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Can the Cloud Really Save IBM? It Might.

The basic plan at IBM comes down to this: Divest less-profitable and unprofitable hardware operations, and invest in higher-profit cloud and software offerings.

Re/code photo illustration

During a conference call with analysts yesterday, IBM executives, according to a transcript of the call, used the word “cloud” 21 times, “services” 23 times, and “software” 27 times.

It’s an informal indicator, but when you compare it to the number of times more traditional IBM words were used during the call, it says a lot about IBM’s priorities. The word “systems” appears 15 times in comments from IBM executives; “hardware” only seven times. “Power,” referring in this case to IBM’s brand of high-end computers, appears 18 times.

If nothing else, it suggests that IBM is clearly happier to talk about its businesses that are growing, and less about its businesses that are declining. When it reported second-quarter earnings yesterday, Big Blue turned in its ninth straight quarter of declining revenue. At $24.4 billion, revenue declined from the same period a year ago by three percent.

The fall was led by its Systems and Technology business unit, which is composed primarily of computing hardware. At $3.3 billion in sales, it fell by 16 percent. Profits, at $4.32 per share, were higher than the year-ago quarter by a healthy 34 percent, and better than the $4.29 analysts expected, primarily as a result of aggressive cost-cutting. IBM shares fell as the market opened this morning.

But here’s what IBM sees in the cloud: A business that could, by the end of next year, be as big as its current hardware operation, but twice as profitable.

Revenue from cloud services grew and are on track to bring in $2.8 billion in revenue by year’s end, IBM said. And after adding in private clouds and applications, it will be a $7 billion business, up from about $4.4 billion last year.

The basic plan at IBM comes down to this: Divest less-profitable and unprofitable hardware operations, and invest in higher-profit cloud and software offerings. We’ve already seen IBM strike a deal to sell its x86 systems business to Lenovo. And a deal to sell its chip unit, which is said to lose about $1.5 billion a year, is expected soon.

One way or the other, IBM’s hardware unit is going to get smaller. It brought in about $14.4 billion in 2013, and according to forecasts by the analyst Brian Marshall at ISI, it will bring in a little less than $12 billion by the end of 2015 with a gross margin between 34 percent and 35 percent.

So how profitable could the cloud be? IBM doesn’t yet disclose the gross margins of its cloud operations, but it’s worth looking around at other companies for comparisons. IBM’s closest competitor is Amazon, which doesn’t break out the financials of its Amazon Web Services unit. Educated guesses have pegged the size of AWS at bringing in $5 billion in revenue at a gross margin of 90 percent or higher. A gross margin of that size would equal that of IBM’s software unit, which as of yesterday was 89 percent.

But comparisons are tricky. A small cloud services rival, Rackspace, has historically turned in gross margins of about 67 percent on a revenue base of about $1.5 billion a year. Rackspace prides itself of providing intense service and support to its customers, and that logically leads to a lower profit margin.

But IBM also has applications to deliver via the cloud, and wants to do so via mobile devices like Apple’s iPad and iPhone. The applications business would resemble that of and Workday. At, gross margins have historically been higher than 75 percent. At Workday, the cloud-based human resources software firm, they’re north of 60 percent.

So let’s give Big Blue the benefit of more than one doubt and assume the combined cloud business grows to $11 billion in annual revenue with a 70 percent growth margin by 2015. (This is a key year, because CEO Ginni Rometty has promised to deliver $20 in earnings per share.) That works out to a gross profit of nearly $8 billion.

Assuming Marshall’s forecast for the hardware business ($11.8 billion in revenue and about $4 billion in gross profit) holds, that means the cloud could be about as big as hardware on a revenue basis, but twice as profitable.

There’s a lot of uncertainties around this big bet that Rometty has made on the cloud, and a lot could go wrong between now and the end of 2015. But at least now it’s clear why IBM wants to talk so much about the cloud.

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