- Despite IBM’s efforts to achieve growth in next gen businesses, the decline in legacy system drags consolidated performance and could strain margins as Legacy business is the second most profitable one in terms of gross margins.
- Among strategic strengths that IBM possesses, its margins are superior to that earned by its rivals. This can provide sufficient buffer for IBM during new launches and periods of high cash burn.
- Part of IBM’s is to leverage on its cognitive platform, Watson and Hybrid cloud offering to boost its sales from analytics.
International Business Machines Corp. (IBM) (NYSE:IBM) is in the midst of significant changes as it finds new ways to tackle muted growth in its legacy hardware operations. The C-Suite headed by Ginni Rometty has taken quite aggressive steps by divesting unattractive businesses and charting a new course on high rewarding areas like analytics, cloud, mobile and security, with a strong emphasis on its cognitive platform, Watson. These areas are some of the fastest-growing in the industry and set the foundation for next-generation IT.
IBM’s new reporting format clarifies its areas of focus by grouping next gen businesses as “strategic imperatives”. These newer products now account for over a third of IBM’s total revenue and grew 12% year on year in 2Q16, but sequentially a tad lower. As these products become a bigger part of IBM’s total revenue, growth will likely stabilize at a higher level.
Legacy Decline More Than offsets Growth in Strategic Imperatives
As IBM shifts its focus toward emerging technologies, deemed “strategic imperatives,” sales growth has suffered and demand for legacy products remains depressed. IBM’s strategic imperatives include analytics, cloud, mobile, security and social. Analytics and cloud are two of the largest segments, expanding at 4% and 30%, respectively. Technology services and cloud platforms is IBM’s largest core segment, accounting for about 43% of total revenue.
The analytics and cloud segments are the primary growth drivers of these initiatives. However, the slump in consolidated revenues implies that strategic imperatives are not growing fast enough to offset weakness in legacy segments like Systems and Global Business Services. IBM states that it continues to see strength in the Strategic Imperatives, and in 2Q16, it delivered 12% revenue growth, led by cloud. Enhancing Service capabilities is also a strategic priority for IBM. Cloud-as-a-Service revenue was up 50% on a rolling year basis during the quarter, and posted an annual run rate of $6.7 billion ( which was up from $5.4 billion sequentially)
IBM’s margins have improved in the past decade as the company has increased the portion of revenue generated from its strategic imperatives: security, analytics, cloud and mobile. Margin improvement will continue to depend on customer adoption of these imperatives as legacy IT services, such as infrastructure outsourcing, face pricing pressure. Declining demand for software further exacerbates challenges. IBM has some of the highest gross margins in the industry. The company reported around 50% gross margins in FY15. This is largely driven by IBM’s software offerings. The level of margin that IBM earns compares favorably with some of its competitors. Cognizant (40%), Accenture (30%) and Hewlett Packard Enterprise (29%).
The Silver Lining
The Watson platform and Hybrid Cloud are what can be considered IBM’s economic moat in the industry. Analytics is a focus for IBM, generating about $18 billion in 2015 sales spread across services, software and hardware. In addition to traditional analytics products, IBM is making greater investments in cognitive computing with its Watson platform. Increases in structured and unstructured data combined with declining storage costs are driving growth. IBM has committed nearly half of its research spending to cognitive and analytics, which has exceeded $15 billion since 2010. IBM is also betting on hybrid-cloud services as a way to differentiate the company’s products amid a decline in public-cloud prices. IBM’s strategy focuses on connecting customers’ legacy IT systems to either public or private clouds. In addition to basic computer and storage services, IBM is marketing the company’s ability to integrate customer-facing cloud applications to legacy back-end systems as a unique component of its offerings. IBM has made several cloud-based acquisitions and has invested heavily in data centers to drive growth.
IBM is transforming itself from a traditional hardware, software and services company into a cognitive solutions and cloud platform provider. Going by investment patterns and signals from management, IBM has shifted its operational focus and is offering various analytics and cloud products in each of these segments. The Cognitive Solutions unit focuses on various security and analytics software products. The Watson product suite, a real strength for IBM and a USP, is part of this segment and analyzes unstructured data, providing insights across almost all industries.
In Global Business Services, the company is shifting its focus from legacy packaged software to cloud application deployment. Within Technology Services, IBM is focused on hybrid cloud products in addition to legacy data-center work, which remains under pressure.
Legacy infrastructure outsourcing has been under pressure for IBM and the rest of the industry for the last few years, which will likely continue as clients modernize their data centers. This decline is driven by a preference for software in the data center, cloud computing and competition from offshore vendors. If IBM could exploit this trend, strategic imperatives could clock enough growth to support legacy operations.
Investors must remember where this stock has come from (well north of $200 a share). Furthermore the decline in revenue over the past few years has had a lot to do with divestitures and not weakening fundamentals. We will watch this stock closely to see when it gives us an interesting setup.