Cover Story
IBM shareholders have been blue for the past few years, as the tech giant's stock has stalled. But they'll be smiling again. Big Blue's new strategy is working.
A quiet revolution is under way at International Business Marchines, and it's being led by an unlikely revolutionary:Chief Executive Samuel Palmisano, an IBM lifer who few though would so radically depart from the blueprint drawn by his predecessor, Louis Gerstner, when he took the reins at Big Blue in March 2002.
In its most recent querter, software accounted for a fifth of IBM's revenue and surprisingly for the bulk of its eraning-some 40%, up from 29% five years ago. Under Palmisano, IBM is reinventing itself again. It's shed its disk-drive and personal-computer business to focus on less volatile operations with fatter margins, and has boosted productivity by slashing costs and spreading facilities around the globe.
Welcome to the New Big Blue, the world's second-largest software company-quite a change from the hardware giant that invented the disk drive 50 years ago and lived high on the mainframe, or the service outfit it successfully morphed into under Gerstner-one whose revenues had stalled in recent years. "We have globelly integrated the supply chain, software development, services delivery," says Palmisano. "I would say we're just two or three years into a multi-year journey, with ongoing productivity gains to be had. As a result of all this work, IBM today is much more focused than we were-four years ago."
This year, IBM's revenues are expected to clock in at $90.7 billion versus $91.1 billion last year and $96.3 billion in 2004, when it had the PC operation, which was sold to China's Lenovo last year. Earnings are expected to grow 12%, to $5.98 a share, from $5.32 last year, and then by an other 9%, to $6.54 in '07. There are also signs of an incipi ent revival in the services division, whose top-line growth has failed to hit the Armonk, N.Y.-based company's 6%-to-8% annual target. (Last year, services accounted for 53% of IBM's revenue; hardware and financing, 27%, and software, 20%.)
But Big Blue's stock (ticker: IBM) hasn't kept pace. IBM's largest shareholders are mostly index funds that must own the shares to meet their investment mandate. The roster of bulls on the stock has shrunk since the hon'ible first quarter of 2005, when the company badly missed earnings forecasts, O\ving to weakness in Europe and slower-than-expected service contract signings. The bad news clobbered IBM share holders, wiping out more than $11 billion of stock-mar ket value overnight.
Today, even after a hearty rebound from its sum mer low of 72.73, IBM trades at 15 times earnings, for a ~arket cap of $137 billion. Compare that with 25 times for storage king EMC (EMC), 23 for PC behe moth Dell (DELL), and 20 for Microsoft (MSFT) -the only software company larger than IBM. Grat ingly for IBM, Hewlett·Packard (HPQ) will become America's largest tech company this year, with an estimated $97 billion in sales. IBM shares are well below their 2002 high of $126, . reached just before Palmisano took the helm.
There's no dearth of disbelievers. "IBM is in a long term decline, and now they're talking about being a soft ware company. This is my problem: They're still a massive services company," says Fred Hickey, editor ofthe High TechStrategist newsletter. "And buying back shares, gen erating 'other income' and enforcing patents is not, to my mind, a good long-term story."
Palmisano and his lieutenants aim to change that perception, in part by emphasizing strong profits, even in an environment where infonnation-technology spending growth has slwnped to single digits. The plan is to sell corporate "solutions" that integrate offerings from all three of IBM's massive product lines. They're aiming for double-digit per-share earn ings growth: five to six percentage points from reve nue growth (from acquisitions and existing opera tions); three to fow' points from productivity gains, and two points from share repurchases, fueled by the consistent growth of cash.
IBM has $10 billion in the till, and that's allowed it to sharply boost its dividend each year while indulging in a blizzard· of software acquisitions over the past couple of years and making more speculative investments, includ ing an ownership· stake in China's Guangdong Development Bank through a Citigroup consortium last month.
IBM today is "a high-torque engine," says Palmis ano, who answered Barron:~ questions bye-mail be tween business trips to China and Europe. Higher-mar gin businesses and lower costs "allow us to generate significant profit earnings and cash flow, even in this more moderate growth environment. Simply put, we generate more profit from every dollar of revenue than most of om" competitors .... Some people say that IBM is a services-led company. That's wrong."
Key to the growth strategy is software. A decade ago, IBM's software was just the stuff that ran on its main frames. IBM dumped that business under Gerstner, in stead pursuing "middleware" - software that connects complex applications or systems at big corporations, let ting them exchange data, or allowing new applications to link to older legacy systems and multiple applications to create larger ones.
Middleware operates on non-IBM computers, too, and lets IBM team up with vendors such as GerITIa ny's SAP (SAP). Today, IBM is the world's largest middleware vendor. Last year, about half of its soft ware revenue of $15.8 billion came from middleware sold under the WebSphere, Lotus, Tivoli, Rational and DB2 brands; And the company's legacy software busi nesses, which sell programs such as the operating systems for IBM mainframes and servers, don't blow anyone's doors off, but they're big money makers.
Middleware is a key element in IBM's strategy of selling "solutions" to corporatiens to help them integrate their husinessefo\.
IBM's gross profit margin for software in the third quarter was 85%-nearly triple that on services. And its pretax margin on software is expected to clock in at 31.3% this year, up from 22.8% in '01.
If that level is indeed reached, it should command a higher stock-market valuation. Just ask Banc of America Securities' Keith Bachman, who wrote re cently: "Software will increasingly become a key cata lyst for the stock as it becomes a higher percentage of IBM's revenues, led by its acquisitions and solid organic growth in key branded middleware. Ulti mately, as software grows as a percentage of revenues and profits, we believe that investors will gradually afford IBM a higher multiple."
The vision now? ·To make the services division look more like software. Obviously, increased software sales will bring commensurate service contracts; a sale of a computer program is often accompanied by a service contract that could be five times as large. But IBM wants to transform services altogether.
Middleware is the software that helps companies ap ply what is called "Service Oriented Architecture." SOA has become a buzzword for the growing trend through out the IT industry to make computer systems more flexible and adaptable to changing business needs.
IBM's SOA custOlners can even purchase "service products," just as they can buy hardware and software. Example: Computer security involves a variety of time consuming processes around identity management, net work monitoring, distributing and installing patches, fixes and the like. Lots of these traditional, time-consuln ing and labor-intensive tasks can be automated. Further more, the software that replaces labor can be used re peatedly, at much lower cost than having the same tasks done manually, and is clearly mor~ profitable than selling labor. HDFC Bank, India's second-largest financial institution, chose IBM -not an Indian company-for a software project to identify new business opportunities by monitoring customer feedback from e-mails and phone calls.
Right now, IBM sells more than three times as much in SOA product" and services as anyone else. It has 46% of a market that is expected to jump to $34 billion by 2010 from $8.6 billion now. Sales of IBM's WebSphere software, a major component of SOA solutions, grew 30% in the third quarter.
IBM is also making inroads in another service-like soft ware area, the market for information on demand, which the company thinks could reach $69 billion in the next three years. (It doesn't break out current revenues from this area.) One example is the Crime Information Ware house, an organization that stitches together hundreds of databases with information about crime patterns and po tential suspects and their addresses, and uses satellite im aging and mapping of cities by precinct to make informa tion available to detectives speeding to crime scenes. A big customer: the New York City Police Department.
IBM argues that packaging software and services can dramatically change the growth and profit potential of its service business. Says Steve Mills, head of IBM's software division: "My business model is a very attrac tive one, but it's based on delivering licenses to custom ers. In a labor-centric business, you'd like to have a lot of customers, but you're limited by the amount of labor. If you carry the assets through, the benefits begin at the bottom line. You have certainty of outcome and the abil ity to execute with greater speed, helping ensure greater profitability. Does it have a top-line contributory effect? Yes, if you pick up the pace."
Acquiring the software expertise is key.
Since Palmisano took over, IBM has bought 51 compa nies, 31 of them in software, for $11.5 billion. The acquisi tions center on SOA, information on demand or service management-managing a client's computers and inter nal business services. In recent months, it purchased In ternet Security Services, a software-based computer secu rity ·outfit; File Net, an information-on-demand service, and MRO Software, a service-management specialist.
IBM generally buys a dozen companies a year, and Mills & Co. look at many others. Big Blue is also an active venture-capital investor.
For all that critics carp at the small size of IBM's acqui sitions, the deals have filled technology gaps and given the company a foothold in emerging markets. They've been re markably successful, partly because many companies are already writing software for IBM hardware or are famil iarwith IBM's services division and because, once the com panies are acquired, IBM's sales force and consulting-and services division have new reasons to call on customers to introduce their latest products. From 2002 through 2004, Big Blue completed 24 acquisitions priced below $500 mil lion, two-thirds of which were software vendors. On aver age, revenue grew 25% a year at these new units, and the deals were accretive in the second year af ter they closed. The pretax margin went from minus 6% in the first year to plus 12% in the third.
After a disastrous first-quarter performance in 2005, IBM radically restructured its service unit, splitting it into two parts and shaking up its management. The changes are beginning to pay off, although the operation still is not performing as well as Wall Street would like it to.
Clearly, software could overtake ser vices as the largest part of IBM soon. Mills won't say when, but he's trying to boost software revenue by 6%-to-9% a year, which he figures results in 10%-12% earnings growth.
Still, much depends on the perform ance of the service division, which ac counts for more than half of IBM's reve nue, but is growing at just 3%, well be low the target of 6%. Signs of revival have emerged: Contract signings have bounced off a four-year low, but in the third quarter still were 5.4% below the $11 billion year-earlier level because of deals that didn't close. In a recent re port, Cowen & Co. pointed out that IBM's $109 billion order backlog is 10% below its peak, which was hit in 2004, and has been flat for eight quarters, while growth has lagged its rivals.
Blame competition: In a stagnant mar ket, IBM has heen attacked by tlw likes 01' Ae('('nt.ure (ACN), the former Andpl' sen (~onsulting, and HP, and is battling Indian rivals, such as Infosys Technolo gies (INFY), Wipro Technologies, a Wipro Ltd. (WIT) unit and Tata Consul tancy (TCS.Mumbai), which provide ser vices at lower cost and without any bias toward IBM products.
The Indians are moving into lucrative consulting contracts. And even though sal aries and attrition.rates are rising on the subcontinent, they're still five times cheaper than in the U.S. Tata Consultan cy's revenue surged 42% in the Septem ber quarter. Says Rusi Brij, CEO of Mum bai-based Hexaware Technologies (HEXWMumbai), which provides IT and process outsourcing: "IBM and Accen ture will not bill for less than $150 an hour on PeopleSoft [enterprise programs]. We do it for $80 to $90."
Indian businesses are likely to keep gaining share. And in the next couple of years, some $110 billion in outsourcing deals will be up for renewal, according to Technology Partners International. Says Pip Coburn, the well-regarded technol ogy strategist who steers Coburn Ven tures: "Services is too big to grow effec tively. It's slow growth, managed excep tionally well, but I doubt we'll ever see a meaningfully larger multiple."
However, after the disastrous first quarter performance in 2005, IBM radi cally restructured the service unit, split ting it into two parts and shaking up its management. The first unit, led by Mike Daniels, works on technology infrastruc ture, data outsourcing, business process outsom'cing and business-transformation outsourcing. The second, headed by Ginni Rometty, focuses on global business ser vices and consulting. (IBM bought Price waterhouseCoopers consulting in 2002.)
And IBM is taking the fight to the sub continent itself. Last summer, it held an analysts' meeting in Bangalore, attended by a score of senior executives, including Palmisano and Bob Moffat, whose mission is to cut costs from IBM's suppliers and to boost productivity. Big Blue plans to invest $6 billion in India over the next few years.
While IBM has de-emphasized hardware over the years, it still is one of Big Blue's cash cows. The company is No. 1 in one of the hottest sectors: blade servers.
In 2004, it bought outsourcing outfit l>ak,dl, allli is I'llmored to he hunting for an other Indian firm. Today, it has 4:1,000 em ployees in India, but itl' capabilitiel' are glo bal. Moffat points out that, when the lion ized Indian actor Rajkumar died on April 12, sparking riots, IBM's broad reach let it shift data-center operations to Brazil and Colorado. And, he says, India is only one of the places where IBM will profit: "I can tell you five other centers with lower costs, in cluding Vietnam and China."
Today, IBM says, shorter-term sign ings are improving. Service-oriented ar chitecture sales are generating big con tracts. Indeed, IBM's service operation is the software division's second-largest sales channel. Daniels says the company is focusing on gaining business from firms that want to outsource depart ments other than IT, including finance,
procurement, human resources and call centers.IBM is also walking away from insufficiently profitable contracts.
The services operation, he adds, has had "nine consecutive quarters of margin expansion," even as top- line growth has been sluggish. Offshore sites go a long way to reducing costs. For a labor-based service contract. the gross margin is about 40%. For a software-based security service package, the figure can top 60%.
Daniels says the company's target of 6% top-line growth is "very realistic." IBM il' focusing at last on smaller- and medium-size businesses in the developed and emerging worlds, which don't need the giant multi-year contracts associated with Fortune 500 clientl'.
This quarter, contract growth il' healthy: IBM won a $300 million contract to help revamp Scotland's public health ser vice, a seven-year $863 million deal to run a data center for the State of Texas, and is ex pected, with Siemens (S1), to sign by year end a lO-year contract worth €6.5 billion ($8.45 billion) to modernize technology for the German military.
Says Daniels: "All the things I de l'cribed to you are necessary to take us from $50 billion to the next $50 billion. The service business had to be revital ized. We've responded boldly and we're focused on markets with significant growth opportunities."
Meanwhile, the cash-cow hardwaredivi sion keeps ticking, with growth in the third quarter spm·ting by 8.8%, versus 5% in 2005, as mainframe revenue shot higher and because of gains in IBM's Technology Collaboration operation. Mainframes and servers account for 60% of hardware sales, and IBM has been gaining share in recent years in the server market from Sun Mi crosystems (SUNW), HP and others. Margins have fattened after IBM dumped the PC business.
Technology Collaboration is IBM's R&D and semiconductor-design unit. Through it, IBM partners with variow; in dustries and has even allowed its partners to build on once-secret IBM patents. (IBM spends about $6 billion annually on R&D and boasts 40,000 patents worldwide.) IBM processors are the core chips in all the major videogame consoles, including Sony's new PlayStation 3. Bob Djurdjevic of Annex Research in Scottsdale, Ariz., a long-time IBM watcher, predicts that Tech nology Collaboration "will become so large that it deserves comparison to IBM's shift to services several years ago."
Even if you don't buy the entire IBM turnaround story, the company's "tack needs only part of it to work to show significant improvement.
Thanks to divestments and the move to more annuity-like revenues, "IBM has certainly become a more stable and more predictable company. That would argue for a higher-than-historical multiple," says A.M. Sacconaghi, Sanford C. Bem stein's technology analyst. In the past cou ple of years, IBM has generally bounced between the low 80s and high HO". Histori cally, it has traded at a market multiple. Give the shares a market multiple on next year's earnings, and you get a price of $105-15.7 times Sacconaghi'" estimate of $6.70 a share for '07. That's about 15% above its recent price of 91.
In fact, Sacconaghi maintains, IBM "is even cheaper than it appears" because earnings this year are being depressed by an unusually large pension-related cost of 86 cents a share. That should moderate because IBM is ending its defined-benefit programs, as of 2008, and moving to de fined-contribution 401(k) plans.
IBM could boost its share price by exit ing the capital-intensive, cyclical chip busi ness, Sacconaghi says.
Another bull on the stock is David Go erz, chief investment officer at HighMark Capital Management. "Looking out into '07 and particularly into '08, consulting services should do particularly well," he says. "IBM is remaking itself and the question is whether it deserves to be reratedat some point. Right now, I'm will ing to give them the benefit of the doubt. They should grow faster than the market. This isa good long-term investment that will benefit from a stronger cyclical economy. The stock is an outperformer by at least 10% to 15% over the market."
The market's disdain for IBM shares dismays Palmisano. "We have a top share in servers and Linux, NO.1 in blade serv ers, which is a huge growth area-ana lysts say the worldwide blade market can grow from $2.2 billion in 2005 to more than $11.2 billion by 2010- NO.1 in supercom puting, NO.1 in SOA, where the bluning of software and services is evident. We're NO .1 in middleware." And he declares:
"IBM is a stronger company today than it was four years ago, with stronger margins, solid cash and earnings."
You don't need a computer to know what that trend could do for IBM's shares._
