Tough Road Ahead for IBMs Palmisano

IBM's newly appointed CEO's many challenges include reining in expenses, strengthening a sagging hardware business and making the company more responsive to changing customer demands.

Lou Gerstner righted once floundering IBM and steered it back to profitability, but despite those accomplishments his successor, Samuel Palmisano, faces some daunting challenges of his own.

Among them, customers and industry analysts say, IBMs newly appointed CEO will need to further rein in expenses at the corporate giant, strengthen its sagging hardware business and make the company more responsive to changing customer demands -- all while finding a way to ignite stronger revenue growth.

While Gerstners pending retirement after an eight-year tenure has fueled questions about Big Blues future, the company quelled speculation about its future leadership yesterday by announcing Palmisanos promotion from chief operating officer to CEO. The decision by IBMs board becomes official March 1.

Palmisanos appointment was warmly received overall.

"Sam is a very good man, who is much more customer- and industry-oriented than Lou," said Bob Cancilla, director of corporate systems planning for Republic Indemnity Co. of America in Encino, Calif.

Cancilla, a 30-year IBM customer, who said he first met Palmisano when the executive headed up IBMs server division, believes the new CEO will bring a welcomed new emphasis on technology and service.

"Lou was a brilliant financial guy that did a superb job in turning the company around," Cancilla said. "Now its time to rebuild it from a computer, software and customer service standpoint."

Palmisano, who has worked at IBM since graduating from college in 1973, has held leadership roles in many of IBMs largest divisions and is considered to be extremely knowledgeable about the companys internal workings as well as the competitive landscapes it sells into.

"Sams a very talented executive," said John Jones, a market analyst with Salomon Smith Barney in San Francisco. "Hes engaging and a real hands-on executive. We think hell have a positive impact on the companys business going forward."

Andy Neff, a market analyst with Bear Stearns, said Palmisano will benefit from his detailed understanding of IBMs vast interests.

"He knows all the players; hes run all of their businesses at some point," Neff said. "And Gerstner is going to hang around a little bit to make sure everyones happy," he said, noting that Gerstner will stay on as chairman through 2002 to assure a smooth transition.

Outsider a better choice?

But some are wary of embracing Gerstners successor just yet.

Industry analyst Rob Enderle, of the Giga Information Group, said hes not sure whether a career-long IBM employee is the ideal choice to lead the company.

From his perspective, Enderle said, IBM still needs to streamline its operations and reduce its work force to effectively compete against more cost-efficient competitors. And when it comes to cutting jobs, he said, executives with personal ties to employees may hesitate to take the actions needed.

"The things that need to be done might best be done by an outsider," Enderle said, "because there are relationships you have to break."

Such thinking largely motivated IBMs board in 1993 to hire Gerstner, then CEO of RJR Nabisco, to lead the computer company. The appointment marked the first time in its history, dating back to 1911, that it picked someone outside the company to lead it.

Gerstner arrived at a turbulent time, with the company having lost nearly $16 billion in three years as it struggled to compete with lower-priced competitors.

Just as the board expected and employees feared, Gerstner didnt hesitate to make the tough calls his predecessors avoided, swiftly slashing the companys operating expenses by more than $7 billion, eliminating aging product lines and ultimately laying off more than 60,000 workers.

While investors largely supported the moves, news reports at the time revealed rising resentment within IBMs ranks toward their new CEO.

"He was definitely the bad guy," Cancilla said, "but he was a sweetheart to the financial guys."

Indeed, Gerstners efforts quickly paid off as the company went from losing $8 billion in 1993 to posting a profit of $3 billion in 1994.

Over time, IBMs stock soared, and with it, employee morale.

With more layoffs a possibility, Enderle questioned whether 28-year IBM employee Palmisano would be willing to take such actions.

"When youre an outsider, the fact that you have to fire somebody or demote them or ship them to another job isnt as difficult because you dont know them," Enderle said.

Services business boom

In addition to cutting IBMs operating expenses, Gerstner oversaw a broadening of IBMs revenue base, in particular its services business, which has grown to become the companys biggest source of revenue and profits.

In fact, it was IBM Global Services impressive performance during Palmisanos three-year leadership of the division that cemented Gerstners selection of him as his heir apparent.

"Theres no question that he did a great job while he was in charge there," Neff said.

IBMs surging services business proved particularly beneficial last year when hardware sales, once IBMs bread and butter, dropped dramatically during an industrywide slump.

In essence, Gerstners success in turning around IBM was no more clearer than it was last year during one of the computer industrys worst downturns, said Jones of Salomon Smith Barney.

"Last year, most of the other companies that I follow either lost substantial amounts of money or their earnings were down significantly," he said. "Meanwhile, IBMs stock went up 42 percent, and the earnings were on a comparable level with 2000."

"That performance is a testament to the work that Gerstner has done over the last eight years," he added.

But despite the companys impressive performance in a tough climate, Jones said Palmisano still faces a challenge to revive IBMs lackluster hardware business.

"The hardware businesses need more growth than theyve been generating," he said.

Over the last eight years, Gerstner has struggled with limited success to revitalize IBMs mainframe, server and PC sales.

IBMs mainframe business, once the undisputed technological leader in high-end computing, lost substantial market share to Unix-based systems from relative newcomer Sun Microsystems Inc. and longtime rival Hewlett-Packard Co.

Over the last 18 months, however, IBM has regained some ground thanks to a refreshment of its entire product line and the release of new technologies, such as its Power4 microprocessor that features a dual-CPU core.

PC sales, on the other hand, have proven more problematic, with IBM reportedly losing about $2 billion since 1998. Earlier this month, the company that largely revolutionized business with its introduction of its first PC more than 20 years ago, announced it would contract out its desktop PC production in an effort to save money.

In reporting the companys fourth quarter results earlier this month, John Joyce, IBMs chief financial officer, admitted that hardware sales continue to remain a drag on the bottom line.

"Microelectronics and hard disk drives continued to have significant year-to-year declines … [and] PCs declined significantly," he said in a conference call with analysts.

Given how IBMs weak hardware sales have dragged down the companys overall revenues, market analyst Neff believes Palmisano should consider abandoning some of its businesses, such as personal computers.

"They need to scale out of the areas that are less strategic, and a good example of that would be PCs," he said. "They need to focus on where their strengths are."