Transcript of Lou Gerstner's remarks to securities analysts

New York City

July 31, 1995

Remarks have been edited for style

Jerome B. York, senior vice president and chief financial officer, IBM:

Good afternoon to all of you and thanks for coming.

Two years ago -- actually two years and four days to be exact -- we announced a series of actions designed to improve IBM's competitiveness. As you may recall, these actions included a plan to reduce our expenses by $7 billion annually and that target was upped to the $8 billion level a year later.

As you know, we've made a substantial amount of progress in two years, reducing our expense structure by some $1.5 billion and generating very substantial free cash flow that has enabled us to fix our balance sheet and, of course, buy back a little stock and Lotus along the way.

Although our expense reduction efforts have been important, as of a year ago our focus began shifting very heavily to revenue growth.

Through the first half of this year, our revenues grew at a 16 percent year-over-year rate as reported or about nine percent at constant currency. And this revenue growth, in combination with the expense reduction, has resulted in our two most recent quarters being all-time records. And, of course, the stock is up from the mid-40s when we started two years ago to 110-and-change as of the time I left to come over here this afternoon. So, it's clear that we've made a lot of progress.  It's equally clear that we have more than a little bit left to do.

Now, in March of 1994, Lou Gerstner met with you in this auditorium to outline IBM's strategic priorities for revenue growth.  Today, he'll give you an update.

So it's my pleasure to introduce Lou Gerstner.

Louis V. Gerstner, JR., chairman and chief executive officer, IBM:

Thank you. I want to start by apologizing for the fact that we postponed this meeting twice.  We were originally scheduled to do it in March, and then right in the middle of the Lotus deal.  I must confess, the thought did occur to me that we're on a roll here:  Since we started postponing these meetings, the stock is up 30 points and maybe we had found the secret.  But Jerry wouldn't let me do that.

I do want you to know that, coming from a consumer background, I did ask Hervey Parke to do a survey of what you wanted to hear me talk about -- or hear us talk about. We did this about a month or so ago, and we got back a real dog's breakfast in terms of responses. It was all over the place. Some of you wanted to hear from seven or eight of us; some of you wanted to hear from only one of us. Some of you wanted to hear about sales; some of you want to hear about technology.  So, I've decided to talk about something that's of interest to me.

I'm not going to talk about financials. Jerry reviewed our second quarter with you two weeks ago.  I want to talk a little bit about our strategic perspective as I did with you last year.

You can talk about strategies in lots of ways -- we can talk about our financial strategy, but I think Jerry's covered it with you very well in the past:  our expense reduction, our strategy for cash, our priorities for cash, our views of our development spending.

I could talk to you about our strategy from a technological point of view.  We're very excited about the BiPolar to CMOS transition.  We are very excited about the AS/400 going to PowerPC.  We're very excited about our leadership in parallel processing and DASD.  And, of course, we're very excited about our networking strategy, and Lotus being a very important part of that.  But I'm not going to talk about strategy from a technical point of view, although obviously we can take questions on our technology later.

Instead, I want to talk to you about strategy from a perspective that I think is very important in any company, but is particularly important in this industry, and that is strategy from the point of view of the customer. Because this is an industry that is remarkably insolent in the way it deals with customers. It is very customer-insensitive.

We have decided to organize IBM around five customer groups.  We have done this. And this will be the prism through which you will see our view of growth. And it also is the fundamental driving force behind our resource deployment and our development spending.

Why customers?  Well, we've redefined the mission of IBM to encompass two objectives: The first is that we will continue to be the leading foundry of the intellectual capital that drives this industry.  But secondly, and equally important, we are going to become the leader translating the technology into value for customers. Because as I talk to customers all over the world, of all sizes and shapes, perhaps the thing they tell me the most is that the translation of this technology into value is difficult, sometimes bewildering, and a subject that IBM and the industry at large simply does not spend ample time in both its development budgets and its marketing activities.

So, let's talk about our five customers. I'll do that very briefly and we can take some questions on these subjects or any other subjects you want to ask about.

The first customer group which we'll focus on shouldn't be a surprise. It's large businesses and institutions. This is obviously the most logical, high-priority customer group for IBM. This is our turf.  This is our stronghold. We have relationships with nearly all of the world's largest institutions, relationships that our competitors wish dearly they had. But for sure we're not taking these customers for granted because they are changing in their view of information technology in very significant ways. There is the relentless pressure throughout the world on large enterprises to reduce costs, increase cycle time, go global, improve customer satisfaction, flatten organizations -- and in every other way to develop competitive advantage.

And this technology is the technology of reengineering.  Information technology is the technology that allows radical restructuring of enterprises.

Let me tell you what these customers are telling us about their IT requirements. First of all, they are seeking -- more than ever before -- solutions. They want integrated technologies from the industry once again. They don't want piece parts. And as a result, their needs are driving a partial reintegration of the industry. The industry, as you know, disaggregated about 15 years ago and broke up into what had been originally eight or 10 competitors into 60,000.

And the customer basically assembled the technology on his or her premises, driven by that wonderful promise the industry made of interconnectivity and openness.

Now, because customers are demanding solutions and not piece parts, you see 760 transactions last year in the merger and acquisition area in this industry totaling $68 billion -- up from 530 and $21 billion the year before.  You can't pick up the paper today without seeing another alliance. Very recently: Compaq/Cisco, Intel/Oracle, Novell/ FileNet, Sprint/MCI and America On-line.

What goes round comes round.

When I stood here two years ago, when we first got started here, I remember that the strategy driven by the investment bankers at the time was to break IBM up into a bunch of little pieces and follow the model of the piece-part approach to the industry. And it would have been exactly the wrong thing to do at that time because the industry's coming back our way. All of these competitors I just mentioned are trying to do what IBM does every day. And that is, integrate all the parts of this industry into solutions.

The second thing that the customers -- the large customers -- are telling us, is that they are evolving very quickly toward a very new model of computing.  It's neither the host-based system that IBM created, nor the desktop model that Microsoft and Intel are credited with creating.  It is a much more sophisticated model that includes the best of both previous models combined with a very significant new dimension called networking.

High-speed, high-bandwidth technologies such as ATM are transforming today's client/server networks into truly interactive global networks. What we call network-centric computing -- making possible massive interconnection between enterprises, institutions, customers and individuals. It affects private networks, as well as public switched-networks, and even the most public of all networks -- the Internet. New applications on these networks will be fast enough to support true interactivity -- nearly limitless bandwidth for video, audio, x-rays, photos, designs -- whatever you wish.

It will change the way information technology is used.  People will communicate and interact as teams, collaborating across companies and national borders. Large customers will be directly connected with suppliers, distributors, retailers and customers. The nature of the commercial transaction as we know it in the world today will change -- as well as the definition of value and competition.

So while I'm going to talk to you briefly about five distinct customer segments -- each of them does have a different demand for what they need from IBM -- I also want you to know that this new model of computing that is driven from the corporate sector is also driving very powerful interconnectivities among these five customer sets -- and again, playing to IBM's unique strength as an integrator.

Now, these two developments -- growing demand for full solutions and this new computing model -- are causing large enterprises to focus on four things:  interconnectivity and open standards; creating a common architecture out of the chaos the piece-parts era created in their enterprises; a strong need for systems management tools, and very strong interest in network integration and management capabilities. Now in light of all of this, what are we doing about it?

Well first of all, we've gotten very, very serious about solutions as the driving force for what we do at IBM. Over the last two years we have totally refocused our sales force from what had been a geographically-based sales force to a sales force that is focused entirely on specialization.  In particular, specialization by industry for our largest customers.  Thirteen industry groups operating worldwide independent of historical geographic boundaries.  We've taken all of our services businesses and structured them into a global services business -- for consulting, systems integration and outsourcing.  We are today the world's largest system integrator -- 25,000 people, in every country in which we do business, 10,000 systems integration contracts.  We have focused on product specialization as well.  We now have 15,000 product specialists where only a few years ago, arguably, we had none.  We now have 42 open system centers in 32 countries that permit customers to test, build and integrate heterogeneous solutions.

And our industry solution groups are gaining strength every month in terms of creating applications that produce true solutions for their industry clients. A good example is the Canadian-based Footprint Software Company we bought in May. Bought under the leadership of our financial services industry group, Footprint is a leader in applications software for the banking industry -- several banking industries -- and it's a leader in object-based applications. Objects is an important part of our technical underpinning of all of our solution work.

In terms of the new computing model, we've responded -- obviously first and foremost -- with the acquisition of Lotus. Stand-alone desktop productivity applications is where the puck used to be. Obsession with operating systems is fighting the last war. Now the action is on how you tie it all together. And Lotus Notes is a critical component -- but not the only one -- in our plans for integrated systems.

In systems management, the third of the most important priorities of our large enterprises, we introduced SystemView in May.  It helps customers easily and more affordably manage what they have today, which are very heterogeneous systems, with many, many suppliers that arose at the time of the piece-part makers.  You will see us roll out enhancements to SystemView on a regular basis.

Our flagship middleware is very important in this new network model to support the high volume of commercial transactions that will occur across networks and to organize and manage the vast amount of data that will be created. And most important, we are opening up all of our products to work on all popular industry platforms and to exploit all networks. CICS runs on all IBM platforms plus Sun, HP, DEC, NT server, Windows, and Mac.  DB2 now runs on MVS, OS/400, HP, and Solaris -- as well as our SP2 supercomputer.

In the network area itself, we're increasing every day the portfolio of our ATM products and IBM's Global Network today is the world's largest data network. And by year's end it will be the world's largest, global ATM network -- high-speed, high-bandwidth. And we're in discussion with a number of partners around the world to extend the capability of the IBM Global Network.  It's important to understand that this is not one of those on-line networks where people go to get information.  High-speed, high-bandwidth networks will change the way customers buy information technology.  They will be able to subscribe to very rich portfolios of applications and services versus what they do today -- which is build or buy, maintain, upgrade them -- themselves.  For many, IGN will be their IT infrastructure.

And finally, super-servers will play a very critical role in this new computing model. But they must be open and optimized for networks. That's why we're putting so much emphasis on our leading position in parallel supercomputing with our SP2 line, and it's why we have reinvented our S/390 mainframe product line in the last two years. You know, 1991 was the previous peak year for MIPS shipped for S/390, and 1994 saw the new peak. In the first half of 1995, MIPS shipped on the S/390 line are up 55 percent.

So this is our turf -- our historical turf -- and what I can tell you is that we are winning back share in this market. And we intend to be very aggressive in continuing to win back share.

Now, let's turn to our next customer group: small- and medium-size businesses.

This is, believe it or not, 50 percent of the enterprise market -- 50 percent in the small- and medium-size business. Fifty-two million small- and medium-size businesses around the world. That's businesses with less than 1,000 employees. That doesn't even count China, Russia and other developing markets.

They spend $230 billion on information technology. That's our projection for this year. It's very, very fragmented in terms of the suppliers. Not so easy to get data, but it is reasonably clear that we are the leader in every single market in the world with the exception of Japan. A 10 percent share, so we've got lots of room to grow.

Traditionally, inside of IBM, this was a market opportunity that was dispersed.  It was undervalued in the IBM culture, and it lacked a global, integrated strategy. These customers have an even higher demand for packaged solutions. They're entrepreneurs. They don't have IT staffs. They want a turnkey package that's easy to install, run and maintain. This goes a long way toward explaining why 70 percent of AS/400s are shipped to small- and medium-size companies.

Third parties are very critical to this customer group for coverage and they also need a hands-on local relationship.

So where are we today in this largest-of-all markets? In 1993, our revenue was in decline and we were losing money. In 1994, we restored growth and profitability. This year we're projecting double-digit revenue and profit growth. We're pulling together a worldwide strategy under a single executive.

Looking ahead, we're working very hard on branding -- changing the perception that existed a few years ago in this category of customer that "IBM is not for me."

We've begun doing something I was used to doing all the time -- but it's not done very often in this industry -- called tracking studies, where we're tracking quarterly customers' behavior and reaction to the company.  The results are very encouraging in this market segment.  We are making progress changing our image.  We've seen marked improvements in perceptions of value, responsiveness, approachability and creativity.  But we've got a lot more to do in areas like easy-to-use products and IBM as an easy-to-approach-and-do-business-with company. We're focusing very much on packaging our solutions for this segment.

And again, there's a very important role here for IGN. These institutions -- these small- and medium-size companies -- lack networking skills, but they see the opportunity to compete as "micro multi-nationals" with the larger companies.  And we are finding opportunities to provide their total network solutions.

And finally, this customer segment illustrates the very important shift in our marketing strategy -- a shift away from a single channel of direct sales to a much greater emphasis on what is known as direct-response marketing: the use of telephonic capabilities and database capabilities to grow your business.

Our direct response marketing volume in 1992 was essentially zero. Last year it was $2 billion. This year, it will more than double again. We have this capability now in 50 countries. We're building infrastructure, hiring skills and setting up the sophisticated databases that are needed for this capability.  We sell virtually the entire product line.  At current growth rates, we will be the largest direct marketer in the world -- in any industry -- by the end of the year.

Finally, I haven't touched on the emerging markets of China, India, central Europe, Russia -- where fundamentally, the entire market, in most cases, is small- and medium-size businesses.  So in a sense, this market is even bigger than the numbers I've given you.

Let's turn to our third customer group, which is consumers. We've recently done a lot of work on the consumer market to decide whether we should pursue it aggressively and if so, where and when. And we've defined this market in a certain way that I want to explain to you. You can define it lots of ways -- by channel, by product. But we define it by behavior.  We define it as individuals who buy information technology products and services with their own money.  A $54 billion market in 1993.  We expect it will grow to $116 billion by 1998, a 17 percent growth rate.  In 1993, consumers represented 18 percent of the U.S. market.  In the 1993 to 1998 period, they will represent 39 percent of the growth in the U.S. market.  The product category includes home PCs, PC peripherals, software games, network services -- you know what they are.  And interestingly, most categories and growth rates are the same all over the world.

It's a highly fragmented business and, therefore, represents an opportunity for us. It is obviously being driven by the underlying and very basic long term trend toward computer literacy in the world.  Those of you who have children know the difference between those of us who were born on the dark side of the PC world -- and those who are on the light side.

Thirty-four percent of the U.S. population was comfortable with this technology in 1990. In 1995, that number grew from 34 to 56 -- and it's expected to go to 62 percent by the year 2000. Very similar trends in Europe and Asia. So we're right in the middle of this boom.

It's a growth opportunity we cannot ignore and we will not ignore -- if only because of the trend I mentioned earlier: the commercial and the consumer markets are being integrated by the new computing model and we want to be operating across that entire model.

Now, this is not a business in which we historically have had a focus. We do not have a leading position from which to start -- but we do have a position. We have several billion dollars' of sales today in this business, primarily in consumer PCs and on-line services.

Importantly, the studies we've done show that the IBM brand is well known among consumers, has very positive attributes and it's very extendible into this space. We have a global manufacturing capability and we can command prime shelf space.

But we've got a lot of things to work on. We've got to work on the perception that we have expensive products. We've got to improve the look and feel of our products. We need to learn to do much better at high-volume, low-margin manufacturing as we've learned in our PC business. And we and the rest of the industry have to better understand product cycles, fulfillment cycles, shelf life, quick-response logistics, marketing -- all those things that drive consumer businesses. Most importantly, we've got to lead the industry in ease of use.

Now, where will we compete?  Well, in this study we did we considered 70 different product and service categories and we boiled it down to 10. I'm not going to tell you those 10 because they're competitive at this point, but I will tell you what our next steps are.

We are in the process of establishing a new integrated worldwide consumer unit -- a whole new division within the company that will operate worldwide. We're looking for a leader to run it. We will focus initially on six to 10 major countries. We will move all related hardware, software and services into the new unit. We will have a dedicated marketing and development organization, but we will draw on common IBM technologies. And we will attract world-class partners.

Stay tuned on this one. This is all futures.

Now let me talk about the fourth customer group -- which is both present and future -- and that's OEM, the sale of our technology to other manufacturers. It's one of the unsung success stories in IBM. It's one of the fastest growing segments in the IT industry. It's growing 16 percent a year and we're growing much faster than that. Our OEM sales were a few-hundred-million dollars in 1992. They were $3.3 billion in 1994. And they should top $4 billion this year. From zero to $4 billion in a little over three years.

Our margins are competitive with the OEM industry in every segment. In IBM Microelectronics, our gross profit margins increased 16 points from 1993 to 1994 and they should increase about the same this year. In storage, our margins increased 15 points from 1993 to 1994 and they should improve about 13 more points this year.

Our OEM customers value the very rich intellectual property that exists inside of IBM -- which, in the past, we put a bushel-basket over and did not make available outside the company. You know we ranked number one in patents in the U.S. in the last two years.  We ranked number one through the first six months of this year.  What you may not know is that IBM leads in software-related patents.  We have 1,700 U.S. software patents. We have 40 percent of all front-of-the-screen software patents.  We have 27 percent of all database patents.  We're filing 600 software patents a year versus 100 for a well-known West Coast competitor.

When we first entered this market, we basically sold what we had.  And if we ran out, that was it, no more. We never designed anything specifically for the OEM customers. Since then, we have made a lot of progress in building up a marketing infrastructure, designing industry- standard parts and developing channel partners.

These are very important customers of ours. Our top 11 OEM customers will do $2 billion with us this year. And they're all our competitors. Almost all: Apple, Unisys, Toshiba. Virtually all of Apple's 1994 and 1995 PowerMac product line is supported by IBM technology -- not just our PowerPC chips but our DASD and memory.

Going forward, our technology will appear in some unexpected areas. You all know the world is rapidly going digital. Things that are "dumb" today will be intelligent tomorrow.  Once digital, these products will be tied together into the entire digital infrastructure.  Again, the new computing model.

For example, in most factories, all the controllers running machine tools aren't connected to anything. Potentially valuable data is lost. Connecting those little brains in each one of those machine tools would yield very valuable information -- resulting in better utilization of assets, optimization of schedules, and redirecting production from one factory to another.

You can expect us to continue to invest heavily in basic semiconductor and storage technology.

Our last customer group is distributors and third parties -- retailers, value-added resellers, as well as the independent software developers.

Historically, IBM has treated these important institutions as middlemen -- as conduits that we can use to distribute our products to the "real" customer.

No longer. We now view these people as critical customers themselves. Our job is to help them succeed and make money. We tip our hat to Lotus and how it learned to work with industry partners and ISVs. We will learn from Lotus. I've just talked about the importance of the consumer in the small- and medium-size businesses. We can't afford to send a salesperson out to every consumer and mom & pop store around the world. We need to work with third parties, so our growth strategy in the future is heavily focused on ensuring that we treat them well, serve them well and manage the inevitable conflicts that exist.

So, those are our five customer groups and some of the things we're doing to exploit our opportunities. Cutting across all of them is our over-arching strategic view of the business which I mentioned earlier. That is: the industry is rapidly moving to the point where it values services and solutions more than raw technology. The emerging computing model is moving away from the stand-alone desktop model, the stand-alone host model, into a highly connected collaborative world. The new technology supporting ease of use and ease of management will grow in importance.

And finally, there's an extraordinary amount of excess capacity in this industry. Success will go to those who lead at the forefront of where the growth is -- and not lead in the old dimensions of the industry.

Thank you very much.

Copyright 1995