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What’s Bugging Big Blue

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DQI Bureau
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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.

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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."

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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.

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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.

Big

Blue’s Blues

IBM’s stock sank to a

four-year low of $67.60 on July 1. Here are the problem areas driving down

the company’s shares and what it is doing to fix them:

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:

IBM has laid off about 2,000 service employees. It’s using automation

and foreign workers to lower costs.

Microelectronics

Its chipmaking group is expected to lose $233 million this year, after

making $284 million in pretax income in 2001.

Response:

IBM is shedding its low-margin manufacturing. In the last month, it laid

off 1,500 workers and shut down aging chip production lines in Burlington,

Vt.

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.
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.
DATA:

SANFORD BERNSTEIN, COMPANY REPORTS
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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

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