The computer industry goes through technology cycles. With each cycle, a new crop of companies emerge that dominate the industry. The winners in the previous cycle usually fade into oblivion. Who remembers Burroughs, Digital Equipment, Wang, Prime Computer or Control Data? The leaders in this cycle are cloud companies, Facebook, Google and Amazon.
The winners in the last cycle – the software cycle – were Microsoft, Oracle and IBM. They dominated the industry. Their business model was simple. Sell software licenses that are installed on on-premise hardware (wrap it in outsourcing for extra margin). The profit margins were enormous because software has little marginal cost of production. The industry was defined by those who could best develop code for enterprises and, more importantly, sell it to them.
IBM, Microsoft and Oracle’s latest earnings reports highlight the challenge these old-school companies face. Their press releases all focused on how they were getting into the ‘cloud’. The elephants of the industry tried to convince investors that they are experiencing success with the new technology paradigm – even comparing their performance to competitors that didn’t exist a few years ago like Workday and Netsuite. In the cases of IBM and Oracle, the smart money was not impressed and their share prices traded down. Microsoft, on the other hand, traded up because its cloud presence in the form of Office 365 Live is gaining traction versus Google Apps, its only competitor.
IBM faces the biggest challenge in the new technology cycle. IBM decided correctly in the 1990’s to get out of application software and focus on middleware. This strategy has worked well for almost 20 years. IBM focused on selling middleware to the CIO, not apps to the end user. However, in the cloud era, CIO’s will lose power and control. More and more end-users — particularly C-level end-users — will drive technology purchases. End-users don’t buy middleware – databases, development environments and system/security management — they buy apps like collaboration, human resources management, customer relationship management, supply chain management, production management (ERP) and financial recordkeeping. Not surprisingly, the cloud leaders sell end-user apps like Google, Workday, Salesforce.com, E2open and Intuit. For IBM to compete in the cloud it is going to have to get back into applications and fast.
The other troubling event this week for IBM was the CIA decision to use Amazon Web Services for its outsourced cloud, not IBM technology. This highlighted the tremendous lead that AWS has over all competitors in providing rentable cloud infrastructure. IBM Global Services has always been focused on large data center outsourcing which is clearly associated with the old software model, transitioning to something like Amazon Web Services will be tough.
The other hurdle that IBM faces in the cloud is ‘ticket size’. IBM is used to million dollar contracts; the cloud is characterized by thousand dollar contracts. It remains to be seen if IBM can restructure its sales organization to deliver profit on deals below $10,000. I have shorted IBM; I think they are in real trouble that no manner of financial engineering can disguise.
Oracle is in a better place than IBM in that it has an apps business. Now it remains to be seen if it can move that business to the cloud at acceptable profit margins. Looking at Salesforce.com and E2open, leaders in enterprise cloud apps, it is not clear that the cloud era will be as profitable as the software model. SFDC has rarely made acceptable profits and its stock price which trades at 325 times earnings is beginning to drop. I have shorted Salesforce.com because I think that it is overvalued; I am long E2open.
Microsoft might be the surprise winner in the enterprise cloud. Its dominance of the collaboration space with Exchange and now Office 365 Live is impressive. The recent strength of Microsoft’s stock price is surprising given the weakness in the PC market and the failure of Windows 8 and all things mobile. But the market must be looking at Office 365 Live and seeing a long-term winner in the most fundamental of all computer apps, collaboration involving email, calendar, contacts and tasks. Microsoft also has the only real competitor to Salesforce.com in CRM Dynamics with its many industry vertical editions.
Some people believe that Salesforce.com’s high relative valuation at 6.7x revenue (IBM trades at 2.4x, Oracle at 3.9x and Microsoft at 3.0x) is due to its acquisition value. The theory is that IBM will be forced to buy Salesforce.com to muscle into the cloud business. With a minimum price tag of $22B, even IBM, with its $12B of cash, would be stretched to make sure a large acquisition. In any event, the value destruction caused by such an acquisition – as the Salesforce.com gets revalued as part of IBM – would be massive at about $15B. Even IBM can’t take such a hit. It would make Hewlett-Packard’s disastrous acquisition of Autonomy look smart.