Who is in the Cloud?

Both IBM and Microsoft have attempted to transition from the low-margin legacy businesses (PCs, servers, printers) into high-margin fast-cloud-based businesses (Cloud, mobile, analytics, databases) in last few years.   Other than suffering from the same currency headwinds, both have their own issues to deal with.

For IBM, there is not any evidence that the execution of the strategic shift has been making meaningful impact yet.  Although company has boasted the nearly 50% y/y growth in Cloud service, but it only represents a small portion of the total pie (less than 1/3 of the revenue).  With 12% decline in revenue “across every segment,” one may wonder if the new strategic imperatives are cannibalizing the existing old legacy customers.  However, it is not all bad for IBM.  IBM is still the leader in Big Data, No. 3 with 18% market share in database market, strong offering in NoSQL, Cloud, and consulting capabilities.

And to be fair, MSFT and others (Oracle, SAP, Apple, and Google) is facing the same problem.  There is an immediate gross margin pressure on Azure, which is the second largest hyper-scale cloud infrastructure platform next to Amazon’s AWS.  Microsoft has used Azure, most significantly unprofitable, as a loss leader to secure enterprise relationships of most significantly profitable (29% operating margin) AWS in Q415.   The bottom line is that everyone is on the same boat in suffering its GM in order to migrate to the less profitable but at scale Cloud space.

So, the deck has been reshuffled.  The real question is who has the bad hand.  BM is the more exposed to this new regime shift as its database accounting for 20% of its software revenue, compared with Microsoft’s 10%.  Moreover, Microsoft has been the leader in decoupling the clouds from the hardware, such as “Hybrid Clouds,” “Intelligent Cloud,” or most recently “Serverless Applications.”  Many customers will be running jobs seamlessly between their own data centers and Microsoft’s. This approach makes Microsoft run some very visible cloud businesses, including Office 365, Cortana Analytics, Skype, Outlook Email, OneDrive, Bing, to name a few.

In the most recent ending full year, IBM’s annual revenue fell by 8.5% (vs. Microsoft’s -2%), its profits fell by 18.6% (vs. Microsoft’s +8%).  As a result, just within last 2 years, IBM has underperformed MSFT by a whopping 60% (IBM –23% vs. MSFT +37%).   Nobody could have foreseen the day that the Big Blue, a virtual monopoly in the data processing market since 1930, would have been overcome by a small PC DOS software company in less than 30 years.  Following the 15th consecutive quarter of declining revenue, IBM’s 2015 annual revenue $81.7 billion dropped back to its 1998 level.  IBM stock at $150 also fell at the lowest level since late 2010.  Given the continued negative pro forma, IBM’s share has not yet been at the inflection point to show its true color. The fact of the matter is that the transitions to the cloud will continue to play out over time for both IBM and MSFT as the right business model.  That being said, the enterprise cloud is also one of the most competitive spaces with rivals like Amazon, Google, and Oracle.

If this is a battle of price-cutting, Amazon and Google would have a significant edge.

If this is a fight of providing corporate customers support, then it is led by Microsoft and IBM.

In that situation, IBM will have to provide much better services than Microsoft in order to justify its higher margins.   For Microsoft, both the lower gross margin for Azure and weaker PC demand are considered transitory.  Their higher-margin business, such as Commercial Office Licensing, Windows Pro, Server and Tools, will eventually accelerate the gross profit dollar growth.  On the other hand, both IBM’s revenue and stock have peaked since 2011.  At this point, the continued loss 1% a year in market share since 2008 is alarming.  We don’t see any catalysts, yet, for IBM to bounce back on both fronts in the foreseeable future.

Finally, IBM’s annual revenue grew at -14% (versus Microsoft’s +1%) with a long-term future growth is 9% (vs 7%).  IBM’s market cap is around 134 billion (vs. 443 billion).  In return, IBM stock is priced with a P/S of 1.3 (vs. 4.8), a P/E of 8.7 (vs. 20.6), and a P/B of 1.5 (vs. 5.4).   At these more than 3x valuation levels, all our models indicate a “Neutral” for MSFT and “Underweight” for IBM.  Considering the zero-sum gain nature of the competition in the Cloud business, this would suggest that MSFT-IBM would be a good long-short pair trade.

 

 

 

 

 

 

 

 

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