IBM’s Efforts to Shift to Cloud Come With Profit Sacrifice

Updated on
IBM CEO Ginni Rometty
Ginni Rometty, Chief Executive Officer of International Business Machines Corp., is focusing returning IBM to growth through new initiatives like data analytics, mobile and cloud computing -- where technology is delivered via the Internet, instead of stored onsite. Photographer: Angel Navarrete/Bloomberg

IBM is banking on the cloud to drive future growth. For now, that shift is taking a toll, as fourth-quarter results and the 2015 profit forecast show.

Chief Executive Officer Ginni Rometty is focusing on returning International Business Machines Corp. to growth through new initiatives like data analytics, mobile and cloud computing -- where technology is delivered via the Internet, instead of stored onsite. Cloud computing gives clients more flexibility in ordering software and can limit their need for IBM’s servers and mainframes, crimping profits.

“It’s critical for the company to convert those clients to cloud-based solutions, which may impact profitability but will improve visibility in the long term,” said Bill Kreher, an analyst at Edward Jones & Co. “It is going to take execution and it is going to require patience.”

That’s because Rometty is trying to transform a 103-year-old company with more than $90 billion in revenue and 430,000 employees. Revenue shrunk across every reported unit and every geography in the fourth quarter, and IBM’s new guidance for 2015 operating earnings trailed some analysts’ estimates.

IBM shares fell 3.1 percent to $152.09 at the close in New York, for the biggest decline since Dec. 12. The stock fell 14 percent last year.

The shift to new initiatives has not been quick enough to halt 11 straight quarters of falling revenue, and earnings fell last year for the first time in more than a decade.

Cloud Growth

IBM’s revenue from the cloud came in at $7 billion for 2014, with cloud offerings delivered as-a-service at an annual run rate of $3.5 billion. But for now, IBM says it doesn’t have enough scale to offset narrower margins.

“For 2015, specifically, we are dealing with some transitions in our business,” Martin Schroeter, IBM’s chief financial officer, said on a conference call with analysts. “For example, while we are fully participating in the shift to cloud, margins are impacted by the level of investment we’re making and the fact that the business is not yet at scale. We will see some year-to-year benefit to margins in 2015 as the business ramps, but we won’t be at scale.”

The public cloud market is projected to balloon to $128 billion in three years, according to researcher IDC.

IBM’s cloud revenue accounts for more than just the public cloud, where customers store data on off-premise servers. The company also counts hardware, software and services sold to clients to build private clouds, which are completely on-premise, and hybrid setups that link on-site and off-site hardware, Schroeter said on the call.

‘Paradigm Shift’

SAP SE is feeling similar pains. The German company cut its 2017 profit target this week as a shift to software delivered over the Web hurts margins. Clients are opting for cloud-computing versions of software delivered online, which is hurting sales of traditional programs installed on computers. Revenue is then delayed as it’s received over the course of subscriptions rather than as upfront fees.

“It’s difficult to change the business model quickly,” Daniel Ives, an analyst at FBR & Co., said of IBM. “The paradigm shift is toward the cloud and that’s where the attention is centered.”

Delivering software and services via the cloud is only one hurdle IBM is facing in its massive transformation. There’s also currency headwinds, job cuts and waning demand for older software and services to deal with. IBM forecast operating earnings for 2015 of $15.75 a share to $16.50 a share, compared with analysts’ estimates for $16.50 on average.

Stronger Dollar

Overseas sales have been crimped by a strengthening dollar and slowing growth in some emerging markets. IBM’s sales to Brazil, Russia, India and China -- the so-called BRIC nations -- fell 21 percent in the last three months of the year. Adjusted for currency swings and divested businesses, it was still a drop of 8 percent.

IBM also took a $580 million charge in the quarter for “workforce rebalancing” as the company adjusts to new ways of doing business.

IBM’s disappointing 2015 forecast overshadowed fourth-quarter earnings that beat analysts’ estimates. Schroeter said revenue won’t grow in the first quarter, and he wouldn’t answer questions about profit expectations beyond 2015.

Rometty, for one, was confident enough in IBM’s results to skip the earnings conference call. In October, she joined for the first time to reassure investors when the company scrapped long-held forecasts for 2014 and 2015 in October.

“2015 is going to be a year of investment,” said Kreher, the analyst at Edward Jones. “The leap of faith for the investment community is getting from today to two years from today.”

Before it's here, it's on the Bloomberg Terminal. LEARN MORE