For Big Blue, the Big Enchilada

Having edged out other software rivals, IBM takes on Microsoft

Growing up on New York's Long Island in the 1960s, Steve Mills used to do a lot of home-renovation work with his old man. A few years ago, Mills cooked up a project that would make Bob Vila proud. He converted the attic of his 90-year-old Tudor home in Bronxville, N.Y., into a two-story rooftop library. The addition, which took two years to complete, features walnut paneling and a spiral staircase. "I particularly like the more complex projects," says Mills, an IBM senior vice-president who heads the software division. "I have the patience to get things done."

The most challenging renovation he has taken on, however, has been at the office. Mills, 52, has led an eight-year makeover of IBM's (IBM ) $13 billion business-software division. In 1995, he and John M. Thompson, then head of the software group, prodded Chairman Louis V. Gerstner Jr. to create a stand-alone software division with its own sales force. Their argument: Focused software companies, from Oracle Corp. (ORCL ) to Microsoft Corp. (MSFT ), were growing like weeds at 20% per year, while slow-growing IBM, clinging to its mainframe roots, risked missing out on one of the industry's hottest and most profitable sectors.

Gerstner agreed. Mills, first as general manager and since July, 2000, as software chief, has focused IBM on the hidden yet critical programs that make up a company's computing infrastructure. He's making headway. In the third quarter, IBM registered 27% growth in important Internet software. Problems remain though. Older corporate offerings dragged down total software sales by 3%, to $3.1 billion. Still, the numbers are rosy compared with rivals Oracle and BEA Systems Inc. (BEAS ), whose sales both fell by more than 23% in the most recent quarter.

Indeed, IBM is making life miserable for many of its rivals. Thanks to its July, 2001, acquisition of database maker Informix, IBM last year surpassed Oracle as leader in the market for programs that store and organize corporate data, snatching a 35% share vs. Oracle's 32%. It's hot on the tail of BEA Systems, a $1 billion San Jose (Calif.) maker of software that dishes up Web applications. And it's ramping up to challenge Microsoft for sales to midsize businesses. "Software is becoming a bigger part of our story," says Mills.

Growth from software is key. IBM's $35 billion tech-services juggernaut has slowed to a crawl due to the anemic economy. And hardware sales, a $33 billion slice of the computer giant, have been falling off a cliff faster than Wile E. Coyote. Indeed, CEO Samuel J. Palmisano is ditching such capital-intensive businesses as hard drives to focus on software. He's spending half of IBM's $5 billion research-and-development budget on it. And why not? Last year, software accounted for 17% of IBM's sales but 28% of its pretax profits. Gross margins in IBM's software have topped 80% the past two years, compared with 30% for hardware and 20% for services. "Software is where the profit growth will come from in the long term," says Gartner Inc. analyst Thomas Bittman.

Now, IBM is taking the fight to Microsoft's home turf, the $150 billion market for software to run midsize companies. With its Office suite, database, and computer-server programs, Microsoft rules here. IBM, which has long targeted big corporations, traditionally struggles with smaller companies. But in September, IBM announced a partnership with J.D. Edwards & Co. (JDEC ) in which the provider of tech services to midsize companies will base its entire software menu on IBM programs. And on Oct. 18, IBM will release scaled-down versions of its application-server, database, e-mail, and network-management programs that are easier to maintain and are up to 80% cheaper than IBM's standard versions, the company says. Eric Shuster, an analyst with AMI-Partners, says the effort is "going to resonate."

Still, unseating Microsoft is a tall order. With a $5.2 billion R&D budget, Microsoft is the only company spending more on software research than IBM. It also has much more experience with consumers. Microsoft Chairman William H. Gates III says IBM's research does not "translate into products as well, and they don't package stuff as high-volume, low-price." Mills counters that IBM's products are more sophisticated and solve more complex problems than its rival's. "Microsoft provides simple products for simple problems," he says.

But some of those simple programs have bruised IBM. Case in point: IBM's Lotus Development Corp., which it bought in 1995 for $3.5 billion. Lotus was a pioneer in collaborative software, which companies use to exchange and store data. But IBM has been slow to remake Lotus for the Web. Last year, in the collaboration market, Microsoft's rival Exchange/Outlook programs claimed a 40% share, up from 36% in 2000, while Lotus slipped from 50% to 49%. In the most recent quarter, Lotus sales fell 15%. To recoup, in September IBM released a version of Lotus to help clients cut maintenance costs by automating such tasks as desktop upgrades.

This is the kind of competition Mills thrives on. The 27-year IBM veteran wages these battles by busting out his toolbox. Next year, he plans to increase by 5% his 10,000-strong direct-sales force. But the heart of Mills's effort is WebSphere, a group of programs that link computers, serve up Web applications, and process online transactions. In the fourth quarter, Mills will unveil the first WebSphere release in almost two years. Big Blue is counting on the new version to power it past BEA, its biggest rival in this category. "BEA does not have a complete set of products," says John A. Swainson, IBM general manager of the middleware division. BEA claims that Big Blue sells on the basis of relationships, not superior software. "Customers who are all Blue would buy it," says Alfred S. Chuang, CEO of BEA.

What Mills doesn't develop, he buys. He has spent some $2 billion on acquisitions, including the $1 billion Informix deal. In the past six months, he has purchased five small companies that should help plug holes in IBM's growing portfolio--and he's hunting for others. "There are many smaller companies that represent interesting opportunities," says Mills.

IBM has another weapon: It smothers customers with TLC. Mills insists senior engineers spend half their time with clients. Last year, IBM's WebSphere software was tapped for one of the Internet's toughest tasks--running eBay's online auction business. Big Blue beat out incumbents Microsoft and Sun Microsystems, even though eBay had never before bought a lick of IBM software. "They convinced us they were willing to stand by us no matter what," says Maynard Webb, president of eBay Technologies.

Now, Mills is focusing his workforce on a new project: helping companies cut costs by automating the job of tying software packages together. Connecting software applications, says IBM, accounts for nearly 40% of all tech costs. Sun Microsystems Inc. (SUNW ) and Hewlett-Packard Co. (HPQ ) are developing similar programs, but, says Gartner analyst Joanne Correia, "IBM has a leg up there."

Panasonic, for one, would agree. Robert Schwartz, Panasonic's chief information officer, says he slashed his tech costs by 15% thanks to WebSphere. Panasonic, which switched to the software about 18 months ago, now uses it to run its e-commerce system. Over the next few years, Schwartz expects savings to reach 25%. "Anything we buy in the future has to fit with WebSphere," he says. Those words bolster the work in progress at IBM software. But Mills will need more such testimonials to finish the restoration.

By Spencer E. Ante in New York

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