The New IBM

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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% five years 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 (EMC), 23 for PC behemoth Dell (DELL), and 20 for Microsoft (MSFT) -- the only software company larger than IBM. Gratingly 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 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."

Changed for the Better: Software increasingly is playing a larger role in IBM's revenue and income mix. So are acquisitions, with target firms tending to generate more sales after Big Blue buys them. But investors have been skeptical, keeping the company's shares trading in a relatively narrow range over the past two years, and far below the $126 they fetched in early 2002, before Samuel Palmisano became CEO.

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."


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.

Cover Story -- Part II