Does IBM Have an Accounting Problem in SoftLayer? Is A $3 Billion Write-Off Looming?
Ten years ago, Amazon Web Services began offering cloud services, and soon thereafter, the company unabashedly proclaimed, “In the fullness of time…computing is moving to the cloud”
Amazon’s “everything-to-the-cloud” enthusiasm caught a lot of people by surprise, and it was met with plenty of skepticism. Not surprisingly, it was heresy to the likes of IBM, seller of expensive hardware such as its zSeries mainframes.
After all, IBM had turf to protect. Cloud data centers are not built around IBM technology, so if everything moved to the cloud — what would IBM sell?
Ten years later, it’s clear: Amazon appears to have been right. Pretty much everything is moving to the cloud. The cloud is cheaper, faster, more secure*, and, in our opinion, there’s really no solid argument for staying with the inefficient and expensive hardware and software of the on-premise computing past.
The problem for IBM: It got a late start on the public cloud.
Look at IBM annual reports in 2011 and 2012 and you’ll see CEO Ginni Rometty casually dismiss cloud, barely mentioning the word in each of her first two letters. The planning and priority of IBM management back then, if you’ll recall, revolved around a $20 earnings per share “roadmap,” a much ballyhooed 2015 earnings goal.
The problem for IBM: It got a late start on the public cloud.
The realization finally came in 2013, seven years after Amazon launched its cloud business that, indeed, cloud computing is the future — and that future is already here. In our view, the company then made a hurried buy of SoftLayer in mid-2013 to get in on some sweet cloud infrastructure action. They shelled out $2 billion, then went in hard with an investment of another billion dollars, bringing their total to a cool $3 billion.
Which gets us to IBM’s $3 billion accounting problem, an issue CFO Martin Schroeter, I believe, is surely aware of, and one that he must be planning on disclosing shortly…
Remember Hewlett-Packard’s embarrassing acquisition of Autonomy?
In our opinion, Softlayer is a comparable situation to, and potentially just as embarrassing as Hewlett Packard’s disastrous purchase of software maker Autonomy in 2011 for $10.3 billion.
Just like with IBM’s purchase of SoftLayer, HP appeared desperate to stay relevant in a rapidly changing world, and in our view rushed to buy Autonomy without performing adequate due diligence. HP ended up writing off 85% of their investment the following year in a maelstrom of controversy, and at last check, they’re still pointing fingers in litigation.
We believe a write off of SoftLayer of similar magnitude (85–90%) is almost certainly in the forefront of CFO Schroeter’s mind these days. To comply with generally accepted accounting principles, a sizable write down is necessary, since SoftLayer is likely worth a tiny fraction of what IBM has invested. As we’ll explain in a bit, SoftLayer is niche cloud player with limited functionality and limited upside. Its infrastructure products are not competitive in mid- and enterprise-level markets.
SoftLayer is likely worth a tiny fraction of what IBM has invested.
But first, let me mention a couple of twists to this story, which make it particularly interesting. The first is that, in our view, IBM doesn’t like to admit mistakes, especially when it comes its vaunted acquisition machine. There have been over 125 acquisitions since 2000, and I can’t find a single write-down. The fact that IBM doesn’t have any write-downs is suspect — nobody is that good all the time — and it just gets worse when you start looking at the $3 billion mess that is SoftLayer.
Another twist: HP came clean relatively soon after its botched acquisition of Autonomy, but IBM has yet to admit that the SoftLayer acquisition in July 2013 was a mistake. And, too, we believe IBM probably doesn’t want to tell investors that it threw $1 billion more at the mistake and that effort failed as well.
Compounding the problem, IBM management made numerous specific representations to investors about SoftLayer, assuring investors that it meets the needs of IBM’s enterprise customers.
CEO Ginni Rometty told investors on CNBC* that SoftLayer was built from the “bottom up” for enterprise, and that the acquisition was “very wise,” while CFO Schroeter made glowing representations, claiming SoftLayer was “enterprise grade, enterprise capable,” and that it was “critical to the kind of enterprise clients we’re attracted to.”*
IBM bought a small potatoes cloud operation.
So where are SoftLayer’s enterprise customers, anyway? We can’t find a single enterprise customer that selected SoftLayer over the hyper-scale data centers run by Amazon, Microsoft and Google.
Enterprise customers are IBM’s bread-and-butter, the core of its customer base. IBM can get in the front door and pitch SoftLayer to enterprise, that’s a given — so why doesn’t enterprise want to move production workloads to the SoftLayer cloud?
It’s likely because SoftLayer can’t do the job. SoftLayer is a hosting scale provider and has never been anything more than that. It can’t attract enterprise workloads because it lacks dozens of critical features and services that are routinely offered by hyperscale cloud providers.
Meanwhile, in our opinion, IBM has not done much to add to SoftLayer capabilities. During the three years IBM has owned SoftLayer, the company has added just a few new services. By way of comparison, over the same time period Amazon Web Services added over 2,000 major new features and services to its cloud, many of which are game changers, like Aurora, Lambda, and Workspaces.
So, wait a sec, you might ask, didn’t IBM know it was buying a Little League cloud operation back in 2013? What sort of due diligence did IBM do on SoftLayer before its $2 billion acquisition? Shouldn’t it have been obvious to IBM that there was a massive “technology gap” between SoftLayer and the hyperscale cloud providers that it wanted to catch?
Founder Lance Crosby and VP Marc Jones were upfront with IBM about SoftLayer’s technology when IBM came a-calling in 2013. SoftLayer’s business model was built around purchasing off-the-shelf servers out of a Super Micro catalog. They took standard white box servers, connected them together, and rented them out.* That’s it, nothing special, no super secret sauce, no unique edge in technology.
Will IBM try to hide their mistake?
As CFO Schroeter knows, goodwill booked as a result of an acquisition can stay on the books indefinitely, but it must be tested at least annually to see if its value is still accurate. As Schroeter prepares to close the books, he’ll have to gauge how much SoftLayer is worth in today’s market. Is it worth anywhere close to the $3 billion that IBM has invested?
Unfortunately for IBM, we believe a realistic value for SoftLayer is somewhere in the $300 to 400 million area, about one-half of its annual revenue. And that may be too generous. Values for smaller cloud providers have declined dramatically in recent quarters. Hewlett Packard, also late to the cloud, failed to find a buyer for its cloud, and simply shut it down. Same thing happened at Verizon. Others that have struggled include AT&T, Fujitsu, and CenturyLink.
Unfortunately for IBM, we believe a realistic value for SoftLayer is somewhere in the $300 to $400 million area.
Why are the values of smaller, hosting scale cloud providers headed south? It’s due to the sheer breadth and scope of hyperscale cloud offerings — which encompass literally thousands of features and services that you can’t find on SoftLayer.
One more thing you should know: Goodwill impairment charges — like the one that IBM should for SoftLayer — are non-cash charges. They don’t cost anything. Billions of dollars have already been blown. And so you should think of an impairment charge as more like a confession. It’s a way of being honest with shareholders, as it tells them how much money was wasted, and that management made a mistake.
Got a question? Contact us: info@wormcapital.com.
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Arne Alsin and Worm Capital clients are currently long Amazon and also own options positions in IBM and stand to benefit if the trading price of Amazon increases and/or the trading price of IBM decreases.
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Footnotes:
1 IBM only has $17.1 billion in net equity making a $3 billion charge highly undesirable. The low level of net assets is due to massive stock buybacks; over $46 billion in cash has been spent on buybacks since Rometty took over in 2012.
2 CEO Rometty, on CNBC in 2014: “One of the acquisitions we made there, one of the big ones last year, was something called SoftLayer, that’s right. And you know, that is to me very wise. They were built bottom up, public cloud, for the enterprise.”
3 CFO Schroeter, RBC Conference in 2014: “We bought SoftLayer a year ago, just over a year ago. SoftLayer is our kind of enterprise grade, enterprise capable cloud.” Morgan Stanley 2014 Conference: “The reason we bought SoftLayer was to have a differentiated platform within enterprise cloud.” Citi 2015 Conference: “The SoftLayer platform is critical to the kind of enterprise clients we’re attracted to.”
4 SoftLayer wasn’t really in the cloud infrastructure business when it was purchased by IBM in 2013, despite what management says. It’s more accurate to say SoftLayer was in the “dedicated hosting” or “dedicated server” business. Which doesn’t cut the mustard for enterprise. You’ve got to deliver multi-tenant (virtualized) public cloud infrastructure, and a enormous scale (hyperscale), just to be in the conversation.
