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IBM's Gerstner counting on services in lean times

PHOTO: BLOOMBERG

International Business Machines Corp Chairman Louis Gerstner learned in May that a telecommunications company had decided to replace a competitor's computers with IBM's.

``But it wasn't a hardware decision,'' Gerstner recounted.

The unidentified customer wanted IBM's services ability to put together a wireless network, and ``that took total precedence,'' he said, over whose machines were used.

Services -- in particular outsourcing contracts, where companies turn over management of entire computing departments to IBM -- have sustained IBM through fat and lean quarters. The largest seller of computer services and hardware has counted on its 150,000-member Global Services group to help earnings rise while many rivals have reported earnings declines.

"Services will increasingly drive all other [information technology] decisions," Gerstner told analysts in May. ``It will drag hardware and software, not the other way around."

Armonk, New York-based IBM on Wednesday said second-quarter net income rose 5.4 percent to US$2.05 billion, or US$1.15 a share, from US$1.94 billion, or US$1.06, a year earlier. Sales slipped to US$21.6 billion from US$21.7 billion in the year-earlier quarter.

IBM plans to build a new facility based in East Fishkill, New York, manufacturing the world's most advanced 12-inch wafer semiconductor. Analysts say sales in IBM's microelectronics group, which included semiconductors, will be crucial to the company's second-half results. PHOTO: BLOOMBERG

IBM was expected to earn US$1.15 per share on sales of US$22.6 billion, the average estimates of analysts polled by First Call/Thomson Financial.

In the second quarter, IBM's services revenue increased 6.8 percent, and the division signed US$16 billion in new business.

The rise in services sales almost made up for declines in sales of hardware and software.

Louis Gerstner, IBM chairman To post profits through good times and bad, IBM is increasingly relying on income from its services division. The company's computer services and hardware group has helped earnings to rise while many rivals have reported earnings declines. The strategy has led to copycats. Compaq has moved to build its services capabilities. Hewlett-Packard has said it plans to purchase Comdisco to boost its services business. But Gerstner scoffs at the notion that rivals can simply acquire a services arm. "It takes years of discipline, of capital, of experience," Gerstner says. "It's a totally different model from running a hardware business or a software business."

Gerstner, who has been chairman since 1993, has long said his company's steady sales flow from multiyear services contracts, its geographic diversity and its varied products, from software to microchips, will keep IBM profitable, even as growth slows. The second quarter provided a stringent test.

IBM rivals had reported slowing spending in Europe. Required currency translation to the dollar pulled IBM's results down in the June quarter. More than half of IBM's sales come from outside the US, and a rising dollar means overseas revenue is worth less when converted.

During the second quarter, IBM announced outsourcing agreements with customers such as Japan Airlines Co, Asia's largest carrier; Fiat SpA, Italy's largest industrial company; and NTL Inc, the UK's biggest cable-television company.

``Services businesses can and do run counter to economic downturns,'' Gerstner has told analysts. ``When economic conditions drive business to be more efficient, services offerings help them reduce costs.''

In a recent Merrill Lynch & Co survey of 65 US and European chief information officers, 88 percent agreed with Gerstner that corporations increasingly will decide whether to spend informa-tion-technology dollars on the basis of services contracts, rather than specific hardware or software needs.

Compaq Computer Corp's move to build its services capabilities is a validation of the Gerstner strategy, analysts say. Compaq, facing sluggish sales of personal computers, has announced job cuts this year totaling 8,500, or 12 percent of its workforce. IBM has said it expects to add to its 316,000 workforce this year.

IBM's shares have climbed 23 percent this year. Many rivals' haven't fared as well. EMC Corp shares are down 73 percent, Sun Microsystems Inc is off 50 percent, Hewlett-Packard is down 17 percent and Compaq shares have risen 4.1 percent.

Many analysts have endorsed Gerstner's services-led strategy, which calls for helping clients integrate computers and Internet- related software into fast, complex networks.

Before the second quarter, services had generated two-thirds of IBM's revenue growth since 1994 -- US$20 billion of the US$32 billion total.

The services group brought a US$95 billion sales backlog out of the second quarter, representing annuity-like income from multiyear contracts.

Gerstner has scoffed at the notion that rivals can simply acquire a services arm. Hewlett-Packard said this week it plans to purchase Comdisco Inc's services business for US$610 million.

Hewlett-Packard dropped an effort last year to acquire PricewaterhouseCoopers' consulting arm.

"It takes years of discipline, of capital, of experience," Gerstner has said. "It's a totally different model from running a hardware business or a software business." Gerstner's total compensation last year was US$13.7 million. He was also granted options covering 650,000 IBM shares. If sold at today's closing price, they would be worth about US$67.8 million.

The 59-year-old Gerstner is widely expected to relinquish his chief executive's title, and perhaps that of chairman, when his contract expires March 1. Chief Operating Officer Samuel Palmisano, a 28-year IBM employee who turns 50 later this month, is widely viewed as the certain successor. Palmisano is a former head of IBM's services business.
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