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Monday, December 04, 2006

The New IBM
By Leslie P. Norton
A quiet revolution is under way at International Business Machines, and it's
being led by an unlikely revolutionary: Chief Executive Samuel Palmisano, an IBM
lifer who few thought 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 quarter, software accounted for a fifth of IBM's revenue
and, surprisingly, for the bulk of its earnings -- some 40%, up from 29%
fiveyears ago. Under Palmisano, IBM is reinventing itself again. It's shed its
disk-drive and personal-computer businesses 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
globally 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 another 9%, to $6.54 in '07.
There are also signs of an incipient 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
horrible first quarter of 2005, when the company badly missed earnings
forecasts, owing to weakness in Europe and slower-than-expected service-contract
signings. The bad news clobbered IBM shareholders, wiping out more than $11
billion of stock-market value overnight.
Today, even after a hearty rebound from its summer low of 72.73, IBM trades at
15 times earnings, for a market cap of $137 billion. Compare that with 25 times
for storage king EMC, 23 for PC behemoth Dell, and 20 for Microsoft
-- the only software company larger than IBM. Gratingly for IBM,
Hewlett-Packard 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 software company. This is my problem: They're
still a massive services company," says Fred Hickey, editor of the High-Tech
Strategist newsletter. "And buying back shares, generating '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 information-technology
spending growth has slumped 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 earnings growth: five to six
percentage points from revenue growth (from acquisitions and existing
operations); three to four 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, including an
ownership stake in China's Guangdong Development Bank through a Citigroup
consortium last month.
IBM today is "a high-torque engine," says Palmisano, who answered Barron's
questions by e-mail between business trips to China and Europe. Higher-margin
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 our 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 mainframes. IBM dumped that business under Gerstner,
instead pursuing "middleware" -- software that connects complex applications or
systems at big corporations, letting 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 Germany's SAP (SAP). Today, IBM is the world's largest
middleware vendor. Last year, about half of its software revenue of $15.8
billion came from middleware sold under the WebSphere, Lotus, Tivoli, Rational
and DB2 brands. And the company's legacy software businesses, 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
corporations to help them integrate their businesses.
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
recently: "Software will increasingly become a key catalyst 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. Ultimately, 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 apply what is called "Service
Oriented Architecture." SOA has become a buzzword for the growing trend
throughout the IT industry to make computer systems more flexible and adaptable
to changing business needs.
IBM's SOA customers 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, network monitoring,
distributing and installing patches, fixes and the like. Lots of these
traditional, time-consuming and labor-intensive tasks can be automated.
Furthermore, the software that replaces labor can be used repeatedly, at much
lower cost than having the same tasks done manually, and is clearly more
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 products 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 software 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 Warehouse, an organization that stitches
together hundreds of databases with information about crime patterns and
potential suspects and their addresses, and uses satellite imaging and mapping
of cities by precinct to make information 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 attractive one, but it's
based on delivering licenses to customers. 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 ability 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 companies, 31 of them in
software, for $11.5 billion. The acquisitions center on SOA, information on
demand or service management -- managing a client's computers and internal
business services. In recent months, it purchased Internet Security Services, a
software-based computer security outfit; FileNet, 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 acquisitions, the deals
have filled technology gaps and given the company a foothold in emerging
markets. They've been remarkably successful, partly because many companies are
already writing software for IBM hardware or are familiar with IBM's services
division and because, once the companies 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 million, two-thirds of which were software
vendors. On average, revenue grew 25% a year at these new units, and the deals
were accretive in the second year after they closed. The pretax margin went from
minus 6% in the first year to plus 12% in the third.
Clearly, software could overtake services 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 performance of the service division, which accounts
for more than half of IBM's revenue, but is growing at just 3%, well below 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 report, 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 market, IBM has been attacked by the likes of
Accenture, the former Andersen Consulting, and HP, and is battling Indian
rivals, such as Infosys Technologies, Wipro Technologies, a Wipro Ltd.
unit and Tata Consultancy, which provide services at lower
cost and without any bias toward IBM products.
The Indians are moving into lucrative consulting contracts. And even though
salaries and attrition rates are rising on the subcontinent, they're still five
times cheaper than in the U.S. Tata Consultancy's revenue surged 42% in the
September quarter. Says Rusi Brij, CEO of Mumbai-based Hexaware Technologies,
which provides IT and process outsourcing: "IBM and Accenture
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
technology strategist who steers Coburn Ventures: "Services is too big to grow
effectively. It's slow growth, managed exceptionally well, but I doubt we'll
ever see a meaningfully larger multiple."
However, after the disastrous first-quarter performance in 2005, IBM radically
restructured the service unit, splitting it into two parts and shaking up its
management. The first unit, led by Mike Daniels, works on technology
infrastructure, data outsourcing, business process outsourcing and
business-transformation outsourcing. The second, headed by Ginni Rometty,
focuses on global business services and consulting. (IBM bought
PricewaterhouseCoopers consulting in 2002.)
And IBM is taking the fight to the subcontinent 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. In 2004, it bought outsourcing outfit Daksh, and
is rumored to be hunting for another Indian firm. Today, it has 43,000 employees
in India, but its capabilities are global. Moffat points out that, when the
lionized 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, including Vietnam and China."
Today, IBM says, shorter-term signings are improving. Service-oriented
architecture sales are generating big contracts. 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
departments 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 is 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 clients.
This quarter, contract growth is healthy: IBM won a $300 million contract to
help revamp Scotland's public health service, a seven-year $863 million deal to
run a data center for the State of Texas, and is expected, with Siemens (SI), to
sign by year end a 10-year contract worth 6.5 billion euros ($8.45 billion) to
modernize technology for the German military.
Says Daniels: "All the things I described to you are necessary to take us from
$50 billion to the next $50 billion. The service business had to be revitalized.
We've responded boldly and we're focused on markets with significant growth
opportunities."
Meanwhile, the cash-cow hardware division keeps ticking, with growth in the
third quarter spurting 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 Microsystems,
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 various industries 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
Technology 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 stock
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.
Bernstein's technology analyst. In the past couple of years, IBM has generally
bounced between the low 80s and high 90s. Historically, 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's 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 defined-contribution 401(k)
plans.
IBM could boost its share price by exiting the capital-intensive, cyclical
chip business, Sacconaghi says.
Another bull on the stock is David Goerz, 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 rerated at some point. Right now, I'm
willing to give them the benefit of the doubt. They should grow faster than the
market. This is a 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 servers, 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 supercomputing, No. 1 in SOA, where the
blurring 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

posted by OttoKee  # 5:30 PM

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