Never mind computers and tech services. IBM's radical new focus is on revamping customers' operations -- and even running them

It was over a lunch in Cincinnati two years ago that IBM Chief Executive Samuel J. Palmisano got his first inkling of Big Blue's next act. Palmisano was talking business with A.G. Lafley, CEO of Procter & Gamble Co., one of IBM's big customers. At one point, Lafley asked Palmisano to estimate how many of P&G's 100,000 employees it truly needed to keep on its payroll. When Palmisano didn't venture a guess, Lafley stunned him by saying that P&G might be able to get by with only a quarter of its workforce. Specialized service companies might be able to handle everything else, from human resources to customer care.

For IBM's new CEO, Lafley's idea delivered a strong jolt of the future. “We saw it as an industry shift,” he recalls. Palmisano was already an expert in technology services, such as running data centers and managing companies' computing operations. Working under former CEO Louis V. Gerstner Jr., he had helped rescue a struggling IBM in the '90s by building its then-modest services division into a $40 billion behemoth. But what Lafley was suggesting was far bigger. It stretched beyond revamping computer systems and stitching together new networks. If other CEOs were entertaining similar thoughts, a vast new market could emerge.

Over the past two years, Palmisano has built these concepts into a strategy that would be laughable -- if it weren't so serious. His goal is to free IBM from the confines of the $1.2 trillion computer industry, which is growing at just 6% a year. Instead of merely selling and servicing technology, IBM is putting to use the immense resources it has in-house, from its software programmers to its 3,300 research scientists, to help companies like P&G rethink, remake, and even run their businesses -- everything from accounting and customer service to human resources and procurement. “We're giving our clients a transformational lift,” says Palmisano.

While Palmisano looks out at the world through thick glasses, he's not short on vision. He expects that within 10 years IBM could build an annual revenue stream of as much as $50 billion in business consulting and outsourcing services. If so, Palmisano will have created a second services miracle and hitched IBM to a crucial growth market. And in the process, his company will be fixing -- or running -- big chunks of the world's business.

No Sure Bet

Palmisano is out to transform the very nature and image of Big Blue, a nickname derived a half-century ago from the company's muscular blue mainframe computers. His goal is to carry IBM beyond that 20th century legacy, beyond computing and, yes, beyond blue -- while making IBM as indispensable to clients today as it was during the heyday of mainframes.

The change at IBM is palpable. The number of employees focused on business rather than pure technology has leaped from 3,500 in mid-2002 to more than 50,000 today -- out of a total of 330,000. And that's growing at more than 10,000 a year. Meanwhile, in a painful process, other employees are exiting by the thousands -- those in administration and computer repair, for instance, and from shuttered offices in Germany and Scandinavia.

Entire divisions are now in play. With the sale of the money-losing PC division to China's Lenovo Group Ltd., Palmisano cuts loose a big piece of the company's computer legacy. Meanwhile, he has snapped up more than a dozen business-service outfits in the past year, including Daksh, a 6,000-employee Indian customer-relations shop. Late last year he hired James Liang, a former Morgan Stanley mergers ace, to pick up the pace. “We're committed to completely reinventing the portfolio over the long haul,” says Palmisano.

Yet getting there will be a slog -- and coming out on top is no sure bet. To pull off his strategy, Palmisano must win a torturous trifecta: He must manage wrenching change inside IBM while, as a pitchman, convincing corporate customers worldwide to hand over their operations. And he must deliver decisive results. This means turning laggards into leaders everywhere from emergency rooms to blast furnaces. “I think IBM is on the right track,” says analyst Steven Milunovich of Merrill Lynch & Co. “But it's not going to be clear for two years if they're right or not.”

Why has Palmisano embarked on such a risky adventure? In truth, he has little choice. The world of computing that IBM long ruled is increasingly becoming a commodity business. Ruthlessly efficient Dell Inc., fresh from its conquest of the PC market, is climbing up in servers and even tech services. Dell's services, which focus on setting up computer systems, are still small compared with IBM's $46 billion services business, but they are growing at more than 30% annually and are expected to hit $4 billion this year. “The big question is: Will services go the same way hardware has? We think it will,” says Steve Meyer, a vice-president in Dell's services unit.

IBM, with its legions of PhDs and closets full of patents, is not built to duke it out with the likes of Dell. Palmisano's strategy promises a neat escape. Instead of battling in cutthroat markets, he takes advantage of all the low-cost technology by packaging it, augmenting it with sophisticated hardware and software, and selling it to customers in a slew of what he calls business transformation services. That way IBM rides atop the commodity wave -- and avoids drowning in it.

The danger? Simple. An IBM stumble would spell slower growth and smaller profits, undermining its research-driven business model and its position atop the corporate tech world. Palmisano has only to reflect on IBM's sorry state in the early 1990s to taste the consequences of falling short now.

The initial challenge is to make a grand vision that can sound threatening or full of hype into a must-have. McDonald's Corp., for instance, last year decided not to hand over its accounting and finance operations after IBM promoted the idea, opting to keep everything in-house instead. Even William H. Davidow, co-author of the 1992 book The Virtual Corporation, which championed the idea of handing off tasks to partners, cautions execs against going too far or too fast. “It would scare me to death if all my administration and strategy functions were outsourced to one company. You become a hostage,” he warns.

To win over lukewarm customers, IBM might be tempted to offer overly favorable terms for unpredictable long-term contracts. This poses another risk. Time and again, tech companies have misjudged the actual costs of running companies' ever-changing computing operations. As a result, they lose money on the deals for years. That's what happened with IBM's contract to run computing for JPMorgan Chase & Co., which the bank dissolved late last year when it took back control. That was a technology deal, not operations outsourcing, but the same uncertainties apply.

IBM faces strong competition as it forges into alien territory. The most potent rival is consultancy Accenture Ltd. The $15.6 billion services giant has been dipping a big toe into business process outsourcing. While Accenture can't match IBM's tech skills or research staff, it outguns IBM in business expertise. “IBM is genetically a technology company,” says Joel P. Friedman, president of Accenture's BPO unit. “I think our history of solving business problems and our industry knowledge gives us an enormous advantage.” Accenture notched $2.2 billion in BPO revenues last year, up 50%, while IBM's business outsourcing and related revenues hit $3 billion, a 45% gain.

Challenging both IBM and Accenture are aggressive Indian outsourcers, including Wipro and Tata Consultancy Services Ltd. Wipro's BPO business is going gangbusters and hiring about 1,400 employees per month. They offer customers lower costs but without the operational makeover IBM promises -- which they view as risky. “We believe making changes at the customer end will be very hard,” says T.K. Kurien, head of Wipro's BPO business. “Nine times out of 10 you'll fail.”

Glimpses of Greatness

Still, if Palmisano and his crew fend off rivals and prove the skeptics wrong, the opportunities are enormous. Market researcher IDC estimates that in IBM's target markets, nearly half a trillion dollars are already flowing to outsourcers in everything from HR to industrial design. It expects the field to grow by 8% to 11% per year. Merrill Lynch's Milunovich figures that this new business could heat up annual growth in IBM Global Services from less than 5% a year over the next few years to as much as 9%, excluding currency effects. Business services promise to pretty up profits, too. Analysts haven't made estimates yet, but IBM's senior vice-president for strategy, J. Bruce Harreld, says the company will be able to achieve 20% operating-profit margins -- double the margins in traditional tech services.

IBM's commitment to Wall Street is to deliver single-digit revenue gains and double-digit profit gains. Analysts expect the $96 billion company to expand revenues 7% this year, not counting the spun-off PC unit. They project a 12.5% gain in earnings per share, so Palmisano is good for now. But analysts are nervous about a 7.5% decline in IBM's overall outsourcing backlog last year, as the average length of IT deals declines. Palmisano is counting on gains from his new initiatives to sustain growth.

Investors, it appears, need more convincing. IBM's stock has been trading recently at about $90 a share, after briefly reaching $126 in 2002. The trouble? Palmisano is selling visions that can seem a bit vaporous to investors grounded in mainframes and tech services. With his business-services push, Palmisano is building on top of the “On Demand Business” campaign he launched 2 ½ years ago. The idea there: to use advanced computer and software technologies to quicken the flow of knowledge within corporations so executives can react instantly to changes. That's still a work in progress. Now, with business services, it's as if he's building a big addition onto a house that's still under construction.

But Palmisano has gotten glimpses from early IBM deals of the magic that business outsourcing can work. In 2002, Marathon Oil Corp. wanted to trim costs in its finance department and at the same time give top execs an up-to-the-minute view into how the company was performing. IBM's consultants analyzed Marathon's business processes and suggested fixes. The average time to complete financial processes, such as accounts payable, shrank from 18 days to eight. They also built a “dashboard” on execs' PCs to help monitor the business. When the consulting project was complete, Marathon handed much of its finance operations directly to IBM in a seven-year, $100 million to $200 million outsourcing contract. “IBM is changing its definition from international business machines to international business models,” says analyst David Cearley of researcher META Group.

IBM's early wins include groundbreaking contracts with some two dozen large companies and government agencies. Dun & Bradstreet Corp., for instance, just handed over some of its essential credit report data-processing operations to IBM. This is work that companies in the past would rarely entrust to outsiders. For the U.S. Postal Service, IBM is using complex algorithms from its research scientists to optimize mail handling and shipping. Then there's the unprecedented partnership with Boeing Co. The two companies are teaming up to create and market technologies for network-centric warfare.

Such joint projects call for a new type of IBMer -- people like Saul J. Berman, a business consultant who came to the company with PricewaterhouseCoopers Consulting, which IBM bought in 2002 for $3.5 billion. Berman's resume includes stints as a management professor and a retail executive. IBM used to sell machines. Now, in a way, it sells well-connected teammates. Berman identifies so deeply with one of his clients, Virgin Megastores, where he's helping reorganize the handling of merchandise, that he seems like a staffer. When he travels, he invariably stops in at the local Virgin outlet and prowls the aisles looking for surprises or things that are amiss. If a CD is in the wrong spot, he'll move it back. It's like he owns the place.

Team Players

On a recent rainy night in Los Angeles, Berman gives a guided tour of the Virgin store on the Sunset Strip. Pleased that several dozen shoppers turned out in spite of the deluge, he ambles through the store pointing out newer types of merchandise, including cell phones and Ben Sherman designer clothing. He's trying to get Virgin to hire IBM to devise a strategy to help the retailer diversify to avoid being undercut by rampant Internet music pirating and steep discounting by Wal-Mart Stores Inc. “The question I ask the Virgin people is, 'Are you a music store or a lifestyle store? What are you?”' he says.

As IBM morphs from computer company into business expert, the blue-suited computer salesman of the past is being symbolically elbowed aside by people like Berman -- who tours Virgin dressed in black. But this makeover isn't as easy as hiring a batch of new employees to add new gloss. IBM is also overhauling its workforce by retraining and redeploying many longtime staffers, even some at the very top. For the past six years, IBM Research manager William Pulleyblank ran the company's Blue Gene project, creating the world's most powerful computer. Now he has a very different role -- as a business consultant. Late last year, IBM set up a Center for Business Optimization and put him in charge. Pulleyblank's task is to harness mathematics to solve the thorniest conundrums involving inventory management, pricing optimization, and the routing of shipments.

Even the vaunted 38,000-person sales force is undergoing a painful overhaul. In the 1990s, salespeople representing the various IBM business units were essentially on their own -- looking for hot opportunities to sell individual products or services. But Palmisano is busy “reintegrating” IBM in front of customers by bringing together specialists from computers, software, consulting, and even research. That's tougher than it sounds. People who don't play well with others get replaced. These teams gather with customers, which often leads to discussions about business problems and strategies.

In its pursuit of vital industry experience, IBM -- much like an eager college intern -- is sometimes willing to work for free. IBM's unpaid partnership with the Mayo Clinic dates back to a cocktail party in 2000 in Mayo's hometown of Rochester, Minn., where IBM has a computer factory. A Mayo employee and an IBMer realized that scientists at both companies were working on genomics research. This soon led to joint projects on gene profiling of leukemia cells, and a published paper in a scientific journal in 2003. This is not the kind of connection that Dell, Accenture, or Wipro is likely to make.

IBM and Mayo quickly moved on to a more ambitious project: changing the way medical research is done. They set out to gather data on 4.5 million patients and to make it easily searchable by researchers -- but without compromising patients' privacy. A research task that used to take five people a year can now be done by one person in 15 seconds. Eventually, Mayo and IBM believe, physicians will tap into a vast storehouse of data, real-time, when they're diagnosing patients. “This is the way to transform the way we practice medicine,” says Dr. Nina M. Schwenk, chairperson of Mayo's Information Technology Committee. And for IBM, it's a foot in the door of the $1.4 trillion health-care business.

While IBM had plenty of skilled engineers in Rochester, they practically needed brain transplants if they were to do breakthrough work for Mayo. So the company sent some of its brightest engineers back to school. Working with the University of Minnesota, the company arranged in 2003 for a series of three-day crash courses in everything from molecular biology to protein sequence analysis. So far, 50 people have taken the classes. Nothing illustrates more starkly the gyrations at IBM: Engineers who once worked on a fading family of mainframe-style computers are now helping to chart the future of medicine. “Part of your job is to be a visionary,” says Jeffrey Tenner, one of the engineers. Now IBM is directing part of its Rochester staff toward bioinformatics, privacy, and regulation compliance -- all skills learned through the Mayo alliance.

Leveraging Success

While IBM has forged cozy ties with Mayo, the business payoff is still unclear. IBM's goal with this alliance and others is to take lessons and turn them into products and services to sell within the industry. The Mayo work has led to a new software product for medical research. Other health-care products are on the way. And IBM is hoping one day to manage patient databases or networks of health-care organizations.

The Mayo alliance is now a model for forging research and development linkups with clients. Late last year, in quick succession, it struck up R&D alliances with Honeywell International Inc. and Boeing. The 10-year Boeing deal teams Boeing's military command systems expertise with IBM's facility with databases and collaboration. “This alliance with IBM is unique in the industry,” says Roger F. Roberts, head of Boeing's Space & Intelligence Systems business. “We share our strategies, we share our R&D, and we offer joint solutions for customers.”

IBM doesn't wait around for clients to come to it with R&D projects. Engineers are encouraged to dream up products and peddle them to potential customers. IBM engineer and cycling enthusiast Bryan Streimer, for example, rigged up a wireless heart-rate system to alert family members if a cyclist has a heart attack on the road. IBM channeled Streimer's invention into an electric pill dispenser, which it's developing for Danish electronic device maker Bang & Olufsen. If patients forget to take a pill on schedule, the device calls their cell phone. Now IBM is helping a British mobile-phone carrier build a new business offering wireless medical alert systems.

While the product design deals are nice one-offs, IBM's strategy hinges on winning broad long-term contracts. The seven-year, $180 million contract with D&B that was announced last October shows how it's done. For D&B, IBM not only pulls together credit information on 63 million companies but also handles customer support, telemarketing, electronic credit-report distribution, and crucial finance operations. IBM uses advanced analytics software to size up D&B's customers and identify good prospects for additional services for the telemarketing staff.

A lot of these newfangled service deals haven't been around long enough to show results -- but a few have. At Nextel, for instance, IBM's takeover of the company's customer-service operations helped improve its customer satisfaction ratings from also-ran to top of the heap. P&G is another success story. In January, 2004, IBM took over part of P&G's human resources in a 10-year deal valued at $400 million. P&G has so far outsourced 3,500 jobs, including some in computing and customer relations. In HR, it had set 21 standards for speed and accuracy in such categories as payroll and expense management. The IBM-run operations met them all. In the month before IBM took over, P&G had met only nine of the goals, according to market researcher Gartner Inc.

With those victories under its belt, IBM is scrounging for new markets. In addition to its four original businesses -- accounting, HR, customer service, and procurement -- it is now plowing into six others. They include after-sales service for consumer electronics, insurance-claims processing, and supply-chain optimization. The old IBM would have studied for many months before deciding whether to enter these new businesses. This time, it has set up small SWAT teams to work with a handful of initial clients and launch businesses. This is in some cases a tough sell. “These are markets we're making. A client may not have thought of doing this before,” says Ginni Rometty, managing partner of IBM Business Consulting Services.

Plenty of pitfalls lie ahead. But for companies like IBM that bank on innovation, there's little choice but to create new markets and exploit them. “In the past, IBM defended the mainframe against client-server computing and PCs,” Palmisano says. “We're not defending the past anymore.” No, IBM is off and running into a new world of business, beyond computers. So long, Big Blue.

GRAPH: Palmisano's Progress Report

PHOTO (COLOR): LOOKING FORWARD: Instead of defending markets, Palmisano is making new ones

PHOTO (COLOR): ON SITE: Berman keeps close tabs on consulting client Virgin Megastores

PHOTO (COLOR): ROMETTY: IBM's consulting boss sells services clients have never considered

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By Steve Hamm

With contributions by Spencer E Ante, New York

How IBM's Business-Services Strategy Works

Big Blue's methodology isn't set in stone, but here's how it played out with Marathon Oil

A PUSH FOR CHANGE

In 2002, Marathon Oil's executives want to trim costs in the finance department and put in place monitoring tools so that managers can follow daily operations and make quick adjustments. They call in IBM consultants and researchers to talk it over.

IBM RESPONDS

Big Blue's consultants and software developers analyze Marathon's business processes. They suggest ways to reduce accounts payable and other processes from 18 days to eight. They build a “dashboard” on execs' PCs to help monitor the business.

THE PATH FORKS

While some clients keep control of their business processes and technology supplied by IBM, Marathon hands much of its finance operations directly to Big Blue. Other customers go further, having IBM manage human resources and customer service.

IBM CREATES NEW PRODUCTS

IBM builds new businesses around the knowhow it develops for early customers, such as Marathon. Already, IBM has sold the business-analysis dashboard it created for Marathon to more than a dozen other clients -- and has installed it within IBM itself.

1. What is IBM's corporate or multibusiness strategy for the twenty-first century, and how is it different from its long-standing strategy?

2. What does the case title "Beyond Blue" mean?