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Can the Hybrid Cloud Market Generate Fresh Growth for IBM?

IBM's (NYSE: IBM) stock recently popped after the tech giant posted its second-quarter earnings. The rally likely surprised some investors, since its headline numbers were weak. IBM's revenue fell 5% annually to $18.1 billion, though still beat expectations by $400 million. Its adjusted earnings fell 31% to $2.18 per share, though they also topped estimates by nine cents.

It might seem like IBM just tripped over a low bar, which had been practically placed on the floor to account for the COVID-19 crisis. But three other facts seemingly held the bears at bay.

Three cloud icons depicting the public, hybrid, and private clouds.

Image source: Getty Images.

First, IBM's cloud revenue rose 30% annually, with 17% growth at Red Hat, and accelerated from its 19% cloud revenue growth in the first quarter. Second, its gross margin expanded annually as the expansion of its cloud platforms and Red Hat boosted its scale, productivity, and operational efficiencies.

Lastly, investors seemed reassured by CEO Arvind Krishna's focus on the "hybrid cloud" market, which he mentioned dozens of times throughout IBM's conference call. Let's see what the hybrid cloud actually is, and why Krishna believes it could unlock fresh growth opportunities for IBM.

What is the hybrid cloud?

There are three major types of cloud platforms: private, public, and hybrid. Private clouds store a company's data in on-site servers, while public cloud services -- like Amazon (NASDAQ: AMZN) Web Services (AWS) and Microsoft (NASDAQ: MSFT) Azure -- store that data remotely.

Many large companies store their data on private clouds so they can access it more quickly and securely. It's also generally costly and time-consuming to migrate all of a company's data to a public cloud service.

Hybrid clouds allow companies to split their data between the private and public clouds. For example, a company might store its more recent data on private servers while migrating its older data to a public cloud, and use public cloud services to analyze both its local and remote data. This setup is usually more flexible, cost-effective, and easier to scale for large companies.

The global hybrid cloud market could grow from $45.7 billion to $128 billion between 2019 and 2025, according to Mordor Intelligence, and IBM believes it will profit from that growth.

Understanding IBM's hybrid cloud plans

IBM's servers and mainframes are widely used in private clouds. However, IBM's public cloud platform is a tiny underdog compared to AWS, Azure, Alibaba Cloud, and Alphabet's Google Cloud.

Servers in a data center.

Image source: Getty Images.

IBM doesn't plan to go head-to-head against those public cloud leaders. Instead, it's launching new hybrid cloud deployments for its private cloud customers. IBM's hybrid cloud platform, which was greatly expanded by its Red Hat acquisition, runs on open source software, so it's fully compatible with AWS, Azure, and other leading public cloud services.

When Arvind Krishna took the helm earlier this year, he said he would lead Big Blue in "two transformational journeys" across the cloud and AI markets with hybrid cloud deployments. To do so, Krishna wants IBM to link the private and public clouds with an open source framework, which would provide it a foundation to cross-sell additional services.

IBM's hybrid cloud platform offers various technologies -- including Watson analytics, encryption services, and Internet of Things (IoT) tools -- which crunch data on both private and public cloud platforms. Those deployments could also boost sales of IBM's z15 mainframes, which offer additional hybrid cloud features, in on-site data centers.

Krishna declared IBM's hybrid cloud platform will "help clients modernize mission critical workloads" during the conference call. He also revealed IBM's hybrid cloud platform had generated $23 billion in revenue over the past 12 months, or 30% of IBM's top line; over 2,400 customers were using its container solutions; and nearly 600 of its clients were using Red Hat's services.

But don't ignore the main challenges

IBM believes the hybrid cloud market will boost its revenue over the long term, but investors should keep two facts in mind.

First, IBM pursued the hybrid cloud market for years under former CEO Ginni Rometty, and the declines in its legacy businesses still regularly offset the growth of its cloud-related businesses. Bringing in Red Hat could tilt the scales in IBM's favor, but that turnaround hasn't happened yet.

Second, Amazon and Microsoft both offer virtual private clouds (VPCs), which are public cloud services quarantined from the rest of their platforms, as secure and easily scalable alternatives to private clouds. VPCs could convince some companies to fully commit themselves to Amazon and Microsoft's cloud services instead of leaving the door open for IBM's hybrid cloud services.

The key takeaway

IBM's business is growing a few green shoots, and hybrid cloud deployments could certainly boost its revenue per client and strengthen its defenses against Amazon, Microsoft, and other cloud giants. However, investors should wait a few more quarters to see if that strategy will finally generate consistent growth for IBM, or if its weaker businesses will erase those gains.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool's board of directors. Leo Sun owns shares of Amazon. The Motley Fool owns shares of and recommends Alibaba Group Holding Ltd., Alphabet (A shares), Alphabet (C shares), Amazon, and Microsoft and recommends the following options: long January 2021 $85 calls on Microsoft, short January 2021 $115 calls on Microsoft, short January 2022 $1940 calls on Amazon, and long January 2022 $1920 calls on Amazon. The Motley Fool has a disclosure policy.

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