What's Bugging Big Blue

Investors fear that Corporate America's woes will cast a shadow on IBM's services business

Last year, investors flocked to IBM (IBM ) as a safe haven in the tech downturn. Its stock soared more than 40% during 2001, to close the year at 121. But this year, investors have fled. The company's shares have slid more than 40%, compared with an 11% decline for the Dow Jones industrial average and a 20% drop in the Standard & Poor's 500-stock index. On July 1, IBM stock hit 67.6, its lowest level in four years. It now trades at about 70.

What's ailing Big Blue? The soft economy, accounting concerns, and a continuing slump in tech demand certainly hurt the company in the first half of the year. But it took the scandal at WorldCom Inc. in late June to send IBM shares to their new low. WorldCom's financial woes threw doubts on its services contract with IBM rival Electronic Data Systems Corp. (EDS ), which gets nearly 3% of its revenues from WorldCom.

Investors are spooked that similar troubles throughout Corporate America could hurt IBM's services business, which at $35 billion is the world's largest. Indeed, its customers include struggling Italian carmaker Fiat (FIA ) and troubled telecom-gear maker Lucent Technologies Inc. (LU ) "There's a lot of worry about the services business," says analyst Steven Milunovich of Merrill Lynch & Co. "The comfort level with IBM as a safe haven has lessened."

IBM is hardly in crisis, but there is some reason for the worry. The company's services group, which helps customers dream up, build, or manage computer systems, accounts for 41% of the company's revenues and 47% of its pre-tax profits. Now, sagging profits have forced many IBM clients to cut back their services contracts. Long-distance player Sprint (FON ), telecom-equipment-maker Nortel Networks (NT ), and retailer Ames Department Stores (AMESQ ) are just a few IBM customers that have restructured contracts in recent months. In a June interview, IBM Global Services head Douglas Elix said reworked contracts were cutting a few percentage points of growth from the services unit--the company's growth engine in recent years. Nevertheless, he says, "most of the tough adjustments have been done or started."

New CEO Samuel J. Palmisano, who took over from Chairman Louis V. Gerstner Jr. on Mar. 31, is moving fast to adjust to the difficult economic times. He's sticking with the company's fundamental strategy of providing a range of software and hardware to customers--all wrapped together with the company's white-glove service. But he's fine-tuning the approach by trimming expenses, exiting poorly performing, low-margin businesses, and moving the company further away from its manufacturing roots. In the past six weeks, for instance, the company has sold off a chip-packaging plant in Endicott, N.Y., and shut down aging chip-production lines in Burlington, Vt.

The chief executive also is pushing the 315,000-person company to be more nimble. For example, he has given 400 sales execs the ability to cut prices on the spot to close deals, in addition to the 60 managing directors who could do so in the past.

Will Palmisano's moves be enough to put IBM back on track? They're a solid start. Palmisano's house-cleaning will help the company begin growing again when the economy perks up. Still, he has substantial work ahead of him to get IBM back to its market peak. The services group, in particular, may not be the growth engine for the company that it has been in the past. Though it averaged 12% growth over the past five years, the unit boosted revenues 5% last year and is expected to increase them only 2% this year, to $35.7 billion, according to Sanford C. Bernstein & Co. IBM's total sales from continuing operations are expected to drop 4% in 2002, to $79.9 billion, while net income falls 12%, to $7.1 billion, Bernstein says.

Palmisano will likely have to turn to IBM's software business to drive revenues. The unit sells businesses everything from software to run their mainframes to programs for Web commerce. Software revenues are expected to be flat this year at $12.8 billion, Bernstein says, but there are some gems that could take off in the years ahead. For example, IBM has about 30% of the market for application server software, which handles e-commerce programs for corporate networks. That market is expected to grow 15% annually in the next five years, rising from $2.3 billion in 2001 to $4.4 billion in 2006, according to researcher IDC.

IBM is taking steps to capitalize on such opportunities. This spring, the company introduced a new version of its application server, called WebSphere, that technology analysts, including Tyler McDaniel of market researcher Hurwitz Group Inc., say is a substantial step forward. And this fall, the company will release a new, streamlined version of WebSphere for small and medium-sized businesses. It's also laying the groundwork to move into promising new markets. On July 9, IBM and Nokia announced an agreement to develop software that distributes digital media securely over wireless networks. "This is the next generation of e-business," says Rodney C. Adkins, general manager of the IBM group that makes software for mobile phones, handheld computers, and other devices.

Still, there's more work to be done. The software group needs to knock down more walls between its hodgepodge of groups, eliminate more redundancy, and market IBM as an integrated software brand, many analysts say. For example, while IBM acquired the database software maker Informix last summer, the company has yet to fully integrate Informix's product with its own database offering, and it has not had any major layoffs in the business. "If they are going to turn this around, they need to leverage their size and act more quickly," says Thomas Bittman, a vice-president at researcher Gartner Inc.

Most Wall Street analysts are skeptical about IBM's ability to rebound quickly. In the past few weeks, at least 16 of the 21 analysts covering IBM have lowered their earnings and sales estimates for this year and next. For the most part, Wall Street remains concerned about weak tech spending. But investors also want the company to change its accounting practices to disclose more financial information. For example, they want to know how much income IBM gets from asset and real estate sales. "They give you a little visibility but not nearly as much as you need," says Ken Smith, a portfolio manager at Munder Capital, which holds 2.3 million shares of IBM after selling more than 400,00 shares in the first quarter. "That makes me leery of making IBM a large holding."

The next milestone for IBM comes on July 17, when it reports earnings for the second quarter. Investors such as Smith are looking for signs of improvement--especially in services, software, and microelectronics. Goldman, Sachs & Co. analyst Laura Conigliaro is expecting IBM to report $1.5 billion in net income for the quarter, on $19.0 billion in sales from continuing operations. If the company can meet expectations in the second and third quarters, "that would begin the process of stabilizing the stock," she says. With investors and analysts wary, IBM will be a show-me story for the rest of the year.

By Spencer E. Ante in New York

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