IBM's Revved-up Software Engine

Software now contributes more profit than services, and it's emerging as Big Blue's most reliable generator of growth

By Steve Hamm

For nearly five decades, IBM (IBM) was known as the world's largest computer company. Then, as its strategy shifted, most people started calling it a tech services outfit. Well, that description doesn't fit so well anymore. That's because the label fails to recognize the huge boost IBM gets from its software division. Investors wondering whether to hold onto their IBM shares or buy more would be smart to keep a sharp eye on software.

Here's the big surprise: Big Blue's $16.8 billion software business now contributes even more profit to the bottom line than services, and it's just now emerging as the $91 billion company's most dependable growth engine. "Software is not only the fastest-growing but the most entrepreneurial and the most profitable part of IBM," says analyst Bob Djurdjevic of Annex Research.

The company needs all of the help it can get in the revenue category. Overall revenues have been essentially treading water over the past year. That weighs heavily on its stock, which has been trading in the mid-70s after reaching its recent peak of $89 last December. If IBM is to excite investors again, software must play a key role in making it so.

TIPPING POINT.

IBM's rapid-fire series of software acquisitions over the past few weeks has made a lot of people sit up and take notice. On Aug. 10, it announced a plan to purchase document-management software maker FileNet (FILE) for $1.6 billion. The previous week, it spent $750 million on MRO Software (MROI) and an undisclosed amount on Webify Solutions. Altogether, the three companies could add about 3%-4% to the company's annual software revenue. These moves cap off a three-year period when IBM Chief Executive Sam Palmisano has overseen the purchase of 31 software companies. And analysts expect more to come (see BusinessWeek.com, 8/10/06, "Big Blue's Software Spree").

To Steve Mills, the executive vice-president and general manager of IBM's Software Group, these recent data points prove that his über strategy is working. He points out that at the end of last year, the newer and faster-growing segments of his business accounted for 52% of overall software revenues. To him, that means the business reached a tipping point that will allow it to accelerate 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."

Even as he tries to stoke revenues with acquisitions and expanding markets, Mills faces the challenge of keeping some of his core software businesses growing at healthy rates. Over the past few years it has lost market share to leader Oracle (ORCL) in database software, and that hurts sales of its other products since many of them are attached to the database. At the same time, its sales of tools for corporate software developers have tapered off. That's because so many corporations now rely on outsourcing companies to write their custom-made applications. IBM gives volume discounts to outsourcing companies.

HEALTHY MARGINS.

Given those headwinds, Mills' goals are quite ambitious. He aims to grow software 6% to 9% per year, with new acquisitions contributing 2% to 3%. Already, Mills's unit is helping to prop up the rest of IBM. 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.

The profit picture for software is even prettier.