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Annex Bulletin 2005-15                            May 23, 2005

Confidential Client Edition

 

IBM CORPORATE

Updated 5/23/05, 11:45 AM PDT (adds several charts)

Update to Annex Research’ Five-year IBM Forecast

Tweaking Big Blue

IBM Touts Its “Small Is Beautiful” Strategy (SMB, Emerging Markets), New Growth Businesses, But Message Falls on Deaf Ears on Wall Street

PHOENIX, May 23 – It was supposed to be Big Blue’s usual semi-annual dog-and-pony show for Wall Street analysts.  But the Friday (May 20) half-day session turned out to be much more than that.  After a disappointing first quarter (see “Slammed and Dunked,” Apr 2005), it was a chance for top IBM executives to demonstrate to investors that they’ve got a handle on the problems and a sound strategy to overcome them.

They did it by stressing the importance of the small and medium business (SMB) market, of  emerging (large) countries, of BPO (business process outsourcing), and of solutions and globalization in general. 

IBM CEO, Sam Palmisano, declared that the company was “back on track” after it “hit a bump” in the first quarter.  Speaking of the recently announced globalization and redistribution of resources, he said, “these moves are not just about lowering labor costs; they’re about doing the right tasks, with the right skills, in the right places.”

IBM expects the productivity gains to deliver $300 million to $400 million of net cost savings per year.  It hopes to grow 1.5 to 2 times faster than the GDP, and plans to generate another 1% to 2% of revenue growth through acquisitions – for an aggregate annual revenue growth of 5% to 8% over the next several years.

Other IBM executives sounded similarly bullish. 

“Strategic actions that we have taken have improved the financial profile of the company, with a solid balance sheet, strong cash flow, investments in profitable growth,” boasted Mark Loughridge, the CFO.  “As we execute this strategy, there will be bumps along the way, but we’re positioned to capitalize on the emerging growth opportunities.  We’re committed to delivering a double-digit earnings growth over the longer term.”

The messages fell on deaf ears.  Despite such bullish comments, the IBM stock dropped about 1% at the start of trading; cut its loss in half mid-way through executive presentations; and then dropped again at the end of trading, even as the Dow Jones industrials average, of which IBM is a part, rose later in the day (May 20 – see the chart).

SMB Market.  One reason for Wall Street’s phlegmatic skepticism may be that there really wasn’t much new in IBM strategy or tactics.  The company has been talking about the SMB importance for over two years now (see “Finally Heard,” Jan 2003, “Finally Heard – Part II,” Nov 2003; “SMB Express,” [clients click here] Feb 2005, and our iSeries Whitepaper).  Can the leopard change its spots?  For, the results have not backed up IBM’s rhetoric. 

“For the full year (2004), the SMB (small and medium size business) grew at a lower rate than IBM as a whole (8% vs. 9%), giving rise to questions if Big Blue’s SMB campaign may be running out of steam,” we wrote in January.  In other words, 2004 was a year of a tepid increase for what is supposed to be IBM’s fastest growing market.

Text Box:  
 
(An excerpt from “SMB Express,” Feb 2005)

IBM seems to agree.

“In the SMB market, we have less than 3% share,” said John Joyce who heads up the $36 billion-IBM Global Services (IGS), the company’s biggest unit whose first quarter sub-par performance dragged down the overall results.  “By the way, we are the leader with less than 3% share.”

“IBM has only been a large enterprise-type company and big deals,” Joyce added, contrasting its tiny SMB share with an 8% market share for all enterprises.  “We in services… need to be able and cover smaller transactions.”

No kidding.  We’ve been preaching that since at least 1996 (see “Break-up IBM,” Mar 1996).  But this time, with its feet held to the fire by the poor first quarter showing, Big Blue seems to be finally doing it.

“Small is beautiful, and we’re thinking small while acting big (globally),” was IBM’s implied message to Wall Street.  And the company is putting its money where its mouth is.

Text Box:  So IBM is investing about $300M in business partner relationships.  “Our (services) business in the SMB market grew slightly faster than the rest of the business, based on the initiatives with business partners,” Joyce said.  He added that a number of new short-term incentives for the IBM services sales force would help it focus on SMB rather than “everybody hovering over the megadeals.”

Again, Halleluiah!

Text Box: Mixed Messages
 
Even as IBM claims to be now catering to SMB market, it is projecting a clubby corporate image with ads like this one at New York’s LaGuardia airport
“The hotly contested ‘megadeals’ are often like the game of chicken:  The last bidder to say ‘no’ gets stuck with the deal,” as we put it in the Annex Bulletin 94-46, Oct 1994, - i.e., more than a decade ago!

“The megadeals have been declining over the last several years,” Joyce said.  “The average size of a megadeal has been cut in half over the last three-to-four years.  And even large customers have been reducing the size and the length of their transactions.”

So IBM needs to be able to handle more smaller transactions, he concluded.  (There are) “lots of activities around incentives and coverage of smaller transactions, so we don’t have the experience we had in the first quarter.”

BPO Market.  Another arrow in IGS’ (and, therefore, IBM’s) quiver is the business process outsourcing (BPO) market, which IBM calls Business Performance Transformation Services (BPTS). 

Like the SMB market, the BPO idea is nothing new.  Accenture, for example, has been pitching the concept since at least 1996 under the name “transformational outsourcing.”  Perot Systems called it “functional outsourcing” in about the same time frame (see the “Holy Grail” story, slide - Jan 2004).  As other vendors hopped on the BPO bandwagon, they tried to market it under new different names as if it were an original idea.

Whatever the name, the concept is fairly simple, though the execution is anything but.  An IT services vendor breaks down the client’s business processes into discrete modules; automates them in a factory-like style; and then rearranges them in a new way so as to make the client more nimble and efficient.

That’s BPO in a nutshell.  It’s like using Lego pieces to create forms of art (see some samples from Legoland).  As we put it in our “Holy Grail”-piece, that takes creativity:

The IT services vendor brings to the table his toolkit and paints.  The toolkit consists of various building blocks, along with instructions on how to use them.  Just as software development, for example, evolved from writing individual lines of code, to using macros and icons and applets to speed up the creative process, so will the creation of new corporate forms – using the various IT building blocks.

 

The IT services vendor also teaches the client how to use his tools and paints and brushes.  Together with the client, he designs a kaleidoscope of shapes that the client CEO wants his ‘adaptive enterprise’ to take, depending on the needs of the marketplace.”

So we advocated a new corporate position – that of a Chief Creative Officer – “a corporate artist of sorts (even if the term sounds like an oxymoron)”:

“The CCO would play the role of the virtual mother in procreation of the ‘adaptive enterprise,’ partnering with the corresponding number at the IT services company (the virtual father).  The CCO should report directly to the CEO and have the power to cut through the bureaucratic webs that tie his corporation to the old legacy systems and habits.”

(Excerpts from “Holy Grail”, Jan 2004)

Back from theory to practice, the BPO market has been and will be the IT services industry’s fastest-growing segment.  In IBM’s case, it was up 87% in signings, and up 64% in revenues in the latest period.  “It is already delivering about one-and-a-half points of growth to the services business,” said IBM’s Joyce.

IBM expects the overall services market to grow at 6% over the next four years, but the BPO segment will grow at 10% per year, Joyce added.

IBM expects overall outsourcing to continue to grow, albeit at a reduced rate (8% per year).  Integration services and consulting will grow at 6% and 5% per year respectively, while maintenance will decline at 2% per year (see the chart).

Services Acquisitions.  Finally, IBM seems to have also heard us on the need for acquisitions in the services market:

“Looks like Big Blue is partially implementing our recommended “Save, Spend & Split”- growth strategy.  We first annunciated it two years ago, and reiterated it last April (see “Save, Spend and Split,” May 2003, and “Ditto, Ditto! Is Anybody Listening?”, Apr 2004).

IBM is spending some money on some (small) acquisitions in the services arena, and it has split off a major chuck of its unprofitable hardware portfolio (see “Good Riddance, Finally?,” Dec 2004).” 

(see “Quality over Quantity,” Mar 2005)

On Feb 2, for example, IBM beefed up its financial services unit’s “Lego collection” with an agreement to buy Equitant, a company that caters to clients looking to outsource their financial administration.  A Dublin, Ireland-based company, whose 200 staff manage about 44 billion euros ($57 billion) in client assets, provides web-based order-to-cash services. 

IBM also bought this year Corio (SMB, BPO benefits), HealthLink, and Liberty Insurance Services…

IGS’ embryonic acquisition strategy is not nearly as well defined and strategically focused as is IBM software unit’s, for example.  That’s where growth by acquisitions (42 and counting) has been a part of its business MO (modus operandi) for about a decade now (see the chart).  But it is a start and a step in the right direction for both IGS and IBM.

Software.  Like IGS’ Joyce, the head of IBM software, Steve Mills, also talked about downsizing of transactions.  “Our typical transaction size is now (only) $50,000,” he said. 

So IBM software unit faces similar challenges as does IGS – doing more for less.  But having been at it longer, and having been hardened in tough battles against vigorous competitors, IBM software already has an impressive track record of growth through acquisitions and partnerships.

More than 10,000 people in Big Blue software unit’s sales and support function work with its 8,000 partners.  And these range from Independent Software Vendors (ISVs), to systems integrators, to resellers.

IBM Software Partners:

ISVs

100+ Global ISVs

2,000+ Regional ISVs

System Integrators

75+ Global SIs

2,300+ Regional SIs

Resellers

2,500+ Value Added Resellers

1,000+ Software Resellers

And sometimes, IBM software gets to play offense even against the industry’s most formidable foes, such as Microsoft, the largest software company in the world.

“It’s a dog-eats-dog fight out there in the software business,” Mills said.  “We actually go after the competitive installed base.  Last year, we converted over 300 Microsoft Exchange customers to Lotus Notes.  We were able to do it because we offer a better value proposition, better scalability, and a far superior security.”

Low key and quietly confident, Mills has handled 42 acquisitions in the 1995-2005 time frame, more than any other IBM executive.  And the IBM acquisition effectiveness is improving, according to Loughridge, the CFO.  In 2000, about 34% of acquisitions met or exceeded IBM expectations.  That percentage has surged to 74% in 2004.

Mills’ unit also invests $2 billion annually in development, about a third of IBM’s corporate R&D budget.  And much of it goes into the so-called “middleware” products  (e.g., WebSphere, Tivoli, DB2, Lotus Notes...) that have helped fuel the zSeries (mainframe) revival.

“Our strategy hasn’t changed; our focus is on middleware software,” Mills said, the largest IBM software segment that accounts for about a half of its business (see the chart).

Hardware.  Bill Zeitler’s presentation on the company’s hardware strategy was probably the most upbeat and the most candid of all IBM executive comments. 

“After several years of outgrowing the market and gaining share, we turned in a very disappointing performance in the first quarter,” he said, not trying to mince words or come up with excuses.

While IBM was busy completing the Lenovo PC deal, Dell and other competitors selling computer servers pounced on IBM's low-end server business.  “We weren’t fast enough to respond,” he said.  Zeitler also cited problems with a long-delayed data-storage machine and weaker-than-expected mainframe sales.

Zeitler then stepped through his individual product lines’ strategies and remedies that have been put in place.  On the mainframe side, he noted that its security, integration qualities, along with new workloads (Linux, Java), would ensure that the zSeries resumes its upward march (just as we also noted in our zWhitepaper: “Poughkeepsie Spring”).

“There is now twice as much (mainframe) capacity installed worldwide than there was in October 2000, when we brought the zSeries out,” Zeitler said (see the chart).  Which means that in the last five years, as much new mainframe computing power was created as in the first 35 years of its existence.

Zeitler was also optimistic about IBM’s low-end servers.  “I am pretty sure we’ll be the fastest-growing Intel server again for the rest of this year,” he said.

Text Box:  But perhaps the most significant systems and technology unit’s new strategy, and arguably the only real new IBM strategy, was its Engineering & Technology Services (E&TS) business.  No responsible company would outsource its R&D, Zeitler opined, but many realize that there is symbiotic value in R&D collaboration. 

“We believe that there is a very substantial opportunity in this market,” he said.

Indeed, the E&TS new contract signings shot up 96% in an otherwise lackluster IBM first quarter, according to Joyce, whose IGS helps Zeitler sell his new idea to prospective customers.  Microsoft (xBox360), Sony, Nintendo – all leading gaming and entertainment providers that sell to consumers – are among the E&TS best customers.  Which gives IBM a sort of a back door entrance into the consumer markets – a business area from which Big Blue has been virtually absent since its inception.

In short, “we are positioned for growth,” Zeitler summed it up.  And so is evidently IBM, Wall Street’s phlegmatic reaction to its latest strategy report card notwithstanding.

Emerging Markets.  IBM’s discovery that the world’s major emerging markets (Russia, India, Brazil, China) may be the key to its future long-term growth, is perhaps the only relatively new strategy that Big Blue unveiled both on May 20, and on April 14, when it released its first quarter results.

In 2004, these four countries contributed a point to IBM’s 8% growth.  Their aggregate $4.2 billion revenues grew at 25%, over four times the corporate average.  In the last two years (2002-2004), IBM’s business in Russia surged by 59%, in India’s by 49%, in Brazil by 21%, and in China by 15%.  That’s several times faster than the competition, IBM claims.

The growth of IBM’s much larger business in its traditional major western countries pretty much stalled during the same period.  Japan and Germany markets declined by 1% and 2% respectively in 2002-2004, while France, U.K. and U.S. ones grew by 2%, 3% and 4% respectively.

Again, no surprise there.  The IBM chart shown to Wall Street on May 20 mirrors that which we published in June 1996, when we first advocated Big Blue’s investments and expansion in the emerging markets (see “Eastern Europe’s Renaissance”).  More recently, we did it in an October 2004 report (“To Russia with Love and $$$”).  Once again, it seems that IBM has to have its feat held to the fire before it starts shuffling them. 

And shuffling the resources from low growth-high cost western countries, to the high growth-low cost emerging markets, is what the latest IBM restructuring is about, according to Doug Elix, the company’s top global sales and distribution executive, who delivered a lively and interesting talk.

“A massive shift of resources to high growth areas, both geographic and horizontal,” is under way, Elix said (see the charts for details).  IBM is targeting growth where technology drives the creation of business value.

Solutions.  Elix and other IBM executives also talked about “solutions opportunity” as if it were a novel idea:

“Solutions are growing faster than the rest of the market. While point products will remain an important part of our business, we need to focus on high-value solutions to meet clients’ needs and drive our growth” – reads the sub-heading from a Doug Elix chart.

Actually, IBM’s former CEO, John Akers, also sought refuge in solutions rather than products when he first ran into trouble 17 years ago:

“In 1988, Akers repeated this management feat as he urged IBM's people to orient their thinking away from IBM products, and toward the customer "solutions."  Therefore, one could rightfully dub 1988 as "the year of the solution" -- as we did contemporaneously in one of our ANNEX BULLETINS.”

(An excerpt from “Akers: The Last Emperor?”, June 1991)

But talk is cheap.  Akers’ did not walk his talk.  So we all know what happened to him in the end (Akers – see “A Nice Guy Who Lost His Compass,” Jan 1993).  It was not until IBM put some muscle into services in the early 1990s that Big Blue began to be perceived as a services, not just a product, company.

Summary & Outlook

IBM has already shifted its model from commodity-like businesses to higher-value-higher-margin operations through divestitures and a change of strategic emphasis, especially in the last three years, said IBM’s Loughridge, the CFO (see the above chart and “Quality over Quantity,” Mar 2005).

This trend will continue in the next four-to-five years, though the rate of the margin improvement will diminish over time.

Since there has not been much new in IBM’s May 20 Wall Street pitch, there is not much change to our forecast.  Overall, we expect a 2% compound annual growth in IBM revenues over the next five years.  But thanks to the sale of the PC business to Lenovo, and the continuation of the company’sText Box:  emphasis on quality over quantity, this will translate into a 6% compound annual growth of net earnings. 

By 2009, IBM should be a $106 billion-company with double-digit (11%) net margins.  And that’s the kind of outlook the IBM shareholders should be cheering, instead of panning, as they did on May 20 (also see the forecast charts below).

Happy bargain hunting!

Bob Djurdjevic

For additional Annex Research reports, check out... 

2005 IT: Tweaking Big Blue (May 2005); Dell Rings the Bell (May 2005); Stock Buybacks: The Phantom Is Back (May 2005); EDS Misfiring on All Cylinders (May 2005);  HP Surges, Dell Slumps; Lenovo Completes IBM Deal (May 2005);  Capgemini Jettisons Healthcare in N.A. (Apr 2005); HP: From India to Poland (Apr 2005); IBM: Slammed and Dunked (Apr 2005); Accenture: Roaring Ahead (Apr 2005);  Fujitsu Unveils New Servers (Mar 2005);  EDS Executive Suite; HP's New CEO (Mar 2005);  An iSeries Revival (Mar 2005); EDS Booster Club Fees Rise (Mar 2005);  An Upside-Down View (Mar 2005);   The Worst of Both Worlds (Mar 2005);   Octathlon 2005: Accenture Wins (Mar 2005);  IBM Global Services: Smaller, Shorter - Better? (Mar 2005);  IBM 5-yr Forecast: Quality over Quantity (Mar 2005); Rumor Lifts EDS', Fujitsu's Shares (Mar 2005); Capgemini: Turning the Corner (Feb 2005);  IBM Servers to Grow Again (Feb 2005);  Carly's Fickle Fans (Feb 2005);  CSC: Gearing Down on Purpose (Feb 2005);  EDS: Grossly Overpriced Stock (Feb 2005);  IBM Historical Update: 2004 Shot in the Arm (Feb 2005); New HeadTurners Series #1 (Feb 2005); IBM: A Crescendo Finale! (Jan 2005); Accenture: Strong Finish, Better Start (Jan 2005); Annex Coverage 2004: IT Services Dominate (Jan 2005)

2004 IT: EDS: The Titanium Stock (and other Wall Street tales) (Dec 2004); IBM PC: Good Riddance (Dec 2004); Fujitsu: Recovery Continues (Nov 2004);  IBM Server Renaissance (Nov 2004);  HP Hits Home Run (Nov 2004); Capgemini: Revenue, Stock Soars (Nov 2004); EDS: Jordan's Swan Song? (Nov 2004);  To Russia with Love and $ (Oct 2004); IBM: Slow Quarter No Longer (Oct 2004); Accenture: Revenues, Profits Up, Stock Down (Oct 2004); Capgemini: A Takeover Target? (Oct 2004); Sellout of America (Oct 2004); Spy Wars (Sep 2004); Outsourcing Boomerang (Sep 2004); EDS to Cut Up to 20,000 More Jobs (Sep 2004); Capgemini Stock Plummets on Unexpected Loss (Sep 2004); HP Savaged by Wall Street (Aug 2004); Moody's Lowers the Boon on EDS (July 2004); HP: Delivering Value Horizontally (June 2004); Accenture: Revving Up a Notch (June 2004); Beware Your CFO! (May 2004)IBM: Changing of the Guard (May 2004); Capgemini: Texas-size Home Run (May 2004); Following the Money (May 2004);  EDS: On a Wink and a Prayer (Apr 2004); HPS Wins by a Nose! (Octathlon 2004); Accenture: Burning the Track (Mar 2004);  IGS: "Crown Jewel" Restored? (Mar 2004); HP: Still No Cigar (Feb 2004); Cap Gemini: Another, Smaller Loss (Feb 2004); CSC: Good Quarter Gets Boos (Feb 2004); EDS: "Hot Air Jordan" Flaunts Flop as Feat (Feb 2004); IT Industry: Whither Goeth It? (Jan 2004); Cronyism Is Alive and Well at EDS" (Jan 2004)

Or just click on and use appropriate  keywords.

Volume XXI, Annex Bulletin 2005-15
May 23, 2005

Bob Djurdjevic, Editor
(c) Copyright 2005 by Annex Research, Inc. All rights reserved.
e-mail: annex@djurdjevic.com

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