Last year, investors flocked to IBM as a safe haven in the tech downturn. Its
stock soared more than 40% during 2001, to close the year at 121. But this year,
investors have fled. The company’s shares have slid more than 40%, compared
with an 11% decline for the Dow Jones industrial average and a 20% drop in the
Standard & Poor’s 500-stock index.
What’s ailing Big Blue? The soft economy, accounting concerns and a
continuing slump in tech demand certainly hurt the company in the first half of
the year. But it took the scandal at WorldCom Inc in late June to send IBM
shares to their new low. WorldCom’s financial woes threw doubts on its
services contract with IBM rival Electronic Data Systems Corp, which gets nearly
3% of its revenues from WorldCom.
Investors are spooked that similar troubles throughout Corporate America
could hurt IBM’s services business, which at $35 billion is the world’s
largest. Indeed, its customers include struggling Italian carmaker Fiat and
troubled telecom-gear maker Lucent Technologies Inc. "There’s a lot of
worry about the services business," says analyst Steven Milunovich of
Merrill Lynch & Co. "The comfort level with IBM as a safe haven has
lessened."
IBM is hardly in crisis, but there is some reason for the worry. The company’s
services group, which helps customers dream up, build, or manage computer
systems, accounts for 41% of the company’s revenues and 47% of its pre-tax
profits. Now, sagging profits have forced many IBM clients to cut back their
services contracts. Long-distance player Sprint, Nortel Networks and Ames
Department Stores are just a few IBM customers that have restructured contracts
in recent months. In a June interview, IBM Global Services head Douglas Elix
said reworked contracts were cutting a few percentage points of growth from the
services unit–the company’s growth engine in recent years. Nevertheless, he
says, "most of the tough adjustments have been done or started."
New CEO Samuel J Palmisano, is moving fast to adjust to the difficult
economic times. He’s sticking with the company’s fundamental strategy of
providing a range of software and hardware to customers–all wrapped together
with the company’s white-glove service. But he’s fine-tuning the approach by
trimming expenses, exiting poorly performing, low-margin businesses, and moving
the company further away from its manufacturing roots. In the past six weeks,
for instance, the company has sold off a chip-packaging plant in Endicott, NY,
and shut down aging chip-production lines in Burlington, Vt.
The chief executive also is pushing the 315,000-person company to be more
nimble. For example, he has given 400 sales execs the ability to cut prices on
the spot to close deals, in addition to the 60 managing directors who could do
so in the past.
Will Palmisano’s moves be enough to put IBM back on track? They’re a
solid start. Palmisano’s house cleaning will help the company begin growing
again when the economy perks up. Still, he has substantial work ahead of him to
get IBM back to its market peak. The services group, in particular, may not be
the growth engine for the company that it has been in the past.
Though it averaged 12% growth over the past five years, the unit boosted
revenues 5% last year and is expected to increase them only 2% this year, to
$35.7 billion, according to Sanford C Bernstein & Co. IBM’s total sales
from continuing operations are expected to drop 4% in 2002, to $79.9 billion,
while net income falls 12%, to $7.1 billion, Bernstein says.
Palmisano will likely have to turn to IBM’s software business to drive
revenues. The unit sells businesses everything from software to run their
mainframes to programs for Web commerce. Software revenues are expected to be
flat this year at $12.8 billion, Bernstein says, but there are some gems that
could take off in the years ahead. For example, IBM has about 30% of the market
for application server software, which handles e-commerce programs for corporate
networks. That market is expected to grow 15% annually in the next five years,
rising from $2.3 billion in 2001 to $4.4 billion in 2006, according to
researcher IDC.
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IBM Global Services The division’s sales dropped 3% in the most recent quarter, to $8.22 billion. Customers are paring back contracts; new deals are taking longer to sign. Now, in the wake of WorldCom, investors are fleeing services firms that may be exposed to troubled companies. Response: |
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Microelectronics Its chipmaking group is expected to lose $233 million this year, after making $284 million in pretax income in 2001. Response: |
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Computers IBM’s server and PC sales are expected to decline 10% this year, to $10.7 billion, because of weak demand. Response: After an overhaul of the PC group that outsourced desktop manufacturing and eliminated 19 of 22 product lines, the business is on target to turn a small profit this year, following a $153 million pretax loss in 2001. |
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Accounting In the past, IBM used financial levers, such as gains from its pension funds, to boost profits. The accounting practices were legal, but some investors say they gave an overly rosy view. Response: In March, IBM released more data in its annual financial statement. It now breaks out intellectual property income as a separate line item, instead of combining it with SG&A to make overhead expenses look lower. Analysts still want more information. |
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DATA: SANFORD BERNSTEIN, COMPANY REPORTS |
IBM is taking steps to capitalize on such opportunities. This spring, the
company introduced a new version of its application server, called WebSphere,
that technology analysts, including Tyler McDaniel of market researcher Hurwitz
Group Inc, say is a substantial step forward. And this fall, the company will
release a new, streamlined version of WebSphere for small and medium-sized
businesses. It’s also laying the groundwork to move into promising new
markets. On July 9, IBM and Nokia announced an agreement to develop software
that distributes digital media securely over wireless networks. "This is
the next generation of e-business," says Rodney C Adkins, general manager
of the IBM group that makes software for mobile phones, handheld computers, and
other devices.
Still, there’s more work to be done. The software group needs to knock down
more walls between its hodgepodge of groups, eliminate more redundancy, and
market IBM as an integrated software brand, many analysts say. For example,
while IBM acquired the database software maker Informix last summer, the company
has yet to fully integrate Informix’s product with its own database offering,
and it has not had any major layoffs in the business. "If they are going to
turn this around, they need to leverage their size and act more quickly,"
says Thomas Bittman, a vice-president at researcher Gartner Inc.
Most Wall Street analysts are skeptical about IBM’s ability to rebound
quickly. In the past few weeks, at least 16 of the 21 analysts covering IBM have
lowered their earnings and sales estimates for this year and next. For the most
part, Wall Street remains concerned about weak tech spending. But investors also
want the company to change its accounting practices to disclose more financial
information. For example, they want to know how much income IBM gets from asset
and real estate sales. "They give you a little visibility but not nearly as
much as you need," says Ken Smith, a portfolio manager at Munder Capital,
which holds 2.3 million shares of IBM after selling more than 400,00 shares in
the first quarter. "That makes me leery of making IBM a large
holding."
The next milestone for IBM comes on July 17, when it reports earnings for the
second quarter. Investors such as Smith are looking for signs of improvement–especially
in services, software, and microelectronics. Goldman, Sachs, & Co analyst
Laura Conigliaro is expecting IBM to report $1.5 billion in net income for the
quarter, on $19.0 billion in sales from continuing operations. If the company
can meet expectations in the second and third quarters, "that would begin
the process of stabilizing the stock," she says. With investors and
analysts wary, IBM will be a show-me story for the rest of the year.
By Spencer E. Ante in New York in BusinessWeek. Copyright 2002 by The McGraw-Hill Companies, Inc