When I was young, IBM dominated computing. In the tech world, when comparing platforms, everyone said, “Nobody ever got fired for buying IBM.” IBM was a standout role model for sales success, product leadership and investor returns.
Now, not so much. IBM’s stock fell almost 5% on Wednesday after the company reported “lackluster” results. For the week IBM lost about $20 per share – almost 12%. Quarterly revenue last quarter fell 3%, making 20 consecutive quarters of declining revenue for the once-dominant behemoth and Dow Jones Industrial Average (DJIA) component.
CEO of IBM Ginni Rometty (Photo by Neilson Barnard/Getty Images for New York Times)
The stock is still up from January 2016 lows of $125, and you might think this pullback is a buying opportunity. But you would be wrong. For long-term investors the stock has fallen from about $194 when CEO Ginni Rometty took control to the recent $160 — a 17.5% decline over five years. And that is after spending $9 billion on payouts (mostly share buybacks) to prop up the stock!
But because of its long-term “growth stall” the odds are almost a certainty things will continue to worsen for IBM.
(c) Adam Hartung and Spark Partners
Growth Stalls are Deadly Accurate Predictors of Future Value Declines
When a company has two consecutive declining quarters of revenue or earnings, or two consecutive quarters of revenue or earnings lower than the previous year, that company is in a “growth stall.” After stalling, 93% of companies will struggle to consistently grow a mere 2%. Seventy percent will lose more than half their market cap.
I made this same call, to not own IBM, in May 2014
. Then IBM had registered a stall on both the quarter-to-quarter metric, and on the year-over-year quarterly metric. IBM was clearly in a “growth stall” and showed no signs of turning around its fortunes. Now IBM has failed to grow quarterly revenue for five years!
Supported by the company PR and investor relations departments, optimists will claim there is reason to think things will improve. For example, in September 2015 IBM executive John Kelly predicted that Watson would be the next “huge engine” for growth. Today the Cognitive Computing segment that is Watson is about the same size it was then. In fact none of the five IBM segments are showing strong growth.
The reason a “growth stall” is such an accurate predictor of future bad results is its ability, in a very simple way, to describe when a company falls out of step with its customers/marketplace. The market went one way — in this case to mobile apps, mobile devices and cloud computing — while the company remained in outdated businesses and launched competitive offerings too late to catch the early market makers. At IBM, Cognitive has not become a big new market, while the historical Business Services and Systems segments keep shrinking, and Cloud Services is simply out-gunned by competitors like Amazon.
Rometty should be replaced by someone from outside IBM.
Meanwhile, the CEO keeps her job and even achieves pay raises! In 2016 IBM’s stock had dropped 36% since Rometty took the CEO position, yet the board of directors payed out the max bonus, leading the LA Times to headline “IBM’s CEO Writes a New Chapter on How To Turn Failure Into Wealth.” Last year the company share price bounced of its lows, but still far below what it was when she took the job, and in 2017 the Board increased her bonus from 2016! And the CEO will be granted a long-term pay incentive of $13.3 million in June (to be paid in 2020).
Like Immelt at GE, Rometty should be fired. If there were an updated list of the “5 Worst CEO’s Who Should Have Already Been Fired,” CEO Rometty surely deserves to be on it. And a new leader needs to implement an entirely new strategy if IBM is ever to regain its lost glory.
IBM’s stock may bounce around quite a bit. It’s shareholder base is very large. And really big investors, like pension funds and mutual funds, are very slow to dump their positions. But, eventually, everyone realizes that a shrinking company is not a value creation company, and they keep selling shares into any sign of strength. Big investors eventually recognize when a Board is unwilling to actually help lead a company, and unwilling to face down a bad CEO and replace her with someone more competently able to turn around a perennial terrible performer. So they start selling before the bottom falls out — like Sears and AT&T after they were removed from the DJIA.
There’s a lot more downside potential for IBM’s valuation.
In IBM’s case, the shares are at about $195 when the first data indicating a growth stall were evident (Q3 2012). They then peaked at $213 in March 2013. And it has been an ugly ride since. he “bounce” in 2016 from $125 to $180 was actually the best selling opportunity since September 2014 (just after I made the call to get out). At $160, IBM is down about 18% since the growth stall started (largely due to share buybacks) and revenues have kept dropping. According to “growth stall” analysis there is a 69% probability IBM’s shares will fall to $85 per share — or less — before the company fails, or starts a true, long-term recovery under new leadership.
Most readers of this column will already know that on Sunday, April 9, 2017 United Airlines forcibly removed a 69-year-old passenger from a flight, over his objections. United employees had Chicago Aviation Police board the plane, grab the passenger (who had a valid boarding pass) and drag him off the plane as if he were a hijacker. In the process the police banged his head on an armrest, leaving him battered and bloodied. When the passenger returned to the plane the police again forcibly manhandled him, restrained him and took him off the plane strapped onto a stretcher.
All so the airline could board a flight attendant that needed to reach the plane’s destination in order to make her next working flight. In other words, United’s front line management chose to not only inconvenience a paying customer, but physically abuse that customer so the airline would maintain its operating crew schedule.
After, the company CEO Oscar Munoz apologized for “re-accomodating” customers. Since about 40,000 people are “re-accomodated” — or bumped from oversold flights — annually, the CEO’s apology covers the 3,675 United customers bumped in 2016. But, he did not apologize for United employees taking action that directly led to the physical abuse of a customer.
Most of us would not believe this story if it were part of a fictional movie. How could it be possible for a front-line employee to think it is acceptable to forcibly eject a paying customer already on the plane?How could it be possible that a CEO would be so uncaring as to not apologize for a clear, horrific lapse in judgement by someone on his management team? Whatever the situation, every action taken by United merely served to make the situation worse. How could a company so large be so mismanaged — from the bottom to the top?
Blame “Operational Excellence”
That is the problem with CEOs, and leadership teams, that focus on “operational excellence” as a strategy. They become so focused on efficiency, cost cutting and business operations that they forget about customers — or anything else. All that matters is keeping the business operating, while trying to keep costs as low as absolutely possible. Management, from bottom to top, is rewarded for operational performance, while all other metrics are ignored. Including customer satisfaction.
In “operationally excellent” companies the focus on low costs is driven by a desire to keep prices low. The perception among management is that customers care only about price, so there is no reason to track anything other than costs. If they keep costs (and prices) low customers will be happy, regardless of anything else in the customer’s experience.
United Has Abused Customers For Years
This is not the first time United has had this kind of problem. In 2009 Canadian musician Dave Carroll became a sensation after producing a series of YouTube videos that chronicled his experience after United baggage handlers destroyed his guitar. The baggage handlers clearly did not care about his guitar. Nor did the gate agents, the baggage department or the customer service department. After many, many calls United personnel simply decided Mr. Caroll’s broken guitar would not be compensated — even though they broke it — and he should just “get over it.”
In 2013, United came in dead last in the Airline Quality Rating. United’s response (as I detailed in a 2013 Forbes column) was simply that “they did not care.” Quite literally, lowering cost was more important that being dead last in customer satisfaction.
In 2016, United fired its CEO after discovering he was bribing government officials to obtain favorable treatment at New Jersey and New York airports. The pressure to lower cost in the “operationally excellent” strategy was so paramount that judgement falters not only at low levels, but all the way up to the CEO.
Operational Excellence Hurt WalMart As Well As United
United isn’t alone in its failures due to operational excellence focus. WalMart has been the victim of bad management judgment for the same reason. Remember in July, 2014 when a WalMart truck driver who had been awake for 24 hours hit a car in New Jersey killing comedian James McNair and seriously injuring comedian Tracy Morgan? That driver had been on the road longer than he should, with insufficient sleep, in his effort to meet operational deadlines – and was charged with aggravated manslaughter, second-degree vehicular homicide and 8 counts of third-degree aggravated assault charges.
This happened just two years after investors learned WalMart was accused of bribing Mexican government officials to keep costs low there — bribery that caused the departure of the WalMart Mexico president, and eventually Walmart’s CEO. In both cases, at the top and at the front line, judgment was impaired by leadership’s focus on operational efficiency.
Unfortunately, too many business leaders put too much energy into operational excellence. They focus on cutting costs, improving operations, and trying to offer low price as the primary reason customers should do business with them. They quickly lose sight of customer needs, wants and wishes as they overly simplify their business’ offering into price. And this leads to bad decision-making all the way from the CEO to the front line manager — who will drive customers away in his effort to meet operational metrics and goals.
Once Locked In Operational Excellence Is A Hard Strategy, And Culture, To Change
United clearly needs a cultural change. But will it make one? Given the CEO’s reaction to this incident, it appears highly unlikely. Locked in to viewing his company operationally, Munoz appears to have lost common sense when it comes to customers – and running the business in a way that can lead to long-term profitability. Herb Kelleher, founder of Southwest Airlines, and Richard Branson, founder of Virgin Airlines, knew there was more to a successful airline than flight schedules and cheap fuel purchases. So far United’s leadership has failed to see the obvious.
(Photo: CEO of Amazon.com, Inc. Jeff Bezos, TOMMASO BODDI/AFP/Getty Images)
Amazon.com is now worth about the same as Berkshire Hathaway. Amazon has had an amazing run-up in value. The stock is up 17% year to date, and 46% over the last 12 months. By comparison, Berkshire has risen 3.1% this year and Microsoft has risen 5.6% —while the S&P 500 is up 5.8%. Due to this greater value increase, Jeff Bezos has become the second richest man in the world, jumping past Warren Buffett while Bill Gates remains No. 1.
Obviously, it wouldn’t take much of a slip in Amazon, or a jump in Berkshire, to reverse the positions of the companies and their CEOs. But it is important to recognize what is happening when a barely profitable company that sells general merchandise, technology products (Kindles, Fires and Echos) and technology services (AWS) eclipses one of the most revered financial minds and successful investment managers of all time.
Warren Buffett (Photo by Paul Morigi/Getty Images for Fortune/Time Inc)
Berkshire Hathaway was a financial pioneer for the Industrial Era. Warren Buffett bought a down-and-out textile company and created enormous value by turning it into a financial powerhouse. At the time America, and the world, was still in the Industrial Revolution. Making things – manufacturing – was the biggest industry of all. Buffett and his colleagues recognized that capital for these companies was deployed very inefficiently. Often too much capital was invested in poor ways, while insufficient capital was invested in good opportunities. If Berkshire could build a capital base it could deploy that capital into high-return opportunities, and make above-average rates of return.
When Buffett started his magical machine he realized that capital was often in short supply. Companies had to ration capital, unable to build the means of production they desired. Banks were unwilling to lend when they perceived any risk, even when the risk was not that great. Simultaneously investment banks were highly inefficient. The industry was unwilling to support companies prior to going public, often uninterested in taking companies public, and poor at allocating additional capital to the highest return opportunities. By the time you were big enough to use an investment bank you really didn’t need them to raise capital – they just organized the transactions.
This inefficiency in capital allocation meant that an investor with capital could create tremendous gains by deploying it in high return opportunities that often had minimal risk – or at least risk that could be offset with other investments.
Berkshire Hathaway was a big winner at mastering finance during the industrial era. By putting money in the right place, at the right time, tremendous gains could be made. Berkshire didn’t have to be a manufacturer, it could make a higher rate of return by understanding how to deploy capital to industrial companies in a marketplace where capital was rationed. In other words, give people money when they need it and Berkshire could generate outsized returns.
It was a great strategy for supporting companies in the Industrial Age. And a great way to make money when capital was hard to come by.
But the world has changed. Two important things happened First, capital became a lot easier to acquire. Deregulation and a vast expansion of financial services led to a greater willingness to lend by banks, larger secondary markets for bank-originated products that carried risk, the creation of venture capital and private equity firms willing to invest in riskier opportunities, and a dramatic growth in investment banking globally making it far easier to go public and raise equity. Capital became vastly more available, and the cost of capital dropped dramatically.
This made finding opportunities for outsized returns just based on investing considerably more difficult. And thus every year it has become harder for Berkshire Hathaway to find investment opportunities that exceed market rates of return. Berkshire isn’t doing poorly, but it now competes in a world of many competitors who have driven down returns for everyone. Thus, Berkshire’s returns increasingly move toward the market norm.
The Industrial Era is dead — usher in the Information Era. Second, we are no longer in the Industrial Age. Sometime in the 1990s (economic historians will pin it to a specific date eventually) the world transitioned into the Information Age. In the Information Age assets are no longer worth as much as they previously were. Instead, information has become much more valuable. What a business knows about customers, markets and supply chains is worth more than the buildings, machines and trucks that actually make up the physical economy. The value from having information has become much higher than the value of things — or of providing capital to purchase things.
In the Information Era, few companies have mastered the art of information management better than Amazon.com. Amazon doesn’t succeed because it has great retail stores, or great product inventory or even great computers. Amazon’s success is based on knowing things about markets and its customers. Amazon has piles and piles of data, and Amazon monetizes that information into sales.
By studying customer habits, every time they buy something, Amazon has been able to make the company more valuable to customers. Often Amazon is able to tell a customer what they need before they realize they need it. And Amazon is able to predict the flow of new product introductions, and predict sales for manufacturers with great accuracy. Amazon is able to understand what media customers want, and when they’ll want it. Amazon is able to predict a business’ “cloud needs” before that business knows – and predict the customer’s likely future services needs long before the customer knows.
In the Information Age, Amazon is one of the very, very best information companies out there. It knows how to obtain information, analyze those mounds of “big data” to determine and predict needs, then connect customers with things they want to buy. Being great at information means that Amazon, even with its relatively poor current profits, is positioned to capitalize on its intellectual property for years to come. Not without competition. But with a tremendous competitive lead.
So, how is your portfolio allocated? Are you invested in assets, or information? Accumulating assets is a very hard way to make high rates of return. But creating sales, and profits, out of information is far easier today. The relative change in the value of Amazon and Berkshire is telling investors that it is now smarter to be long information rich companies than asset rich companies.
If you’re long GE, GM, 3M and Walmart how well will you do in an economy where information is more valuable than assets? If you don’t own data rich, analytically intensive companies like Amazon, Facebook, Alphabet/Google and Netflix how would you expect to make above-average rates of return?
And where is your business investing? Are you still putting most of your attention on how you allocate capital, in a world where capital is abundant and cheap? Are you focusing your attention on getting the most out of what you know about markets, customers and suppliers, or just making and selling more stuff? Do you invest in projects to give you insights competitors don’t have, or in making more of the products you have — or launching product version X?
And are you being smart about how you manage your most important information tool — your talented employees? Information is worthless without insight. It is critical companies today do all they can to help employees develop insights, and then rapidly deploy those insights to grow sales. If you spend a few hours pouring over expenses to find dimes, consider letting that activity go in order to spend hours brainstorming how to find new markets and new product opportunities that can generate a lot more revenue dollars.