Palmisano Gets the IBM Puzzle

Hardware, software remain key concerns.

When Sam Palmisano takes over as CEO of IBM next month, he will lead a company still in the midst of a business and cultural transformation set in motion by his predecessor, Louis Gerstner.

According to IBM customers and observers, Palmisanos success will be measured largely on how well he navigates the company through its next phase, which includes an increased dependence on services, a revamped software effort and a hardware overhaul.

All the while, Palmisano will face increasing pressure from investors to pump up profits and trim expenses, they said.

"Gerstner shook IBM very hard," said one CIO and longtime IBM customer who asked to remain anonymous. "Now, it is stable financially. He came in and slapped the teen-ager around, and now it has to go out into the world and make a living. The question is, What will IBM be when it grows up?"

Another customer agreed. "Lou was a brilliant financial guy that did a superb job in turning the company around," said Bob Cancilla, a 30-year IBM customer and director of corporate systems planning for Republic Indemnity Co. of America, in Encino, Calif.

In large part, hopes for IBMs future rest on the IBM Global Services division, which is the worlds largest services business with more than 135,000 employees and $35 billion in revenues last year. Palmisano cemented his position as Gerstners heir apparent during his tenure overseeing services from 1998 to 2000, when he was elevated to president and chief operating officer.

"They have transformed IBM from a hardware and software company to a services company," said Sam Albert, president of Sam Albert Associates, a consultancy in Scarsdale, N.Y. "And its becoming a solutions company. By 2005 or 2006, 75 percent of IT will be outsourced. And the beneficiary will be IBM."

Services now makes up more than 40 percent of IBMs bottom line (see chart above), but maintaining that position wont be easy. Premium prices have kept IGS out of the midmarket, where many analysts think the next round of serious growth will occur. In addition, observers expect growth in nontechnology areas such as business process outsourcing, where IBM lags behind rivals such as Electronic Data Systems Corp. A shift toward utility computing could also prove troubling for IBM, which has experience with data centers but owns no networks for remote delivery.

Keith Hunter, executive vice president for transaction systems at Visa International Corp., said that given Palmisanos history with IGS, he expects IBM to continue to emphasize it.

"Before Gerstner, IBM was focused on selling CPUs, [direct access storage device], boxes," said Hunter, in San Francisco. "Gerstner heard us saying, A box is not enough. Speed to market is the key, and we need a partner who can assist us with deploying this stuff fast."

Surging services revenues and profits have provided IBM with stable growth, even during the ongoing recession.

"Last year, most of the other companies that I follow either lost substantial amounts of money or their earnings were down significantly," said John Jones, an analyst with Salomon Smith Barney, in San Francisco. "Meanwhile, IBMs stock went up 42 percent, and the earnings were on a comparable level with 2000."

The Armonk, N.Y., company last month posted fourth-quarter sales that were nearly $1 billion below estimates but still beat Wall Street profit projections. It also beat analyst earnings expectations by a penny.

But as strong as services are for IBM, there are concerns over software and hardware, including desktop PCs, servers and mainframes. Gerstner sought to boost IBMs software division by buying Lotus Development Corp., which makes the Notes program, for $3.3 billion in 1995, and management software maker Tivoli Systems Inc. in 1996 for $750 million. But given their recent lackluster sales, Palmisano must decide whether to pour more money into Lotus and Tivoli or cut them loose at a large one-time loss that will result in long-term savings.

He must make similar decisions on the hardware side of the ledger. While underperforming—it grew a meager 9 percent since 1993, while services jumped 260 percent—the unit still is a sizable business, bringing in more than $33 billion last year.

The units poor performance is all the more disappointing in light of record demand for servers and PCs in the late 1990s. Because of this, some analysts believe IBM needs to trim its product line, most notably by cutting loose its PC business. Since 1998, IBMs PC business is believed to have lost $2 billion.

"I think they need to scale out of the areas that are less strategic, and a good example of that would be PCs," said Andy Neff, an analyst with Bear Stearns & Co. Inc., in New York.

To reduce costs, IBM last month announced it plans to outsource the manufacturing of most of its desktop PCs, although it will continue producing its ThinkPad notebook PCs.

But Palmisano may have to go beyond such moves, including cutting jobs. Some observers question whether Palmisano, who has worked at IBM since graduating from college in 1973, will be willing to lay off longtime colleagues.

"The things that need to be done might be best done by an outsider because there are relationships you have to break," said Rob Enderle, an analyst with Giga Information Group Inc., in Santa Clara, Calif.

When Gerstner was brought aboard in 1993 after serving as CEO of RJR Nabisco Inc., he didnt hesitate to make the tough calls, swiftly slashing the companys operating expenses by more than $7 billion, eliminating aging product lines and ultimately laying off more than 60,000 workers. As Palmisano assumes the throne at IBM after eight years under Gerstner, observers will be looking to see if he is able to make the same decisions. He inherits the largest computer company in the world but one that has lost its trademark arrogance of the decades prior to the 1990s.

"Theres no danger of IBM lapsing into its old arrogance again," said the CIO who did not want to be identified. "All they have to do is watch Microsoft [Corp.] do a number on itself every day. Thats all they need to see."

Additional reporting by Stan Gibson, Jeff Moad and Paula Musich