IBM - International Business Machines

[NomadicRiley]

 

Please do not think I am just retrenching into my position and defending my thesis. I am going to do a bit more scuttlebutt as well.

 

Vinod

 

Vinod,

 

Thanks for the detailed response.  I agree that top executive statements often do not reflect the day to day reality and it is dangerous to rely on them.

 

That being said, I think we can both agree on these high level statements that relate to the challenges facing IBM:

 

* IBM's revenue growth has stalled

* A non-zero percentage of IBM's current revenue stream will move to the public cloud

* IBM is not a current leader in the public cloud

* The larger the percentage that moves to the cloud, the more difficult it will be for IBM to generate revenue growth

 

Note none of this makes any assumptions about IBM's valuation or what their stock will do. 

 

[rogermunibond]

Interesting podcast from a16z about the Dell-EMC acquisition that delves into cloud and who they think the winners will be.  They still think hybrid is the winner not public cloud.  Seems like CIOs are thinking that crazy cheap public cloud services are like teaser rates, intended to get you in the door and dependent, and then the rates rise.

 

http://a16z.com/2015/10/16/dell-emc-why-the-python-just-ate-the-cow/

 

 

[dwy000]

 

Please do not think I am just retrenching into my position and defending my thesis. I am going to do a bit more scuttlebutt as well.

 

Vinod

 

Vinod,

 

Thanks for the detailed response.  I agree that top executive statements often do not reflect the day to day reality and it is dangerous to rely on them.

 

That being said, I think we can both agree on these high level statements that relate to the challenges facing IBM:

 

* IBM's revenue growth has stalled

* A non-zero percentage of IBM's current revenue stream will move to the public cloud

* IBM is not a current leader in the public cloud

* The larger the percentage that moves to the cloud, the more difficult it will be for IBM to generate revenue growth

 

Note none of this makes any assumptions about IBM's valuation or what their stock will do.

 

Obviously Vinod will have his own thoughts but I'd just comment that while a number of the bullets above are true, you can also argue:

- IBM is one of the leaders in private and hybrid cloud (which for the top companies and IBM clients will arguably be more important than public cloud);

- moving to the cloud opens up new opportunities for analytics, big data, data discovery, etc. These are areas that IBM is driving hard towards.  AWS is cheap and wonderful for infrastructure but the value will ultimately be in the software and services that run on that cheap infrastructure.  There IBM (especially in its core markets) is well ahead and can leverage that to grow software and service revenues.

[NomadicRiley]

 

Please do not think I am just retrenching into my position and defending my thesis. I am going to do a bit more scuttlebutt as well.

 

Vinod

 

Vinod,

 

Thanks for the detailed response.  I agree that top executive statements often do not reflect the day to day reality and it is dangerous to rely on them.

 

That being said, I think we can both agree on these high level statements that relate to the challenges facing IBM:

 

* IBM's revenue growth has stalled

* A non-zero percentage of IBM's current revenue stream will move to the public cloud

* IBM is not a current leader in the public cloud

* The larger the percentage that moves to the cloud, the more difficult it will be for IBM to generate revenue growth

 

Note none of this makes any assumptions about IBM's valuation or what their stock will do.

 

Obviously Vinod will have his own thoughts but I'd just comment that while a number of the bullets above are true, you can also argue:

- IBM is one of the leaders in private and hybrid cloud (which for the top companies and IBM clients will arguably be more important than public cloud);

- moving to the cloud opens up new opportunities for analytics, big data, data discovery, etc. These are areas that IBM is driving hard towards.  AWS is cheap and wonderful for infrastructure but the value will ultimately be in the software and services that run on that cheap infrastructure.  There IBM (especially in its core markets) is well ahead and can leverage that to grow software and service revenues.

 

Yes - those are all valid arguments and there are many great opportunities for IBM but the question I keep coming back to is "then why isn't IBM able to grow revenue?"

 

Is it having trouble winning/leveraging cloud opportunities? 

Is the revenue from the wins in the cloud aren't enough to offset declines in other areas?

Something else?

 

[ourkid8]

Yes, the something else is forex.  Backing out forex last quarter and you have the following:  (Eric, thanks for the numbers)

 

1% net income decline (GAAP)

2% net income increase (non GAAP)

 

We should start to see revenue growth in the middle to late 2016.

 

 

Please do not think I am just retrenching into my position and defending my thesis. I am going to do a bit more scuttlebutt as well.

 

Vinod

 

Vinod,

 

Thanks for the detailed response.  I agree that top executive statements often do not reflect the day to day reality and it is dangerous to rely on them.

 

That being said, I think we can both agree on these high level statements that relate to the challenges facing IBM:

 

* IBM's revenue growth has stalled

* A non-zero percentage of IBM's current revenue stream will move to the public cloud

* IBM is not a current leader in the public cloud

* The larger the percentage that moves to the cloud, the more difficult it will be for IBM to generate revenue growth

 

Note none of this makes any assumptions about IBM's valuation or what their stock will do.

 

Obviously Vinod will have his own thoughts but I'd just comment that while a number of the bullets above are true, you can also argue:

- IBM is one of the leaders in private and hybrid cloud (which for the top companies and IBM clients will arguably be more important than public cloud);

- moving to the cloud opens up new opportunities for analytics, big data, data discovery, etc. These are areas that IBM is driving hard towards.  AWS is cheap and wonderful for infrastructure but the value will ultimately be in the software and services that run on that cheap infrastructure.  There IBM (especially in its core markets) is well ahead and can leverage that to grow software and service revenues.

 

Yes - those are all valid arguments and there are many great opportunities for IBM but the question I keep coming back to is "then why isn't IBM able to grow revenue?"

 

Is it having trouble winning/leveraging cloud opportunities? 

Is the revenue from the wins in the cloud aren't enough to offset declines in other areas?

Something else?

[dwy000]

I'd love to hear from others but I think it's a bit of both.

 

Typically, large companies are the slowest and most cautious to change infrastructure (especially if it is the core of their business, like banks and airlines).  Cloud growth has come fastest at the smaller end and with newer companies who weren't burdened with legacy infrastructure.  It's moved up the chain where you now see the IBM's and Oracle's and Microsoft's moving their customers over in a big way - but through private and hybrid primarily.

 

On top of that, and in a similar vein, adopting the analytics and other benefits that centralized infrastructure and big data allows will follow on.  You can't do big data analytics without having big data first.  5 years ago nobody ever used the term "big data" and now it is ubiquitous.  Watson was years ahead of its time.

 

Basically, AWS sells you products while IBM sells you solutions.  It is yet to be seen if they can continue to be the leader in the solutions area given the number of real competitors that have emerged but they are coming at it with a strong reputation, big customer base and good capabilities.

 

[KCLarkin]

That being said, I think we can both agree on these high level statements that relate to the challenges facing IBM:

 

* IBM's revenue growth has stalled

* A non-zero percentage of IBM's current revenue stream will move to the public cloud

* IBM is not a current leader in the public cloud

* The larger the percentage that moves to the cloud, the more difficult it will be for IBM to generate revenue growth

 

 

I would start by looking at the implicit assumptions you are making. You seem to believe that IBM's falling revenue is due to the public cloud (presumably you are referring to IaaS rather than SaaS).

 

* IBM's revenue growth has stalled

- In 2011, BRIC revenue increased 18.6% (+16% adjusted)

- 2015 Q3, BRIC revenue decreased 30% (-7% adjusted)

 

So a naive person might claim that IBM's growth stalled due to Snowden + Strong US Dollar + EM weakness + Divestitures. But actually poor execution didn't help and IBM is losing market share.

 

* A non-zero percentage of IBM's current revenue stream will move to the public cloud

- Probably true, but do you have any evidence of this? The system X business was clearly in trouble but is gone. The storage business is in serious trouble. Otherwise, it is not clear that IBM will be the primary victim of IaaS.

 

* IBM is not a current leader in the public cloud

- IBM is not the current leader in most segments of the IT industry. It is a niche player in the segments where it believes it has a competitive advantage and can earn high returns. Still, IBM's "hybrid cloud" business is a $9.4B business.  AWS "public cloud" is ~$8B business.

 

* The larger the percentage that moves to the cloud, the more difficult it will be for IBM to generate revenue growth

- Possibly true, but there isn't any evidence yet. Just remember that IBM is ~2% of total IT spend. So AWS could be a very large business and still leave plenty of revenue for IBM.

 

AWS is currently ~0.2% of total IT spending. So it is very unlikely the cause of IBM's current troubles. Of course, it could be a major competitor in a few years.

[KCLarkin]

Oh no, did Eddie Lampert really just buy this? First Prem. Now Eddie. This must really be a value trap.

[Guest qanary]

You can add Berkowitz to that.

 

Oh no, did Eddie Lampert really just buy this? First Prem. Now Eddie. This must really be a value trap.

[CorpRaider]

I wonder if Lampert just opened this position of if he did that secret position under accumulation thing.  He owned like half this position two filings ago.  Then it disappeared and came back the next quarter (this most recent filing) at a doubled size position.

[Kiltacular]

Interesting piece.

http://mobile.nytimes.com/2015/11/15/business/ibms-design-centered-strategy-to-set-free-the-squares.html

 

I just came to this thread to post this.  Well worth the read for longs.

[merkhet]

Interesting piece.

http://mobile.nytimes.com/2015/11/15/business/ibms-design-centered-strategy-to-set-free-the-squares.html

 

I just came to this thread to post this.  Well worth the read for longs.

 

Also for anyone else, for that matter...

[vinod1]

That being said, I think we can both agree on these high level statements that relate to the challenges facing IBM:

 

* IBM's revenue growth has stalled

* A non-zero percentage of IBM's current revenue stream will move to the public cloud

* IBM is not a current leader in the public cloud

* The larger the percentage that moves to the cloud, the more difficult it will be for IBM to generate revenue growth

 

 

I would start by looking at the implicit assumptions you are making. You seem to believe that IBM's falling revenue is due to the public cloud (presumably you are referring to IaaS rather than SaaS).

 

* IBM's revenue growth has stalled

- In 2011, BRIC revenue increased 18.6% (+16% adjusted)

- 2015 Q3, BRIC revenue decreased 30% (-7% adjusted)

 

So a naive person might claim that IBM's growth stalled due to Snowden + Strong US Dollar + EM weakness + Divestitures. But actually poor execution didn't help and IBM is losing market share.

 

* A non-zero percentage of IBM's current revenue stream will move to the public cloud

- Probably true, but do you have any evidence of this? The system X business was clearly in trouble but is gone. The storage business is in serious trouble. Otherwise, it is not clear that IBM will be the primary victim of IaaS.

 

* IBM is not a current leader in the public cloud

- IBM is not the current leader in most segments of the IT industry. It is a niche player in the segments where it believes it has a competitive advantage and can earn high returns. Still, IBM's "hybrid cloud" business is a $9.4B business.  AWS "public cloud" is ~$8B business.

 

* The larger the percentage that moves to the cloud, the more difficult it will be for IBM to generate revenue growth

- Possibly true, but there isn't any evidence yet. Just remember that IBM is ~2% of total IT spend. So AWS could be a very large business and still leave plenty of revenue for IBM.

 

AWS is currently ~0.2% of total IT spending. So it is very unlikely the cause of IBM's current troubles. Of course, it could be a major competitor in a few years.

 

I pretty much agree with everything KCLarkin has written.

 

To add to the point about poor execution, I offer a couple of additional supporting points.

 

1. IBM's closest peer in terms of services is Accenture and they are doing just fine.

 

2. IBM's clientele are the Fortune 1000 type of companies. Despite the regional slowdowns they are largely still very profitable and have not cut down on IT spending.

 

Vinod

[TheAiGuy]

Ben Thompson's note today on Google cloud is interesting and relevant to IBM. Here's the link (there's a paywall):

https://stratechery.com/2015/google-hires-diane-greene-google-the-cloud-company/

 

I was also taking a look at Quora and found some interesting notes IBM (sorry if these are reposts):

https://www.quora.com/What-are-the-weaknesses-of-IBM

https://www.quora.com/Which-one-is-the-best-and-has-more-scope-in-the-next-5-years-Amazon-Web-Services-Googles-Compute-Engine-or-IBM-cloud-computing

https://www.quora.com/Is-IBMs-cloud-computing-efforts-losing-to-Amazon-Web-Services-and-Microsoft-Azure

 

and here is a podcast interviewing Tren Griffin, largely about Charley Munger, but has some interesting stuff about IBM:

https://t.co/QOnD566ztZ

[LowIQinvestor]

IBM wants to predict earthquakes and volcanoes with Watson:

http://qz.com/556172/ibm-wants-to-predict-earthquakes-and-volcanoes-with-watson/

 

Full disclosure: Now very long IBM

[AzCactus]

IBM wants to predict earthquakes and volcanoes with Watson:

http://qz.com/556172/ibm-wants-to-predict-earthquakes-and-volcanoes-with-watson/

 

Full disclosure: Now very long IBM

 

Does "very long" mean a 20% plus position of your portfolio or a long intended holding period?

[LowIQinvestor]

That being said, I think we can both agree on these high level statements that relate to the challenges facing IBM:

 

* IBM's revenue growth has stalled

* A non-zero percentage of IBM's current revenue stream will move to the public cloud

* IBM is not a current leader in the public cloud

* The larger the percentage that moves to the cloud, the more difficult it will be for IBM to generate revenue growth

 

 

I would start by looking at the implicit assumptions you are making. You seem to believe that IBM's falling revenue is due to the public cloud (presumably you are referring to IaaS rather than SaaS).

 

* IBM's revenue growth has stalled

- In 2011, BRIC revenue increased 18.6% (+16% adjusted)

- 2015 Q3, BRIC revenue decreased 30% (-7% adjusted)

 

So a naive person might claim that IBM's growth stalled due to Snowden + Strong US Dollar + EM weakness + Divestitures. But actually poor execution didn't help and IBM is losing market share.

 

* A non-zero percentage of IBM's current revenue stream will move to the public cloud

- Probably true, but do you have any evidence of this? The system X business was clearly in trouble but is gone. The storage business is in serious trouble. Otherwise, it is not clear that IBM will be the primary victim of IaaS.

 

* IBM is not a current leader in the public cloud

- IBM is not the current leader in most segments of the IT industry. It is a niche player in the segments where it believes it has a competitive advantage and can earn high returns. Still, IBM's "hybrid cloud" business is a $9.4B business.  AWS "public cloud" is ~$8B business.

 

* The larger the percentage that moves to the cloud, the more difficult it will be for IBM to generate revenue growth

- Possibly true, but there isn't any evidence yet. Just remember that IBM is ~2% of total IT spend. So AWS could be a very large business and still leave plenty of revenue for IBM.

 

AWS is currently ~0.2% of total IT spending. So it is very unlikely the cause of IBM's current troubles. Of course, it could be a major competitor in a few years.

 

I pretty much agree with everything KCLarkin has written.

 

To add to the point about poor execution, I offer a couple of additional supporting points.

 

1. IBM's closest peer in terms of services is Accenture and they are doing just fine.

 

2. IBM's clientele are the Fortune 1000 type of companies. Despite the regional slowdowns they are largely still very profitable and have not cut down on IT spending.

 

Vinod

 

"1. IBM's closest peer in terms of services is Accenture and they are doing just fine."

 

I agree that Accenture is a better comp for IBM. Have you taken a look at Accenture's valuation?

 

ACN trades at 2.15x Revs, 20+ PE ratio, and 18x cash flow

 

IBM trades at 1.5x Revs, 9 PE ratio and 7x cash flow.

 

 

 

 

[ccplz]

So does that mean IBM is undervalued or that Accenture is overvalued?

 

 

[LowIQinvestor]

IBM wants to predict earthquakes and volcanoes with Watson:

http://qz.com/556172/ibm-wants-to-predict-earthquakes-and-volcanoes-with-watson/

 

Full disclosure: Now very long IBM

 

Does "very long" mean a 20% plus position of your portfolio or a long intended holding period?

 

Not a 20% position yet, I intend to hold on for a long time...unless it hits a fair valuation quicker than I anticipate :)

 

While not part of my thesis, my friend is pursuing a job in NYC with IBM Watson and is impressed with how far along their AI capabilities are:

http://www.ibm.com/smarterplanet/us/en/ibmwatson/careers.html

[berkshire101]

Anyone used the Watson machine at the Berkshire 2015 meeting?  I interacted with it and was no impressed.  For one, it didn't work.  A mouse cursor shouldn't be appearing on a touch screen.  The IBM rep didn't know how to fix it.  The GUI was outdated, looked like Windows XP.  So I wasn't sure what Watson even did.

[KCLarkin]

MYOPIA: THE MYTHICAL LONG AWS SHORT IBM PAIR TRADE

 

Many investors, most famously Stan Drunkenmiller, are making an implicit bet that the dominance of AWS in "cloud computing" will cause the downfall of IBM. This is a very myopic view of the very complex IT industry. The impact of AWS on IBM is cloudy at best.

 

"IBM is old technology being replaced by cloud technology.” -- Stan Drunkenmiller

 

To understand what this means, we first need to understand what "cloud technology" means. To keep this short I will focus on the AWS EC2 business and IBM's server business. EC2 is an open-source hypervisor running on white-label x86 servers hosted in an Amazon-leased data center. The "cloud technology" is merely freely available software running on commodity servers.

 

Those who know the history of technology will find the humour in Drunkenmiller's quote. The open source virtualization software used by AWS is the Xen Project. IBM was a contributor to the Xen Project. IBM also pioneered the hypervisor technology that is the core of Xen (and EC2) -- almost 50 years ago.

 

So Amazon's "cloud technology" is really just very old IBM technology ported to x86 servers.

 

AWS IS A BILLING INNOVATION NOT A TECHNICAL INNOVATION

 

To understand the power of AWS, you need to understand what makes it unique. Hosted data centers existed before AWS. Virtualization is 50 years old. x86 servers are old technology. What makes AWS unique is not technology but billing and provisioning. With AWS, a developer can instantly rent a virtual server by the hour. This allows developers to quickly scale up capacity. Importantly, the developer can completely bypass the IT department by using a credit card. This is what enabled AWS to achieve such phenomenal growth and caught IBM flat-footed. IBM sells technology to the CIO not to developers. AWS snuck past IBM's moat through the back door.

 

THE AWS IMPACT ON IBM

 

Since IBM no longer sells x86 servers, IBM primarily serves niche workloads that work best on Unix servers or Mainframes. These are mission critical systems that serve banks, retailers, airlines, governments. There are unique regulatory, security, and performance requirements that will prevent many of these workloads from moving to the public cloud. There is an enormous amount of legacy code that would be too costly and perhaps impossible to port to x86. The switching cost is enormous.

 

The workloads that can easily be ported to AWS are on x86 servers, not IBM servers. So people who claim IBM "lost" the cloud war to Amazon are talking gibberish.

 

The fatal flaw in the long AWS short IBM pair trade is that IBM (at least the server business) is the vendor with the largest moat against the public cloud. More obvious shorts to complete this pair trade would be those relying on x86 -- VMWare, HP, Dell.

 

THE INDIRECT IMPACT

 

AWS is not really the disruptive threat to IBM that many imagine. Rather, it is just the next wave in the relentless commodification of the server business. The real threat to IBM is the low-end disruption of x86 servers(running LINUX or Windows Server). This is an ongoing process and has already decimated the Power server business. IBM needs to continue to innovate the Mainframe and Power systems to keep them relevant in a sea of x86 data centers.

 

However, there is an indirect impact on IBM from AWS. First, Amazon generally prefers market share over margin. This will have a deflationary impact on the IT industry. Still, open source software and commodity hardware have existed for a long time and IBM has prospered. More importantly, at least part of IBM's software, services, and storage business is at risk. But the opportunites of hybrid cloud may outweigh the risk of public cloud. Perhaps most concerning, the consumerization of IT erodes IBM's moat - the sticky relationship with IT departments.

 

IBM's STRATEGIC RESPONSE

 

Given these dynamics, IBM's strategic focus makes sense. IBM is relentlessy moving their product mix away from those products most prone to commoditization and towards "higher value" offerings that are easier to defend. The net result of this portfolio remixing is low revenue growth, margin expansion, and high free cash flow. This is not as sexy as hyper revenue growth but can still be rewarding to shareholders.

 

BOTTOM-LINE

 

IBM is facing severe challenges, no doubt. But are those challenges priced into the stock? So far, Drunkenmiller is winning the bet. “If you want to be short innovation, be long IBM,” is pithy. But it is ironic that AWS, Drunkenmiller's IBM slayer, is just 50 year old IBM technology running on commodity servers. Meanwhile, IBM is creating real innovation in cognitive computing and 7-nanometer chips.

 

---

 

A NOTE ON FINANCIAL ENGINEERING

 

Many accuse IBM of financial engineering due the high level of buybacks. Generally, I think the buybacks are the correct response to IBM's market position. I would rather own more of the mainframe business, a cash cow with a very deep moat, than grow market share in commodity markets. It's true that IBM was desperately buying back stock and under-investing in the business to achieve the Roadmap. But the Roadmap is now abandoned and IBM is following a prudent mix of investment and returns to shareholders.

 

Amazon, on the other hand, is very adept at financial engineering. This is probably their biggest achievement. Amazon manufactures free cash flow via share-based compensation, negative working capital, and capital leases. Looking at the balance sheet quickly dispels the FCF myth. Amazon may be generating significant shareholder value but it is certainly not generating distributable cash flow.

 

---

 

A NOTE OF CAUTION TO AWS BULLS

 

While writing this, I came across a cautionary tale for the AWS bulls. VMWare was the "biggest tech IPO since Google". And investors were right to be excited. VMWare was growing at a similar rate to modern day AWS. Since the IPO, VMWare has grown operating earnings at a 30% CAGR. On every measure, the VMWare business has outperformed IBM. VMWare investors were not as lucky. If you had bought VMW at the end of 2007, you would have enjoyed -4.2% annualized (versus +5.3% for IBM). You can be right about the business but still wrong about the stock.

 

---

Disclosure: I am long IBM. I have been very wrong on IBM for a long time, so you can safely ignore this rant. But after listening to too many "AWS is killing IBM" stories, I am convinced there are many IBM bears who are completely clueless about IBM and the IT industry. Admittedly, my crystal ball is cloudy and I don't know when or if IBM will get out of the current mess.

[Against the crowd]

Very well said

[Picasso]

Good rant KC.  Although when you compare the technology to old IBM tech, you might cause some cringing.  What is OS X based on? Open source unix.  What was the GUI based on?  Xerox technology.  Sometimes it isn't about who pioneered the tech, but who packages it the best. 

 

But overall I largely agree with the bull thesis these days, especially at current valuations.  I just wish Buffett and his cohorts weren't in the stock because it would be a lot cheaper right now.

[TheAiGuy]

Developing thesis on IBM:

 

1) Many companies don't have the ability to figure out cloud by themselves. Amazon is at a competitive disadvantage in high-touch BTB sales (Microsoft is not at a disadvantage here).

 

2) Legacy lines of business have niche software needs, lack the expertise to develop them, and face substantial migration costs to the cloud. These software needs are typically not "core" to the legacy business (i.e. this does not differentiate them) and thus are likely to outsource their development.

 

3) Economies of Scale are restricted to the level of a single server farm, much like in the auto industry where economies of scale are at the factory level. This is not a natural monopoly.

 

--> IBM should be fine.

[scorpioncapital]

There are also different cloud services ranging from commodity ground floor level of providing hosted servers and infrastructure and not much else, providing a platform, and providing specific high value apps and software. AWS operates in the lowest level and the middle level. In the lowest level, it probably has very little advantage. First mover advantage is actually a temporary benefit in a commodity space. What you want is last mover advantage. Their platform, however, I have to say is a very powerful thing. That's a bit of the network effect in action. The more developers get used to it and like it, the more they will by default choose it to develop business products. But I would argue that the highest value level, actual specific software cloud apps is where the best margins and biggest moats will be. And in this respect, I like some of the stuff IBM is doing in that space - but it's not the only one. From what I've seen, there are so many companies offering products and services that IBM is doing right to try and distinguish itself. But yes, this is is a very competitive and fast changing business. Everyone knows the truth. IBM is not Google, or Microsoft, they don't have powerful monopolies but even powerful monopolies wither away over time. To that extend, I can see the value Buffett saw in a company that can still make money after 100 years. Maybe this is the end of the line but it's one hell of a long time. I'd bet they trudge along at worst.