Annex Bulletin 2007-08                              March 1, 2007

Excerpts from CONFIDENTIAL edition (Annex clients click here for FULL version)

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IT SERVICES

Updated 3/01/07, 3:00PM MST

Analysis of IBM Global Services 2006 Business Results

Growth Slows, Profit Surges

Strong Finish in New Contract Signings Not Enough to Bolster Revenue Growth

SCOTTSDALE, Mar 1 - While others in the global IT services arena were looking up, IBM Global Services' (IGS) leaders clearly had their sights set last year on the bottom line.  IGS 2006 revenues inched up by less than 2% from 2005 to $48.2 billion, but its gross profit increased by 8% to $13.3 billion (left chart), pretax profit surged by 48% to $5 billion, and net earnings soared by 60% to $3.6 billion, according to our just-completed analysis of its last year's results.

[charts]

Nevertheless, even after such a remarkable profit improvement, IGS's contribution to the IBM bottom line lags that of software, for example, IBM's most profitable business segment.  In 2006, IGS accounted for 53% of IBM revenues, but only for 38% of its pretax profit (right chart).  Software, on the other hand, contributed 20% to Big Blue revenues and 41% to its pretax earnings. 

Growth Challenges

The most worrisome aspect, however, of the world's largest IT services company remains its now chronic lack of growth.  Long gone are the heady years in the 1990s and the double digit growth rates (right chart) that led us to call this IBM unit a "crown jewel."  In the first six years of the new millennium, IGS' "organic" (without the PwCC acquisition) revenues have grown at an average rate of only 4% per year.  And things are getting worse.  In the last two years, IGS' revenues have risen only about 2% per year.  That's well below the industry average or the growth rates of some of the major competitors.

What is the reason for this?  

[snip]

"Rescoping." The second major reason for a lack of faster growth has been the "rescoping."  The term originally emerged in 2002 when IBM first fessed up about being forced by customers to renegotiate some already closed contracts (red bars on left chart).  That, plus the normal expiries and cancellations, has represented an enormous drain on IGS' backlog, which has been essentially stagnant in the last five years (right).  And without a rising backlog, there cannot be faster revenue growth.

[snip]

Acquisitions. Alas, except for a few small moves, that suggestion has also fallen on deaf ears at Armonk.  And now that EDS is also on a prowl for promising acquisitions with its war chest of $3 billion this year alone (see "EDS Turnaround, Act II," Feb 2007), finding and buying IT companies that would bolster IGS's growth will be that much more challenging.

[snip]

Competitiveness. Speaking of EDS, Ron Rittenmeyer, EDS' new COO, talked a lot at a recent conference in New York about the company's past successes, especially in 2006.  He flashed a slide (right) that showed how successful EDS has been against its four major competitions - IBM Global Services, Accenture, HP Services and CSC.  The slide shows EDS allegedly winning 60% of the time when facing IBM in megadeals.

[snip]

SMB Anyone? Finally, there is one huge market place in which IGS does not appear to be a factor.  At least that's the impression one gets after perusing its financials.  And that's the small and medium size business market.  We feel that this is a growth opportunity - through acquisitions and indigenously -  that IGS may be missing, to its ultimate detriment.  We have seen recently how some other parts of IBM have taken steps to get more aggressive in this fast growing market (see "IBM Lowers Its Center of Gravity, Forms New SMB Division," Jan 2007).  If IGS gets tired of losing market share, perhaps that's the part of the market place to which it may also turn for additional sources of revenues and profits.

[snip]

Outlook

If IGS plays its cards right, even without any major acquisitions, we expect it to surpass the $50 billion-mark in 2007.  Our forecast implies about a 5% aggregate revenue growth, with some sub-segments, such as BPO, for example, continuing to grow in double digits.

We also expect to see IBM's accelerated expansion into India continuing to yield cost savings and performance benefits to IGS customers which will be reflected in improved profitability for IBM.  Of course, many other companies are also well enroute their "Passage to India," so IBM must not overplay its hand on something that's as volatile as labor force.  So hedging its bets and spreading the workloads to other emerging markets would be a smart play.

In the end, success or failure in the IT services market often depend on how nimble a vendor is.  Companies that like to talk about "adaptive" or "agile" enterprises and "business process transformations" would do well to take some of their own medicine.  In IBM's case, that would mean splitting up IGS into smaller semi-autonomous entities by the various industry groups that they serve.  This may not only help improve the growth rates, but also the quality of the services the company delivers.

[snip]

"That's all she wrote," we're afraid, for those of you who are NOT Annex Research clients, who are now reading the complete Annex Newsflash, along with all charts which back up our story.

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Volume XXIII, Annex Bulletin 2007-08
March 1, 2007

Bob Djurdjevic, Editor
(c) Copyright 2007 by Annex Research, Inc. All rights reserved.
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