Summary
IBM has been in trouble for some time with declining revenue and market share. Comparing to ever more innovative products from cloud computing and mobile companies, IBM’s mainframe and traditional software never seem so obsolete. However, the belief that IBM is a technology company is fundamentally misplaced. Almost all of its profits are somehow related to consulting services. The main drive behind its profit, the deep knowledge of different industries, has not changed. Although IBM is late to the cloud and mobile, that is always the case for past several generations of technology. It is amazing for this company to constantly earn +$10bn when they do not get the technology right. Currently, you can buy this stock with 11x PE on the do-not-get-it profit. With the help of recent transformation to better integrate cloud computing, the true value and earnings power of its deep industry knowledge will be gradually reflected in the market price.
A consulting rather than technology company
In the Enterprise IT space, there are many ways to make money but most can be categorized into three segments. The first two are providers of hardware or software as a function. The third is a consulting firm that helps customers integrate and create business value. The general perception is that IBM makes money from technology products. However, a detailed look will reveal that IBM is more like a consulting company rather than a technology provider. Considering that part of IBM’s software sales were also a result of the consulting projects, a big part of IBM’s profit depended on consulting and integration.
Figure 1: Industry breakdown
Source: Company data
IBM makes money from its industry knowledge
The business model change in IBM can be traced back into 1990s’. The strategy to create value as an integrator rather than a provider was set during the time of Louis Gerstner. In his book, he mentioned:
“Sure, there are supply chains, and there are enterprises at various points in the chain that offer only one piece of a finished product: steelmakers in the auto industry; component makers in consumer electronics; or providers of a marketing or tax application in financial services. But before the components reach the consumer, somebody has to sit at the end of the line and bring it all together in a way that creates value. In effect, he or she takes responsibility for translating the pieces into value. I believed that if IBM was uniquely positioned to do or to be anything, it was to be that company.”
Unlike software or hardware companies who just provide functions to the customers, IBM developed most of its solution with the biggest companies in the world. During this process, it accumulated the knowledge of how the actual business works. This knowledge does not show up in any financial statements, but it is the real building block for the whole company. I would argue that customers pick IBM not because the products are better, but because IBM knows how business works with technology. Among system integrators, IBM has the biggest market share covering almost all industries.
Why IBM is not growing
The main reason that IBM makes money in the past is because it knows how to integrate, not only its own products but also others’. The rapid growth in the cloud computing market is definitely a shock to IBM’s traditional business model. The small and medium size companies now purchase individual software functions like CRM or HR from cloud computing providers at a very low cost, creating a boom in the market where IBM is not presented yet.
Figure 4: Business model difference
Source: Company data
IBM was never supposed to directly compete with those software providers. But as an integrator, IBM was not able to leverage its vast industry knowledge base to create integration solutions for smaller companies. There are several factors that contributed to this: 1) IBM’s mind set of creating complete solution to big customers. Its old business model was not able to incorporate the new cloud computing platform; 2) IBM’s organization that was slow to adopt new technology. This is not the first time when new technology forced IBM to change; 3) Smaller customers that are more focused on gaining access to IT infrastructure that they cannot afford previously rather than building a strategy around IT.
Market misconception about IBM
Despite lagging in the cloud computing, IBM’s most important competitive advantage, the deep knowledge of industry, has not been weakened. It enjoyed margin expansion as an integrator because of a lower input cost (software and hardware). While market thinks that IBM is only for big customers, the industry knowledge can be applied to smaller companies. But acquisitions are not the way for IBM to figure out how to serve smaller customers. The buyback was actually a better reinvestment at current stage.
- Declined price in software/hardware lowered IBM’s cost
If you think of IBM as an integrator, the current cloud computing products become part of its input. The rapid price decline of software and hardware is a big contributor to the margin expansion in recent years. Moreover, the fast growing earnings (or may be just revenue) in software industry can be delusive because of the intense competition and price decline. But it is much harder for competitors to accumulate the knowledge about industries.
Figure 5: IBM service revenue vs. margin
Source: Company data
- Potential growth from serving smaller companies
Thanks to the fast growth in low cost cloud computing services, smaller companies had the chance to use more sophisticated software functions. Some companies are using Salesforce.com for CRM, Workday for HR and some online database for transactional data. Each service is easy and cheap enough on standalone basis, but the customers can definitely get more from an integrated point of view with those existing systems. The fragmented services and a large customer base have created a perfect environment for future integration and business value creation. The growth rate of IBM’s Strategic Imperatives will be an initial sign of whether IBM can get it right.
Figure 6: Growth from IBM’s Strategic Imperatives
Source: Company data
- Buy back is the appropriate choice for now
Buying one cloud computing provider to enter the market cannot help IBM release its underutilized industry knowledge. It is up to IBM itself to figure out a profitable way to provide integration to those small and medium size companies. So when it is still trying internally, buyback is an ideal way to compound return. It is true that IBM needs to invest more on the business, but small acquisitions they made in recent years should be enough to help understand the economics and customers behind the new technology.
Figure 7: IBM’s use of cash vs. EPS
Source: Company data
Conclusion
If you just look at the current earnings and growth trajectory, IBM will never seem to be an attractive investment. But if you think of it as the biggest technology consulting company and an integrator, its accumulated industry knowledge is clearly underutilized and undervalued. The potential market size can be huge considering the fast expansion of fragmented cloud computing services among smaller customers. Current valuation of 11x PE on below-normal earnings can be very attractive to the investors in the long term.
Figure 8: Comps within IT consulting and outsourcing segment:
Source: Company data
Value Pie 