About nine years ago, IBM (IBM) and the Chinese tech giant Lenovo Group (LNVGY) captured global headlines when the Asian company purchased IBM’s PC business. The two are now back together on the negotiating table as IBM moves away from lower-margin businesses while it increases its focus on cloud computing.
IBM’s focus on the higher margin areas is a positive sign for the long term. However, the business is plagued with shrinking revenues as its growth in the new areas (such as cloud) has not been able to offset the declines coming from its old businesses (such as hardware).
Despite its woes, the Big Blue is backed by the legendary investor Warren Buffett who owns 6.3% of the firm and has been optimistic about its future.
An investment in IBM is a bet that the company will be able to turn itself around and as it does, it will emerge as a more profitable firm. Its shares are currently trading at $183.70, which implies a price-to-earnings ratio of just 12.12, making them considerably cheaper as compared to other players in the industry.
IBM has finally agreed to to sell its low-end server business to Lenovo for $2.3 billion. This would be a big step for IBM that has been trying to shift its focus from the declining hardware business to the lucrative software and services operations.
IBM’s hardware business has been dragging the performance of the company for a while. This was clearly evident in its previous earnings release for the fourth quarter when IBM’s hardware sales plunged 27% from last year. This comes after the company reported a 17% drop in hardware sales in its third quarter.
Some of this poor performance can be attributed to its server business. IBM is the third biggest player in this industry with a 13% market share, behind Hewlett-Packard Company (HPQ) and Dell Inc. (DELL). Research firm IDC, however, has pointed out that IBM was the worst performer in its peer group as the company witnessed the biggest decline in its x86 server sales in the third quarter.
Meanwhile, the rumor mill has been grinding away with speculation related to IBM’s hardware units. WSJ has reported that IBM is mulling the sale of its chip manufacturing operations. According to some estimates, the unit got $1.75 billion as revenues in the previous fiscal year, but ended with $130 million in pretax losses.
Furthermore, Re/code has said, citing unnamed sources, that the Big Blue’s software-defined networking (SDN) unit could also be up for grabs for $1 billion.
Shrinking Top line
Due to the hardware woes, IBM’s quarterly revenues dropped by 5.5% from the same quarter last year to $27.70 billion, which is the company’s biggest drop in more than four years.
Moreover, IBM continues to struggle in the emerging markets despite the management change, which was disappointing. In the results, IBM has also reported a 9% drop in revenues from growth markets and a 14% drop in revenues from the BRIC countries. The company is still struggling in China where its revenues dropped 23%.
While IBM has pointed towards its struggling hardware unit as the primary culprit, the company’s inability to post any growth in the emerging markets is also a cause of concern.
On the other hand, its net income climbed 6% to $6.19 billion, which translated into adjusted earnings of $6.13 per share. The business failed to meet the revenue estimates, but managed to deliver better than expected results in terms of earnings.
The company’s aggressive cost cutting measures and modest growth in the software segment (revenues up 3% from last year) also provided support to its bottom line. However, the increase in earnings was largely due to the significant reduction in the provision for income taxes that fell 61% from last year to $777 million. Therefore, overall, the company’s latest earnings were a disappointment.
While IBM is divesting from its lower-margin businesses, it is increasing its focus on cloud computing. In the previous quarter, the company’s revenues from cloud computing rose nearly 70% from a year ago to $4.4 billion.
IBM plans to tap into the growing demand of cloud computing storage as more and more technology buyers are opting to store their data on the cloud, rather than onsite. IBM has announced that it will invest $1 billion in its Watson supercomputer and has established a new Watson group that will focus on developing cloud-based commercial cognitive innovations. Meanwhile, the company has also committed $1.2 billion to double its total number of software centers which will significantly enhance IBM’s global cloud footprint.
What Lies Ahead?
IBM’s move away from hardware could improve IBM’s profitability. But the unit also generates significant revenues. Therefore, the divestments can put further pressure on its already struggling top line. Under this challenging environment, IBM’s future growth will depend on its ability to grow quickly in the new areas, such as cloud computing and data analytics, to offset the declines coming from older ones.
In the current quarter, IBM will incur a $1 billion restructuring charge. The company has forecast earnings of $2.50 per share in the first quarter, which is considerably below the consensus $3.27 per share. However, the full year earnings estimates of “at least $18” per share were slightly above expectations.
Disclosure: This article was written by Sarfaraz A. Khan, with valuable contribution from Gohar Yousuf, research assistant at Half Bridge Business Review. Neither Sarfaraz A. Khan, nor Gohar Yousuf have any positions in the stock(s) mentioned in this article.