IBM Admits It Is Time to Turn Over a New Technological Leaf

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The chief executive officer of International Business Machines (NYSE:IBM), Ginni Rometty, has acknowledged that the technology manufacturer fell short of expectations last year, making it necessary for the company to address its struggling hardware businesses. “We must acknowledge that while 2013 was an important year of transformation, our performance did not meet our expectations,” Rometty wrote in a letter to investors included in the company’s annual report. “While we continue to remix to higher value, we must also address those parts of the business that are holding us back.”

What the company must figure out is how to profit from selling selling technical services to support the burgeoning corporate use of smartphones and tablets.

IBM’s revenue decreased 5 percent last year. Ahead of the technology giant’s release of fourth-quarter and full-year results, analysts were already questioning the quality of IBM’s earnings. After peeling back the layers of the company’s earnings report, it was clear that even though IBM management is able to almost systematically beat Wall Street expectations, the company is no longer the reliable earnings machine it once was. In the seven consecutive quarters through the fourth quarter of 2013, IBM’s revenue has fallen, largely due to weakening demand for its hardware products. “The poor near-term results and question raised about farther out earnings power can’t be ignored,” wrote UBS analyst Steve Milunovich in an October research note to clients.

In the fourth quarter, IBM did manage to beat bottom-line expectations, but the technology company was able to exceed Wall Street forecasts and grow earnings largely because of its efforts to cut costs, which included job reductions, the sale of low-margin businesses, and lower income-tax provisions. Cutting costs, favorable tax brackets, and share buybacks are strategies to boost earnings, but strategies do not make for quality earnings growth. In particular, IBM’s methodical buybacks of its own stock are problematic, even if they do boost earnings per share.

While in some climates, a stock buyback suggests to investors that a company is confident in its future — and willing to invest in that future — it is not always the best sign. In other climates, when revenue is falling, a stock buyback indicates that the company’s executives are mired in problems, reluctant to use cash to launch new products, purchase another company, or build a new factory. Even with the numerous share buybacks, investors bid the stock down 2.1 percent in 2013, making it the only stock in the Dow Jones Industrial Average that lost value in the past year.

Last year’s results not only concerned shareholders but prompted IBM executives to forgo annual bonuses. “In view of the company’s overall full-year results, my senior team and I have recommended that we forgo our personal annual incentive payments for 2013,” Rometty said in January’s earnings press release. IBM management also decided to shrink the company’s workforce for the first time in a decade.

Still, even though revenue has declined on a consecutive quarterly basis, Rometty has reaffirmed the company’s guidance for the current year. “As we enter 2014, we will continue to transform our business and invest aggressively in the areas that will drive growth and higher value,” said Rometty in the earnings press release. “We remain on track toward our 2015 roadmap for operating EPS of at least $20, a step in our long-term strategy of industry leadership and continuous transformation.” But that does not mean the company has not changed course.

As Wells Fargo analyst Maynard Um wrote in a January research note,” IBM has faced some macro and execution challenges and, in our view, has fewer levers to drive EPS without revenue growth.” That being said, IBM needs to find growth strategies, and the name of the game is adaption. As Rometty said in her letter to shareholders, the world is generating massive amounts of data, and the company’s annual report was devoted to its plans to ignite growth through data, with a deeper focus on cloud services and data analytics.

Rometty began her letter to investors with several questions:

“What will we make with a planet generating unprecedented amounts of data? What will we create from — and with — global networks of consumers, workers, citizens, students, patients? How will we make use of powerful business and technology services available on demand? How will we engage with an emerging global culture, defined not by age or geography, but by people determined to change the practices of business and society?”

She then explained that “to capture the potential of this moment,” IBM is reshaping itself to take advantage of that “unprecedented” quantity of data.

The company has already taken an important step along this path by shedding unneeded assets. IBM is moving away from small servers because it recognizes that the progression of technology is leaving such hardware behind. Cloud computing is the future, and providers of that service will offer computing power, software hosting, and data storage for annual fees. Corporate data centers will run on a fraction of the servers once needed. As a result, margins in the software and service side will grow because fewer capital dollars must be spent per customer.

At one time it was said in the computing industry that IBM would never pursue a particular business unless it was believed to be able to generate at least $1 billion annually, and it seems the reverse is also true: The tech company will divest a business that going away even if it still turns a profit. Just as IBM sold Lenovo its PC business before the personal computer industry tanked, Lenovo has agreed to acquire its low-end server business.

To be a competitor among providers cloud computing — where computing services are delivered online rather than via computers — IBM has both turned to acquisitions and higher capital expenditures since Rometty became chief executive two years ago. The company bought cloud-computing storage company SoftLayer Technologies in 2013 for approximately $2 billion, and now IBM is integrating existing hardware and data analytics with its services. In total, the tech giant plans to invest $1.2 billion in the cloud-services business this year.

Primarily, IBM’s mission is to deliver Watson — the Jeopardy-winning computer whose software enables it to learn from past experience, analyze vast amounts of data, and answer questions — through the cloud. The company announced a new business division in January based on the supercomputer. IBM will invest more than $1 billion in that division, and through Watson, customers will be able to mine vast amounts of data, which will be run on SoftLayer’s cloud.

IBM has adapted before to the changes of technology, sometimes before the curve and sometimes a bit later. After introducing its mainframes to the corporate world in the 1960s and 1970s and its desktop personal computer in 1981, which became the industry standard, new computer makers pushed the company to the edge of bankruptcy in the 1990s. But IBM adjusted, learning to sell services and software to companies in the Internet age. Now it is time for Rometty to change IBM once again.

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