IBM’s future in doubt, according to Credit Suisse

IBM is caught in the downdraft of a huge transition in computing, and the company’s hardware and server business is an open wound. This week Bloomberg’s Sarah Frier broke the story that IBM was furloughing its hardware staff for a week at one-third pay sometime in August. This was confirmed by an IBM spokesperson.

The world is shifting quickly to cloud services, which run largely on inexpensive no-name hardware, often custom-built for cloud architectures. I recently wrote about IBM’s recent quarterly results (see “IBM’s numbers show the shifting economics of business IT“). IBM’s marquee “vanity” servers and x86 hardware have a decreasing market and probably are headed to a very abrupt end. IBM tried to sell its hardware business to Lenovo earlier this year, unsuccessfully.

The newest indication of IBM’s shifting fortunes comes from Credit Suisse, whose analyst Kulbinder Garcha downgraded the company’s stock to “underperforming” and wrote this in an investment note:

Organically we believe IBM is effectively in decline, and we see rising headwinds ahead with: i) 34% of gross profit dollars coming from Mainframe and UNIX hardware and associated software, which we believe are under pressure; ii) the shift to cloud continues to present risks given IBM’s technology positioning; and iii) strategic portfolio management is likely to have less of an impact going forward given the smaller potential for divestitures (x86 and Microelectronics), and multiple expansion in the software space limits IBM’s ability to acquire as effectively as in the past.

The challenge for IBM CEO Virginia Rometty is to ride the decline in hardware sales down to its imminent end, either by shedding hardware-related assets or simply walking away from an unprofitable end of her business.

Software accounts for one-third of IBM’s income growth over the past six years, and it has a 40 percent pretax margin. But Garcha believes that IBM won’t be able to continue to grow the software side fast enough to counter the slide in hardware, writing,

There has been a gradual erosion in IBM’s ability to grow, driven partially by pressured IT budgets and the global economic environment, but more importantly, due to the gradual decline in the company’s competitive position across its industries.

IBM has aggressively acquired software companies in its search for high margin revenues, with over 80 percent of its 34 acquisitions since 2010 software-oriented.

This call boils down to the following challenge for IBM:

  • It needs to continue to increase software revenues in a world that is transitioning to cloud services.
  • It needs to jettison or shuttle margin-eating hardware divisions.

And it needs to do it quickly. GigaOM’s Barb Darrow wrote about this news, too (see “It’s Wednesday morning and it’s already been a tough week for IBM“).

In the enterprise software segment IBM has been a strong player, but Credit Suisse is right to say that the competition is stiff. There are a number of entrenched competitors — Salesforce.com, SAP, Citrix, Oracle, Cisco, Microsoft-Yammer — upstarts like Jive, and a few looming wild cards, including Google, whose Google Apps, Google Drive, and Gmail have become the wild card in the game. And I see a real inversion possible in the space, with companies like Box, Dropbox, and Hightail fighting it out for the foundational file-sharing-and-sync market and in places where IBM does not have a horse in that race.

If I were Rometti, I would look back at the success of the Lotus acquisition, take a long look at Jive and the file-sync-and-share market, and spend a few billion to reposition IBM’s enterprise software business strongly toward the future, which is not going to be running on on-premise servers or mainframes but on handheld — or wearable — devices powered by cloud apps.