Two years ago, IBM was stumbling. Its financial performance in the first quarter of 2005 was well below expectations, and the culprit was its big technology services unit, a business under increasing pressure from lower-cost Indian outsourcing companies.
"It wasn't just the miss, it was that revenues were slowing in services," Samuel J. Palmisano, IBM's chief executive, recalled in an interview.
Since then, IBM has made impressive progress. It has increasingly moved up the ladder to offer higher value corporate packages of research, software and services. This is also higher-margin business, where specialized skills matter more than price.
IBM has also hired aggressively in India to narrow the cost advantage of its offshore rivals in traditional technology services like operating data centers for customers and upgrading and maintaining their software.
IBM has been reorganized from a classic multinational company with country-by-country operations, working in isolation, to a more seamless global enterprise with centers of expertise in industries and technical skills, scattered around the world, each a hub in a global network for delivering services.
The changes, according to Palmisano, amount to "a huge reinvention" of the company.
Its experience offers a textbook case of a company successfully navigating the twin challenges of globalization and rapid technological change, at least for a two-year stretch.
So far, it seems to be working. Profit margins at IBM have risen steadily, and it reported record earnings and cash flow in 2006. Wall Street expects the trend to continue when IBM reports its quarterly figures on Wednesday 19 July. The consensus estimate of analysts has earnings increasing 13% from the year-earlier quarter, to about $2.15 billion, or $1.47 a share, on a 5% rise in revenue, to nearly $23.1 billion.
Despite the recent improvement, IBM still faces daunting long-term challenges -- particularly in its services business, which last year contributed 52% of the company's revenue and 37% of pretax income.
The Indian insurgents in the technology services business continue to enjoy a sizable cost advantage. The leading Indian outsourcing companies, like Infosys, Tata Consulting Services and Wipro, have average operating profit margins of more than 20%, according to a recent analysis by Sanford C. Bernstein & Co. The margins at IBM, according to Bernstein, are less than half that -- though a bit higher than the average for the next six largest American technology services companies including EDS, Accenture, BearingPoint and Computer Sciences.
The leading Indian companies are gaining ground at an impressive pace. Last week, for example, Infosys reported that its quarterly revenues rose more than 40 percent. IBM, the world's largest technology services company, dwarfs any of the Indian outsourcers and offers a much wider range of services. But the Indian companies see themselves as the wave of the future in services, and they say their Western rivals, who are hiring by the thousands in India, are struggling to cope.
"We are leading, and the old-line players like IBM are forced to copy our model," said Nandan M. Nilekani, co-chairman of Infosys.
In his view, the American companies are much like the Detroit automakers years ago, and the leading Indian services suppliers are similar to the Japanese car producers. The Japanese upstarts, Nilekani noted, began by supplying lower-cost models, but retained a continuing cost and quality advantage as they moved into the mainstream and luxury car markets.
IBM bristles at the Detroit analogy, and it does seem to be adapting quickly to the global competition instead of being blindsided by it. In fact, the poor performance in early 2005 was an alarm bell -- not so much a call to alter the company's strategy but to accelerate one that was already being put in place.
The financial performance of the services business has been improved partly with old-fashioned cost-cutting. After the bad quarter in 2005, IBM eliminated nearly 15,000 jobs, with the biggest cuts from the services business in Europe. In the second quarter of this year, 3,500 IBM workers were told their jobs were being eliminated, with sharp cuts in the services business in America. A third of the displaced employees typically find jobs elsewhere in the company.
After he became chief executive in 2003, Palmisano began a campaign to change the profile of IBM toward businesses requiring specialized skills and advanced technology, thus commanding higher profit margins. IBM has sold off hardware businesses with lackluster profits. including disk drives, personal computers and printers.
After the stumble in 2005, Palmisano decided to push the shift in services faster -- to try to get more of the new global model in place. If services revenue was going to flatten for a while, IBM needed to find a way to increase profits elsewhere. The answer was to step up the buying spree in the high-margin software business.
"Software had to play a bigger role," Palmisano explained. "Then we could offset the transition in services."
In software, IBM started to build up that high-margin business mainly with acquisitions of small companies in fields like security, data management and e-commerce. Since 2003, IBM has spent $11.8 billion on 54 acquisitions: 36 software and 18 services companies.
The transition into services has been the most ambitious and difficult, involving a wholesale reorganization and a change in the culture of a business that now has 200,000 employees worldwide.
The traditional multinational company, Palmisano explained during an interview at IBM's headquarters in Armonk, N.Y., was a collection of local fiefs, while networked teams will be the hallmark of the global corporation of the future.
IBM has set up global centres for tasks like software development and maintenance, which is a reason IBM employs 53,000 workers in India today. It has also created global and regional teams of skilled experts in particular industries, from airlines to utilities, who travel as needed on projects.
The only way for IBM's services business to grow without continually adding more people is to automate more data centre maintenance and other computing chores with software. "The goal is to replace a lot of labour but do it with software, not replace labour with lower-cost labour," said Virginia M. Rometty, senior vice president for global business services.
Profits have also been helped by moving into high-end services projects that tap IBM expertise in research to apply computer science and advanced mathematics to fields like utility grid optimization and energy conservation, genetics-based personalized medicine, fraud detection and prediction, and traffic management using sensors and congestion-pricing models.
A.M. Sacconaghi, an analyst at Sanford C. Bernstein, says the unanswered question about IBM is: Can the new, higher-margin business grow fast enough to offset the maturing of its traditional services business and rising competition from the Indian outsourcers?
For his part, Palmisano is not declaring victory, but things certainly look better than they did two years ago. "The encouraging thing is that we've made progress," he said. "We're making progress, but there's still a lot to be done."