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This Is Your Father's IBM, Only Smarter
By: Erick Schonfeld 
Issue: May 2002
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How a former has-been kicked its old habits, got open-source religion, and regained its status as one of the biggest, baddest tech companies on earth.

It was one of the most high-profile technology deals to come up for grabs in years, and IBM didn't seem to stand a chance. Last summer Web auctioneer eBay (EBAY) kicked off a ferocious bidding war for the contract to provide software to power the next version of its website. Microsoft (MSFT) already provided eBay with key technologies, and CEO Steve Ballmer was constantly on the phone to eBay boss Meg Whitman, pleading his company's case and dangling the possibility of free ads and promotions on Microsoft's MSN network. BEA Systems (BEAS) -- the market leader in the Web application server software that eBay was looking for -- was also in there pitching. BEA was teamed up with Sun Microsystems (SUNW), another IBM rival with long-standing ties to eBay. Sun chief Scott McNealy was calling Whitman too. IBM, for all its talk of e-business, didn't even count eBay as a customer.

But Big Blue had some heavy artillery of its own in Willy Chiu, a computer scientist who runs its high-volume website lab and is routinely called in to sway important customers. "I have not met a single competitive situation where I have not won," he boasts. After a grueling four-month bake-off in which the contestants had to meet eBay's strenuous performance requirements, IBM won: eBay went with IBM's WebSphere software.

Does IBM's move to Java pose a threat to Windows? Tell us.

Alfred Chuang, the CEO of BEA, still fumes over the loss, charging that the only reason IBM won was that it sweetened its bid with promises of co-marketing and other deals with eBay. "We don't pay our customers," he huffs. But the real key to IBM's victory was much more prosaic and ultimately much more ominous for its rivals. eBay confirms that it was dazzled by IBM's expertise with the open-standard Java programming language and the power Java offered in a world of ever-increasing technological complexity. That's particularly telling given that BEA's partner, Sun, invented Java.

Winning the contract, worth tens of millions of dollars in its initial phase, proved that IBM's e-business savvy extended beyond the captive data centers of its traditional corporate customers and gave IBM a big-time victory in the Silicon Valley backyard of its fiercest enemies. More fundamentally, it illuminated one of the most crucial and overlooked transformations wrought during the celebrated nine-year run of Louis Gerstner, who stepped down as CEO on March 1. In its long-ago heyday, IBM ruled the U.S. tech industry by creating a stubbornly closed, proprietary environment; now it is building open-standards technologies like Java and the Linux operating system into everything it makes -- and finding that customers like eBay are hungry for such technologies' capacity to simplify today's baroque, networked computing world.

In fact, open-standards technologies are powering many of the most remarked-upon aspects of IBM's resurgence under Gerstner. They fuel the explosion of IBM's services business by making it easier for IBM consultants to stitch together varied hardware and software systems. Last June, IBM's revenues from services such as systems integration, product support, consulting, and website hosting surpassed computer hardware revenues for the first time in the company's 91-year history. And while software -- now almost entirely open-standards-compatible -- accounted for just 15 percent of IBM's revenues in 2001, it contributed a third of gross profits. Not surprisingly, everyone from Hewlett-Packard (HWP) to storage giant EMC is trying to copy IBM's services-and-software strategy. Indeed, that's what is behind HP's pending merger with Compaq (CPQ).

But for all of its progress, IBM is still looking for the spark that will ignite companywide revenue growth. Profits grew faster than revenues under Gerstner because of some deft financial engineering. (Gerstner made the numbers with the help of an overfunded pension and massive share-buyback programs.) Last year, IBM's revenues fell 3 percent to $86 billion, while profits fell 5 percent -- albeit during a year of double-digit declines for most of the company's competitors -- to $7.7 billion. As shareholders become less forgiving of accounting acrobatics, new CEO Sam Palmisano will be under increasing pressure to deliver real top-line growth.

Luckily for Palmisano, he has inherited an organization that is poised to do just that. Whether it was prescient or providential, IBM has shifted toward software and services just as competition on the hardware side of the industry has smashed margins to almost nothing. At the same time, the complexity of running a networked business is driving chief information officers everywhere to seek the comforting hand of IT services providers such as IBM. Big Blue's strategy boils down to this: Instead of trying to lock in customers with proprietary technology, it now tries to lock them in with irreplaceable IT services. Open-source technologies are the fountain that feeds that strategy, and they are leading IBM back to a position it enjoyed during its glory days: high-tech domination.

In one of the sleek, blond-wood conference rooms at IBM's Z-shaped headquarters in Armonk, N.Y., a slight, elfin man with curly gray hair is recounting how IBM discovered that open-standards fountain. "Once we decided we were embracing the Internet, and that our job was to help our customers integrate all their business processes and help them connect to all their employees, customers, and partners, how the hell do you do that?" IBM technology strategist Irving Wladawsky-Berger asks. "You need an open platform."

Does IBM's move to Java pose a threat to Windows? Tell us.

It's difficult to overstate just how startling an admission that is, coming from a top executive at a company once famous for both a strict adherence to closed platforms and a towering "not-invented-here" arrogance born of its long tradition of engineering breakthroughs. Historically, IBM software worked best with IBM hardware; that's how the company maintained its lock on customers. But in 1995, two years into Gerstner's tenure, IBM was a beaten company. The massive layoffs and cumulative $16 billion in losses from the early 1990s still weighed on IBM. The Internet had exploded onto the scene, and customers were desperate to tie all their discordant computer systems together and to link them to those at other companies. Something had to change. When Java came along that year, it seemed to be just what Big Blue needed. Java, a programming language, had the virtue of being able to create software that could run on any computer operating system.

The official acceptance of Java and open standards triggered furious debates within the company. At the time, Java was seen as some TV set-top-box experiment (which is what it was originally designed for). "The reaction was that we were going to bet the business on something that does not exist," recalls Scott Hebner, WebSphere's marketing chief. In 1997, Wladawsky-Berger was part of an e-business strategy group that included Hebner, current hardware chief Bill Zeitler, and software chief Steve Mills; they observed that the railroad, automobile, and telecom industries really didn't take off until the various players agreed on underlying standards (such as what gauge railroad track to use or where to put the gearshift in a car). Was the relatively young IT industry any different? In their view, the move to the Internet was the beginning of an industrywide effort to standardize on a common open platform. Java, with all its flexibility, would be crucial to that effort. "If the technology is right for the marketplace," Wladawsky-Berger notes, "companies that do not accept it become an asterisk of history." Hebner explains Java's importance in more concrete terms: "Why would I ever write my applications to a locked-in operating system when I can write to an open platform? Why would I try to create my own gauge?"

That thinking went into developing IBM's new WebSphere software, which was built completely around Java. Even though Java was originally oriented more toward devices such as PCs or set-top boxes, IBM helped make it the standard for enterprise and Web servers. In fact, last year was the first time an annual survey of 10,000 IBM customers found that those customers preferred working with systems centered on Java rather than Windows. As Hebner explains it, "There is a whole new market for building applications on the network, and to do that, you need software that is network-savvy." What IBM is trying to do, he says, is "build an operating system for the Internet."

That ambition goes well beyond Java. In the hardware arena, every server and mainframe that IBM sells has been compatible with the Linux open-source operating system since last year. Linux vastly expands certain capabilities of a mainframe; for instance, a single mainframe running on Linux can do the work of thousands of servers. This is opening up a whole new market for the death-defying IBM mainframe, which last year generated double-digit sales growth for the first time in a decade. The surge boosted sales of complementary products such as database software and storage systems. IBM is also incorporating Web services, another set of hot open-source technologies, into its software.

Adopting open technologies has enabled IBM to advance its products much faster than if it had insisted on developing everything itself -- because these technologies benefit from the input and talents of the larger software community. In turn, because of the company's formidable market clout, IBM's embrace of open systems has given a giant boost to the open-source movement. "They have legitimized Linux and open-source to the CIO/CEO buyer," says Matthew Szulik, CEO of Linux software firm Red Hat (RHAT). Avery Lyford, CEO of Linuxcare, another Linux software company, likens IBM's adoption of open-source to "a papal blessing."

Not everyone holds such charitable views. "I think IBM is the same as in the 1970s," says Shahin Khan, Sun's chief competitive officer. "A company basically interested in gaining control of information technology from its customers." He charges that Java and Linux are nothing more than "convenient vehicles for IBM to put together its disparate product lines." But integrating those product lines, he maintains, is not simply a matter of dusting them with a little open-source code. It actually requires some reconfiguration of the underlying hardware. And since doing all of that is complicated, Khan says, "IBM's solution is to sell professional services. The only way to make sense of IBM's disparate products is to hire 200 people from IBM Global Services. "As Oracle (ORCL) CEO Larry Ellison put it to an audience of software developers in December, IBM's sales pitch is basically: "Hey, whatever you got, this morass, this briar patch of computing, we'll just take it over and we'll raise your prices."

Does IBM's move to Java pose a threat to Windows? Tell us.

Even Gerstner and Palmisano would agree that open systems have helped IBM's services business and, thus, the company's overall position in the tech universe. Open-source technologies allow IBM to tie together heterogeneous computer networks and offer that capability as a service. Indeed, IBM in effect seems to be transforming itself into a gigantic, diversified consulting company called IBM Global Services (which, incidentally, Palmisano helped create). The 150,000 Global Services consultants will furnish customers with whatever technology they want, even from competitors. But you can be sure they will push IBM products first. Today, 60 percent of IBM's sales to large customers include some bundling of hardware, software, and services.

"Today we bundle deals and bring everything IBM offers to the table, and in many cases leave our competitors in the wings with nothing to do," says IBM salesman Mark Edson. IBM also is doing an extremely good job of piggybacking on the sales efforts of other enterprise software companies, such as Siebel Systems and PeopleSoft. Last year such joint sales programs (with more than 9,000 partners) brought in $3 billion in new revenues to IBM -- a fourfold increase from the year before.

IBM's attack-from-all-angles approach, the company believes, is grinding down its rivals. Sitting in his office in Somers, N.Y., one recent morning, Lou D'Ambrosio, head of sales for IBM's software group, reads from an e-mail he received at 9:08 a.m. from a BEA sales executive. "Hello, Lou. Based on the success I am seeing IBM have in the marketplace, I would like to be part of the IBM team." D'Ambrosio says he's getting about 15 such pleas a month from rival salespeople. "Two years ago, I was lucky to get five," he says. IBM's momentum is also apparent in the latest market-share figures: IBM is closing in on Oracle in database software, on BEA in Web server applications software, on EMC in storage, and on Sun in Unix servers. Competitors dispute some of those figures, but it is clear that IBM is gaining ground on long-standing market leaders.

Obviously, all of IBM's sales efforts would be in vain if they were not backed by competitive technology. Here is where the $5 billion that IBM spends each year on research and development comes in handy. IBM scientists were the first to champion the company's moves to Java and Linux, and they continue to push into new areas such as advanced storage systems, self-healing networks, grid computing, and Web-mining software. (See "The Next Big Blue Things.") In 2001, IBM filed a record 3,411 patent applications, making it the country's top patent filer for the ninth year in a row.

Sun's Khan says IBM can brag all it wants about its research, but software developers stitching together enterprise applications today really have only two choices for a development platform: the Sun-invented Java and Microsoft's .Net. "IBM does not have a party of its own," Khan says, so it is attending Sun's. Those are fighting words to Wladawsky-Berger, who clearly doesn't regard Sun as being in IBM's league -- or in Microsoft's either. "For Sun to say when it comes to software you have two choices, Microsoft and Sun, is like saying when it comes to world powers you have two choices, the U.S. and Tajikistan." Then he pauses: "Maybe I am not being fair -- the U.S. and Romania."

For all his dismissiveness, Wladawsky-Berger knows that IBM's open-source approach faces potential pitfalls. IBM still has a lot of work to do to get outside developers to rally around its products. For instance, there are many times more independent programmers who know how to work with Oracle databases than with IBM's competing software. IBM must also guard against fueling suspicions -- which people like Khan are only too happy to fan -- that it isn't an open-source purist. In one Web services standards body, for example, IBM has indicated it wants to be able to get royalties for any intellectual property it contributes. That runs counter to the open-source spirit, and if IBM is ever perceived to be trying to control the movement for its own commercial edge, the company will face trouble winning crucial support from developers.

Does IBM's move to Java pose a threat to Windows? Tell us.

There's a final long-term danger that IBM must be wary of. The endgame of all open-standards technology is a world where tying together disparate hardware and software becomes much easier, almost automatic. With these technologies, says Steven Milunovich, head of Merrill Lynch's technology research team, "much of what now requires a complex IT services market becomes more open and easier to do. So you don't need IBM to do it for you." That day may be years away. For now, IBM's open-source strategy has positioned it to regain some of the dominance it enjoyed decades ago. This time, though, it must keep its pride in check. "You have to be very sensitive to the fact the Internet is bigger than your own company," Wladawsky-Berger acknowledges. "Open-source is bigger than IBM."

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