Warren Buffett has dumped a chunk of his IBM stock -- citing Big Blue's "big strong competitors."
While he's right that IBM has big strong competitors -- including itself, IBM faces many small, strong competitors that have chipped away at its growth.
Before getting into that, let's take a closer look at the bad news that afflicted Big Blue this week. On May 3, Moody's cut its rating of IBM's unsecured debt and on May 4, Buffett told CNBC that Berkshire Hathaway had sold a third of its IBM shares. (I have no financial interest in the shares mentioned in this post.)
Moody's cut its rating on IBM's “senior unsecured” borrowing to A1 from Aa3 due, according to Barron's, to spending that has hurt IBM's cash flow and its belief that IBM will face challenges as it changes its business model.
Moody's concluded that IBM's investments to build and scale its systems integration (SI) business coupled with "high single-digit to low double-digit declines in its portfolio of legacy businesses" would more than offset SI "revenue growth resulting in lower profitability and cash flow over at least the next year," Barron's wrote.
The weird news here was that Moody's raised its outlook on IBM's debt from negative to stable. Perhaps this upgrade is based on its views of IBM's longer-term future. "The ratings could be upgraded if IBM demonstrates revenue growth in the low-to-mid single-digits and reduced competitive pressures throughout its broad operations," according to Moody's.
IBM counters that it is an investment grade company. In so doing, IBM cited operating net income of over $13 billion in 2016 and its spending $15 billion on "R&D, capex and acquisitions" to reinvent "IBM for the cloud and cognitive era." IBM is proud of how it has "shared [its] strategic priorities, including plans for continued investments, with [its] investors and rating agencies," according to Barron's.
Buffett is underwhelmed -- telling CNBC that in the first and second quarters of 2017 he dumped about a third of the 81 million shares in IBM that his company owned at the end of 2016.
When I watched the video of this interview, I felt bad for Buffett who sounded very out of breath as he tried to complete his answers.
My read is that Buffett got taken by IBM's unrealistic financial projections. As he told CNBC, "I think if you look back at what they were projecting and how they thought the business would develop I would say what they've run into is some pretty tough competitors. IBM is a big strong company, but they've got big strong competitors too."
With the obvious caveat that Buffett is smarter and richer than I will ever be, he failed to do a deep analysis of IBM's growth strategy when he bought its stock. After all, IBM has suffered declining revenues for the last 20 quarters in a row.
And at the core of IBM's failure to grow are long-simmering weaknesses in two critical dimensions of growth -- capabilities and culture -- that makes IBM its own worst enemy.
Capabilities, as I wrote in my book, Disciplined Growth Strategies, are what a company does -- e.g., product development, manufacturing, distribution, sales -- to win new customers and keep old ones happy.
One of IBM's weak capabilities is product development. As I wrote last November, IBM imposes numerous internal mandates on its product development teams – such as requiring that products can be usable by vision-impaired individuals regardless of whether there is strong demand for the feature, that software can run on mainframes – regardless of whether there is a large market of mainframe users for the product, and that the product is available in at least nine languages (again without regard to the market requirement).
IBM's culture -- the values and actions that ought to be directed at attracting top talent and motivating people to win in the market place -- is having the opposite effect. Indeed, as I pointed out last November, IBM's original values -- respect for the individual, the best customer service in the world, and excellence -- are all being violated through the company's current conduct.
These deep flaws in IBM's growth strategy create opportunities for big and small competitors. Buffett is right that IBM faces big competitors in the cloud services industry -- IBM's total infrastructure services (cloud and otherwise) revenue was down 2% annually after rising 3% in the fourth quarter, according to the Street.com. And Amazon, Microsoft and Google dwarfed its market share.
But IBM is also vulnerable to small, focused rivals who take advantage of IBM's inability to develop products that offer customers better performance at a lower price and its disadvantage when it comes to attracting and motivating top talent.
These rivals are taking customers away from IBM in many industries, including these three:
- Identity management. This $2 billion market for protecting computer systems from unauthorized users features smaller rivals like SailPoint that has been growing at 30% a year to $130 million in revenue on the strength of its product development and culture.
- Process improvement software. This is a $15 billion market that helps companies make their business operations more efficient. One startup, Celonis, automates the development of process maps and expects to triple its revenue this year as it takes market share from IBM and others in the SI industry.
- DevOps is a $2.3 billion market whose products cut the cost and shorten the time to market for software development. Xebia Labs is a DevOps supplier growing at over 100% a year and is likely to keep growing that fast this year as it wins business from IBM and others.
Capitalism has a wonderful way of getting rid of big companies that fail to adapt. Aggressive startups give customers more for their money than do bloated incumbents. IBM will continue to be vulnerable to such upstarts and Buffett should dump the rest of his shares to cut his losses.
