STILL, MUCH DEPENDS ON THE PERFORMANCE of the service division, which accounts for more than half of IBM's revenue, but is growing at just 3%, well below the target of 6%. Signs of revival have emerged: Contract signings have bounced off a four-year low, but in the third quarter still were 5.4% below the $11 billion year-earlier level because of deals that didn't close. In a recent report, Cowen & Co. pointed out that IBM's $109 billion order backlog is 10% below its peak, which was hit in 2004, and has been flat for eight quarters, while growth has lagged its rivals.
Blame competition: In a stagnant market, IBM has been attacked by the likes of Accenture (ACN), the former Andersen Consulting, and HP, and is battling Indian rivals, such as Infosys Technologies (INFY), Wipro Technologies, a Wipro Ltd. (WIT) unit and Tata Consultancy (TCS.Mumbai), which provide services at lower cost and without any bias toward IBM products.
The Indians are moving into lucrative consulting contracts. And even though salaries and attrition rates are rising on the subcontinent, they're still five times cheaper than in the U.S. Tata Consultancy's revenue surged 42% in the September quarter. Says Rusi Brij, CEO of Mumbai-based Hexaware Technologies (HEXW.Mumbai), which provides IT and process outsourcing: "IBM and Accenture will not bill for less than $150 an hour on PeopleSoft [enterprise programs]. We do it for $80 to $90."
INDIAN BUSINESSES ARE LIKELY to keep gaining share. And in the next couple of years, some $110 billion in outsourcing deals will be up for renewal, according to Technology Partners International. Says Pip Coburn, the well-regarded technology strategist who steers Coburn Ventures: "Services is too big to grow effectively. It's slow growth, managed exceptionally well, but I doubt we'll ever see a meaningfully larger multiple."
While IBM has de-emphasized hardware over the years, it still is one of Big Blue's cash cows. The company is No. 1 in one of the hottest sectors: blade servers.
And IBM is taking the fight to the subcontinent itself. Last summer, it held an analysts' meeting in Bangalore, attended by a score of senior executives, including Palmisano and Bob Moffat, whose mission is to cut costs from IBM's suppliers and to boost productivity. Big Blue plans to invest $6 billion in India over the next few years. In 2004, it bought outsourcing outfit Daksh, and is rumored to be hunting for another Indian firm. Today, it has 43,000 employees in India, but its capabilities are global. Moffat points out that, when the lionized Indian actor Rajkumar died on April 12, sparking riots, IBM's broad reach let it shift data-center operations to Brazil and Colorado. And, he says, India is only one of the places where IBM will profit: "I can tell you five other centers with lower costs, including Vietnam and China."
Today, IBM says, shorter-term signings are improving. Service-oriented architecture sales are generating big contracts. Indeed, IBM's service operation is the software division's second-largest sales channel. Daniels says the company is focusing on gaining business from firms that want to outsource departments other than IT, including finance, procurement, human resources and call centers. IBM is also walking away from insufficiently profitable contracts.
THE SERVICES OPERATION, HE ADDS, has had "nine consecutive quarters of margin expansion," even as top- line growth has been sluggish. Offshore sites go a long way to reducing costs. For a labor-based service contract. the gross margin is about 40%. For a software-based security service package, the figure can top 60%.
Daniels says the company's target of 6% top-line growth is "very realistic." IBM is focusing at last on smaller- and medium-size businesses in the developed and emerging worlds, which don't need the giant multi-year contracts associated with Fortune 500 clients.
This quarter, contract growth is healthy: IBM won a $300 million contract to help revamp Scotland's public health service, a seven-year $863 million deal to run a data center for the State of Texas, and is expected, with Siemens (SI), to sign by year end a 10-year contract worth &euro;6.5 billion ($8.45 billion) to modernize technology for the German military.
Says Daniels: "All the things I described to you are necessary to take us from $50 billion to the next $50 billion. The service business had to be revitalized. We've responded boldly and we're focused on markets with significant growth opportunities."
Meanwhile, the cash-cow hardware division keeps ticking, with growth in the third quarter spurting by 8.8%, versus 5% in 2005, as mainframe revenue shot higher and because of gains in IBM's Technology Collaboration operation. Mainframes and servers account for 60% of hardware sales, and IBM has been gaining share in recent years in the server market from Sun Microsystems (SUNW), HP and others. Margins have fattened after IBM dumped the PC business.
Technology Collaboration is IBM's R&D and semiconductor-design unit. Through it, IBM partners with various industries and has even allowed its partners to build on once-secret IBM patents. (IBM spends about $6 billion annually on R&D and boasts 40,000 patents worldwide.) IBM processors are the core chips in all the major videogame consoles, including Sony's new PlayStation 3. Bob Djurdjevic of Annex Research in Scottsdale, Ariz., a long-time IBM watcher, predicts that Technology Collaboration "will become so large that it deserves comparison to IBM's shift to services several years ago."
Even if you don't buy the entire IBM turnaround story, the company's stock needs only part of it to work to show significant improvement.
Thanks to divestments and the move to more annuity-like revenues, "IBM has certainly become a more stable and more predictable company. That would argue for a higher-than-historical multiple," says A.M. Sacconaghi, Sanford C. Bernstein's technology analyst. In the past couple of years, IBM has generally bounced between the low 80s and high 90s. Historically, it has traded at a market multiple. Give the shares a market multiple on next year's earnings, and you get a price of $105 -- 15.7 times Sacconaghi's estimate of $6.70 a share for '07. That's about 15% above its recent price of 91.
In fact, Sacconaghi maintains, IBM "is even cheaper than it appears" because earnings this year are being depressed by an unusually large pension-related cost of 86 cents a share. That should moderate because IBM is ending its defined-benefit programs, as of 2008, and moving to defined-contribution 401(k) plans.
IBM could boost its share price by exiting the capital-intensive, cyclical chip business, Sacconaghi says.
Another bull on the stock is David Goerz, chief investment officer at HighMark Capital Management. "Looking out into '07 and particularly into '08, consulting services should do particularly well," he says. "IBM is remaking itself and the question is whether it deserves to be rerated at some point. Right now, I'm willing to give them the benefit of the doubt. They should grow faster than the market. This is a good long-term investment that will benefit from a stronger cyclical economy. The stock is an outperformer by at least 10% to 15% over the market."
THE MARKET'S DISDAIN FOR IBM SHARES dismays Palmisano. "We have a top share in servers and Linux, No. 1 in blade servers, which is a huge growth area -- analysts say the worldwide blade market can grow from $2.2 billion in 2005 to more than $11.2 billion by 2010 -- No. 1 in supercomputing, No. 1 in SOA, where the blurring of software and services is evident. We're No. 1 in middleware." And he declares: "IBM is a stronger company today than it was four years ago, with stronger margins, solid cash and earnings."
You don't need a computer to know what that trend could do for IBM's shares.