ARMONK, N.Y. When International Business Machines ibm company Corp. sold a unit that makes computer-network gear to Cisco Systems Inc. in 1999, it looked like another of the defeats IBM had been suffering for years at the hands of nimbler rivals. "We were a distant and irrelevant competitor," concedes IBM Chief Executive Louis V. Gerstner. Fighting networking leader Cisco, he adds, was a "battle we weren't going to win."
But this retreat was a strategic one. In addition to $300 million in cash, IBM received a five-year Cisco commitment to buy $2 billion in computer chips and a promise to recommend Big Blue to its customers for installation and consulting services.
Today IBM is Cisco's biggest installer, with sales of services at Cisco installations up 11-fold last year. The Cisco agreement paved the way for similar pacts with telecom giants Alcatel SA, Lucent Technologies Inc. and Nortel Networks Inc. -- vaulting IBM to the No. 1 spot in networking services, with more than $3 billion in sales last year.
Far more than the big boxes that made it famous, services and high-tech parts are what IBM is about these days. The careful cultivation of their growth is likely to be remembered as the chief legacy of Mr. Gerstner, who is preparing to step down after eight years at the helm. He has identified IBM President Samuel J. Palmisano as his likely successor when he leaves, which he has said could be "in a very short period of time."
IBM Profit Rises 15% as Services Unit Continues to Be Firm's Growth Engine (April 19). At the beginning of 2000, IBM looked tired as nearly every major technology company was outstripping it in growth rates and stock-market performance. But as the dot-coms imploded and competitors were hammered by a sharp computer-spending slowdown, IBM kept sales rising and boosted its market share in many categories -- not just services, where it is No. 1, but also in semiconductors, supercomputers, laptops and database software. Investors noticed. Today, among technology firms, only Microsoft Corp. has a market value larger than IBM's $202 billion.
Mr. Gerstner became a management hero after he came from RJR Nabisco in 1993 to rescue IBM at a time when it was reporting multibillion-dollar annual losses. Since his arrival, net income has risen 18% annually and earnings per share, bolstered by stock buybacks, have grown 24%. The stock is up more than ninefold since then; over the same period, the S&P 500 is up less than threefold. IBM stock fell as low as $80.06 in December but started rising early this year, and closed Friday at $116.10, down $1.15 in New York Stock Exchange composite trading.
In the first quarter -- as services and parts became the majority of its sales for the first time -- IBM reported an earnings gain of nearly 16%. The strong results easily exceeded Microsoft's earnings gain and came as profits at rivals Compaq Computer Corp., Hewlett-Packard Co., and Sun Microsystems Inc., plummeted. Critics say the industry-leading performance is a one-time fluke, an artifact of comparisons with a weak quarter a year ago and an economic slowdown hitting its rivals that won't last forever.
In an interview reflecting on his tenure and the future, Mr. Gerstner says the results mark the beginning of a new era, one in which computer hardware will continue its transformation into a commodity that commands lower profit margins. In his outlook, services will remain strong, as many large companies look for ways to control information-technology spending and turn over vast chunks of their computer operations and employees to vendors such as IBM. Driven in large part by such outsourcing deals, IBM's outstanding service contracts surged a remarkable 40% in the past 12 months to $87 billion.
Mr. Gerstner also says IBM is reaping substantial rewards from a decision he made early in his tenure to sell IBM's chips technology to outside companies rather than adhere to the long IBM tradition of keeping it exclusively in Big Blue's own computers. The biggest benefit has come in specialized semiconductors, where sales last year were $4 billion, and first-quarter revenue more than doubled. In March, Sony Corp. signed a deal to use IBM chips in a future video-game machine. Nintendo Corp. already is putting IBM chips in a new Game Cube that will go on sale later this year.
Services are "going to move in this decade to being the front edge of the industry," Mr. Gerstner says, driving the sales of hardware and software. He says big companies will start outsourcing things such as sales-force automation and operation of their Web sites as widely as they buy payroll services today. "Hardware and software is going to be sold inside a services wrapper," Mr. Gerstner says. IBM, which had $88 billion in total revenue last year, is putting its money where Mr. Gerstner's mouth is. Over three years, it is spending $5 billion on new semiconductor fabrication plants and $4 billion on giant computer centers for hosting and servicing customers' computer operations.
Skeptics in the Crowd
The IBM story has some skeptics. Bob Djurdevic, president of market watcher Annex Research, Phoenix, says IBM's condition is "nowhere nearly as rosy" as Mr. Gerstner asserts. He says the first-quarter growth was compared with a year-earlier period that was "the pits." He adds that IBM's big-computer product line -- the mainframes and midrange iSeries -- suffered revenue declines and that software revenue shrank, in part because of sales declines at the Lotus and Tivoli units, the flagship acquisitions of Mr. Gerstner's tenure. Even the services growth, he says, is exaggerated because the year-earlier revenue was hampered by the end of the year-2000 services boom. And services have never provided the kind of fat profit margins that have historically made hardware and software such great businesses.
Mr. Gerstner says that mainframes are declining, but he says they remain highly profitable. He says the other hardware and software problems are being corrected with the introduction of new products at Lotus and Tivoli and improved technology for its long-suffering storage division. He concedes that "gross margins are lower" in services but adds "the pretax margins aren't too bad relative to where the hardware side of the business is going, as more and more of the hardware in this business commoditizes." Mr. Gerstner says that the services and semiconductor strategy evolved from decisions he made shortly after he arrived in 1993 and found a company being dismantled by "previous management that said, basically, 'We can't manage this thing anymore.' " He decided to keep it together.
As a former IBM customer at RJR Nabisco and American Express, Mr. Gerstner says he knew big companies wanted to have the option of a one-stop supplier. "I verified with a whole bunch of customers that while IBM didn't always do it effectively, IBM was the only hope of having somebody who could look across all of the parts of the industry and help the customer integrate a solution." The strategy is also aided by the difficulty many companies are beginning to have in hiring good technical people, and in managing complex information infrastructures. With 137,000 employees in services, IBM has no shortage of bodies to throw at problems. It also says it has economies of scale that allow it to take over in-house operations and save customers money doing so.
IBM isn't alone in targeting services. Compaq bought struggling Digital Equipment Corp. in large part to get its service arm. Hewlett-Packard tried to buy the services arm of PricewaterhouseCoopers last year for as much as $18 billion. Mr. Gerstner says that he could have increased the size of the business faster by buying a large competitor, but he says he decided to use "toehold acquisitions" totalling $1.8 billion over seven years rather than "to smash it together with another large organization where you could have years of integration problems." Even without big acquisitions, IBM's global services business is by far the world's largest, with $33.1 billion in revenue last year, 72% larger than No. 2 Electronic Data Systems Corp.'s $19.2 billion. Computer Services Corp. and Accenture Corp., the former Andersen Consulting, both have slightly more than $10 billion in annual revenue. Those companies tout their independence from hardware makers as a way to avoid conflicts-of-interest in recommending the best products to customers.
A Leg Up
IBM's long ties with customers can give it a leg up. Earlier this year, Franklin Templeton Investments, a San Mateo, Calif., mutual-fund manager, gave IBM a $480 million, 10-year outsourcing contract that turned about 150 Franklin employees into IBM workers and allowed Franklin to close one of two data centers it owned. Allen J. Gula, Franklin's chief information officer, didn't want to bring in a series of vendors to bid on the contract because he thought that would spook employees. Familiar with IBM's work from previous jobs, Mr. Gula sought a bid only from Big Blue. Mr. Gula says he decided to outsource when Franklin acquired Fiduciary Trust Co., and he needed to combine the two companies' computer operations. "We could have done it ourselves, but it would have cost a lot more and taken a lot longer."
Mr. Gula says that IBM has perfected the art of smoothly taking over such operations and their personnel. "They have a three-hour show," Mr. Gula says -- and just one hour into the presentation, Franklin employees "were all pretty comfortable" at the prospect of joining IBM. Big Blue stressed that career opportunities were better at a place where "data-center operations are a core competency," as opposed to a necessary evil, as they are at most companies. Goodyear Inc. turned to IBM to develop a system that allows its 3,300 dealers to order tires, pay invoices and check inventories over the Internet -- hosted at IBM's data center in Raleigh, N.C. Andy Traicoff, Goodyear's director of e-commerce, says the company concluded that a system that's live 24 hours a day, 365 days a year "is very costly to support," and would have mandated hiring new telecom, software and hardware personnel available at all times. At IBM, he says, "you're monitoring many systems so you can spread the costs." IBM services is completing work on a redesign of The Wall Street Journal Online, says Neil Budde, publisher. He declined to disclose the size of the contract.
Jumping on the Web
IBM was the fastest among major high-tech companies to build data centers to host customers' e-business. At its 245,000-square-foot Web-hosting facility in Boulder, Colo., 6,500 IBM employees watch over 145 mainframe computers and 13,000 midrange servers that run applications and store information for thousands of customers who don't want to handle the work in their own data-centers. IBM is also spending $1 billion to support the development of free Linux software because it sees a big opportunity to provide services to customers who install Linux systems. And it further boosted its services business by turning defeats into strategic alliances, much in the way it did with Cisco.
This has been especially evident in the software field. In 1999, IBM decided to get out of most of the corporate-software-applications business. "We were spending $1 billion a year, but we weren't No. 1 or No. 2, and we were irritating the other 90% of the software industry," says Robert Timpson, who manages alliances in IBM's software group. As IBM retreated niche by niche, it often demanded valuable promises from former software competitors that have boosted its other businesses. IBM now has 59 strategic alliances with software makers. IBM halted sales of its CorePoint software that helps companies keep track of their dealings with customers after getting category leader Siebel Systems Inc. to agree to recommend IBM's database software, its computers and its services to Siebel customers. IBM moved the 700 people in the CorePoint group to other parts of IBM and "migrated" customers to Siebel and other partners.
Stephene Garnett, vice president of alliances at Siebel, says that before the deal with IBM, Siebel salesmen always recommended databases and services from others because IBM was a competitor. Now, Mr. Garnett says, "IBM's share of our services business has gone from zero to 20%. By year end they'll be No. 1 or 2." Mr. Timpson says corporate customers who adopt major software packages typically spend less than 25% of their budget on the software itself. In many of its alliances, IBM now gets first crack at the 50% of the spending that goes for services, the 15% for hardware and the 10% for infrastructure software such as databases. Software vendors like the link to IBM because it lets them promise customers that reliable services are available, and IBM's 25,000 salespeople can also drum up new business for the vendors.
Financial Fusion Inc., a Sybase Inc. unit that makes Internet-banking software, says that its IBM relationship created about $6 million of its $29 million in revenue last year because of referrals provided by IBM. But IBM gets far more. When Washington Mutual, the big Seattle bank, told its IBM salesman that it was looking for software to run an Internet-banking application, IBM recommended Financial Fusion. It resulted in a "multimillion-dollar, multiyear Web-hosting relationship" for IBM, says John Treadway, head of corporate marketing for Financial Fusion. Technologically, IBM has long been the leader in obtaining U.S. patents, receiving 2,886 last year. Mr. Gerstner says that that inventiveness is finally starting to translate into valuable products -- after a long period of playing catch-up to competitors.
Despite Mr. Gerstner's move to cut IBM's research-and-development budget to 5.7% of revenue from 9%, IBM became the first company to produce integrated circuits using copper, which run faster and cooler than aluminum ones. On Friday, it announced it had devised a way to "stretch" silicon atoms to make chips run 35% faster. It has built the world's most powerful supercomputer and smallest disk drives. Mr. Gerstner maintains that "we didn't cut the R, we cut the D" by closing overlapping development labs. His decision to sell more of the fruits of IBM's research boosted licensing deals to $1.7 billion last year from $200 million when he started.
The biggest payoff is shaping up in semiconductors. Rather than battling fruitlessly with Intel over chips for personal computers, IBM turned its attention to chips with special usefulness in telecommunications. One of the first companies to work with IBM back in 1996 was Juniper Networks /q-quote.cgi?sym=jnpr&type=company> Inc., then a seven-person Silicon Valley start-up. It wanted to make faster routers to direct data traffic. Pradeep Sindhu, chief technical officer of Juniper, says IBM "put a lot of its technology resources into fundamental advances in chip building." Its customers work with IBM engineers to design customized chips that IBM manufactures.
As a result, IBM became a leader in "flip-chip" design, which permits pins carrying information in and out of the chip to be attached to the flat back of the chip rather than only on the sides. That means a Juniper network processor could have 1,500 pins, compared with 200 or fewer on a standard microprocessor. Helped by IBM's chips, Juniper has become one of the fastest-growing suppliers of high-speed routers for data communications.