IBM and the Value of Self-Disruption

By Charles King, Pund-IT, Inc.  April 20, 2016

Silicon Valley loves disruption, at least some of the time. That’s one reason venture capitalists and other speculative investors push the valuation of ostensibly nimble “unicorn” start-ups into nosebleed territory.

But when it comes to well-established mainstream companies, disruption is seldom considered a virtue or blessing. And when established companies proactively choose to follow a disruptive path rather than being pushed onto one by other forces, many investors swoon with what might be politely called an attack of conventional wisdom-induced vapors.

Self-induced corporate disruption

To one degree or another, IT vendors of every stripe are following self-disruptive paths, and for good reason. Traditional hardware and software businesses are being pressed by a variety of technologies, including those leveraging cloud computing services, software-defined infrastructures, big data information sources and many others.

With those pressures continuing to grow, vendors are rethinking and reshaping their core businesses. But their individual paths and forward progress differ markedly. For example:

  • Tired of being whipsawed by fickle investors, Dell CEO Michael Dell successfully took his company private in 2013. Dell is currently on track to complete the purchase of EMC, the IT industry-s largest-ever corporate acquisition.
  • EMC spent years expanding its business well beyond its leadership position in enterprise storage with strategically far-reaching acquisitions (VMware, RSA, Virtustream), partnerships (VCE) and development efforts (Pivotal). It is now enthusiastically embracing the Dell acquisition.
  • After numerous executive changes and failed high profile acquisitions (Autonomy and EDS), HP found stability with Meg Whitman (formerly of Ebay) as CEO. At the end of last year, the company successfully reorganized into separate companies that focus on PCs and imaging (HP) and one on enterprise IT solutions (HPE).
  • By purchasing struggling Sun Microsystems in 2010, Oracle seemed on track to become a mainstream IT system vendor. But the company has mostly focused on high performance appliances and systems, leveraging its core database and business application solutions.

IBM and innovative self-disruption

What about IBM? The company began its self-disruptive efforts long before other vendors, shifting away from its longstanding hardware-centric business. The result has been a fundamental, innovative restructuring that IBM has taken pains to explain, often repeatedly, to investors and analysts. It’s also arguable that IBM is further along in its transformation than most other vendors. In fact, the company’s Q1 2016 earnings call yesterday offers considerable food for thought in that respect.

IBM transformation hinges on efforts in what the company calls “strategic imperatives” in cloud computing, cognitive/analytics, mobile technologies and security. This new earnings report suggests those efforts are mostly bearing fruit in terms of both financial performance and growth. Those areas now account for well over a third (37%) of IBM’s overall revenues and are also growing far faster as a group (14% YoY, or 17% adjusted for currency) than IBM’s traditional business lines.

Revenues in some especially important areas, including cloud delivered as a service are growing even more robustly, with a run rate of 42% YoY (or 46% adjusted for currency) compared to Q1 2015. IBM is also continuing to invest in related strategic acquisitions, such as the deal for Ustream announced in January that will significantly expand cloud video services, and add high profile clients, including A&E Networks, BBC America, HBO, Scripps Networks Interactive and Verizon.

In addition, the company is adding key executives to lead some strategic efforts. David Kenny, the CEO of The Weather Company (whose digital assets were acquired by IBM in January), was recently named to lead the Watson Business. IBM also hired Bob Lord, former president of AOL and onetime CEO of Razorfish, as its first Chief Digital Officer (CDO). In that role, Lord will be tasked to “accelerate and scale all aspects of IBM’s digital presence, operations and ecosystem,” and will report directly to CEO Ginni Rometty.

The revenues/earning equation

It’s worth noting that IBM continues to be notably profitable despite generating lower overall revenues. That’s a point that some analysts harp on, and the markets responded to the earnings report by shaving IBM’s share price by about 6%. But it’s a point worth considering from a broader historical perspective.

For example, in this latest earnings report IBM said that it had generated $18.7 billion in total quarterly revenues with $8.67B in gross profits and $2.01B in net income. But compare that to IBM’s performance a decade ago, in Q1 2006. At that time, the company’s quarterly revenues ($20.66B) were nearly $2B higher than they are today but its gross profits and net income ($8.09B and $1.71B, respectively) were both considerably lower than the Q1 2016 numbers.

It’s also important to consider the impact of global financial issues on IBM. About 2/3 of the company’s overall business is done outside the U.S. and the continuing strength of the dollar against other currencies is a hurdle the company faces regularly (taking a 3% hit on revenues & profits this quarter).

Final analysis

Despite IBM’s generally solid performance, the news from Q1 2016 wasn’t entirely good. Some of the new strategic imperatives are growing far more rapidly than others, a situation the company would obviously like to rectify. Plus, certain traditional IBM businesses are faring worse than others. For example, sales in storage fell to $433.5M, demonstrating continuing weakness as IBM and the larger industry move toward software-defined storage. Plus, there was a double digit drop in Power System revenues after four quarters of growth, reflecting IBM’s realignment of the Power brand’s focus to the Linux market.

The news there isn’t entirely bleak. IBM’s Flash, object-based and software-defined storage solutions are doing well, and efforts around the OpenPOWER Foundation, including Google and Rackspace developing new systems based on the upcoming IBM POWER9 processors, bodes well for future business.

Overall, IBM is demonstrating exceptional financial strength. During the course of Q1 2016, the company spent $3.6B on acquisitions and capital, closing ten deals that should add measurably to its future business. It also returned around $2.2B to shareholders ($1.2B in dividends and $0.9B in share repurchases). Perhaps most notably, IBM finished Q1 with $14.9B of cash on hand — a strong balance sheet that should allow the company a free hand in pursuing additional strategic investments.

In essence, IBM’s Q1 2016 earnings report highlighted the successful progress of a company in the midst of a disruptive, fundamental transformation. That process still has some ways to go, and certain areas need obvious improvement. But the results of IBM’s willing, proactive self-disruption are remarkable by nearly any measure.

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