IBM Makes a Bold Move Into the Cloud with Softlayer Acquisition

Mike is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

IBM (NYSE: IBM) recently announced that it would purchase privately held Softlayer, the world's largest private cloud computing firm. The reported purchase price of about $2 billion suggests that IBM is serious about making a bold move into the cloud on the heels of similar moves by major rivals like SAP (NYSE: SAP) and Amazon (NASDAQ: AMZN). Although investors cannot directly play this private transaction, it certainly looks poised to create significant synergies as well as some juicy medium-term profit opportunities for investors with suitable time horizons.

While no merger is risk-free, this transaction offers some clear advantages for IBM. In particular, it should permit the company to make a decisive move into the rapidly expanding world of start-up support. If things unfold as IBM hopes, the company may look very different in five or 10 years' time. For now, it might be helpful to compare IBM against some of its most aggressive and well-known competitors.

IBM and the Competition

Although IBM competes against software giants like Microsoft as well as consulting giants like Accenture, its biggest competitors in the cloud computing and server-hardware space may be Amazon and SAP. All three of these firms are highly diversified, but they are also known to compete vigorously for a finite base of deep-pocketed business customers. As IBM moves more decisively into the world of cloud computing, it is likely that they will continue to clash.

IBM is the largest of the three firms: Its market capitalization of $226 billion exceeds that of Amazon by roughly $100 billion and surpasses that of SAP by about $135 billion. IBM is also solidly profitable--in 2012, it pulled in $16.6 billion on total revenues of $103.2 billion. This compares to a solid $3.8 billion profit on revenues of $21.3 billion for SAP and a narrow loss of $87 million on revenues of $64 billion for Amazon. Despite its loss, Amazon remains more expensive than IBM or SAP. Its price-to-book ratio of about 14.9 is a full three ticks higher than that of IBM and far more impressive than SAP's 4.7. Although these firms are relatively well-capitalized, IBM's debt-to-cash ratio of about 2.5 could become worrisome in the coming years.

What Does Softlayer Do?

Softlayer manages about a dozen data centers around the world and offers server-rental services that have proven to be wildly popular. It serves tens of thousands of start-ups and mid-sized firms that prefer not to operate in-house server networks. These outfits are free to rent space within Softlayer's data network on a monthly, annual or long-term basis, and the fees that the company charges are proportional to the volume and length of each rental contract. This is not a groundbreaking business model: in addition to the competitors named above, several public and private firms engage in this activity. However, Softlayer is a major player in the space and has clearly found a winning formula.

Potential Synergies, Savings and Other Advantages

Since this is a private transaction, IBM is under no obligation to report on its financial particulars. However, it seems clear that it will eventually produce substantial cost savings and synergies. If IBM is able to slow the expansion of its mainframe business and leverage Softlayer's more cost-effective servers-for-hire, it could save many millions of dollars on an annual basis. Moreover, the company may be able to divert some of the funds that it devotes to old-fashioned sales and marketing to maintaining and upgrading Softlayer's existing network. Meanwhile, IBM should see a significant revenue boost from this deal: analysts estimate that Softlayer could add as much as $500 million in revenue to IBM's top line over the coming fiscal year.

Does IBM's Position Improve?

On paper, this deal has obvious benefits that should materially improve IBM's competitive position. In a technology industry that is ever more reliant on cloud-based platforms and "flexible" server space, IBM's lucrative but aging mainframe and fixed-server business is beginning to show its age. While large companies undoubtedly still need large, custom-built servers that can be operated in-house, tech start-ups and even medium-sized firms are often unable to make the significant outlays necessary to procure such infrastructure. These fast-growing firms generally turn to IBM's more nimble, cloud-focused competitors to find solutions to their issues. Simply put, the Softlayer acquisition should establish IBM as a solid cloud-based alternative.

Long-Term Outlook and Possible Plays

While there will still be a place for traditional in-house servers and mainframes for some time to come, these expensive pieces of hardware may soon be relegated to the engine rooms of major Internet companies or security-conscious government agencies and contractors. Meanwhile, smaller and more nimble firms will accelerate their migration to the cloud. IBM is now positioned to take advantage of this medium-term trend, and its stock price could benefit as a result.

In sum, this deal does not offer an arbitrage opportunity or special distribution. However, it does offer some interesting synergies that could benefit IBM's shareholders in the long run. If the company can successfully integrate Softlayer into its operational structure, it may well raise its dividend or use the extra cash flow to fund a program of share buybacks. Investors who believe in the future of the cloud would be remiss not to take a look at this situation.

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Mike Thiessen has no position in any stocks mentioned. The Motley Fool recommends Accenture. The Motley Fool owns shares of International Business Machines. and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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