- IBM is currently in the midst of a major organizational impasse, though not in a situation as critical as in 1993.
- IBM has engaged in cost controls and huge share repurchase programs, which has led to profit margin expansion and earnings growth even though the topline has been more or less stagnant.
- The scale of the share repurchase program could be hindering IBM’s research and development spend, which is so critical in today’s ever changing world of technology.
IBM (IBM) is currently in the throes of a major organizational impasse. This is nothing compared to what it faced in 1993 when Louis Gerstner was able to turnaround the company and save it from near bankruptcy. However, the steps taken in the coming quarters would decide the future trajectory for the company. IBM has showed 10 consecutive quarters of falling sales, before currency adjustments are made. A part of it can be explained by the divestures of its legacy businesses which were not reaping a significant margin. However a major part is also due to a lack of growth in the Global Technology Services (GTS) and Global Business Services (GBS) businesses which bring around 60% of the group’s revenue.
When reviewing a technological company it is important to look at the strategic direction the company has been taking for at least a decade instead of looking at the recent quarterly results. One of the major decisions taken by the management under the previous CEO, Sam Palmisano, was to bring greater efficiencies within the entire system. They were able to increase the gross margin from 37% to over 52% during his tenure.
This increased margin helped it show 11 consecutive years of increasing bottom line even when the revenues were generally flat.
However the management also took a major financial decision which is being followed even now. This was about returning value to shareholders through buyback of shares. In the past decade IBM has been buying shares at an average rate of $10 billion every year. By expunging more shares the company has fewer outstanding shares which in turn increase the Earnings per share (EPS), which in turn helps increase the share price by reducing P/E. Ten years back they had over 1.7 billion shares outstanding. Currently this number is down to less than a billion shares. This option is generally favored over the option of giving dividends as it does not entail extra tax burden on the shareholders.
However a major flaw in this approach is the level to which it is followed. When there is no additional use of cash by the company, it is better to return the profits to the investors. However a behemoth like IBM which needs to find newer vistas of business growth can deploy this cash for R&D expense or making acquisitions which will provide future growth. Even if a small fraction of this is diverted to R&D and acquisitions it can lead to positive learning for the organization and provide it with a better product pipeline in the tumultuous and constantly evolving technological world.
Currently IBM is aggressively pursuing an entry into the cloud computing arena. However it has the disadvantage of a late entrant. There are already well established players like Amazon, Microsoft, Google and Oracle. Amazon is facing competitive pressures in spite of being one of the first movers in this space. Also this contributes a minuscule 2-3% of its gross revenue. For a technology firm to have sustainable growth it needs to have a target business, where, due to its market share it can have an overall high profit margin and huge cash flows, which can then be invested in newer areas.
Google has its search engine, Microsoft has its operating system and office suite, Apple has its lead in consumer electronics and Oracle has its enterprise software products and database management system. However IBM does not have a clear lead in any particular business segment. Within the application development segment it is in competition with other firms like Cognizant, Accenture and TCS. It is hemorrhaging money in its hardware business and is slowly divesting out of this segment. The newer areas like cloud computing is already crowded with major price reductions in the offing.
The path ahead
The management would need to take a hard look at its current strategy. With increasing automation and competition within the software services arena there would be a steady decline of margins. The company earned $16.48 billion in 2013 whilst performing a share buyback of $12.78 billion and paying $4.06 billion in dividend. This program of buyback would need to be curtailed massively if the company is to conserve capital and invest in newer products. The buybacks have also increased relative to the buybacks taking place a couple of years back.
To be fair to the company it is not the only firm using the buyback to increase the EPS. Since 2008 over $1 trillion have been used by the top 100 companies in S&P for share buybacks. If this capital was invested in building capacity it would have led to better returns for the companies and the economy as a whole. We need to only view the example of HP which spent tens of billions of dollars between 2003 and 2011 for share buybacks and is now struggling for relevance. Within the next couple of years IBM will need to answer a simple question: Whether they are playing to win? Or are they playing not to lose?
Currently the software services offerings are a cash cow for IBM. However they must utilize the profits in this area to research and develop new streams of revenue where they can maintain their advantage over other software majors. Currently the research budget is around $6 billion. They can easily increase it to double digit for the next five years.
As we move to a cashless economy, security would be a major requirement within applications. IBM has already moved in this direction with a partnership with Apple where both the companies will develop apps and software for corporate users. Instead of focusing on the Fortune 100 clients the IT juggernaut should also look at revenue from small and medium businesses. This would require the organization to be more nimble and agile in its functioning.
After the disappointing results of third quarter the company’s stock fell more than 9% and the company had to discard its EPS target of $20 by 2015. However the biggest mistake by the firm was to set this target in the first place. Having a long term target is appreciable however the entire management team was more focused on meeting the quarterly targets every year rather than focus on expanding the core business.
Every decade brings with itself a major technological change in which few firms are able to come out unscathed. First there was the mainframe revolution, then we had the start of PC era, the 90s saw the rise of internet giants, the last decade was about mobility and finally we are looking at the unfolding of a social media and cloud computing decade. Even infallible giants like Microsoft have had to modify their approach with changing headwinds.
One option for the firm is to look for another Iacocca. A person who is from the research sector can bring forth new ideas and new approach to solve the current conundrum. There can be a division of power at the top where sales and strategy is under one wing and research and acquisitions is under another.
After the current hammering of the stock it is selling at price earnings ratio of 10.26. The company has not seen such low levels since the financial crisis of 2008-09. Few believe it is a value stock and some view it as a sinking ship. The reality might be somewhere in between. IBM has shown time and again that it has the wherewithal to rise from the ashes like a phoenix. However it could be a while before the firm finds its footing and brings out a product which can provide it enough propulsion to deliver consistent higher earnings. Till that time we might see a slowly declining profit margin and market value. Wait and watch would be an ideal approach for interested investors in the present state.