Can IBM remake itself with hybrid cloud play Red Hat?

SINGAPORE (Nov 19): Legendary corporate icons can plunge from their exalted status to irrelevance in little or no time. The unfolding saga of General Electric, the world’s largest company by market capitalisation until Microsoft overtook it at the start of the tech boom in 1999, is a case in point. GE, which has been slowly shedding assets since the global financial crisis in 2008, has seen its downward slide escalate over the past two years. Its once lofty stock has plunged 77% from its recent July 2016 peak, and is down 87% from its July 2000 all-time high when it initially rebranded itself as an “industrial internet” company.

A much slower unravelling is seen at another tottering global corporate icon, IBM, or International Business Machines, a pioneering tech company that is now a shadow of its former self. IBM stock is down over 40% from its peak five years ago despite US$50 billion ($60 billion) in share buybacks.

Last week, IBM announced that it was acquiring hybrid cloud player Red Hat for US$36 billion in an all-cash transaction. It hopes the “transformational deal” — the largest in the history of software — will help expedite its makeover from a has-been teetering on the brink of disaster into a player in the tech space. The two companies have been partners for nearly 20 years. IBM is trying to sell the Red Hat deal, the largest in its 107-year history, as a “game changer”. The combination, it claims, will make it the world’s No 1 hybrid cloud provider, “offering companies the only open cloud solution that can help them unlock the full value of the cloud for their businesses”.

To be sure, IBM has stumbled many a time in recent decades, only to reinvent itself and, much to the chagrin of investors, falter again. The Armonk, New York-based company, originally called The Computing-Tabulating-Recording Co, nicknamed “Big Blue”, dominated mainframe computers used by corporates in the 1960s and 1970s, only to see its position undermined, initially by mini computers and later by personal computers popularised by Apple in the late 1970s. Although it eventually took a plunge into the new era in 1980 by making PCs, it made the fatal error of licensing the software from a then-upstart called Microsoft. In the PC era, the real money was not in making low-margin Apple clones, but the software. By the late 1980s, rival PC makers such as Dell, Hewlett-Packard and Compaq had left IBM PCs in the dust.

IBM has long branded itself as an integrated company that bundled hardware, software and services to corporate clients. In 1992, it posted US$8 billion in annual losses, a record at the time, causing its stock to plunge 75% from its 1987 peak to just over US$10. It brought an outsider called Lou Gerstner from cigarette and cookie maker RJR Nabisco to steady the ship. Gerstner began refocusing IBM as more of a software, solutions and services firm away from its hardware roots. Its PC business was sold to Beijing-based Lenovo Group in 2004. IBM bought the consultancy arm of PWC, but continued to shrink in size.

By 2011, IBM was again in trouble. As part of yet another makeover, it installed a woman, Virginia “Ginni” Rometty, as CEO, and resurrected Watson, its home-grown artificial intelligence program, just as investors were starting to chase hot technologies like AI. It also lured billionaire value investor Warren Buffett, CEO of Berkshire Hathaway, to buy into its juicy rejuvenation story. Buffett began building a stake, citing its “leading position in the tech space and its desire to return billions of dollars in additional funds to investors over the next five years”.

IBM stock rebounded 35% after Buffett started buying, to peak at US$215 in March 2013. At the height, Berkshire owned 81.3 million shares, or nearly 9.9%, of IBM. Yet, as IBM reported revenue declines for 18 consecutive quarters, the Oracle of Omaha quietly began unloading his stake and by early this year, he had completely washed his hands of Big Blue. Buffett cited “big, strong competitors” such as Amazon.com, Microsoft, Cisco, Dell-EMC and Oracle as a reason for IBM not achieving what he expected it to when he first took a liking to the stock. In the six years he owned the stock originally bought for nearly US$15 billion, Buffett barely broke even despite a mouthwatering 5% annual dividend.

Fork in the road

To understand the dire shape IBM is in, look no further than its quarterly reports for the last 28 quarters, or seven years. Not only have its revenues steadily declined over that time but its earnings too have barely grown, staying at a low-single-digit rate for years, despite fancy financial engineering including hefty share buybacks.

In some ways, IBM had reached a fork in the road where it had to make a deal, any deal, because maintaining the status quo was no longer an option. Financial engineering works, until it does not. No company, not even a storied one such as IBM, can keep borrowing to pay dividends and buy back shares when its revenues are shrinking and margins in most segments are under pressure.

Today, more than half its revenue comes from long-term services contracts and software licences, and 15% from hardware. The real “growth segment” of IBM, which it calls “Strategic Imperatives”, accounts for less than 30% of its revenues. So, even if its new businesses like cloud and Watson grow at a rapid rate, they will not really move the needle.

Cloud is the current holy grail of computing. Instead of storing, accessing and processing data on their own servers, corporate clients have for nearly a decade been gradually shifting more of their data to remote servers either through public cloud infrastructure managed by the likes of Amazon Web Services (AWS), Microsoft’s Azure and Google Cloud Platform, or private cloud remote servers that the corporates manage themselves or outsource to someone to manage them exclusively for their use. There are also, increasingly, companies that use both public and private cloud remote servers, as well as keeping some key data on-premises in what is called a hybrid cloud strategy. Large companies such as JPMorgan Chase & Co and Sony have had serious data breaches in recent years and, as a precaution, want to keep some of the most essential data on-premises even though they believe most of it should be in the cloud or on remote servers.

The acquisition of Red Hat comes relatively late in CEO Rometty’s seven-year tenure and is seen as a concession that IBM’s current strategy of trying to grow organically just isn’t working. Instead of expanding into the cloud space early, IBM dragged its feet only to find others had built an insurmountable lead. Instead of making transformational acquisitions like of Salesforce.com or Service­Now when it had the cash and their stocks were trading at a third of their current price, IBM bet on its own ability to keep growing. Indeed, IBM’s own software business has sputtered in recent years. Its total cloud revenues, including Infrastructure as a Service, and Platform as a Service, amounted to just over US$2 billion last year, or less than one-tenth of Amazon’s AWS annual revenues. And while AWS is still growing at 40% annually, IBM’s cloud revenues have barely grown at double-digit rates in recent quarters.

Red Hat is a juggernaut in open source computing using Linux. It is also a player in virtualisation, a software that helps corporates reduce the number of physical servers they use and cut the energy required to power and cool them. It is a major player in middleware, which is software that sits between an operating system and an application. In addition, it makes software that helps companies integrate data between public cloud and on-premises servers. It has a burgeoning private cloud platform or container orchestration business that includes Open Stack and Open Shift.

Red Hat has built a reputation as the “Switzerland of Cloud”, where its software remains neutral between competing cloud environments as companies move data from one to another. Cloud services providers have also traditionally boxed their corporate customers into proprietary systems that prevent them from offering connections into their on-premises technology. Red Hat’s neutrality allows companies to access data from the competing public cloud infrastructure of AWS, Microsoft Azure and Google Cloud without batting an eyelid.

IBM sees a near US$1 trillion opportunity in hybrid cloud by 2020. An average mid-sized firm in the US has up to a thousand applications running across five to 16 different clouds. Currently, companies have migrated between 10% to 20% of their data to the cloud. The main driver of this shift is cost savings. If you were JPMorgan or General Motors, why would you keep all your data processing and storage in-house when you can put it on a remote server and let Amazon or Google do everything for you? Yet many companies have been reluctant to embrace the cloud for fear that their workload or data would become locked into a specific cloud environment. Red Hat’s OpenShift container software helps IBM access data from on-premises servers to, and between, cloud service providers using open source software.

Another slow-growing company

But while Red Hat may give it an entry into the hybrid cloud business, IBM is actually buying a slow-growing company like itself. More than half of Red Hat’s revenue this year will be generated by its traditional on-premises server operating-system business, which is not directly tied to the cloud and has a slowing growth rate, notes Toni Sacconaghi of Sanford C Bernstein in a recent report. Moreover, IBM may be getting into cloud services in a big way a bit too late. Cloud is no longer a hot new thing. RBC Capital Markets in a recent report notes that cloud service providers’ capital expenditures grew an annualised 32% in the last quarter compared with a whopping 66% growth in the previous one. The slowdown in capital expenditure is sign that growth expectations at end-user firms are moderating.

Still, there is no doubt that there is a long runway left for cloud services providers, not just in cloud infrastructure but also Platform-as-a-Service where Salesforce.com or ServiceNow are key players, and Software-as-a-Service, where WorkDay and Shopify are players. Whether IBM can muscle in and take market share from the incumbents that are likely to expand their hybrid cloud services over time is another story. Clearly, IBM’s best days are over and while the Red Hat deal is a nice new twist in its storyline, it is unlikely to a catapult it to the frontlines of tech alongside current giant innovators Amazon, Microsoft, Apple and Google’s parent Alphabet.

Assif Shameen is a technology writer based in North America

This story appears in The Edge Singapore (Issue 857, week of Nov 19) which is on sale now. Subscribe here