Daily Update: The Disruption of IBM, An Alternate View of IBM’s 2015 Profit Goal, IBM Sells Fabs to GlobalFoundries

Good morning,

IBM is a company I’ve been wanting to write about ever since I started Stratechery, and this week is a big week. So today is a blowout.

On to the update:

The Disruption of IBM

In many respects IBM is a marvel. Born over 100 years ago through a merger of tabulating makers, IBM has always been enterprise focused: with regards to tabulating machines Wikipedia notes:

The company focused on providing large-scale, custom-built tabulating solutions for businesses, leaving the market for small office products to others.

This has been IBM’s modus operandi for their entire existence, and the guiding light that has pulled them through some of their darkest moments. The most famous of these came in the early 1990s, when IBM, having lost the dominant position in computing it had established with the System/360 and expanded with the IBM PC in the 1980s, was on the verge of going bankrupt and planning to break itself apart to better compete with its more nimble competitors (something that certainly sounds familiar given the recent news about eBay, Symantec, and especially HP).

It was at that critical moment Lou Gerstner – an outsider to not just IBM but to the technology industry – was named CEO. Moreover, it was his outsider perspective that helped him realize that IBM’s key competitive advantage was that it did everything, allowing them to, in the words of the quote above, “provide large-scale, custom-built tabulating solutions for businesses, leaving the market for small office products to others.” And so Gerstner changed IBM’s entire business from selling products to selling “solutions”, and at just the perfect time: soon companies realized this Internet thing was pretty important, and they had best get online, and there was IBM, already solving their internal IT issues, ready to hold their hand as they moved onto the Internet.

This explicit focus on the enterprise and ability to solve complex problems – and the lock-in that resulted – kept IBM relatively immune from the consumer-driven changes that were hurting many of its potential competitors. More importantly, IBM became convinced that their immunity was permanent.

Back in 2010, then-CEO Sam Palmisano announced that IBM was committed to delivering $20/share in profit by 2015; it is this commitment that many blame for IBM’s current troubles (this excellent article in BusinessWeek that I linked to in May is probably the best articulation of this line of thinking), but I think the commitment to a particular profit number – and the associated willingness to cut to get there – was actually a symptom of the aforementioned overconfidence in IBM’s position. While announcing the 2015 plan, Palmisano said:

[The consensus view is that] product cycles will drive industry growth. The industry is consolidating and at the end of the day consumer technology will obliterate all computer science over the last 20 years.

I’m an East Coast guy. We’re going to have a slightly different view. Product cycles aren’t going to drive sustainable growth. Clients in the future will demand quantifiable returns on their investment. They are not going to buy fashion and trends.

Enterprise will have its own unique model. You can’t do what we’re doing in a cloud.

It’s hard to believe, but those words were spoken just over four years ago. “You can’t do what we’re doing in a cloud.” In contrast, IBM’s executives uttered the world “cloud” 28 times during Monday’s earnings call where they announced an earnings decline and the abandonment of the aforementioned profit goal.

Again, though, the goal was a symptom, not a cause, for it followed Palmisano’s belief that enterprises would always require “large-scale, custom-built tabulating solutions” that only IBM could supply. The cloud, with its consumer-esque ease-of-use – and more importantly, associated uniformity/lack of customizability – didn’t fit enterprise’s “unique model.” To put it another way, IBM was already in trouble by the time Palmisano made that goal; being competitive in the cloud in 2014 would have meant significant investment in 2010, which would have meant believing lots of businesses would ultimately do what IBM was doing “in a cloud.” And, had IBM appreciated where the world was going and committed to it, there is no way that Palmisano could have countenanced the profit goal. Symptom, not cause.

From a broader perspective, it’s clear that Palmisano learned the wrong lesson from Gerstner’s turnaround. In his view IBM abandoned broadly applied product development for customized solutions; why would the world go backwards to broadly applicable products, no matter how they were delivered? “You can’t do what we’re doing in a cloud.”

The thing is, Palmisano was right; something that is interesting about most cloud solutions is that few are really doing anything new. Rather cloud service providers are simply taking operations that were formerly done on premise and moving them to a cloud that is available for any enterprise to use. And, as Palmisano realized, the inherent lack of customization in such a model means that most cloud services are on a feature-by-feature basis inferior to on-premise software.

The reality, though, is that the businesses IBM served – and the entire reason IBM had a market – didn’t buy customized technological solutions to make themselves feel good about themselves; they bought them because they helped them accomplish their business objectives. Gerstner’s key insight was that many companies had a problem that only IBM could solve, not that customized solutions were the end-all be-all. And so, as universally provided cloud services slowly but surely became good-enough, IBM no longer had a monopoly on problem solving.

That’s it in a nutshell: IBM was disrupted by an inferior technology that they viewed as inferior and summarily dismissed, right up until it was too late. It’s nearly textbook.

An Alternate View on IBM’s 2015 Profit Goal

There is another fascinating angle to IBM, and it’s an outgrowth of Palmisano’s profit goal. A proposition I’ve played around with, both on Stratechery and Exponent, is whether or not it is desirable for companies to try and live forever. Popular sentiment is that they should: witness how many people are criticizing IBM for all of the money they have returned to shareholders over the last decade.

But step back for a moment: instead of feeding that money to a sprawling company (still over 400,000 employees!), by buying back stock and issuing big dividends IBM has allowed investors to put that money to work elsewhere, and I’m sure some of it has made its way to a few of the startups that are currently upsetting IBM’s business. From an economic perspective, this is great news! I’ve written that startups succeed because they have better incentives, so shouldn’t we all be happy that IBM didn’t waste billions trying to compete?

In summary, IBM is in trouble because Palmisano prioritized shareholders over IBM’s long-term health (whether or not that was intentional), but one can argue that the industry as a whole is better off.

IBM Sells Fabs to GlobalFoundries

A lot of tech folks were understandably focused on IBM’s “sale” of its Microelectronics business to GlobalFoundries. “Sale” is in quotes because IBM is actually paying GlobalFoundries $1.5 billion to take the business off of their hands.

This payment gets at why this transaction isn’t as big of a deal as it seems: IBM gets to take a lot of capital off of its books (improving its return on invested capital), but is completely beholden to GlobalFoundries both contractually and because IBM’s POWER uses copper-based chips. In other words, it’s not like IBM can suddenly go price-comparing foundries.

It’s harder to see what GlobalFoundries gets out of the deal, although I bet it has a lot to do with patents; IBM has a lot of them when it comes to chips, which will allow GlobalFoundries to negotiate new cross-licenses, significantly reducing the cost structure of their current fabs and enabling them to be more competitive with TSMC and Samsung in particular (and Intel if they ever enter the foundry-for-hire business).

Taking this back to IBM, though, it shows the degree to which IBM itself has become much less of a solution company: back in the 90s IBM provided everything a business needed, from PCs to servers to customized software, with a hefty consulting fee to make it all work. By the mid-2000s, though, PCs were pure commodities, so IBM dumped the business, and earlier this year, IBM did the same to their x86 server line; the writing is now on the wall for POWER. The mystery is why IBM didn’t think the same democratization and commodification would happen to their software, especially once there was nothing left to tie together.

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Have a great day.