Dear friend, your pal Deep Throat here. The REAL reason for the spin-off is below:
I know you are wondering about any insight I may have into the recent shenanigans going on in IBM, in particular with regards this new company imaginatively called NewCo. Rather than wait for you to reach out, I thought I would share this inside knowledge with you. But please remember this is between us only, and is not to be shared. All right, having said that, lets move on.
Just to recap, the other week IBM announced that it would spin off much of it’s GTS division into a new company, which will then be owned by the existing shareholders of IBM. NewCo will have revenue of approx 19b and include about 90,000 employees. Which is 27% of IBM’s existing employee base. Note that IBM is giving up 22% of its revenue, but 27% of it’s employees. Therefore, just by default, IBM increases sales per employee on the remaining IBM side. Lets dig into the why, the who, and the outcomes of this giant t–d of an idea.
As you are well aware, I have been part and parcel of IBM endeavoring to figure out what it wants to be when it grows up. The trouble is, it seems a hundred year old company doesn’t know either. So lets start there:
Why spin off NewCo?
The public story from IBM is that spinning out this company will allow IBM to focus on “high growth and high margin areas.” In this case that means Cloud and AI. I will ignore the success/failure of NewCo for the moment. So what IBM is saying is, “we need to focus, and this low margin services c-ap is more than we can handle, and is driving down shareholder value.” (Much more on this later).
Well IBM themselves have stated that they won't complete this non-trivial exercise until the end of 2021. Think about that for one minute. IBM says they can’t grow the company fast enough, so getting rid of 90,000 employees and $19b in revenue will solve that little problem. But wait, this process will take 16 months. It WILL BE a major distraction for senior management for the foreseeable future. This is not a small undertaking. You have to decide not only who will go from Sales, or the Services side, but who will go from payroll, legal, HR, marketing etc. I suppose they can look at the people in the division(s) now, and go, “You’re it,” but many of the back-office functions are a “shared service”, paid from each division back to Armonk (Legal for example). Someone has to go with this NewCo, just to make it FUNCTION as a company. Think of the manpower that is needed just to do this. So NO, this will NOT allow IBM to focus laser-like on Cloud or AI for at least 16 months. And that’s IBM’s timeline. AI is another word for Watson, but just to be clear, Watson Health is comatose, (pun intended), so what makes anyone think that AI will grow fast?
Meanwhile, IBM has invested far less in cloud than our competition. Now we will have a much smaller revenue base to invest. Hell, the first thing Krishna did was INCREASE the dividend, (pressured by Rometty and Kavanaugh), to prevent the stock from following Watson Health down the toilet.
The real reason for the spin off
So why do any of this if IBM will have LESS money to invest as a ratio of revenue, and given IBM’s appalling track record in BUYING companies, and very few other successful spin outs to point to, what gives? Well our CFO, Kavanaugh approaches IBM as a leverage buyout CFO. In other words, how can I cut costs, yet increase shareholder value? (there’s that phrase again). Since 2014 IBM’s tried laying off thousands and thousands of US employees, slowing down investments, raising the dividend, and going massively into debt to buy Red Hat. Yet the stock price has come down 40% while even Oracle (damn you Larry), has doubled in price since then. And that's being kind. I’m leaving out MSFT. Believe it or NOT, IBM looks at Oracle, not exactly a leader in Cloud, and goes, “They have far less employees, less revenue, yet their market cap is 70% higher. Sh–, if I just match them in PE I’ll be a frigin’ hero.” So yes, this is nothing more than a financial exercise. IBM senior execs are highly experienced. Do you really believe for one minute they cannot manage a low margin business and their growth business AT THE SAME TIME?
OK, so its a financial engineering deal, what does the Board of Directors Say?
Have you ever seen what a BoD meeting is like? These mostly non-tech guys who really have no idea what all IBM acronyms stand for, come in for a day and half of mind numbing PowerPoints. When they arrive, they are spritely (mostly), by the time they leave, they are mostly comatose, and need help from their chauffeur just to make it up the ramp of their G8 jets. Let me explain how this works.
The CEO (for 8 years Rometty) kicks things off. Essentially saying look how great things are. And “what a wonderful job I’m doing”. Then it’s the turn of the SVP’s (or their surrogates), to speak. Now clearly, all presentations have gone through many revisions, and approvals, but the theme is the same. Look how great we’re all doing. You’d think that there would be a standard format for all these. Well you’d be wrong. Each SVP uses whatever template he chooses. Oh sure, there is the same information, but if you don’t live and breath IBM all day every day, much of it goes over their heads. Can you imagine a day and half of this? No wonder the BoD has not done anything. Remember their mission; their job is to represent the shareholders. Well, how has that worked out? Of course it doesn’t help that Rometty is the Chairman of the Board. In other words, when she stands up and says “what a great job I’m doing”, she’s essentially talking to herself as the leader of the board. It’s like she’s looking in the mirror going, “You look great today.”
So whose in charge here?
As I said at the beginning, IBM just raised its dividend by one penny. This is mostly symbolic, but it sends a message; we will support the stock price no matter what. Which leads us back to Jim Kavanaugh. Kavanaugh is all about shareholder value. And if there is one thing that will wake up the BoD from their slumber during the meetings, it is the phrase “shareholder value.” That's like saying “squirrel” to a dog. Its a reflex. So when “shareholder value” comes up, packaged the right way in a day and half of PowerPoints, then they will go along. Of course their history in prompting “shareholder value” at IBM is pathetic, but at least they can claim they were doing their job.
Red Hat
I kept this part separate as clearly this is the talk of the town. But as a refresher, IBM went deep into debt to buy a company with 3b in revenue. IBM now owes over 60b in debt, yet has only 12b in cash. No wonder IBM will dump as much debt onto NewCo as the market will stand. Red Hat was executed by Krishna, but Ginni wanted a “big deal.” And Whitehurst who came along with this, has done his job. He protected his shareholders, his employees and did himself a good turn also. A perfect Trifecta. Well done. Analysts say the RH purchase will deliver mojo to IBM. Come on! What is the number one thing the market, esp tech, care about? Growth of course. So unless somehow, RH can spur IBM to massive growth, (not likely, see below), don’t expect massive increases in value. Krishna and Whitehurst are great guys to have c—tails with, but can they stand up to Finance? Apparently not yet.
The future
So will RH drive IBM revenue? Sure, a little, but nothing like MSFT, GOOG, or AWS growth. I mean even Kavanaugh HIMSELF said that they expect growth to be in the single digits for the foreseeable future. So explain to me Jim why we’re doing this then, if until at least two years out we’re growing under 10%? Where on earth will AWS and MSFT be by then. It doesn’t even bear thinking about.
Kavanaugh has also said that IBM might go on the acquisition hunt. With what? We’re 64b in debt now, and assuming he gets his way and dumps a third or more of that onto NewCo, that still leaves 40b in debt (lets be kind, maybe 35b), with revenues of ~60b. I hope money remains cheap. And IBM has bought 60 companies under Rometty. Would you trust IBM’s track record on this front to help drive growth?
In summary
Spinning off NewCo is:
a) A financial engineering way to get rid of 90,000 employees, then let someone else lay them off
b) An attempt to increase shareholder value, (squirrel!). So far no one is impressed
c) Get rid of a bunch of debt
d) Show (naïve) analysts IBM is a fast moving company. I'm constantly amazed how dumb many of them are
e) Potentially allow for a fleet of acquisitions to bail out the lack of investment for the past eight years (assumes increase in valuation)
f) Show determination and grit
Will it work?
The Magic 8 Ball says; “Don’t Count On It”
If I hear anything else, I will pass it on.
Your friend
Deep Throat