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IBM's Palmisano Sets His Course

Since his ascension to Big Blue's throne in March, 2002, IBM (IBM) watchers have studied new CEO Sam Palmisano's actions in the hope of gleaning clues about his intentions for the world's No. 1 technology company. In offering somber earnings news, announcing minor layoffs, and selling some marginal business lines, Palmisano didn't much tip his hand.

Well, consider IBM's laid out flat on the table. On July 30, Big Blue announced it would purchase the consulting arm of auditing giant PricewaterhouseCoopers for a cool $3.5 billion, including $2.7 billion in cash with the remainder in stock and convertible debt.

The deal, which represents the largest acquisition by the tech behemoth since it snapped up Lotus in 1995 for the same price, suggests that IBM's wallet is going to open more frequently than it did during former CEO Louis Gerstner's tenure. But in addition to hinting at a key difference in strategy, the purchase will also be a critical test of Palmisano's leadership.

FILLING A NICHE. Gerstner was a staunch opponent of major acquisitions, arguing that big deals disturbed corporate culture and rarely worked out. When IBM did buy during Gerstner's reign, the goal was usually to acquire customers or a specific product that filled a niche. Witness the Apr. 24, 2001 deal for database company Informix. Gerstner paid $1 billion cash to buy market share and some solid software in an effort to compete with sector giant Oracle.

That's not the case with the PwC deal. True, IBM is buying PwC customers, and IBM Global Services head Doug Elix made it clear that Big Blue values PwC's blue-chip clients. But the logic behind the acquisition is that sales growth of high-tech products has slowed, while sales growth of tech services has risen smartly.

According to figures presented by IBM and PwC, the industry expects the share of profits from sales of software and services to rise to 41% in 2005, up from 29% in 2000. The share from hardware is expected to downshift to 42% by 2005, from 58% in 2000.

LUCRATIVE AREAS. Palmisano wants to grab a bigger slice of those profits sooner rather than later, and the view is that making an acquisition will be more expeditious than waiting for IBM to grow organically. PwC's 30,000-strong staff of consultants will instantly swell the ranks of IBM's own Global Services consulting unit by 20%, to nearly 180,000. And PwC specializes in some heavy software-integration tasks, such as setting up advanced inventory-and-production control systems as well as customer relations management systems.

Those lucrative areas -- some of the most profitable business software niches around, with margins in the mid double-digits -- have traditionally been weak spots for IBM. Palmisano is hoping to fill those holes with his new PwC troops.

Of course, the core asset of any service business, PwC included, is its employees. That's both good and bad. IBM won't have to support new software systems. But it will have to keep its talented PwC staffers happy and involved, or the deal could end up looking like a giant payout to PwC partners with IBM getting little in return. And Palmisano may have to struggle to meld the two teams.

BONUS BABIES. PwC's legions pride themselves on their aggressive, can-do attitude. Company policy holds that consultants must be ready to get on a plane to almost anywhere in the world with short notice. In contrast, the more staid IBM has built a reputation as a humane place to work, bending over backward to accommodate telecommuters and others who want to balance work and family commitments.

PwC consultants are also used to fat paychecks with large bonuses during big years, an expectation that IBM might have trouble getting them to shed, given that its own culture is one where salaries are far more stable.

Just as difficult will be assuaging the fears of software companies that see the move as a way to edge them out. The deal seems to alienate Oracle (ORCL), a big PwC partner and a Big Blue rival in the contentious database and Web software field. And it could frost relations with Web application-server powerhouse BEA Systems (BEAS), another strong PwC partner. As IBM has made inroads in Web application servers, BEA seems to have grown increasingly wary of Big Blue and its marketing tactics.

TRANSFERRING LOYALTIES? One big risk is that BEA, Oracle, and others could end up doing more business with what will now be competing consulting companies, such as KPMG Consulting and Cap Gemini Ernst & Young. Customers hoping to use Oracle and BEA software could end up choosing a company other than IBM for services help.

For its part, IBM has long claimed to be technology-agnostic, and it does in fact support many customers that use both BEA and Oracle products. And considering that PwC expects to post only $4.9 billion in fiscal 2002 revenues, IBM is paying less than one times sales for PwC, which some analysts see as a bargain. Big services firms usually go for three to four times sales.

Further, PwC had been in talks with Hewlett-Packard two years ago for a similar deal, albeit with a price tag of $18 billion. But PwC was clearly highly motivated to sell its consulting wing in an environment in which consulting no longer goes together with auditing and tax work. Rather than play Russian roulette with an initial public offering in the unpredictable stock market, it's no surprise PwC CEO Greg Brenneman chose the cash and a deal with Big Blue.

SLIM MARGINS. IBM claims that the acquisition will start to add to its bottom line by the last quarter of 2003. Still, Palmisano clearly will have work to do folding in the new kids on the block, apart from the cultural differences. PwC expects to have operating margins of a mere 4% on fiscal 2002 revenues. The $4.9 billion PwC expects to take in is only one-seventh of IBM Global Services' 2002 revenues of $34.9 billion.

Plus, because the PwC acquisition will swell IBM's consulting work force by one-fifth, Palmisano will need to squeeze more revenues per employee out of PwC, not to mention higher margins, to bring it in line with the rest of IBM's operations.

Perhaps most important, Palmisano will have to make doubly sure that Wall Street can see that he's maintaining organic growth within IBM and not just boosting the bottom line through acquisitions, a favorite trick of such erstwhile CEOs as Tyco's Dennis Kozlowski and WorldCom's Bernie Ebbers.

If Palmisano can make this deal a clear win, he'll look brilliant. If not, he may face questions from Wall Street, customers, and his own employees -- not to mention impatient investors who might not hesitate to clobber Big Blue for the slightest stumble. By Alex Salkever

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