Annex Bulletin 2005-08                                       March 7, 2005

Confidential Client Edition

IT SERVICES

Analysis of IBM Global Services’ 2004 Business Results

Smaller, Shorter - Better?

Strong Organic Growth (w/o Major Acquisitions) Will Be Hard to Come By

PHOENIX, Mar 7 – IBM Global Services (IGS), Big Blue’s erstwhile “crown jewel” and the growth engine of the 1990s, is sputtering again.  Not that its 8% growth rate in 2004 was bad, mind you, especially when compared to major competitors’, like EDS or Fujitsu.  And it matches the overall growth rate IBM reported last year. 

But IGS is no longer driving IBM’s growth.  That’s the “new news.”  Its 8% revenue increase is a far cry from the double-digit annual surges to which we were accustomed in the early- to mid-1990s.

Besides, even the 8% rise is more than meets the eye.  Take away the favorable currency impact, and IGS’s real 2004 growth was about half of that amount.

No surprise there.  We said three years ago that IGS would need (major) acquisitions to grow.  It acquired PwCC in 2002, which did give it a temporary boost (see the chart).  But in 2004 and beyond, IGS is back to the old grind. 

Again, as predicted.  Losing $13 billion per quarter through “rescoping” and various other contract terminations doesn’t help its growth case, either (see the chart).

What’s IGS to do?

So what's IGS to do?

“For years IBM has stressed its ability, thanks to its large scale, to take on huge, long-term contracts that promise it steady streams of revenue for years to come,” the Wall Street Journal noted in a Feb 24 article on IGS. “But Mr. (John) Joyce (IGS’s head) said that IBM has discovered that smaller contracts are more profitable and are preferred by customers.”

Really?  That’s like discovering that the Earth is round.  Here’s, for example, what we recommended back in June 1996 to the late Dennie Welsh, the founder of IBM’s services business, on the subject of European market (the same principles, of course, apply elsewhere):

“…(IBM) would have an additional competitive benefit by driving the market toward the more complex deals, in which IBM has a “built-in” advantage in Europe due to its range and reach.  At the same time, IBM would not totally extricate itself from the (smaller) national deals, which can often be more profitable than the hotly-contested ‘megadeals.’  

In other words, we think that IBM should change its current style of thinking – ‘think global-deliver local,’ to ‘pay global-deliver as the customer needs’.”

Since that time, we have also repeatedly urged both IBM and its competitors to consider the small and medium (SMB) business market as the source of future growth – for precisely the reasons IBM’s Joyce “has just discovered.”

Well, guess better late than never… Of course, smaller deals tend to be more profitable – at the gross profit level.  But they are also more expensive to win (from the SG&A standpoint).  Which is why IT services competitors haven’t been exactly stumbling over each other to get into the SMB market in the last nine years, the gross margins allure notwithstanding.

Well, that’s about to change now.  Not only because the megadeals are fewer and harder to come by.  But because there are now ways to reduce the selling and delivery costs (through web-based applications) that weren’t available nine years ago.

So stand by not just for IGS, but also other competitors to discover that the Earth is round.  Capgemini, for example, is already blazing the trail, as you saw in our review of its 2004 results.  Its SMB business segment is the fastest growing and the most profitable (see “Capgemini: Turn ing the Corner,” Feb 2005).

Meanwhile, the death of the traditional outsourcing is “greatly exaggerated,” if we may borrow from Mark Twain.  In IGS’s case, it is still its biggest segment ($19 billion or 42% of the total), and also the fastest growing (up 13% in 2004).  It’s just that it’s not as profitable as consulting or smaller service deals.  So over time, one can expect the growth of outsourcing to slow down as the SMB activities pick up.

Profit Boost from Maintenance

Furthermore, IGS, whose net margins are around 7%, is getting a profit boost from IBM maintenance.  We figure that the latter has net margins of about 19% - more than three times higher.  Which is why IBM chose several years ago to report maintenance as a part of IGS, thus making its erstwhile “crown jewel” looking better and shinier.

Over the last 10 years, for example, we estimate that IGS earned about $17 billion on revenues of $276 billion.  Maintenance operations, on the other hand, earned about $12 billion on revenues of only $63 billion.

Outlook

Since we’ve already done the revenue and P&L forecast for IBM, which included a segment on IGS, we incorporate it here by reference:

IBM Global Services.  After years of being the fastest growing segment of Big Blue’s business, IGS is likely to become a drag on IBM’s growth this year and next.  Unless, of course, John Joyce, IGS’s head, does something rather dramatic to turn things around. 

The reason for our relative pessimism were the disappointing IGS new contract sales and “rescoping” results in 2004.  One curtailed the fresh new blood supply; the other drained it in enormous amounts.  And in an annuity-type business, such shortfall leaves deep and long-lasting scars on its financial results and prospects for growth.

What sort of dramatic steps can Joyce take?  Well, he must either sharply curb its “rescoping” losses, or significantly increase its new contract sales.  Or both.  Or IGS must seek to acquire companies that can bolster its growth (see “Save, Split and Spend,” Apr 2005).

Since there is no evidence that either of the three IGS boosters are in progress, we are expecting its revenues to grow at 4% both this year and next.  This would put it at just shy of the $50 billion mark by the end of 2006.

Of course, should IGS take our advice and implement one or all three steps we recommended, its growth rates will be higher than those outlined in this forecast.  And so will IBM’s.

(An excerpt from IBM Revenue Forecast, Feb 2005)

IGS’s recent acquisition of Ireland's Equitant, which caters to companies looking to outsource their financial administration, is a step in the right direction.  The Dublin-based Equitant -- whose 200 staff manage about 44 billion euros ($57 billion) in revenues for clients -- provides order-to-cash services that streamline the process from ordering a product through to final payment for it.  Equitant has been working with IBM in a marketing partnership for the last year.

But IGS will need to do a lot more of those kinds of deals this year and next if it is to accelerate its meager rates of growth.  For, one swallow does not make a spring.

Happy bargain hunting!

Bob Djurdjevic