IBM Faces Tough Challenges in the Cloud

I’ve researched “the Cloud” in order to evaluate if IBM’s business is threatened. It’s important to define what Cloud computing is. There is an official definition put forward by the National Institute of Standards and Technology (NIST) here. If you're a nontechical person, I highly recommend you watch the short video clip here. It will give you an idea of how transformative the Cloud is to IT operations.

There are three types of Cloud computing:

• SAAS (Software as a service)
  • Users are able to run software through a thin client like an internet browser
• PAAS (Platform as a service)
  • Per stackoverflow.com, PAAS provides “users computing platforms which typically includes operating system, programming language execution environment, database, web server, etc.” It’s important to note users in this context are not end users but rather system administrators.
• IAAS (Infrastructure as a service)
  • There’s much less ambiguity in IAAS. From NIST, “The capability provided to the consumer is to provision processing, storage, networks, and other fundamental computing resources where the consumer is able to deploy and run arbitrary software, which can include operating systems and applications.”

Cloud computing becomes even more nuanced when we talk about the deployment models for SAAS, PAAS and IAAS.

Deployment models from the National Institute of Standards and Technology

• Private Cloud. The Cloud infrastructure is provisioned for exclusive use by a single organization comprising multiple consumers (e.g., business units). It may be owned, managed and operated by the organization, a third party or some combination of them, and it may exist on or off premises.
• Community Cloud. The Cloud infrastructure is provisioned for exclusive use by a specific community of consumers from organizations that have shared concerns (e.g., mission, security requirements, policy and compliance considerations). It may be owned, managed and operated by one or more of the organizations in the community, a third party or some combination of them, and it may exist on or off premises.
• Public Cloud. The Cloud infrastructure is provisioned for open use by the general public. It may be owned, managed and operated by a business, academic or government organization, or some combination of them. It exists on the premises of the Cloud provider.
• Hybrid Cloud. The Cloud infrastructure is a composition of two or more distinct Cloud infrastructures (private, community, or public) that remain unique entities but are bound together by standardized or proprietary technology that enables data and application portability (e.g., Cloud bursting for load balancing between Clouds).

Why am I boring you with these nuances?

It can get confusing when companies issue conflicting press releases declaring which company leads the industry in “Cloud” revenue. When IBM (IBM, Financial) declares itself “King Kong of Cloud,” it’s categorizing every variation of Cloud computing into one bucket such as public SAAS, private IAAS, etc. On the other hand, Amazon (AMZN, Financial) will also declare itself the leading Cloud supplier. What it means is that it’s the leading supplier of public IAAS. Amazon is the undisputed leader in IAAS, and it can be objectively measured in terms of number of servers, number of datacenters, number of geographic regions served, computing power, storage space, etc. Below is Gartner’s magic quadrant for IAAS. Gartner’s conclusions are highly influential in the IT world. Leaders are shown in the upper right. You can see how far behind IBM is in this space.

IAAS

PAAS

Here’s the Gartner Magic Quadrant for PAAS. You can see that IBM is average and Amazon doesn’t compete in this space. You’ll also notice that Microsoft (MSFT, Financial) and Google (GOOGL, Financial) perform well in relative ranking in both spaces. My research leads me to believe PAAS is an ambiguous term where people have different interpretations.

There’s no Magic Quadrant specifically dedicated to a unified SAAS category. SAAS is too broad and can range from Google Docs to mobile games to many flavors of enterprise software. SAAS vendor comparisons are done at a more discrete level. When IBM says it’s a leader of Cloud computing and it throws SAAS into that bucket, it’s difficult to tell how sticky the SAAS component is. On the other hand, Netflix (NFLX, Financial) is on Amazon’s IAAS platform and one can have a high degree of confidence that Netflix will stay with Amazon. It should also be noted that SAAS offerings can be built on top of Amazon's IAAS.

What does this mean for IBM’s future prospects?

Let’s take a look at IBM's last fiscal year. It is separated into the following divisions.

1. Global Technology Services
2. Global Business Services
3. Software
4. Systems and Technology
5. Global Financing

Here’s IBM’s revenue and gross margin %.

Here’s IBM’s gross profit split.

IBM describes each of its divisions (From FY2014 10-K):

• Global Technology Services (GTS) primarily provides IT infrastructure and business process services.
• Global Business Services (GBS) has the mission … is to drive initiatives that integrate IBM content and solutions and drive the progress of the company’s strategic imperatives.

• Software consists primarily of middleware and operating systems software. Approximately 70% of external Software segment revenue is annuity based, coming from recurring license charges.
• Systems and Technology (STG) provides clients with innovative infrastructure technologies to help meet the new requirements of data, Cloud and engagement — from deploying advanced analytics to moving to digital service delivery with the Cloud and securing mobile transaction processing.
• Global Financing facilitates IBM clients’ acquisition of information technology systems, software and services by providing financing solutions in the areas where the company has the expertise.

You can see from the pie chart that software accounted for 47.7% of the company’s gross profit. In addition, many of the services IBM provides is related to software (i.e., implementation, upgrade and support). In short, IBM has a lot riding on the success of its software division. Software revenue is almost entirely “Middleware.”

Per Wikipedia,

IBM WebSphere refers to a brand of computer software products in the genre of enterprise software known as "application and integration middleware." These software products are used by end-users to create applications and integrate applications with other applications.

My original thought process was if companies move to IAAS instead of managing their own datacenters, then they wouldn’t need IBM’s middleware which would be disastrous. Here’s what I learned. I incorrectly assumed IAAS came with middleware so even if customers went with Amazon Web Services (AWS) they could still potentially buy IBM’s middleware. I then googled, “What middleware do most people use for AWS?” The results returned Oracle Fusion. Oracle Fusion doesn’t fit every situation so again I can’t draw a simple conclusion about IBM’s prospects.

Final thoughts

• IBM acknowledges the transformative nature of the Cloud. In its FY2014 10K, it states:

Cloud: Reinventing IT

Cloud is at the heart of the digital revolution. No enterprise is untouched by this revolution, and the shifts are occurring rapidly.

Enterprises are benefiting from Cloud by using it to transform their IT and business processes into digital services. Much has been written about how Cloud enables the sharing of infrastructure — this is true. However the real promise of Cloud is much more profound. By forcing greater levels of standards up and down the technology value chain, new products and services, and even entire business models, are able to be created in weeks rather than months or years.

• Cloud computing in its various forms provides customers with performance, flexibility and cost savings. In many cases, customers don’t talk about productivity improvement from the cloud in terms of percentage improvement but rather in terms of multiples with a cost reduction included (i.e. productivity improved by 5x and an 80% reduction in cost). There will be many cases where companies don’t want to deal with the headaches of managing a datacenter and the Cloud will be too attractive to pass up.

• I wanted to be able to say “X% of IBM’s earnings are at risk because of the Cloud.” Instead, my honest conclusion is that enterprise IT is a fluid industry. IBM has thousands of customers with different requirements. The fact that IBM is behind in public IAAS is not a positive. IBM has many legacy customers, and it's possible IBM upgrades its offerings in time to be good enough to keep those customers. I don’t have conclusive data to back up that narrative one way or another.

• I feel confident that IBM will not be a serious contender in public IAAS. IBM would need to invest billions of dollars to catch up and would need to underprice leaders (Amazon, Microsoft and Google) to capture market share. I just don’t see that as economically viable.
• There is a good article by Ed Scannell from TechTarget.com here.

Notable highlights.

• “[IBM’s] recent financial statement [for the quarter] showed overall software revenues dropped 10% to $5.8 billion, or 3% adjusting for currency.”
• “The company’s middleware products, which include WebSphere, Information Management, Tivoli and Rational tools, were down 7%, or flat adjusting for currency. Operating systems revenues plummeted 17%, or 9% adjusting for currency.”
• The article paints a picture that IBM is losing business in software but replacing that revenue with the Cloud albeit at a slower pace.
• Overall, I was not able to find a smoking gun pointing to IBM’s imminent decline in the software division.
• I still don’t have a warm fuzzy about IBM or other traditional IT suppliers whose sales depend on datacenters. Today, HP laid off 30,000 workers from its enterprise unit and I have to believe the Cloud had some impact.
• You can read my article "Does Amazon's Lead in The Cloud Make It A Buy?" here.