Photo: Yahoo Finance
In case you haven’t been paying attention, IBM‘s stock has been on a tear of late, more than doubling off the 2009 low.
That may not sound particularly impressive–the market as a whole has doubled off the 2009 low–but IBM’s stock didn’t collapse the way the rest of the market did during the financial crisis. Also, the stocks of some of IBM’s big competitors have fared far worse over this period.
Hewlett-Packard, for example, which has had one disaster after another, is trading well below its 2009 low. Cisco has badly lagged IBM over this period. And Microsoft and Oracle, the latter of which has been perceived as a huge home run, have also underperformed IBM.
Also, unlike any other stock in this group, IBM has not just regained its 2000 tech bubble high–it has blasted way past it. All of the other stocks above are trading way below the levels at which they traded a dozen years ago.
So, what’s going on?
Why has IBM done so well?
The simple answer is that IBM isn’t your father’s IBM anymore.
Your father’s IBM made hardware–mainframe computers, mostly. IBM still makes mainframes–and IBM customers still buy mainframes–but mainframes are now a tiny portion of IBM’s business.
After many years of stagnation in the 1980s and early 1990s, when it got bypassed by the server and PC revolution, your father’s IBM also eventually reinvented itself as a services business. For more than a decade, IBM’s resurgent growth was driven by a global services organisation that implemented and managed global-scale IT and business services for huge corporations and governments.
The services business is still a good business. And IBM is still in that business–to the tune of $60 billion of revenue a year.
But services are no longer IBM’s most important business.
What’s IBM’s most important business?
Today’s IBM, it might surprise you to learn, is first and foremost a software company. And as IBM continues to evolve over the next few years, it will become even more of a software company.
As Microsoft, Oracle, and other software companies have demonstrated, software has vastly higher profit margins than hardware and services. And IBM’s transition to software has driven a lot of its earnings growth and stock performance over the last few years.
Let’s put some numbers on that.
Here’s a chart from IBM’s 2011 annual report. The chart shows the portion of IBM’s operating profit contributed by each of IBM’s three main business lines: Hardware (dark blue), Services (green), and Software (light blue). The top bar shows the company’s operating profit in 2000. The bottom bar shows the same in 2011.
As you can see, Software is now the biggest contributor to IBM’s profit. And it is expected to grow to more than 50% of profit over the next few years:
How does IBM’s software businesses compare to those at other big software and IT companies?
It’s in the big leagues.
IBM generated about $25 billion of software revenue last year.
Oracle, meanwhile, known as a software company, generated only $26 billion–and the majority of that was for updated licenses and “support,” which is also known as “services.”HP, one of the other global IT companies, generated all of $3.2 billion of software sales.
So IBM’s software business is as big as Oracle’s and dwarfs HP’s.
Given the trends in the hardware business in recent years–with the notable and important exception of Apple, which is primarily a consumer company–it’s no surprise that IBM’s stock has done so well while those of its competitors have lagged.
The other reason IBM’s stock has done well, by the way, is that the company has aggressively deployed its massive cash flow–making acquisitions, paying dividends, and buying back stock. (See chart below right).
Other tech companies have been less aggressive about doing this, and as a result, their cash has just piled up, doing nothing.
So, what’s next for IBM?According to management’s “road map,” the company is going to continue to gradually restructure itself and move into higher-value and higher-margin businesses.
This will not produce compelling overall revenue growth: Organically, the company only expects to grow about 2% per year.
But the focus on per-share profit growth, which will be driven by all of the engines above, should allow the company to drive EPS growth of at least 10% per year.
And in a global economy that is still struggling to overcome the massive debt binge of recent years, this is a smart way to continue to create value.