IBM’s Life Line

IBM Corp. was a dinosaur on a path toward extinction four years ago when company strategist John Patrick hit on a way to revitalize the struggling giant.

In “Get Connected,” a paper widely circulated at IBM, Patrick argued that the modern corporation had to be networked not only to its employees, but also to its customers and suppliers around the globe. The solution, he argued, was the Internet, a computer network that at the time was still a little-known tool used largely by hobbyists and academics for e-mail.

Today, Chairman and Chief Executive Louis V. Gerstner Jr. has latched on to Patrick’s “networking” mantra as IBM’s way back to the technological fast track. Today Patrick is IBM’s Internet guru, helping to tailor the company’s products to the new wired world.

“The opportunities in the Internet fall into every category of information technology,” says Patrick, who pictures IBM as a one-stop shopping center for customers seeking to get wired. “We can put it all together and make it work. I don’t know anybody else that can.”

The timing couldn’t be better. After cutting costs, speeding up product development and beefing up marketing, Gerstner has brought IBM back as a powerful technology player. The computing giant--which lost $15 billion between 1991 and 1993--brought in a healthy $5.4-billion net profit last year. Its share price has rocketed 400% from a low five years ago, and the stock is once again an industry bellwether.

Though few refer to IBM as a dinosaur anymore, its long-term prospects are still very much open to question.

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At a time of booming computer sales, IBM’s growth has been held back by its heavy dependence on languishing proprietary mainframe and mini-computer products. Robertson Stephens, a San Francisco investment house, estimates IBM’s revenue will grow just 5% this year and only 4% next year, compared with a growth rate of about 15% for Hewlett-Packard Co. and much higher rates for such companies as Sun Microsystems Inc., Microsoft Corp. and Compaq Computer Corp.

The question IBM faces is simple: Can the once-dominant computing giant use the World Wide Web to transform its weaknesses into strengths and return to growth-company status?

Though impressed with IBM’s streamlining, many analysts question whether the company can move fast enough to effectively exploit rapidly emerging opportunities.

“In markets where the product life cycle is short, they still have great difficulty, and that’s where all the growth is,” says Scott McGready, an analyst at IDC Corp., a Framingham, Mass.-based market research firm.

Indeed, in recent years, IBM has missed out on virtually every major high-profit growth market it has encountered. It has ceded the network infrastructure business to Cisco Systems Inc., the personal computer and server business to Sun Microsystems and Microsoft, and the profitable database business to Oracle Corp.

And much of the company’s profit growth reflects easy cost-cutting gains, such as the $2 billion taken out of its research budget. IBM has boosted earnings per share an estimated 22% this year, but half that gain will come from the billions of dollars the company is spending to buy back its shares. Net profit is expected to grow less than 14% this year.

But give Gerstner credit. IBM is a more vital company today than it was when he took over in 1993. It has regained its image as a technology pioneer. In spite of some snafus, the company was able to show off impressive networking capabilities at the 1996 Olympics in Atlanta, allowing people around the world to use their computers to check the outcomes of sporting events.

In a public relations coup earlier this year, IBM supercomputer Deep Blue defeated world chess champion Garry Kasparov in a widely publicized match. And recently, IBM’s research labs announced a major breakthrough in copper chip technology that should help make semiconductors cheaper and faster.

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The “new” IBM is moving into a new building shaped like a lightning bolt that cuts through the woods near its old Armonk, N.Y., headquarters. After years of cutbacks, IBM last year hired 25,000 people, mostly in networking.

Its trump card is the continued dependence on mainframes to store an estimated 70% to 80% of the data in the world, everything from airline reservations to financial transactions.

Most business data are on mainframes, Patrick says, and with more people accessing that data, “it drives demand for big servers and disk storage and services.”

The growing need to network far-flung computer systems and to tie them into large corporate databases has proven a boon for IBM. The company’s service business, an outgrowth of its old computer maintenance operation, grew 25% last year to generate revenue of $23 billion, making it the world’s largest computer service organization.

“About 50% of money spent on network computing will be spent on services,” says Buzz Waterhouse, general manager of marketing and business development for IBM’s global services group.

IBM’s reputation for reliability remains a key selling point for many major corporations and institutions. The Shanghai Stock Exchange is working with IBM to computerize its trading systems and introduce Western-style risk-management systems. Following big losses at Daiwa Bank, some Japanese banks are doing the same.

The services business could get an important boost from IBM’s strong commitment to Java, which Sun Microsystems is promoting as an alternative platform to Microsoft’s Windows for developing Net applications.

With 2,500 people working on Java applications, IBM is the leading developer of this popular new computer language. Many of the applications are designed to help employees and customers tap into data stored on corporate mainframes.

Banco do Brazil recently hired IBM to lead a $180-million effort to connect computer systems in its branches using Java technology.

Because Java allows developers to write a software application once and run it on any computer system with relatively minor changes, it could help solve one of IBM’s thorniest problems: the reluctance of many software developers to come up with new applications for IBM’s older, less popular computer systems.

But it’s unclear how much of a return IBM will get. It could be years before Java is widely accepted as a standard like Windows. And there may be limits to how far IBM will commit to Java.

“They like to control the things they sell,” says Jim Cassell, vice president at Gartner Group, a technology consulting company.

And while IBM’s service business is showing healthy growth, it is less profitable than its traditional computer business. Putting computer networks together requires hard-to-find and costly technical talent.

Although IBM is packaging some of the networking technology it has developed for its customers as broad-based solutions--a program to help businesses set up shop on the Web, for example--it is unclear how lucrative a business venture that will be.

Although more aggressive than in the past, IBM hasn’t done a stellar job marketing its products.

Take Notes, the software that allows groups to collaborate electronically using central files that are easily accessed and updated. IBM acquired the popular software used for helping teams collaborate when it bought Lotus in 1995 for $3.5 billion. Although IBM boasts that it sold Notes licenses for more than 1.8 million people--double the number of last year--it is falling behind in a highly competitive market.

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Microsoft says its product, Microsoft Exchange, is used by 5 million people, after less than one year on the market.

Aerospace giant Lockheed Martin Corp. recently opted for Microsoft Exchange over Notes for its 200,000 computer users. “Notes is too complex to administer,” says Ronald Kosar, manager of systems engineering for Lockheed.

Chevron Information Technology Co. is leaning toward dropping Notes, which it uses to share product evaluations and other corporate information. Instead, the San Francisco Bay Area-based subsidiary of the oil giant would use Web sites on an Internet-style network.

“Two or three years ago, Notes had a big jump on anything available,” says Jim Nathlich, technical analyst at the Chevron subsidiary. “Now the Web is catching up. It’s a lot easier to do things on the Web.”

The departure from Lotus of Ray Ozzie, the inventor of Notes and the key force behind the product, could also take some wind out of the sails of IBM’s efforts to evangelize Notes.

IBM’s failure to move quickly to turn Notes into a broader industry standard reflects similar failures in the past.

Although its OS2 operating system has been considered by many to be technologically superior to Microsoft’s Windows, IBM was never able to sell much of the software beyond its strong customer base in the banking worlds. A joint venture with Motorola Inc. to develop the PowerPC microprocessor as an industry alternative to Intel Corp. has since been disbanded. And efforts in concert with Apple Computer Inc. to develop first a common software language and then a common multimedia platform to compete with Microsoft were closed down two years ago.

These efforts failed partly because of poor marketing. But they also ended because IBM’s loyalties have always been first and foremost to its profitable proprietary computer lines and the thousands of customers who use them.

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Although IBM’s long-standing customers represent an important stream of revenue, the need to support and continue research on half a dozen completely different computer operating systems that use different technology and run on different software also represent a massive burden to the company.

“IBM has the problem unlike HP, Sun or Digital: They have to support [half a dozen] different platforms,” Cassell says.

IBM is making an effort to give new life to its old computer lines by stressing their Internet potential. For example, the profitable AS400 mini-computer that is popular among small businesses is being marketed as an ideal machine for setting up Web sites. The AS400 is now packaged so customers can easily install the routers and other equipment required to connect to the Internet.

“If you are a plumbing wholesale distributor and you want to make a Web site but you don’t want to know about routers, AS400 is the way to go,” Patrick says. “It’s all integrated, and it has reliability, security and manageability.”

Analysts say that although the effort could help IBM keep its existing customers, it is unlikely to generate new business.

IBM continues to be undermined by the same forces that led Microsoft Chairman Bill Gates to prematurely predict IBM’s demise many years ago: The rise of industrywide standards to replace older systems that run on proprietary software and hardware.

The Net makes it easier for customers to use a range of computer systems, but users are still turning to standard software that runs on fast, cheap hardware and gives them a wider range of applications to choose from.

The Transaction Processing Performance Council, a nonprofit group that benchmarks the performance of different computer systems, recently concluded that Microsoft’s Windows NT running on standard PCs handles computer tasks for as little as a quarter the cost of the IBM AS400. That gap will widen as PCs become more powerful and Microsoft releases improved versions of its NT software.

Where computer makers once made their money coming out with the basic software that operates computers, Microsoft is driving down the prices of operating systems. As a result, the big profits are now being made by companies that develop complex applications that improve a company’s operations.

“The hardware and operating system has become a commodity,” says Paul Wahl, chairman of SAP America, whose best-selling software for improving business efficiency has taken corporate America by storm.

Although SAP recently rewrote its popular R3 software so customers would have the option of running it on their IBM mainframes, the company says the majority of its major growth area is software designed to run such industry standards as Sun Microsystems’ UNIX software and Windows NT. Wahl says 45% of its new customers are choosing to run the SAP software on Windows NT systems.

Although IBM has its own version of UNIX, called AIX, that runs on what it calls the RS6000 series of computers, many analysts say IBM’s version is losing support.

“In the cold light of day, the RS6000 and the AIX isn’t league- leading,” says Gartner Group’s Cassell. And IBM’s alternative to Windows NT, called OS2, is “nearly dead,” he adds.

Under Gerstner, IBM has attempted to light a fire under its personal computer division. And though the business is getting higher marks, it is losing out in some key markets.

In the last three years, IBM’s share of PC sales to the critical large- and medium-sized business sector has fallen from third to fourth place behind Dell Computer Corp., Compaq and Hewlett-Packard, according to market research company IDC.

IBM’s problems have been papered over by a recent revival in demand for mainframe power. But since the power of the mainframes has climbed as prices have dropped, even that revival has barely managed to keep IBM’s total revenue from sales of the machines from falling.

And analysts say demand will turn downward again as most customers complete their transition to the new generation of low-maintenance mainframes IBM recently introduced.

“As soon as the transition is complete, this bubble of people migrating off the old technology will pop, and you will go back to business as usual,” Cassell says. By next year, Cassell expects to see the industry revert to its previous trend of declining mainframe sales.

If that happens, even Patrick’s vision of a healthy Internet business may not be enough to keep the company growing at a healthy pace.

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IBM’s Profit Picture

While service revenue has soared. . .

1997 estimate: $19 billion

. . .mainframe revenue is shrinking. . .

1997 estimate: $5 billion

. . .and software sales are stagnant.

1997 estimate: $12.7 billion

As a result, profit growth is slowing slightly.

1997 estimate: $6.2 billion

Source: Salomon Bros.