Palmisano Says IBM Will Double Up Profits By 2015

May 17, 2010 Timothy Prickett Morgan

Around this time every year, the top brass at IBM take what I presume are their limousines and head south from Upstate New York and chi-chi Western Connecticut down to Wall Street to explain themselves to investors. Well, more precisely, the IBMers gather to talk to Wall Street analysts; the several hundred people on the globe that influence a stock as much as (and perhaps more than) the Brownian investment motions of millions of shareholders sweating their 401(k) retirement funds.

Every couple of years, IBM goes a bit out on a limb and makes some big predictions about how the future IT landscape will look and where Big Blue will fit into it and how it will transform it. As a $100 billion or so behemoth that represents around 8 percent of global IT spending and a much larger share of the data center spend, IBM shapes the environment as much as it exists within its constraints. IBM did this last in 2007, putting a stake in the ground and explaining to investors how it would push profits up into the sky by 2010. Last week at an event here in New York, IBM’s top brass explained how they could push profits up to the stratosphere between now and 2015.

Sam Palmisano, IBM’s president, chief executive officer, and chairman, gets around a lot, glad-handing titans of industry and political bigwigs the world over, as is his job. Palmisano does not speak publicly very often, as is his wont. But Palmisano is getting close to retirement and it is his legacy that is on the line if IBM misses a big opportunity in the IT racket, and he wants to assure IBM employees, partners, and customers that despite all the uncertainty in the world, IBM–not any other company–is in the best position to extract cash from the vast amount of spending the world does on IT systems and business process consulting.

How much cash? How about you try doubling earnings per share to $20 a pop between now and 2015? And IBM is not going to do anything dramatic to achieve this, but stick to its model of increasing its sales of software and services, providing custom-tuned systems to do big transaction workloads, data analytics, and supercomputing.

“We don’t need to get into a new space–smartphones or something–to execute the roadmap,” Palmisano bragged in his presentation last week, taking a shot at Hewlett-Packard‘s acquisition of handheld computing expert Palm. Palmisano said that back in 2007, when IBM claimed it could get to $9 per share in earnings by 2010, a lot of people didn’t believe Big Blue could do it, and no one would have believed it could hit more than $10 a share in earnings, as it did last year. And Palmisano said that IBM bucked a lot of industry trends in the 2000s, believing that the client/server revolution and the PC-centric IT revolution had run its course and, more importantly, believing that customers were not going to self-assemble their IT infrastructure any more as they had in the past. That they would be looking for more integrated solutions and deep expertise to solve business problems that just so happened to have IT as part of the solution. And between 2003 and 2009, IBM was able to show compound growth in the double digits for earnings per share as revenues grew at between 3 and 4 percent at constant currency. Despite the Great Recession of late 2007 through early 2010.

“There are some things that we missed,” Palmisano conceded wryly. “There was nowhere in our financial model where we predicted a financial collapse. We did not plan for that. We did not have an assumption for that, but we did have an assumption that we were going to drive margins and cash and have less dependency on the top line.”

And so by the end of 2009, IBM was extracting 90 percent of its margins from software, services, and financing, with about 50 percent of IBM’s revenues and about 60 percent of its profits coming from an annuity-like revenue stream. (Software and maintenance subscriptions, monthly services contracts, IT leases, and so on.) And so between 2003 and 2009, IBM was able to generate around $80 billion in cash. The company spent $77 billion on share buybacks and dividends, and another $17 billion on acquisitions (mostly small software companies plus a few biggies like Cognos and SPSS), $30 billion on capital expenses, and $41 billion on research and development.

“You can’t do this by assembling commodities, spray painting them a different color, and say that is going to give you differentiation in the marketplace,” Palmisano explained with a certain amount of disdain in his voice. “You actually have to invent things. You have to do mathematics and physics and all of these things that continue to drive the play of margin expansion.”

Looking ahead to the next five years, Palmisano said that customers and investors would be wise to carefully examine the assumptions that the IT industry and the pundits are making. The first assumption that Palmisano called out was that product cycles would drive growth in the IT industry. And the second was that the “industry is consolidating and at the end of the day consumer technology will obliterate–that all computer science for the past 50 years will be obliterated–by smartphones and Web browsers.”

I think it is safe to say that Palmisano was exaggerating for effect, or as the largest vendor of servers in the world, is feeling unloved in a way that Apple, which has half the revenues and profits but which has a market capitalization that is 40 percent higher at a stunning $235 billion, is totally loved. Then again, Apple has great integrated products and has nearly $42 billion–a year’s worth of revenue–in the bank. IBM has blown all its cash on stock buybacks and a few acquisitions and some dividends.

Palmisano said that as far as IBM was concerned, product cycles are not going to be the sole way to drive growth, and as for industry consolidation, he said that this is not new and that perhaps people were a lot later than IBM to respond to this. And for that reason, the IBM plan to grow between 2010 and 2015 looks an awful lot like the plan from the dot-com bubble bursting and then starting to recover in 2003 through 2009. And yet, paradoxically, he said that “if you think about IBM in 2015, it will be as dramatically different as IBM today is versus 2003.”

And so, looking ahead, IBM thinks it can generate another $100 billion in cash in the next five years, and says that it will distribute about $20 billion of that as dividends, do another $50 billion in share repurchases, so about $20 billion in acquisitions. IBM also plans to spend another $25 billion or so on capital expenses to underpin its hardware, software, and services businesses. Combined with another $8 billion in costs being extracted from its $78 billion cost structure.

Some of the incremental $20 billion in revenue generated in aggregate over those five years that IBM is projecting will come through organic growth in software and services and a slight rebound in servers and storage, but also through new packaging (think Smarter Planet stuff or data analytics systems). Business analytics is expected to be a $16 billion business at IBM by 2015, and Smarter Planet initiatives (automating infrastructure like roads, power grids, water systems, governments, and so forth) are expected to bring in $10 billion a year by 2015. Cloud computing is expected to be about $3 billion in new revenue growth by 2015 and emerging markets where Palmisano says a middle class is evolving and will compel governments to start providing the kinds of services we all take for granted (and which require systems) will generate half of IBM’s $20 billion in incremental growth over the course of the roadmap from 2010 through 2015. Added to the steady-freddy systems and services businesses IBM already has, then the company can do about 5 percent revenue growth per year over the next five years. And this is what will allow IBM to double EPS to at least $20 by 2015.

Look at all that money IBM is talking about throwing around. It is just astounding to me what could be accomplished with it aside from buying stock.

What IBM is not going to be doing is trying to become the IBM of old, the one from the 1960s, or a modern conglomerate.

“We’re not going to be the holding company of IT in all spaces and all segments,” Palmisano explained. “We’re not trying to be ITT or GE in the IT space. So don’t think of us that way–all things to all people in all segments–no. We are a much more focused play.” And you can forget about a big bang acquisition, like buying Sun Microsystems or SAP, just to name two, when it comes to IBM’s model looking ahead. “It’s very straight-forward and very shareholder friendly,” Palmisano said of IBM’s strategy. “It’s not a transformation, it is an extension. It is not spending $40 billion to buy somebody because we have the wherewithall.”

And Palmisano took a shot at much younger IT players, many of them from the Left Coast, which do not have the long relationships that the global and centenarian International Business Machines has. “We are not entering markets. We have been in and out of China and India longer than most tech companies have been in existence.”

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