Point of View

Can the empire strike back yet again? IBM has to double down on business outcomes to succeed with its spin-off

November 12, 2020

IBM’s intention to spin off its Managed Infrastructure Services unit is a bold move. In a nutshell, it will spin out the outsourced infrastructure business of its Global Technology Services (GTS) business unit and dub it “NewCo.” While IBM has a strong track record of identifying and divesting assets that either no longer fit the strategic imperatives or have disappearing margins, this spin-off is different. Unlike previous divestitures that were largely products, this business is intricately linked to many other businesses across IBM. Not only that, but it is unraveling Lou Gerstner’s vision of “One IBM,” where all business units were aligned and integrated to help clients on their transformation journey. And you can go even one step further—there are not many parallels across the industry for such a move, if any. Thus, the biggest risk is not around the strategic intent but execution issues. More than anything else, it is about culture and talent. However, we must view Arvind’s strategic move in the context of a rapidly changing competitive landscape. The COVID-19 pandemic accelerated a sectoral shift toward cloud. Service providers are reacting to this shift by expanding from a cloud-first strategy to realigning their organizations with cloud as the cornerstone. First out of the block was Infosys bundling all its cloud assets in the new Cobalt business unit, followed by Accenture with its Cloud First announcement. Having had the opportunity to discuss these issues with IBM’s General Manager for Managed Infrastructure Services, Archana Vemulapalli, we share here the (diverse) views across the HFS analyst community.

Exhibit 1: IBM’s operating margin decline explains the thought process behind the spin-off

Source: HFS Research 2020

 

IBM is not too big to fail, but it was too big to succeed

Taking the cue from Andrew Ross Sorkin’s novel that has become a common phrase in business language, IBM is not too big to fail. In that respect, IBM is in a fundamentally different situation than when Lou Gerstner was literally tasked to avoid bankruptcy. While the leadership team under Arvind Krishna is tearing apart Gerstner’s “One IBM” vision, its conclusion seemed rather that IBM is too big to succeed. Put another way: IBM had lost its mojo. Overly complicated management structures and legacy contracts that continuously drag on earnings have tainted the brand. The financial performance highlighted in Exhibit 1 paints that picture quite drastically. Yet, when you think about innovation, IBM is not necessarily jumping to mind. Clearly, the $34 billion Red Hat bet is meant to change exactly that. One comparison that could provide clues is Microsoft’s reinvention under Satya Nadella. He managed to shift brand perception from being stale and associated with unfair business practices to emphasizing empathy, collaboration, and a growth mindset. His success is stuff for textbooks. Yet, there is one big difference. Microsoft is a software company; IBM is the master of complexity across many technology segments and hence Gerstner’s vision. Having said that, Arvind was pointing out during the announcement that IBM is shifting from services to software and solutions. And with that, the comparison becomes even more relevant. Exhibit 2 provides an overview of the key assets and the strategic focus of the respective new organizations.

Exhibit 2: Details of IBM’s separation underline the challenges for the NewCo

Source: IBM 2020

 

Is IBM NewCo akin to a failed bank?

To be upfront and transparent: We are not suggesting IBM did anything criminal like banks in the global financial crisis. But Arvind and the executives must be looking forward to earnings calls where financial analysts will congratulate them on successful quarters rather than having the millstone of legacy infrastructure services dragging them down again and again. Cleaning up the balance sheet is one of the key motivations for the spin-off. And a pun is intended by suggesting IBM is spinning the outlook of NewCo. The core IBM business will be a jewel, while the future of NewCo is decidedly less clear. If that future is as bright as declared on the announcement to Wall Street, the spin-off wouldn’t have happened in the first place.

Even though Archana was quick to point out that NewCo is not a divestiture, if you look at the history of IBM’s divestitures, you can see they all ended up in M&A. Conceivably, we could see three scenarios:

  • A system integrator could be trying to consolidate the infrastructure services space. As with IBM’s PC business, the potential suitors could have their heritage in the Far East.
  • Private equity or investment companies viewing to break up NewCo and create value in a disruptive fashion.
  • NewCo will rise like Phoenix from the ashes. Accretive value is created by greater focus, and the freedom to go beyond IBM products and solutions.

For the latter, one needs a euphemistic disposition to see that happen. Intriguingly, when Gerstner was confronted with the sectoral shift toward distributed computing as well as the challenge of diminishing the overdependence on mainframes, he went for the integrated model with mainframes being part of it. Now IBM is heading in unchartered territories by taking a new strategic course.

IBM is adamant that NewCo will be set up for success. It is envisaging two fast-growing companies where the key question is “not about where to split, but about how to grow.” It based this on the assumption that there are fundamentally different procurement and decision-making processes for both companies. While arguing that the growth lens between both organizations is different, IBM expects a strong partnership between them. Yet, that is contingent on the scenarios that we have called out. An intriguing point that Archana called out was that NewCo would have more flexibility in choosing products and partners. Could that mean having the freedom to choose from other than IBM products and solutions?

To imagine IBM without mainframes would be taking it one step too far

Where this euphemism gets slightly tempered is around issues such as mainframes. To imagine IBM without mainframes is taking it one step too far. IBM will remain with the core business, but NewCo might offer services around it. Taking the broader portfolio view, hardware and TSS businesses will remain with the core IBM, even though they are not fully aligned with the strategic direction. Yet, Archana was quick to point to the other side of the equation: “If both companies will look the same, we will have failed!” And during the announcement, Arvind went one step further by suggesting, “Our portfolio is hybrid cloud and AI.” But he also stated that he doesn’t envisage further structural M&A activity after the spin-off.

While the strategic direction for the core IBM is sound, the ambition to turn it more or less into a platform play is ambitious. The spin-off alone won’t change IBM’s DNA and culture. The discussion on mainframes was meant to highlight exactly that. To balance and mold the product-centric mindset of Red Hat and the services culture of Global Business Services (GBS) will be a tremendous challenge for Arvind and his leadership team. The talent (and consequently culture) of mainframes and cloud-native could hardly be more different. When challenged whether IBM is about to abandon the integrated model, Arvind suggested that IBM remains committed to Gerstner’s vision, albeit the integrated assets would benefit from the network effects of the platform that is meant to be built.

For NewCo, we take a much more cautious assessment. Despite IBM’s tangible efforts to spin the story, the margin profile and the legacy assets of NewCo make it difficult to get excited about its future. The whole deal logic is about managing investors’ perception and freeing up the management of having to deal with those legacy issues. This freedom comes with a hefty price tag. IBM has earmarked $2.3 billion in cost and charges by the end of 2020. The deal is expected to conclude by the end of 2021.

To succeed, can IBM learn from its struggle to make “Cognitive” work?

While it is too early to expect expansive strategic announcements around the “new IBM,” when Arvind took the reins as CEO, he underlined that he wants to reignite growth, helping clients on their journey toward cloud and AI and winning the architectural battle on Cloud with Red Hat. The announcement of the split is meant to deliver on those imperatives. Arvind announced, “we are sharpening our position as hybrid cloud and AI company.”

Yet, the shift from “cognitive” to “AI” as a strategic pillar for IBM is more than just semantics. Archana took an optimistic view. In her view, IBM was ahead on cognitive but should have capitalized on it. But now it is said to be learning how to operationalize and scale it. Where she was spot on was by suggesting that the challenge is to construct offerings and deals to drive outcomes. In our view, in the past, there was too much Watson washing going on. Much of the focus was on scientific projects or niche requirements. Yet, the challenges of integrating “AI” at scale while progressing toward the OneOffice was all too often marginalized. Thus, identifying and communicating the business outcomes will be central to the success of the new IBM.

The Bottom Line: The pivot toward hybrid-cloud and AI is strategically sound, yet the intention to evolve into a software-led platform company is ambitious.

The acquisition of Red Hat has been a turning point in the cloud strategy of IBM. Now Red Hat is meant to be a catalyst for the transformation of the entire company. In our view, the spin-off heralds the end of the vision of an integrated IBM, and that’s okay. The new IBM will be the dominant force in guiding organizations on their journey toward becoming AI-enabled and cloud-native, helping bring together its decade of educating the world about AI through Watson with its next decade of finally contextualizing it with cloud. Yet, the network effects of the envisaged platform will be more moderate and confined to cloud and AI. Conversely, NewCo is likely to go through more structural changes as investors will have a crack at unlocking more value. And, last but not least, we expect the competition to react to Accenture’s and IBM’s lead in making “cloud” the cornerstone of their organization.

 

Sign in to view or download this research.

Login

Lost your password?

Register

Insight. Inspiration. Impact.

Register now for immediate access of HFS' research, data and forward looking trends.

Get Started