Will IBM Reinvent Itself Successfully?

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

IBM’s (NYSE: IBM) formula for profit growth in recent years has been to cut costs enough to compensate for declining sales, robust share buybacks and transitioning into the higher margin software business. The 4.7% growth in net income in 2012, despite a 2.3% decline in revenue, proves my point. In the first quarter, the company missed earnings estimate for the first time since 2005, and thus came an announcement of further job cuts to reduce costs.

IBM is an over-100 year old technology company, and in today’s world, technology changes with the blink of an eye, so the old daddy of the technology industry is shifting from its century old products and services to better serve the 21st century needs.

Declining hardware business…

IBM has been facing hurdles in maintaining the growth in its hardware segment. The Systems and Technology segment declined 12% in the second quarter of 2013 compared to the second quarter in 2012, and revenue from the server segment declined 11% this quarter. Thus, after selling its PC division to Lenovo nine years ago, IBM is now in talks to sell its x86 server business to Lenovo. It started cutting back jobs last month as a part of the restructuring effort, which will cost $1 billion.

Oracle (NYSE: ORCL), too, reported a 9% drop in Hardware Systems revenue from $1.57 billion in the fourth quarter of fiscal 2012 to $1.43 billion in the fourth quarter of fiscal 2013. That included a 13% decline in hardware systems product sales to $849 million and a 3% decline in hardware systems support revenue to $582 million.

Transition into the software zone…

Revenue from the software segment came in at $6.4 billion, and key middleware products came in at $4.3 billion, up 4% and 9% to same period last year, respectively. This shows IBM is doing the right thing investing in high-growth and high-margin businesses; the software segment accounted for roughly 45% of operating profit in 2012 and management expects to grow that figure to 50% by 2015.

The cloud market is maturing, consolidating and segmenting; IBM’s cloud business was up 70% and the Smarter Planet revenue was up 25% in the first half of the year. The company acquired SoftLayer Technologies, the world’s largest privately held cloud computing infrastructure provider to bolster its cloud services portfolio. Management intends to roll the SoftLayer and the SmartCloud into a new cloud services division and expects it to generate $7 billion in revenue by the end of 2015.

IBM also acquired CSL International to provide virtualization management technology for its zEnterprise systems, thus enabling its clients to manage all aspects of z/VM and Linux on System z virtualization, including CPU, memory, storage, and network resources.

It also announced the plan to support the kernel-based virtual machine technology to further support and speed up the adoption of the Linux operating system across the enterprise. In July, IBM will open its first North American IBM Power Systems Linux Centers to make it simpler for software developers to build and deploy new applications for big datacloudmobile and social business computing on open technology building blocks using Linux and the latest IBM POWER 7+ processor technology. 

IBM’s success in the software segment is evident from its hefty operating margin at over 20%, thus the company seems to be taking the right steps to reinvent itself.

Accenture goes digital…

Accenture (NYSE: ACN) is also hopping on the cloud computing trend and has launched the Accenture Cloud Platform. The company has $400 million put aside to invest in cloud technologies by 2015 to provide a secure, scalable, and enterprise-ready cloud integration system to support the businesses going digital thanks to technology trends like mobile, social collaboration and big data supported by the cloud. The company’s cloud business is already a $1 billion a year business.

It attempts to deliver the right cloud services from its network of providers, as well as blending its own industry solutions and innovations with third party offerings and currently has agreements with 25 different cloud providers including Amazon, Google, Cisco Systems, Microsoft, Netsuite, and VMware. Clients can thus sign up with Accenture to buy pre-configured services making Accenture sort of a cloud broker.

Oracle is late but not far behind…

Even Oracle realizes the potential of the cloud business and is taking active decisions to keep up with the fast growing cloud market. It reported its partnerships with Microsoft, Salesforce.com and Netsuite to reshape the cloud and the perception of Oracle technology in the cloud. For fiscal 2013, software revenue grew 5% to $27.46 billion. That included 4% growth in new software licenses and cloud software subscriptions to $10.32 billion, while revenue from software license updates and product support increased 6% to $17.14 billion.

Oracle will make it possible to run the Oracle Database, Oracle Java, and Oracle WebLogic server on Microsoft Server Hyper-V and Microsoft Azure, and Oracle Linux on Azure effectively making it possible for Oracle customers to move Oracle workloads to Azure. The partnership with Microsoft might be a huge success proving to be profitable for both the tech giants.

Salesforce.com signed a nine year agreement with Oracle to use the latter’s latest technology for its core platform. The two companies also plan to integrate Oracle’s cloud HR technology with Salesforce.com, which would create tremendous opportunities for Oracle’s growing cloud HR business among Salesforce.com accounts.

Impeccable cash flow and attractive earnings estimates…

After a robust second quarter, IBM raised earnings estimate for the year to $16.90 from $16.78 per share, excluding the $1 billion restructuring expenses, and expects the earnings to climb to $20 by 2015. If the stock maintains its current P/E of 14.08 the stock should sell near $280 by 2015, a handsome 42% upside from here, and if the P/E improves upon the improving sentiments, investors might rake in further profits.

With the improving margins due to higher mix of high margin businesses, IBM’s operating (non-GAAP) pre-tax income margin in 2012 was 22.2%, 12 points higher than in 2000 and the free cash flow reached $18.2 billion, $12 billion higher than a decade ago.

Accenture reduced its outlook for revenue growth to 3%-4% from 5%-6% on weaker corporate spending and lowered the upper limit of the EPS range to $4.94 from $4.97 expected earlier. The stock currently sports a P/E 16.72 which is higher than that of IBM.

Analysts expect Oracle to earn $2.92 per share for fiscal 2014 which at a current P/E of 14.49 implies over 28% upside to the stock at $42.31.

Investor friendly dividend and buy-back program...

Management recently declared a regular quarterly dividend of $0.95 per share, thus yielding 1.90% annually; the company has raised its dividend in each of the last 18 years. Along with the dividend hike, the board also authorized $5 billion in additional funds for use in the company’s stock repurchase program. The regular dividend hikes and share repurchase programs is one of the reasons why IBM makes the third largest position in Warren Buffett's portfolio.

Final takeaway

IBM has consistently delivered results. Management was fast to understand that they needed to find new areas of revenue to offset the declining hardware business, and thus became more focused on the higher margin software business, which has played a huge role in keeping the company’s rise even after decline in revenue.

The company is now in a strong position to grow its earnings at a faster rate thanks to the success of its software and services business. And the superb buyback program and a healthy dividend yield takes care of the investors while the earnings rise. I think this trusted company will be a good add to your portfolio in these volatile times. 

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Tushar Agarwal has no position in any stocks mentioned. The Motley Fool recommends Accenture. The Motley Fool owns shares of International Business Machines. and Oracle.. 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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