IBM: A Matter of Rational Self-Interest

It's spending big to grab more of the Net software market

These days IBM's (IBM ) software group is hungrier than Tony Soprano on an empty stomach. Since 2001, it has spent about $1.5 billion, gobbling up seven software companies as it continues to move into software and services. Now, BusinessWeek has learned, IBM is ready to chow down again. According to two execs familiar with the situation, the tech giant is in talks to acquire Rational Software Corp., a leading, yet vulnerable, maker of the digital tools used by developers to create Net software programs that run corporate operations.

For now, price is a sticking point and the deal could fall through. Neither side would comment. But if it happens, Rational would be IBM's largest software acquisition since its $3.5 billion purchase of Lotus Notes Corp. in 1995.

It's easy to see why IBM is eager to get its hands on the Cupertino (Calif.) company. As more corporations use the Net to perform key business tasks, the software that allows them to create applications and Web services is growing in strategic importance. With sales Dataquest expects to hit $5.5 billion in 2004, up from $4.7 billion last year, it's not a sector IBM can afford to ignore. Others certainly aren't: The likes of Microsoft Corp. (MSFT ) and Borland Software Corp. (BORL ) are also piling in. Buying Rational, says analyst Mike Gilpin of Giga Information Group Inc., "would position [IBM] to compete more effectively against Microsoft."

Such a move would also bolster IBM's long-stated goal of increasing the share of sales and profits coming from software. For the last seven years, software chief Steve Mills has focused on building up IBM's position in the key, though hidden, programs that make up a company's computing infrastructure.

So where does Rational, which is expected to earn $37 million this fiscal year on revenues of $628 million, fit in? To understand its import to IBM, it's necessary to delve into the geeky world of toolkits. Essentially, these are the programming tools that corporate software developers use to design the programs that allow consumers to buy books online or enable CFOs to run their financial reporting systems over the Net.

For software providers like IBM, building a strong tools business is critical: It's too expensive to train developers to use multiple toolkits, so buyers usually stick with one and its family of products. That means toolkit providers that lock customers in can drive sales of other software. But while IBM already makes its own basic toolkit, called WebSphere Studio, it doesn't have the high-end software needed to build the most sophisticated applications. It wants Rational to fill that hole.

So if it's such a key market, why is Rational considering selling out? In part, the company is vulnerable because of its past overreliance on the battered tech and telecom sectors. Their troubles caused sales to fall 15% for the fiscal year ended March 31, 2002, and Goldman, Sachs & Co. expects another 9% sales drop in the current fiscal year. That helped send its market cap down 40% in the last year, to around $1.75 billion.

Investors are also worried about the tough competition that could increasingly cloud Rational's future. Borland recently bought three small companies that specialize in design and configuration tools, and it clearly intends to move from basic to high-end tools. But the real threat is Microsoft, which is also making the same move. While Rational has long been allied with Microsoft, the software giant now shows every sign of developing its own tools. Without IBM's marketing muscle and corporate customer base to sell to, over the course of several years Microsoft could walk away with much of the business Rational now does for it. Rational "needs to be closer to IBM," warns Gilpin.

So what's holding up the deal? The main stumbling block, say sources, is price. Ben Howe, who has brokered past IBM deals as mergers and acquisitions chief at SG Cowen Securities Corp., believes Rational could fetch up to $2.5 billion. That assumes a 30% premium to its current market cap, and Rational now trades at a discount to other infrastructure-software companies. For IBM's bargain-hunters, that may be too rich.

By Spencer E. Ante in New York, with Jim Kerstetter in San Mateo, Calif.

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