The problem for IBM: Its operating model is built around selling on-premise computing - including so-called "private clouds" - but the $3.6 trillion IT industry is moving at an accelerating pace in an entirely different direction, to the public cloud, which is a low-margin utility model.
As Adrian Cockcroft, CTO of Netflix (NFLX) said, "There is zero revenue for traditional IT" in the public cloud. Users pay low variable expense (prices have been dropping from cheap to super-cheap) with no capex. Question: How can IBM compete with cheap "rented" computing power? Answer: It can't.
The public cloud is not an environment in which IBM can generate much profit because, as Salesforce.com (CRM) CEO Marc Benioff said, "IBM needs to sell a box, and the cloud is not a box." IBM can't tell its customers to tap into a computing utility (the public cloud) on a pay-as-you-go basis. It needs customers to continue to buy expensive packages of hardware, services and software in order to support its high-margin operating model.
IBM has ceded the low-margin public cloud market to others, and has focused on the private cloud market. It's a strategy doomed to fail, and here's why: When you construct a private cloud, you give up everything that is wonderful and beautiful about the public cloud. Trading capex for low variable expense doesn't happen when you have a private cloud. You still have huge capital outlays when you build on premise. And there's waste involved in building a private cloud. Instead of paying only for what you use, private clouds are built for overcapacity (capacity is typically built to handle 15% above peak usage).
IBM's long-term prospects are troublesome
The move to the public cloud is already entrenched among smaller companies, and upmarket migration appears to be gaining traction. As venture capitalists will tell you, entrepreneurs and startups are all building their IT infrastructure in the public cloud. (There may be an exception, but I couldn't find one, even in companies with over $100 million in funding.) This suggests IBM's long-term prospects are particularly troublesome, as it will have to wean tomorrow's enterprise customers off of a low-expense utility model and onto the high-capex private cloud model.
People in the industry tell me at least half of Fortune 1000 companies are already experimenting with the public cloud. Further, most government agencies are looking hard at the public cloud as a way to save money. Companies and government agencies are generally testing new workloads at this point (as opposed to migrating existing operations), but others are moving much faster.
Samsung recently moved one of its computing hubs to the public cloud, saving $34 million in the process, and Netflix has moved everything (their entire IT infrastructure) to the public cloud. That's a big deal for the likes of traditional IT, since Netflix is one of the biggest consumers of computing power.
IBM's latest earnings miss is just the beginning
The way I see it, IBM has one hand to play and it's a bad hand. It can't get behind the public cloud because it's a low-margin utility. So it's forced to defend the status quo, and ask their customers to continue constructing capex-heavy on-premise computing environments. Now that companies have a choice, they are pushing back on IBM.
That's what I suspect happened during IBM's disastrous first quarter reported last Friday - and, yes, it was a disaster. But for a change in the tax rate, the earnings miss would've been 34 cents instead of 5 cents. In the coming quarters, you're likely to see similar results from IBM: big earnings misses, declines in revenue, and a management team in denial.
(By the way, as much as I don't like IBM, Berkshire continues to be one of my holdings, and is one of my Top Ten picks for 2013. If you'd like to review my Top Ten list and its performance, go here.)
The emergence of the public cloud materially changes IBM's competitive environment. As such, the stock no longer belongs in Berkshire's portfolio for a single, simple reason: It's too risky. Of course, anything is possible, and maybe IBM can make enough acquisitions to compensate for future losses. But it's not Buffett's style to speculate on turnarounds. To borrow from Einstein's characterization of God, Warren E. Buffett does not play dice.