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Vodafone and IBM deal: what you need to know

Vodafone and IBM deal: what you need to know

Originally posted by Joshua Warner @ ig.com

Vodafone and IBM are combining their respective expertise in connectivity and computing power to help accelerate the introduction of new applications that will be unlocked by new technologies such as 5G, Artificial Intelligence (AI), Augmented Reality (AR), edge and Software Defined Networking (SDN).

The new venture builds on a 20-year old relationship between the two companies and comes at a crucial time for the pair. Vodafone is racing to introduce 5G services to customers across Europe while IBM is trying to convince the market that its big bet on the hybrid cloud is the right one.

We have a look at what the deal means for both companies.

Vodafone recruits IBM’s expertise for $550 million

The pair are setting up a new venture that will act as a 'start-up' and the fact both parties will appoint 'dedicated executives' to manage the company suggests both are banking a lot on the new unit delivering results. But, while marketed as a venture of equals, the fact the telecoms giant is paying $550 million means IBM is effectively being paid to take control of Vodafone’s cloud and hosting business for eight years to improve the service it offers to European business customers. The pair will also co-develop new digital products and services.

The new venture is expected to be operational in the first half of 2019, when IBM’s cloud computing services will be rolled-out to all Vodafone’s business customers. Vodafone will be able to turn IBM’s cloud computing services into new products and provide a vast customer base for the company to tap into, while IBM will be able to deliver the infrastructure needed to prepare Vodafone’s business customers for new digital applications.

The majority of businesses are yet to fully digitise their operations and make the move from hosting their own networks to outsourcing it to cloud service providers like Amazon Web Services or Microsoft Azure, and the vast majority that have are using various different cloud systems. This is because different cloud networks can offer unique services or proprietary applications and firms are fearful of outsourcing their entire digital operations to one provider.

IBM estimates 70% of businesses are currently using up to 15 different cloud environments. Its strategy is to work as the middleman between these different cloud service providers, allowing businesses to operate seamlessly across different networks by integrating them altogether. Ultimately, this will speed-up information technology (IT) systems and help introduce new technology, such as AR, to retailers and transportation companies or further automation on factory floors.

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Vodafone is either the largest or second-largest telecoms provider in the UK, Germany, Italy and Spain and faces fierce competition against rivals including BT GroupTelefonicaDeutsche Telekom and Telecom Italia. Ireland, the UK and Germany are key markets that have already started to auction-off 5G capacity to telecoms firms including Vodafone – which is important because 5G must be delivered before new technologies – everything from automated vehicles to precision farming – can become a reality.

What you need to know about investing in 5G

What does the deal mean for Vodafone?

It is unsurprising that Vodafone, which earns just shy of 30% of its revenue from business customers, has looked for help across the pond to improve its cloud computing business. Virtually, all the largest players in the cloud computing market are US-based, which is why Europe is lagging behind the likes of the US and China in rolling-out new technologies such as 5G – tech research firm CCS Insights forecasts just 9% of the world’s 5G subscribers in 2023 will be in Europe. The fact Vodafone is moving now to recruit the assistance of IBM is sensible because securing a US partner would have been inevitable.

What industries and stocks will benefit from 5G?

Vodafone has already been trialling the potential business cases for 5G technology, such as utilising VR and AR in factories, hospitals and offices. IBM’s expertise will turn these trials into real-life deployment. However, the cost of recruiting IBM’s abilities adds to a burgeoning budget to bring the next wave of technology to its customers at a time when the firm is also spending big to expand its footprint in Europe. Vodafone’s deal to buy Liberty Global's cable networks in Germany and Eastern Europe, while it improves scale as the firm squares off against Deutsche Telekom, also leaves it with debt of over €50 billion (net debt of €32 billion) at the upper-end of the company’s limits. Meanwhile, the company has had to spend hundreds of millions on 5G infrastructure and capacity (in the UK it is expected to spend a minimum of 28% of its annual budget on rolling-out 5G) but won’t see a return on these investments for years to come.

The cost of getting the business fit to serve its customers with what they need to deploy the next wave of technology has weighed on Vodafone’s share price, which is currently trading at levels not seen since 2009.

Vodafone releases its third quarter results covering the three months to the end of 2018 on January 25. Read the earnings preview here

What does the deal mean for IBM?

IBM shares also hit their lowest level since 2009 at the backend of last year and, although they have remained on an upward trend since, the stock remains well-below historic levels. Revenue has been in decline and margins squeezed as business for its traditional mainframes slows, and it is yet to fully convince the market that pursuing hybrid cloud-computing can revive its growth prospects.

However, IBM’s annual results showed tentative signs that the firm is returning to growth. Revenue in 2018 ticked-up 1% year-on-year (although stayed flat when adjusted for forex movements), while net income jumped over 52%. Revenue from cloud services jumped 12% to $19.2 billion and IBM exited 2018 generating quarterly revenue from offering cloud computing as a service of $12.2 billion, 18% higher than a year earlier. Chief financial officer Jim Kavanaugh was eager to highlight it was the first year for a while that IBM had managed to report higher annual revenue, operating income and earnings per share (EPS) at the same time.

($, billions) 2014 2015 2016 2017 2018
Revenue 92.8 81.7 79.9 79.1 79.6
Gross profit margin 50.0% 49.8% 47.9% 46.7% 46.4%
Net income 12 13.2 11.9 5.8 8.7
Non-GAAP diluted EPS ($) 16.53 14.92 13.59 13.80 13.81
GAAP diluted EPS ($) 11.9 13.6 12.39 6.14 9.51
Free cashflow 12.6 13.3 11.7 13 11.9

IBM’s progress should install confidence among investors. EPS is expected to rise in 2019 (GAAP of at least $12.45 and non-GAAP of at least $13.90) and free cashflow is to remain broadly flat at $12 billion.

IBM is starting to show the potential rewards on offer by announcing further deals, including a $375 million contract with Juniper Networks to integrate its cloud computing capabilities into Juniper’s existing IT infrastructure. Plus, this year it will complete its welcomed, albeit expensive, $34 billion acquisition of open source software specialist Red Hat, which is likely to enhance the value of the services IBM offers to its partners.

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