What's Ailing IBM? More Than This Year's Earnings

Information Processing

It's bloated, too dependent on mainframes, and hurt by technical glitches

John W. Verity in New York
Business Week

October 16, 1989

This was supposed to be a big year for IBM. Not exactly time to break out the champagne, but a year that would prove to Wall Street and competitors that Chairman John F. Akers has been doing the right thing. Leaner management, 21,000 early retirements, a major reorganization in the U. S., new products from top to bottom, and a revamped marketing strategy--all would help Akers, a former Navy jet pilot, pull IBM out of the four-year earnings dive it went into just after he was handed the controls.

But, barring divine intervention, that won't be. Three days before its third quarter was to end on Sept. 30, IBM warned that its profits for that period would fall short of even the most pessimistic estimates--in fact, as much as 55 below the $2.10 per share reported a year before. IBM stock quickly crashed 11.5 points, to 106, a 52-week low. Analysts have slashed their projections for 1989 earnings to as little as $5.5 billion, or $9 per share--far below earlier forecasts of about $10.50, which would have put IBM within spitting distance of its $10.77 peak in 1984.

MAINFRAME MENTALITY

Now, it seems, a new record will elude Akers until at least 1991. The reasons: Still loaded with excess personnel and other overhead, IBM continues to fly on essentially one engine--mainframe computers. Those big, proprietary machines bring in lots of revenues and profits--an estimated 50% and 65%, respectively, of the company's totals. But they're no longer the stalwart IBM once could depend on: Competition is growing, sales of mainframes seem to be fundamentally slowing, and IBM is having to cut prices to hold on to its 60%-plus market share. Meanwhile, the company hasn't been able to compete effectively in many swifter-changing, small-computer sectors, where its mainframe mentality is a hindrance. Still, as Akers pointed out, ''demand for IBM's products and services throughout our product line continues to be good worldwide.'' IBM blamed short-term factors for its disappointing profits. The strength of the dollar, it said, turned out to be greater than anticipated, adversely affecting currency translations from overseas operations, which contribute more than half of IBM's revenues.

Because of technical glitches, the company has also postponed indefinitely a major new mainframe disk drive that it was to have begun shipping by now. And, surprising some analysts, IBM said it is writing twice as many operating leases this year as last. That will delay the collection of almost $2 billion in revenues until 1990 and beyond. All told, concludes Don Young, a Sanford C. Bernstein & Co. computer analyst, IBM's revenues this year may reach only $62.7 billion, about even with 1988's and some $2 billion less than expected.

NO LAPTOP

Even without those factors, Big Blue faced a tough 1989. A strategic software scheme for unifying its three incompatible computer lines is still mostly promise. Except for PCs, moreover, IBM's small computer business is soft. In midrange computers, its AS/400 minicomputer has come off a bang-up first year that saw perhaps 20,000 previous owners of the old IBM System/38 convert to the new machine. But getting about 200,000 owners of the smaller and simpler System/36 series to change over is proving harder. Many are small businesses that simply don't need the AS/400's sophisticated data base and networking functions.

Beyond that, IBM is almost absent from two of computing's hottest segments. It has no laptop computer, even though that $2 billion, Japanese-dominated market is growing at 40% a year. In engineering workstations, where sales of $4.3 billion are expanding at 30% a year or more, IBM has a mere 2% market share. Even with new workstations expected for early 1990, it may take years for IBM to catch up with market leaders Sun Microsystems, Hewlett-Packard, and Digital Equipment.

In PCs, IBM actually has recovered some lost momentum. Market researcher StoreBoard Inc., for instance, calculates that IBM's machines accounted for 30.3% of 1989 dealer revenues through last August, up from the comparable 1988 period. Still, fewer than 5% of customers using IBM-compatible PCs have installed IBM and Microsoft Corp.'s OS/2 operating system, the machine's basic software. OS/2 is the basis of an ambitious PC-to-mainframe office automation scheme that IBM unveiled last spring.

FAULTY CHIPS?

Mainframes have compensated for these shortcomings until now. But this year, IBM is even stumbling in what it usually does best. Early in the year, the company slipped deliveries of its $1 million-and-up Model 3090-S central processors by a few months because of what it said were low manufacturing yields in logic microchips. Translation: Only a few from each batch worked. Consultants such as the Meta Group in Westport, Conn., say that many of the processors that were installed turned out to be faulty.

Worse were IBM's disk-drive problems. Customers had been expecting a new generation of mainframe disk drives this past summer, with shipments starting about now. The drives, code-named Soquel, would be more compact than the 1980-vintage IBM 3380 drives currently in use, yet would store more data and cough it up faster to the central processor. The new products also would have generated some $1 billion in revenues this year and as much as $8 billion in 1990, according to Soundview Financial Group's IBM analyst, Stephen Cohen. But even with selected customers successfully field-testing the new drive, IBM in August indefinitely postponed the formal introduction of it, claiming that more work was needed to perfect its design.

What went wrong? IBM won't say, but the problem almost certainly relates to the company's attempt to cram more data into each square inch of the disk drive's aluminum platters. James Porter, president of Disk/Trend Inc. in Mountain View, Calif., which tracks the world disk industry, says the Soquel project was delayed several times before last summer. Design and manufacturing problems, he adds, ''are one of those facts of life'' when building advanced disk drives. IBM customers this year watched the company gut hundreds of 3380s when wobbling in their bearings threatened to obliterate data. Loath to repeat that experience, IBM has held off with the 3380 replacement until it's sure the drive can be built in volume.

SECRECY PLEDGE

Even when it has the goods, moreover, IBM is facing unusually intense competition. Amdahl Corp., for instance, has used its affiliation with Fujitsu Ltd. to bring out processors that run 370 software faster than IBM's most powerful machines--and cost 10% less. That has helped Amdahl boost its share of the market for large IBM-compatible processors to 13% from 10% in two years. And Hitachi Data Systems Corp., formerly National Advanced Systems, says it is currently unable to meet demand for its IBM-compatible disk drives.

IBM's response: cutthroat pricing. Gone are the days when it sold at list prices. Now, as its European subsidiaries have done for several years, IBM is slashing U. S. prices by as much as 40%. That tactic may help maintain IBM's market-leading 60%-plus share in mainframes and all the customer influence that engenders. But IBM now risks having all its large customers seek price concessions. The company often secures a secrecy pledge when it grants discounts. Nonetheless, says William D. Easterbrook, who follows IBM for Kidder, Peabody & Co.: ''it's hard to keep these things quiet.'' By cutting prices too much, he fears, IBM risks ''killing the goose that lays the golden egg''--and that funds essential product development. IBM traditionally has used its hefty mainframe profits to subsidize low prices in other, more competitive markets, a strategy few rivals can match.

This threat to mainframe profits is likely to persist until IBM replaces the System/370, probably in 1991. A descendant of IBM's famous System/360, circa 1964, the 370 is becoming easily outgunned in many jobs. The industry is abuzz, for example, over Tandem Computers Inc.'s recent win of a big contract from the California Motor Vehicles Dept. Public documents show that a $10 million Tandem system outperformed a $23 million System/370.

The 370 is soon to face even more competition. In November, Digital Equipment Corp. will introduce its first mainframe-class VAX computer, code-named Aridus. And companies such as Sequent Computer Systems, Pyramid Technology, and Arix are proving that mainframe jobs can now be run for a tenth of the cost on parallel-processing machines built from gangs of cheap microprocessors. Says PaineWebber's Smith: ''IBM is very vulnerable'' in jobs like the one Tandem just won.

What's primarily saving the 370 against technological threats is customers' investment of billions of dollars in software for it--programming that isn't easily discarded just to save on hardware. But that advantage is shrinking. More new programs are being written for small computers than for IBM 370s, mainly because the hardware is cheaper and in many cases easier to program. IBM is working at top speed to create new software that will shield programmers from many of the 370's complexities and help tie it into efficient ''distributed processing'' networks incorporating midrange computers and PCs, too. That's the goal of the company's widely ballyhooed Systems Application Architecture (SAA), an evolving set of software specifications. But it will be years before SAA begins to pay off for IBM as more than a way to mollify customers.

KEY DEALS

The outlook isn't entirely bleak for IBM. It has the leeway to lease 370 and AS/400 equipment at extremely competitive rates--which it has been doing with a vengeance, say competitors. With ''a balance sheet that looks like a bank's,'' as Kidder's Easterbrook puts it, IBM can easily afford to use aggressively priced operating leases to win key deals away from poorer competition. He doubts that IBM is returning to the kind of heavy reliance on leasing it showed before 1980, since leasing will account for only 4% of IBM's revenues this year. That figure should fall once IBM starts selling the System/370's successor.

But with so many problems still dogging the company, the question remains: Is Akers on the right track? Yes, say most analysts, who praise IBM's many recent investments in software companies, its use of faster chips in its PCs, and plans for yet another mainframe disk drive in 1990. They'd just like to see him cut costs faster. Says Easterbrook: ''The best thing IBM could do would be to lose 30,000 to 50,000 people overnight.'' Hardly likely, of course, given the company's practice of no layoffs. Still, IBM has just begun its third early-retirement program in as many years, hoping to trim 600 to 1,000 manufacturing jobs. At least Akers, the ex-fighter jock, knows that he's still flying into flak.

BIG BLUES

IBM has a wide assortment of problems to sort out. Here are some of the biggest:

LAPTOPS This $2 billion U.S. market, dominated by the Japanese, is growing by 40% a year. Yet IBM has no competitive product

WORKSTATIONS Worldwide sales for these powerful desktop computers are $4.3 billion and growing by 30% a year. But IBM's three-year-old RT PC has only 2% of the market

SOFTWARE IBM reports strong sales for its PS/2 line of personal computers. But its proprietary operating system, or basic software, for these machines, isn't keeping pace. And software for networking IBM's entire product line is years from completion

MINICOMPUTERS After a fast start over the past year, sales of the AS/400 mini are slowing. The ''easy'' sales are over

DESIGN AND MANUFACTURING A major new disk drive has been delayed indefinitely while its design is refined. Chip problems delayed a mainframe processor early this year. With typical gross margins in the 70% range, the delays have seriously hurt profits

MAINFRAMES IBM's 3090 mainframe, close to the end of its product cycle, is increasingly vulnerable to smaller machines. Leasing is up, too, which pushes revenues into the future

DATA: COMPANY REPORTS, BW

Photograph: AKERS: COMEBACK DEFERRED PHOTOGRAPH BY DON STEVENSON Graph: A SETBACK FOR IBM Data: Company Reports, BW CHART BY RAY VELLA/BW