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IBM earnings

IBM, a company that had hardware as part of its name, has so transformed itself that hardware is now the smallest part of its product offerings. It was not an overnight process; indeed, it’s taken two decades and two very different CEOs to come to this place. But thanks to Louis Gerstner and Sam Palmisano, IBM has moved beyond just hardware into its own almost peerless domain.

Out of the $23.3 billion in revenue for the second quarter just ended June 30, just $3.9 billion came from the Systems and Technology group, which is IBM’s hardware unit. It’s the second-smallest unit at IBM (NYSE: IBM); the Global Finance arm is the smallest.

As a hardware company, IBM is only a little bigger than Sun Microsystems was just a year ago and about the size of EMC (NYSE: EMC). With $5.2 billion in sales last quarter, IBM’s software business is bigger than the hardware business.

Between Global Technology Services and Global Business Services combined, it’s far and away the largest services company in the world. Business services this quarter were $13.4 billion, 60 percent of total revenue. IBM has an estimated backlog of services work at $132 billion, and services are very high margin, certainly much more profitable than hardware.

The result is a change in how the company presents itself to customers and potential customers. “When IBM now goes to market and reaches clients, it’s the services that they lead with,” Eugene Zakharov, director of the Professional Services Business research at Technology Business Research told InternetNews.com.

“They lead with their consulting capabilities, their integration capabilities, and once the solution is created, IBM decides what kind of software and hardware to use, whether it’s IBM or HP or Dell. So at the end of the day it’s not even IBM hardware they are differentiating any more.”

David Moskowitz, president of the consultancy Productivity Solutions, added that “Hardware used to be what they did. Now it’s just one of the many things that they do. They lead with a business solution that involves not just services but may or may not involve a box.”

Solving hard business problems

Hagen Wenzek, director of IBM Corporate Strategy, acknowledges that the company no longer leads with products. “We see ourselves as someone solving hard business problems,” he told InternetNews.com. “We think about going out and working with the people and provide the right hardware, the right software and services, data and information, everything, to fix the problem.”

Indeed, that’s what’s behind IBM’s latest batch of TV commercials that feature IBM researchers who talk of their work to “build a smarter planet.” Instead of selling z Systems or WebSphere, IBM is promoting its PhDs.

It has good reason to brag. In 2008, IBM was awarded 4,186 patents, the first time any company has broken the 4,000 mark in a single year. IBM beat out Microsoft (2030) and Intel (1776). It has more than a dozen research centers featuring some of the brightest technologists in the world, including multiple Nobel laureates, but they aren’t living in a world of isolation, Wenzek notes.

“[Researchers] have supported [the company] a lot by not being an isolated guy in the ivory tower but by being exposed to what is going on in the market by sitting in on projects,” he said. IBM researchers also routinely sit in on customer meetings.

“They got exposed to what is really necessary in the market and pulled that learning, that interaction with the clients, into the way they do research. I think that’s fundamentally different from an approach of having these folks hidden away working in darkened rooms and trying to come up with great ideas accidentally,” he said.

This de-emphasis on the IT ingredients is also being driven by customers, especially in emerging markets. “We hear from our clients, ‘don’t talk about IT, tell me how can this service shape my economy, how can it help my people get access to credit.’ In the conversations, you want to hide it, you want to focus on the outcome and not the nitty gritty stuff that sits behind it,” said Wenzek.

Next page: The reinventors

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IBM earnings

The reinventors

When RJR Nabiso executive Louis Gerstner took the helm of IBM in 1992, its initials could have stood for “It’s Bleeding Money” or “It Barely Moves.” IBM lost $5 billion that year and was widely viewed as a dead company walking.

Gerstner managed one of the best turnarounds of the decade, but on a quieter level, he also began the process of moving IBM away from its emphasis on commodity products and toward services to clients. He recognized one executive, Sam Palmisano, as someone who shared his vision.

Gerstner made Palmisano president of Integrated Systems Solutions, an IBM business services group, in January 1993. According to a BusinessWeek profile on Palmisano, he challenged an old notion in the company that service contracts didn’t need to make money immediately. He put in the hours, along with the rest of his staff, to grow the business. Palmisano would work his way up the ranks and begin IBM’s first flirtations with Linux in the late 1990s.

Palmisano became President of the company in 2002 and CEO in 2003, and continued the process of shifting the company. He purged the company of anything considered a commodity business – hard drives, printers, and eventually the whole PC line – in favor of higher margin products.

That sentiment is still in force today. During the second quarter earnings call, CFO Mark Loughridge repeatedly emphasized IBM’s shift away from low margin commodity products.

The biggest and boldest move was the purchase of PriceWaterhouseCoopers’s business consulting unit in 2003. PwC had to sell the services group to avoid conflict of interest in light of the Sarbanes-Oxley Act. For $3.9 billion, IBM picked up 30,000 skilled consultants in 52 countries.

That, said Zakharov, was huge. “It really enhanced the services business. It’s where they got their vertical expertise, a lot of client relationships and really jump started that services business,” he said. “PwC had vertical capabilities and the scale that would not just appear within IBM.” That gave IBM the extra expertise needed to service specific industries, like finance, banking, health care, utilities and government.

Wenzek credits something else for IBM’s change: the change in the datacenter.

“The datacenter used to be a storage room for all kinds of hardware to deliver very specific IT loads. Now it actually needs to support very new, very different workloads. It needs to run the utility grid, provide medical health records, needs to operate a city’s transportation system,” he said.

Next page: IBM’s biggest challenger

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“To be able to support that shift, IBM moved and acquired and developed a lot of software, specialized hardware, and a lot of services to automate, standardize and provide self service coming out of a datacenter,” Wenzek added.

IBM’s biggest challenger

So who is IBM’s peer these days? The closest one is not HP or Accenture but Oracle, said Zakharov.

“I think that’s why Oracle acquired Sun, in part, because Sun has some of the hardware where you can run a lot of Oracle apps but it also has a very strong services business. Part of it is maintenance but there’s a big chunk of Sun’s business coming from services, and on the high end. That’s a good mix that’s complimentary to Oracle’s path.”

Moskowitz agreed. “My instinct suggests that Oracle is more likely to emerge as a serious competitor to IBM than HP is, assuming that the three companies stay on the paths they are on. They got BEA to compete with WebSpehere, they got Sun for Java and hardware, neither one being too shabby, and they have their own team of consultants.”

Oracle doesn’t have a services arm to match IBM Global Services… yet. One thing in Oracle’s favor is consistency of leadership. IBM is about to lose its CEO for no other reason than the company’s mandatory retirement age of 62. Oracle CEO Larry Ellison is under no such limitation, but Palmisano will have to retire in the next two to three years and a successor has not yet been named.

Wenzek declined to discuss who might be his new boss. Instead, he said IBM’s next steps will continue on the path of solutions offerings rather than pushing specific technology.

“The next step is to be even more focused and make IT even more accessible, more affordable, to support a broader range of problems and continue to make sure that whenever something becomes a commodity, we take a hard look at it, because commodities are not where we want to be any more.”

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