IBM's Narrow Moat Is Trending Negative

Equity Analyst

Julie Bhusal Sharma

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IBM still brings the “big” to its moniker Big Blue. IBM is one of the world’s largest IT services companies, the dominant provider of mainframes and a prominent player in the public cloud, data management systems, and other software products, like middleware and integration software. While IBM has tried to refresh its diverse offerings, we think IBM’s moat is deteriorating as the cloud transition chips away at IBM’s competitive advantage associated with customer switching costs.

We believe the deterioration of IBM’s business is best told through the lens of IBM’s Global Business Services business. We think that originally, IBM customers selected IBM for their IT services provider due to appeal in specialized functions, whether it be mainframes, databases, or integration software. Before the cloud, these functions needed to successfully interoperate with other IT workloads, which tended to be on a proprietary stack. We think this led IBM’s customer base to further entrench their enterprise with IBM offerings due to the ease of a main IT services provider and the surety of IT functions having interoperability.

However, now with the rise of the cloud and open source software, the possibility of a mix and match IT infrastructure is real. While we think this is not a risk for many loyal IBM enterprise customers (especially those using IBM's mainframes), we do think the trend will continue to hurt all other sides of IBM’s business. We think clients will gradually reduce their IBM offerings as competitors’ value add lowers the cost of switching from IBM products. Fortunately for IBM, we think its enterprise customers are particularly sticky, especially as IBM tends to serve very large customers within regulated industries. Therefore, any change with IBM will be a slow one, in our view.

Business Strategy & Outlook

We assign IBM a narrow moat based on the company’s switching costs and intangible assets permeant throughout the business. We think switching costs are prevalent at IBM because of the interconnectedness of its offerings. IBM’s business looks to cover all aspects of an enterprise’s IT needs, from IT consulting and outsourcing, hardware, software and cloud services. Many of these offerings are interconnected, and we think this largely stems from IBM’s consulting business. A new client, for example, may go to IBM’s consulting arm in search of an IT plan of attack which could lead to sales in all other parts of IBM’s business: from using IBM IaaS, purchasing a new mainframe using IBM’s financing capabilities, and even to using business intelligence software. 

We admit that this web would unravel if its initiator, consulting, were not sticky—but we think otherwise. In our view, IT services consulting firms boast high switching costs because of the continuity in understanding a client’s technology infrastructure over a long period of time. Even if an enterprise wanted to switch to a different consulting firm for a variety of reasons, the benefits of switching likely wouldn’t be worth the loss of the consultant's understanding of a company’s IT history and infrastructure. If this knowledge were lost, a potential replacement of an IT function could lead to costly implications elsewhere. We also think that many of IBM’s customers are slow to change IT consultants and providers because they fear rocking the boat with the mission critical functions served on IBM IT. Some examples include high frequency trading or processing 7 million flight tickets per day.

While we think that consulting is the most crucial segment in justifying IBM’s moat (because it maintains the stickiness of much of IBM’s other offerings), we think it’s worthwhile to delve into the switching cost landscape, in isolation, for IBM software as well. 

We think IBM’s software business, exhibits standalone switching costs. Software offerings consist largely of DB2 (IBM’s database offering), middleware and transaction processing software. We think swapping databases like DB2 is not an easy decision for customers to make due to the cost and time required. In areas like middleware and transaction processing software much of these solutions are catered to mainframe operations and are virtually the only offerings of its kind for IBM mainframes due to the mainframe’s proprietary zOS operating system—making switching not an option. Red Hat platforms OpenShift (container management), Red Hat Enterprise Linux, or RHEL, (operating systems) and Red Hat JBoss (middleware) are now housed in the segment as well, but won’t substantially change the moat makeup of this segment. We assigned RedHat with a narrow moat rating when it was a standalone public entity prior to being acquired by IBM.

We believe that IBM derives a secondary moat source, intangible assets, from the expertise that IBM has acquired throughout its 107-year-old history, particularly in specialty areas such as the financial, airline and networking sectors. Banks, airline operators and network providers operate in mission critical areas, and therefore, have leaned on IBM for years, allowing for IBM to benefit from specialty knowledge on its clients personally and the industry they operate in. We think this specialty expertise is reflected in IBM’s leading position in areas such as software defined networking and services (according to ISG) and management of 50% of global wireless connections. We also think it shows in IBM’s hold on 90% of all global credit card transactions, which we believe is tied to IBM’s virtual monopoly in the mainframe space. IBM makes up 90% of the global mainframe market (which covers an estimated 10,000 installed base). we think that mainframes’ price tag in the millions of dollars is a function of the mainframes intangible assets which leave clients running mission critical functions extremely wary of moving to the cloud mostly due to the extreme sensitivity to speed and reliability, which still can’t be found on the cloud. For instance, mainframes have 99.999% reliability, whereas cloud computing reliability is typically near 99.95%. This is a difference of roughly 5 minutes of downtime versus four hours of downtime per year.

Narrow

Economic Moat

International Business Machines Corp. is an information technology company, which provides integrated solutions that leverage information technology and knowledge of business processes. It operates through the following segments: Software, Consulting, Infrastructure, Financing, and Other. The Software segment combines hybrid cloud platform and software solutions to help clients become more data-driven, and to automate, secure and modernize their environments. It includes all software, except operating system software reported in the Infrastructure segment. The Consulting segment provides capabilities in business transformation and technology implementation. Consulting designs and builds open, hybrid cloud architectures and optimizes key workflows and business processes with IBM and ecosystem partner technologies. The Infrastructure segment offers solutions for hybrid cloud, and is the foundation of the hybrid cloud stack. Infrastructure is optimized for infusing AI into mission-critical transactions and tightly integrated with IBM Software including Red Hat for accelerated hybrid cloud benefits. Infrastructure also includes remanufacturing and remarketing of used equipment with a focus on sustainable recovery services. The Financing segment facilitates the acquisition of information technology systems, software and services through its financing solutions. The financing arrangements are predominantly for products or services that are critical to the end users’ business operations and support IBM’s hybrid cloud platform and AI strategy. The company was founded by Charles Ranlett Flint and Thomas J. Watson Sr. on June 16, 1911 and is headquartered in Armonk, NY.

Earnings data Q2 2023

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International Business Machines Corp. is an information technology company, which engages in the provision of integrated solutions that leverage information technology and knowledge of business processes. It operates through the following segments: Software, Consulting, Infrastructure, Financing, and Other. The Software segment combines hybrid cloud platform and software solutions to help clients become more data-driven, and to automate, secure, and modernize their environments. The Consulting segment focuses on integrating skills on strategy, experience, technology and operations by domain and industry. The Infrastructure segment offers solutions for hybrid cloud, and is the foundation of the hybrid cloud stack. Infrastructure is optimized for infusing AI into mission-critical transactions and tightly integrated with IBM Software including Red Hat for accelerated hybrid cloud benefits. The Financing segment refers to the client and commercial financing, facilitating IBM clients’ acquisition of IT systems, software, and services. The company was founded by Charles Ranlett Flint and Thomas J. Watson Sr. on June 16, 1911 and is headquartered in Armonk, NY.

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