Ibm's Hottest Product Isn't A Product

Big Blue's services division is leaving rivals in the dust

In July, as IBM was preparing to release its second-quarter results, all eyes were on the company's services division. In the weeks leading up to the announcement, rivals Electronic Data Systems, Computer Sciences, and Unisys told Wall Street to expect revenue shortfalls. Analysts at Bear Stearns Inc. and Merrill Lynch & Co. scaled back their growth estimates for IBM, partly because they were jittery about the services business.

Forget jitters. IBM wowed everyone. Service revenues for the period were up 2%, to $8.2 billion, despite the fact that the year-earlier quarter had been pumped up with $1 billion in Y2K-related business. Even more impressive, IBM revealed that it had signed $20.3 billion in services contracts during the quarter--twice the volume inked by EDS and CSC together in the same period. IBM shares jumped 8% in the wake of the announcement, to $117.

For onetime hardware king IBM, the Global Services division (IGS) is proving to be the company's savior. While sales for the rest of Big Blue are barely increasing, the services division is averaging more than 10% sales growth annually. That has helped pull up overall growth at IBM to about 5% per year. By last year, the division accounted for 37% of IBM's $87.5 billion in revenues and 45% of its $7.7 billion in profits. With revenues of $32 billion last year, the group is the largest tech-services company on earth.

Now, IBM services chief Douglas T. Elix has even bigger plans: He expects to double the division's sales in the next five years. That would make it IBM's largest unit, with 46% of Big Blue's revenues by 2005. How does Elix plan to grab more than $30 billion in new business? By redoubling IBM's efforts in e-business services and helping companies move their operations to the Internet. "It's only a matter of how aggressively we can grow the business," says Elix.

SAUCY HP. He'll be going up against some powerful competition. On Sept. 11, Hewlett-Packard Co. disclosed that it hopes to beef up its services division by acquiring the consulting arm of accountants PricewaterhouseCoopers for about $18 billion. PC powerhouse Dell Computer Corp. and Unix server leader Sun Microsystems Inc. are both rapidly building their own service units. And Compaq Computer Corp., which was the first major computer maker to follow IBM into services two years ago with the acquisition of Digital Equipment Corp., is regaining its footing after serious missteps last year. Why all the interest? The global market for tech services is projected to grow 13% per year, to $585 billion in 2004, from $387 billion this year, according to market researcher International Data Corp.

IBM realized early on that mainframes and other tech products were becoming commodities. By designing computer systems for big corporate clients, IBM could maintain a tighter grip on all the technology customers buy. Today, IBM is better than rivals at linking hardware sales to lucrative services. Big Blue generates more than $4 in software and services revenue for every $1 in big hardware sales. That compares with just 24 cents for Sun, 47 cents for Compaq, and $1.52 for the possible combination of HP and PricewaterhouseCoopers, according to Sanford C. Bernstein & Co. "All firms today see that customers want more than just the piece parts--they want solutions," says Elix. "That's something we recognized many years ago."

Now the sprawling services unit does everything from Web-page design and installing local-area networks to managing AT&T's information technology department and helping plot e-business strategy for Swiss supermarket chain Migros. IBM's global scale, broad range of offerings, and close contacts with leading companies continue to give it a leg up on most rivals. "What's important to us is to have suppliers that can work with us on any continent we're on," says Larry Kittelberger, chief information officer at Lucent Technologies Inc., which has a $3 billion outsourcing contract with IBM.

IBM's Elix plans to use those advantages to meet his sales growth goal. He has reorganized IGS to focus more on Web services, where sales in some segments should expand by nearly 50% annually in coming years. That compares with 12% growth in outsourcing, or the management of a company's entire computer operations, according to IDC. He's counting on IBM's years of selling mainframe hardware to the world's top companies to give it an in with many blue chips. And those companies are likely to keep spending, even as ephemeral dot-coms come and go. "IBM's core customer base tends to include more mature, stable organizations that want to get e-commerce-ready," says IDC analyst Richard Dean.

The cornerstone of IBM's services strategy is a division called Business Innovation Services. The unit includes all of the company's e-business and Web-related initiatives--as well as management consulting services that help clients create new business models to take advantage of the Internet. BIS is building design and consulting centers in more than a dozen cities around the globe where companies can meet with IBM project managers to pull together e-business strategies. And the group has beefed up its ability to advise companies in specific industries on such topics as Net security, supply-chain management, and wireless technology. For example, the group developed a system for Swissair that allows passengers to check in for flights using their mobile phones.

Elix has to move fast. Thousands of hungry competitors--ranging from upstarts to behemoths employing tens of thousands of consultants, such as EDS and Andersen Consulting--are scrambling for pieces of the services pie. Small players, such as San Francisco-based Scient Corp. or Boston's Viant Corp., for example, are winning dot-com customers who feel that IBM is too stuffy to create the cutting-edge Internet presence they need. And a reinvigorated HP, merged with PriceWaterhouseCoopers, could compete across the board. The merger would "create a competitor that has taken an enormous leap toward IBM's scale," says Tom Rodenhauser, president of industry watcher Consulting Information Services.

LABOR LIABILITIES? Not that scale is always an advantage. IGS is so huge that some initiatives can fall through the cracks. In the fast-growing market of hosting customers' Web sites, for example, IBM was slow on the uptake and ceded the early advantage to players such as Exodus Communications Inc. And as services grow to nearly half of IBM's revenues, the company will face other stumbling blocks. The division today employs 140,000, and in order to meet his ambitious growth targets, Elix will have to add 20,000 to 30,000 people to IGS every year--no easy feat in today's tight labor market.

Paying for all those new staffers could create additional problems. IBM has gotten pretty good at controlling costs for manufacturing operations. As a services company whose primary asset--and cost--is people, IBM will have a harder time keeping expenses from spiraling out of control. "Hiring and training are going to be Elix' biggest challenge," says Sanford C. Bernstein analyst Toni Sacconaghi. It's a challenge IBM will need to overcome if Elix wants to continue leading in tech services--and keep rivals on the chase.

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