Disclaimer: I worked on this pitch with my colleagues James Rao, Preston Ching and Kevin Lu from the Wharton School for a stock pitch competition. For reference, here are their emails: jdrao@wharton.upenn.edu, kevinlawrencelu@gmail.com and cyjpres@sas.upenn.edu. Credits for the title of this post go to James.
In my last post, I mentioned that I purchased a stake in IBM (~10% of my portfolio), but I don’t think I gave a convincing rationale. This post serves to fill in that gap, explaining my rationale for purchasing IBM a few months ago.
Company Description
What is IBM? The most common answer is a multinational technological giant. Those who have followed the company more closely may add it has significant mainframe, hardware, and software products. But today’s IBM is increasingly positioned as an as-a-service (aaS) provider and within the next decade, its business model will primarily be in a new wave of technological strategic imperatives, CAMS: Cloud, Analytics, Mobile, Security and Social. Cloud computing, a method of storing and working with data, is increasingly on the rise due to the easier accessibility and transferability. Analytics services utilize big data- representative of vital value chain activities like procurement, management, and scale- to make evidence-based business decisions. Mobile solutions bring together IBM’s versatile technologies to accelerate business initiatives and drive digital innovation. Security in an increasingly dangerous world is vital to protect business insights and proprietary property, and collaborative solutions are necessary in an interconnected world. IBM operates under five business segments (Exhibit B). Cognitive Solutions leverages the power of AI to create meaningful applications for businesses; Global Business Services provides consulting and management services to clients; Technology Services and Cloud Platforms provides infrastructure services; Systems focuses on providing hardware and operating systems; and Global Financing deals with payment plans, reselling of used equipment and financing.
In 2017, IBM’s strategic imperatives represented 46% of overall revenue with growth of 11% to take up almost half of IBM’s overall revenue. This halfway point suggests IBM is quickly reaching an inflection point from its current transition period, having redefined its core strengths and business segments. The fundamental underlying business model change has been from products to services. Before, IBM sold on-premise hardware or goods that their customers had complete ownership of. Now, IBM, like many other companies and industries in an increasingly rent-based, sharing economy, has focused on annuity services based on subscription models. IBM’s continued strength in forming partnerships with other tech and industry-focused players, as well as its role as an integrated service provider, will accelerate its transformation in a changing world.
Summary of Investment Thesis
In 2010, IBM’s CEO, Sam Palmisano, set an EPS target of $20 by 2015. It was amid a time of declining revenues and public scrutiny surrounding IBM’s implementation of new turnaround strategies to reposition the historic tech firm in an increasingly disrupted world. Over the years, enthusiasm waned as investor fatigue began to set in after quarters of deteriorating top-line numbers. We believe this sentiment was augmented recently as Warren Buffet exited his position in IBM, citing “big competitors”. Today, despite revenue growth in the fourth quarter of last year and nearly half its business coming from its new ‘strategic imperatives, IBM is trading at historically low multiples. We believe investors have grown tired and abandoned the stock right at the moment when IBM is beginning to show the greatest signs of resurging strength.
“Cloud computing” and “artificial intelligence” have become buzzwords of modern society, but few understand the underlying meaning of these terms. We believe that this lack of understanding characterizes the investor sentiment regarding the prospects of IBM. After researching the technology behind this seeming transformation of the IT industry, it becomes apparent that IBM is far from lagging behind other competitors like Amazon Web Services (AWS) and Microsoft. In addition, when a company is radically changing its suite of products, the past record is not a good indicator of future prospects; therefore, we do not endorse the strategy of many analysts of projecting past trends into the future. Instead, our thesis comprises of three major segments: (1) Contrary to public opinion, IBM is actually a leader in the new cloud computing space and figures suggest that this cloud revenue is more accretive to value than that of other cloud vendors like AWS, (2) IBM’s legacy business is an asset rather than a liability since large legacy clients provide a ready market for IBM’s new suite of services and (3) the as-a-Service fee structure and off-premise offerings provide both predictable annuity revenue and lower costs of operation that will drive value for the long term.
Firstly, anecdotal evidence and comparisons with other firms suggests that the market is not valuing IBM the same way it values other players in this space, despite the fact that IBM is a leader in the cloud computing space with cloud revenues over four times that of its next largest competitor, Google. Secondly, those who do not understand that not all cloud revenue is created equal will fail to understand that while a company like AWS has a higher market share, IBM actually has a larger presence in the enterprise-focused, stickier PaaS and SaaS segments of the market. Thirdly, the investment community exaggerates the decline in IBM’s legacy business but fails to acknowledge that the mainframe is still a very integral aspect of the industry and we are merely witnessing its commoditization rather than its demise.
What’s better than having the first-mover advantage? Already having a captive market, and this is exactly what IBM’s legacy business provides. IBM’s long-time clients- large, established companies with mission-critical systems hosted on IBM’s systems in integral industries- are all economically more receptive to staying with IBM. In addition, the trend towards the “hybrid cloud” further increases switching costs for legacy customers because they will be utilizing IBM services both on-premise and off-premise. In fact, on their most recent earnings call, management expressed enthusiasm in moving IBM’s entire $120bn backlog to the cloud.
Finally, many investors cite lowering service revenues and transactional revenues as reasons to exit IBM. On the contrary, this is exactly what we’d expect from a company undergoing a change from providing on-premise services to remote services. Previously, IBM would sell hardware/license software and provide continual maintenance services to its clients; now, all the maintenance is done in-house leading to a decline in service revenue. However, this change results in increased annuity-based revenue which is more predictable and sustainable than the company’s legacy business.
To reiterate, what led us to believe that IBM is undervalued on the basis of a misunderstanding in the market was the fact that many assets for IBM are currently considered as liabilities by the investment community. This is reflected in the current valuation of IBM relative to its direct peers (like Oracle and SAP SE). Our valuation based not on the past record but on predictions about the future of this industry suggests a 65% upside for IBM. We believe our valuation was based on modest estimates regarding the future of the industry and IBM’s respective market share thereof. In addition, this analysis does not include the effect of share repurchases and dividends (current dividend yield is about 4%). These factors suggest even a larger upside for IBM over the next 3-5 years.
Industry Overview (Cloud Computing)
Our story begins in 2002, when the so-called “IT Sector” began to conflate two breeds of IT companies: the consumer-goods companies (Lenovo, Microsoft, Hitachi, etc.) and the enterprise-focused firms (Oracle, SAP SE, etc.) Traditionally, all IT companies serviced both segments of the industry; in fact, IBM itself had a Personal Computing (PC) division and hard disk division. In these consumer-goods markets margins were razor-thin, and companies essentially competed on price. Moreover, the development of technology burgeoned the commoditization of these products to the point where a once lucrative growth opportunity devolved into a perfectly competitive one. Therefore, IBM elected to be the latter, sold its hard drive and PC businesses (to Hitachi and Lenovo in 2002 and 2005, respectively), and a transformation ensued. Prior to this, IT solutions were simply another “product” companies would buy. Samuel J. Palmisano, the CEO at the time, coined the term “On-Demand Businesses”. In essence, these businesses did not operate in a transactional nature; they expected their IT solutions to improve the underlying business itself, from supply-chain procurement to data integration. Increasingly, enterprise-focused IT companies became consultants (in fact, Services made up half of IBM’s revenue for the latter part of the last decade). While radical changes have occurred since the early 2000s, they can all be traced back to the concept of On-Demand Businesses- specifically, businesses never wanted to wait for IT services; rather, they wanted IT services to continually be molded into the daily operations of the company. To this end, the majority of IBM’s Service contracts are a combination of each segment.
More recently, a new trend has taken hold: the diversion from hardware altogether. IBM had early success with its various operating systems (in particular, its xSystems and Blade); however, clients soon realized that on premise IT servers were cost-ineffective. To use an analogy, a college graduate with the option to rent an apartment or buy a house will most likely rent an apartment. An on-premise server(s) is akin to buying a house, and property taxes, utilities, and lawn-mowing expenses for houses are analogous to cooling systems, IT departments and server maintenance for on-premise systems. Continuing with the analogy, wealthy/older individuals are the only ones who could afford houses, even mansions. Naturally, on-premise systems are only cost-effective to the largest companies with the highest volumes; however, they were the only option for a long time as companies had no way to outsource their physically large servers. Enter cloud computing: the ability to rent IT services from a cloud vendor. Cloud computing comes in three flavors: Infrastructure-as-a-Service (IaaS), the most basic data storage systems; Platform-as-a-Service (PaaS), platforms or operating systems to build applications upon; and Software-as-a-Service (SaaS), actual applications, both general and industry specific, for clients to leverage. However, these are not separate offerings; rather, they’re a tiered-system. For example, a client cannot leverage applications produced by IBM without first housing its data on IBM servers- as a result, these offerings are not of equal quality. Instead, they are ranked in order of stickiness: it is easy for a company to move its data from Oracle to IBM but difficult to use another vendor’s applications as this would require worker retraining and a temporary shut-down of operations.
When comparing different firms in the cloud computing space, this realization is critical. To begin, when asked “Who are the top three cloud vendors?” most industry professionals respond, “AWS, Microsoft and Google.” While it is true that Microsoft and Amazon Web Services hold the top two positions, respectively, Google actually ranks 4th. The real standings, notwithstanding the fact that cloud revenues are difficult to measure in their current state, are Microsoft ($20.4bn run-rate), AWS ($18bn run-rate), IBM ($17bn run-rate) and Google ($4bn). It is apparent by this comparison that this industry has three large leaders, but even this is not the correct way of viewing this space. AWS focuses almost exclusively on IaaS, running virtually no applications for its clients, while IBM focuses on offering a suite of services (as aforementioned, most contracts cover all segments). Moreover, AWS services the smaller breed of corporation, so it is difficult to make the comparison with IBM, whose clients mainly include large companies in the financial sector. Additionally, Microsoft is, at its core, a consumer goods business and as we discussed, it is becoming increasingly difficult to service both enterprises and consumers considering the commoditization of various technologies. If this is the case, then why has IBM been given such a dismal future by the investment community?
Well, in the past, IBM has been the undisputed leader in the mainframe business- to this end, every business hosting mission-critical systems would have utilized IBM servers. Therefore, a large portion of IBM’s revenue base consisted of this legacy business that once was the norm; since other companies had less reliance on this business (for example, AWS never sold mainframes), they found it easier to switch to the new model than IBM. However, a large reason why the adoption of the as-a-Service model hasn’t been stronger is because of the reluctance to move on-premise systems onto the cloud. The main concern clients have regards security, and while this reluctance has been tempered somewhat in recent years, it is likely to remain a paramount issue. In fact, mainframes still remain the preferred method of running mission-critical systems. According to the State of the Mainframe 2017 Report, over 60% of organizations report that they have no plans to discontinue using the mainframe while over 70% plan to stay on the mainframe for upwards of 6 years. According to the same report, almost 74% of CEO’s reported that mainframes were “very important” in performing large-scale transaction processing on mission-critical systems. Clearly, the “switch to the cloud” is not as pronounced as indicated by the literature and media coverage on the issue. The real widespread issue here is the adoption of the “connected mainframe”, that is, an on-premise server, albeit smaller, that leverages the security/privacy advantages of being on-premise while also enjoying the benefits of off-premise as-a-Service functionality. The term to coin here is the “hybrid cloud”, essentially a conflation of utilizing the services of a cloud vendor while still hosting certain sensitive data on a private cloud. The adoption of this is startling- according to RightScale’s State of the Cloud 2018 Report, 81% of CEO’s admit to utilizing some form of the hybrid cloud.
The problem here, as in the past, will be the commoditization of the mainframe. As the importance of an on-premise mainframe diminishes to simply holding sensitive data, companies will have less incentive to upgrade to new IBM products. For example, back in 2003, IBM introduced its Blade servers as part of its xSystems- rest assured, xSystems enjoyed dramatic growth over the next few years as companies replaced their “outdated” systems with this new technology. We believe that this is not likely to happen in the future, and investments in creating state-of-the-art software will likely not produce a favorable return on investment. However, history has shown us that IBM is not in the commodity business- seeing some sort of divestiture/sale in the future is not a remote possibility and such an event will bolster investor confidence if not yield direct monetary value.
Industry Overview (Artificial Intelligence)
It was the moment of truth. IBM’s Grand Challenge project of putting in a computer called Watson against Jeopardy legends was finally being aired on television screens across America. And Watson gave them a show, handily beating the other contestants with $77,147. But Watson, and the greater AI industry, will be worth many times more those winnings in coming years.
IBM’s Watson was one of the first significant forays into AI by a blue-chip tech company and with that, IBM gained a natural first-mover advantage. Powered by their underlying DeepQA software architecture, Watson was a heavyweight in what was, at that time, a small world. However, the tides of change have come, and increasingly, the AI space is more competitive. There are smaller AI platform start-ups backed by large venture capital firms looking to gain a share of what is a fast-growing, high-margin business. There are also the perennial tech companies like Amazon, Microsoft, and Google which are building out their AI software and platforms. This may represent increasing competition and put pricing pressures on IBM’s current AI business model. Nonetheless, out of all of these, IBM’s Watson has been able to maintain strong brand recognition and reputation, as well as a broad portfolio of services to provide.
But why did IBM choose to display Watson on Jeopardy? This was a very conscious decision on the part of IBM management- it is very easy to create a computer that can answer trivia questions, but extremely difficult to create one that can handle what in tech lingo is called “natural language”. Here is a sample Jeopardy question: A porch adjoining a building, like where Mummy often served tea. To begin, this is not even a question; to make matters harder for a computer, the answer is not “Terrace” but “What is a terrace?” Finally, the answer depends on our human experiences or what we expect would happen under certain circumstances. What makes AI different from a computer is the ability to “learn” from questions like these, similar to how a baby learns a language. More than that, AI can decipher unstructured data, that is, data that isn’t organized into an excel sheet. Some examples include doctor dictations, handwritten notes and images. It is estimated that over 90% of all the data on the internet is unstructured, giving AI a large potential market.
The nature of feeding highly sensitized and private competitive data to third-party AI tech will provide an economic moat to IBM Watson against both fragmented startups and the larger FAANG tech players. Significant portions of their future growth will come from Watson’s Internet of Things (IoT) in which IBM has made a $3 billion commitment. According to IDC, global spending on IoT will reach $772.5B by this year, an increase of 14.6%. This strong industry growth is driven by increasing enterprise adoption, with Gartner reporting that by 2020, 65% of enterprises will have adopted IoT products. Exhibit C1 shows the areas most likely to have the hottest growth, while Exhibit C2 displays IBM’s competitive landscape advantage in capabilities and strategies as an industry leader. Currently, it’s considerably crowded and fragmented in IoT platform services, but over time, only the larger players able to maintain profitability will survive, benefitting incumbents like IBM. While to most onlookers, it seems that IBM is too outdated; the reality is that IBM Watson is actually known for its most comprehensive and widest set of uses and abilities. In AI, initial data input is essential to train the computer algorithms and programs effectively, and IBM’s considerable head start and pre-existing partnerships with major Fortune 500 companies will prove to be vital in gaining executives’ trust in handing over these private data sets, especially given IBM’s increasing strength in cybersecurity.
In 2015, only one healthcare organization used IBM Watson Health for oncology, but by 2016, there were eight. Now, the technology has been deployed across 155 hospitals and organizations and diagnosis capabilities have dramatically increased as well, serving 147,000 patients, according to Watson Health General Manager Deborah DiSanzo. In a healthcare industry defined by stringent regulations on patient privacy and information protection, IBM’s reputation for both cybersecurity and trusted partnerships will be essential in convincing companies to release their data. Large healthcare organizations are well known for their conservatism toward technology, and IBM still does well in marketing itself outward to other executives and IT managers. IBM requires critical data input synergies to run AI platforms like Watson effectively. The more time and instances an AI program is used, the better it is in providing solutions; in other words, a built-in sustainable competitive advantage. Watson’s progression over different versions is showcased in Exhibit C3, drawn from a 2012 presentation that Watson has likely continued to make advancements since. Their recent acquisition of Truven Health Analytics will provide further information advantages by expanding their database to 300 million patients and double IBM Watson’s employee numbers (Truven previously used data analytics to help players in the healthcare industry reduce costs). All of this leads to why IBM officials have said that Watson is “a big part of our growth in overall analytics which was $17 billion last year” (Earnings Call).
When it comes to AI, the name of the game is data. A company can have the most sophisticated machine learning algorithms, but these are generally unhelpful without the input of massive amounts of data. Take the simple example of Amazon’s Alexa which is widely recognized to have the most advanced voice recognition in the world- while the technology behind Alexa is simple compared to other voice recognition systems, Amazon’s scale gives it access to large datasets that make Alexa more powerful by the second. Another consumer example is Apple’s Siri- while Siri seemingly gets “better” with every new iPhone, the technology behind this AI system changes little, if at all. Additionally, many AI platforms (including Watson to some degree) are open source, making “proprietary technology” hardly a differentiating competitive advantage. After consulting with machine learning experts at the University of Pennsylvania, we came to the conclusion that a company with little access to data will never win in the AI market. This implies that the big winners in the AI world will not be small technology start-ups; rather, it will be those with the greatest access to data: Amazon’s Alexa, Microsoft’s Cortana, Google’s DeepMind and IBM’s Watson. Of all these, it is generally accepted by experts that Watson offers the most comprehensive suite of services in the industry. This realization also sheds light on the reasoning behind many of IBM’s recent acquisitions. IBM’s major problem has always been little access to data, and this was a direct result of the company electing to be enterprise-focused. To use a comparison, Amazon owns the data of the millions of shoppers that visit www.amazon.com every day; however, IBM is locked away from the data gathered by airlines, credit card companies, etc. because it is a third-party vendor with no direct access to consumer channels itself. To mitigate this, IBM has purchased companies solely for the data they provide- examples include Truven with millions of medical images and The Weather Channel in 2014. Each acquisition brings IBM closer to bridging the gap between the industry-known sophisticated architecture of Watson and the breadth of data gathered by its clients.
Comparisons
What we’ve established thus far is that the reality of this industry is construed by the headlines we see on financial reporting services, and the numbers IBM has shown do not necessarily reflect a poorly run business as much as they reflect a changing industry. To reiterate, IBM was the largest (and some may say only) player in the enterprise-focused IT solutions space before the entrance of cloud computing and artificial intelligence- rebalancing operations to meet with these changing needs requires considerable time and investment; moreover, there are other players in this space. While it is difficult to compare IBM to Amazon and Microsoft since the latter two do not report unconsolidated figures other than revenue for their cloud segments, we can compare IBM to two of its direct competitors: Oracle and SAP SE.
For our comparison, we use figures for the previous ten years using three metrics: operating margin, return on invested capital (defined as net income into the sum of debt and equity) and return on equity (defined as net income into shareholder’s equity). Both IBM and Oracle display a favorable showing during the period 2010-2013 due to the economy coming out of a recession; SAP does not display the same trend, most likely as a result of its operations being mostly based in other countries. After 2013, all companies display a downwards trend; however, as expected, the trend is more pronounced in IBM’s numbers due to its being a leader in the legacy business. Looking solely at operating margin, we see that Oracle has the highest and steadiest showing with an average margin of 36% for the period presented, relative to 24% for SAP and 19% for IBM. Bringing returns into this picture, however, a contradictory picture emerges. Oracle has the lowest ROIC of 14%, followed by 17% for SAP and 29% for IBM. Looking at ROE, IBM again takes the lead with a 38% average ROE for the period presented, followed by 20% for Oracle and 19% for SAP. While IBM does have a larger debt burden than both of its comparisons, it takes the #1 spot in both ROIC and ROE, leading us to conclude that IBM is more profitable relative to its competitors despite lowering margins and declines in earnings.
The theme in this piece is a changing industry; in a changing industry, the past record is not as useful as we’d like it to be in predicting future performance. In this regard, trend is as important as absolute numbers. For all three companies, we define the trend by comparing the average metric from 2008-2010 to that from 2015-2017. For all three companies, the trend in operating income has been relatively stable, but the trend for the other two metrics have been severe. For IBM, ROIC has dropped from 32% to 20% and ROE has dropped from 43% to 25%. For Oracle, ROIC dropped from 16% to 10% and ROE dropped from 23% to 14%. For SAP, ROIC dropped from 20% to 12% and ROE dropped from 22% to 14%. We attribute this widespread decline in profitability to the tech-shock that we have been referring to; unless a company operated purely in the cloud computing segment, it was hit by this dramatic shift. For example, Salesforce, which operated almost exclusively in the SaaS segment, did not display this trend. Thus, we can expect this trend to reverse as these new technologies become a larger part of their revenue base. For IBM in particular, “strategic imperatives”- the name given to these technologies- just began to comprise half of IBM’s total revenues (in stark contrast to prevailing investor sentiment that cloud computing makes up a relatively small portion of IBM’s total revenues, we should add). What confounds us, however, is the relative valuations of these companies. While IBM has displayed a similar trend of deteriorating profitability, it still holds industry leading metrics, yet its valuation does not reflect this fact. The 5-year average P/E ratio for SAP SE is about 25.6, Oracle 20.5 and IBM 12.3. We attribute these differences to the lack of understanding of IBM’s competitive position- when a company shows declining revenues for six years, people begin to stop believing in future prospects, however fruitful. In addition, IBM is the oldest of the three companies presented, and we do believe there is a stigma of IBM being “stuck in its old ways” which disregards the fact that the numbers prove otherwise.
Key Value Drivers
Rather than focusing on increasing aggregate cloud revenue, IBM is focused on improving the quality of cloud revenue. We inquired on www.ibm.com’s live chat with a sales representative, “Our company would like to outsource our data storage systems using your servers. Can we please have pricing on your IaaS offerings?” Their reply: “Let me connect you with a specialist who will explain to you the different packages we offer to leverage both our servers and platforms for your company at the same low cost.” Unlike other major players in this field, IBM is focused on improving its PaaS and SaaS growth on top of basic data storage solutions with an as-a-Service run-rate of over 12% of total revenues. This increases the stickiness of IBM products, keeping with its legacy strategy. Previously, it wasn’t cloud solutions or AI-enabled applications but mainframe systems and software licenses; nevertheless, the strategy has remained the same: increase switching costs for clients. In addition, different offerings have different competitors; for example, the IaaS space has intense competition with AWS and other larger firms while SaaS has competition with smaller players like Salesforce. This is favorable for IBM for the reasons aforementioned regarding data.
Entrenched relationships with large clients gives IBM a ready market for new services. In addition to the size and volume of clients that used IBM’s legacy business, the type of clients also matters. For example, a retail company might find it easier than an insurance company to switch cloud vendors because it is easy for the retail company to retrain workers with new technology. The majority of IBM’s revenue (~30%) comes from the financial sector (financial services, banking and insurance) who find it easier to stay with IBM because of trust, cost, etc. Secondly, while IBM’s business has been derided in the media, its products have not. IBM products are still the standard for the industry: to quote an industry analyst in the technology sector, “if you’re running a family business, of course you’ll wanna switch to AWS IaaS because it costs less. But if you’re launching a rocket, you better hope you’re running IBM systems if you don’t want it to fail.” Finally, switching costs are directly correlated with the size of a company; considering that IBM primarily services larger enterprises, this correlation is very favorable for IBM.
Increased annuity revenue drives predictable revenue. In 2013, Adobe switched its licensing fee model to a subscription model- while subscribers were angry at the switch, the company performed phenomenally. A similar switch away from transaction-based revenue is occurring in the technology industry, and, in particular, IBM. Previously, IBM would license software to clients: this would be a one-time transaction which included software, specialized hardware, middleware, etc. However, now the company is switching to a pay-as-you-go model, evidenced by the rise in as-a-Service revenue as a percentage of total revenue. While this necessarily decreases transactional revenue, and to a large extent, service revenue, it dramatically increases the more favorable annuity-based revenue which is more predictable.
Recent acquisitions in data-heavy companies fortify the abilities of the Watson platform. If you look through a list of IBM acquisitions for the past five years, you will realize that in the past, IBM focused on increasing its data capabilities. Now, its focused on increasing its data through acquisitions of lateral companies. This is most apparent in IBM’s foray into the healthcare industry, where over 80% of data consists of unstructured physician notes, medical images, etc. Anecdotal evidence suggests that AI in healthcare can increase the ability of doctor’s to accurately diagnose rare diseases. More notably, data mining can create ways to reduce costs in this notoriously cost-ineffective industry. In this space, the most recent acquisition was that of Truven Health Analytics (2016), which has access to millions of medical radiology images to feed into Watson; in 2015, the company acquired Explorys, Phytel and Merge Healthcare, all companies that will leverage the power of Watson to create efficiencies for healthcare providers and payers. Another lateral acquisition was The Weather Company in 2014, giving Watson access to weather data across decades. Given the sophistication of the Watson platform and the speed at which it can decipher unstructured data, these acquisitions greatly enhance the competitive advantages of the Watson platform.
Opportunities and Risks
Opportunities:
Tech partnering instead of price competition: Many of IBM’s nascent business segments are in industries where there can be a high element of mission-critical cooperation. Various platforms, software, and hardware can be partnered together to create higher value to clients and drive future growth. This provides an opportunity for IBM to collaborate with other tech companies to generate market synergies and grow the overall economic pie rather than become stuck in detrimental price competition. Especially for high-innovation tech industries, it can be much more important to work together to drive a higher overall adoption rate and gain public acceptance and awareness. Reaching an inflection point for AI, cloud, and other industries’ adoption would be vital to all the players involved. We have reason to believe IBM is planning to utilize this potential opportunity, given that they emphasized partnerships with SAP Hana and Apple Core ML at their recent 2018 IBM Think Conference. Finally, since 2003, IBM has emphasized its dedication to open source technologies which burgeons the industry as a whole.
Accelerating Growth in New Trends: IBM’s bets on less well-known technological trends could pay off in the long-term as possibilities such as block-chain and quantum computing move into a larger marketplace and demand grows for these services. Many developers in financial services are considering using IBM’s platform for the growing “blockchain-as-a-service” market. This, too, involves collaboration in open source software and providing forums like Slack channels for developers to exchange ideas and build stronger human capital.
Emphasis on Cybersecurity: Cyber-crime damages are predicted to reach $6 trillion annually by 2021. With the growing risk of data breaches and cyber hacks, companies may refocus even more emphasis on data security and protection. IBM has a strong reputation for software security and with that recognition, they could have the most to gain compared to some of their competitors. IBM’s security is well-integrated into their platforms and their securities business within strategic imperatives is growing the fastest and may only accelerate in increasingly unsafe times.
Risks:
Too Much Marketing, Too Little Return: It is our opinion that IBM is currently overspending on promotion for Watson. In fact, in its most recent earnings release and call, the word Watson was mentioned at least 200 times; in addition, Watson was the focus of IBM’s recent THINK conference. If Watson does not perform as we hope or as quick as we assume in our model, our valuation and the reputation of IBM may both be affected. In addition, if IBM decides to divest Watson because of poor performance, then over $17bn of development over the past five years will have been in vain. Finally, the more resources that are spent advertising the platform, the less resources are being used to further develop it against competitors or compliment it with strategic acquisitions.
HR Recruiting Disadvantage: In an industry where tech firms compete for the best programming and scientist talent, IBM may still not be known as an enticing place to work for engaged millennial workers. This may require them to miss out on better employees or pay a premium for the same quality of talent. However, they have mitigated this by dramatically shifting the age demographics of their current workforce. Over the past five years, they have phased out more than 20,000 of their American employees who are ages 40 and over, bringing in younger talent with more nuanced understandings of IBM’s new business model segments. These younger employees will mitigate IBM’s current human capital deficit as IBM continues to redefine and turnaround its brand.
Over-Optimistic Industry Forecasts: In tech, there tends to be over-optimistic forecasts on just how quickly new emerging markets are growing. For example, Bluetooth technology was projected to grow very dramatically for many years. While it did eventually reach an inflection point of heavier adoption, many of these forecasts were later adjusted downwards. While IBM is well-positioned in technological segments that will be prominent over the next decade, it’s tougher to determine exactly when exponential growth will take off. Because of this, the time frame for this investment runs the risk of being longer than originally expected.
Acquisitions May Take Longer Than Expected to be Integrated in Operations: Over the past decade, IBM has engaged in hundreds of acquisitions to strengthen its new product portfolio. A large reason for the recent decline in margins is the difficulty of efficiently integrating this number of acquisitions into IBM’s core operations. In addition, in recent years profitability has almost halved, further indicating a failure to efficiently integrate acquisitions. If IBM cannot keep its profitability in line with its acquisitions, earnings may further deteriorate despite the company gaining market share.
Valuation
For our valuation, we conducted two analyses: a sum-of-the-parts (SOTP) analysis and a multiple analysis of the whole company. We conducted our SOTP analysis by breaking down revenue into strategic imperatives and non-strategic imperatives (with the exception of global financing since it is focused on the general financial structure of IBM). Strategic imperative revenues have increased at a CAGR of ~10% since they were introduced in 2014 and generally reflect revenues in IBM Watson and cloud services. By taking into account our future expectations of these industries, we applied a conservative positive growth rate for strategic imperatives’ revenue and continued the negative growth rate projection for non-strategic imperatives’ revenue. Eventually, we expect strategic imperatives to make up the majority of IBM’s revenue. Pre-tax income margin was also kept conservative and constant from prior years according to the respective segments. Practically, we expect modest margin improvement as acquisitions become integrated within the company’s operation; moreover, management expects margin improvement in 2018. We also concentrated interest within the global financing segment since IBM’s treats it as a separate company within IBM, consolidating all debt within it.
We then conducted a comparable company analysis for each individual business segment. We used the EV/EBIT multiple for capitalization instead of EV/EBITDA since we believe EBIT provides a better representation of the profitability of the company as IBM has a significant amount of capital assets that would affect EBITDA values and the final valuation. In addition, we believe that the effective integration of acquisitions will directly affect EBIT, providing us with a “check” on our assumptions. If IBM’s margins continue to deteriorate, this will be a sign that we did not correctly gauge the ability of management to improve margins. The mean EV/EBIT was used for technology services and cloud platforms, global business services and global financing. We calculated the mean multiples by taking the average of companies operating exclusively in the different segments of IBM. The low EV/EBIT was used for Systems for a more conservative valuation since the average multiple for data center companies are significantly inflated. There are no comparables for cognitive solutions because many companies in this space are private and recent transactions offer little public information on the multiples these companies were purchased for. Hence, we decided to use a conservative EV/EBIT multiple of 15x for this portion which is equal to the current EV/EBIT multiple assigned to IBM. Implied EV for each business segment were summed, and we concluded that the implied return on investment is approximately 65% over the next 3 years.
For the whole company analysis, operating income contributions across all 5 business segments were summed and we used an industry average EV/EBIT multiple of 15x for the base case, 18x for bull case and 10x for bear case. The risk-adjusted return on investment, with the weighted average of 60% for base and 20% each for bull and bear, is approximately 51% over the next 3 years. This analysis does not take into account the company’s dividend yield of approximately 4% per annum and share repurchases which have averaged 4.1% of total capitalization per annum over the past five years.
Khursheed Holdings 