IBM: A New CEO and an Old Problem

International Business Machines Corp. (NYSE:IBM) has a new CEO, but an old problem: falling sales and earnings, write-offs and declining shares.

On Monday, the computer hardware company reported first-quarter operating earnings of $1.84 per share, down 18% from the same period last year. Revenue came at $17.6 billion, down 3.4% over the same period.

Meanwhile, the company took a $900 million charge against earnings as part of its restructuring efforts to cover restructuring costs for its Global Technology Service division and withdrew its annual profit guidance.

In a statement, CEO Arvind Krishna, who just assumed the role this year, commented on the company’s performance amid the ongoing coronavirus outbreak:

“IBM remains focused on helping our clients adapt to the immediate challenges of the COVID-19 pandemic, while we continue to enable them to shift their mission-critical workloads to hybrid cloud and expand their use of AI to help transform their operations. Our first-quarter performance in the cloud is a reflection of the trust clients place in IBM’s technology and expertise today and positions us to continue building an enduring hybrid cloud platform for the future.”

Wall Street wasn’t pleased with IBM’s performance, sending its shares lower on Monday.

The company’s declining earnings and sales, along with its deteriorating stock price, can be traced to a string of strategic mistakes made decades ago, like the outsourcing of software to Microsoft (NASDAQ:MSFT) and hardware to Intel (INTC) back in the 1980s. Bruce Greenwald and Judd Kahn wrote about these decisions in their book, “Competition Demystified.”

“Occasionally, enormous consequences flow from decisions that at the time do not seem strategic. When IBM entered the personal computer business, it chose an open-standards approach and made two build-or-buy decisions that probably seem inconsequential and merely tactical. Rather than developing the operating system itself, it licensed one from a tiny company no one has ever had heard of. It made a similar choice for the microprocessor, giving that business to another supplier.”

The result? Once small companies–Microsoft and Intel — surpassed IBM to become two of Wall Street’s most favored companies. “These companies, rather than IBM, became the beneficiaries of the boom in personal computing,” Greenwald and Kahn added. “In retrospect, these were strategic decisions with enormous consequences.”

IBM has tried hard to remedy this situation through “creative destruction” – dropping mature low-profit technology businesses and replacing them with emerging high-margin markets like the cloud and internet security. In the most recent quarter, for instance, cloud revenue of $22 billion was up 13% (and up 16% adjusting for divested businesses and currency).

Then there’s IBM’s big bet on the next emerging cloud market — the “hybrid” multi-cloud. That’s a computing environment that brings together multiple cloud providers and clouds–public, private and software-as-a-service.

And that’s why the technology giant paid top dollar to buy Red Hat. The open-source technology company brought to IBM an innovative hybrid cloud platform and a vast open-source developer community.

The good news is that IBM’s bet is beginning to pay off. Red Hat revenue gained 18% (up 20% adjusting for currency) and was normalized for historical comparability.

Still, IBM’s creative destruction strategy is a slow and painful process, hurting financial performance. Things will get worse before they get better as the new businesses do not grow fast enough to make up for the lost revenue and profits in the old business segments.

That could, perhaps, explain why IBM’s excess return on invested capital lags behind the competition, as illustrated in the table below.

Source: Compiled from GuruFocus on April 21, 2020.

Meanwhile, Wall Street anxiously watched and valued IBM as a technology company in the mature hardware business, characterized by sluggish sales and price and profit erosion. It then shunned the stock, looking for better opportunities elsewhere in the technology universe.

Disclosure: No position in IBM.

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