IBM's Problems May Be Fatal

Aug.21.14 | About: International Business (IBM)

Summary

IBM has put itself into the high-end corporate niche, where profit margins are shrinking.

IBM may be failing within that niche.

Financial engineering will no longer cover it up especially if interest rates rise.

IBM IBM is trading below early 2013 levels and has lagged the S&P 500 throughout the recovery.

But things could be about to get a lot worse.

When I first started working on this piece I believed the problem the company faced was that it was aiming at the wrong customer set in the wrong way, and thus underperforming. Under Sam Palmisano and, now, Virginia Rometty, IBM has abandoned most consumer and small business markets in favor of serving large enterprises, where solutions are often customized and hard to replicate.

But if it's even failing in that niche it really has no place to go.

Sales for the June quarter of $24.36 billion, and net income of $4.14 billion, $4.12 per share. A better bottom line than last year's net income of $3.23 billion, $2.91 per share, but the top line was $24.92 million, higher than 2013's figure. IBM shares have been flat all year while those of Microsoft (MSFT) are up 41% and Apple (AAPL) 53%.

IBM has kept the stock where it is through financial engineering. IBM borrows money to buy back stock, which raises earnings per share. It costs it less to pay the interest on that debt than to buy the stock, thanks to low interest rates. If interest rates rise it's game over for that.

But veteran tech journalist Robert Cringely, in his new book, "The Decline and Fall of IBM", says the company is even failing within its niche.

"The company has probably been doomed since 2010," Cringely writes, "Customers no longer trust IBM to manage projects well, get the projects finished, or have the projects work as promised. IBM is now hard pressed to properly support what they sell."

The best evidence that Cringely may be right is the relative success of Hewlett-Packard (HPQ), a company once dead on its feet, which came in over estimates on revenues this quarter and has been modestly successful in making a transition to cloud. This could not have happened had IBM been running on all cylinders - there just isn't that much new business in this niche for that to be possible.

Even if IBM did not have internal problems, it would not be a buy. For years now it has been pushing "up the stack" in technology, doing increasingly large jobs for large clients. These just don't scale nearly as well as mass market solutions delivered by devices or the cloud. Write once and sell millions works better than write once and sell once. In its deal to sell Apple iPads it's IBM that will be doing the custom programming. Apple will mainly be booking profitable sales.

The most damning number may be this one, from CSI Monitor, IBM's revenue per employee. This was down to $227,883 in the last quarter and has been falling steadily. This has fallen to the bottom quintile of the S&P 500. While IBM could raise that through more layoffs, that's not a winning strategy in the long term. It has to get more sales to grow, not just shrink the payroll.

Growth comes from leveraging capital and leveraging people, and if your products are made by hand right now growth is not happening. And if you can't perform even within the hand-made niche, then you're in real trouble.

IBM turned 100 this year. Will it make it 105?

Disclosure: The author is long AAPL.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.