IBM: Big Blues

I was reading “The Intelligent Investor” the other day and in it Benjamin Graham describes IBM as a “wonderful performer” in the Introduction chapter. Given that my edition was from 1971, it got me wondering whether this 47 year old investment advice still holds. On the other hand, Mark Cuban famously said in 2014 that “IBM is no longer a tech company”. What did he mean by that, was he right, and more importantly, is IBM still a wonderful performer?

A quick reminder of IBM’s glorious history

IBM is an old company by any standard, and in computer history terms, it’s a bona-fide dinosaur — they existed before the first electronic computers. In fact, it is so old that there is a very long wikipedia article dedicated to its history. To name a few notable achievements in company’s history, before giving us the PC in 1981, IBM practically invented mainframes, helped land humans on the moon, controlled the Space Shuttle, invented relational databases, the first optimizing compiler, and launched the first commercially available laser printer (which to be fair, was invented by another IT industry dinosaur — Xerox).

IBM’s business transformations

IBM had to keep reinventing itself to avoid the fate of dinosaurs as technology kept changing, and it’s been quite successful at that. They successfully transitioned from mainframes to personal computers in the 80’s, pivoted out of commodity hardware (disposed of the printer business in 1991, personal computer business in 2004, x86 servers in 2014) into business services (boosted by the 2002 acquisition of a part of PwC Consulting). This transition is illustrated by the following chart:

IBM Revenue Streams: “sales” means software & hardware revenue, “financing” is the revenue from extending loans to their customers to purchase IBM products/services. Compiled from IBM Annual Reports.

However, they seem to have missed two major opportunities in the IT world at the beginning of the 21st century — cloud and mobile. To address that, IBM launched new “strategic imperatives” in 2012, that include analytics, cloud, cognitive (IBM’s generalization of the term “AI”), social & mobile, and security.

IBM joined the cloud game through the SoftLayer acquisition in 2013, and on the mobile front tried to get a piece of the “business apps on iOS” market, but not to much success. The 2016 annual report merely mentions the mobile business as growing, but no specific numbers are given (accounting rules require separate disclosure of any substantial business segment which implies mobile is not a substantial business). Cloud is reported as bringing in $10.2 billion in 2016, but it should be noted that roughly half of it ($5.6B) comes from “foundational offerings — where the company provided software, hardware and services for clients to build their own clouds.” (IBM 2016 Annual Report, p57). They’re essentially building clients’ data centers and count that towards their cloud revenue.

On the artificial intelligence (AI) front, IBM was an early player in the market — they famously beat Kasparov at chess in 1997, and won Jeopardy in 2011. From then on IBM heavily invested in turning Watson into a business-friendly AI platform by investing in Watson Health (medical decision support), Watson IoT (Internet of things big data analytics platform), and Watson Platform (a data analytics platform). According to the 2016 annual report, Health is the strongest focus in this area with IBM employing over 7,000 people on Watson Health.

While it has been rolled out to dozens of hospitals worldwide as of end-2016, it’s success does not seem certain — one would expect skyrocketing revenue if the solution outperformed doctors in a significant way.

Is IBM still a wonderful performer?

After going through a decade of slowly growing revenues in the early ’00s, IBM posted revenue loss for 22 consecutive quarters, returning 2016 annual revenue slightly below the 1998 level. The management seems to have managed oscillating revenues well as earnings nearly tripled from $7,524 million in 2002 to $22,540 million in 2012. This was probably one of the reasons why Warren Buffett, well known for avoiding tech stocks, invested in IBM back in 2011.

Why are revenues falling?

IBM’s two main revenue streams, sales and services are falling since 2011 (although services seem to have slightly recovered in 2016). This can be explained by the changing IT landscape in the past seven years: companies are rapidly moving their data centers to the cloud (which isn’t powered by IBM hardware), and require more IT consulting in areas (like user experience design, mobile apps, and digital marketing) where IBM doesn’t have a significant skill set.

IBM recognized this and reacted by building it’s “digital economy” know-how by starting it’s own digital agency: IBM Interactive Experience in 2014, which it boosted by a series of acquisitions — from 2015 until 2017 they acquired six consultancies. That could be what Buffet was referring to when he said that “IBM is a big strong company, but they’ve got big strong competitors, too” after selling roughly a third of his stake in 2017.

Is Cuban right?

Cuban’s bashing of IBM can likely be summarized with the following excerpt from the 2013 annual report

In the 14 years from 2000 until the end of 2013, IBM generated roughly $165 billion of cash flow, 81% of which was returned to shareholders through stock buybacks and dividends. Add to that $32 billion of acquisitions in the period, and you get an understanding of what Cuban was referring to — IBM has been reacting to the market changes (as opposed to changing the market as they used to) by buying market players in areas where they are weak.

Regarding stock buybacks, they had a proclaimed goal of hitting a specific earnings per share figure by 2015, so one can see how Cuban thinks that IBM’s management is focusing too much on their shareholders instead of focusing on their customers and competitors. That could explain how IBM’s management missed the mobile, cloud, and AI opportunities described above.

Looking at revenue per employee performance metric, IBM lags in revenue per employee against its competitors like HPE, Amazon, and Microsoft, although they’re still ahead of pure services companies like e.g. Accenture. This explains why they want to move significant parts of their workforce oversea to cut costs — they expect the trend to continue.

Conclusion

As stated before, in the past decade IBM’s management focused too much on their investors instead of on company growth. As a result, they missed a lot of opportunities since 2005:

• Who else could have sold the cloud to enterprises (while it was still considered “unsafe”) if not IBM?
• Similarly, who else could have sold mobile apps, design thinking, and all modern “digital trends” to big enterprises if not IBM?

Still, not everything is gloomy. The services business seems to be half way through the “digital transformation” (I know, it sounds strange to think of IBM as needing digital transformation, but they do. Maybe “modernizing” is a better word?), their services backlog is still very healthy (more than two years worth of at the 2016 pace), and mainframes are apparently still a thing (most of their Q4 2017 growth actually came from the mainframes). So, IBM is likely here to stay. And despite what Mark Cuban says, they are still at tech company.

There are even a few “moonshot” opportunities for growth in IBM:

• Watson could still turn out a success. After more than three years “in production” that does not seem likely though — Google seems to be the key player in AI, with AlphaGo, TensorFlow, and Cloud AI APIs. They also started experimenting in the health sector.
• Blockchain opportunities through their Hyperledger project (for example, they recently signed the Maersk deal)
• They still seem to be a key player in Quantum Computing

There is a big if around all items on this list, so growth for IBM, even in the long term does not seem like something worth paying for a lot.