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IBM's Red Hat Acquisition Begins to Pay Off

International Business Machines Corp. (IBM), sometimes referred to by the nickname "Big Blue," is trying hard to bring back the old glory days of innovation and growth with the hybrid cloud.

Big Blue has been in the midst of "creative destruction," shunning mature low-profit technology businesses and replacing them with emerging high-margin markets like the cloud and internet security.


On July 20, the computer hardware company reported second-quarter operating earnings per share of $2.18. Total revenue came in at $18.1 billion, down 5.4% over the same period. That's on top of a 3.4% decline in the first-quarter reported back in April.

However, there is a ray of hope for Big Blue's future: a strong showing of its cloud business. Total cloud revenue of $6.3 billion was up 30% for the quarter, or 34% adjusting for divested businesses and currency. Total cloud revenue of $23.5 billion over the last 12 months was up 20 percent, or 23% adjusting for divested businesses and currency. According to the earnings report:


"Our clients see the value of IBM's hybrid cloud platform, based on open technologies, at a time of unprecedented business disruption," said Arvind Krishna, IBM chief executive officer. "We are committed to building, with a growing ecosystem of partners, an enduring hybrid cloud platform that will serve as a powerful catalyst for innovation for our clients and the world."



Thanks to the company's 2018 purchase of Red Hat, an open-source software solutions company, the technology giant ventured into fast-growth segments of the IT industry like "hybrid" multi-cloud, which is a computing environment that brings together multiple cloud providers and clouds--public, private and software-as-a-service.

IBM paid $33 billion for Red Hat, which was a third of Big Blue's current market cap and more than twice its cash chest. But now it is paying off. Red Hat revenue was up 17% year-over-year during the quarter, normalized for historical comparability, helping boost GAAP gross profit margin by 100 basis points, or 48%. Wall Street cheered these improvements in Big Blue's margins, sending its shares sharply higher on Monday afternoon.

Still, IBM's creative destruction strategy is a slow and painful process, hurting financial performance. Things usually turn worse before they turn better as the new businesses do not grow fast enough to replace the lost revenue and profits in the old business segments.

That could, perhaps, explain why IBM's excess return on invested capital (i.e. the product of the return on invested capital minus the weighted average cost of capital) lags behind its peer group, barely creating any economic value, as illustrated in the tables below (the top chart is for the second quarter of 2020, while the bottom chart is for the first quarter).

Company

ROIC

WACC

Excess Return (ROIC-WACC)

IBM

7.84%

6.10%

1.74%

Accenture (ACN)

24.66

6.02

18.64

Cognizant (CTSH)

17.80

7.74

10.06



Source: Compiled from GuruFocus on July 21, 2020.

Company

ROIC

WACC

Excess Return (ROIC-WACC)

IBM

15.76%

6.40%

9.36%

Accenture

46.08

6.14

39.94

Cognizant

22.20

7.20

15.23



Source: Compiled from GuruFocus on April 21, 2020.

Thus, in my opinion, investors are better off deploying their capital elsewhere in the IT industry, where management is more efficient and effective in creating value than IBM.

Disclosure: No position in IBM.

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This article first appeared on GuruFocus.