In my previous article, I took the chance and reflected upon what I learned, and how my thoughts have changed since I wrote the two IBM (IBM, Financial) articles during 2014. I wrote the following provocative statement towards the end of the article: “I’m not sure how many investors would have bought IBM if Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) had not been a shareholder.” The reason why I made this statement was hinted in my conclusion sentence of the article: IBM’s business is too complicated and there are a good amount of disconfirming evidences.
Let me first clarify that I think there is a lot to like about IBM. I am not against it at all. My intention for writing this article series is not to reinforce what everyone already knows, but hopefully, to provide another angle in looking at IBM.
For me, I have ruled IBM out of my circle of competency after reading IBM’s annual reports for the past 25 years, a few books on the history and the business of IBM as well as the recent investor presentations and earnings call transcripts of IBM.
In one of my previous articles, I wrote the following criteria in terms of ruling a business out of my circle of competency:
I know a business is within the boundary of my circle of competency if:
- I understand the business model,
- I understand the most important factors that will make the business succeed or fail in the long run, and
- I can come up with reasonably good assessment of how these factors will play out in the next 5-10 years.
I went through the exercise with IBM.
IBM has 5 business segments –
- Global Technology Services (GTS) primarily provides IT infrastructure and business process services.
- Global Business Services (GBS) provides IT consulting and application management services.
- Software consists primarily of middleware and operating systems software.
- System and Technology is the hardware, systems, storage and semiconductor business.
- Global Financing is the financing arm of IBM.
The financing segment is obviously the non-core business so we can take it out for the purpose of our discussion. GTS,GBS, Software and System and Technology each has its own business model, each one of them is complicated because each segment has vastly different competitive dynamics, is subject to different product cycle and service cycle and has totally different economics.
Let’s start with the service business, which includes GTS and GBS. They have been the big money makers for IBM since Lou Gerstner took over IBM in the early 1990s. GTS and GBS used to deserve their success because when Lou Gerstner built the service division, he made sure the service teams knew very well how to implement technology, how to support manage the projects, how to listen to the customer and how to get the results. However, things get more complicated as Sam Palmisamo and Ginni Rometty started to relentless cut cost by massive layoffs and sending works offshore. It is widely known that Sam Palmisamo laid out this 2015 roadmap for IBM while he was in charge. One of the goals was to achieve “at least $20 operating EPS by 2015.” In order to achieve this goal, management has to cut cost if revenue is stagnant. They have to cut more costs if revenues are falling. The consequences are gradual but real. Service quality has been compromised in order to the make the profit goal, which hurts IBM’s reputation, which hurts the hardware and software business as IBM needs the Services division to help sell its hardware and software.
Moving on to the System and Hardware business, during the Q4 2014 earnings conference call, IBM’s management talked about the product cycle of System z. According to the management team, IBM was in the 10th and final quarter of the product cycle for System z. IBM spent five years and $1 billion on the new System z13. IBM has also divested System x to Lenovo. I knew very little about the System z product cycle or System x. So I found it extremely hard, if not possible to assess whether the divestiture was good decision or not even though I’ve read a lot about IBM.
I’ve also read from a book called “The Decline and Fall of IBM” that a technology called “unified computing will soon be able to build systems to replace IBM's greatest mainframes for a fraction of the cost. The Technology called Hadoop has application to storage and other elements of IBM’s hardware businesses. Soon IBM’s unique or proprietary technology will not be enough for it to complete in the market place.” I don’t know enough to assess whether this statement is true, but if it is true, then IBM’s hardware business will be facing some serious challenges.
The Software business is even more complex than the Services Business and Hardware business. It consists primarily of middleware and operating systems software. Within the Software segment, there are seven specific capabilities – WebSphere, Information Management, Tivoli, Watson, Workforce, Rational Support and Mobile. I think it is safe to say that any non-technology background investor would have a hard time understanding these capabilities and assessing IBM’s competitive advantage in each of them, or on aggregate.
To make things more complicated, IBM’s management has added another layer of complexity by coining up the concept of those so-called “Strategic Imperatives,” which include Data, Cloud, Analytics and System of Engagement. These strategic imperatives are what management believes the future of IBM but yet they have revenue streams impacting all segments, but mostly Software.
Let’s walk through an example. Here are the components of IBM’s SmartCloud:
While the tenet is obviously as-a-service but there are four of them. In order for you to assess the competition, IBM's position and to project what the future is likely like for IBM’s cloud, don’t you have to at least understand the market in each of these as-a-service-area? Let’s start with PaaS, or Platform as a Service. I do not have a technology background so I have to learn everything from the ground up. In simple terms, PaaS provides developers a platform for them to develop apps or cloud-based software. Obviously IBM is not the only one in the space. Microsoft and Google are both IBM’s competitors with Microsoft’s Azure and Google’s App Engine. I have the faintest idea why would a customer would choose IBM over Microsoft or Google.
Ditto to IaaS or SaaS. In IaaS, IBM competes against Amazon, Rackspace and others. I really don’t know how to assess IBM’s competitiveness. You can take management’s words and just believe IBM has a huge competitive advantage in all the areas, but I think it is very dangerous believing what management says without knowing why.
Aside from the complexity in IBM’s business model in each of its segment, another layer of complexity comes from the rapid change in technology that IBM’s business is subject to. Yes, IBM has shifted its business model from a hardware-centric to a software-centric one. Yes, the margin profile is much better now. However, one of the consequences, which I think very few people take into consideration, is that a software-centric business model is also more vulnerable to much more rapid technological changes. This is certainly true for all those strategic imperatives IBM has listed. IBM is trading higher margin for more uncertainty.
Then there is the complexity of IBM’s culture and structure. IBM itself, aside from the businesses, is a pretty complicated fellow. The organization is hierarchical, and the culture has changed gradually and slowly since Gerstner took it over in the early 1990s. I would not be surprised if IBM is subject to what Warren Buffett (Trades, Portfolio) calls the ABC symptom – Arrogance, Bureaucracy and Complacency. The trouble with this level of complexity is that you can imagine very often simple problems or decisions can get very complicated due to the organizational structure and culture. In a world where things change rapidly, this is certainly not ideal.
Now let me get back to my three questions regarding circle of competency?
1. Can I understand the business model? Barely.
2. Can I understand the most important factors that will make the business succeed or fail in the long run? No.
3. Can I come up with reasonably good assessment of how these factors will play out in the next 5-10 years? Absolutely no.
I am not saying that IBM is not understandable. I just think there are a lot of important moving pieces, and it is too complicated for me. I probably could spend a few more months and maybe a few more years to really understand the business, but the opportunity cost is too high. I’d rather move on to the companies I can understand as opposed to trying to figure out what Mr.Buffett sees that others don’t see.
There is nothing wrong with admitting I don’t know and acting accordingly. There is nothing wrong with missing out on something you don’t understand. But to follow Mr.Buffett without knowing why, is perilous in my opinion.