so maybe this is why moneyflow on ibm has been so negative.
I.B.M. Shrugs Off Loss of a Service Contract It Once Flaunted
By GRETCHEN MORGENSON
Published: September 16, 2004 NY Times
Back in December 2002, when J. P. Morgan Chase announced a seven-year, $5 billion deal to outsource much of its data processing to I.B.M., both companies bragged that the contract - the largest of its kind for I.B.M. - would reduce costs, create value and propel innovation at J. P. Morgan.
Now both companies are saying, uh, never mind.
In a major blow to I.B.M.'s grand corporate strategy of providing technology services to companies large and small around the globe, J. P. Morgan Chase said yesterday that it was pulling the plug on the contract less than two years into its existence. The 4,000 J. P. Morgan employees who moved to the International Business Machines Corporation as part of the deal will return to the bank early next year.
"We believe managing our own technology infrastructure is best for the long-term growth and success of our company as well as our shareholders," said Austin Adams, chief information officer at J. P. Morgan Chase.
The 2002 contract was the centerpiece of I.B.M.'s transformation from a technology manufacturer to a technology manager, a strategy devised and overseen by the chief executive, Samuel J. Palmisano. According to analysts, the contract with J. P. Morgan was among the largest such outsourcing contracts ever signed; only a $6.9 billion deal won by the Electronic Data Systems Corporation to manage information technology for the Navy was larger.
Trying to put the contract loss in the best possible light, however, I.B.M. said it was simply a result of J. P. Morgan Chase's merger this year with Bank One. "The combined firm found itself with an abundance of I.T. assets," an I.B.M. spokesman, James Sciales, said. "This decision was like other business decisions related to the merger."
I.B.M. also said the contract's cancellation would result in an unspecified earnings gain in 2005 because the company would no longer be making investments related to the deal. It said the lost contract would be reflected in the company's backlog of information technology services, to be disclosed next month when I.B.M. announces its third-quarter results.
But yesterday's announcement made some analysts wonder whether I.B.M.'s technology outsourcing strategy - its response to what it calls the on-demand era - is as promising or as profitable as the company has led investors to believe.
"This was Palmisano's grand vision, and this was the reference account," said Fred Hickey, editor of The High-Tech Strategist, an investment newsletter in Nashua, N.H. "This whole on-demand strategy kicked off just a couple of years ago was predicated on these kinds of large accounts they were going to win. Now, not very long after starting it, they're pulling it back. You have to question whether this strategy is going to be successful or if services will be, as Sun's Scott McNealy says, the graveyard for old tech companies that can't compete."
Mr. Hickey, who is largely negative on technology stocks, has made a very small bet against I.B.M. in his own portfolio.
The company declined to say how much its future revenue would decline because of the scuttled deal. But in a note to clients, Bill C. Shope, an analyst at J. P. Morgan Chase, said that I.B.M.'s loss in revenues from the contract would be some $700 million to $800 million a year.
I.B.M. shares declined slightly yesterday, falling 0.4 percent, to $86.37.
There is no denying that I.B.M.'s future is heavily reliant on success in global services. Revenues from that unit now account for half of I.B.M.'s sales, which totaled $89 billion in 2003. Hardware revenues were roughly a third of the company's total sales in the first half of 2004, reflecting I.B.M.'s relatively recent exits from the disk drive, consumer PC, aluminum semiconductor and chip packaging businesses. Software sales accounted for just 15 percent of total revenue in the period.
But even amid I.B.M.'s big push into services, revenue growth in the unit is slowing. Services revenue rose only 2 percent in the second quarter of 2004, after accounting for currency exchange rates. In 2003, services revenue grew 9.3 percent.
Indeed, during 2003, global services provided the only bright spot for I.B.M. in revenue growth. Software sales rose only 1.9 percent last year, in constant currency, and hardware, financing and enterprise investments all declined.
While services dominate I.B.M.'s revenues, gross profit margins in the business - at 25 percent in the second quarter - are the lowest at the company.
Mr. Sciales said that the cancellation of a deal the company had characterized in a news release as groundbreaking and "the largest of its kind," had not caused great concern at the company over its on-demand strategy. He said the deal with J. P. Morgan was not the largest servicing agreement signed by I.B.M., but declined to identify any contracts the company had struck that were larger.
Neither would Mr. Sciales disclose the revenue that I.B.M. booked during the quarters that the J. P. Morgan contract was in place, or how big the earnings gain resulting from its cancellation would be.
I.B.M. is not the only technology services company that has experienced problems with long-term contracts. Electronic Data, its chief rival in the business, has struggled with some of its largest contracts. Cap Gemini, a competitor in Europe, has also encountered problems.
Bill Fleckenstein, president of Fleckenstein Capital in Seattle, said that long-term contracts struck by technology services companies like I.B.M. and Electronic Data were almost impossible for investors to assess for profitability. That is because, under accounting rules, the companies devising the contracts have wide leeway in the amount of expenses they can assign to the business during a given period. If expenses are underestimated, the contracts look far more profitable than they really are.
Moreover, the expenses and how they are assigned are rarely disclosed.
"What's really needed is some clarity on this issue," said Mr. Fleckenstein, who has bet against I.B.M. in his portfolio. "They have been crowing about on-demand and how great their backlog is. If losing the contract is a good thing, why is getting more of these types of contracts also a good thing? No facts are given on this, the supposed wave of the future for their business."
