Sunday, May 5, 2013

Is IBM Losing It's Way?

In the late Sixties, our family moved up to Westchester County, and the influence of a growing IBM was spreading all over the county from Armonk to Yorktown Heights and many other locations.  The corporate motto, implemented by Thomas Watson, was "THINK."  Aside from Bell Labs, IBM was the top industrial research laboratory in the country.

Its history of innovation came from hiring the brightest people and applying their efforts in a well-funded, disciplined approach to technological innovation and problem solving.  Fast forward several decades, of course, and IBM ran aground; it was blindsided by technological changes, a bloated cost structure, and management hubris.

When Lew Gerstner was recruited as CEO in 1993, the outlook was dire.
"Gerstner happily quotes the doom-laden predictions about IBM’s future that were prevalent when he took over as CEO in 1993, a year the company posted an $8 billion loss, and IBM shares that had sold for $43 in 1987 could be had for $12. IBM’s "prospects for survival are very bleak," wrote the authors of the book Computer Wars."
The strategy put into place under Lew Gerstner was essentially extended by his recently retired successor Sam Palmisano.  CEO Virginia Rometty is now at the helm of this icon of American business, and she comes from a very successful career in sales at IBM.

Warren Buffett's Berkshire Hathaway recently added a cool $10 billion to his stake in IBM.  When this was announced in January, I started reading up on IBM, and it seemed very much in the wheelhouse of the megacap public stocks Berkshire owns, and has owned for a very long time.

Leading up to the release of first quarter 2013 earnings, I trudged and slogged my way through the slides and audio files of IBM's Analyst Day.  There is a lot of material, with some interesting industry material and quite a bit of corporate puffery.  The meeting was held at the company's Innovation Center in Almaden, California. Almaden is the home of many innovations which are at the heart of modern computing and databases; IBM and Almaden lead U.S. industry in the number of technology patents issued in recent years. This is a high powered laboratory, staffed with the same caliber of scientists that Thomas Watson said were key to the long-run success of the company.

CEO Rometty's introductory presentation was so amped up and hyperkinetic, I could barely finish listening.  There was far too much information, presented too fast, with the CEO interrupting her own bullet point lists to move into asides, each with their own bullet point lists.  I couldn't figure out if we ever did complete the five key corporate strategies or not.

There was an off-key remark early which I will paraphrase, "I know that you all (analysts, I presume) are looking at all this very expensive real estate and saying, "Why?"  I know, and believe me, we think about this every day, but let's move on."  I realized that the CEO, who clearly has command of her business, was nervous.  But, seriously, would any serious institutional owner be wondering about this issue as a key to the buy, sell or hold decisions?  I doubt it.  It's such as short-term issue, not worthy of an industry leader.

The theme of short-termism continued in the overall tenor of IBM's first quarter 2013 earnings release, which the Street characterized as IBM's first "miss" in eight years.  Morningstar analyst Grady Burkett wrote,
"IBM first-quarter results came in well below our expectations, as the firm's hardware and software results disappointed. Overall revenue declined 5% year-over-year to $23.4 billion, while free cash flow declined to $1.7 billion, versus $1.9 billion generated in last year's first quarter. We expect to adjust our 2013 forecast to reflect this quarter's weakness."
On the short-term side, the CEO made extensive references to failures in the sales organization to bring in orders from large customers planned for the quarter.  As a result of this unsatisfactory performance, the sales leader was reassigned.  This kind of commentary and action seems more appropriate for an emerging technology company than for a $100 billion+ revenue company.  Again, I found this unseemly for a company which Warren Buffett has found worthy of substantial new investment.

If I try to distill the key points from the Analyst Day, here's what I took away. IBM stands at the intersection of software, hardware and services.  It operates in businesses which have cycles of innovation and commoditization.  Examples of the latter range from the x86 and other commodity server lines to some database and analytic consulting.

IBM's consistent strategic goal is to "move to higher value."  This is done by acquisition, divestitures, and remixing research and development budgets.  The CEO noted that IBM had divested $15 billion in low-margin revenue over the past ten years.  It would have been nice to have the comparable number for acquisitions as a benchmark.

Acquisitions are for the purpose of getting the company quickly into a new space or to expand its capabilities.  The target company must have intellectual property which is scalable, which seems like one of the problems with HP's acquisition of Autonomy.  It should also help IBM to expand its geographic reach among is 170 countries today.

CEO Rometty said that the company is placing a significant investment bet on Africa, and particularly in sub-Saharan Africa.  This, in contrast to the short-termism referenced above, seems to be a very long-term prospect.  It seemed like something an NGO would like to hear, but it's hard to envision how the ROI works for this kind of investment.

Software already provides about forty percent of operating earnings today, and some analysts see this crossing over fifty percent by 2015.  Understanding this business would seem to be key for estimating the company's future margins.  Standard and Poors rates the company's outlook "stable" and its prospects "low risk," but it also wrote,
“IBM’s good market position and broad product and revenue base provide cash flow and ratings stability,” she said. “Highly competitive industry conditions, a moderately acquisitive growth strategy, and significant share repurchases currently constrain the potential for a higher rating.”
Much of the company's total return to shareholders have come from dividends and share repurchases.  While this has been well executed financial engineering, the company needs to better articulate how the business model works in the current commoditization cycle in which the new CEO has taken over the portfolio.

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