The Exchange

IBM Attracts Short Sellers as Revenue Growth Slips

It used to be said that no one ever got fired for buying IBM (IBM). But lately, the tech giant has become targeted for selling — selling by stock shorters betting IBM’s share price will fall.

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The total number of IBM shares sold short hit 18.3 million last month, up from 13.4 million at the end of 2012, according to data from Nasdaq OMX. New figures for this month won’t be released until August 26.

“IBM is an F,” says Brad Lamensdorf, co-manager of the actively managed Ranger Equity Bear Exchange-Traded Fund (HDGE). IBM is the top position in the $200 million stock-shorting fund.

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IBM famously navigated the transition from mainframes to personal computing, flourishing as it diversified into software, consulting and outsourcing. But Big Blue appears to be struggling with the current shift into cloud computing, as big companies cut IT costs by outsourcing their computing networks.

This was evident in IBM’s second-quarter results. IBM sales fell 3% to $24.9 billion, less than the $25.4 billion analysts had expected, as hardware and software revenue fell short. Earnings per share of $3.91 were 14 cents higher than analysts expected.

The company’s shares have bounced around all year and are down 2% in 2013, trailing cloud competitors such as Amazon.com (AMZN), up 17%, and Salesforce.com (CRM), up 6%.

Big companies renting time on cloud servers from Amazon and others don't need to buy their own servers from IBM. And rented cloud-based software from Salesforce.com and its ilk can replace all manner of IBM's software and service offerings. Some cloud products are based on open-source standards, providing even lower-priced competition for IBM.

A benefit from the cloud?

IBM, though, says it will benefit from the move to the clouds, both with its own cloud service offerings and with consulting gigs to help customers plan their shifts. It has said it aims to increase cloud-related revenue from $3 billion to $7 billion by 2015, a figure which would still be less than 10% of total sales.

The company does not report extensive details about its cloud business every quarter, however, and disclosed last month that the Securities and Exchange Commission was investigating the way it reported cloud-related revenue.

The bigger problem is that the parts of IBM benefiting from the cloud, such as outsourcing and consulting, produce a lot less of Big Blue’s profits than the segments that are hurt by the cloud, including sales of servers and integration software.

Overall, businesses that generate about 49% of IBM’s revenue will be helped by the spread of cloud technology, and units producing 38% will be hurt, according to Credit Suisse analyst Kulbinder Garcha. At first glance, these numbers seem pretty beneficial to IBM.

But all revenue is not equal. IBM’s businesses being hurt by the cloud may produce less revenue but they have higher profit margins and brought in 58% of IBM’s pre-tax income.

The biggest problem

The biggest problem is in IBM’s vast software division. The unit, which includes everything from the Lotus Notes email platform to Cognos business analytics, produced $25.4 billion of IBM’s $104.5 billion of total revenue last year. But it had a pre-tax profit margin of about 37% versus 7% margins in hardware and 16% margins in services, Garcha notes.

IBM is losing market share in four of its five largest software businesses, according to analysts. IBM’s own cloud offering is growing fast – 70% last quarter, the company said. But it's still small and may not be able to generate much profit amid so much competition.

The company is also engaged in a costly round of mergers and acquisitions to compete with the cloud platforms offered by Amazon, Microsoft (MSFT) and Google (GOOG). In June IBM agreed to pay a reported $2 billion for SoftLayer Technologies, which operates 13 cloud data centers around the world. The price is about five times SoftLayer’s revenue for the previous 12 months, according to Moody’s Investors Service.

“Everyone is at the point where they’re starting to compete,” says Lamensdorf, who expects massive price cutting in cloud offerings to continue. “You’re going to see margin problems in the whole group.”

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