Don’t Buy IBM — It Lacks Sustainable Competitive Advantage

&l;p&g;&l;img class=&q;dam-image getty size-large wp-image-938539884&q; src=&q;×0.jpg?fit=scale&q; data-height=&q;639&q; data-width=&q;960&q;&g; President &a;amp; CEO of IBM Corporation Virginia M. Rometty speaks on the third day of China Development Forum (CDF) 2018 at Diaoyutai State Guesthouse on March 26, 2018 in Beijing, China. China Development Forum (CDF) 2018 is hosted by the Development Research Center of the State Council of China on March 24-26 in Beijing. (Photo by VCG/VCG via Getty Images)

On April 17, IBM announced shrinking margins and flat currency-adjusted revenue&a;mdash;and it failed to boost its forecast for the year. The stock lost over 6% after the announcement.

Is this a great buying opportunity? No, and that&s;s because IBM lacks a sustainable competitive advantage. (I have no financial interest in IBM securities).

Before getting into that, let&s;s take a look at its weak first quarter report. As &l;em&g;&l;a href=&q;; target=&q;_blank&q;&g;Bloomberg&l;/a&g;&a;nbsp;&l;/em&g;reported, its revenue of $19.1 billion was $300 million above analyst estimates but flat compared to the year before without currency fluctuations. IBM&s;s profit margin fell 0.6 percentage points to 43.2%.

IBM disappointed on earnings per share for the quarter and for its 2018 EPS forecast. Its adjusted EPS of $2.45 fell three cents short of analyst expectations. What&s;s more, Wall Street expected IBM to boost its 2018 EPS forecast but the company kept it at $13.80 a share, according to Bloomberg.

For five years, IBM suffered quarterly revenue declines&a;mdash;a trend it reversed in the fourth quarter of 2017. Sadly, that reversal appears to have been due mostly to cyclical factors&a;mdash;mainframe customers replacing old machines.

Indeed, the &l;a href=&q;; target=&q;_blank&q;&g;&l;em&g;Wall Street Journal&l;/em&g;&l;/a&g; reported that IBM is at the end of this cycle, noting:

&l;/p&g;&l;blockquote&g;Several analysts expect the mainframe cycle to tail off by the end of the year, creating a challenge for IBM to maintain its momentum, especially since hardware sales tend to also have a beneficial effect on revenue in other divisions. Toni Sacconaghi, an analyst at Bernstein Research, estimates that hardware drives sales of related support services, software, storage and financing that historically have made up roughly 40% of IBM&a;rsquo;s operating profit.&l;/blockquote&g;

IBM CEO Ginny Rometty has been touting so-called strategic imperatives&a;mdash;including social, mobile, analytics and cloud&a;mdash;as the key to its future growth. But strategic imperatives accounted for a declining share of revenues in the first quarter, 47%, compared to 49% in the fourth quarter of 2017.

As &l;a href=&q;; target=&q;_blank&q;&g;&l;em&g;CNBC&l;/em&g;&l;/a&g; reported, that decline was a &q;disappointment to&a;nbsp;Cantor Fitzgerald analysts who expected that balance to be unchanged in the first quarter.&q; What&s;s more, strategic imperative growth slowed from 17% in the fourth quarter to 15% in the first.


One of the biggest of these&a;nbsp;strategic imperatives&a;nbsp;is cloud services. Sadly for IBM bulls, the company is losing ground there. In the first quarter of 2018, IBM&s;s cloud business grew 14%&a;mdash;far more slowly than the 24% average, according to Bloomberg.

Can IBM turn this around and become a company that persistently beats analyst expectations for revenue and profit growth and raises its forecasts? I don&s;t think so. That&s;s because it lacks a sustainable competitive advantage&a;mdash;an idea that Warren Buffett&a;mdash;who invested $10 billion in IBM before selling his position — calls a moat.

A sustainable competitive advantage is difficult to understand and nearly impossible to achieve. But you can tell if a company has one because it keeps growing faster than investors expect. As I wrote in &l;em&g;Disciplined Growth Strategies&l;/em&g; — very few companies can do that.

But the one that does it better than any other is Amazon. Its growth rate is accelerating as it gets bigger. For example, in the &l;a href=&q;;&g;fourth quarter its revenues grew 38% to $60.5 billion&a;mdash;&l;/a&g;far faster than its five year average revenue growth of &l;a href=&q;; target=&q;_blank&q;&g;nearly&a;nbsp;24%&l;/a&g;.

Competitive advantage is measured by market share leadership which flows from three sources.

&l;strong&g;Giving customers more bang for the buck&l;/strong&g;

When people buy things, they compare different suppliers on a ranked set of factors. For Amazon customers those factors, or customer purchase criteria (CPC), include price, fast delivery and reliable service. Consumers choose Amazon because it does better than its competition on these CPC.

While the CPC for IBM&s;s customers vary, my interviews with six companies that compete and win against IBM say that its customers are frustrated because IBM tries to make them buy too many of its products and services — this making them pay more for a less effective solution. No wonder IBM is growing more slowly than rivals.

&l;strong&g;Harnessing capabilities to win at scale&l;/strong&g;

Winning and keeping customers &a;mdash; especially when a company has millions of them &a;mdash; depends on doing certain things well. For Amazon, such capabilities include offering a wide selection of products and services, operating an efficient supply chain to fulfill orders; and providing excellent customer service.

One of IBM&s;s weakest capabilities is product development. As I&s;ve learned from people who spent over a decade there, IBM develops new products much more slowly than do competitors.

IBM puts a premium on making sure that its products meet internal requirements &a;mdash;such as working in many different languages and inter-operating with a broad array of its products.

Thus IBM introduces products way later than do faster rivals&a;mdash;and those IBM products have features that customers often don&s;t want to buy.

&l;strong&g;Sustaining competitive superiority&l;/strong&g;

While many large companies can do the first two things in one industry &a;mdash; think Apple in smart phones &a;mdash; very few can stay ahead as competitors try to copy their strategies and make successful bets on new growth opportunities.

Amazon did this first in online book selling and has continued to lead &a;mdash; it controls about 40% of the U.S. e-commerce market; its Echo devices have about 75% of the smart-speaker market; it runs a major Hollywood studio; and its Amazon Web Services (AWS) unit leads with over 40% of the cloud computing market, according to the Journal.

We know IBM is not sustaining its position in cloud services because its growth is slowing down.

The right CEO can make a big difference — just look at how well Microsoft has&a;nbsp;done thanks to the&a;nbsp;successful cultural change managed by &l;a href=&q;; target=&q;_blank&q;&g;Satya Nadella&l;/a&g;.

Until IBM gets a new one, it will lack a sustainable competitive advantage. Avoid this stock.

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