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Food for Deep Thought: 42 is IBM's answer to Life, the Universe and Everything...

Transformation is the word... don't overuse it

Trillian chats to a depressed Marvin the Robot in the 2005 film version of Hitchhiker's Guide to Galaxy. C Walt Disney Pictures

Analysis Deep Thought calculated the number 42 to be the Answer to the Ultimate Question of Life, the Universe and Everything. Over at IBM it was the frequency the word "transform" was used to explain another dire quarter.

The supercomputer in The Hitchhiker's Guide to the Galaxy took 7.5 million years to determine the importance of the digits - the big brains at IBM don't have that long to turn around the leaky sales tanker.

CFO Martin Schroeder was again thrust into the spotlight last week to explain why the firm in Q1 reported a five per cent year-on-year decline to $18.7bn, its sixteenth consecutive quarter of top line shrinkage.

He used the words “transform”, “transforming” or “transformation” 42 times on the conference call. It’s almost as if the senior IBMer was trying to make a point.

Changing course is no easy feat for monster sized tech firms, it can involve raising capital and operating expenses, sacrificing gross margin and squeezing operating margin - all under the glare of Wall Street.

IBM has billed itself as a software and services company so it was then of note that software declined one per cent as reported despite benefiting from an estimated $150m to $180m from acquisitions in the year. Exclude the buys and software was actually down four per cent, equating to one of the weakest quarters for IBM software in three years.

Total services signings were $8bn, which was 17 per cent down on the prior year in constant currency and billions below some analysts forecasts.

Broken down by the recently revamped divisions, Cognitive Solutions and Industry Services slipped, so did Systems, Global Financing and Technology Services and Cloud Platforms. Currency played a big part here but the burden on foreign exchange cost is a reality for all US tech vendors with overseas operations.

Getting those Wall Street money-people and customers to buy into Big Blue’s vision is no easy sell - no matter how many times Schroeder repeats the word transform. And IBM’s not alone here, any tech vendors of size are looking over their shoulders with nervousness at cloud upstarts.

Schroeder said on last week’s call that IBM’s “strategic areas” - cloud, mobile, security, analytics, social - grew 17 per cent in constant currency or 14 per cent as reported, equating to 37 per cent of group revenues.

This suggests the rest of IBM’s business fell 10 per cent, said senior analyst Tony Sacconaghi, at investment researchers Bernstein, who reckoned IBM is “challenged by three distinct structural forces”.

These included a “migration to off-premise and as a service offerings, impacting software and services; the downstream impact from recent weak UNIX sales; and maturity on the traditional outsourcing business”.

“We believe these structural headwinds are likely to continue to pressure revenues for the foreseeable future,” Sacconaghi added.

IBM carved up the business in spring 2015 after selling System x to Lenovo, is making multiple buys of cloud and software companies, and seems to be constantly hiring new skills while expunging some of the old guard.

Schroder said “significant action to transform our workforce and shift our skills base to new areas” this quarter led to a pre-tax charge of $1.5bn - but he also revealed a tax refund of around $1bn plus interest took much of the sting out of that expense.

“The amount of the tax benefit was essentially equivalent to the charges on an after-tax basis. It important to recognise that these actions are impacting our profit and margins this quarter while improving our position for the future.”

IBM is said to be getting rid of around 14,000 workers worldwide this year, with multiple units in the UK impacted including UK Labs, Global Business Services and Global Technology Services.

Bloodletting elsewhere last year saw Cisco chop 6,000 workers and hire 7,000 newbies; HPE has started to axe 30,000; and more recently, Intel has confirmed intent to shed 12,000 staff. Of course Dell and EMC are about to collide in the next few months.

Schroder told analysts on the conference call, “it’s important to recognise that these actions are impacting our profit and margins this quarter while improving our position for the future”.

In an ideal world, IBM needs to spin up plates in new areas of business at the same rate that others are slowing down, all while hoping things don’t come crashing down around it.

The company spent $2.5bn on six acquisitions in Q1, taking the total to $9bn splashed in the past 12 months.

The buy of The Weather Company was the most substantial in the quarter - IBM is merging the weather data and cloudy “insight-driven platform” with Watson to form the Watson IoT service.

Other events from Q1 saw Big Blue playing pals with VMware to speed up adoption of hybrid clouds, and getting chummy with GitHub to develop the “next-generation” of fluffy white apps for large biz.

All of IBM’s “relevant” software is now available to buy in IBM’s cloud, it said.

Other buys in the three months saw IBM pick up cloud video service provider Ustream, three digital design agencies, Saleforce consulting and implementation services outfit Bluewolf, and complete the deal for cloud-based healthcare data services firm Truven - which adds 8,500 clients including US employers, health insurers, hospitals, clinicians, life science companies and government agencies.

IBM again restructured into new business segments some weeks ago to reflect the shifting sands internally: Cognitive Solutions was created to house security, social, transaction processing software and analytics - analytics is by far the largest element.

“Many of these are new opportunity areas like Watson Health and Watson IoT, opening up revenue and profit pools beyond traditional IT,” said Schorder, “because we’re building new businesses in new markets, they’ll ramp over time”.

Global Business Services is largely unchanged though it now includes results for consulting, global process services and application management units. Systems includes z Systems, power and storage and related OS software. Global Financing is unchanged.

WebSphere and related software were rolled into Technology Services and Cloud Platform, highlighting the importance of integration software in the age of hybrid cloud, at least that is what IBM said.

“The primary driver of these changes to our operating structure and subsequently our segments in the realignment of our software portfolio as software value shifts to new areas,” said the CFO.

Gross margin is a good indicator of whether the changes IBM pushed through are making a positive contribution, but in this respect, the CFO reiterated it will take time to improve - gross margin fell to 46.5 per cent from 48.2 per cent a year ago.

“The gross margin is impacted by a lower level of transactional revenue and the fact that more of our new areas where we’re investing are cloud-based and build over time,” said Schroder.

He claimed Big Blue is moving into higher margin areas, “these are as-a-service businesses and so we do expect them to take a while to ramp”.

The pre-tax profit was slapped about by higher levels of investment in Watson Platform, Watson IoT and Watson Health, as well as restructuring costs, and currency. It fell 21 per cent year-on-year to $2.3bn, and was was flattered by the aforementioned tax break.

IBM generated $3.3bn of cash in the quarter and $2.3bn of free cash flow, up $1bn year-on-year helped by the tax benefit.

The firm spent $1bn on cap-ex, largely investment in cloud capacity, and $2bn was returned to shareholders. Big Blue ended the quarter with nearly $15bn in cash and $46bn in debt.

Acquisitions will continue to be a drag on profits in the near term said Schroeder but IBM said it will continue to invest at a “high level” with much of those bets on cloudy firms selling stuff as-a-service.

“So where are we in the transformation? It is a continued focus on shifting our investments into those strategic imperatives, it is making sure that the space we’re moving into is higher margin and… making sure we’re investing aggressively to keep those businesses growing.

"Both the higher investment levels and the return profile put some pressure on our profit in the near term but we're confident it's right for the long term." ®

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