a rapidly changing environment. It's not built to adapt and innovate. It's geared to meet quarterly earnings targets, aided by aggressive cost cutting and share buybacks.
By the way, don't presume IBM can acquire its way out of its predicament. Companies positioned for the IT industry's paradigm shift to the cloud are crazy-expensive. IBM paid five times revenue, or $2 billion, in a recently completed acquisition of SoftLayer, a mid-tier cloud company that will generate about $400 million in low-margin revenue this year. The elite companies in the space, such as Workday (NYSE:WDAY) -- which won't be profitable for years -- are priced at more than 10 times forward revenue.
A Future Without High-Margin Models?
We are hurtling at warp speed toward an ultra-high-speed fully connected world, and it has all sorts of interesting implications for operating models (and, hence, for investors). The new economic ecosystem will be tighter (think one marketplace, increased homogeneity) flatter (fewer intermediaries), and more transparent. Most competitive advantages (there are many types, such as location, logistics, brand, design, etc.) are sure to diminish -- everybody knows each other's business, copying and emulating are easy -- while other competitive advantages (such as scale) will increase in importance.
Thinking out loud, it's easy to imagine a future where high-margin models like IBM's are rare, if they exist at all. In the new ecosystem (a fully connected world), high-margin models will be difficult to defend. The takeaway for investors: All things being equal, market leaders with low-margin operating models have a wider moat.
Take Costco (NASDAQ:COST), for example. Anyone can copy Costco's model, but why would they bother? Invest a boatload of capital to make 2% on sales? It's just not going to happen.
It's sort of ironic, isn't it? All things being equal, models that make less are safer than models that make more. IBM has been a fascinating case study, but most of my time is devoted to models I'm interested in buying. (If you're looking for a stock idea or two, check out my recommendations and performance here.)