During the latter part of last year, International Business Machines Corp.’s (IBM, Financial) shares were beaten down over 26% as the company missed sales estimates for two consecutive quarters and faced skepticism concerning its plans to diversify into other business lines to help rekindle its lackluster growth. Although the company’s revenue increased last year, most of that growth was attributable to the introduction of a new mainframe system. That business dropped 41% in the fourth quarter.
An examination of the chart below highlights how revenue for the company crash-dived during 2018, after cresting at a peak in 2017.
For its fourth quarter, the company posted earnings per share of $4.87 versus the analysts’ consensus of $4.82. IBM generated $21.8 billion in sales, a decline of 3% from last year compared to the $21.73 billion average analysts estimate. Analysts were pleased the company increased its fiscal 2019 guidance for $13.90 per share compared to $13.81 for the previous year.
Despite the uninspiring fourth-quarter results, there are grounds for cautious optimism based on the company’s plans for growing its cloud computing and artificial intelligence services units. Indeed, the company showed growth in the fourth quarter in exactly these areas, which are key to its strategic initiative in exiting old lines of business and entering the burgeoning and promising cloud database sector. IBM hopes to enhance its cloud services capabilities for existing and potential customers by offering its strong data analytics and AI capabilities through Watson, its AI software business.
Indeed, there are signs of life for these promising new lines of cloud computing database services. The company’s combined cloud services and data analytics revenue grew 5% in the fourth quarter to $11.5 billion. For 2018, the company cloud computing business grew to $19.2 billion — a respectable 12%. IBM’s artificial intelligence cognitive software business hosted on the Watson platform as well as cybersecurity services posted sales of $5.46 billion, exceeding analysts’ projections of $5.25 billion.
Three years ago, the company’s cloud computing and AI software services accounted for 25% of its total business; for 2018, those business units that are key for implementing IBM’s strategic initiatives accounted for 50% of its overall business operations. For the company’s diversification goals, this is a promising trend in the right direction.
Cloud services is a burgeoning and profitable area, as more corporations seek either to complement existing IT capabilities or move their computing needs entirely to the cloud due to lower costs and a more efficient use of resources. When assessing the potential market for cloud computing services, investors should note Microsoft’s meteoric growth over the last several years has been due to the rapid growth of its own Azure database services unit.
IBM believes the optimum strategy for establishing a presence into the lucrative cloud market is by partnering with other corporations to either provide an extension of a company’s existing cloud capabilities or to offer these firms its own hybrid capabilities. This approach seeks to leverage a company’s existing in-house capabilities with the superior resources IBM can provide in data analytics and cognitive software capabilities.
IBM believes there is room in the hybrid cloud computing sector for a company to use multiple cloud providers in order to achieve the most efficient and cost-effective cloud computing solutions for their needs. This differs from the approach of both Microsoft (MSFT, Financial) and Amazon (AMZN, Financial), who generally do not partner with other third-party cloud database providers in delivering their own cloud computing services.
In order to help kickstart its plans for expanding into the vast cloud computing market, IBM purchased specialized open software Linux services provider Red Hat Inc. (RHT, Financial) for $34 billion. IBM believes Red Hat will allow it to sell customized software products to developers who design complex applications that can run on both in-house IT data centers as well as cloud computing platforms, such as Amazon’s AWS and Microsoft’s Azure.
Although IBM claims the deal will start to boost its free cash flow and improve margins in 2019, many analysts view the purchase price for Red Hat as exorbitant. IBM paid a hefty premium, which amounted to 63% above the stocks’s then-closing price of $116. Many investors will want to see the hefty price paid for the company’s capabilities converted into a stream of revenue in the near future.
IBM’s recent agreement with telecommunications provider Vodafone (VOD, Financial) is an example of how the company hopes to gain a foothold in the cloud services market by strategic partnering with third parties to increased its cloud business. The deal demonstrates how telecommunications firms with existing cloud capabilities are joining with larger corporations that have greater resources to benefit their existing customers. IBM will provide Vodafone’s customers with greater cloud resources that far extend their in-house computing resources.
The purchase of Red Hat and the company’s plans to diversify into the cloud computing business presents risks, as it may not be as transformative as hoped or capable of generating sufficient revenue to pull IBM out of its tepid growth cycle. Additionally, the company faces stiff competition in the cloud services business.
If the steady growth in its cloud services unit continues unabated, Big Blue could be well poised to take advantage of the current diverse and complex needs of corporations looking to integrate their in-house cloud and legacy systems with IBM’s vastly greater and more complex capabilities.
Disclosure: I have no positions in any of the securities referenced in this article.
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