Editor’s note: Krista Macomber is an analyst with Technology Business Research. IBM on Wednesday reported a big drop in hardware sales. Macomber takes a look at the reasons why.

HAMPTON, N.H. – IBM (NYSE: IBM) will continue to post revenue and profitability declines in 4Q13 as it works to stabilize its hardware business during its long-term adaptation to cloud computing.

IBM posted its sixth consecutive year-to-year revenue decline in 3Q13, with total revenue of $23.7 billion falling 4 percent during the quarter.

Historically an industry bellwether, IBM’s financial performance is a testament to the disruptive nature of cloud-driven buying behaviors in traditional IT infrastructures.

Cloud is steadily eroding IBM’s traditional hardware business, Systems and Technology Group (STG), which posted deteriorating financial performance in 3Q13. STG revenue fell 17 percent year-to-year compared to a 12 percent loss in 2Q13, and pre-tax margin fell from 3.2 percent in 3Q12 and -3.8 percent in 2Q13 to -5.1 percent in 3Q13.

IBM’s goal for the unit in 2014 is to stabilize profitability — underscoring that IBM recognizes the market will be cutthroat, as it joins its Tier 1 OEM competitors Dell and HP in adapting to new IT buyers in the enterprise, workload-led purchasing decisions, and demand for IT as a Service.

TBR believes that IBM will successfully evolve, as it has wide-ranging hardware, software and services capabilities and know-how in tailoring its messaging to business pain points, and is not afraid to acquire and divest business units to remain relevant amid changing market dynamics. However, IBM’s progress toward its 2015 EPS goals remains limited. Furthermore, customers’ deployments of public, private and hybrid clouds will continue to erode demand for traditional hardware buildouts.

[More IBM analysis is available online from TBR at WRALTechWire.]

Hardware Down in Growth Markets

Growth markets led IBM’s hardware business in declines during the quarter, and the vendor will face tough competition and economic conditions in returning this unit to growth.

IBM reported that two-thirds of its hardware revenue declines during 3Q13 were due to challenges across its STG product lines in growth markets (total Power, System x and storage revenues declined 38%, 18% and 11% year-to-year, respectively). IBM reported that System z increased by double digits in mature markets, which considering the product line’s 6% total growth, implies steep growth market declines. Approximately half of the decline to IBM’s hardware revenue was due to poor execution in growth markets, and the other half was due to China’s in-process economic reform plan. Total growth markets revenue fell 9% year-to-year, underperforming the mature markets for the first time.

IBM expects a change in the growth markets trajectory in 4Q13, and that the unit will return to growth in 2014. This is a tall order, considering IBM has been discussing execution challenges in the region for several quarters to limited avail, and China’s plan will not be completed until late 1H14. IBM faces aggressive, lower-priced competitors such as Huawei and Lenovo in these regions. However, IBM’s refreshed System x portfolio will help to drive volume of units shipped, and its updated midrange System zEnterprise mainframe, launched during 3Q13, will help to spark large-scale and profitable contracts in these regions.

Next Steps

IBM is positioning NeXtScale to capitalize on hyperscale infrastructure buildouts.

Until last month, IBM was notably silent regarding its efforts to stem continued x86 server market share attrition to ODMs, which are winning large-scale x86 server deals from the world’s largest service providers, such as Amazon and Google, through their ability to quickly and cost-effectively fulfill high-volume orders for customized and highly dense servers. This trend contributed to continued double-digit System x revenue declines for IBM in 3Q13. In September, IBM launched its NeXtScale server line. TBR believes that NeXtScale was developed with the goal of tapping opportunities around hyperscale data center buildouts by service providers and enterprises. It will also help IBM to bolster its presence in the high-performance computing (HPC) market by expanding its reach downstream.

NeXtScale offers scalability, performance and energy efficiency, but in a standard rack configuration — signaling IBM’s recommitment to the market for high-density servers, which customers are rapidly deploying to support cloud buildouts. TBR anticipates that IBM’s existing HPC customer base will be the earliest adopters of NeXtScale, but IBM will leverage its partner base to extend the reach of NeXtScale into large cloud deployments. IBM will target MSPs and eventually large and midsized enterprise customers as adoption of hyperscale infrastructures trickle downstream.

Targeting Linux

IBM is repositioning Power away from HPC to tap Linux opportunities as well.

IBM’s Power server line got its start in HPC, but IBM is now adjusting its strategy. TBR believes IBM will use x86-based offerings to cover the HPC space, as these servers are increasingly capable of handling these workloads more efficiently and at a lower price point. It will then adapt Power to be more open and target specific virtualization and data-facing workloads, such as real-time operational analytics. IBM reported that HPC accounted for approximately 10 percent of the Power revenue declines in 3Q13, as it shifts focus to target larger and more rapidly-growing Linux opportunities. IBM’s plans to invest $1 billion in Linux-on-Power innovations, and integration of the platform into IBM’s SmartCloud Entry and PureFlex portfolios will help IBM to stem double-digit declines. Rejuvenating the ISV ecosystem, including through the OpenPOWER Consortium, will be key to success of this adaptation.