Founded in 1911, the current version of International Business Machines (IBM, Financial) reminds me of Microsoft (MSFT, Financial), which spent nearly 13 years after the dot-com crash of 2001 trading sideways. Then, over the course of the next seven years, the stock price increased 10-fold following a turnaround.
There are some very key differences between the two organizations, but as far as the potential for a turnaround and return to growth, I believe IBM has solid prospects ahead - if it can do the right things from a business standpoint. Unfortunately, that's a pretty big "if."
The company has over 2,300 artificial intelligence-related patents and is a Gartner Magic Quadrant leader in AI for developers, and while it is trying to evolve into a hybrid cloud and artificial intelligence leader, IBM still carries a lot of weight in the form of labor and research and development expenses that I believe are unneccessary to its core business model. Moreover, its critical stronghold on the mainframe market makes a business pivot difficult.
The cycle of capital
At the risk of sounding callous, I believe IBM will need to find a way to let go of a significant portion of its workforce if it doesn’t start growing faster. The company employs more than 307,000 people around the world to generate $60.5 billion in revenue. That equates to just shy of $200,000 per employee. To be frank, I think that's too low; the company's revenue does not justify having that many employees.
IBM has become less of a technology company and more of a consulting firm over the years, and yet the stock judged on that basis still looks overvalued. IT Services industry leader Accenture (ACN, Financial) trades with a market capitalization of $185 billion, which is 52% higher than IBM, yet Accenture has been able to squeeze out more than $7 billion in profits from roughly the same sales turnover as IBM, though it has done so through twice as many employees. To put that into context, IBM produces $1.85 billion in net earnings. Wth more than 720,000 employees producing north of $10,000 per year per hire in net income, it's clear that Accenture is running an extremely unprofitable operation. IBM, on the other hand, gets $5,800 per hire with half the labor. It’s easy to see the misallocation of capital for both of these companies. It’s hard to correct.
On the other hand, while Accenture spends zero dollars on Research and Development, IBM spends over 20% of its gross profit on R&D. You can’t have it both ways, being a consulting firm and trying to stay a technology leader as well. The expenses associated with both are too high. As a consulting firm, IBM is actually overvalued by my estimates, but if IBM’s patent database can be utilized to become its main source of revenue, even being the third or fourth AI pure-play on the market would be huge.
Where’s the opportunity?
IBM has already seen a sizable shrinking in revenue, going from $98 billion in 2013 down to $55 billion in 2020. Now, it’s starting to grow again. IBM has a long-standing history as a pioneer in mainframe computers. However, with the advent of Personal Computers (PCs), the business suffered a significant decline. IBM has shifted its focus towards a new "platform" business, centered around hybrid cloud and Artificial Intelligence (AI).
These segments are expected to grow at 21% and 37% rates, respectively, through the end of the decade, according to the company. IT Services, especially at Big Blue, provide durability through high switching costs because of the integrated understanding of client technology infrastructure, which is developed over a long period of time. However, it’s also not as profitable as SaaS subscriptions. With a renewed focus on AI, IBM has an opportunity to turn consulting engagements into recurring subscription revenue.
Does anyone remember Watson? IBM seemed to have the largest competitive advantage of any company in the technology industry with Watson, but maybe it made the same mistake with the Jeopardy-winning AI as it did with operating systems. Watson was unveiled in 2011 on the popular game show, crushing the show’s biggest all time winners Ken Jennings and Brad Rutter. Now, some 12 years later we’re not even talking about it in the mainstream tech world. It seemed like Watson would be the ChatGPT that we know today, but it never came into fruition.
Also in 2011, potentially anticipating the boom years to come, Warren Buffett (Trades, Portfolio)’s Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) bought 64 million shares of IBM. However, nearly 6 years later the Oracle of Omaha would sell the position at a loss and thankfully he found a faster, fitter horse in Apple, which generates $2.3 million in revenue and $580,000 in net profit per employee per year and only spends 16% of its gross profit on R&D.
IBM will pay you to wait and see
The potential for growth based on IBM’s recent past seems unlikely; however, the company does pay out a decent 4.5% dividend yield for those willing to wait and see if it can better compete with the current leaders in cloud and AI. This was likely a reason IBM bought Red Hat in 2019, to focus on more of a platform strategy to pool resources at higher margins. Again, that’s why this reminds me of Microsoft, which shifted strategy in 2014 under then new CEO Satya Nadella. IBM seems to be aiming for a turnaround, but whether it will be successful or not, only time will tell.
The consulting segment has over 140,000 employees producing $19 billion a year in sales. Yes, clients that go to IBM’s consulting arm for an IT plan of attack could lead to sales in all other parts of IBM’s business; however, when only one-third of revenue comes from 45% of your employees, there needs to be a change.
Tough competition
IBM Cloud has about 3% of the market with Amazon's (AMZN, Financial) AWS and Microsoft's Azure dominating with 34% and 21% share, respectively. IBM is carving out a niche by going “hybrid,” which basically means that users can choose multiple cloud providers (like with Snowflake (SNOW, Financial)) or have a provider with an on premises IT system. This model is helpful for big industries away from technology that depend on data security as a core ingredient to their own businesses, like banks and airlines to name a couple.
AI and everything under that umbrella category is going to be a major focus for every big (and small) tech companyfor the foreseeable future. IBM has a wide variety of of AI solutions to put Watson to work at scale. Only time will tell if the company is successful or not in doing so, but personally, I don’t think that IBM is going anywhere. It still manages 50% of global wireless connections and 90% of global credit card transactions with a 90% stronghold on the mainframe market with roughly 10,000 installations. These are critical functions of everyday life which can’t be found in the cloud.
That said, while the stock many not see 10-fold growth in the next decade, investors are at least fairly compensated with the dividend, and the company could still outperform the broad market indexes if it puts its AI patents to better use.
