Ibm: A Bull's Eye And A Long Shot

Are IBM's years of woe over? Wall Street seems to think so. Fresh revenue growth and narrowing losses have inspired buy recommendations--pushing the stock to the mid-50s from less than 42 in September. Still, the picture is cloudy. Growth is coming from a surge in services and a turnaround in PCs. But neither business is highly profitable. In services, the plan is simple: cut costs and pursue business more selectively. In PCs, the plan is bolder--and much more of a long shot. Using the hot new PowerPC chip, IBM plans to create a new industry standard that redefines what a PC is.

For years, as IBM tried to halt its slide, its top executives and Wall Street analysts agreed on one thing: By moving aggressively into providing professional services, such as consulting and systems integration, the computer giant could make up for plunging profits in hardware. The good news is, a decade after IBM began talking about a major push in services, it is finally getting somewhere. The bad news: So far, services haven't done much for the company's bottom line.

As IBM prepares to close the books on 1993, its services business stands out as one of the bright spots. For the nine months ended Sept. 30, worldwide service revenues--excluding those from maintaining hardware--shot up 32%, to $6.6 billion. That includes such activities as running customers' data centers (outsourcing), designing new information systems to solve specific problems (systems integration), and high-level consulting (business process reengineering). For the year, service revenues will top $9.65 billion, reckons John B. Jones Jr., a Salomon Brothers Inc. analyst (chart). That would be 15% of total revenues, up from just 4.8% in 1989. The pie includes European service revenues--about $2.3 billion last year--and sales by the Federal Systems Div., which brought in $2.2 billion last year and which the corporation now is looking to sell.

Profits are a different story. IBM doesn't disclose them, and analysts say they're hard to detect. One drag has been IBM's superaggressive bidding for contracts to build up its outsourcing business. Its Integrated Systems Solutions Co. (ISSC) subsidiary has been undercutting competing bids by as much as 30%, say rivals such as Electronic Data Systems Corp. (EDS) and Computer Sciences Corp. (CSC). The result, says Bonnie Digrius, vice-president at consultants Gartner Group Inc., is that IBM's gross margins in services may be as low as 10%, compared with an estimated 23% for EDS. Its operating margin: 2% or less, vs. 12% at EDS and 6% at CSC. IBM declines to discuss its profits specifically, but a spokeswoman says, "We are not buying market share."

ISSC, established in 1991 to serve U.S. customers only, will have revenues of $4.7 billion this year--including $2.5 billion in business from within IBM, says Digrius. Now, the focus is shifting to profits, says Dennie Welsh, who was named general manager of IBM North America services in October. He's chairman of ISSC and also oversees service activities in IBM's 40-odd sales areas around the country.

Welsh, 50, joined IBM in 1966 to work on the Apollo space program and rose through the ranks to manage large systems-integration contracts with the federal government. His newly formed services empire is designed to improve responsiveness and cut costs. "We're trying to eliminate redundancies," he says. "We're focused very heavily on being the low-cost provider of solutions." For ISSC, that means identifying more profitable deals and slashing sales, general, and administrative expenses--as a percentage of revenues--from double to single digits, says Samuel J. Palmisano, ISSC president.

A NOVICE. Despite its minimal profitability, however, ISSC has achieved important goals for IBM. It was created at a time when EDS and other outsourcers were scooping up longtime mainframe customers. Big banks and corporations were cutting overhead by selling entire data-processing departments--computers, employees, the lot--to companies such as EDS and buying back computing services at a fixed fee. Now, ISSC's outsourcing "keeps customers in the same church," says Howard Anderson, president of Yankee Group, a consulting firm. "Maybe they're in a different pew, but they can come back to [buying IBM gear] real easily."

As a novice, IBM didn't appreciate all the intricacies of outsourcing, analysts say. "IBM underestimated the cost of managing some early projects," says Bob Steinerd, a former IBMer who's now director of services research at market researcher Dataquest/Ledgeway. "It really got burned." Last year, ISSC signed a 10-year, $3 billion deal to run McDonnell Douglas Corp.'s information systems. "Our best estimates are that [ISSC] is losing money in the early years of the contract," says Wendell Jones, general manager of the aerospace company's computer division. "We'll be profitable every year of the contract," the IBM spokeswoman says.

NEW EMPHASIS. But Big Blue can utilize the close relations that outsourcing establishes to sell customers other services. For instance, IBM's recent 10-year, $415 million outsourcing contract with Southern Pacific Rail Corp. could lead to millions of dollars of revenue from future development projects. The Southern Pacific deal is one of the biggest this year, but Palmisano reports that he hopes to sign 8 to 10 more of similar size by yearend.

Even with Welsh's new emphasis on improving profitability, IBM's ranks of service personnel are swelling. Mainly because it agrees to hire its clients' data-processing workers, ISSC has seen its head count grow from about 11,000 employees last year to about 15,000 workers today. That puts upward pressure on costs, but Palmisano says that the outsiders bring valuable skills with them, including in-depth knowledge of specific industries. ISSC hopes to apply that knowhow in the 16 industries it's focusing on.

If IBM has any major weaknesses in services, analysts say, there are two: First, the company has yet to match its biggest competitors in depth of consulting expertise. To change that, it's teaming up with specialist consulting firms and aggressively hiring experienced talent to run its industry groups. ISSC hired John Singleton, former chief information officer of Bank of America, to head its banking practice, for instance. And then there's the lingering suspicion that when it comes to selecting the right computers and software for a client's needs, IBM will always lean toward its own products. Short of shedding services altogether, IBM may never allay such fears completely. It will just have to win customers' confidence the way it's doing now, contract by contract.

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