International Business Machines Corp. has a problem: Both the international and the machine aspect of its business are in sad shape.
That, though, has been the case for a while, which makes it hard to understand the market's panicky reaction to IBM's announcement Monday that it will fall short of its target for $20 (U.S.) per share in adjusted earnings next year.
The stock immediately tumbled more than 8 per cent as analysts rushed to digest the news that IBM was both abandoning its long-held profit goal for 2015 and shelling out $1.5-billion to convince GlobalFoundries Inc. to please, please take Big Blue's chip-manufacturing unit off its hands.
But, really, where was the shock in all the bad news? IBM's revenues have been flattening for years; its sales of $97-billion over the last 12 months are slightly below the mark it first reached in 2007. The company, once a hive of innovation, has watched others pioneer the Internet, social networks and search services while it has focused on aggressively cutting costs and managing Wall Street expectations.
Some of its best engineering has occurred on the income statement, where management's policy of massive stock buybacks has shrunk the number of shares outstanding from 1.6 billion in 2005 to just under a billion now. Fewer shares, of course, mean less need to divvy up profits, and so can make relatively tame growth in overall earnings look mightily impressive when transformed into earnings per share (EPS).
Until recently, Wall Street knew it could count on IBM to deliver steady double-digit gains in EPS, year after year, as the share count dwindled. Even Warren Buffett, famously wary of technology, bought a 5.5-per-cent stake in Big Blue back in 2011, predicated in part on the company's long-term vision and vigorous buyback policy.
Mr. Buffett has a habit of being right in the long run, but not always – witness his investment in British grocer Tesco, which is in the throes of an embarrassing accounting scandal. With all due respect to the Sage of Omaha, anyone who looked hard at IBM's financial statements had to suspect that zealous cost cutting and perpetual share buybacks would eventually hit their limits. The company's success ultimately depended on it either being able to boost its revenue or extract more profit from each dollar of revenue.
Either possibility was becoming increasingly difficult as the tech world shifted away from IBM's favourite model, which involved licensing software to big companywide computer networks that could generate steady demand for IBM hardware and consultants.
Software services are now increasingly being delivered online – from the "cloud" – rather than from big machines physically located on a company's premises. Users often pay by how much they use the services, rather than by buying a licence. They also have far less need to buy expensive hardware or hire expensive consultants to manage their in-house networks.
All of that has created headwinds for IBM. It's been trying to move away from hardware manufacturing, and the decision Monday to dump its money-losing chip operation follows on a deal earlier this month to sell part of its server business to Lenovo. But, as it attempts to remake itself, it's encountering lower demand in emerging markets. It said Monday that revenue from the BRICS countries – Brazil, Russia, India, China and South Africa – fell 7 per cent in the most recent quarter.
IBM would like to focus on high-margin software, especially programs that can help companies analyze the "big data" they are collecting. It's a wonderful aspiration. But the company's sheer size means that it's difficult to find the incremental revenue from software that would translate into meaningful gains.
All of that suggests that anyone counting on an immediate rebound in IBM's fortunes should think again. After years of managing its business to meet Wall Street's expectations, it's going to have to find ways to grow its business, not just its earnings per share.
Ian McGugan