Can IBM Keep Cutting Its Way to Profits?

(Originally published here.)

Businesses have a few ways to boost profits: sell more stuff, shift to selling more profitable stuff or cut costs. International Business Machines Corp. has done fine with the latter two, but for half a decade has gone nowhere with the first. This is the context for IBM’s plan to sell its low-end server business to Lenovo Group Ltd. for between $2.5 billion and $4.5 billion: It’s another entry in the cost-cutting ledger that does little to promote growth.

Let’s be charitable and start with the good news: According to analyst estimates compiled by Bloomberg, IBM’s net income before one-time expenses rose by more than 14 percent in 2013, compared with 11 percent for the companies in the Standard & Poor’s 500 Index. Since 2007, IBM’s profits have soared by 77 percent, versus 42 percent for the broader market index.

The issue is the lack of sales growth. In 2007, IBM had about $99 billion in sales. This year, analysts predict sales of about $100 billion. Even more troubling, sales have been falling since 2011. The difference has come from a heroic increase in profit margins thanks in part to getting rid of lower-margin units.

The question for shareholders, such as Warren Buffett’s Berkshire Hathaway Inc. — the largest owner with a 6.3 percent stake in the company — is whether IBM can keep boosting profits solely through higher margin sales. Investors are certainly skeptical: Shares of IBM underperformed the S&P 500 by more than 30 percent in 2013. They have two reasons to be concerned. First, there is some limit to how much IBM can cut costs without sacrificing the quality of the underlying product. Second, IBM’s rising profitability will attract even more competitors that could threaten its position within the business-services sector.

IBM makes money as an efficient and secure operator of the “back office” for large companies and government agencies. This means selling lots of expensive software and hardware upfront along with multiyear contracts for consulting services. The danger is that, as with everything from housing to music, companies may switch from buying something they keep onsite to renting over the Internet. Inc. and Inc. provide some of the same types of business-management services as IBM, but let companies rent them relatively cheaply from centralized data centers.

It’s hard to know the impact these companies have had on IBM’s business. Salesforce has experienced rapid revenue growth from a very low base, while Amazon has been relatively secretive about the exactsize and profitability of its massive Web services division. This is why some analysts think the shift from in-house to outsourced computing power constitutes a serious threat to IBM’s ability to make money.

It still might be foolish to underestimate IBM’s chances for turning things around. The company has repeatedly proven its ability to adapt to changing market conditions — unlike some other technology pioneers, such as Nintendo Co. Ltd or BlackBerry Ltd. The question for investors is whether IBM can pull off yet another life-saving transformation.

(Matthew C. Klein is a writer for Bloomberg View. Follow him on Twitter.)


About Matthew C. Klein

I write about the economy and financial markets for Bloomberg View. Before that I wrote for The Economist on a fellowship provided by the Marjorie Deane Financial Journalism Foundation. I have worked at the world's largest hedge fund and read every FOMC transcript since May, 1987.
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