IBM From Big Blue Dinosaur To E-Business Animal IBM's services now matter more than its hardware. That's the key to Lou Gerstner's remarkable turn-around--and to IBM's future.
By David Kirkpatrick

(FORTUNE Magazine) – Pat Zilvitis is chief information officer at Gillette in Boston and a huge IBM customer. But it's not the quality of Big Blue's PCs, servers, and mainframes that draws him. "I often don't know if I need hardware or software or services, and I don't care," he says. What Zilvitis likes is the ability to draw on IBM's unmatched breadth of products, people, and services. "I don't view IBM as a hardware vendor anymore," he says. "I think of them as an IT vendor that can help me in a number of different ways. If I've got a requirement, I go to [my IBM rep] and expect to get the right expert."

That must be music to Lou Gerstner's ears. He has spent most of his six years as IBM's CEO working to get customers to think this way. IBM has always promised data-processing "solutions" to its clients, but for decades those solutions were built around its hardware. Gerstner has engineered a remarkable transformation: Services, not products, are the engine that drives the new IBM.

The change has come at the right time. According to figures IBM only recently released, its software division is doing well, regularly scoring pretax margins of 20%-plus. IBM's problem is hardware. While sales of computers traditionally bring higher margins than sales of services like outsourcing and systems integration, the business is getting tougher. IBM has done a great job of milking its mainframes, which, with sales of server computers, still yield a 25.7% pretax margin. But monitors, storage equipment, and memory chips are far less profitable, with just a 5.8% margin last year. (To secure steady demand for such businesses, last month Gerstner scored two big deals: a $16 billion, seven-year agreement to sell parts to Dell Computer; and a $3 billion pact to supply disk drives to storage leader EMC.) IBM has been hammered in PCs; that division lost $992 million in 1998.

So the company really needs services. Last year customers paid it $23 billion for offerings such as these: to plan, install, and run their computer systems; to connect remote offices; to manage Lotus Notes installations; and as noted in IBM's hip (yes, hip) advertising campaign, to bring them up to speed in e-business. That's a 22% increase in revenues, which now account for 29% of IBM's 1998 sales of $82 billion--a figure that rose just 4% from 1997. Better yet, last year's pretax profit margin on services (including the maintenance of IBM computers) was 11.9%, up from 10.4% in 1997 and 10.2% the year before. In fact, pretax profits on such services were up 30% last year, reaching $3.8 billion, or 39% of IBM's total pretax profit of $9.7 billion. And if Gerstner can make IBM a force in the high-level, high-margin consulting dominated by the likes of McKinsey and Andersen Consulting--he's not there yet--profits will grow even more.

We may, in fact, have to redefine IBM as a services company: The Gartner Group research firm in Stamford, Conn., predicts that services will represent 46% of IBM's revenues by 2003 (see chart). Adds Sam Albert, a consultant and IBM watcher in Scarsdale, N.Y.: "IBM--International Business Machines--is becoming IBS, where 'S' is for services, software, and solutions." Shareholders back the shift; since Gerstner arrived in 1993, the stock has risen from just above $25 (split adjusted) to about $180.

With Sam Palmisano, who now runs the global-services division (and with Palmisano's predecessor, Dennie Welch), Gerstner has done an extraordinary job weaving services into every part of the complex fabric that is IBM. That was the plan behind Gerstner's controversial first step--canceling John Akers' scheme to break up IBM into a loosely affiliated network of "Baby Blues" built around different products. Gerstner saw that by keeping the company together, he could offer corporate customers a lot more than the trusted IBM name--he now also offers the widest range of products and experts in the business, a package capable of addressing virtually any IT dilemma.

"The trends are with IBM for the first time in 15 years," says Merrill Lynch analyst Steve Milunovich. "It's a services-led sale for them now, and that's appropriate because we are in a more solutions-oriented world." Corporate computing is getting more and more confusing; these days a typical FORTUNE 500 business must serve its suppliers and customers via its Website, manage complex enterprise-software packages, wirelessly connect its sales force, and last but not least, sell products over the Web. Worse yet, it must do all this using software and hardware from myriad sources, including Cisco Systems, Dell, Microsoft, Oracle, SAP, Sun Microsystems, and others. Says Tom Bittman, who heads Gartner Group's research on IBM: "Complexity drives services. The more you go to a heterogeneous world, the more services become necessary."

The potential is great. "There is $700 billion spent internally [each year] by companies on people, space, and facilities to perform IT services," Palmisano told a group of securities analysts last fall. "A big chunk of that is available to us." (IBM refused to talk to FORTUNE for this story.) The promise of services was underscored last year, when Compaq paid $8.5 billion for Digital Equipment Corp. in order to get its hands on Digital's massive global-services arm and assemble a company that looks a lot like IBM.

IBM headed into services full-bore back in the early '90s, when it bid aggressively to win major outsourcing contracts with the likes of Eastman Kodak and Hertz. In such deals, IBM typically takes over everything--the customer's IT employees become IBM employees, and IBM owns the customer's computers, which it then manages. Long-term outsourcing deals represent about half of IBM's services revenue, or almost $11 billion in 1997, according to Dataquest, which has yet to crunch IBM's 1998 figures. (The two other big slices of services are systems development and integration, and maintenance; then come software support, consulting, training, and business-management services). Outsourcing is a fabulously reliable business: IBM is guaranteed $51 billion over the next few years from outsourcing contracts with companies such as Dayton Hudson, which just signed a $400 million, five-year pact; the revenue will be booked as the services are delivered. Even Dick Brown, the new CEO of archrival EDS, endorsed IBM last summer. Then CEO of global telecom company Cable & Wireless, Brown signed a ten-year, $3 billion outsourcing pact that was IBM's largest ever outside the U.S.

Palmisano has renegotiated the early outsourcing deals at more favorable terms. Indeed, IBM has so proved its competence that customers like Monsanto have agreed to "sole source" contracts--they chose IBM without getting formal bids from outsourcing rivals like EDS or Computer Sciences Corp. Clients in sole-source deals pay as much as 30% more than they would if they had asked for competitive bids. But they seem willing to pay that price to work with someone they view as a technology leader. Explains Robert Zahler, a lawyer with Shaw Pittman Potts & Trowbridge, a Washington, D.C., firm that represents large customers in services transactions: "IBM has been able to leverage its 50- or 60-year heritage of being in front of these customers." Adds Linda Cohen, the top services analyst at Gartner Group: "IBM has so many sole-source deals because they have thought leadership. People say, 'Of course they ought to be able to manage it. They invented it!'" Cohen notes that IBM has put a large chunk of its R&D labs under the supervision of the sales organizations that work with banks, manufacturers, and other large companies. Says Cohen: "When clients ask who is investing the most in what will become useful information technology for business, I can honestly say IBM."

Big customers also like the scope of what IBM can do. Merrill Lynch CTO John McKinley, who has worked with outsourcers like EDS, AT&T, and Compaq as well, says, "IBM's ability to extend out from the traditional data center all the way to the desktop is probably unique in the industry." What IBM calls its services value chain comprises five elements--assessing, planning, designing, implementing, and running a customer's IT infrastructure. Said Palmisano in September: "We can assist a customer anywhere along this value chain." At Merrill, that meant rolling out 15,000 workstations and also helping the giant brokerage redesign its trading systems to handle heavier volumes.

When Big Blue first promoted its services, it had to convince skeptical customers that it was not out simply to sell IBM hardware. A decade later, only competitors raise the issue; IBM can cite many examples of not stuffing its own products into a customer's system. At Bank One in Columbus, Ohio, for instance, IBM recently purchased and installed heavy-duty storage equipment from EMC even though IBM makes similar products. "I've been involved in hundreds of these deals," says attorney Zahler. "I'm not aware of any client who would say they're dissatisfied because IBM insisted on using its hardware or software."

Nevertheless, IBM's services growth has helped sell hardware. The fear of product stuffing has evaporated not so much because of IBM's agnosticism but more because customers don't much care what hardware and software they have, as long as IBM makes the whole system work. Ironically, this makes it easy for IBM to install lots of its own products, which it does. So Bank One, which last year signed a seven-year, $421 million outsourcing contract with IBM, may have EMC storage units, but huge swaths of its IT infrastructure are from IBM. Says Bank One senior vice president Mike Keller: "Where a product from Hitachi or EMC or IBM is equivalent, by running this service capability for us, IBM does get an advantage."

There's nothing nefarious about this. It's simply confirmation of a fact IBM understood when it first got into outsourcing: Increasingly, services are the heart and soul of its customer relationships. Says Gartner's Bittman: "It used to be that technology was strategic for IBM, and services helped sell technology. Now services-plus-software is more strategic. Services are IBM's primary form of account control."

Of the many services IBM offers, outsourcing has among the lowest margins. To boost profits, IBM must get into businesses where its advice is as important as its ability to run a network. Looking to take the lead in the trendiest such area, Gerstner has ordered the company to focus on e-business.

When Gerstner first arrived, his critics jeered at his lack of industry experience. They forgot he'd spent 13 years at McKinsey, learning to navigate within large companies. More important, in his later jobs as president of American Express and CEO of RJR Nabisco, Gerstner had been a big buyer of IT services. As a result he understood that the advent of the Internet would bewilder already overloaded execs looking to take control of their computing systems, and he has exploited that worry to the fullest. Since 1997, IBM has spent hundreds of millions of dollars on a worldwide advertising campaign touting its e-business savvy. The campaign, which shows a series of real-world managers struggling with Web-related problems, has had extraordinary impact. Says Robert Shaw, CEO of USWeb/CKS, a leading e-commerce consulting company: "I love it! Everybody loves it! They're basically creating the market with this great ad campaign." Shaw, who prides himself on his company's with-it status, even allows that there is steak behind the sizzle of IBM's message. "They do sort of get it," he concedes, something he says about few other rivals.

IBM claims it has 10,000 e-business customers, some of which get nothing more complicated than having IBM host their Website on one of its servers. But e-business can also mean something truly profitable for IBM, like creating and implementing a totally new relationship between a business and its customers. If a company is weighing such a critical gamble, the first place it might turn is to the company whose software and hardware is at the heart of its business systems--and for many that means IBM.

This is why Federated Department Stores chose IBM when it wanted to remake its rudimentary Macy's Website into a full-fledged e-commerce hub. Says Kim Miller, vice president for Internet strategy at "When we did our due diligence, IBM came to the top of the list very quickly. There weren't others who understood the legacy of our systems the way IBM could." hired IBM in June, and after pell-mell development launched the site on Nov. 4. Where they once had 5,000 products, the site now sells 250,000. IBM also created a set of software "wizards" that help visitors find the products they need. Big Blue now hosts the site and serves as consultant.

The e-business campaign is also helping IBM drive into the small and medium business markets. Besides creating software tools to help such companies develop and maintain Websites, IBM has gone so far as to partner with Vallon, a tiny Minneapolis company that has actual website factories there and in South Dakota. Dozens of workers sit next to one another at PCs, cranking out pages for companies looking to Webify quickly. Vallon, which markets under the name NetPropulsion, guarantees to build and deliver a site in seven days for the low, low price of $150 to $2,000. Says CEO Alan Discount: "We're doing to Websites what Henry Ford did to the automobile."

This is a partner for IBM? Actually, Vallon started out as a competitor. IBM first ran into it when the two were bidding to develop Websites for customers of Kinko's, the copy-center chain. Realizing that Vallon's service would appeal to small businesses, Big Blue proposed to help the private company financially and create a partnership. Now IBM markets the service and hosts the sites Vallon creates. Gerstner wants to have two million small-business customers by 2001, says Discount, adding: "IBM's vision is that if they own the connectivity to those customers, they can feed all sorts of business processes through that pipe." In other words, once IBM connects with a small business, it will try to sell all kinds of things, such as services to help manage accounting, inventory, or human resources.

For bigger companies, Palmisano offers a more sophisticated blend of software and services. One of IBM's hottest services helps companies apply complex tools called business-intelligence software to transform marketing. The software pulls together a variety of data about a company's customers, which the company can then sift for ways to better target particular markets.

KeyCorp, a major banking company in Cleveland, was already a hardware and software customer when it selected IBM's services division to install a business-intelligence system that would let it pull together customer data from checking accounts, home equity lines, insurance, and other products. Says JoAnn Boylan, executive vice president of Key Technology Services: "We wanted to become a direct-marketing company, understanding who our customers were so we could then very specifically target them with products." IBM brought in business-intelligence experts and drew on the expertise in its financial services research labs. Two staffers worked full-time at Key for a year, helping the bank learn how to cull better info from its databases. One tangible result: Response rates to KeyCorp's direct-mail campaigns have quintupled.

Engineering that kind of change helps IBM bring in big profits. But, says Cohen of Gartner Group, "IBM's challenge is to step up their higher-level business consulting." Few IBM customers will trust Big Blue with full-scale reengineering projects, preferring consultants like Andersen Consulting, McKinsey, and Price Waterhouse Coopers. In 1997, for example, Ryder System hired IBM to manage its tech infrastructure but also brought in Andersen for higher-level "solutions" development. Andersen, the hottest consultant in the IT field, eschews low-margin outsourcing contracts, preferring to focus on high-end data installations that can reinvent a business. It gets those contracts in part because, unlike IBM, it has the reputation of knowing how to transform a company's IT systems in a way that's in sync with a client's industry. Outsourcing negotiator Zahler says that IBM's customers rarely feel that IBM understands their industry in detail. Even satisfied customers like Kim Miller at say that this is not IBM's forte. "E-commerce is retail," she says, "and Microsoft or IBM or USWeb/CKS are not retailers. We have to educate them on what retailers expect. All of them, including IBM, have to do better at that." If Palmisano and Gerstner really want the highest margins in the services business, they need to take an even bigger step beyond the company's roots as a purveyor of technology.

If the scores of interviews FORTUNE conducted with IBM customers and partners are any indication, IBM may well get there. Says Merrill Lynch CTO McKinley, who until last year had the same job at GE Capital and who has dealt with IBM for decades: "I'm very optimistic about their future because they are really making a transition to a services-based company. It's much like what Jack Welch is doing at GE." With testimonials like that, it's not hard to understand why IBM awarded Lou Gerstner a 70% pay increase for 1998. Guys who get compared to Welch don't come cheap.