IBM Lays Out Plans for Future Growth and Profits

March 14, 2011 Timothy Prickett Morgan

It’s not every day that I get invited up to IBM Country up north of me to spend the day with the top 20 executives at Big Blue. In fact, it was only last Tuesday. So I decided to go, despite the flooding on the local roads between where I live in upstate Manhattan and IBM’s TJ Watson Research Center in Yorktown Heights. My faithful rented Zipcar and a general sense of direction got me where I was going despite the road closures, and the highlight for me was meeting some of the techies who work at IBM Research, including the top people behind the Watson question-answer machine.

I made it clear to them that when we all lose our white-collar jobs to Watson-alikes tuned for law, medicine, and just about any kind of analysis, we know where they live. (Don’t worry. I was joking. I think.)

I am not going to talk about Watson and its implications today, because, quite frankly, I am still mulling it over. I will eventually be covering a whole bunch of things that I learned at IBM Investor Day last week, but for now I am just going to talk about what IBM is going to do with its business to boost its profits.

IBM is a bit like a pig that is able to sniff out truffles underground. If you want a career in this IT racket, follow the pig and watch where it digs. That’s the best advice I can offer you. That is why The Four Hundred newsletter was conceived in June 1988 and went to press for the first time about a year later, once we forged a publishing alliance with Reed/Elsevier in Europe.

IBM has been a global company for a long time, since the 1930s for sure, but it really caught on to the globalization wave in 2003 and decided that it needed to do to itself what it was prescribing for its services customers: namely, to consolidate its massive back office operations with “shared services” that all IBM divisions and branch offices use. IBM eliminated all the systems that made each branch, country, and geographic region distinct and now all of Big Blue uses a single, consolidated set of applications for human resources, global sales, supply chain, real estate, finance, legal, IT, marketing and communications, and sales transactions. It sounds idiotic that this was not done a long time ago, but I look at my own processes and systems just running this small publishing business and I am not about to start throwing too many stones. The point is, between 2005 and 2010, IBM was able to eliminate $6.2 billion in costs from its own operations by moving to shared services, by doing a better job integrating across its divisions, and by re-examining its own workflow for key functions inside the company. And looking ahead to between now and 2015, IBM thinks it can remove another $8 billion of cost from its $80 billion cost base.

This is a staggering amount of money, and it will no doubt happen because of increased automation (driven by smart analytics, I would guess) and fewer people pushing paperwork and processes. What else could you possibly expect from International Business Machines?

Sam Palmisano, IBM’s president, chief executive officer, and chairman–does that mean he gets three paychecks?–started off the Investor Day, which was held in the same auditorium where the Watson QA machine crushed Ken Jennings and Brad Rutter in the Jeopardy! game showdown last month. The set was still up, and two of the financial analysts in the crowd volunteered to go up against the machine in Wall Street-friendly categories. After Watson started running the board, they had to turn the machine’s response time down by 500 milliseconds to let them even get on the board.

Palmisano said that the world was going through “the third supercycle of growth,” the first being the Industrial Revolution and the second being the period between the wars with the rise of the middle class in the Western Economies. Now, it is the turn of the Eastern and Southern economies. Palmisano said that people are talking some nonsense about what is going on in the world’s economy. “It’s not all of the things you read,” Palmisano said. “It’s the emergence of the middle class.” Or, more precisely, I would say, the emergence of the middle class in China, India, Brazil, Russia, and about 16 other hot countries where IBM is eager to drop in new branch offices and chase business.

In 2000, explained Bruno Di Leo, general manager of growth markets at IBM’s Sales and Distribution unit, IBM had its own operations in 42 countries outside of the Western economies (this includes North America, Western Europe, and Japan, basically the countries that fought World War II); these countries had a total of 95 branch offices. By 2010, IBM was in 53 growth markets, which had a combined 218 branches. The plan is to grow this to 78 countries and 451 branches in the next five years.

Asia is a particular hot spot, and one that IBMers are fond of talking and bragging about. Palmisano bubbled with enthusiasm during the question and answer session on Investor Day. “There is a lot of confidence in Asia,” Palmisano said. “If you ever want to feel really, really good about life, go to Asia. I mean, you can really feel good. Young people are inspired, there’s a can-do attitude, governments want to work with you, businesses want to invest. You wouldn’t recognize that you are on this planet.”

Well, we can’t all go to Asia. The world doesn’t work like that, now does it, Sam?

What IBM is doing to make more profit from this globalized world is get away from as much commodity hardware as it can and shift to more profitable software and services while retaining mainframes, high-end boxes based on Power and X64 chips, and creating custom machines and software to run myriad specific jobs–like playing Jeopardy!, Homeland Security, or Wall Street data feed analyst. Look at the shift from 2000 through 2010, when free cash flow at IBM increased from $6.7 billion in 2000 to $16.3 billion in 2010, and earnings per share nearly tripled, from $3.88 to $11.52:

IBM’s evolving portfolio mix boosts the bottom line. (Click graphic to enlarge.)

Palmisano recapped 2010, and quipped that Wall Street must be getting bored after “record, record, record,” referring to the record margins, free cash flow, and earnings the company raked in last year. That was $99.9 billion in revenues (4 percent), with $14.8 billion in net income (up 10 percent) and $11.52 in earnings per share (up 15 percent) compared to 2009.

IBM doesn’t care if its revenues grow, in case you haven’t noticed in the past decade. Which is why IBM has been pleased to sell off disks, PCs, and printers, trading a short-term revenue loss for a near-term profit gain and a longer term profit improvement and revenue rebound as it builds out its software and services businesses.

Between 2000 and 2010, IBM spent $44 billion on capital expenses, $16 billion on 50 acquisitions, $58 billion on research and development, and $107 billion on dividends and share repurchases. This is a hell of a lot of money by any Terran standard. And those investments allowed IBM to throw off $100 billion in free cash flow. (Or more precisely, some of those investments drove that cash flow while other portions will drive future cash flow. But you get the idea.) It took IBM a decade to throw off that $100 billion in cash, but by moving into fast-growing markets and moving up the value chain into software and services and tooling its servers for very specific kinds of engagements, like Smarter Planet infrastructure management stuff, IBM thinks it can throw off another $100 billion in half the time, between now and 2015. Here’s the EPS roadmap, which Mark Loughridge, IBM’s chief financial officer, called The Matterhorn:

IBM’s roadmap to increasing profits. (Click graphic to enlarge.)

Those 20 growth markets are what will help IBM do it, with them growing from 21 percent of worldwide revenues for Big Blue in 2010 to 30 percent by 2015. That’s half of the revenue growth IBM expects to see, by the way. IBM will also spend another $20 billion on acquisitions between now and then, which will drive more revenues. But again, IBM is not hung up on revenue growth, but profit growth. Coupled with $3 billion in cost savings, plus $70 billion in share buybacks and dividends, IBM says that it can easily boost EPS to $20 by 2015.

Note: IBM is only putting $3 billion of the $8 billion it expects to see through work rejiggering and cost savings through 2015 in the model, leaving it a $5 billion buffer in case the economies in the East tank or other weird things happens. Such as a massive earthquake and tsunami in Japan, which happened three days after the IBM Investor Day meeting.

IBM could not predict the Great Recession or the earthquake/tsunami double punch in Japan, but the company’s financial model and business model allows it to rebound from such blows. Countries and the people who live in them, and who are not international or so flush with cash, are never as fortunate.