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Annual Annex Research Five-year Forecast for IBM

From Here to Eternity…

…Will Be a Downhill Slide for IBM, Unless Something Radical Happens

PHOENIX, Apr. 29 - If “Only Diamonds Are Forever,” as James Bond thought, then Big Blue certainly isn’t a diamond.  Nor is the IBM future another “From Here to Eternity” script. 

It’s only fitting that this Annex Research report is being published on the eve of IBM’s 2002 annual meeting, the first for Sam Palmisano as the new CEO.  For, we suspect that he may dwell on the past. 

After all, 87 years of almost unfettered growth is about as close as any corporation can come to being “eternal.”  Over $1.2 trillion of aggregate revenues, and some $92 billion of cumulative net earnings are proof of it (see “Gerstner’s Legacy: Good Manager, Poor Entrepreneur”, Jan. 2002) 

But what we do not expect Palmisano to tell the shareholders is the sad truth - that the party is over.  Unless something pretty radical happens pretty soon, from now on, Big Blue is in for a downhill slide… eventually into oblivion.  Five years from now, IBM will be a considerably smaller company making a lot less money than today.  That’s the bottom line conclusion of our 2002 update to the Annex Research annual five-year forecast for IBM.

Actually, the Big Blue party has been over for some time now, as you - our clients - know very well (see our IBM 5-year Forecast 2001: An Unenviable Legacy, June 2001).  But Wall Street seems to be discovering it only now, and even at that, rather timidly [still hoping for growth in 2003 (!?) - see “On Wall Street, Sky Is Always Bluer - Next Year!”, Jan. 2002]. 

The outgoing chairman, Lou Gerstner, and more than a dozen top IBM executives who cashed in on their stock options while pulling the wool over the eyes of Wall Street Sheeple and the public, also knew the party was over (see "Sir Lou OutLayed Lay!", Apr. 1, 2002, and "Gerstner: Best Years Are Behind", Aug. 10, 1999).  But they kept the con game going for as long as they could.

So the surprise is not that IBM is on a downhill trend.  That’s something we’ve all discerned several years ago (see "IBM's Best Years Are 3-4 Decades Behind", July 1999).  The “new news” in our latest forecast is that the slope of decline seems to be steeper than we thought a year ago.

The reason?  First, the Armonk farm is running out of white rabbits.  The New York State Attorney General, the Justice Department, and the SEC are combining to deprive the Big Blue accounting magicians of white rabbits they have been pulling out of their black hats (see “Smoke and Mirrors Galore,” July 2000 and  SEC Launches Formal Probe of Wall Street Research, Apr. 25, 2002),  “SEC to Tighten Stock Option Rules”, Apr. 5, 2002). 

The IBM shareholders should thank Enron’s Ken Lay for the sudden vigilance of heretofore slumbering financial policemen.  Because we are likely to be getting more truth and less fluff from now on.

The second reason is that ever since the demise of its mainframe cash cow, which peaked in 1990 (see the above “hockey stick” chart), IBM “has been a one-string violin.”  That one good string, of course, was the IBM Global Services unit (originally known as ISSC, founded 11 years ago - see “IBM Reenters Services Business,” Annex Bulletin 91-27, May 17, 1991). 

And now, even that one string is fraying (see “Tough Times, Soft Deals,” Apr. 25, 2002).  After a rough start (a 3% revenue decline in the first quarter), we expect IGS to show modest growth this year.  But unless that unit also changes its tack dramatically, we estimate that 2002 may be remembered as the peak year for IBM services, as 1990 ended up for its mainframe business.

Which means that those among the IBM competitors (or partners) who have been used to playing the “follow the leader”-game in lieu of crafting their own strategies, are likely to find themselves eventually, like the Japanese mainframe lemmings 10 years ago, squished, bruised and crushed at the bottom of the hill (see Industry Stratification Trend, Mar. 30, 1990).  

Hard to Believe?

Hard to believe?  Still some “Doubting Thomas’s” around?

Trust us, it’s no harder to believe that than it was believing that value would eventually go out of computer hardware and into software and services (that was our 1986 prediction, see Annex Bulletin 86-44, Nov. 6, 1986, reinforced again in 1990 - see Industry Stratification Trend, Mar. 30, 1990).

Or when we said in the same March 1990 Annex Bulletin that by the end of the decade, the IT services companies would be at the top of the food IT industry’s food chain, and the all-powerful Japanese would be in trouble (see the chart).

Or when we wondered at the IBM annual meetings at the height of another IBM omnipotence era (in 1983-1984), why “IBM Is Mortgaging Its Future?” (see Annex Computer Report, Mar. 1983), using some $35 rent-to-purchase conversions as its white rabbit of the day.

Or when we questioned the IBM chairman at the 1997 IBM annual meeting in Dallas why he was similarly using stock buybacks to create an “illusion of prosperity?” (see Stock Buybacks Questioned: Is IBM Mortgaging Its Future Again?, 97-18, 4/29/97).

Or when Dennie Welsh and yours truly practically had to drag the then IBM new leaders (Lou Gerstner and Jerry York - in their first year on the job), kicking and screaming away from their hardware infatuation, and into realizing that the name of the game for the 1990s will be IT services (see “ISSC: A Model Operation,” Annex Bulletin 94-06, Jan. 1994). 

Here’s an excerpt:

“So, should ISSC be a role model for IBM in the 21st century?  No.  ISSC should be the role model for IBM marketing and services units - today!  Who's got time to wait for the 21 century?!  The battered IBM shareholders certainly don't...”

Eventually, top IBM leaders came around to realizing that, too.  And by 1996, ISSC became the global leader of the IT services industry, the position it still holds, at least in terms of size.

So you can take our forecast or leave it.  But at least now you know which end has been up in the past.

Segment Forecast

As for our detailed segment-by-segment forecast, they say “picture is worth a thousand words.”  Our charts and tables do not paint a pretty picture.  They assume, of course, that IBM does nothing dramatic, but rather follows the course that the Gerstner administration has proudly set for the company (before Sir Lou bailed out, of course).

We expect the overall IBM revenue to decline at a compound annual rate of 7% during the next five years.  This compares to a 2.5% compound annual growth in the last five years, with $88.4 billion in 2000 being the peak.

IBM net earnings are likely to erode faster (about 17% per year), due to shrinking margins and sizeable fixed costs.

This suggests that if there is anything certain about the IBM future, it is that the dirty word “layoffs,” or the more acceptable “restructuring,” will once again figure in it.  (“Poor Sam?”  Actually, “poor IBM employees” seems more appropriate).

Hardware, which has already shrunk so much that it is already smaller than the IBM Global Services, will continue to contract during the next five years at about 14% per year.

As for IGS, after a likely spurt in the second half of this year, we expect IGS to continue to shrink.  As long as it only pursues its large company focus, IGS will continue to slide downhill along with its best customers.  Which means a 3% annual decline over the next five years, about the same rate as that of IBM software.

With hardware maintenance and hardware-driven rentals and financing also shrinking at about 4% annually, we just don’t see any upside potential in IBM’s existing businesses.

What’s To Be Done?

So “what’s to be done?”  That’s a perennial quandary of business leaders, especially when their businesses head south.

In a nutshell, what IBM needs is another revolution.  Assuming, of course, that this time, it would fight on the right side, for a change.

IBM started the PC Revolution in 1981, only to surrender most of its spoils to Microsoft.  

Infatuated with its self-importance and centralized computing, IBM never caught on to the network-driven “client/server” trend of the mid-1980s.  It lost many battles to DEC, then the omnipotent-looking competitor, before regaining some respectability in the 1990s.

Text Box:

IBM almost missed the Internet Revolution, which its chairman initially called “network-centric computing,” and thought it was about enterprises, not individuals (!?) [see “Louis XIX of Armonk,” (Aug. 1996)].  

What IBM needs to do if it is to reverse the looming decline is at least two things. First, start marketing aggressively, and not just paying lip service, to medium and small companies, the growth engine of the U.S. and global economy.  Second, be sure to catch the next wave, whatever that is, and whenever it occurs.  

We’ve already told you in our Friday’s Annex Bulletin that the growth is from the bottom (see “Tough Times, Soft Deals,” Apr. 25, 2002).  Amid the woeful cries about bad luck and weak demand by IBM and other IT vendors, which have been resonating down the Wall Street canyon, came Friday’s report by the U.S. Commerce Department indicating the U.S. economy grew at a 5.8% annual rate in the first quarter, the fastest growth in more than two years!

Consumer spending rose 3.5%. Business investment fell 5.7%, the fifth straight decline. Military spending rose 19.6%, fastest since 1967. Imports cut 1.2 percentage points from GDP.  Etc.

This suggests that the IT vendors and the U.S. economy come from two different planets.  But the truth is that most IT vendors are reaching for the low hanging fruit - the large companies’ business - and are thus missing the boat at the low end of the customer pyramid, where the growth is.

The sooner IBM and its competitors realize that, the sooner will they all have a chance to return to growth, rather than moan about a lack thereof.

As to the second point - catching the next wave, the best way to do it is not for Big Blue to sit around and pray, hoping the inspiration would magically come out of the blue.  Rather, IBM should go out and seek it proactively - meaning IBM should go fishing.  Instead of wasting money on stock buybacks, IBM should start buying up a whole lot of promising upstarts, hoping to find a pearl among the oysters.

Had Gerstner had the foresight to do it, can you imagine how many creative ventures a company could have acquired for $46 billion it has squandered on share repurchases? 

But that’s water under the bridge now.  The first signal of whether or not Sam Palmisano is up to the job of returning IBM back to growth will come on just that issue - stock buybacks.  If he allows that nonsense to continue, most sensible shareholders should head for the hills.  And most valuable IBM employees should get their resumes out on the street, before the hordes of laid off Big Blue Sheeple get theirs.

Happy bargain hunting!

Bob Djurdjevic

[Also check outSam's Dull Scalpel (June 4), Looming IBM Write-offs (May 23), "No New News at IBM" (May 15),  "Looming IBM Layoffs" (May 14),  "Sam Is No 'Change Agent'," (May 6), Additional Stock Buybacks Authorized (Apr. 30, 2002),  "IBM 5-Yr Forecast: From Here to Eternity?" (Apr. 2002),  “Tough Times, Soft Deals,” (Apr. 25, 2002), "A Disastrous Quarter," (Apr. 17),  Industry Stratification Trend (Mar. 30, 1990),  “Gerstner’s Legacy: Good Manager, Poor Entrepreneur” (Jan. 2002),  "Big Blue Starting to Unravel," (Apr. 8, 2002), SEC Launches Formal Probe of Wall Street Research (Apr. 25, 2002),  “SEC to Tighten Stock Option Rules” (Apr. 5, 2002), "Sir Lou OutLayed Lay!" (Apr. 1, 2002), "IBM Pension Fund Vapors," (Mar. 23, 2002), Is IBM Cheating on Taxes, Annex Bulletin 99-17 (May 1999),  IBM 5-year Forecast 2001: An Unenviable Legacy (June 2001) "Break Up IBM!" (Mar. 1996), Fortune on IBM (June 15, 2000), “Smoke and Mirrors Galore,” July 2000), Annex Bulletin 98-14 ("Wag the Big Blue Dog"), Armonk's Fudge Factory (Apr. 9, 1999)Where Armonk Meets Wall Street, Greed Breeds Incest (November 1998)Stock Buybacks Questioned: Is IBM Mortgaging Its Future Again?, 97-18 (4/29/97),  "Some Insiders Cashed In On IBM Stock's Rise, Buybacks" 97-22, 7/27/97,  Djurdjevic’s Forbes column, "Is Big Blue Back?," 6/10/97;  “Executive Suite: How Sweet!,” (July 1997), "Gerstner: Best Years Are Behind", Aug. 10, 1999), "IBM's Best Years Are 3-4 Decades Behind Us" (July 1999), "Lou's Lair vs. Bill's Loft" (June 1999),  "Corporate Cabbage Patch Dolls," 98-39, 10/31/98; Djurdjevic’s Chronicles magazine October 1998 column, "Wall Street Boom; Main Street Doom", “Louis XIX of Armonk,” (Aug. 1996), "Mountain Shook, Mouse Was Born" (Mar. 25, 1994) etc.]

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Volume XVIII, No. 2002-12
April 29, 2002

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

P.O. Box 97100, Phoenix, Arizona 85060-7100
TEL/FAX: (602) 824-8111

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