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Could IBM Become the Next Microsoft?

International Business Machines (NYSE: IBM) has redefined itself primarily as a cloud company. After stagnating for years as an IT services company, it orchestrated a $34 billion takeover of Red Hat in 2019, and in 2021, spun off its managed infrastructure business into Kyndryl.

Microsoft (NASDAQ: MSFT) also transformed itself into a cloud company (in the 2010s), and in many respects, IBM’s metamorphosis resembles that of Microsoft years ago. Moreover, the cloud business has changed significantly over the past decade.

These evolutionary changes for the two companies have some investors asking whether IBM is trying to make itself into the next Microsoft and, if it is, whether it can succeed in that effort.

IBM vs. Microsoft

Given the history of IBM and Microsoft, it’s really not all that strange that one of the oldest tech companies around would want to take on the characteristics of a successful, younger entity. IBM had already been operating for 64 years when Bill Gates and Paul Allen founded Microsoft in 1975. IBM actually helped perpetuate Microsoft’s growth surge in 1980 when it agreed to make Microsoft the operating system provider for the iconic IBM PC.

Since then, both companies have made some radical changes in the last 42 years. IBM exited the PC business in 2004, and providing PC operating systems is no longer a primary growth driver for Microsoft. Today, Microsoft prospers due to cloud growth, and IBM has followed its lead by building a new identity as a cloud company. IBM even made its cloud and cognitive software head, Arvind Krishna, its CEO, in January 2020. Likewise, Satya Nadella headed Microsoft’s cloud efforts before becoming CEO in 2014.

Still, the cloud approaches each takes have differed significantly. In Microsoft’s case, it built a full-fledged cloud infrastructure business to compete directly with Amazon‘s AWS, which pioneered the cloud and had attracted fewer competitors at that time. Conversely, IBM’s Red Hat purchase came after more players such as Alphabet, Alibaba, and many others had become cloud providers.

IBM has more heavily emphasized the hybrid cloud. The hybrid cloud facilitates communication between private and public clouds. Though IBM is not the only hybrid cloud provider, its solution utilizes different technologies to allow public and private clouds to work as it capitalizes on an open-source system with no vendor lock-ins.

But despite the differing approaches, IBM probably wants to achieve Microsoft-like growth. Microsoft was so successful that its market cap is now nearly $1.9 trillion, up from $320 billion in February 2014 when Nadella became CEO. In contrast, IBM’s stock fell for most of the 2010s. Consequently, Microsoft’s market cap is now about 16 times IBM’s market cap of around $115 billion.

How their financials compare

Despite its massive size, Microsoft has consistently posted double-digit revenue and earnings growth. In its fiscal fourth quarter (which ended June 30), its $51.9 billion in revenue increased 12% year over year. Still, net income only climbed 2% during Q4 to just under $16.7 billion. Both the cost of revenue and operating costs grew faster than revenue, and this weighed on net income.

Even as its earnings growth slows, Microsoft’s revenue growth still outpaces that of IBM. In the second quarter of 2022, IBM’s revenue came in at just under $15.6 billion, a 9% growth rate compared with Q2 2021. Hybrid cloud revenue also surged 16% during this time, a welcome sign considering IBM’s desired direction. This led to $1.5 billion in non-GAAP income in Q2, 81% more than in the same period last year. IBM reduced operating costs by 3% during that time as it was preparing for its spin-off of Kyndryl, which affected its costs in 2021.

IBM has remained stable amid the bear market in tech. It has outperformed not only Microsoft but also the S&P 500 over the last year.

IBM data by YCharts

Additionally, IBM has maintained a lower P/E ratio, trading at 21 times earnings versus 26 for Microsoft. Still, with Microsoft growing revenue more quickly, some investors might perceive Microsoft as a more appealing choice despite the higher multiple.

Is IBM the next Microsoft?

Although IBM seems to walk in Microsoft’s footsteps in many respects, investors should not expect IBM to strictly follow its lead. Instead of relying on cloud infrastructure, IBM took a different path, targeting a niche with its hybrid cloud focus.

Moreover, the good news for IBM shareholders is that the company does not need to become the next Microsoft to transform itself. Now that it is driving higher revenue growth levels, its smaller size could help bolster a more positive outlook on IBM stock. If IBM can maintain or expand its current growth pace, its stock could outperform the indexes on a longer-term basis.

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Will Healy has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Alphabet (A shares), Alphabet (C shares), Amazon, and Microsoft. The Motley Fool has a disclosure policy.

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