IBM (NYSE:IBM) is like Japan. Both have their own, distinctive cultures that value conformity and technical prowess. Both are known for their rigidity and hierarchy. And both react to structural change in a way that this author terms "the earthquake model."
The earthquake model of structural change implies a slow build-up of tension, which causes no noticeable difference for years, followed by a sudden, disruptive shift. Japan has experienced political and economic earthquakes many times in its history, and, interestingly enough, so has IBM.
Lou Gerstner's tenure as CEO (1993-2002) marks a notable IBM earthquake. The company, which had been the nearly uncontested leader in the tech world for decades as a producer of mainframe computers, PCs, and consistently unexciting but functional software, nearly went bankrupt before Gerstner transformed it into mainly an IT services firm.
The ground is again moving under IBM's feet. Pundits claim that the present changes could be the end of Big Blue. Will the company's edifice remain standing when the shaking stops?
IBM is in the midst of an earthquake, but the cause of the Tech firmament's movement has an ethereal name. It is the transfer of storage and computing power onto the Internet commonly known as The Cloud.
The linked Wiki article provides much more in-depth information about the Cloud, but for this report, we will assess its probable effect on each of IBM's three main business lines: Hardware, Software, and Services.
Before going any further, let's take a look at the most recent levels of annual revenues and profits for each of these lines:
Figure 1. Source: IBM financial statements, YCharts Research analysis
After noting that Hardware (including Financing) represents only 7% of IBM's after tax profits, let's take a look at how the shift toward the Cloud has the potential to affect IBM's hardware business.
The first problem is that the servers used for Cloud implementations-termed "x86 systems" from the Intel chips that power most of them-are generic and commoditized. As anyone who has taken an Economics course knows, it is hard to differentiate oneself or extract outsized economic rents from a generic, commoditized business.
To avoid getting caught up in a commodity price war with other makers, IBM announced it would sell its x86 business-probably worth somewhere around $3 billion in revenues per year-to Lenovo in January of 2014.
The second problem of cloud computing from IBM's perspective is that, because so many people are shifting to the Cloud-renting computer power rather than making capital expenditures-the relative importance of the market for owned machines and the dollars spent on them is shrinking.
Pedants may take umbrage, but I'm going to call these machines "UNIX servers" because UNIX is the operating system that most of these high-end computers run. IBM is the dominant force in the UNIX server market, with nearly 60% market share (Oracle (NASDAQ:ORCL) is the runner up with only mid-teens percent market share).
The effect of the shift to the Cloud has been visible in IBM's hardware segment revenues over the past several years.
Figure 2. Source: IBM financial statements, YCharts Research analysis
Part of the notable decline after 2011 is due to the fact that IBM hemmed and hawed about selling the business since 2012, and this caused some client flight.
Due to the sale of the x86 business to Lenovo, IBM's revenues will shrink by around $3 billion this year (all else held equal), which translates into a revenue growth headwind of around 3 percentage points. Profits in this business are low, so hardware margins will likely expand after the sale.
IBM probably makes about $7 billion in revenues from the UNIX market. This line (along with the line for storage devices) is facing Cloud headwinds, so around 7% worth of IBM's total revenues is likely to be a drag on growth. Let's say that 7% of revenues shrinks by 5% per year for 5 years; the total effect on IBM's top line will be a drag of less than half a percentage point per year.
IBM's consulting business is inextricably tied to its hardware business. According to my friend, who is a retired executive of an IBM Consulting competitor, one of IBM's sales strategies has been to bundle its hardware, services, and software products together in order to make direct price comparisons between competitors more difficult. An IBM salesperson anxious to seal a services deal may be able to sweeten the offer by packaging in some cut-rate hardware or software, for instance.
IBM's sale of its x86 server business to Lenovo might make these kinds of packaged deals more difficult, and may cut into the services business. However, the majority of IBM's consulting (help desk staffing and technology outsourcing) does not depend on hardware sale (otherwise companies like Infosys (NASDAQ:INFY) and Wipro (NYSE:WIT) would be severely disadvantaged and they are not).
The bit of IBM's consulting that is tied to hardware sales (technology implementation and integration) is mainly tied to the UNIX business that IBM is planning to hold onto. This is business like building out a new Enterprise Resource Planning (ERP) system using SAP (NYSE:SAP) software or installing a new Oracle accounting database. Despite what bubbleheaded pundits in the financial press may say, companies like Salesforce.com (NYSE:CRM) and their Cloud-based products are not driving the big software companies out of business. Granted, consulting on multi-million dollar ERP implementations is not a rapid growth business, but mid-single-digits is probably a pretty good ballpark guess.
Because of IBM's packaging strategy, it is harder to know what the ultimate impact of the Cloud will mean for IBM longer term. It could mean lower revenues on the technology outsourcing side, but again it might mean that profitability increases if the lost revenue is relatively low-margin business.
Look back at the pie charts above showing the proportion of revenues generated by each of IBM's business lines. Are your eyes drawn to Software?
With a 27% share of revenues but a 48% share of profits, it is a natural place for a profit seeking executive to focus; indeed, the new CEO of IBM, Virginia "Ginni" Rommety, is betting big that software is where her company's future lies.
Thanks to the ubiquity of mobile communications, widespread use of the Internet, and increasing transaction volumes online, the amount of data generated in a single day is staggering. But data is meaningless without the ability to gather it together, interpret it, and transform it into information.
IBM has a strong position in what is termed middleware-software, which allows data from different systems to be shared (where it can then be aggregated and reported on). In addition, it has spent years working in the field of artificial intelligence in the form of its Watson project, and is claiming that Watson is on the verge of being able to be commercialized (e.g., helping doctors diagnose illnesses, helping financial advisors structure portfolios, etc., etc.).
While indirect, this is one way that IBM may be able to profit from the earthquake of the Cloud.
In addition, over the past few years, IBM has been buying smaller companies with Cloud technology and know-how. A recent Bloomberg article laid into IBM for having lost a Cloud computing contract for the CIA to Amazon.com but, for whatever it is worth, IBM has just begun to cobble together its Cloud capability, mainly through these kinds of acquisitions.
This author is actually more circumspect about IBM's ability to generate returns for its owners by the direct provision of Cloud services. Amazon is already an enormous player in this field and other powerful players like Google (NASDAQ:GOOG) and Microsoft (NASDAQ:MSFT) have more experience than IBM in Internet technology and Cloud provisioning. Each seems to be intent upon winning market share through price cutting, and this is a scary dynamic for a late entrant to the field like IBM.
In this author's opinion, if IBM can parlay its advances in AI, its strength in middleware, and develop some technical competence in Cloud technology (to make more credible bids for private clouds like the CIA deal), it will probably be better for shareholders than if it were to get into a slugfest with Internet titans to provide Cloud services more broadly.
What's Not Moving?
Even during an earthquake, there are some things that don't move around too much. The same is true for IBM during the present Cloud shake-up.
IBM's immovable hardware market is that for mainframe computers-likely worth around $5 billion per year in revenues. In this niche market-made up of clients who are mainly governments, banks, and educational institutions-IBM holds a near monopolistic position, and it is tough to see this position changing quickly if at all.
Mainframes can be used to power the same kind of processes that UNIX and x86 servers carry out, of course, but their security, stability, and computational power means that most often, they are employed in highly critical situations (such as preparing statements for investment banking clients and counterparties or analyzing data at the Internal Revenue Service).
This is not a mass-market, of course, and because one main customer group is governmental agencies, fiscal shortfalls (like those in the U.S. and Europe in the aftermath of the financial crisis) can depress demand. Demand also depends on the product cycle-if you are planning on spending millions of dollars on a mainframe system, you're likely to hold off if you know a newer model will be coming out soon.
Despite these characteristics, the mainframe business is a wonderful one for IBM. Not only are customers relatively price-insensitive, but the products that this hardware is bundled with-both consulting and software-are lucrative and long-lived. From a customer perspective, there are not many other choices, the costs of switching are large, and the benefits of switching uncertain. Truly, this is one case in which the old maxim that you can't get fired for buying an IBM holds very true, indeed. This is almost certainly one of the features that attracted Buffett to make his 2011 investment of around $11 billion in the firm.
A lot of pundits have been critical of the steps IBM has been taking to meet the financial goal Sam Palmisano set for his successor in the CEO spot, Ginni Rommety: generating $20 per share of operating profit by 2015.
One of the ways in which Rommety has moved the firm closer to the $20 per share goal is by reducing the number of shares outstanding using share buybacks. And while many observers, including the Oracle of Omaha, love the effect on their shares of a company buying back shares, one of the unintended consequences of their doing so is a rebalancing of a firm's capital structure.
Issuing debt to buy back shares-what IBM is, in practice doing-means that the firm become more and more highly levered. Leverage can increase profitability during good times, but it is a double-edged sword and can injure just as surely as it can help.
We can see the step-by-step increase in IBM's leverage ratio during each CEO's tenure over time in the following graph.
Figure 3. Source: IBM financial statements, YCharts Research analysis
Increasing leverage means that a company can generate progressively higher ROEs even as return on assets stays the same. However, it also means that the cushion of equity that protects shareholders from shocks due to business downturns gets thinner and thinner.
Leverage is a problem if a company runs into the kind of a business issue that makes it unable to service its debt. To analyze how severe of a problem IBM's leverage was, we looked at the amount of long-term debt a company holds versus the amount of cash flow from operations it is generating.
Figure 4. Source: IBM financial statements, YCharts Research analysis
This graph is shocking when one considers that the present relationship of debt to cash flow from operations is even higher than the level when IBM was at risk of going bankrupt (1992-1993).
However, looking only at Cash flow from Operations implicitly ignores the shift of IBM's business away from capital-intensive manufacturing toward capital-lite services.
To look at this, I compared IBM's long-term debt to its Owners' Cash Profits. OCP deducts an estimate of maintenance capital expense, so takes the requirements of maintaining the capital assets of the company into account. Here is that graph:
Figure 5. Source: IBM financial statements, YCharts Research analysis (one year's data deleted in the interest of clarity)
There is a bit of an uptick at the end, but this graph certainly does not suggest that IBM is in imminent danger due to its leverage level.
This author is extremely cautious about leverage and believes that it is crucial to look at the effects of a company's operational and financial leverage to understand the potential effect on valuation. Starting from a position of extreme suspicion and worry about the degree to which IBM's leverage has increased over time, this author has at last come to peace with this aspect of the company, thanks mainly to Figure 5.
All of these factors combine together to paint a mixed, though not pessimistic view of IBM as an investment candidate. See our full report, which offers a transparent, data-driven valuation for the firm (email registration required).
IBM's Historic Bets
In 1964, IBM was in danger of becoming a footnote in the history of business and computing; within a decade, it was the most important computer company in the world.
In 1992, IBM was in danger of going bankrupt; a decade later, it was a beacon of strength and sanity in the Tech sector.
Both of these transformations were enormous, surprising, and hinged on a big, risky bet (System/360 mainframes in 1964, Services in 1992).
After seemingly standing still for so long as competitors moved into the cloud, the ground is now shaking below IBM's feet and it is in a position where it must make another bold and risky bet. If history is a guide, a decade from now, we will be looking back at another example of its grand transformations.
 Leverage ratio = Total Assets / Total Shareholders' Equity
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.