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IBM CORPORATE

Annex Research Five-year Forecast for IBM

Save, Spend and Split

A Three-pronged Strategy Recommendation: Key to IBM’s Growth Beyond 2004 Will Be Savvy Acquisitions

PHOENIX, May 8 - Now that Sam Palmisano is firmly in control of the Big Blue battleship, people have been asking us what strategy advice we would give him, just as many kept popping the same question 10 years ago, when Lou Gerstner took over the IBM helm (see “Gerstner Spills the Beans…”, Dec 2002).

Well, our advice to Sam would be pretty simple.  We see a three-pronged triad that could be the basis of continued IBM turnaround and growth.  It could be summed up as a “triple S-strategy” - Save, Spend and Split.  And here’s why…

The only way Big Blue may get nimbler and substantially bigger beyond 2004 is through savvy acquisitions, preferably in the services sector.  Which is basically the same advice we offered the IBM CEO over a year ago (see “From Here to Eternity…”, Apr 2002).  Here’s an excerpt:

“As to… 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.”

For, IBM’s chances for substantial “organic” growth beyond 2004 are well… slim to none.  That’s one of the conclusions we reached last year, and again now, upon completing the 2003 update to our five-year forecast for IBM.  Here’s what we said a year ago:

“Had Gerstner had the foresight to do it (grow by acquisitions), can you imagine how many creative ventures a company could have acquired for $46 billion it has squandered on share repurchases?”, we said in “From Here to Eternity…” (Apr 2002).

But first things first…. Before being able to spend billions of dollars on such acquisitions, IBM will first have to Save.  So forget the wasteful stock buybacks, for example, as we also said over a year ago:

“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.” (see “From Here to Eternity…”, Apr 2002).

Well, Sam appears to have listened.  Dropping stock buybacks was one of the first major decisions IBM’s new CEO has made to reverse the hemorrhaging of cash on unproductive scams that his predecessor had instituted (see “Turnaround Continues...”, Apr 15, and “Start of a Real Turnaround?”, Jan 17). 

Last but not least, IBM will have to Split up if it is to grow.  Yes, partly along the line of the IBM break up that we proposed over seven years ago (see "Break Up IBM!", Mar 1996).  But also internally, like an amoeba, so as to facilitate renewed growth (see Annex Bulletin 93-17, Mar 1993).  Such is the price of success.  The bigger you get and the faster you grow, the more often you have to split up so as to continue growing:

“As the Austrian sociologist, Leopold Kohr, wrote in his 1957 book, ‘The Breakdown of Nations,’ (that’s right - 1957, not 1975!), ‘it is always bigness, and only bigness, which is the problem of existence - social, as well as physical.’ Kohr concluded that the only solution must lie in cutting down of the substances and organisms which have ‘outgrown their natural limits’.” (see “Death of Corporation,” July 1999).

In business, determining what such “natural limits” are is both an art and a test of a CEO’s mettle and humility.  Most industrial era’s CEOs have tended to be empire builders.  They thought that “bigger is better.”  The former IBM CEO was one of them. 

Big Blue needs the other kind.  It needs a CEO who will recognize that bigness can be a handicap, not just an advantage.  And that nowhere is that truer than in the IT services business.  Over the next five years, we’ll see what kind of a CEO Palmisano will turn out to be.  It will be his Split strategy, or a lack thereof, that will tell the tale.

Five-year Forecast

Barring IBM’s adoption of our three-pronged recommendation, Big Blue as we know it today will begin to shrink again after 2004.  And it may never again reach or surpass the revenue peak of $88.4 billion it attained in 2000. 

We expect IBM revenues to decline at a compound annual rate of 1% during the next five years (2003-2007).  But, the revenues will grow by about 8% this year, and before flattening out in 2004.  After that, stand by for their descent to pre-1997 levels ($78 billion) over the following three years (see the chart on page 2).

As we’ve already noted in “Shrunk by the Marketplace” (Apr 17), IBM 2002 revenues were merely at the same level it was five years earlier (in 1998).  Which means that, unless IBM adopts an aggressive acquisition strategy, the company will have wasted a decade by basically staying put or shrinking.

One reason for an expected lack of growth over the next five years is that IBM is in too many declining businesses.  The only Big Blue business unit that can be expected to show any kind of growth is IBM Global Services (IGS). 

We figure that the services (without maintenance) will grow by about 7% annually between 2003 and 2007.  That’s when it will account for about $43.4 billion or 56% of IBM’s total revenues.  With maintenance, which we figure will decline at about 3% annually, IGS will represent about 61% of IBM’s total in 2007. 

IBM hardware products, on the other hand, not long ago the mainstay of Big Blue’s business and its pride and joy, will drop by 13% compounded annually between 2003 and 2007.  Hardware will account for only $16 billion or just over one-fifth of IBM revenues five years from now.

Software revenues will also drop, albeit at a slower rate.  They will decline at 1% annually to 16% of IBM 2007 revenues.

As a result, IBM profit margins will erode as will the company’s earnings.  Big Blue gross margins have already dropped from 56% to 37% between 1990-2003.  Operating margins shrank from 16% to 11% during the same period.

IBM net margins, on the other hand, had remained relatively stable between 1990-2001 (at about 8% to 9%), despite the many turbulent changes that had taken place at Armonk during the 1990s decade.  Then they tumbled to 4.1% in 2002, mostly on the heels of the write-offs associated with sale of hard disk products to Hitachi.

We expect the IBM net margins to bounce back this year to just over 8%, and then rise again to 9% in 2004.  After that, however, the negative effect of IBM’s declining hardware businesses will take its toll on IBM earnings.  As a result, the net margins will slide down to about 5% in 2007. 

That’s barring any unforeseen calamities during that period, of course, which could make things even worse for Big Blue.  Or better, if Big Blue decides to Save, Spend and Split. 

Happy bargain hunting!

Volume XIX, No. 2003-09
May 8, 2003

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

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