Why IBM And Cisco Are Actually Twins

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

Editor's Note: The initial paragraph references IBM's PC business. IBM sold off their PC business to Lenovo in 2005. This article has been corrected and Motley Fool apologizes for the error.

At first glance, International Business Machines (NYSE: IBM) and Cisco (NASDAQ: CSCO) appear very different. The former is a $230 billion behemoth that provides IT services, while the later is "only" a $130 billion company that sells devices like routers and switches which regulate traffic on the internet. But I believe that IBM and Cisco are much more similar than you might think. In fact, I believe that the two tech giants will grow to become more and more similar over the next few years.

Core business

Over the past decade, IBM has successfully implemented what I believe is the most successful business transformation in corporate America. It moved from a less-profitable hardware business to a highly-profitable software business with a special emphasis on the IT segment. You see, IBM's margins were collapsing because it was selling PCs, a highly competitive consumer product. The switch to IT services greatly improved IBM's profit margins and turned it into the world leader in this field. Cisco has been walking in IBM's path. 

Like IBM, Cisco took a run at consumer products. It turned out worse than IBM's consumer business. Cisco's Flip video division flopped, and management shut it down. It sold its Linksys home router business to Belkin. Cisco and IBM learned the same lesson: consumer markets are low-margin, ultra-competitive, saturated businesses. The only sure way to win in a consumer- oriented market is to be a monopoly like Microsoft (NASDAQ: MSFT). Mr. Softy controls approximately 90% of the market for operating systems. When you're so dominant - you have the privilege to become a "price- maker" rather than a "price- taker" and make big profits. But there aren't many "Microsofts"out there...

IT services is a profitable and less competitive business than hardware. That's the place to be because it's the custom software and services that keep big companies running smoothly. So you're going to see Cisco selling more software and services. Cisco says it wants to be the No. 1 IT company in the world. Today, that title goes to IBM. Cisco probably won't dethrone IBM. But the world is big enough for the both of them. Cisco won't exit its core business of internet traffic regulation. That should continue to grow as Internet use grows worldwide. So Cisco's focus on services isn't as big as IBM's, but it shouldn't be, either. IBM bought more than 130 software and services businesses to help it transform. Cisco became what it is today by acquiring over 150 businesses. Cisco knows how to successfully buy businesses. That's a great skill that many companies don't have. It'll use that skill to acquire more software and services businesses. On its latest conference call, management listed five recent acquisitions. Four were software companies.

Financials of a transformation

You can see the Cisco is transforming by looking at the numbers. Like IBM, Cisco's services revenues are growing. IBM grew services from 39% of sales in 2000 to 59% today. Cisco's services business has grown from 16% of sales in 2008 to 22% today. Also, IBM's capital spending as a percentage of net income fell throughout its transition. It's the same story with Cisco. Cisco's capital spending was 16% of net income in 2008. Today, it's at its lowest level yet, around 11%. Thicker net margins and lower capital spending is what you want to see. That means IBM and Cisco are investing less money in the business while making more profit. In time, both IBM and Cisco might reach Microsoft's astoundingly high operating margin (at 35%) and incredibly low capital spending (at 7%).

The Fool looks ahead

I believe that Cisco's transformation will be like IBM's. Cisco should wind up with a more profitable business that produces more free cash flow. That should lead to more share repurchases and big dividend growth. Make sure you're there. 

 

Once a high-flying tech darling, Cisco is now on the radar of value-oriented dividend lovers. Get the low down on the routing juggernaut in The Motley Fool's premium report. Click here now to get started.


Shmulik Karpf has no position in any stocks mentioned. The Motley Fool recommends Cisco Systems. 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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