IBM Spinoff Should Rejuvenate Cloud Effort

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Finally. On October 9th, IBM announced that it will split itself up by breaking up the company into two pieces, spinning off its legacy IT services businesses to focus on cloud. IBM shares rose about 6% on the news the first day, thought they have pulled back to be close to where they were when the deal was announced.

The change is sorely needed — IBM CEO Arvind Krishna is wise to pursue the strategy as the company needs some sort of catalyst to drive growth in the era of the cloud explosion. This deal should put IBM in a better position to compete with other cloud titans such as Amazon Web Services (AWS), Google, and Microsoft Azure by putting more focus on its prized Red Hat unit. It should also enable IBM to compete more strongly against other large tech conglomerates pursuing cloud, such as Hewlett Packard Enterprise (HPE) and Oracle. This is the catalyst needed that could push shares higher.

IBM’s share price has been stagnant for many years — especially compared with other cloud giants such as Microsoft and Amazon — frustrating investors that would like to capture the upside it the company’s vast cloud holdings, where it is regarded by many as the #3 cloud infrastructure player behind Amazon Web Services (AWS) and Microsoft.

NewCo on the Go

In the move, expected in 2021, the bulk of IBM’s IT Infrastructure Services will be spun off as an independent public company, leaving IBM free to focus entirely on hybrid cloud and artificial intelligence (AI), with its Red Hat division as the anchor.

The new spinoff, temporarily nicknamed NewCo, will have about 90,000 employees and $19 billion in revenue and continue to function as IBM’s partner, doing business with its former parent as needed while maintaining enough autonomy to allow both companies more flexibility. NewCo will include IBM’s Managed Infrastructure Services unit, which comprises roughly three-quarters of IBM’s Global Technology Services (GTS) business. The remaining GTS unit, Technology Support Services (TSS), will stay with IBM. Both companies will continue to sell IBM systems including storage and compute infrastructure, including mainframes.

The idea is that the original company, IBM, will become more of a standalone company focused on cloud technologies and platforms, while managed services and infrastructure are spun out. IBM can draw customers to the Red Hat business while minimizing conflicts with other public clouds on the infrastructure side.

Emulating Microsoft?

The obvious comparison to IBM’s strategy is to draw parallels to Microsoft when it rapidly shifted directions toward cloud in 2014, which was accompanied by a CEO shift. Satya Nadella, the CEO of Microsoft, gets much of the credit for transforming Microsoft after taking over from Steve Ballmer in 2014. IBM’s Krishna took over IBM from former CEO Ginny Rometty in 2019. This came just after Rometty made the deal of her career, purchasing Red Hat for $34 billion.

Red Hat may be the key to everything, when you consider that the deal value represents about a 30% of IBM’s entire market cap of $120B, while Red Hat is growing about 17% year-over-year and the rest of IBM is flat. The Red Hat deal looked pricey at the time, but with the explosion of cloud valuations in the past year, one could argue it now looks more reasonable.

“This represents an important shift in our business model,” said Krishna on a conference call with financial analysts during the week of the announcement. “We will go from having over half our revenue in services to one where the majority will come from software and solutions.”

The problem with IBM historically has been twofold: 1) Investors have had a hard time understanding its complex structure and lack of transparency in the functioning of various business units 2) The company has lacked a compelling “story” around a core product line.

Other than from what we see about the Watson Artificial Intelligence ads on TV, what do we know about what IBM? The story has been less clear-cut than that of Amazon or Microsoft. As Krishna looks at these challenges, they are all solvable. The new IBM, spin off and liberated from IBM’s consulting businesses, could anchor the story around Red Hat, which is a leader in Linux operating systems and its OpenShift cloud management software. Red Hat has few rivals with its breadth of hybrid cloud solutions, other than VMware (VMW). IBM has other key cloud assets including a large security businesses.

IBM’s October Surprise

Perhaps the biggest surprise in this deal is that it’s actually happening, given IBM’s historical sluggishness. But Krishna has been clear in his focus on IBM’s intent to be a leader in hybrid cloud and AI. He says the strategy has been part of a plan all along. CEO Krishna told financial analysts on a conference call on October 8th that IBM purchased Red Hat with the goal of establishing its OpenShift software as a platform for hybrid cloud workloads. According to IBM, just 25% of all global workloads are virtual (that’s up from 20% cited by Krishna during IBM’s second-quarter earnings announcement in July).

This is where IBM hopes to excel, offering OpenShift with AI-driven solutions for data management and security, and grabbing a share of what IBM sees as a $1 trillion opportunity.

Value Creation Ahead?

The question is how much the action can generate value and create growth. Between 2018 and 2019, for instance, revenues for IBM’s Managed Infrastructure Services fell 6%, and the downward trajectory continued into the first half of 2020, with a 4% year-over-year decline in 1Q 2020 and 5% last quarter. Meanwhile, IBM reported in April that growth in Cloud & Data Platforms was up 32 percent and Red Hat revenue was up 18 percent. That growth slipped a bit to 17% when second-quarter earnings were released in July, but it is still more robust than any other segment.

Krishna says the spinoff will be less about jettisoning slow-growing businesses and more focused on the growth. “Our decision-making is based on looking at what clients value, looking at what is strategically important….”

Overall, spinoffs in the technology industry have had mixed result. For example, Forbes contributor Johathan Boyar this year reported data showing that spinoffs have lagged. Others, such as fund manager Joel Greeblatt, author of “You Can Be a Stock Market Genius,” point to spinoffs as a prime area of value creation by aligning incentives and focus in the newly created entities.

It looks like a good plan on paper. IBM shareholders might feel like they don’t have much to lose. IBM shares are down 10% on a year-over-year basis and the company hasn’t grown in years. Microsoft, in comparison, is up 54%; Amazon is up 90%; and Oracle is up 8%.

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