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How IBM's Business Is Changing

IBM (NYSE: IBM) has had an interesting run recently, returning to growth for the first time in 22 quarters. Still, the market remains skeptical, valuing the company at just 11.2 times forward earnings, and longtime shareholder Warren Buffett exited his entire position last quarter.

In light of all these crosscurrents, management decided to give investors the first in what might be a series of investor presentations throughout this year. In it, management outlined the company's long-term vision, set new growth targets, and hosted a Q&A with 10 top executives.

Here's the story they're trying to sell the Street.

cover page for IBM's investor briefing along with logo.
cover page for IBM's investor briefing along with logo.

Image source: IBM.

A shift in product mix

The most apparent way IBM is changing is in its product mix, shifting away from hardware to more of a software and services model. This follows overall trends in the IT industry, so IBM is really just keeping up with the times. Of course, IBM also handles the most mission-critical and private data for the very largest corporations, so it must also handle workloads built on legacy codes and equipment, in addition to innovating to new models and solutions.

Modernizing these workloads takes effort, and the company has spent much of the last few years updating its product portfolio. Hardware has decreased from 25% of IBM's 2007 revenue to just 10% in 2017. This was partly due to the divestment of its PC and low-end server business in the 2000s, combined with the acquisition of roughly 34 companies, mostly in software and services, over the past three years.

In addition, the way in which software is sold has changed, and over the past 10 years, IBM has moved from 47% recurring as-a-service revenue to 61% as-a-service revenue as of 2017. And 22% of revenue, or $17 billion of IBM's business, now occurs within the IBM cloud, up from just $4 billion a few years ago.

Embedded in this mix are the company's Strategic Imperatives, which include analytics (especially cognitive computing), cloud, mobile, security, and social. The mix of Strategic Imperatives has grown strongly, from just 27% of revenue in 2014 to 46% of revenue last year.

The how

To implement these changes, the company has overhauled internal processes and personnel -- 50% of the IBM workforce is new to the company within the last five years, and CFO James Kavanaugh pointed to a 35% reduction in corporate "layers," which has sped up the organization.

In addition to modernizing its workforce, management has also made sure new products are designed in a sleek, intuitive manner, almost like consumer products. To that end, the company hired 15,000 designers in the recent past, reallocated a lot of its real estate footprint to more open work spaces, and implemented internal net promoter scores for clients to better gauge customer satisfaction.

These changes and tools mark a big difference from how IBM operated just a few years ago.

Reallocating capital

All of this work has, of course, taken some investment. IBM ramped investments in research & development, capital expenditures, and bolt-on acquisitions from $34 billion between 2012 and 2014 to $37 billion between 2015 and 2017, even as its revenue declined. A clear shift began in 2015, when the company scrapped its earnings-per-share targets and heavily dialed back on share repurchases.

The company will continue to invest, but now forecasts growth and operating leverage going forward, targeting low-single-digit revenue growth, mid-single-digit pre-tax income growth, and high-single-digit EPS growth over the long term.

Leading new technologies

One of the criticisms of IBM has faced is that it was late to the cloud computing game. Perhaps vowing not to make the same mistake again, IBM is actually a first-mover in several exciting fields such as blockchain technology and quantum computing. As it has for the past 25 years, IBM led the tech industry in patents filed last year, with over 50% of the new patents in these emerging fields.

How IBM is not changing

With all the new things going on at IBM, some things are not changing. The company still serves 95% of the Fortune 500, helping these large enterprises with their most mission-critical workloads and data. Therefore, all of these innovations are merely a means to the same end and same customer base.

And even with all of these improvements, there's still a lot of skepticism around IBM's growth potential, as the current transition has already taken more than five years. Management has hinted at more presentations this year, so investors should stay tuned for new developments, and monitor the company's progress toward its new growth targets.

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Billy Duberstein owns shares of IBM. His clients may have positions in some of the stocks mentioned. The Motley Fool is short shares of IBM. The Motley Fool has a disclosure policy.

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