IBM Faces Impatience Despite Retooling

ARMONK, N.Y. (AP) _ When Sam Palmisano addresses IBM's annual shareholder meeting this month, Big Blue's chief will unfurl plenty of good news. And yet investors in the audience could be forgiven

Monday, April 17th 2006, 10:17 am

By: News On 6

ARMONK, N.Y. (AP) _ When Sam Palmisano addresses IBM's annual shareholder meeting this month, Big Blue's chief will unfurl plenty of good news. And yet investors in the audience could be forgiven for being impatient with the boss.

After all, while Palmisano's four-year reign has dramatically reshaped the technology company, by one key measure it has been unsuccessful. Since he became CEO on March 1, 2002, IBM's shares have dropped 20 percent, shaving about $50 billion from its market value.

Still, it would be hard to say Palmisano hasn't shown significant results.

With a lack of sentimentality more reminiscent of an outsider than the IBM lifer that he is, Palmisano has sold off underperforming units, reshuffled management and hacked big benefit costs such as employee pensions.

While profit had teetered from $8.1 billion in 2000 to $3.6 billion in 2002, it was back to $7.9 billion last year, despite tepid revenue growth in the past few years. Gross profit margins hit their highest mark since 1996.

But investors still worry about where it goes from here. Can an already massive IBM grow at anything more than moderate rates? Is IBM's key services division experiencing short-term hiccups or a deeper funk?

``There are buds springing up all over the business, but none of them are big enough to make anyone say, `Wow, they are really turning things around,''' said Bob Djurdjevic, a longtime IBM watcher with Annex Research.

IBM is by no means the only core tech stock to sag since March 2002. Microsoft Corp. and Intel Corp. are in the same boat. But in that period, the Dow Jones Industrial Average, which includes IBM, has gained 7 percent. The tech-heavy Nasdaq index is up 29 percent.

For now, Wall Street analysts seem to share Palmisano's optimism, having set a median target for the stock of $99.50, well above its recent trading range in the low $80s, according to Thomson Financial.

IBM's board also appears to be firmly in his corner, having upped Palmisano's compensation package to $19 million in 2005.

But investor sentiments could sour if IBM shares tread water much longer. One milestone comes Tuesday as IBM reports first-quarter earnings. The annual meeting follows one week later in Tulsa, Okla.

IBM would not make Palmisano available to comment, in keeping with his limited public profile. But other executives acknowledge being frustrated by the company's inability to excite investors.

``It (ticks) some of us off,'' said Robert Moffat, who is overseeing IBM's drive to streamline its services organization. ``I have been in the company 28 years. We have never been in a better position.''

The corporate name of International Business Machines Corp. describes only part of today's IBM, which sells not just computing hardware but also software and consulting services. It is the world's largest vendor of information technology.

That field is often called ``mature.'' It's growing only at mid-single-digit rates. But Palmisano, 54, has bet that IBM can grow faster than the broader market.

The path, in his view, is to concentrate on top-tier offerings with high profit margins _ from supercomputers to custom microchips to Web management software to ``business performance transformation'' services. IBM now leaves commodity items _ even ones it essentially invented, like PCs and disk drives _ to others.

Perhaps the biggest obstacle to this vision is that competition is tougher than ever in services, a labor-intensive field that accounted for 52 percent of IBM's revenue but 35 percent of pretax income in 2005.

In recent years, lower-cost providers around the world, plus increased savviness on the part of corporate customers, have made it harder for giants like IBM to win or renew enormous services contracts. Increasingly, customers are breaking up big jobs and parceling them out to multiple vendors in hopes of lowering costs and preserving flexibility.

As a result, the average size of technology outsourcing deals reached with the world's 2,000 biggest companies fell 8 percent to $296 million in 2005, according to TPI Inc. which tracks the field.

That could play against IBM's strengths as a vast soup-to-nuts provider that still struggles to be nimble.

``I'm not sure they really have a competitive differentiation today to the same degree that they had eight years ago,'' said Peter Allen, managing director at TPI.

In one telling figure, IBM's pipeline of services deals under contract was unchanged in 2005. That means any business the company won during the year just replaced contracts that had run out.

IBM says the statistic reflects a recent push to be more selective in services deals it pursues, putting more of a premium on profitability than the sheer size of a contract.

``I think they are aware of the market dynamics, the trend toward smaller deals,'' said Martin Shagrin, an analyst with Victory Capital Management. ``It's just a matter of, `Can you execute in that kind of environment?' I think we'll get the answer this year.''

Other parts of IBM are primed to see much faster growth, including the microchip-making division, which Palmisano held despite some clamor on Wall Street for him to sell it off.

The group could be near a home run with its Cell Broadband Engine, which combines nine separate processors in one chip for hyper-realistic graphics and other advanced computational functions. Cell is the brains in Sony Corp.'s upcoming PlayStation 3 game console and is expected to run a range of hardware from IBM and other companies.

Even so, it might require mind-boggling gains from chips to seriously change investor opinion about a company that already posts $24 billion in hardware revenue and $90 billion overall.

Consequently, Shane Greenstein, an expert in technology markets at Northwestern University's Kellogg School of Management, suggests it might take an enormous development, like the birth of the personal computer or the Web, to truly invigorate IBM.

``They need another big idea,'' he said. ``IBM's got to create it themselves, or wait for someone else to create it and get on the bandwagon.''

IBM clearly expects investors to maintain a long-term view. The company's dividend provides just a 1 percent annual yield. Much more of IBM's cash gets spent on research and development (consistently about 6 percent of revenue). IBM also has spent $24 billion buying back shares since 2002.

But executives say no moon shot is required to dramatically boost fortunes. They say the repositioning of the past few years has set IBM up to reap the benefits in the coming years.

``If we stick to our knitting, we'll be fine,'' said Adalio Sanchez, head of a new IBM unit, technology collaboration solutions, which aims to help customers increase their ``innovation,'' IBM's biggest buzzword.

It is one of many efforts to take advantage of IBM's scope by linking traditionally disparate parts of the 329,000-person company. For example, IBM is trying to use less labor in its services unit by deploying specialized pieces of software for certain tasks.

IBM also is cutting costs the old-fashioned way: with cheaper labor. The company now has 40,000 people in India, up from just 9,000 at the end of 2003.

The buildup has drawn the notice of India-based services rivals such as Infosys Technologies Ltd., whose revenue has soared from $120 million to $2 billion in seven years. ``They are a threat,'' Infosys co-founder Kris Gopalakrishnan acknowledged.

Another plan has Moffat, who squeezed billions in costs out of IBM's internal supply chain, trying to replicate the feat in the services unit. Moffat has had 70,000 IBM consultants classified according to their hourly billing rate and categories of expertise. Now those employees have been placed into an internal ``marketplace,'' essentially a dispatching service that can be queried any time to help services contracts run more efficiently.

Like Palmisano and much of IBM's brass, Moffat has been with the company long enough to have survived its near-death experience of the early '90s, before Lou Gerstner famously refocused IBM as a services provider. Moffat recalls seeing IBM's work force crater from 410,000 to 210,000 in a few years, and says the painful memories still inspire the executive team.

``A lot of us have a lot of pride that we're not going back to the point,'' he said, ``where people are going to question whether we're a great company.''