Key IBM Growth Engine Appears to Sputter

A growth engine in IBM Corp. appears to be sputtering, illustrating the challenges with the company's broader strategy of enticing businesses to let Big Blue take over vital operations from designing products to handling payroll and customer service.

The unit in question is a research-and-design team for hire known as Engineering and Technology Services, or E&TS.

With 1,400 engineers, E&TS has an impressive client list. It customized the chips used in video game consoles made by Microsoft Corp., Nintendo Co. and Sony Corp. It has helped design components for the Pentagon and defense contractors. It built a portable MRI device for the Mayo Clinic and data-collecting "black boxes" for cars in the United Arab Emirates.

IBM does not reveal precise figures for the group, but its revenue jumped 93 percent in 2004 and 39 percent last year, when it was expected to sign close to $1 billion in contracts. While that is a small slice of the company's $90 billion in revenue, IBM has said the unit has an outsized impact, partly because it can it help drive lucrative hardware deals -- an important multiplier at a time when overall sales are virtually stagnant.

E&TS also gives IBM new ways to harvest its $6 billion-a-year research and development arm. And to cite IBM's annual report, "E&TS is a key component" of Big Blue's plans to help customers tackle their biggest "business performance transformation" problems. In IBM's view, just like other business processes can be outsourced, so can R&D.

E&TS "represents a unique opportunity for the company," said the report, filed Feb. 28. It called out the unit's "strong revenue growth" and made no indication that expectations were for anything but more of the same.

And yet E&TS revenue dropped 15 percent in the first quarter. In a slide show for investors accompanying the earnings report, IBM blamed the decline on a particularly strong performance in the same quarter the previous year.

Then last week, IBM revealed that E&TS had seen an 8 percent revenue drop in the second quarter. The slide show cited a "business realignment."

E&TS did go through an internal shift this year, getting folded into the new "technology collaboration solutions" group that combines several IBM efforts to help customers with hardware engineering and design.

IBM spokesman Ed Barbini said he could not explain how the reorganization hurt E&TS's revenue. Instead he said that E&TS's prior results were heavily boosted by big contracts with the small universe of video game makers, and so now the group is shifting its focus toward other fields, including aerospace, health care and telecommunications.

Forrester Research analyst Navi Radjou sees other factors at play. IBM is struggling to unify the sales strategies for the formerly disparate groups in technology collaboration solutions -- and to tie them to the company's vast services and consulting arm, he said.

Radjou also blames the simple fact of competition, particularly from lower-cost service providers in India.

Even though those companies can't match IBM's vast in-house research and design prowess, they have enough resources to snare major accounts. For example, Radjou noted, the product-design services group at India-based Wipro Ltd. cites Boeing Co. and General Motors Corp. as customers.

Annex Research analyst Bob Djurdjevic said he suspects E&TS's problem is that it arose almost accidentally, when customers sought out IBM for help on design problems. Now it is shifting into a more traditional consulting business that finds it harder to sell itself rather than just fill orders.

IBM's claim of "'organizational reasons' is a euphemism for 'we took our eyes off the ball,'" he said.

"Sony came to IBM and Microsoft (did too) and lo and behold after six or seven spins of the wheel, they realized, 'There's a business here.' Now they're trying to drive the boat and they realize the boat doesn't go where they want it to go."

Djurdjevic considers E&TS in an "embryonic" stage and says it bears watching as an important opportunity for IBM. But he said the company would be wise to admit its inherent challenges.

"These ideas are not something you can pick up regularly every quarter, the black box for this or the game console," he said. "I'm not sure that will ever be a smooth business."


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