A Big Step Back For Big Blue

It was a notable upset. On Mar. 11, Hewlett-Packard Co. (HPQ ) landed a $150 million outsourcing deal with Renault, snatching the plum contract away from archrival IBM (IBM ). HP will manage PCs for 87,000 of the carmaker's employees in 26 countries. HP's $14 billion tech services unit doesn't get much respect, but with last quarter's growth rate topping 14%, it's looking a lot spiffier than the industry leader. "We're absolutely winning against IBM," says Mike Rigodanzo, senior vice-president for technology services at HP.

IBM's sprawling $46 billion services division has certainly run into a rough patch. Services have been the company's growth engine for a decade, but they grew just 6% in the first quarter. That news prompted IBM's May 4 announcement that it will take a restructuring charge of up to $1.7 billion and eliminate as many as 13,000 positions, mainly in Europe, where demand was slowest.

Here's what's happening: While the company has been focused on its future, the present is coming up and kicking it in the pants. IBM has been investing rapidly in business consulting services to help companies transform the way they do business, yet its less glamorous, traditional tech services still pay a lot of the bills. Signings of short-term contracts for installing computers and software and for systems integration were down 9% in the first quarter. So services chief John R. Joyce needs to shore up that end of the business. "I still think they have the winning strategy at the high end of the enterprise, but they have to make some repairs short term," says analyst William Shope of JPMorgan Securities (JPM ).

It's a surprising shift. The latest quarter is the first time in years that this piece of IBM's business has fallen short of its targets. The company blames poor execution and slow demand in Europe. Mediocre hardware sales may also have played a role. Sales of PC servers rose a disappointing 8%, while mainframe sales actually declined by 16% -- troubling since many short-term services contracts are an outgrowth of hardware sales.

IBM vows to get back in the game. To boost sales to small and midsize businesses, it's adding a tele-sales unit. It's eliminating the layer of management that oversaw Europe, and assigning pricing and marketing decisions to the people in individual countries -- with the goal of closing deals more aggressively. IBM has set up small teams to go into companies, size up their computing needs in a couple of weeks, and recommend changes. And it hopes to close more of the smaller contracts by conducting frequent deal status reviews. "We want to make sure we have the right management systems and the right way of reaching the customer," says Don DeMarco, vice-president in Information Technology Services for the U.S. market.

While the moves seem smart, they're not likely to deliver a major growth spurt immediately. If there isn't improvement by the end of the year, though, IBM will have to make more fundamental changes.

For IBM's services strategy to succeed, it needs to maintain a balance of multiyear outsourcing deals and short-term contracts. Industrywide, the length of outsourcing agreements is declining, largely because customers don't want to be locked in with a single supplier for as many as 10 years. Though IBM remains the worldwide services leader, with its share holding steady at 7.8% in 2004, the trend toward shorter contracts caused its order backlog to drop 7.5% last year and an additional 1% in the first quarter. IBM had been relying on a healthy flow of short-term contracts, of less than one year, which deliver revenues and profits immediately rather than over several years. Now it must get its portfolio back in balance.

The company's European management reorganization likely won't help that much. Starting three years ago, IBM began shifting its sales force to place high-powered sales executives in direct contact with large customers. A new category of employees, called managing directors, deals directly with a large client or two, has authority over pricing, and coordinates all of the salespeople from the company's divisions who deal with those clients. The strategy hasn't delivered the stellar results IBM was looking for, especially in Europe. So it's doubtful the new staff shifts will make a huge difference in sales.

The smaller-business push doesn't seem like a quick game-changer, either. The market for small and midsize business has long been seen as ripe for the large tech outfits but has proved difficult to harvest. Two years ago, IBM began creating services tailored for these smaller clients, and in the past couple of months it launched 11 new offerings -- including an e-mail security scanning service that costs as little as $1 per user per month. In January it acquired Corio Inc. to beef up its ability to deliver online applications to smaller businesses. And in March it announced a $300 million investment in recruiting and training regional services companies to deliver its offerings.

The trouble is, smaller businesses are typically more cautious than big ones about adopting new technologies. Plus, IBM has to convince those local services outfits, some of whom it competes with, that it really wants to be their friend. That may be tough. "They have to get out of their comfort zones to boost growth, but it requires a substantial change in how they do business," says analyst Bob Djurdjevic of Annex Research.

There's another initiative that's intriguing -- but still in the planning stages. DeMarco has asked IBM Research scientists to take the knowledge and technology developed for large consulting clients and design sophisticated, prepackaged services for smaller customers. These bite-size services could be delivered by IBM or by its regional partners. "It changes the economics," says DeMarco. "You're less dependent on consultants and more focused on automating things through technology, and that lowers the costs."

When Joyce, formerly IBM's chief financial officer, took over as head of global services a year ago, it seemed as if he had inherited a smooth-running machine. Now it looks like he has something of a turnaround project on his hands. Joyce must stoke up those traditional services offerings without forsaking the future. Rivals Accenture (ACN ), HP, and Dell (DELL ) will surely make IBM pay a high price if he stumbles.

By Steve Hamm in New York

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