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Summary

  • The sale of the servers business shows the direction of the management's vision.
  • The investments in the cloud segment will be hugely beneficial in the long-term.
  • The focus on the high-margin segments will drive the profitability of the company.

International Business Machines Corporation (NYSE:IBM) has had a good start to the year - the stock is up about 4% year-to-date. When we talk about the stock performance of IBM these days, it should be kept in mind that the stock will not show large price swings due to the changes going on at the company. Over the last twelve months, the stock has lost more than 7%, so a gain of about 4% might not look like anything special; however, it does indicate that things are going in the right direction. The company has made some changes in its product mix by letting go of its x86 server to Lenovo (OTCPK:LNVGY). The deal will allow the company to get out of the highly-competitive market of servers and focus on other segments. We believe that this step of the company would improve its overall profit margin.

Getting Rid of The Low-Margin Segments?

IBM has adjusted its strategy by letting go of the businesses which offer low margins. The company announced its plans to sell its x86 server business unit in January 2014, which is now approved by the Indian authorities, as India is an important market for Lenovo; this approval was important for the company. IBM will sell this business unit to Lenovo for roughly $2.3 billion dollars. IBM will receive $2 billion in cash, and the rest will be paid in the form of Lenovo's stock. The X86 server business unit was not bringing considerable profits to the table; during the last year, this segment brought in $4.6 billion in revenues, and the company struggled to break even in the segment. The cash coming in from the deal can be invested in the business units which offer greater profit margins. The company can also use this cash to buy back shares or give an increased dividend. In addition, the deal includes all the assets and employees associated with x86 server. This will decrease the salary and maintenance cost of the company.

Another reason why letting go of x86 server is the increasing competition by the new entrants. IBM's position in the servers business was very strong in the past, however, the dynamics of the business have changed drastically over the last few years. The servers are now becoming smaller and less expensive due to increased competition. Furthermore, the introduction of software based solutions has hurt the business heavily. Companies like Google (NASDAQ:GOOG) and Facebook (NASDAQ:FB) do not even buy servers from other manufacturers; these companies now make their own servers.

Furthermore, Severgy has recently come up with an x86 based power server with a remarkable hardware. The margins were already low in this business segment, and the increasing competition would have made it even more difficult for the company to survive. The structure of the deal indicates that IBM expects Lenovo to get better value from the business; a portion of the price will be paid in Lenovo's stock, which shows that IBM management believes there is a chance of Lenovo's stock growing in the future.

Potential in Cloud

IBM has recently announced its plans of investing $10 million in the New Zealand market to cater to the needs of private organizations as well as public sector agencies. Previously, IBM announced that it will expand its footprint in cloud computing worldwide by investing $1.2 billion. As I mentioned above, the company is focusing on high-margin segments, and the Cloud computing is one of the fastest growing businesses in the world. The investments in this segment will go a long way in enhancing the margins of the company.

Towards to end of the last year, cloud computing security services market was expected to be worth $2.1 billion, while this year, it is expected to reach $3.1 billion dollars. According to McKinsey&Company, the annual economic impact of cloud computing will be in the range of $1.7-6.2 trillion by 2025. There is no doubt that this segment will be hugely important for the company over the next few years. IBM expects to generate around $7 billion dollars of revenues from cloud computing services. Given the track record of IBM and the investments being done, we believe the target is achievable.

Conclusion

IBM's strategy to improve its profitability is working out, and it is apparent in its recent moves. Firstly, the strategy of the company is evolving to keep an optimum product mix with high profit margins. Secondly, the company is making high-margin investments, i.e. cloud computing, which is expected to grow tremendously over the next few years. Moreover, the company has already made huge cost cuts, and plans to continue to do so until it reaches a billion dollars in cost reductions as discussed in our previous article. We believe that these factors will contribute to better profitability in the coming quarters.

Source: IBM Is Making All The Right Moves