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Another Perspective

The Gerstner Comparison

IBM has vowed to boost pre-tax earnings per share above $20 in 2015, a big jump from last year's $15.25.  It expects it will hit this target even though its revenue may be 4 percent lower in 2013 than in 2012 and 6 or 7 percent below that of 2011.  Basically, IBM believes it can continue to improve the quality of its results even if it fails to boost profit quantity by keeping downward pressure on costs, upward pressure on margins, eluding competition and repurchasing shares to shave its EPS denominator.

IBM's EPS Plans
IBM has built a strategy that aims to deliver
earnings per share above $20 in 2015

IBM has done all of this for two decades, and its strategy generally produced excellent results.  But for the past year or two IBM has run into headwinds.  The outcome has been unsatisfactory, at least as far as investors are concerned.  Shareholders are disappointed with IBM's reduced revenue even though they are pleased by its sustained profitability.  These investors worry that other companies have keener insights into the future shape and direction of technology markets, foreclosing IBM's new opportunities and displacing its past accomplishments.

Customers are uncertain, too.  They fear that IBM's efforts to adapt to changing conditions may result in changes to its products, pricing, and policies that will put them in a corner.  To be sure, customers with a strategic dependence on IBM products and services want IBM to return to growth.  They want Big Blue to attain this growth by reinvigorating legacy lines of business even as it moves into new markets.  They have long since adjusted, perhaps reluctantly, to IBM's withdrawal from the market for clients and for many peripheral devices, reducing its role to that of a supplier of servers and storage subsystems.

But now they see something different, something unsettling in IBM's behavior.  IBM is becoming a substantial buyer of X86 servers and a reseller of cloud services based on these machines rather than its own proprietary computers or its own engineering interpretation of industry standard X86 hardware.

Customers have been rattled by IBM's decision to invest billions of dollars in SoftLayer and use it to supplant its SmartCloud services even as its sales force tries to promote IBM's own systems as the basis for customers' computing facilities.  Investors see the same dissonance and come to the same conclusion: IBM doesn't believe it can be successful if its remains confined within its current range of offerings and it does not believe it can create new products and services to expand organically.

IBM apparently sees its best opportunities, perhaps its only opportunities, in services based on equipment and know-how outside its range of competency.

Even if IBM has made a brilliant choice identifying SoftLayer as a company that has a superior cloud computing platform and the skills to support it, it might have erred in acquiring it.  It remains to be seen whether IBM can properly manage this company.  If IBM has made a multi-billion dollar mistake, outsiders who uncritically admire IBM will be late to see it and company insiders who have excessive faith in their top management will stay the course wherever that leads.  On the other hand, critics who rush to find fault in IBM's execution may well regret their haste.

IBM segments 9 months
The 2013 Story So Far
IIBM is having a difficult year and is scrambling to produce
a blowout fourth quarter .  .  .  if it can.

The situation seems to boil down to this: If IBM's future depends on the company transforming itself by acquisition and subsequently finding new markets, it must be sufficiently deft to keep its legacy customers mollified for a few more years as it builds what amounts to a new company.  If IBM's legacy customers bolt, even if they flee to one of the new IBM units, the old IBM may not be able to shed the burden of high fixed costs that it now can shoulder without difficulty not scale back production in a way that preserves profitability.

Even before IBM's overt efforts to transform itself became so visible, strains were showing.  IBM's hardware operations reported a 25 percent decline in pretax income for all of 2012.  For the first nine months of 2013, IBM's hardware operations shrunk by 15 percent and ran into the red by more than $700 million.

IBM's software and services operations seem to be in better financial shape than its hardware business.  And the company is very optimistic about its new activities such as the expansion into cloud computing.  The upshot is that customers and investors focused on the new parts of IBM imagine a bright future and have a lot to be happy about.  Those who believe Big Blue must cling to the old portions of its empire, at least for a few years, fear the old businesses will collapse; they don't have much to be cheerful about right now.

The optimists would win the battle for investors' faith and customers' loyalties if they could prove that IBM has what it takes to build up its cloud computing business the way it grew its more traditional services during the past two decades.  But there is a huge difference between the conditions under which IBM built its services business into an empire with well over $50 billion in annual revenue and the situation the company faces as it pursues a cloud services market that could be as large or even larger.

IBM segments 2012
Not A Difficult Comparison
Investors should be easy to please as they compare
this year's results to IBM's achievements
to an unimpressive 2012

When IBM began building its services business twenty years ago, typical enterprise computing shops were spending about 30 percent of their budgets on hardware, a similar portion on software and the remaining 40 percent on personnel including consultants and other outside advisers.  IBM saw that hardware was becoming cheaper faster than most customers were growing.  Software was still growing, in part because customers were demanding more from systems, middleware, and comprehensive application suites, but the growth rate was modest.  (There were exceptions, such as the rapid rise of SAP, and other comprehensive applications cultures, but IBM didn't have any winning horses in that race.)

However, if IBM could replace customers' programmers and software consultants with its own people, its total business opportunity would grow.  Customers' expenditures would shift from their own personnel budgets to IBM's.  Over time, IBM could replace most services staffers in high-salary areas with personnel based in Asia, improving margins and giving IBM opportunities to win deals with aggressive pricing when there was no alternative.  IBM had the managerial skill and corporate discipline to manage this type of services business to yield good financial results while maintaining its reputation for competency.

The key to IBM's early success in services was that nature of its competition.  IBM's services business didn't compete with other services companies like EDS.  IBM's competition was the in-house IT department, and in instance after instance IBM overwhelmed this adversary.  These days the enterprise services business is mature, and IBM is more likely to compete with other services companies like Infosys and Tata than with homegrown IT departments.  The traditional enterprise services market has become huge.  IBM is its most formidable participant.  Investors and customers alike are generally pleased by IBM's success, and by every indication traditional services will be a steady, profitable business for IBM now and in the foreseeable future.

The cloud business is another matter entirely.  It is not based on activities already performed within enterprise computing departments.  Some of the best prospects are companies with growing IT budgets, but they are not the old line industrial, financial, and governmental entities that IBM has served throughout its history.  Instead, they are often young companies using computers to support interactions with customers, particularly customers using mobile client devices.

IBM doesn't have the pricing power in cloud services it has in the enterprise services market.  But that doesn't mean it lacks advantages.  The IBM brand is quite valuable.  IBM's wealth provides assurance to companies concerned about the business risks, real or imagined, that might accrue to a less successful cloud services supplier.  And users who want to move work from in-house IBM systems to a cloud supplier will be inclined to talk to IBM first, even if they also consider other service providers.

Nevertheless, investors are skeptics.  They will want IBM to prove it can succeed in cloud services before they give Big Blue shares a boost based on projected profitability.  Prospective customers will similarly want to go with IBM if it looks like a winner, but not if it seems to be groping for a valid business strategy.  IBM has to prove its acquisition of SoftLayer is a better for everyone--customers, investors, and IBM itself--than the poorly executed SmartCloud adventure.

Among other things, IBM will have to boost the size of its cloud services business by an order or magnitude, from the single-digit billions range into double digits.  It was able to do this pretty quickly in traditional enterprise services.  Thus the company's history shows it can do a terrific job building out a new business segment.  But today's IBM has yet to prove it has the commercial capability it enjoyed in the 1990s, after the arrival of Lou Gerstner and before the detonation of the dot com bomb.

The company's current management has one big advantage and one big disadvantage compared to the situation faced by the Gerstner regime.  The advantage is that IBM is a much stronger company now than when Lou Gerstner came to Armonk.  The disadvantage is that Gerstner had an easy act to follow.

— Hesh Wiener November 2013

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