Mad Dog 21/21: Legacy System

In mid-2017, IBM chairman and CEO Ginni Rometty will turn 60. If she honors IBM’s traditions, December 31 of next year will be her last day as CEO. With time running low, Rometty is driving Big Blue to undergo dramatic change. She is making strategic acquisitions, executing significant disposals and forcing changes in the ranks of top executives. There’s no more Ms. Nice Gal, if there ever was one. For Rometty and for IBM, it is do or die . . . or, as some fear, perhaps both.

The most noteworthy moment in Rometty’s tenure came in October 2014, nearly three years after she took office, about halfway through an expected six-year term. After considering her current situation, her possible futures and her likely legacy as a leader of IBM, Rometty disavowed a key promise made by her predecessor, Sam Palmisano.

Palmisano had said that after he was gone, IBM would deliver increased earnings year after year, reaching profit of at least $20 per share for 2015. Rometty, however, was getting very different results from those her predecessor had expected. So, addressing the company’s shareholders, customers and employees, she announced revised goals and recalibrated everyone’s expectations.

Sam Palmisano and Ginni Rometty: Palmisano’s legacy was a promise Rometty couldn’t keep; her legacy is bound to have a different nature.

It’s impossible for an outsider to say whether IBM’s diminished results came as Rometty followed plans laid down by Palmisano or, instead, resulted from Rometty’s decision to take a different course. Whatever the case, IBM’s financial results have disappointed optimistic investors. Beginning with Rometty’s second quarter at the helm, IBM’s revenue fell in every subsequent quarter, for a total of 15 quarters, including the most recent fourth quarter 2015 results. Throughout this four-year period, IBM’s profits have been substantial, but smaller than the sums Palmisano had imagined Big Blue could produce. Moreover, IBM is likely to report an additional decline in per-share profit for 2016. The company said this as it announced year-end results for 2015.

IBM has been shedding business segments that have yielded unsatisfactory results or which, in the view of IBM’s management, were likely to disappoint in the future. At the same time, IBM has acquired businesses that it believes promise growth and high profit margins in coming years.

Notably, last October, IBM said it would acquire much of the Weather Company–basically all of it except for its cable television activities. David Kenny, formerly Weather’s chief executive, was put in charge of all the activities under IBM’s Watson rubric, which will include the operations that gather and exploit IBM’s new trove of weather data.

IBM’s 2015 Revenue by Segment: IBM reported declining revenue for 2015 in every business segment except its leasing operations.

Dave Kenny looks like Ginni Rometty’s heir apparent or possibly a two-step heir if another executive is interposed when Rometty departs. Kenny not only heads what is IBM’s headline-grabbing Watson business but also brings along a personal background that undoubtedly appeals to his boss. Kenny did his undergraduate work at the General Motors Institute, where Rometty worked for a couple years after graduating Northwestern University before she moved to IBM.

Another area that IBM believes will give it potential for growth and improved profitability is advertising, which appears to be defined broadly by Big Blue’s management. Henry Blodget‘s Business Insider says Big Blue’s adventure in advertising and related services, a part of Global Business Services called IBM iX, has stealthily grown to substantial size; it currently employs about 10,000 people. Recently, IBM further bolstered this group by acquiring firms that current and future clients will use to express themselves via the Internet. IBM took over Clearleap and Ustream in late 2015 and early 2016, respectively, companies in the video production and distribution fields. It also acquired Resource/Ammirati, a digital advertising agency, and two European companies that provide related services.

This is not your father’s IBM. More importantly, it’s not Rometty’s predecessor’s IBM.

The old IBM is still around, of course. And it is still larger than the new one that is emerging as Rometty and her executive team struggle to graft a new company onto the branches of the old one. But there is a problem. The old IBM hasn’t been growing. On the contrary, revenue is under pressure as IBM’s customers cut back on their traditional purchases of goods and services, migrate to newer and less expensive alternatives (even if the new stuff comes from IBM, and that is not always the case), or migrate to new vendors selling systems that formerly came from IBM (which is the case now that IBM’s X86 business has been sold to Lenovo).

IBM enthusiastically promotes is victories in the marketplace, which are significant, but when it combines these wins with losses it has taken at the end of each quarter, the aggregate financial picture is a grim portrait of a company that absolutely must change if it wants to halt it slide. Right now, growth is something IBM may promise the faithful among its shareholders, but it is a promise that cannot be kept soon, if at all.

In 2015, IBM’s revenue fell from continuing operations fell to $82 billion, a decline of 12 percent from its intake during 2014. Its net income was off by 15 percent under GAAP (generally accepted accounting principles); the picture looks less gloomy when viewed through a different lens, as IBM explains in its presentations to shareholders and other interested parties. IBM was able to get favorable tax treatment of its activities in 2015. As a result, the company’s pre-tax profit decline of more than 20 percent was cushioned.

IBM’s Hardware Business Q4 2015: Big Blue reported quite positive revenue growth in its two proprietary server lines, but suffered a downturn in sales of disk and tape storage subsystems.

One of the reporting segments that severely suffered is what IBM calls Global Business Services. Revenue fell 12 percent for the year, the same proportion that characterized IBM in its entirety, and pre-tax profit was down by 23 percent. The results are obviously unacceptable to Rometty. This outcome is a striking example of the strategic management problem she hopes to solve by emphasizing new ideas under the Watson brand and empowering new executives like Kenny, Watson’s new pilot.

While hardware now directly accounts for less than 10 percent of IBM’s revenue (and a much smaller slice of the company’s profits), the indirect effect of hardware on sales of software and services is still pretty important. During 2015 it became clear that disposing of the X86 server business might have led to a big improvement in the profitability of IBM’s server business, but it still left Big Blue with a severe hardware headache: storage.

IBM’s disk and tape trade is in dismal shape, facing times as challenging as it did when IBM was late moving from big-platter disks into small-platter RAID and when the company’s success in tape was due as much to StorageTek’s stumbles as to its own engineering prowess. During the fourth quarter of 2015, IBM’s storage revenue fell 7 percent (in constant currency), even as revenue from the sale of mainframe servers jumped 21 percent and revenue from Power servers climbed 8 percent (both servers figures as also based on calculations made as if the equipment was measured in a constant currency, not the appreciating dollar that shaved points off deals done in other relatively weak currencies).

Few shareholders focusing on IBM’s profit margins would be heartbroken if the company sold its storage business, but no investor would enjoy the effect such a move would have on Big Blue’s top line. Storage accounts for about a third of IBM’s hardware revenue or $2.5 billion to $3 billion a year.

Nevertheless, if Rometty’s IBM decided to stand by its storage group, to repair it rather than shed it, the company’s shareholders would most likely bear it. The most interested investors, such as Warren Buffett, have a lot of faith in IBM and its management, and will continue to let the Rometty team run IBM the way they wish. These investors can count on Rometty taking the situation as seriously as death.

Rometty is acutely aware that she is only a couple years away from retirement. She is undoubtedly pondering what will soon become her legacy and inevitably comparing her track record and her place in IBM history with that of Lou Gerstner. Alert shareholders, employees and corporate customers understand that there will probably be some pretty dramatic developments in the IBM story during this year and next. For the most part, these parties expect IBM to deliver improved results. They are prepared to praise and reward Rometty when she delivers the goods, as they did recently when IBM announced its CEO was getting a very substantial bonus. On the other hand, if it starts to look like Rometty’s legacy will disappoint all the many people who have an eye on her and her IBM, they won’t hesitate to bury her in obloquy.