On the surface, IBM seems to be cruising. Its stock is trading near a six-year high, at almost $106, and its overall financial performance has been improving steadily for more than a year. On May 29, the company raised this year's per-share earnings forecast after stepping up a stock repurchase plan.
Yet the company is battling a bugbear that keeps it from breaking out and prevents the stock from really soaring. Ironically, its problem is with the $48 billion-a-year business that saved it from ruin in the 1990s: IT services. What was once IBM's (IBM) growth engine seems to be turning into a chronically slow-growing, low-margin drag on the rest of the company.
Fresh evidence of IBM's trouble with services came May 30, when the company revealed that it had just eliminated 1,573 services jobs, mostly in North America, bringing to 3,023 the total jobs cut in the high-cost region this quarter alone. That's a small percentage of the company's total workforce of more than 355,000. Yet when weighed against rapid growth in low-cost India, where the staff topped 53,000 at the beginning of the year, the cuts underscore the biggest challenge facing Big Blue: the Indian tech industry.
Indian Rivals Force Change
IBM remains the No. 1 tech-services company in the world, with 7.2% of the market last year, but its share slipped from 7.5% in 2005, according to Gartner Dataquest (IT). India's tech-services exports grew 32%, to $31 billion last fiscal year, ended in March, and are expected by analysts to top $60 billion by 2010. With a combination of low labor costs, high quality, and efficiency in how it handles jobs, the Indian companies have forced IBM and other Western services giants to fundamentally restructure the way they do business and massively shift work offshore. "The Indians are doing to the world's IT processes what the Japanese did to manufacturing," says analyst John McCarthy of Forrester Research (FORR).
IBM's answer isn't as simple as moving more jobs offshore. The company has developed a system that lets it shift work to the areas with available skills at the lowest-available costs. The goal is to deliver higher-quality services at competitive prices. "Clearly one opportunity associated with globalization is costs," IBM Chief Executive Samuel Palmisano told a gathering of stock analysts on May 17. "You have access to expertise wherever it is in the world—if you have the infrastructure and the relationships to take advantage of it."
Job reductions are nothing new for IBM's huge global-services workforce, which has been under the knife continuously in the past two years. The cuts started when IBM, shocked by very poor results for the first quarter of 2005, began a major restructuring in Europe and the U.S. that eliminated 15,000 jobs in a matter of months. Ever since then, every few months, a new batch of jobs is trimmed from high-cost countries, including 700 in the first quarter of this year.
The trend is likely to continue. In the first quarter, the largest chunk of the services business, called Global Technology Services, grew a relatively healthy 7%, but its operating margin narrowed, shrinking by 2.5 points to just 7.8%. In comparison, the top Indian services outfits have operating profits of between 25% and 30%.
And their quarterly revenues are growing 30% to 40% year over year. IBM "is in a transition," says S. Padmanabhan, an executive vice-president at Tata Consultancy Services, India's largest IT-services firm. "We have been doing this for over 35 years, and it has taken a lot of intellectual capital to fine-tune the process. It's taking these companies time to reach our level of maturity."
Leaner and Leaner
Meanwhile, the Indians are taking on larger and larger contracts, and doing ever more sophisticated work. Even IBM's seemingly most solid relationships can become unstuck. For instance, when China's Lenovo Group (LNVGY) bought IBM's personal computer business two years ago, IBM became a major supplier of services for Lenovo's operations. Yet Lenovo is now undertaking a massive cost-cutting campaign, and, according to a source familiar with the situation, the company has opened up bidding on its effort to integrate all of its operations using run-the-business software from SAP (SAP). Neither Lenovo nor IBM would comment on their relationship.
Why are the Indian companies able to underprice IBM and still make a much better profit? Part of the answer is geography. The Indians typically employ about 80% of their staffs in low-cost countries and place the remaining 20% near their clients in the U.S. and Europe.
To improve its efficiency, IBM has adopted the so-called Lean Operations discipline developed by Toyota Motor (TM) for manufacturing cars. It's adapting Lean so it applies to a global service organization, something the top Indian companies began two years ago. The basic principle of Lean Operations is that a company should be making continuous, incremental improvements in its business processes. That's one of the ways IBM figures out where it can eliminate work. The company also keeps a master database, nicknamed "Blue Monster," of all of its services employees. Supervisors use the information to track who is working on what project and when they'll be available for another assignment. In this way, the company hopes to minimize the amount of time people are between assignments.
All of this cost-cutting is the task of Robert Moffat, senior vice-president for integrated operations. His goal is to make the Global Technology Services workforce 10% to 15% more efficient each year. The key for him is to take costs out of the equation through a combination of workforce globalization, process improvements, and replacing manual labor with software. In a little more than six months, Moffat said at the May 17 analysts' meeting, he has rolled out the new formula for 22 of IBM's largest clients in seven countries. In some cases, he said, the clients have seen up to a 50% improvement in productivity. Now, Moffat is extending the new system to 600 more accounts.
All of this huffing and puffing over efficiency won't calm the frazzled nerves of IBM's 155,000-strong services workforce. True, there are still abundant employment opportunities in the company. About 30% of the people whose jobs are eliminated find other jobs within the behemoth, and, in the first four months of this year alone, IBM hired more than 19,000 people. But a lot of those hires were made in India. For the U.S. workforce, there is always fear that jobs will be lost to foreigners.
For investors, the fear is just the opposite—that IBM won't make the shift quickly enough. Only then will its massive services business be healthy again.