Why IBM Should Increase Capital Expenditures

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Technology giant International Business Machines has made great strides in its huge business transition. During the past few years, IBM has spent a lot more money on software and services, particularly when it comes to the cloud. At the same time, the company has pulled back on its exposure to hardware. This is a painful transition, but a necessary one, because IBM revenue has been stagnant for several quarters in a row.

Specifically, IBM's total revenue is down 3% during the first six months of 2014, year over year. The key culprit is hardware; but this stands to change. IBM is investing a lot of money in new strategic initiatives, and real progress is starting to materialize.

However, how much progress IBM makes in these initiatives may be limited, because the company spends a lot more money on returning cash to shareholders through dividends and share buybacks than it spends on capital expenditures. Through the first half of 2014, dividends and share buybacks made up 89% of IBM's capital allocation program, with the remainder being sourced to capital expenditures. 

IBM ventures into the cloud
IBM is investing in cloud-based services, with the goal of branching out away from hardware. This makes sense, because hardware has been weighing on IBM for some time. Hardware has been the company's worst-performing segment since the start of the year. Revenue from IBM's systems and technology business declined 16% through the first six months, year over year.

By contrast, IBM has experienced very good results in its businesses outside of hardware. Cloud revenue soared more than 50% during the first half of the year. Cloud-as-a-service revenue more than doubled to a $2.8 billion annual run rate.

These results are the product of greater investment in new, high-growth areas. In the first quarter of 2014, IBM launched Bluemix, its cloud platform-as-a-service for the enterprise. IBM invested $1.2 billion to expand its SoftLayer cloud hubs. IBM also invested $1 billion at that time to bring Watson to the enterprise.

IBM made progress implementing these initiatives last quarter. Bluemix became available in June, new SoftLayer data centers were opened, and IBM divested its customer care business. Going forward, IBM will invest $3 billion during the next five years in research and development in next-generation chips, which will be critical for cloud and big data systems.

There's room for greater capital spending
For many years, IBM has undergone a transition away from hardware and into other areas, such as software and services. This was done to improve profitability. Hardware is a much lower-margin business than software and services. The results have been clear to see.

From 2000-2013, IBM's operating pre-tax margin more than doubled, from 10% to 21%. Not surprisingly, this has required a great deal of internal investment -- IBM's capital expenditures have totaled $59 billion just since 2000.

As huge a number as that is, the money IBM has spent on capital expenditures has actually paled in comparison to how much the company spends on returning cash to shareholders. Since 2000, IBM has spent $108 billion on share repurchases and an additional $30 billion on dividends. If anything, IBM has underallocated its capital spending.

IBM stated in its most recent conference call with analysts that the overarching strategy for the expansion of its cloud platforms and offerings in big data is to get a strong foothold in the emerging businesses of IT. IBM believes that these investments will set up the company for better growth during the long term.

If this is indeed true, then it makes sense for IBM to maximize its investment in these areas. As it stands, IBM has spent $13.9 billion on dividends and share repurchases during the first half of the year, and just $1.7 billion on capital expenditures in the same period. But even if IBM didn't want to cut back on dividends or share repurchases, it has $9.7 billion in cash sitting on the balance sheet it could draw from. This makes sense, because that cash is earning almost nothing, and simply sitting on the books for IBM right now.

In light of this, it's reasonable to question whether IBM is investing enough in development. 

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The article Why IBM Should Increase Capital Expenditures originally appeared on Fool.com.

Bob Ciura has no position in any stocks mentioned. The Motley Fool owns shares of International Business Machines. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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