IBM's Revved-up Software Engine

Software now contributes more profit than services, and it's emerging as Big Blue's most reliable generator of growth

For nearly five decades, IBM (IBM) was known as the world's largest computer company. Then, as its strategy shifted, most people started calling it a tech services outfit. Well, that description doesn't fit so well anymore. That's because the label fails to recognize the huge boost IBM gets from its software division. Investors wondering whether to hold onto their IBM shares or buy more would be smart to keep a sharp eye on software.

Here's the big surprise: Big Blue's $16.8 billion software business now contributes even more profit to the bottom line than services, and it's just now emerging as the $91 billion company's most dependable growth engine. "Software is not only the fastest-growing but the most entrepreneurial and the most profitable part of IBM," says analyst Bob Djurdjevic of Annex Research.

The company needs all of the help it can get in the revenue category. Overall revenues have been essentially treading water over the past year. That weighs heavily on its stock, which has been trading in the mid-70s after reaching its recent peak of $89 last December. If IBM is to excite investors again, software must play a key role in making it so.


IBM's rapid-fire series of software acquisitions over the past few weeks has made a lot of people sit up and take notice. On Aug. 10, it announced a plan to purchase document-management software maker FileNet (FILE) for $1.6 billion. The previous week, it spent $750 million on MRO Software (MROI) and an undisclosed amount on Webify Solutions. Altogether, the three companies could add about 3%-4% to the company's annual software revenue. These moves cap off a three-year period when IBM Chief Executive Sam Palmisano has overseen the purchase of 31 software companies. And analysts expect more to come (see, 8/10/06, "Big Blue's Software Spree").

To Steve Mills, the executive vice-president and general manager of IBM's Software Group, these recent data points prove that his über strategy is working. He points out that at the end of last year, the newer and faster-growing segments of his business accounted for 52% of overall software revenues. To him, that means the business reached a tipping point that will allow it to accelerate growth in the future. "The underlying fundamentals of the business are now giving us the ability to deliver a sustained better rate of growth," he says. "This happened very gradually at first, but now it's showing its effects."

Even as he tries to stoke revenues with acquisitions and expanding markets, Mills faces the challenge of keeping some of his core software businesses growing at healthy rates. Over the past few years it has lost market share to leader Oracle (ORCL) in database software, and that hurts sales of its other products since many of them are attached to the database. At the same time, its sales of tools for corporate software developers have tapered off. That's because so many corporations now rely on outsourcing companies to write their custom-made applications. IBM gives volume discounts to outsourcing companies.


Given those headwinds, Mills' goals are quite ambitious. He aims to grow software 6% to 9% per year, with new acquisitions contributing 2% to 3%. Already, Mills's unit is helping to prop up the rest of IBM. Software revenues of $4.2 billion in the second quarter increased a healthy 5%, while the overall company grew just 1% and services revenues were down 1%. This was the fifth quarter in a row in which software revenues outpaced both overall growth and services growth.

The profit picture for software is even prettier.

Annex Research estimates that for 2006, software will account for 20% of IBM's revenues but 37% of its profits. Meanwhile, services, which represent 53% of revenues, account for 35% of profits, and systems and technology (mostly hardware products), which represent 24% of revenues, account for just 12%. IBM's software unit enjoys gross margins of 84.2%, compared with 35.9% for hardware and 27.7% for services.

IBM, with 26,000 programmers, 12,000 software salespeople, and a vast array of products, is the world's second largest software maker, after Microsoft (MSFT). The product portfolio includes slower-growing operating systems and management software for mainframe computers and faster-growing chunks, including data management, information and application integration, collaboration, software-development tools, Internet software, and content management. The most successful products fall within the so-called "middleware" segment—software that sits between computer operating systems and run-the-business applications like payroll that a company's executives and employees use day to day. IBM leads the $80 billion middleware market with an 18% share ($12.6 billion in revenues last year), compared with less than 10% shares for Oracle and Microsoft.


Now a fundamental shift is taking place in middleware that could light a fire under IBM's software business. More and more, companies are using a new kind of technology called service-oriented architectures (SOA) for building new computer systems or revamping old ones. Using open standards, they create software components that automate different business functions—from auditing to order taking. These components are treated as services that any new application can tap into for additional functionality.

SOA allows companies to build new applications faster, reuse older software, and reuse the new components they create. So it's fast and efficient. No wonder an April survey of chief information officers by Merrill Lynch (MER) showed that 87% of them expect SOA to be the " next big thing" in enterprise computing.

IBM is already the leader in SOA, and that puts it in a great position to benefit from its soaring popularity. Mills' group has a 44% share of the market, compared with 13% for second-ranked Sun Microsystems (SUNW) and 10% for BEA Systems (BEAS), according to WinterGreen Research. The tech-market researcher expects the SOA market to grow from $630 million this year to a nosebleed-inducing $17.75 billion in 2011. If IBM continues to dominate the market, it could rake in the lion's share of those revenues.


Motorcycle maker Harley-Davidson (HDI) shows how SOA works—IBM-style. The company has a vast portfolio of applications for running every aspect of its business. But it found that once its applications are created they're very hard to change. So it bought IBM software and hired IBM consultants to revamp its systems using SOA technologies so they can be more flexible.

The first step: creating a new credit-approval system for dealers. The project was completed in April, and has made it possible to rapidly introduce new loan options for dealers and customers. Now the company plans on adopting SOA for all aspects of its business. "It's easy to see how the success of our credit-approval project can be repeated in other parts of our company," says Chief Information Officer Jim Haney.

The way IBM's software and services units teamed up to handle Harley's project spotlights an advantage few competitors can match.

Because it has strong software and services businesses, IBM can leverage one against another. When companies buy new software, they typically spend up to five times as much on services to install and maintain it. So IBM's software sales often carry with them huge services contracts. To make both its software and services more compelling for customers, IBM has created prepackaged solutions for different industries combining the two. The shift by corporations to SOA plays to IBM's strengths, too, because when companies build or buy software components, they often need consulting expertise to design their new systems and knit together all of those pieces.


To make life simpler for customers, IBM last month introduced a catalog of premade components and a collection of templates designed for more than 15 industries. It developed these pieces in the course of more than 2,000 SOA engagements. The Webify purchase adds pages to the catalog, since Webify has focused on components and templates for the telecommunications industry and government.

IBM typically acquires companies that fill holes in its product portfolio. Webify fits into its WebSphere family of products that help companies integrate one application with another. MRO joins its Tivoli products used for managing complex computing systems. And FileNet bolsters its presence in the much-in-demand content management space. "It's a great entry point for their services consultants, too," says analyst Allan Krans of market researcher Technology Business Research. "If it brings more engagements for the consultants, that's a good business."


Yet IBM's strengths in software and services also create vulnerability. There's intense pressure from customers to reduce their need for expensive and labor-intensive services by making software easier to install and integrate. But IBM relies on its software unit to tee up engagements for its consultants.

"IBM has invested in software. They know how important it is. But they have a business-model problem," says Mark Lewis, executive vice-president and chief development officer for EMC (EMC). "The more capability they put into software, the more it hurts their services business." EMC has used 24 acquisitions over the past three years to build a $3.6 billion enterprise software group, and Lewis says his juiciest target is taking sales away from IBM's services business. IBM's planned acquisition of FileNet, however, will catapult IBM to the top of the document-management market, ahead of EMC's Documentum Division

IBM denies it's holding back on its software innovation to pave the way for services. It says that no matter how many features you put into software, there's almost always a role for technology and business consultants to help customers use it to best advantage. "The customer doesn't want to buy individual pieces of technology that they have to put together. They want solutions," says Kristof Kloeckner, IBM Software's strategy chief.

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