IBM Once Again Looking To Software For Growth

When Lou Gerstner reshaped IBM in the 1990s, the former chairman and CEO transformed a company that relied on hardware for most of its sales and profits into a services powerhouse.

The shift rippled through the IT industry, with IBM Global Services (IGS) becoming the model many vendors emulated as they, too, recast their products as drivers for an expanding services business. But now, IBM is in the midst of another seismic shift: Software, not services, is the company's new growth engine.

The quiet shift drew a spotlight in recent weeks as IBM set off on a buying tear. Big Blue followed one pricey acquisition, its $1.6 billion FileNet buy, with a second, its $1.4 billion Internet Security Systems deal, and mixed in smaller purchases of MRO Software and Webify Solutions. Swallowing four companies in a month is unusually aggressive for IBM, but the company for years has been a voracious acquirer—particularly in the software market, where it bought two dozen companies in the past two years.

The billions IBM is spending to expand its software portfolio make sense when you look at its bottom line: IBM's software division generates more profit than any other, including the much-larger IGS. While IGS accounted for $47.4 billion in sales last year, operating costs pulled its gross profit to $12.3 billion. IBM Software, headed by 32-year IBM veteran Steve Mills, has a stratospheric 87.5 percent profit margin. It posted a profit of $13.8 billion on sales of $15.8 billion last year.

IBM is betting big on Mills' unit. Three of the five largest acquisitions in IBM's history have been for its software group: FileNet, Rational (bought in 2003 for $2.1 billion) and Lotus (acquired in 1995 for $3.5 billion). Other billion-dollar purchases include Informix in 2001 and Ascential last year.Splashy as the big buys are, IBM's software success stems from hundreds of smaller deals and decisions made over the past few years. After its troubled Lotus takeover, IBM swore off applications. Mills staunchly maintains that IBM will never do a big applications acquisition on his watch. That strategy—if it stands—will allow IBM to stay out of the tough ERP market—where dwindling revenue and margins drained the life out of onetime leaders PeopleSoft and Siebel Systems—and instead profit from selling the middleware and services applications customers need to integrate their systems.

IBM Software frequently goes shopping in its partner network to fill gaps in its vast portfolio. Its Webify acquisition, made in early August for an undisclosed sum, was typical. Webify specialized in component technology for services-oriented architectures (SOAs), a hot growth area, and had deep industry expertise in two fields, health care and insurance. An IBM partner for several years, Webify already had fine-tuned its technology to work with IBM's WebSphere software and was accustomed to selling in conjunction with IBM.

"Most of our significant customer wins have been with IBM, with the software group or global services group," said Webify CEO Manoj Saxena. "IBM approached Webify because it saw an opportunity to accelerate its offerings to the market. I think a lot of it had to do with our joint customer successes."

Building ISV partnerships has been a priority, particularly as IBM works to deepen its midmarket footprint. While any number of vendors offer their partners sales, co-marketing, and training incentives, IBM partners say the company distinguishes itself with the depth of its partner assistance programs.

Hosted financial apps maker Intaact, San Jose, Calif., has worked with IBM executives on crafting its marketing strategies, building market recognition, and tapping customer leads., Intaact CEO Robert Jurkowski said. "Lots of vendors provide technology or product services but don't really provide much beyond that," he said. "IBM provided more than we expected. They've done a very good job partnering in the industry and not competing, like Microsoft."Mills says his goal is to continue the software group's ferocious growth, targeting annual revenue increases of 6 percent to 9 percent and double-digit profit growth. But nipping at IBM's heels are equally savvy rivals—especially Oracle, which gained a beachhead in IBM database and middleware accounts by buying up key IBM partners like PeopleSoft, Siebel and J.D. Edwards. Eschewing applications worked for IBM when it could align with top applications players and serve as their preferred infrastructure backbone. It's riskier in a consolidated market where leaders like Oracle and SAP have their own middleware to push.

Still, IBM has shifted with the software winds since Mills began helming the division a decade ago. As the group plows resources into SOA, security and other booming areas, it's well-positioned to continue picking off attractive acquisition targets and quietly powering IBM's growth.