<%@ LANGUAGE=VBScript %> <% Set asplObj=Server.CreateObject("ASPL.Login") asplObj.Protect Set asplObj=Nothing %> FULL CLIENT EDITION - Annex Research 5-yr forecast for IBM (Apr 8, 2004)

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Analysis of IBM Global Services’ 2003 Business Results

“Crown Jewel” Restored?

IGS Returns to Growth Thanks to PwCC Acquisition, Weak Dollar

PHOENIX, March 22 – Eight years ago almost to the day, we urged the former IBM CEO to consider splitting up Big Blue (see "Break Up IBM!", Mar. 20, 1996).  We felt the IBM stock was grossly undervalued at the time (it was trading at about a quarter of today’s price - $25 vs. $90 to $100).  Breaking up the company, we thought, would force the “Wall Street stoneagers,” the crowd of analysts who followed IBM back then, to give credit where credit was due. 

IBM Global Services, or Integrated Systems Solutions Corp. (ISSC), as it was known at the time, the company’s biggest “crown jewel,” was alone worth at least 92% of IBM’s market cap at the time, we said.  But “since ISSC/IBM Global Services is indistinguishable to investors from the rest of IBM, the (low corporate IBM) P/E and P/R ratios apply to them, too,” we pointed out. 

(In 1996 to-date, the IBM stock had an average price/earnings (P/E) ratio of 15, and a price/revenue (P/R) ratio of 0.81.  At the same time, the shares of publicly-traded ISSC competitors - EDS and CSC - which had not done nearly as well as ISSC/IBM services - were trading at P/E ratios of 28.5 and 32.5, and P/R ratios of 1.18 and 1.05 respectively).

But Lou Gerstner was more interested in empire-building than in increasing the shareholders’ value the old-fashioned way.  So he opted for increased central control, and for stock buybacks as a way to force Wall Street to elevate its IBM valuation. 

The strategy worked.  For a while… But the play also left the current IBM leaders saddled with a lot of unprofitable baggage.  Furthermore, the biggest “crown jewel,” IBM Global Services (IGS), became an “erstwhile crown jewel” in the 2000-2002 period, as its once impressive double-digit growth flattened out and even turned south in some quarters (see “Big Blue Stock to Take a Dive?”, Jan 2002 and “Analysis of IBM’s Second Quarter Results,” July 2002).

Back to Growth…

So IBM took action.  In at late July 2002, it bought PriceWaterhouseCoopers Consulting (PwCC) for $3.5 billion to bolster its growth, and to augment its ailing consulting business.  

The strategy worked.  At least mathematically…  One and a half years after the PwCC acquisition was completed, IGS is back to double-digit growth.  In 2003, its revenues were up 17%, from $36.4 billion to $42.6 billion.  It was the best growth rate since 1995 (see the chart).  And we expect IGS also to grow this year (by about 8%).

IGS’ estimated net profit also jumped by 17%, from $3.2 billion to $3.75 billion.  Its operating margin, perhaps the fairest gauge of competitive profitability comparisons, edged up slightly – from 12.7% in 2002, to 12.9% last year.

But… there is always a but, isn’t there?  IGS’ 17% revenue surge in 2003 represents about a flat or slightly higher “organic” performance, after adjusting for currency translations and the PwCC acquisition ($35.6 billion vs. $35.4 billion, up 0.5%).  (At the bottom line, however, we figure that an apples-to-apples comparison between 2002 and 2003 would represent a 5% drop in net profit, from $3.2 billion to $3.05 billion).

Business Segment Analysis

Still, “flat or slightly higher” 2003 performance beats the revenue declines from prior years.  Plus, IBM and IGS management deserve kudos for a smooth integration of the PwCC operation into the Big Blue fold.

PwCC is today an invisible part of the 60,000-people strong BusinessText Box:  Consulting Services (BCS) unit, whose revenues surged by 38% in 2003, from $9.3 billion to $12.9 billion.  Of course, both figures are “as reported,” without adjusting for PwCC or foreign exchange gains.

Outsourcing, on the other hand, continues to be the fastest-growing part of IGS on an “organic” or any other basis.  Its revenues were up 14% in 2003, from $15 billion to $17.1 billion.  The fact that outsourcing is also IGS’ biggest segment, accounting for 40% of the total, bodes well for the unit’s overall growth, too.

Integrated Technology and Maintenance segments also rose in 2003, at 8% and 7% respectively.  But these growth rates mean that both IGS units basically stayed flat in constant currency.

Maintenance Boosts IGS’   Profits; IGS Net Drag on IBM

As we had noted in our previous Annex Bulletins on IGS, hardware maintenance has been a boon to IGS’ profits over the years.  IGS, on the other hand, has been a net drag on IBM’s earnings.  How’s that possible?

Well, consider the facts… During the last 10 years, IBM services without maintenance contributed $235 billion to IBM revenues, and $17 billion to the company’s net profit.  Maintenance, on the other hand, accounted for only $57 billion of total revenues, but dropped $11 billion to Big Blue’s bottom line.  That makes the maintenance net margin more than three times higher than that of the rest of the IGS services (19% vs. 6%).

Text Box:

IBM’s corporate net margins averaged 8% during the last 10 years.  Which means that the IBM services without maintenance (a 6% contribution) has been a net drag on IBM net margins.  Together, however, which the way IBM reports its results, IGS accounts for nearly half the net profit that IBM earned during the 1994-2003 period ($28 billion out of $60 billion).  That’s another reason why IGS still deserves to be IBM’s “crown jewel.”

Text Box:

Perhaps the most important reason, however, is that IGS has allowed IBM to reestablish account control through its long-term contracts.  Having a customer pay for the value it derives from the IBM equipment over time had been the mainstay of IBM’s success prior to the late 1970s.  When IBM sold off its lease base in the early 1980s, Big Blue basically relinquished account control, and subjected itself to the vagaries of competition (Can you imagine that?  The word was a near heresy in the “good old days” of IBM under the two Watson’s).

Well, many of IBM’s big customers are now once again locked into long-term contracts with Big Blue.  So getting into the IT services game was sort of a trip back to the future for IBM.

“Rescoping” Challenge

The term “locked in,” however, must be used loosely and advisedly.  For, many of IBM biggest customers have proven that they can renegotiate their contracts (downward) in the last two to three years.  It’s a process that the IBM CFO, John Joyce, termed “rescoping” in his July 2002 teleconference with Wall Street analysts.

“Rescoping” may have been a new word in the English language, but a depletion of IBM’s backlog has been something that we have been warning about since the fourth quarter of 1999 (see the chart).

Text Box:

In fact, so much “rescoping” has been going on that in 2003, for example, the year in which the process was supposed to have “stabilized,” according to IBM’s CEO, Sam Palmisano, IBM was losing on average about $11 billion of its backlog each quarter.  As a result, even after a stellar IGS new contracts sales performance ($55.4 billion in 2003), the backlog went up by only $8 billion.  Since 1999, IBM averaged $9 billion of losses due to “rescoping,” cancellations and expirations of its services contracts.

So rather than “stabilizing,” process seems so be accelerating.  Stemming the “rescoping” challenge, therefore, is one of the major challenges that IGS faces.  Over-delivering and under-promising, instead of the other way around, is one way of keeping happy customers.  Such a change in tactics may be an answer to the IGS challenge.  Alas, the new contract sales may then suffer, too.  And that’s something of which Wall Street would take a dim view.

So IGS faces a quandary.  If the company takes a long-term view, however, there is little doubt that its shareholders would be better served with a change in sales tactics to over-delivering and under-promising.  It’s not much fun for any sales organization having to start each quarter about $11 billion in the hole, is it?  Especially with a bunch of hungry competitors nipping at its heels.


IBM and IGS executives have made it seem as if their OnDemand marketing concept was the answer to IGS’ future growth and all other challenges.  It isn’t.  The only thing that's really new about the OnDemand idea is its name.  And IBM's effort to turn it into an "era," analogous to the "mainframe era," or the "client/server era" (see “Different Strokes for Different Folks,” Dec 2003).

The way we see it, the OnDemand idea is the modern-day realization of usage-based computing, a term that we first used back in 1984 (yes, 20 years ago!) in reference to IBM.  We asked, "Is IBM a Utility?" in an editorial.  OnDemand is also the evolution of other IBM marketing schemes that didn’t take, such as “e-commerce” or “network centric computing.”

So what will it take to restore IBM’s biggest “crown jewel” to its former luster?  Well, a lot more than marketing slogans.  Stopping the hemorrhaging that the “rescoping” is causing, for example, is much more important.  So is finding new markets to grow the business, such as SMB (small and medium business market).

If IGS goes back to basics and focuses on substance that had made it great in the 1990s – delivering best value for the money – its “crown jewel” status may indeed be restored.  If not, the OnDemand fluff and all the hoopla that came with it will end up as yet another passing fad.

Happy bargain hunting!

Bob Djurdjevic

For additional Annex Research reports, check out... 

2004: "Cap Gemini: Another, Smaller Loss" (Feb 2004);  "CSC: Good Quarter Gets Boos" (Feb 2004); "Hot Air Jordan" Flaunts Flop as Feat (Feb 2004); "Cronyism Is Alive and Well at EDS" (Jan 2004);  "Five Most and Least Likely Forecasts for 2004" (Jan 2004)

2003 IGS:  "IBM OnDemand: Different Strokes for Different Folks" (Dec 2003); "Investing in Growth" (Apr 2003)

2003 IBM: "IBM vs. HP: Spinning Global Server Market Shares" (Nov 2003);  "Finally Heard, Part II," (Nov 2003), “Small Is Now Big at Big Blue” (Oct 16),  “On the Nose But No Cigar” (July 16), “A Paler Shade of Blue” (June 2), “Save, Spend and Split” (May 8), “Shrunk by the Marketplace” (Apr 17), “Turnaround Continues...” (Apr 15), "Finally Heard!" (Jan 29), “Start of a Real Turnaround?” (Jan 17).

2002 IGS: "Half or Double Trouble?" (Aug. 12, 2002), "IBM to Take $500M Charge" (Sep 3, 2002), IBM-PwCC Update (Oct 2, 2002), Analysis of IBM Second Quarter Results (July 17, 2002), IBM Layoffs Confirmed! (Aug 14, 2002), Analysis of IBM Third Quarter Results (Oct 16, 2002), Boom Amid Gloom and Doom (Oct 10, 2002)

2002 IBM: “Gerstner: The Untold Story”  (Dec 27), "Gerstner Spills the Beans" (Dec 13), "On a Wing and a Prayer" (Oct 21), "IBM-PwC Tie the Knot" (Oct 2), Big Blue Salami (June 19), "Looming IBM Layoffs" (May 14), "IBM 5-Yr Forecast: From Here to Eternity?" (Apr 2002),  “Tough Times, Soft Deals,” (Apr 25, 2002), “Gerstner’s Legacy: Good Manager, Poor Entrepreneur” (Jan 2002), IBM Pension Plan Vapors: Where Did $17 Billion Go? (Mar 2002), "Sir Lou OutLayed Lay!" (Apr 1, 2002).

A selection from prior years: Is IBM Cheating on Taxes, Annex Bulletin 99-17 (May 1999),  IBM 5-year Forecast 2001: An Unenviable Legacy (June 2001) "Break Up IBM!" (Mar. 1996), Fortune on IBM (June 15, 2000), “Smoke and Mirrors Galore,” July 2000), "Slam Dunk of Bunk" (Jan 2000), Annex Bulletin 98-14 ("Wag the Big Blue Dog"), Armonk's Fudge Factory (Apr. 9, 1999)Where Armonk Meets Wall Street, Greed Breeds Incest (November 1998)Stock Buybacks Questioned: Is IBM Mortgaging Its Future Again?, 97-18 (4/29/97),  "Some Insiders Cashed In On IBM Stock's Rise, Buybacks" 97-22, 7/27/97,  Djurdjevic’s Forbes column, "Is Big Blue Back?," 6/10/97;  “Executive Suite: How Sweet!,” (July 1997), "Gerstner: Best Years Are Behind", Aug. 10, 1999), "IBM's Best Years Are 3-4 Decades Behind Us" (July 1999), "Lou's Lair vs. Bill's Loft" (June 1999),  "Corporate Cabbage Patch Dolls," 98-39, 10/31/98; Djurdjevic’s Chronicles magazine October 1998 column, "Wall Street Boom; Main Street Doom", “Louis XIX of Armonk,” (Aug. 1996), "Mountain Shook, Mouse Was Born" (Mar. 25, 1994), “A Nice Guy Who Lost His Compass” (Jan 26, 1993), “Akers: The Last Emperor?” June 1991), Industry Stratification Trend (Mar. 30, 1990) etc.]

Or just click on and use "financial engineering" or similar  keywords.

Volume XX, Annex Bulletin 2004-08
March 22, 2004

Bob Djurdjevic, Editor
(c) Copyright 2004 by Annex Research, Inc. All rights reserved.
e-mail: annex@djurdjevic.com

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