The Nature of the IBM ‘Crisis’

A.M. Sacconaghi of Bernstein Research asked the money question during IBM’s conference call on Monday: “Is there a crisis at IBM?”

The reply from Virginia M. Rometty, IBM’s chief executive, was by turns measured and impassioned. The technology industry, she said, was going through a period of “unprecedented change” but IBM was taking a “series of very bold actions” to successfully navigate the transition in the long term, despite the company’s financial setback in the third quarter.

“We’ve got to reinvent ourselves,” Ms. Rometty said, “as we’ve done in previous generations.”

The big reinvention, of course, came in the 1990s. Early in that decade, the profitability of IBM’s mainframe business was collapsing and the company was in a tailspin, before it turned itself around.

Photo
The theme that IBM's profit performance relies as much on financial engineering as on computer engineering has been around since Louis V. Gerstner Jr. led the company in the 1990s. Credit Colin Braley/Reuters

This week’s earnings surprise has prompted comparisons with IBM’s predicament of two decades ago. The situation, in fact, is significantly different in most respects. In 1993, when Louis V. Gerstner Jr. was brought in as the first outsider to head IBM, the company was in dire financial straits. By contrast, IBM this year is still expected to generate profits of $16 billion. That is about $3 billion less than last year, but this remains a company that is producing immense profits.

My colleague, Andrew Ross Sorkin, wrote a column looking at IBM’s sizable stock buyback program. The theme that IBM’s profit performance relies as much on financial engineering as on computer engineering has been around for a long time, back to the Gerstner era. And it is fair comment. The buyback program started under Mr. Gerstner, picked up under his successor, Samuel J. Palmisano, who became chief executive in 2002, and accelerated further under Ms. Rometty. In the five years before Ms. Rometty became chief executive in 2012, IBM bought an average of 4.5 percent of its shares a year. In her tenure, that percentage has climbed to 6.5 percent.

So IBM has relied increasingly on share buybacks to hit its earnings-per-share targets. But the notion that IBM has mortgaged its future to do so is a hard case to make. The evidence is notably thin. IBM’s spending on research and development as a share of revenue is 6 percent, the same share as it was in 2000.

Some on Wall Street have suggested that if wasn’t buying back its shares it could have made a big “transformative” acquisition instead of the many, smaller ones that IBM then grafts onto its software and services businesses. The most comparable technology company to IBM is Hewlett-Packard. HP has made big corporate purchases over the years including Compaq, EDS and Autonomy. The track record clearly favors IBM’s more disciplined approach.

Under Ms. Rometty, IBM has made multibillion-dollar investments in fields that are growing rapidly, including data analytics, cloud computing and its Watson artificial intelligence technology. On Monday, Ms. Rometty insisted: “The strategy is correct. Now it’s our speed of execution that needs to improve.”

In a report on Tuesday, Mr. Sacconaghi wrote, “While under-nourishing for some, ‘stay the course’ and a focus on its organic growth initiatives (big data, Watson, SoftLayer) is probably the right move, but it squarely places IBM in the ‘show me story’ camp.” (SoftLayer is the cloud computing company IBM bought last year for $2 billion, and IBM is investing an additional $1.2 billion to build more cloud data centers around the world.)

Photo
Virginia M. Rometty, IBM’s chief executive, at the company’s headquarters in May.Credit Fred R. Conrad/The New York Times

Ms. Rometty is certainly correct that speed is the issue for IBM. The company’s new businesses are growing fast, but they are not yet large enough to make up for the erosion of profitability of its traditional software, services and hardware lines. And the new businesses like cloud computing and delivering software over the Internet as a service are threatening the lucrative old ones.

In enterprise technology, the new things do not ordinarily displace the old products altogether. They are partial substitutes and enough of an alternative to alter the economics of the old business. PC-style, microprocessor-based computers did not replace mainframes. In fact, today’s mainframes are doing more computer processing than ever, but they are no longer the money machines they once were. Prices dropped and the economics of the business changed.

That’s what happened in the 1990s, and IBM responded by moving to the higher-profit ground of software and services. Now, cloud computing appears to present a similar challenge to IBM’s traditional software and parts of its services business, like maintaining and updating software applications for corporate customers.

The same forces, to be sure, are threatening all the established suppliers of computing technology to corporations. But that doesn’t lessen the challenge for IBM. And seeing the issue clearly does not necessarily carry over to solving it.

If today bears little resemblance to 1993 for IBM, what about some years before the full-blown crisis hit? John F. Akers, who died earlier this year, was the chief executive who was replaced by Mr. Gerstner. In 1985, my colleague, David E. Sanger, wrote a magazine article on Mr. Akers’s efforts to overhaul IBM. In the article, Mr. Akers declared, “In the last three or four years, we have literally turned the company upside down.”

IBM is a very different corporate culture today, in part because of the company’s near-death experience in the 1990s. It should be far easier for Ms. Rometty to accelerate the “speed of execution,” as she put it. Still, there are echoes of the past in the job she faces.

Related Coverage:

Weak Results at IBM as Its Strategy Shifts

Weak Results at IBM as Its Strategy Shifts

The chief executive called the results disappointing as the company said it would pay $1.5 billion to shed its chip-making unit.

The Truth Hidden by IBM’s Buybacks

The Truth Hidden by IBM’s Buybacks

IBM has posted large earnings and sent out large dividends to shareholders, but the company’s success has been tied more to financial engineering than actual performance.