Do Not Be Fooled By IBM Cloud Contract Announcements

| About: International Business (IBM)
This article is now exclusive for PRO subscribers.

Summary

IBM is signing "baseball" contracts, using length to increase the apparent size of the deals.

These are "outsourcing" contracts, not real cloud deals. They are replacement revenue.

To grow IBM needs to create new markets, not serve its old markets for less.

If you read the tech media (or company PR) today, you might think IBM (NYSE:IBM) is on the comeback trail.

"IBM Signs Multi-Billion Dollar Cloud Computing Deal with a Dutch Bank." "IBM Signs 1 Billion Euro Contract With Lufthansa." "IBM Inks $1.25 Billion Cloud Computing Deal With WPP." It says "more are coming."

The problem is that these are baseball contracts. They're like the $325 million deal outfielder Giancarlo Stanton supposedly signed with the Miami Marlins last month. As Keith Olbermann noted of that contract, "It's a scam." The Stanton deal "averages" $25 million a season, but the Marlins are actually getting the slugger for a below-market rate of about $10 million for next year, and there are opt-outs - this agreement is unlikely to go its full 13-year length.

Length is the key to making deals look big, and length is what IBM has piled on to its latest "cloud computing" deals. The ABN-AMRO deal is for 10 years. The Lufthansa deal is for seven years. So is the WPP deal. More important, these aren't really "cloud" deals in the normal sense. These are outsourcing deals, just like the one recently signed with Reuters. They are not what they appear to be.

More important for investors, they are not material. IBM says it will have $7 billion in cloud revenue next year, but it admits over half will come from existing products that are shifted to cloud delivery. IBM is expecting $94 billion in sales this year - that is way down from last year. There is a reason for this. Contracts like the ones IBM just signed.

The whole point of cloud is that you're squeezing out costs. You're replacing purchases of servers and software with service leases, and as a client you are saving money. For the vendor, it means less income, even if you retain market share.

And IBM is not retaining its share in this market. Companies that were born in cloud, like Amazon.Com (NASDAQ:AMZN) and Google (NASDAQ:GOOG) (NASDAQ:GOOGL), are getting the biggest shares of the new market. For these companies this is incremental revenue - revenue on top of what they were making before. For IBM this is replacement revenue - revenue that replaces what they were making before. And there is less of it.

I would change my view if IBM were creating new markets through cloud technology. Contracts to manage factories and facilities, to integrate real products with the cloud to reduce service costs, to make street lights traffic lights instead of stop lights - these kinds of real "Internet of Things" contracts it puts in its TV ads would be game-changers, providing additional revenue. But if you're replacing one expensive method of outsourcing with another, cheaper method of outsourcing the net impact on revenue and earnings is negative, not positive. Don't be fooled.

Disclosure: The author is long AMZN, GOOG, GOOGL.

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.