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Annex Research’ Five-year Forecast for IBM

Stagnant Revenues, Declining Earnings

The Elusive Century Mark: Why Big Blue Won’t Be a $100 Billion Company

PHOENIX, June 1, 2000 – John Akers, IBM chairman in the good old days when the company looked omnipotent, predicted in a January 1985 interview with the New York Times that the Big Blue would become a $180 billion company during his expected 10-year tenure at the helm (i.e., by 1994).

It didn’t happen, of course.  By 1994, IBM was “only” a $64 billion company, and Akers was history, having been given the boot by the Board in January 1993.

When Lou Gerstner succeeded Akers in April 1993, the first priority of the new IBM chairman was to stop the hemorrhaging of what was left of a once great computer company, whose revenues and profits had grown for eight decades at double the rate of the U.S. gross domestic product (12% vs. 6%). 

By May 1994, Gerstner and his new lieutenants were done wielding their axes and carrying out deep cuts in personnel and materiel.  (Incidentally, the downsizing plans had been prepared under Akers, but the former IBM chairman did not have the nerve to implement them.  It was easier, of course, for the new broom to sweep clean). 

Ever since May 1994, the name of the game and the IBM leaders’ main challenge had been generating new growth.  Ever since 1994, the computer industry was practically bursting at the seams, driven by an explosive growth of the Internet and related e-commerce applications.

And how have the IBM leaders met such a challenge under more than favorable economic and IT market conditions?  Well, you be the judge.  IBM revenues grew at a compound annual growth rate of 6% between 1994 and 1999, half of the company’s growth rate for the prior 82 years!  As of 1999, IBM was an $87.7 billion-company, not even half of Akers’ pipe dream for 1994.

Text Box:

IBM’s Downhill

That’s the good news.

That’s the good news?

Yes, because from now on, the outlook for IBM under its present management and on its current course is all downhill. 

All downhill?

Yes.

Isn’t that good?

Yes.  In skiing.  But not in business growth.  You see, by the year 2004, we expect IBM to be an $84 billion-company.

An $84 billion company?  But that’s smaller than it is today.

Which is why we said the Big Blue is on “downhill” trends.

But didn’t Gerstner promise us a faster growth after the Y2K problems are over?

Actually, he did not.  He tried to tone down expectations of faster growth.  “It is not necessary to us” for IBM to increase its revenue in double digits, according to a May 10 Wall Street Journal report about Gerstner’s annual address to security analysts.

Perhaps for the first time since he became IBM chairman, “Gerstner’s remarks contained less bluster, and more apology,” the Journal also noted.

The IBM chairman had better start practicing new and creative ways of apologizing since he is evidently all out of new and creative ways to grow the Big Blue even at the IT industry average, let alone faster than that.  Perhaps a peek into Akers’ 1991-1993 playbook may help? For, there is much for which to apologize. 

Text Box:

Throughout the last five years, for example, IBM has been basically a one-string violin.  The only Big Blue business segment to grow in double digits was services.  Now, even that string is starting to fray.  In the first quarter, for example, the IBM Global Services revenues shrank by1%, joining five other declining business segments (“Waiting for Godot”).

Five-year Forecast

Over the next five years, we do expect IBM’s IT services to return to profitable growth.  But not in the double digits, and certainly not at the 22% compound annual growth rate that this unit had recorded in the 1994-1999 period. 

We expect the services to grow at a 7% compound rate between 1999 and 2004.  Which means that by 2004, services (including maintenance) will represent about $42 billion, or half of IBM’s total.

This assumes, of course, no divestitures between now and then.  Which is frankly an unlikely scenario, given the number of unprofitable businesses, such as the PC unit, which Armonk kept sheltering under its corporate umbrella for years.  After such divestitures, the relative revenue share of IBM services can only get bigger.

IBM software may also show modest growth - in the low single digit range.  And that’s it!

And that’s it?

Yes.  That’s it.  Hardware, for example, will decline at a 5% compound annual rate despite a 6% growth in customer financing (inclusive in the decline). 

By the end of 2004, hardware revenues will be only $29 billion, down from $38 billion in 1999, and down from the $48 billion in 1990.  Of course, the hardware revenues could be considerably smaller - sooner, if IBM does what it should have done a long time ago - dump its unprofitable businesses.

The revenue picture we’ve painted above for IBM over the next five years, stagnant as the prospects are, is still relatively good news.  Because IBM’s earnings are likely to steadily decline, as less profitable businesses (e.g., services) take on an ever growing share of the company.

By that stage, however, the current IBM chairman will probably be long gone, counting the hundreds of billions of dollars in cash and stock options with which the Board has showered him in recognition of such “visionary leadership.” 

It’s a good thing Armonk is not a capital of a banana republic.  They shoot people in banana republics for abuses like that. 

On the other hand, maybe IBM’s headquarters will be remembered as the capital of a “banana empire;” the little town Text Box:  outside of New York City where “Louis XIX of Armonk” and his pals on the IBM Board grew Big Blue bananas along the Old Orchard Road. 

Which will go on until people eventually go bananas when they discover that “Lou and pals” also bought more than $34 billion of the Big Blue bananas (IBM stock, on Wall Street).  Whereupon IBM Board may decide to change its tack and paint them all yellow.

Just kidding, of course.  But not entirely.

An Unpublished Bulletin

Over three years ago, on Dec. 31, 1996 to be exact, we wrote an Annex Bulletin that was never published (see APPENDIX A).  “Spiked” is the term media editors would use.

The reason?  A source inside IBM double-crossed us.  First, this source kept spilling the beans about a supposedly secret, $21 million-study that McKinsey & Co. did for IBM.  As it turned out, this Gerstner’s former consulting “alma mater” had evidently come to similar conclusions as we had done much earlier - that IBM was still way too dependant on “big iron.”  Except that McKinsey did it with access to insider data, while we concluded that based on publicly available information.

Then just as we were about to publish the story, our source chickened out, fearing persecution by IBM senior management whose spokesperson had denied the existence of such a report when questioned about it. 

In other words, Armonk lied. 

Nevertheless, we killed the story (to protect our source).  Guess “banana empires” can be as dangerous as banana republics?

Well, over three years later, we think that it may be instructive to look back at that Annex Bulletin and compare it with what we know today about IBM’s position in the marketplace.  So we bring it to you as Appendix A to this five-year forecast for IBM.

As you will see, Gerstner & Co. had sufficient outside warnings that the Big Blue was in a bad strategic shape.  Yet with exception of pushing the services, a trend that we had both recommended (as far back as 1991), supported, and that had been in effect since about 1989 (in other words, services growth had nothing to do with any “vision” Gerstner and his cronies had produced), Armonk did very little to diversify away from both, the “big iron,” and the big customers that buy it.

Sooner or later, most people, even on Wall Street, will realize that it is no longer possible to correct such strategic mistakes by painting the “Big Blue” bananas yellow.

Happy bargain hunting!

Bob Djurdjevic

 

APPENDIX A

Volume XI, No. 96-56       (excerpts from An Unpublished Annex Bulletin)       Dec. 31, 1996

Copyright 1996 by Annex Research.  All rights reserved.

A Secret McKinsey Report Told the IBM Chairman What He Wanted to Hear - Grow the S/390 Business!

At IBM, S/390 Is Still King!

A $21 Million-Study Awarded to Gerstner’s “Alma Mater” as All Other Consulting Contracts Are Reportedly Terminated

PHOENIX - A secret, $21 million-study by IBM chairman’s former consulting “alma mater,” McKinsey & Co., reportedly concluded that IBM is strategically in a worse shape now than it was before Lou Gerstner took its helm.  At least that’s what some insiders think.  The reason?

Because the mainframe is still king at IBM.  And unless the company found a way of making the S/390 a growth business, its future profitability may be in jeopardy.  That’s because about 78% of what McKinsey called the “real profits” at IBM come from the S/390; about 11% from the AS/400, while all remaining IBM businesses contribute only 11% to the bottom line.  Insiders who have seen portions of the McKinsey report were unable to explain how this consulting firm arrived at the term “real profit.”  But whatever the methodology, the McKinsey numbers and its conclusions, which were apparently also recently presented to the IBM Board, fitted neatly with the Big Blue chairman’s view - “at our core, we are a technology company” (see ANNEX BULLETIN 94-12, 3/25/94).

“I think that they (McKinsey) must have taken all software, products and services which large customers use in their data centers and called it ‘S/390,’” one IBM insider speculated.

Text Box:  Which is quite plausible.  For, the S/390 and AS/400 hardware divisions, even with the operating systems software thrown in, would only account for about one-third of IBM’s net profit and less than one-fifth of IBM’s 1996 revenues.  But, as you saw in our ANNEX BULLETIN 96-42 (8/21/96), about 70% of IBM’s 1996 revenue comes from some 4,000 of its large customers.  Which would make the 78% S/390 profit share plausible if defined by customer set, rather than IBM’s current organizational charts.

If so, sounds like McKinsey hit on the same IBM strategic weakness as our above report - too much dependence on large customers - the “Dinosaurs Club,” as we put it last August - the industrial era elites whose market power and wealth has been eroded in the last two decades by the proliferation of cheap desktop technologies - the PC, the Windows and the Internet.

But unlike our recommendation, that IBM must break up so as to become nimbler, and should aggressively enter new consumer and small company markets, McKinsey seems to have given the IBM chairman a $21 million-answer he wanted to hear - grow the S/390 business.  Which means doing more business with ever fewer and smaller dinosaurs.  That’s some recipe for long term growth and prosperity!  With recommendations like that, IBM competitors can relax and rejoice.

Slow IBM Services?  It gets worse, though... (for IBM shareholders).  McKinsey has apparently also concluded that the most successful IBM operation in the 1990s, the IBM Global Services, including its outsourcing subsidiary, ISSC, is not profitable enough, and that its growth needs to be curbed.  And that, as a part of the effort to make the S/390 a growth platform again, IBM should foster friendlier relations with other IT services companies - the IBM Global Services’ competitors.

This recommendation may come as a shock to all those who have come to see IBM Global Services/ISSC as the world’s biggest and most successful IT services operation.  This includes Wall Street, which has only of late started to recognize that IBM services was by far the most profitable part of the company in 1995 (see ANNEX BULLETIN 96-19, 3/20/96).  About the only way someone could have reached such an odd recommendation (to stunt the growth of IBM services) would be if one were to credit all outsourced hardware, software and support services to the hardware platforms.  We estimate that the S/390 component may have accounted for about one-third of the values of the recent outsourcing deals.

Besides, if profitability were the main criterion of success (as we have argued in the past), we wonder what McKinsey has recommended that IBM should do with its unprofitable or marginally profitable hardware businesses?  (e.g., the PC division, which has also had a banner year in 1996 in terms of shipment volumes).

Split Personality. The fact that McKinsey has reportedly recommended that IBM coddle up to the IBM Global Services’ competitors, and curb its own, highly-successful services operation, is another sign of a “split personality” and inherent conflicts which result from its vertically integrated structure.  Which is why we thought that spinning off IBM services would avoid such management friction, as well as serve IBM shareholders’ best interests (see ANNEX BULLETINS 96-19, 3/20/96 and 96-42, 8/21/96).

Damage Control? No wonder the McKinsey study, which was reportedly procured through the offices of the chief IBM strategist, Bruce Harreld, has been kept so hush-hush at IBM that even some very senior corporate officers had not heard of it.  No wonder all IBM units have been reportedly ordered by the corporate communications office to terminate all their consulting contracts in 1997.  So that no other consultants would offer opposing opinions?  Or worse, from the “PR” standpoint, scoop out the secret McKinsey conclusions and recommendations?

Ostensibly billed as a part of the on-going efforts at IBM to cut expenses, an odd assertion considering the lavish ($21 million) IBM spending on Gerstner’s former “alma mater,” Armonk’s “austerity” moves seem to be, in fact, a damage control exercise by the keepers of Gerstner’s personal “PR” image.

Even before officially assuming the CEO position (on April 1, 1993), Gerstner had fired Akers’ head of “PR” and installed his own man - David Kalis.  It was the first Gerstner appointment as the new IBM CEO (see ANNEX BULLETIN 93-19, 3/29/93).  Both men joined Big Blue from RJR Nabisco, where they had held identical respective positions.

At the time, we interpreted Gerstner’s first move as a sign of “toughness, decisiveness and quickness.”  Which it was.  What we did not realize back then was that it was also a sign of cronyism and of his priorities - ME, first; IBM, second.  And his future imperial management style - “Le Big Bleu, c’est moi!” (see ANNEX BULLETIN 96-42, 8/21/96). 

New Imperial Court. Shooting potential messengers of bad news is not a new sport at Armonk.  In the waning years of the John Akers’ era at IBM, for example, the former IBM chief had also developed a “bunker mentality.”  He also tried to “control and manipulate things.”  And Akers’ top “PR” person was also more loyal to her boss than to the corporation which wrote her pay check, often to the detriment of the latter:

“We are convinced that many of IBM mistakes were a result of the subordinates feeding their bosses the pleasing, ‘politically correct,’ recommendations, rather than standing up for what they believed in with courage and conviction,” we wrote in the above referenced March 1993 ANNEX BULLETIN.  “Of course, the ‘spinelessness’ was not just the subordinates’ fault.  It was a result of people seeing the carcasses of messengers of bad news scattered around the IBM MC (Management Committee) room.”

Which was one reason we applauded the choice of an outsider for the top IBM job, figuring that a “new broom sweeps clean.”  We were hoping back in 1993, that the incoming Gerstner Administration would “eradicate the IBM culture’s corporate spinelessness” as one of its first priorities.

As it turned out, however, nearly four years later, the Gerstner Administration has merely evolved into a different imperial court.  “If you don’t kiss up to the ‘Emperor,’ forget about any promotions,” complained one IBM insider.

Nothing unusual there.  But even Akers, whom we mistakenly dubbed the “Last Emperor” in 1991, had never stooped as low as to deny his field generals the “radars and satellites” which help them maximize the effectiveness of their troops. 

One other “empire” did, however, the Soviet Union.  It also tried to “control and manipulate” the information.  And look where it is now - in the dustbin of history.  How long will it be before IBM starts to lose battles, and then wars?

So McKinsey may have been right, albeit for the wrong reasons, when it concluded that IBM was in a worse strategic shape now than it was when Gerstner took over. r

P.S. On Dec. 31, 1996, the IBM stock was worth $38.88.  In July 1999, it reached its all time high of $139.  Now (June 1, 2000), it is still trading around $108.  “They shoot people for abuses like that in banana republics…”  


NOTE: The print edition of this report, of course, contains additional charts and tables not included here.

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Volume XVI, No. 2000-15
June 1, 2000

Editor: Bob Djurdjevic
Published by Annex Research;
e-mail: annex@djurdjevic.com

P.O. Box 97100,      Phoenix, Arizona 85060-7100
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