Sum of the Parts: Another Shakeup at IBM

10/19/2020 5:00 am EST

Focus: TECHNOLOGY

Jason Clark

Contributing Editor, The Prudent Speculator

Shares of IBM (IBM) recently rose following news that the technology giant plans to spin out its infrastructure business, observes Jason Clark, a value investing expert and contributing editor to The Prudent Speculator.

In an open letter to his IBM team, CEO Arvind Krishna wrote, “We have decided that the managed infrastructure services business of our GTS segment will become an independent company … we expect the new company to be created sometime toward the end of 2021."

He added, "IBM will sharpen its focus on its open hybrid cloud platform and AI capabilities. And the new company will focus on delivering managed infrastructure services.”

In our view, the shakeup was long overdue. For decades, IBM has been slow or unwilling to innovate. Management worked hard to stay stuck in neutral, firing or pushing out executives that wanted IBM to focus, a practice that was especially prevalent under CEO Louis Gerstner in the early 1990’s.

While Mr. Gerstner’s early work was largely positive, IBM’s big bet on OS/2 nearly broke the firm. Even though it was clear that Windows 95 was crushing OS/2, management compounded the problem when it went out and bought Lotus Development, thinking that adding an office suite to a sinking ship would magically right it.

Gerstner was replaced by Sam Palmisano in 2002, who grew IBM to the largest IT company in the world by 2009 and made acquisitions, such as PWC Consulting, that should have put IBM as the leader in cloud computing.

That didn’t happen because IBM refused to invest in databases and double-digit growth became unsustainable, requiring profitability to be shored up by cost-cutting measures.

Unfortunately, while Larry Ellison and Jeff Bezos were rapidly investing in cloud computing, Mr. Palmisano was busy doing nothing, justifying the inaction by stating, “Enterprise will have its own unique model. You can’t do what we’re doing in a cloud.”

Mr. Palmisano’s view could not have been more wrong. And when Ginni Rometty took over in 2012, the revenue decline continued.

Ms. Rometty’s IBM continued the tradition of refusing to make meaningful investments in the cloud business (until a last-ditch effort to acquire Red Hat last year), instead focusing on share buybacks to prop up earnings per share.

While we long have believed and continue to think that IBM shares are significantly undervalued, we were not unhappy to see Ms. Rometty depart earlier this year, but it was unclear to us that Mr. Krishna would be able to reverse decades of overpromising and systematic underinvestment.

It is still too early to tell if Mr. Krishna’s plan is going to be a success, but the concrete steps to move away from the all-in-one model and towards a specialization (read: market leader) model should be applauded.

Mr. Krishna’s letter seems to fully recognize the same future IBM’s competitors do, “Today, hybrid cloud and AI are swiftly becoming the locus of commerce, transactions, and over time, of computing itself.”

Even though IBM has a long way to go before any level of success can be declared, we are thrilled that the company appears to be headed in the direction of a hybrid cloud and AI solutions.

Both markets, we think, have plenty of upside potential given their relative newness, plus IBM can rely on Red Hat’s expertise (Red Hat’s CEO Jim Whitehurst took over as IBM’s President in April). It is likely to be a bumpy road as IBM transforms.

But we think that the company may actually start to reward us more handsomely (the dividend yield is currently 5.1%) for its position in our broadly diversified portfolios. Thinking that the sum of the parts is worth more than the whole, our target price for all of IBM is now $184.

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