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Should IBM Break Up?

There are, on paper, two IBMs.

Hewlett-Packard, eBay and Symantec are doing it. EMC is under pressure to do it. Why shouldn’t IBM follow in the footsteps of the other big tech companies and break up?

Following Big Blue’s shockingly bad financial results disclosed this week, CNBC’s David Faber raised that very question in an interview with CEO Ginni Rometty, who dismissed the idea outright. But given its size, the degree to which it missed its earnings target and the abandonment of a long-promised five-year earnings goal, the idea of a corporate split is within the realm of possibility.

Except that any such breakup would be a hugely complicated affair and is likely more costly to execute than the strategy the company is already following, which includes slowly peeling off underperforming businesses like the chip unit it just unloaded. Still, let’s dream for a moment.

There are, on paper, two IBMs. There is the $57 billion (2013 sales) services business that is mature and on the decline, and then there’s the $40 billion hardware and software business with some challenges, but also a lot of potential. Theoretically, it could be a clean split.

But here’s why it wouldn’t be: Both of IBM’s services units serve as the tip of the spear for the others. Those in-the-trenches services personnel know what the customers need and help sell them IBM hardware and software.

“Breaking up IBM would accomplish little,” said Patrick Moorhead, head of the research firm Moor Insights and Strategy, based in Austin, Texas. “Together it leads with business consulting and follows on with software that is often attached to hardware, which in turn requires the help of its Technology Services unit to run. It’s a big package, and so a breakup wouldn’t help anything.”

But Big Blue has to do something. The two services divisions, Global Technology Services and Global Business Services, have posted combined revenue declines for 10 straight quarters. And signings, the combined lifetime value of contracts, have declined for five straight quarters and, according to Sanford Bernstein analyst Toni Sacconaghi, are at $29.3 billion, the lowest level since 2002. Gross margins in both service units have also declined.

On Monday’s conference call with analysts, CFO Martin Schroeter said some large deals fell through the cracks: “We have some pretty big deals … I wouldn’t say that those deals are gone. Those deals are still out there and the teams continue to work them.”

What’s happening? Sacconaghi argued that GTS, which specializes in outsourcing, appears to be maturing. And in GBS, the business consulting unit, many of IBM’s customers are spending more on cloud software with companies like, Workday, NetSuite and ServiceNow, and less on the old-school on-premise software that IBM has traditionally helped them manage. “The weakness is worrisome,” he wrote. A further slowdown in GBS could lead to further damage to hardware and software. In time the shift to cloud software, Sacconaghi conceded, could lead to more IBM consulting deals, but that’s far from assured.

Meanwhile, IBM has a response to this that could turn the tide, but it’s still in its early innings. All of its business software is being repurposed to run in the cloud, and IBM even has its own cloud service called SoftLayer to offer to customers. If IBM is to have a future, that future is in the cloud; its combined cloud operations are on the way to eclipsing its traditional computing hardware business as early as next year. And recent plans to run SAP’s application on its cloud and to team up with Apple to build cloud-friendly mobile applications for the iPhone will only make it bigger.

This brings us to the hardware business, where sales have fallen by 16 percent in the first nine months of the year. During the quarter, hardware gross margins fell to 34 percent from 40 percent, the steepest decline of all of IBM’s business units.

Hardware is primarily comprised of the 50-year-old mainframe business and the high-end Unix server business. IBM has long dominated the mainframe business, but that’s like saying it’s a big fish in a lake that’s steadily drying up. And the Unix server business — where IBM competes with Oracle and HP — is on a long, slow death march to zero.

The more likely long-term scenario is a familiar pattern of shedding assets. So far this year it has rid itself of two businesses accounting for $7 billion in revenue: The commodity server business went to Lenovo in January, and this week it announced that it is paying GlobalFoundries $1.5 billion to take its chip-manufacturing operation off its hands. Last year, IBM sold it off its $1.2 billion customer service business to Synnex. Other notable divestitures include the sale of the PC business to Lenovo in 2004.

This strategy dates back to the 103-year-old company’s early years: Remember the IBM typewriter? In 1991 they were packaged up with printers into a company now known as Lexmark. And who remembers that IBM once operated a food services unit that sold grocery scales, meat grinders and cheese slicers? It sold that off in 1934.

Nothing is safe from the chopping block at IBM. But rather than dramatically cleave itself in two all at once, IBM will more likely eliminate atrophying businesses as newer ones get up to speed. Whether this strategy can save a company that is more focused on financials than on engineering is another matter.

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