Enterprise Computing Jumps on the Supply-Demand Curve

The traditional enterprise computing server suppliers are in an ever-faster game of musical chairs with cloud computing competitors. Recent cloud price cuts will accelerate enterprise adoption of the cloud, to the economic detriment of IBM, HP, Oracle Sun.

Many IT executives sat down to a cup of coffee this morning with the Wall Street Journal opened to the Marketplace lede, “Price War Erupts in Cloud Services.” Cloud computing from the likes of Amazon, Google, and Microsoft is “changing the math for corporate executives who spend roughly $140 billion a year to buy computers, Internet cables, software and other gear for corporate-technology nerve centers.” This graphic begs the question,

50 Million Page View Web Site Costs“Gee, maybe my data-center computing model for the company needs a strategic re-think?” And while there’s a very active consulting business by the usual business-transformation consulting suspects, the no-cost answer is: yes, cloud computing is a valid model that most enterprises and applications should move to over time.

This blog post, though, is not about the nuances of cloud computing today. Rather, we need to take a look at how the supply-demand curve for enterprise computing must impact the traditional enterprise server business — hard. (And yes, I am breaking a vow made during Economics 101 to never mention economics in polite company).

Cloud computing is sucking the profits out of the traditional server business.

For over fifty years, in the case of IBM, the traditional server companies including HP and Sun sold big iron, proprietary operating software and storage, and lots of services at high margins. In the past two decades, Intel’s mass-market silicon evolved into the Xeon family that took away a large percentage of that proprietary “big iron”. Yet the Intel specialist firms such as NCR and Sequent never could beat the Big Three server suppliers, who took on Xeon-based server lines of their own.

Cloud computing is sucking the profits out of the traditional server business. IBM is selling its Xeon business to Lenovo, and is likely to considerably reduce its hardware business. Oracle’s Sun business looks like a cash cow to this writer, with little innovation coming out of R&D. HP is in denial.

All the traditional server companies have cloud offerings, of course. But only IBM has jettisoned its own servers in favor of the bare-metal, do-it-yourself offerings from Amazon, Google, and lately Microsoft.

Price-war-driven lower cloud computing prices will only generate more demand for cloud computing. Google, and Microsoft have other businesses that are very profitable; these two can run their cloud offerings lean and mean. (Amazon makes up tiny margins with huge volume). To recall that Economics 101 chart:

Supply-Demand Curve

The strategic issue for IT executives (and traditional-supplier investors) is what happens over the next five years as lower server profits hollow out their traditional supplier’s ability to innovate and deliver affordable hardware and software? Expect less support and examine your application software stacks; you’ll want to make migration to a cloud implementation possible and economical. The book isn’t even written on cloud operations, backup, recovery, performance and other now well-understood issues in your existing data centers.

Meanwhile, what are your users up to? Like PCs sprouted without IT blessings a generation ago, cost-conscious (or IT schedule averse) users are likely playing with the cloud using your enterprise data. Secure? Regulatory requirements met? Lots to think about.

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Why IBM Will Exit the X86 Server Business

With hardware profits almost non-existent, IBM’s server hardware strategy needs a hurry-up fix. Jettisoning the X86 business and its sales/marketing employees will free up much-needed cash flow dollars. But the System z and Power series remain expensive to support.

Q4-2013 Was a Hardware Business Debacle
IBM’s systems and technology division (S&T), also known as hardware, saw sales fall 26% , as pre-tax earnings fell by $768 million to $200 million. As the press release says in grim, adjective-free prose:

Total systems revenues decreased 25 percent.  Revenues from System z mainframe server products decreased 37 percent compared with the year-ago period.  Total delivery of System z computing power, as measured in MIPS (millions of instructions per second), decreased 26 percent versus the prior year.  Revenues from Power Systems decreased 31 percent compared with the 2012 period.  Revenues from System x decreased 16 percent.  Revenues from System Storage decreased 13 percent.  Revenues from Microelectronics OEM decreased 33 percent.

With pre-tax income of $7.0 billion, S&T’s $0.2 billion contribution represented a mere 2.9% of company gross profits.

For the year 2013, S&T segment revenues were $14.4 billion, a decrease of 19 percent (down 18 percent, adjusting for currency).   Corporate revenues for 2013 totaled $99.8 billion. S&T gross margins were down 3.5 points to 35.6%, compared to rising overall IBM margins of 48.6%.

IBM generated free cash flow of $15.0 billion, down approximately $3.2 billion year over year. A lot of that short-fall can be laid at the doorstep of the S&T division.

IBM’s hardware division is a declining business, falling from 21.3% of company revenues in 2007 to 14.4% in 2013, now with inadequate profits. Moreover, the S&T division requires a billion-dollar-plus annual R&D budget and bears the costs of IBM’s semiconductor fabs — on obviously declining unit volumes. S&T is not pulling its weight.

Those are the problems driving a strategy to sell off the X86 commodity server portion of S&T.

The Hardware Market is Changing Rapidly
Last April, I argued emphatically that the whole of IBM was better off retaining the X86 business. IBM hardware, including X86, drive software and services revenues in other parts of IBM, and support a robust partner community that services small and medium establishments too small for IBM direct sales to efficiently cover.

What’s happened since then is IBM’s acquisition of SoftLayer Technologies, a cloud “Infrastructure as a Service” supplier, which specializes in bare-metal X86 servers with options for using IBM’s Power servers. SoftLayer is now IBM’s cloud strategy instantiated.

I still believe killing off hardware choices for customers for IBM customers will result in a declining IBM top line. But the financial situation outlined in the previous section begs for a look at IBM’s options.

The Corner Office View
The sale of IBM’s X86 business has the following pieces:

  • Generates cash from the sale
  • Allows a reduction in sales and marketing expenses such as X86 advertising and trade shows
  • Allows for a permanent reduction in staff in X86 R&D, marketing, and sales
  • Creates a multi-billion dollar software and service recurring revenue opportunity at SoftLayer.

Unlike a year ago, IBM’s X86 customers can be encouraged to move their X86 workloads to the SoftLayer cloud and rent the computing they require. No more fork-lift upgrades, data center floor-space, HVAC limits, and all the other considerations of running your own data center. Same high-quality IBM software available. Lots of work completed on cloud auditability and compliance, making SoftLayer attractive for large enterprise workloads.

With some effort, the IBM partners can be incentivized to get their small-business customers into the cloud. “The corporate data center is so twentieth century.” This limits customer, channel, and revenue loss. It’s a viable cannibalization strategy.

Exiting the X86 server business, IBM no longer has to engineer, develop and qualify X86 servers to its very high standards, nor bear the costs of that quality. What replaces X Series X86-based customer products at SoftLayer can be built to lower cloud-quality standards — “if it breaks, reboot on another instance.” In short, IBM can squeeze costs at its own SoftLayer data centers by moving to commodity cloud servers it builds instead of using over-engineered and -differentiated X Series machines designed for customer data centers.

All indications are that IBM wants to get this done soon.

What About the Rest of S&T?
The three pieces of S&T are servers, storage, and microelectronics.

Microelectronics exists to lower the costs of fabricating the proprietary System z  mainframe and Power Systems servers, which are still an enormously profitable ecosystem. IBM still has its own semiconductor fab, and partners with GlobalFoundries to share costs on semiconductor R&D.

The competitive pressures on System z  mainframe and Power Systems servers are mostly from X86 servers of all sorts. IBM is not contemplating exiting the System z or Power hardware market. But it does have a declining margin problem and an inexorable workload trend that favors commodity, X86 computing. Expect no immediate upheavals in the proprietary server segment.

Storage is an expected component in a system-level hardware sale. There are no commodity threats to IBM’s storage business, but there are options that include the cloud. Expect no immediate upheavals in the storage segment.

Nevertheless, an unbiased cost-cutter would take a hard look at exiting Microelectronics. That is, exiting the semiconductor fabrication business — revenues down 33% in Q4 to a run-rate of under $2 billion — and working with a fab partner on future System z  and Power Systems server designs. Intel would fit that bill.

However, the likely IBM reaction to losing the control of its key proprietary hardware semiconductor fabrication can be politely summed up as “over my dead, blue body.” But the numbers don’t lie: without the X86 business, z and Power have an additional fab-based financial burden to bear that is impossible to hide. Storage and Microelectronics can’t make it up. If S&T revenues continue to decline as they have for the past seven years, another server shoe must eventually drop.

[Update January 24, 2014: IBM announced a definitive agreement to sell its X86 business to Lenovo for $2.3 billion in cash and Lenovo stock.]

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IBM X-series

IBM X-series