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A Big Blue Feeding Frenzy


After nearly five decades of thinking of IBM (IBM) as the world's No. 1 computer company, most people are just getting comfortable with the idea of calling it a tech-services outfit. Well, it turns out that label doesn't fit so well, either. It fails to recognize the huge boost that IBM is getting these days from its $16.8 billion software division. IBM has long been second only to Microsoft Corp. (MSFT) in the world software business, but only recently has that part of the company emerged as its most reliable growth engine. "Software is not only the fastest-growing but also the most entrepreneurial and the most profitable part of IBM," says Robert Djurdjevic of Annex Research Inc.

That point has been driven home in the past few weeks by a rapid-fire series of software acquisitions. On Aug. 23, IBM announced plans to buy Internet Security Systems Inc. (ISSX) for $1.3 billion. That follows its $1.6 billion purchase of document-management software maker FileNet Corp. (FILE), a $750 million deal for MRO Software Inc. (MROI), and a smaller deal for Webify Solutions Inc. All together, those four companies could add 4% to 5% to IBM 's annual software revenue. Even before this, IBM was a steady buyer of smaller but fast-growing software outfits -- more than 30 software companies in the past 3 1/2 years.

A TIPPING POINT

IBM's master plan is to use the acquisitions to tap new software lines while milking its mature products for profits. The company already has a broad lineup, ranging from databases and collaboration software to packages for powering Web sites and integrating applications. At the end of last year, the faster-growing segments of the business, including collaboration and systems-integration packages, accounted for 52% of overall software revenues. To Steven A. Mills, senior vice-president for software at the Software Group, that means the business reached a tipping point that will allow it to speed growth in the future. "The underlying fundamentals of the business are now giving us the ability to deliver a sustained better rate of growth," he says. "This happened very gradually at first, but now it's showing its effects."

IBM has shown that it can turbocharge sales at the companies it purchases by selling their products through its 11,000-strong software salesforce. Its 2004 acquisition of Candle Corp., a maker of computer-systems management software, resulted in a 25% sales increase for that company's products last year.

POWERFUL ENGINE

Even so, the software group's goals are quite ambitious. Mills aims to expand software 6% to 9% per year, with new acquisitions contributing 2% to 3% of that growth. IBM CEO Samuel J. Palmisano had better hope Mills succeeds: Already, his unit is propping up the rest of the company. Software revenues of $4.2 billion in the second quarter increased a healthy 5%, while the overall company grew just 1%, and services revenues were down 1%. This was the fifth quarter in a row in which software revenues outpaced both overall growth and services growth.

Just as important is software's outsize contribution to profits. Annex Research estimates that for 2006, software will account for 20% of IBM's revenues but 37% of its profits. Services, which represent 53% of revenues, account for 35% of profits.

IBM's $91 billion overall revenues have been essentially treading water for the past year. That weighs heavily on its stock, which has been trading in the mid-70s after reaching a recent peak of 89 last December. And as Mills works to stoke IBM's fire, he still faces the challenge of goosing sales of older software businesses. Over the past few years he has lost market share to leader Oracle Corp (ORCL). in database software. That hurts sales of other products, since many of them are attached to the database.

Of course, IBM also fuels its service side when it brings on new software products. Those sales often include huge service contracts, and customers who buy new software typically spend up to five times as much on service to install and maintain it. Just another reason why IBM is not likely to ease up on its dealmaking anytime soon.

By Steve Hamm


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