BUSINESSWEEK ONLINE : DECEMBER 13, 1999 ISSUE
BUSINESS WEEK E.BIZ -- COVER STORY

Inside IBM: Internet Business Machines
Big Blue is doing a boffo Net business--some $20 billion is driven by demand for e-business. 'They get it,' says a rival. 'Every day they tell a better story'

To prepare for his annual meeting with Wall Street last May, IBM Chairman Louis V. Gerstner Jr. had an assistant pull the financial reports on 25 of the ''real Internet standard bearers''--companies like Yahoo! (YHOO), America Online (AOL), Amazon.com (AMZN), eBay (EBAY), and E*Trade (EGRP). Last year, those companies generated combined revenues of about $5 billion--and lost $1 billion. Yet the market value of the Internet 25 together was 50% greater than that of IBM (IBM). ''Go figure,'' Gerstner deadpanned when he delivered the news to analysts. ''Now, I am not suggesting that you view us as an Internet company, but I think it is worth noting that IBM is already generating more [e-business] revenue and certainly more profit than all of the top Internet companies combined.''

Get ready to adjust your thinking. The marquee names of the Internet Age may be dot.com companies, but the big dot in the New Economy these days is IBM. While Amazon's Jeffrey P. Bezos and Yahoo!'s Timothy Koogle get all the Internet kudos, Gerstner has been quietly zipping past competitors, large and small, to emerge as a leading arms supplier to the Information Age. Today, IBM is doing it all: helping merchants hang their shingles online, advising corporate chieftains on how to reshape their businesses top-to-bottom, even wiring local courthouses. ''They get it,'' concedes Edward J. Zander, president of rival Sun Microsystems Inc. (SUNW) ''Every day they're telling a better story.''

NO CHOICE. And it's one that Zander and other rivals don't much enjoy hearing. Big Blue, despite its dinosaur image, is doing a boffo business from the Net. IBM estimates that 25% of its revenue--some $20 billion--is driven by e-business demand. That's nearly 50% more than Internet darling Sun, whose servers are de rigeur for most Web businesses. Even sweeter: About 75% of IBM's e-business revenue comes from sales of Net technology, software, and services--fast-growth, fat-margin businesses--and not the old mainframe computers for which IBM is so well known.

Just as surprising is how Gerstner is seizing the Internet inside IBM. The 57-year-old CEO, once jeered for his lack of computer industry experience, has done an extraordinary job of weaving the Web's vast reach into every corridor of the company--its products, its practices, its marketing. The results have been stunning: Online sales, mostly of PCs, are expected to top $12 billion for the year, skyrocketing nearly 400% from $3.3 billion last year. The productivity gains from using the Net have been just as profound. The company figures it will save $750 million by letting customers find answers to technical questions on its Web site. And by handling a portion of its internal training over the Net instead of in classrooms, IBM will save $120 million. All told, IBM will whack nearly $1 billion out of its costs this year by taking advantage of the Web.

Suddenly, International Business Machines is looking a lot more like Internet Business Machines. Surprised? Don't be. Gerstner doesn't have a choice. Every company from the tiniest dot.com startup to IBM's biggest rival is using the Net to skin costs to the bone and to reach new customers. And even though Gerstner has been hard at work doing just that, IBM's gargantuan size has made a wholesale Internet conversion tough. PC and server sales, for one, are going nowhere. While competitors Dell Computer Corp. (DELL) and Sun rack up Internet-fueled sales growth of 25% and 40%, respectively, IBM's revenues have been stuck at an Old Economy rate of 7%. This year, analysts estimate, Big Blue will grow a tad faster--9%, bringing revenue to around $90 billion.

That's not nearly fast enough in the New Economy. But if Gerstner can hook more of IBM's revenue to the Net, he may be able to pull IBM out of the slow lane. With $15 billion of IBM's Net-driven revenues growing at more than 30%, the time may not be too far away when the company's slow-growth businesses such as mainframes and storage systems are no longer a drag.

This is Gerstner's chance for IBM to reclaim the mantle of leadership, and it may be his last. If IBM blows the Internet, which is becoming more pervasive with every mouse click, it blows its franchise--perhaps once and for all--as the leading high-tech supplier to Corporate America. In the Internet Age, it's not just Sun, Microsoft (MSFT), Hewlett-Packard (HWP), or Compaq (CPQ) that Big Blue frets about. Every day, nimbler challengers, ranging from e-consultant Scient Corp. (SCNT) to Net software maker BroadVision Inc. (BVSN), keep chipping away at Big Blue's turf. Says IBM senior vice-president and longtime Gerstner confidant Lawrence R. Ricciardi: ''We had to be ready to respond, or we would be dinosaur bones.''

Y2K FREEZE. In some markets, IBM is playing catch-up. The company has been slow to woo the dot.com crowd, for instance, leaving that to Sun, HP, and a slew of startups that sell PCs, servers, and software. The trouble is, Web companies will soon buy as much computer gear as traditional companies. ''We've had to adapt our model to them,'' concedes Gerstner. ''We were late.''

The events of the past couple of months underscore IBM's urgency to focus on e-business. In early October, the company disclosed that it will yank its Aptiva home PC off retail shelves in North America, making them available only through its Web site. IBM also will lay off up to 10% of its PC workforce. The moves, IBM hopes, will stanch the flow of red ink in a unit that lost nearly $1 billion last year. Analysts expect IBM to lose approximately $400 million in PCs this year.

Then on Oct. 20, the company shocked Wall Street with news that sales of large computers--one of its slowest-growth areas, but among the most profitable--had dried up because customers were locking down their operations for the rest of the year to prepare for Y2K. The buying freeze, IBM told analysts, will hurt the company through the first quarter of next year. The news sent IBM's stock tumbling 15%, to 91 from 107. The company also announced another layoff of up to 6% of the workers in its computer server group.

And now IBM's accounting method has come under scrutiny. On Nov. 24 it was disclosed that Big Blue is being criticized for its policy of bundling one-time gains, such as the $4 billion earned from the sale of its Global Network business to AT&T (T), into operating income. That, critics claim, makes it difficult for the average investor to assess the company's performance because operating income is typically used as an indicator of pure sales success since it excludes taxes, interest and other items.

''VERY AGGRESSIVE.'' Nonsense, the company says. IBM maintains that it's following Securities & Exchange Commission guidelines and provides analysts with all the data they need to evaluate the company's efficiency. As for Y2K, IBM says, that's a temporary hit on its big iron computers while customers sort out last-minute changes before the new millennium. But Gerstner says demand for e-services and software is strong. And analysts agree. They expect sales for online systems to gain momentum sometime after the first quarter, when companies will have finished wrestling with Y2K. ''E-business is the next big thing on the road map for a lot of companies,'' says Gartner Group Inc. analyst Tom Bittman.

If Gerstner is right, after years of upheaval, Big Blue could once again be on solid terrain. Gerstner believes that the advent of the Internet will befuddle execs already struggling to take advantage of the new technologies. Companies around the globe will spend $600 billion a year by 2003 on e-business, according to market researcher International Data Corp. More importantly, some 62% of that amount will go to consultants and the like who can sort out how to use all the bedeviling technology. By contrast, just 29% will be spent on hardware and 9% on software. ''The real leadership in the industry is moving away from the creation of the technology to the application of the technology,'' says Gerstner. ''The explosive growth is in services.''

That couldn't be better for IBM. Building powerful computers and software that don't fail, as well as providing tons of services--especially tons of service--is second nature to IBM. Its army of 130,000 consultants in its Global Services unit is unmatched in the industry and does three times more Net work than the $1.9 billion combined revenues of Andersen Consulting, Electronic Data Systems (EDS), and Computer Sciences (CSC), according to IT Services Advisory LLC, a research and advisory firm in Hillside, N.J. In the past three years, IBM has handled 18,000 Internet jobs for its customers, from shaping an Internet strategy to Web page design to hosting entire online storefronts.

Now IBM's e-business client roster is stoked with the biggest names in industry--from Ford Motor (F) to Charles Schwab (SCH), and from Prudential Insurance to the New York Stock Exchange. In a Merrill Lynch & Co. survey last month, 53 chief information officers at major corporations cited IBM as one of only two computer companies--the other was Sun--that are best positioned to handle their Internet projects. ''They are very aggressive about building their expertise in the online world,'' says Rhonda Wells, director of e-commerce for Payless ShoeSource Inc. (PSS), which chose IBM when it wanted to build a full-fledged e-commerce hub--in three months. ''IBM has a strong knowledge of brick-and-mortar businesses, not just Internet businesses.''

How did Big Blue catapult itself to such heights after such lows? Credit Gerstner. He recognized as early as 1994 that the killer app for the Internet was going to be transactions--not simply having the best browser or the coolest search engine. One of Gerstner's first moves was to shift 25% of IBM's research and development budget into Net projects. He declared that every IBM product must be Internet-friendly. And he began to push all software development toward the Java programming language. There was also a crash effort to tie Lotus Notes software tightly to the Web. ''The Internet was a major change and opportunity for IBM. The first person who saw its value was Lou,'' says G. Richard Thoman, chief executive of Xerox Corp. (XRX), who worked with Gerstner at IBM, RJR Nabisco, and American Express (AXP).

MUSHROOMING SERVICES. To get the massive, 225,000-person organization focused, Gerstner shook things up. He set up the Internet Div. and appointed Irving Wladawsky-Berger, a respected IBM exec and computer scientist by training, to head it. Wladawsky-Berger made sure that every product in IBM would work with the Web. Then he sat down with his staff and figured out what IBM calls the ''white spaces''--the empty spots where the company needs to develop products. Indeed, Gerstner looks back on his move as a ''bet-the-company decision.''

Gerstner's smartest move, though, may be e-business services. Today it seems like a no-brainer, but in 1995, the industry was obsessed with snazzy new products, from network computers to superfast search engines. Gerstner could have focused on trying to gain leadership in Web cruisers or browsers--after all, IBM had its own browser, which it wound up scrapping. Instead, Gerstner decided to use services to distinguish IBM from the pack. ''We concluded this [the Internet] was not an information superhighway,'' says Gerstner. ''This was all about business, doing transactions, not looking up information.''

Now service is paying huge dividends. The company's e-business services revenue is growing at a galloping 60% and is expected to hit $3 billion this year. And Gerstner says that number could easily double if you include (as he says competitors do) portions of IBM's huge outsourcing jobs that use the Net to deliver software and services. ''They have an incredible pool of professional services,'' says Jeff F. Lucchesi, chief information officer for DHL Airways Inc. IBM helped create DHL Connect, an online shipment scheduling and tracking system that uses IBM software to connect a variety of computers so that customers can get estimated shipping charges immediately. When Lucchesi needed a special Java program, IBM had a team on the job within 24 hours. ''That's something that tells me I'll use them again,'' says Lucchesi.

No wonder Gerstner is adding services as fast as he can. In the past year, IBM has launched 20 new Net-related services including privacy consulting and an online service designed for small to medium-sized business. For as little as $99 a month, IBM will provide all the hardware, software, and services that small businesses need to get online. Big Blue is even in the application service provider (ASP) market, delivering enterprise software from companies such as PeopleSoft (PSFT), Great Plains Software (GPSI), and ebank.com (EBDC) over the Net.

Still, the big money is in IBM's traditional customer base--the thousands of big companies that have yet to tap the Net and transform their businesses. IBM refers to such companies as below the e-line. Gerstner isn't just out to help them set up cybershops, he's zeroing in on Web-izing all of their business operations--their supply chains, customer service, logistics, procurement, and even training. ''The Internet is ultimately about innovation and integration,'' says Gerstner. ''But you don't get the innovation unless you integrate Web technology into the processes by which you run your business.''

Above the e-line, IBM is a straggler. That's why in April, Gerstner created a swat team to focus exclusively on selling IBM products and services to Web companies. It's also trying a novel sales approach. Together with Conxion Corp., an Internet service provider, and the Silicon Valley Bank, IBM is offering up to $1 million in technology and services free of charge for six months to 24 Net startups. The idea is to help incubate startups without them burning through all their funding. At the end of six months, the startup can buy or lease the equipment or simply take a hike.

For all these efforts, IBM's pole position in the Internet race isn't guaranteed. For one, Gerstner hasn't been able to solve his hardware problem. Sure, once companies get past Y2K they'll want more mainframe power to handle massive online businesses. But mainframe prices are falling faster than sales are rising. And in the white-hot Web server business, made up mostly of Unix computers, IBM has been a no-show. That's why its computer business looks anemic compared with Sun's 25% growth. For the year, IBM's sales of Unix systems are expected to reach $3.2 billion, up 7%, says Sanford C. Bernstein & Co. Says Sun Chairman Scott G. McNealy: ''They're not nearly the systems provider they used to be.''

''UNINSPIRING COMPETITOR.'' That has left IBM on the sidelines during one of the biggest boom periods for Web servers. ''We have been an uninspiring competitor against Sun and HP,'' admits Gerstner. ''We're behind in that arena, and we have to take that share back.''

Even so, hardware may be the least of Gerstner's worries. The e-biz field is no longer Big Blue's to romp in virtually uncontested. Sun and Microsoft are beefing up their focus on servicing e-biz customers. A revitalized HP is zeroing in too. Even chip giant Intel Corp. (INTC) is steering its considerable might there, spending $1 billion to set up rooms of servers to host Web sites. And then there is the raft of hot startups that claim IBM and other big companies are just too bloated to work on Net time. ''We have the look and feel of a speedboat,'' says Rudy Puryear, the former head of Andersen Consulting's e-business practice who now heads Chicago-based e-consultant Lante Corp. IBM, he says, is a ''battleship.''

Some rivals are even taking a page from IBM's playbook--and using it against them. Earlier this year, HP emulated IBM's hugely successful e-business marketing campaign with its own e-services campaign--even hiring a member of the team that launched the e-business campaign to do it. HP's e-services strategy could be a danger to IBM, if it works. That's because HP, which lacks IBM's consulting muscle, is trying to create do-it-yourself Net technologies. In HP's view, companies should easily be able to add new features and services onto their Web sites, no big consulting contracts necessary. Says Nick Earle, chief marketing officer for HP's enterprise computing unit: ''We always bristle when people say we copied IBM. We learned from the good things that they did, but that was over three years ago. In Internet time, that's a lifetime.''

That's why Gerstner isn't letting up. He's pumping more than 50% of IBM's huge $5 billion R&D budget into Net projects, up from 25% in 1996. What's next? IBM wants to be the supplier of technology and services to link all manner of digital devices such as pagers, cell phones, and handheld computers. IBM will either license the technology to others or build the infrastructure and rent the capability.

MASSAGE CHAIRS. To present this vision to customers--and within IBM--Gerstner is up to his old tricks. In Feb. of 1998, IBM set up the Pervasive Computing Div., headed by Mark F. Bregman, another former IBM research scientist. Much like Wladawsky-Berger did in the Internet Div., Bregman has spent the past 18 months analyzing the market and working with other areas of IBM to develop strategies centered on devices, software, and services that make the Net accessible anywhere, anytime.

The first offering: software that lets any type of digital device, say a cell phone or Palm handheld, fetch content off the Net. Sounds simple, but it isn't. Right now companies are struggling to deliver pages to screens of any size. Bregman's group has put together a service that companies can rent that will translate content from any Web site and deliver it to any screen. ''The idea,'' says Bregman, ''is to offer infrastructure as a service. It's more like a utility. You just pay the bill.''

Already IBM is lining up customers. On Nov. 29, PlanetRx, an online pharmacy, will go live with a service that allows virtual shopping via Palm handheld devices. Telecom companies Nokia (NOK), Ericsson (ERICY), and Sprint PCS (PCS) have signed on, too. ''Moving information from 17-inch screens on your desk to where it can be used on the Web from anywhere is an important trend,'' says John F. Yuzdepski, a vice-president at Sprint PCS. ''IBM's technology allows a ubiquity of access to information.''

The technology is one thing, but if Gerstner is going to build a new IBM, he has to create an Internet culture. That work began in Atlanta four years ago. When you walk in the door at IBM's Atlanta Web design office--dubbed the ''Artz Cafe''--dogs are camped out alongside Web designers and an iguana. Four workers sit astride massage chairs getting worked over by masseuses. Ping-pong tables double as conference tables, and there's a billiard table upstairs where workers can go to clear their heads after long hours toiling at--gasp--Macintosh computers. ''To attract the cool, younger people in the Internet business we had to break with the whole IBM culture,'' says Kerry Kenemer, a creative director who sports a goatee. ''We're the only creative bone in the entire IBM body.''

Now, IBM is trying to spread the culture throughout its organization. On Nov. 15, the company launched Project Springboard. After pouring $100 million into its four-year-old Atlanta Web design center, it's broadening that approach and opening e-business integration centers around the world. Instead of just design services, these centers will offer customers a place to tap IBM specialists and outside experts to set up next-generation e-business solutions.

The centers reflect a hipper IBM that the company hopes will be able to attract Web-savvy employees. In some areas, IBM is angling to siphon off creative types by setting up shop in cool areas of the country. In Los Angeles, for example, the center will be near the MTV and Sony (SNE) studios. The company is even lightening up on job titles. One worker in Chicago goes by the title ''concept architect and paradoxiologist.'' (Translation: Someone who works on tough Internet strategies.)

That's not the only Silicon Valley-ish move the company is taking. Like Intel and Cisco (CSCO), IBM has quietly invested $60 million in venture funds that focus on Web technologies. Of course the company wouldn't mind a big IPO payday, but it is mostly using these deals to provide ''headlights'' into cutting-edge technologies. IBM has hit pay dirt on at least one investment so far: In August, it invested $45 million in Internet Capital Group, a holding company that funds business-to-business Web companies. That was just before its public offering. Now IBM's investment is worth $619 million.

NEW HORIZON. What's the next e-business frontier for Big Blue? It's getting companies to turn over entire business processes to IBM that are conducted over the Web. ''The way we think of e-business is that it's really the opportunity to do the next level of transformation,'' says Richard B. Anderson, who has been given the task of taking IBM to the Web.

Consider what IBM is doing for United Technologies Corp. (UTX) IBM uses the Net to handle $5.8 billion worth of general procurement for Carrier Corp., UTC's Farmington (Conn.) subsidiary. The company won't talk about the actual savings of the system, but says it has been a phenomenal success--increasing efficiency, cutting costs, and becoming a gold mine for collecting information about purchasing habits. Now UTC has the data that will allow the company to talk to suppliers and get better discounts. But UTC insists it's not about cutting costs. ''This is all about turning data into information and turning that information into action,'' says Kent L. Brittan, vice-president for supply management for UTC.

That's the sort of phrase Gerstner might coin for his next analyst's meeting. Back in May, for just a few hours after Gerstner's Wall Street meeting, IBM was like a dot.com company: Its shares shot up 20 points, the kind of movement associated with Web giants eBay or Yahoo. But if Gerstner can continue to convince customers that he has truly remade IBM into Internet Business Machines, he may yet join the Internet 25.

By IRA SAGER
Contributing: Peter Burrows in Santa Clara, Calif., David Rocks in Atlanta, and Diane Brady in Greenwich, Conn.

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