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Why International Business Machines Corp. (IBM) And Cisco Systems, Inc. (CSCO) Are Actually Twins

Editor’s Note: The initial paragraph references IBM’s PC business. IBM sold off their PC business to Lenovo in 2005. This article has been corrected and Motley Fool apologizes for the error.

At first glance, International Business Machines Corp. (NYSE:IBM) and Cisco Systems, Inc. (NASDAQ:CSCO) appear very different. The former is a $230 billion behemoth that provides IT services, while the later is “only” a $130 billion company that sells devices like routers and switches which regulate traffic on the internet. But I believe that IBM and Cisco are much more similar than you might think. In fact, I believe that the two tech giants will grow to become more and more similar over the next few years.

International Business Machines Corp. (NYSE:IBM)

Core business

Over the past decade, International Business Machines Corp. (NYSE:IBM) has successfully implemented what I believe is the most successful business transformation in corporate America. It moved from a less-profitable hardware business to a highly-profitable software business with a special emphasis on the IT segment. You see, IBM’s margins were collapsing because it was selling PCs, a highly competitive consumer product. The switch to IT services greatly improved IBM’s profit margins and turned it into the world leader in this field. Cisco Systems, Inc. (NASDAQ:CSCO) has been walking in IBM’s path.

Like IBM, Cisco took a run at consumer products. It turned out worse than International Business Machines Corp. (NYSE:IBM)’s consumer business. Cisco’s Flip video division flopped, and management shut it down. It sold its Linksys home router business to Belkin. Cisco Systems, Inc. (NASDAQ:CSCO) and International Business Machines Corp. (NYSE:IBM) learned the same lesson: consumer markets are low-margin, ultra-competitive, saturated businesses. The only sure way to win in a consumer- oriented market is to be a monopoly like Microsoft Corporation (NASDAQ:MSFT). Mr. Softy controls approximately 90% of the market for operating systems. When you’re so dominant – you have the privilege to become a “price- maker” rather than a “price- taker” and make big profits. But there aren’t many “Microsofts”out there…

IT services is a profitable and less competitive business than hardware. That’s the place to be because it’s the custom software and services that keep big companies running smoothly. So you’re going to see Cisco Systems, Inc. (NASDAQ:CSCO) selling more software and services. Cisco says it wants to be the No. 1 IT company in the world. Today, that title goes to International Business Machines Corp. (NYSE:IBM). Cisco probably won’t dethrone IBM. But the world is big enough for the both of them. Cisco won’t exit its core business of internet traffic regulation. That should continue to grow as Internet use grows worldwide. So Cisco Systems, Inc. (NASDAQ:CSCO)’s focus on services isn’t as big as IBM’s, but it shouldn’t be, either. International Business Machines Corp. (NYSE:IBM) bought more than 130 software and services businesses to help it transform. Cisco became what it is today by acquiring over 150 businesses. Cisco knows how to successfully buy businesses. That’s a great skill that many companies don’t have. It’ll use that skill to acquire more software and services businesses. On its latest conference call, management listed five recent acquisitions. Four were software companies.

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