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Finding Growth in a Cloud
01/22/2014 10:30 am EST
This technology company is facing mounting skepticism and ongoing drops in revenue, and MoneyShow's Jim Jubak, wonders if this new strategy is enough to overcome the obstacles still in its path.
Yesterday, January 21, International Business Machines (IBM) reported a seventh straight quarterly drop in revenue. Revenue fell 5.5% to $27.7 billion for the fourth quarter of 2013. That was below the $28.3 billion projected by analysts.
The company specific problem for IBM is that revenue for its older core hardware business is falling like a stone, while the company is still trying to build revenue for newer businesses, such as cloud services.
In the fourth quarter, for example, the systems and technology hardware division reported a 26% drop in revenue year over year. (Net income fell 79% from a year ago.) For the quarter, revenue in this division came to $4.3 billion.
It's no longer enough for IBM to target software and services, in general, to make up for the shortfall in hardware. IBM's software division didn't exactly tear up the track in the fourth quarter, with revenue climbing just 3% year over year. Technology services revenue fell 4% in the quarter, and business services revenue advanced just 1%.
So, where is growth supposed to come from for IBM? Cloud computing will play a central role, if I can judge from the deals IBM CEO Ginni Rometty has pursued since taking over as head of the company two years ago. Her biggest acquisition was the $2 billion purchase of cloud computing storage company SoftLayer Technologies in 2013. IBM has recently said it will invest $1.2 billion in its cloud services business in 2014. And this emphasis on the cloud ties in with the company's decision to build a new business unit around its Watson supercomputer. The idea is that a Watson supercomputer can analyze large volumes of data and let customers mine that data.
Finding growth in the cloud looks like a reasonable strategy. IBM's cloud revenue climbed 69% in 2013 to $4.4 billion.
But I think it does lead to two problems for investors in IBM.|pagebreak|
First, there's the fundamental question of whether revenue growth from cloud services (and other potential sources of growth) is enough to offset the decline in hardware revenue. IBM's strategy—or maybe call it a hope—is that it can manage the decline of hardware revenue and income, so that the pace is slow enough that it doesn't overwhelm the growth from cloud services. Investors won't know if that strategy is successful until the numbers come in. I think this is one of those Show me questions stocks can face, given the increasing skepticism I sense about IBM among investors who have come to mistrust the way the company has used stock buybacks to increase earnings per share and to distract attention from its revenue problems.
Second, there's the unfamiliarity that many investors have with the cloud computing space. It's pretty clear to me that much of the discussion about investing in cloud computing doesn't fully discriminate between commodity cloud services—the space occupied by giants such as Amazon.com (AMZN) and Google (GOOG)—and the kind of value-added cloud-based services that IBM is looking to sell. The first space, in much investing discussion, seems to be dominated by worries that falling prices—and prices for public cloud services drop every month—will kill margins. (It doesn't help that it isn't easy to figure out what the profit margins are at Amazon and Google for public cloud services.) But, to the degree I understand these businesses, I'd conclude that profit margins for the cloud business at Amazon and Google are huge—even with what is undoubtedly intense competition. And I've seen calculations that conclude that gross margins for IBM's value-added cloud services are in the vicinity of 90%. Which is why the company has decided to target cloud services for growth and to explore selling its server hardware business.
But the market's unfamiliarity with the dynamics of the cloud computing business makes IBM's decision to pin its growth strategy on the cloud adds a second Show me problem to the stock. I think IBM is going to have to prove that this strategy works with some hard numbers.
Until the company begins to report numbers that make it clear that this growth strategy works, I doubt that IBM's shares will do much of anything. But the potential for this strategy to work is certainly there—and I'd watch the company's numbers over the next few quarters to see if IBM can start to answer that Show me skepticism.
Full disclosure: I don't own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund, I liquidated all my individual stock holdings and put the money into the fund. The fund may or may not now own positions in any stock mentioned in this post. The fund did not own shares of IBM as of the end of December. For a full list of the stocks in the fund see the fund's portfolio here.
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