 From the CUBE studios in Palo Alto in Boston, connecting with thought leaders all around the world, this is a CUBE conversation. IBM's new CEO has an opportunity to reset the direction of the company. Outgoing CEO, Ginny Rometti, inherited a strategy that was put in place over two decades. It became fossilized in a lower margin, services led model that she helped architect. Ginny spent a large portion of her tenure shrinking the company so it could grow, but unfortunately she ran out of time. For decades, IBM has missed opportunities to aggressively invest in the key waves that are now powering the tech economy. Instead, IBM really tried to balance investing innovation with placating Wall Street. We believe IBM has an opportunity to return to the big blue status that set the standard for the tech industry, but several things have to change. Some quite dramatically. So we're going to talk about what it's going to take for IBM to succeed in this endeavor. Welcome to this special Wikibon CUBE insights powered by ETR. In this breaking analysis, we're going to address our view of the future of IBM and try to accomplish three things. First, I want to review IBM's most recent earnings, the very first one under new CEO, Arvind Krishna, and we'll discuss IBM's near-term prospects. Next, we'll look at how IBM got to where we are today. I want to review some of the epic decisions that it has made over the past several years and even decades. Finally, we'll look at some of the opportunities that we see for IBM to essentially remake itself and return to that tech titan that was revered by customers and feared by competitors. First, I want to look at the comments from new CEO, Arvind Krishna. And let's try to decode them a bit. Arvind in the first earnings call that he held, and in interviews as well, and also internal memos, he's given some clues as to how he's thinking. This slide addresses a few of the key points. Arvind has clearly stated that he's committed to growing the IBM company and of course, increasing its value. This is no surprise, every IBM CEO has been under pressure to do the same. We'll look at that further a little later on in this segment. Arvind also stated that he wants the company, he said it this way, to lead with a technical approach. Now, as we reported in January when Krishna was appointed to CEO, we're actually very encouraged that the IBM board chose a technical visionary to lead the company. Arvind's predecessors did not have the technical vision needed to make the bold decisions that we believe are now needed to power the company's future. As a technologist, we believe his decisions will be more focused on bigger technical bets that can pay bigger returns, potentially with more risk. Now, as a point of just tactical commentary, I want to point out that IBM noted that it was doing well coming into the March month, but software deals especially came to a halt as customers focused on managing the pandemic and other parts of the business were okay. Now, this chart pulls some of the data from IBM's quarter. And let me make a few comments here. Now, what was weird here, IBM cited modest revenue growth on this chart, this was pulled from their slides, but revenue was down 2% for the quarter relative to last year, so I guess that's modest growth. Cloud revenue for the past 12 months, the trailing 12 months was 22 billion and grew 23%. We're going to unpack that in a minute. Red Hat showed good growth, Stu Miniman and I talked about this last week, and IBM continues to generate solid free cash flow. Now, IBM, like many companies, they prudently suspended forward guidance. Some investors bristled at that, but I really have no problem with it. I mean, it's just way too much uncertainty right now. So I think that was a smart move by IBM and basically everybody's doing it. Now, let's take a look at IBM's business segments and break those down and make a few comments there. As you can see in this graph, IBM's 17 plus a billion dollar quarter comprises their four reported segments, cloud and cognitive software, which is, of course, its highest margin and highest growth business at 7%. You can see its gross margin is really, really nice, but it only comprises 30% of the pie. Services, global business services and GTS, global technology services are low growth or no growth businesses that are relatively low margin operations, but together they comprise more than 60% of IBM's revenue in the quarter and consistently throughout the last several years. Systems, by the way, grew nicely on the strength of the Z15 product cycle. Z was up by 60% and dragged storage with it, but unfortunately power had a terrible quarter and hence the 4% growth, but decent margins compared to services at 50%. IBM's balance sheet looks pretty good. It took advantage of some low rates recently and took out another $4 billion in corporate debt. So it's okay. I'm not too concerned about its debt related to the Red Hat acquisition. Now I want to come back to cloud at 22 billion for the past 12 months and growing at 23%. What? You say that sounds very large. I don't understand. It's understandable that you don't understand, but let me explain with this next graphic. What this shows is the breakdown of IBM's cloud revenue by segment from fiscal year 19. As you can see, the cloud and cognitive segments or segment, which includes Red Hat, comprises only 20% of IBM's cloud business. I know, kind of strange. Professional services accounts for 2 thirds of IBM's cloud revenue with systems at 14%. So look, IBM's defining cloud differently than most people. I mean, actually this, what percent of the cloud business of AWS, Azure, and Google Cloud come from professional services and on-prem hardware? It's just, this just doesn't have real meaning. And I think, frankly, it hurts IBM's credibility as it hides the ball on cloud. Nobody really believes this number. So, I mean, there's really not much else I can say there. But look, why don't we bring in the customer angle and let's look at some ETR data. So what this chart shows is the results of an ETR survey. That survey ran, we've been reporting on this, ran from mid-March to early April. And more than 1,200 respondents and almost 800 IBM customers are in there. If this chart shows the percentage of customers is spending more on IBM products by various product segments that we chose with three survey samples. April last year, January 2020 and the most recent April 2020 survey. So the good news here is that container platforms, OpenShift, Ansible, the staples of Red Hat are showing strength, even though they're notably down from previous surveys. But that's the part of IBM's business that really is promising. AI and machine learning and cloud, they're right there in the mix and even outsourcing and consulting and really across the board. You can see a pretty meaningful and respectable number or percent of customers are actually planning on spending more. So that's good, especially considering that the survey was taken right during the middle of the COVID-19 pandemic. But if you look at the next chart, the next scores across IBM's portfolio, they're not so rosy. Remember, net score is a measure of spending momentum. It's derived by essentially subtracting the percent of customers that are spending less from those that are spending more. It's a nice simple metric. It's kind of like NPS and ETR surveys. Every quarter with the exact same methodology for consistency so we can do some comparisons over a time series, it's quite nice. And you can see here that Red Hat remains the strongest part of IBM's portfolio. But generally in my experience, as net scores start to dip below 25%, it kind of get into the red zone, the so-called danger zone. And you can see many parts of IBM's portfolio are showing softness as we measure in net score. And even though you see here, the outsourcing and consulting businesses are up relative to last year, if you slice the data by large companies, as we showed you with Sagar Kedakia last week, that services business is showing deceleration. Same thing we saw for Accenture, EY, Deloitte, et cetera. So here's the takeaway. Red Hat, of course, is where all the action is. And that's where IBM is going to invest, in our opinion. And we'll talk a little bit more about that and drill into that kind of investment scenario a bit later. But what I want to do now is I want to come back to Arvin Krishna. Because he has a chance to pull off a Satya and Adela like move. Them is different, but there are definite similarities. I mean, you have an iconic brand, a great company that's in many technology sectors. And yes, there are differences. IBM doesn't have the recurring software revenue that Microsoft had. It didn't have the monopoly in PCs. But let's move on. Arvin has cited four enduring platforms for IBM. Mainframes, services, middleware and the newest hybrid cloud. He says that IBM must win the architectural battle for hybrid cloud. Now, I'm going to really share later what we think that means. There's a lot in that statement, including the role of AI in the edge, both of which we'll address later on in this breaking analysis. But before we get there, I want to understand from a historical perspective where we think Arvin is going to take IBM. And to do that, we want to look back over the modern history of IBM, modern meaning of the post-mainframe dominance era, which really started in 1993 when Lou Gershner took over. Look, it's been well documented how Lou Gershner pivoted into services. He wrote his own narrative with the book who says elephants can't dance. And you know, look, you can't argue with his results. The graphic here shows IBM's rank in the Fortune 500. That's the green line over time. IBM was sixth under Gershner, and today it's number 38. The blue area chart on the insert, it shows IBM's market cap. You know, look, Gershner was a hero to Wall Street and IBM's performance under his tenure was pretty stellar. But his decision to pivot to services, set IBM on a path that to this day, marks the company's greatest strength, and in my view, its greatest vulnerability. Name a product other than mainframes in which IBM leads. I guess, middleware, I guess, web sphere, okay. But you know, IBM used to be the leader in the all-important database market. Semiconductors, storage, servers, even PCs back in the day. All right, so look, I don't want to beat on this too much, I can say it's been well-documented. And I said earlier, Ginny essentially inherited a portfolio that she had to unwind, and hence the steep revenue declines, as you see here. And because she had a jettison, the so-called non-strategic businesses. But the real issue is R&D, and how IBM has used its free cash. And this chart shows IBM's breakdown of cash use between 2007 and 2019. Blue is cash return to shareholders. Orange is research and development, and gray is capex. Now, I chose these years because I think we can all agree that this was the period of tech defined by cloud. And you can see, during those critical, early formative years, IBM consistently returned well over 50%, and often 60% plus of its free cash flow to shareholders in the form of dividends and stock buybacks. Now, while the orange appears to grow, it's because of what you see in this chart. The point is the absolute R&D spend really didn't change too much. It pretty much hovered, if you look back, around five and a half to $6 billion annually. The percentage grew because IBM's revenue declined. Meanwhile, IBM's competitors were spending on R&D and capex, what were they doing? Well, they were building out the cloud. Now, let me give you some perspective on this. In 2007, IBM spent $6.2 billion on R&D. Microsoft spent $7 billion that same year. Intel 5.8 billion, Amazon spent $800 million. That's it. Google spent $2.1 billion that year. In that same year, IBM returned nearly $21 billion to shareholders. In 2012, IBM spent $6.3 billion on R&D. Microsoft that year, $9.8 billion, Intel $10 billion, Amazon $4.6 billion, less than IBM, Google $6.1 billion, about the same as IBM. That year, IBM returned almost $16 billion to shareholders. Today, IBM spends about the same $6 billion on R&D. About the same as Cisco and Oracle. Meanwhile, Microsoft and Amazon are spending nearly $17 billion each, sorry, Amazon 23 billion. And IBM could only return $7 billion to shareholders last year. So, while IBM was returning cash to its shareholders, its competitors were investing in the future and are now reaping the rewards. Now, IBM suspended its stock buybacks after the Red Hat deal, which is good in my opinion. Buybacks have been a poor use of cash for IBM, in my view. Recently, IBM raised its dividend by a penny. It did this so it could say that it has increased its dividend 25 years in a row. Okay, great. Not expensive, so I'm glad that investors were disappointed with that move. But since 2007, IBM has returned more than $175 billion to shareholders. And somehow, Arvin has to figure out how to tell Wall Street to expect less while he invests in the future. So let's talk about that a little bit. Now, as I've reported before, here is the opportunity. This chart shows data from ETR. It plots the cloud landscape and is a proxy for multi-cloud and hybrid cloud. It plots net score or spending momentum on the Y-axis and market share, which really isn't market share as we've talked about. It's a measure of pervasiveness in the data set. That's plotted on the X-axis. So the point is, IBM has presence. It's pervasive in the marketplace. Red Hat and OpenShift, they have relevance. They have momentum with higher net scores. Arvin's opportunity is to really plug OpenShift into IBM's large install base and increase Red Hat's pervasiveness. Well, at the same time, lifting IBM's momentum. This, in my view, as Stu Miniman and I reported last week at the Red Hat Summit, puts IBM in a leading position to go after multi and hybrid cloud and the edge. So let's break that down a little bit further. When Arvin talks about winning the architectural battle for hybrid cloud, what does he mean by that? Here's our interpretation. We think IBM can create the de facto standard for cloud and hybrid cloud. And this includes on-prem, public cloud, cross-clouds or multi-cloud, and importantly, the edge. Here's the opportunity. It's to have OpenShift run natively, natively everywhere on-premises in the AWS cloud and the Azure cloud, GCP, Alibaba and the IBM cloud and the Oracle cloud everywhere natively so it can take advantage of the respective services within all those clouds. Same thing for on-prem, same thing for edge opportunities. And I'll talk a little bit more about that in a moment. But what we're talking about here is the entire IT stack running natively, if I haven't made that point, on OpenShift, the control plane, the security plane, the transport, the data management plane, the network plane, the recovery plane, every plane, a red hat led stack with a management of resources is 100% identical everywhere, the same cloud experience. That's how IBM's defining cloud. Okay, I'll give them a mulligan on that one. IBM can be the independent broker of this open source standard covering as many use cases and workloads as possible. Here's the rub. This is going to require an enormous amount of R&D. Just think about all the startups that are building cloud native services and imagine IBM building or buying to fill out that IT stack. Now I don't have enough time to go too deep to all other areas but I do want to address the edge, the opportunity there and weave in AI beyond what I said above, which I want to stress, the points I made above about hybrid multi-cloud include edge. The edge is a huge opportunity but IBM and many other if not most other traditional players we think are kind of missing the boat on that. I'll talk about that in a minute. Here's the opportunity. AI inference is going to run at the edge in real time. This is going to be incredibly challenging. We think about this, a car running inference AI generates a billion pixels per second today. In five years it'll be 15 times that. The pressure for real time analysis at the edge is going to be enormous and it'll require a new architecture with new processing models that are likely going to be ARM based in our opinion. IBM has the opportunity to build end to end solutions powered by Red Hat to automate the data pipeline from factory to data center to cloud and everywhere. Anywhere there's instruments IBM has an opportunity to automate them. Now rather than toss traditional Intel based IT hardware over the fence to the edge which is what IBM and most people are doing right now IBM can develop specialized systems and make new silicon investments that can power the edge with very low cost and efficient systems that process data in real time. All right, look, I'm out of time but some other things I want you to consider. IBM transitioning to a recurring revenue model interestingly back to the future, right? IBM used to have a massive rental revenue stream before it converted that base to sales. But if Arvin can recreate a culture of innovation and win the day with developers via its Red Hat relationships, as I said recently he will be CEO of the decade. But he has to transform the portfolio by investing more in R&D. He's got to convince the board to stop pouring money back to investors for a number of years, not just a couple of quarters and do whatever they have to do to protect the company from corporate raiders. This is not easy, but with the right leader, IBM a company that has shown resilience through the decades I think it can be done. All right, well thanks for watching this episode of the Wikibon Cube Insights powered by ETR. This is Dave Vellante and don't forget these episodes are available as podcasts wherever you listen. I publish weekly on siliconangle.com where you'll find all the news. I publish on wikibon.com, which is our research site. Please comment on my LinkedIn post. Check out ETR.plus, that's where all the data lives. And thanks for watching everybody. This is Dave Vellante for Breaking Analysis. We'll see you next time.