The Fed suckered IBM into a failing cloud strategy?
Economist David Stockman, who is probably best known for being President Reagan’s budget director back in the era of voodoo economics, has been particularly outspoken about IBM as a poster child for bad policy on the part of the US Federal Reserve. How this would be isn’t immediately obvious but I think is worth exploring because IBM is far from the only company so afflicted. There’s an important effect here to be understood about corporate motivations and their consequences.
So I’ll begin with a story. Almost 40 years ago there was a study I worked on at Stanford’s Institute for Communication Research having to do with helping farmers in Kentucky be more successful by giving them access to useful government data. The study was sponsored by the United States Department of Agriculture (USDA) and it gave portable computer terminals to farmers along with access to databases at the USDA, National Oceanic and Atmospheric Administration, Department of Commerce, etc. The idea was that with this extra knowledge farmers would be able to better decide what crops to plant, when to plant them, when to harvest them, etc.
It didn’t work.
The farmers, even those farmers who made greatest use of the data, were no better as commercial farmers than the control group that had no special information or communication resources.
But this doesn’t mean they didn’t benefit from the data. Those farmers who used their terminals most found the data useful for speculating on commodities markets. These were hedging strategies to some extent but the best traders took them much further, significantly supplementing their farm income. They weren’t better farmers but they were better businesspeople.
It was an unintended consequence.
Now back to IBM. With the Great Recession of 2008 the Federal Reserve under then chairman Ben Bernanke lowered interest rates almost to zero in an attempt to make the recession less severe by spurring business spending to lead a return to growth.
This didn’t work, either. The recession dragged on and on but the companies that were expected to spend us back to better economic health didn’t do so. Traditional monetary policy said that given really cheap money companies would invest in their businesses.
Instead they tended to borrow money and invest in their own shares. At least that’s what IBM did.
And it’s easily understandable why IBM did this. Their cost of money has been about one percent. The dividend yield on IBM shares has been around two percent. On the basis of dividend savings alone it made sense to buy back and retire the shares as long as interest rates remained low. This Fed-driven stock arbitrage (and not IBM’s actual business) has been in large part behind the strength in IBM shares over the past several years.
There are several problems with this policy, however. For one thing, interest rates eventually go back up. They haven’t yet but eventually they will and at that point IBM may find itself selling shares to retire debt.
Another problem with this policy is that it decouples IBM’s stock from the reality of IBM’s operating businesses. Sales go down, operating profits go down, but earnings go up because there are fewer total shares. The longer this goes on and the more used to such unreality you become as a company the harder it is to get back to minding the business, which for the most part IBM hasn’t done.
The last problem with this policy is that money spent buying back shares does nothing to help the business, itself. Here’s an interesting video featuring former Intel CEO Craig Barrett where he explains around 41:25 into the video why it is, exactly, that companies can’t cut costs to get out of a recession -- that they have to spend their way out. "Invest their way out," Barrett says.
IBM, totally ignoring Barrett’s advice, has primarily tried to cut its way back to prosperity and it doesn’t work.
The result of all this is that IBM management has lost touch with reality. They no longer know what to do to save the company. I’m far from the only person saying this, by the way. Check out this clip from CNBC. It used to be only I was saying this stuff, now many pundits are catching-on.
Which brings us finally to IBM’s cloud strategy. Remember IBM’s future is supposedly based on mobile, cloud, and analytics -- mobile being the Apple/IBM deal I wrote about last week. Just in the last week or so IBM CEO Ginni Rometty has started to back away from cloud as the basis of IBM’s future and for good reason: it can’t work.
Cloud is an industry where prices are dropping by half every year and will continue to do so for the conceivable future. It’s an industry where the incumbents not only have very deep pockets, the biggest of them aren’t even reliant on cloud for their survival. Amazon is the cloud leader, for example, yet if their cloud business went under you’d hardly see it as a blip in the company financials -- it’s such a small part of Amazon’s business. So too with Google.
But what about IBM? Unlike these other companies, IBM has to actually make money on its cloud investments because it's told the world that will be the basis of much of its income moving forward. Except it won’t, because cloud computing has become a commodity and IBM has never been successful in a commodity business.
And then there is Microsoft. Microsoft, too, has said that it’s future is reliant on cloud success (Windows Azure). Microsoft has more money than IBM and a more motivated work force. Microsoft will do whatever it takes to win in the cloud. It has done it before, investing tens of billions to build, for example, the Xbox franchise which may possibly still be in the red. IBM doesn’t have that kind of patience, motivation, or deep pockets.
IBM will sell cloud services to their existing customer base at prices above the market right until those customers come to understand that IBM’s cloud isn’t any better than the others. Then the companies and governments will switch to cheaper providers and IBM will abandon the sector just as it has so many others (PCs, on demand, and now X-series servers, too).
But now we know it wasn’t Ginni’s fault for failing to understand her own business, It’s all the Fed’s fault for failing to anticipate an unintended consequence of its own policy -- that people would generally rather eat ice cram than make it.