IBM Growth Seen Tied to Far-Reaching Services Division

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IBM has been known mainly for its large mainframe, server and personal computers, but with companies clamping down on technology budgets, IBM's growth may increasingly depend on the broad-reaching services it sells with those systems.

Services--everything from providing and managing computer systems in a company's offices to developing specialized software and management processes--are seen growing faster in 2002 than computer sales or consulting.

"It's a very good business in good times and it's a great business in bad times," says Bob Zapfel, general manager for strategic outsourcing at IBM

"I would say that as the economy has softened, especially in the U.S., but really on a worldwide basis, we've clearly seen an even greater level of interest from companies in outsourcing," Zapfel says.

IBM CEO Louis Gerstner, who is expected to step down this year, began pushing services in the mid-1990s, but the services business really picked up steam in 2001.

"We're really seeing that we had more new customers in the fourth quarter of a large scale than we've had in our history," Zapfel says.

IBM's customers range broadly, from the National Basketball Association, which runs the basketball league that includes teams like the New York Knicks, to utility holding company Xcel Energy, which has 3 million electric customers in 12 states.

Analysts and consultants who differ on whether technology spending will decline in 2002 or increase slightly, agree on one point--companies like these will turn to outsiders like IBM and competitor EDS to cut costs.

IBM sees the value of outsourcing even in its own business, as seen when it announced on Tuesday a $5 billion deal to contract out all of its U.S. and European desktop manufacturing operations.

Influential Goldman Sachs analyst Laura Conigliaro said in a recent research note that she expects IBM to post low double-digit revenue growth in outsourcing in 2002, while hardware sales will decline about 2 percent.

It is these services deals--and the revenues they have brought IBM this year--that Hewlett-Packard CEO Carly Fiorina says she hopes to find through HP's proposed merger with rival Compaq Computer.

Mixing In Services Revenue

One reason IBM and others are turning to services is that the contracts often stretch for years, creating steady revenue streams. For instance, outsourcing contracts typically involve monthly payments over five to ten years and run from $10 million to $1 billion, IBM's Zapfel says.

Because contracts take six months to 18 months to sign, they usually survive budget cuts, Gartner analyst Bruce Caldwell says.

They can also help cut costs by 10 percent to 30 percent, according to Gartner. IBM can cut costs in a data center, for instance, by up to 30 percent because it can run the service as part of a much larger off-site operation, thereby increasing efficiency.

"In this downturn in the economy, project-based services are cut," Caldwell says. "These are short-term, project-oriented things like consulting, development, integration, deployment. Those are more easily postponed, canceled or delayed than outsourcing."

That means that while corporate technology spending is expected to grow about 10.5 percent annually through 2005, long-term service contracts are expected to grow 12.5 percent. Business process and transactions, including areas like e-commerce, will grow 15 percent, he says.

In 2001, these long-term service contracts in the United States and Canada totaled $100.6 billion, according to Gartner, and in 2002 will be $113.5 billion.

About 38 percent, or $33 billion, of IBM's $88 billion in 2000 revenues was in services. Of that, these long-term service contracts made up about 40 percent, or about $14 billion. In the third quarter of 2001, services grew to 43 percent of revenues while hardware fell to 37 percent.

Hosting Is Hot

One of the hottest growth areas in services is hosting, in which IBM manages Web sites and other Internet-based services for outside companies, typically at an IBM location.

The NBA, which runs a Web site with player and league information, started working with IBM in 2000 primarily because it wanted the ability to respond to sudden increases in Web traffic.

"We get these huge spikes in traffic depending on what's going on--we've got the Slam Dunk contest going on and when someone makes a fantastic shot we get a huge surge in traffic right then and there," says Michael Gliedman, chief information officer at the NBA. "IBM has extensive experience dealing with those kinds of event-driven traffic patterns."

The scenario at Minneapolis-based energy company Xcel is a bit different. Xcel has outsourced all of its technology operations, including billing, to an IBM office in Boulder, Colo.

"I wanted more of a partnership than just a vendor relationship," says Dick Kelly, president of enterprises at Xcel.

Kelly says he got that, with IBM guaranteeing the company a 10 percent savings and agreeing to help the company trim costs to make its earnings-per-share goals.

"If you just handle IBM like a vendor, they are no different than any other vendor and that's how they are going to respond," he says. "You have to get to the point where if you are doing something dumb they tell you 'don't do that,' even if it means they are going to make less money in the short-term."

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