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IBM’s Narrow Moat Is Slipping Amid Digital TransformationsIBM’s Narrow Moat Is Slipping Amid Digital Transformations Julie Bhusal Sharma Equity Analyst Business Strategy and Outlook | by Julie Bhusal Sharma Updated Jun 11, 2021 IBM still brings the “big” to its moniker Big Blue. IBM is the world’s largest IT services company (per management), the dominant provider of mainframes and a prominent player in the public cloud, data management systems and other software products, like middleware and integration software. While IBM has tried to refresh its diverse offerings, we think IBM’s moat is deteriorating as the cloud transition chips away at IBM’s competitive advantage associated with customer switching costs. We believe the deterioration of IBM’s business is best told through the lens of IBM’s Global Business Services business. We think that originally, IBM customers selected IBM for their IT services provider due to appeal in specialized functions, whether it be mainframes, databases or integration software. Before the cloud, these functions needed to successfully interoperate with other IT workloads, which tended to be on a proprietary stack. We think this led IBM’s customer base to further entrench their enterprise with IBM offerings due to the ease of a main IT services provider and the surety of IT functions having interoperability. However, now with the rise of the cloud and open source software, the possibility of a mix and match IT infrastructure is real. While we think this is not a risk for many loyal IBM enterprise customers (especially those using IBM's mainframes), we do think the trend will continue to hurt all other sides of IBM’s business. We think clients will gradually reduce their IBM offerings, from Infrastructure as a Service to software to outsourcing functions (like payroll processing and talent management) as competitors’ value add lowers the cost of switching from IBM products. Fortunately for IBM, we think its enterprise customers are particularly sticky, especially as IBM tends to serve very large customers within regulated industries. Therefore, any change with IBM will be a slow one, in our view. Economic Moat | by Julie Bhusal Sharma Updated Jun 11, 2021 We assign IBM a narrow moat based on the company’s switching costs and intangible assets permeant throughout the business. We think switching costs are prevalent at IBM because of the interconnectedness of its offerings. IBM’s business looks to cover all aspects of an enterprise’s IT needs, from IT consulting and outsourcing, hardware, software and cloud services. Many of these offerings are interconnected, and we think this largely stems from IBM’s global business services, or GBS. A new client, for example, may go to IBM’s GBS in search of an IT plan of attack which could lead to sales in all other parts of IBM’s business: from using IBM IaaS, purchasing a new mainframe using IBM’s financing capabilities, and even to using business intelligence software. One example of such interconnectedness is that within the global technology services, or GTS, segment, 90% of IBM’s largest clients use IBM outsourcing, 60% of which revolves around outsourcing related to mainframes. This means at least 90% of IBM’s largest GTS clients are contributing to revenues in GBS (where outsourcing is housed) and 60% of those customers are generating revenues in Systems (due to mainframes) which often requires spend in cloud & cognitive for mainframe transaction processing software. We admit that this web would unravel if its initiator, GBS were not sticky--but we think otherwise. In our view, IT services consulting firms boast high switching costs because of the continuity in understanding a client’s technology infrastructure over a long period of time. Even if an enterprise wanted to switch to a different consulting firm for a variety of reasons, the benefits of switching likely wouldn’t be worth the loss of the consultant's understanding of a company’s IT history and infrastructure. If this knowledge were lost, a potential replacement of an IT function could lead to costly implications elsewhere. We also think that many of IBM’s customers are slow to change IT consultants and providers because they fear rocking the boat with the mission critical functions served on IBM IT. Some examples include high frequency trading or processing 7 million flight tickets per day. While we think that GBS is the most crucial segment in justifying IBM’s moat (because it maintains the stickiness of much of IBM’s other offerings), we think it’s worthwhile to delve into the switching cost landscape, in isolation. Under IBM’s largest segment, GTS, IBM provides infrastructure as a service, platform as a service and hosted private cloud offerings. However, we believe IBM is behind others in the global public cloud, most notably Amazon, Microsoft and Google. We think IBM’s technology services business is a moaty business because moving from any cloud provider poses significant costs and time. While many companies could still find it worthwhile to move to other cloud providers, like AWS, we think IBM’s typical customer is extremely sensitive to such change given the mission criticality of the data stored--such as banking data. Additionally, we think IBM’s customers have more on-premise workloads than the average enterprise, making a switch to non-IBM public cloud providers less pressing. We think IBM’s second largest segment, cloud & cognitive solutions, also exhibits standalone switching costs. This segment consists largely of DB2 (IBM’s database offering), middleware and transaction processing software. We think swapping databases like DB2 is not an easy decision for customers to make due to the cost and time required. In areas like middleware and transaction processing software much of these solutions are catered to mainframe operations and are virtually the only offerings of its kind for IBM mainframes due to the mainframe’s proprietary zOS operating system--making switching not an option. Red Hat platforms OpenShift (container management), Red Hat Enterprise Linux, or RHEL, (operating systems) and Red Hat JBoss (middleware) are now housed in the segment as well, but won’t substantially change the moat makeup of this segment, in our opinion--as we estimate Red Hat offerings will make up about 15%-20% of the segment’s revenue going forward. We assigned RedHat with a narrow moat rating when it was a standalone public entity prior to being acquired by IBM. We believe that IBM derives a secondary moat source, intangible assets, from the expertise that IBM has acquired throughout its 107-year-old history, particularly in specialty areas such as the financial, airline and networking sectors. Banks, airline operators and network providers operate in mission critical areas, and therefore, have leaned on IBM for years, allowing for IBM to benefit from specialty knowledge on its clients personally and the industry they operate in. We think this specialty expertise is reflected in IBM’s leading position in areas such as software defined networking and services (according to ISG) and management of 50% of global wireless connections. We also think it shows in IBM’s hold on 90% of all global credit card transactions, which we believe is tied to IBM’s virtual monopoly in the mainframe space. IBM makes up 90% of the global mainframe market (which covers an estimated 10,000 installed base). we think that mainframes’ price tag in the millions of dollars is a function of the mainframes intangible assets which leave clients running mission critical functions extremely wary of moving to the cloud mostly due to the extreme sensitivity to speed and reliability, which still can’t be found on the cloud. For instance, mainframes have 99.999% reliability, whereas cloud computing reliability is typically near 99.95%. This is a difference of roughly 5 minutes of downtime versus four hours of downtime per year. Fair Value and Profit Drivers | by Julie Bhusal Sharma Updated Jan 21, 2021 Our fair value estimate for IBM is $125 per share. This implies a 2021 enterprise value/EBITDA of 11 times. We forecast IBM's revenue will rise at a compound annual growth rate of 2% over the next five years, as the company’s segments gradually change weights. Driving our financial model is our expectation for IBM to continue to shed market share in global IT services, leading to customer losses in its global business services. As a result, we expect IBM technology services to see a compound annual decline rate of 1% from 2021 to 2025 as more sticky IBM software is applicable in other clouds. Consequently, we expect IBM to benefit from growth in its cloud & cognitive software as its customers transition to hybrid infrastructures, even if it’s not to the IBM cloud, as our outlook suggests. We forecast IBM’s hardware business to continue to be a lumpy one, with continuing waves of new mainframe models and keeping IBM’s financing arm in business. We do not think direct Red Hat sales will play a large part in organic revenue growth. Even with Red Hat recently acquired, the acquisition is likely to only return $150 million each year in synergies. This assumes that 10% of IBM’s user base who are not Red Hat users adopt the technology within 30 select countries. We doubt that this would be much greater than 10% as moving to Red Hat Linux is a very conscious decision for companies, in our opinion. The change to Red Hat Enterprise Linux will either entail changing from Windows operating system, which likely means massive turnover in an enterprise’s engineering team. Or, if an enterprise already has Linux, this means getting rid of one’s own internal Linux servicing division or switching paid Linux providers. All of these decisions aren’t easy or intuitive ones in our opinion, which contributes to our outlook on Red Hat synergies. On profitability, we expect IBM’s gross margins to gradually increase from 48% in 2020 to near 50% in 2025 as customers switch over to SaaS subscriptions. Risk and Uncertainty | by Julie Bhusal Sharma Updated Jun 11, 2021 We think that IBM is subject to a medium fair value uncertainty rating given two frictions: the intensity of competition in cloud providers moderated with IBM’s low customer concentration and large, but slow-to-change customer base. We think the company’s business and technology services segments are the most at risk as many customers increasingly become aware of outsourcing capabilities that their cloud service provider can take over, with higher quality servicing or more technologically advanced capabilities. We are also unsure about the company's ability to monetize much of its ongoing development. While IBM is creating quantum computers, these computers are not yet ready for commercial use. Once they are, the market for enterprises who can afford these machines, will be minute, in our opinion. Other areas, like blockchain services, show more upside and make it hard for new entrants to enter, especially in the shipping space, which requires a massive coordination of shipping companies, retailers and governments. We also think IBM could benefit from the increasing demand for software defined networks, and their services. However, in both of these cases, we think the revenue upside won't be massive and won't allow IBM to overcome lost revenue in some of its core businesses today. We think IBM’s environmental, social, and governance risk lies namely in the possibility that customers’ data is compromised by security threats. This is a risk for virtually all software companies – but even if such attacks were to occur, we think IBM’s business would not be affected in the long run. Capital Allocation | by Julie Bhusal Sharma Updated Jun 11, 2021 We rate IBM’s capital allocation as Poor based on our assessment of a sound balance sheet, poor investments, and appropriate shareholder distributions. We think IBM’s balance sheet is sound based on its healthy cash cushion and manageable debt. IBM had cash and cash equivalents of $14 billion and total debt of $62 billion at the end of fiscal 2020, with less than 25% of total debt due over the next three years. We think the firm’s investments are poor as IBM has had massive resources to keep up with innovation – but has failed to keep up with cloud-only peers, largely due to execution in our view. While IBM’s acquisition of Red Hat was the largest deal in the company's history, we don’t think IBM paid an outrageous amount for the company, as we valued Red Hat at a market capitalization of $26.8 billion prior to the announcement. IBM acquired Red Hat for a deal price of $34 billion, giving it a premium of our fair value estimate of close to 30%. However, this is relatively in line with software deal premiums we would expect in such acquisitions. While we don’t think this premium was outrageous, we think that it was unnecessary to own Red Hat, given that the major synergy is solely that IBM has a greater customer base to sell to. If we assume that Red Hat was purely an instigator to change IBM's perception, we don’t think the benefits will be to the extent that IBM’s brand requires. Finally, we believe IBM’s shareholder distributions are appropriate, as dividends and share repurchases are not diverting R&D efforts, in our view, as our poor investment rating hinges more heavily on execution issues. Our capital allocation rating is informed by our review of IBM’s management. IBM is steered by CEO Arvind Krishna, who has held the executive positions since April 2020, before which he had over 30 years of experience at IBM. We think Krishna’s experience has former senior vice president of Cloud and Cognitive software at IBM is fitting as we consider the business segment to be the driver of IBM’s success or failures in the future. However, we think Krishna will need to work hard to deflect IBM’s weak brand perception--which we concede, is a massive task. |
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